Last week, Annaly Capital Management Inc. (NYSE:NLY) filed its report for the second quarter of 2014. Annaly reported core earnings of $300.4 million, or $0.30 per share, while book value increased to $13.23 per share from $12.30.
This $0.93 book value increase is about 7.5 percent, or over three times the dividend Annaly paid out in the quarter. The mREIT is now priced at around a 13 percent discount to this stated book value at the end of the second quarter, with it appearing likely that book value increased further so far in the third quarter.
Annaly was the largest mortgage REIT for years, and one of the more conservative mREITs, even among others that invested solely within the agency-backed mortgage market. Though always employing leverage, Annaly generally maintained a lower leverage rate than most of its peers.
Annaly reported a leverage rate of 5.3x during Q2, which was up slightly from the prior quarter. Annaly's net interest rate spread, or profit margin, increased by 40 percent, from 0.90% to 1.26%. Net interest margin for the quarter was 1.57%, compared to 1.32% in the prior quarter and 1.20% in Q2 of 2013. Annaly's constant prepayment rate was 7%, which was slightly higher than in Q1, but still well below the 17% CPR in Q2 of 2013.
Low prepayment rates make it much easier to manage portfolios of mortgage-backed paper, because prepayments force the portfolio out of positions and require replacement through new transactions. Also, recently falling interest rates will correspond to increasing RMBS prices, which is why Annaly's book value should have increased so far in Q3.
If we use the price changes in the iShares 10-20 Year Treasury Bond (NYSEARCA:TLH) and 20+ Year Treasury Bond (NYSEARCA:TLT) ETFs as indicators for the direction and strength of value changes, these ETFs have respectively increased by 1.7% and 2.9% since the start of Q3. Because of Annaly's leverage, its book value should have increased more than these ETFs, provided its prepayment rate did not also substantially increase. This low rate environment makes some level of increase prepayments very likely.
Usually, when interest rates decrease, mREIT margins via interest rate spreads narrow, so it is unusual that Annaly's spread grew so much during the second quarter. Much of the spread widening is because Annaly unwound about $26 billion of short dated swaps. These swaps would normally be held to hedge short-term interest rate increases, and would be an insurance expense that would normally lower profitability.
Annaly reported being about half hedged at the end of the second quarter. Annaly correctly guessed that protection from interest rate increases was unnecessary through the second quarter and this would continue to pay off so far in the third quarter. If interest rates were to remain at this level through the end of the quarter and Annaly were to keep this reduced rate of hedging, holdings should increase in book value by about five percent and spreads will perform better than other mREITs that are fully hedged.
Annaly's holdings in commercial mortgage backed securities were about 11 percent of stockholder equity as of June 30, 2014. Annaly's CMBS holdings have a substantially higher yield than agency RMBSs and the mREIT mitigates default and interest rate risk by limiting its use of leverage outside of agency-backed holdings.
The book value of such CMBSs may underperform in this environment, as recent strength to agency debt valuation is based on a flight to safety, and CMBSs with greater default risk could benefit less or decline in value. Because of the more significant holdings of agency-backed RMBSs, changes to CMBS values are negligible.
Performance could vary dramatically depending on whether Annaly kept hedges low and/or increased leverage into the start of the third quarter. Share price relative to book value and price performance relative to TLT and TLH in Q3 indicates Annaly could increase from here even if interest rates do not continue to decline.
Given recent rate movement and global macro news, it is unlikely that Annaly is yet to substantially change its rate of hedging. Annaly may also be able to acquire swaps now, at near-term low rates, and hedge the next few quarters at a lower expense, though it is entirely possible that it will pay handsomely to continue waiting for interest rates to bottom.
If rates stay here, Annaly should likely increase to at least a ten percent discount to last stated book of $13.23, or about $11.90. The probable book value increase so far in Q3 should also support a price at or above this level. So long as interest rates don't spike upwards in the coming weeks, Annaly should perform well compared to the broader market.
Disclosure: The author is long NLY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.