In 2013, the increase in treasury yields and interest rate volatility negatively affected the book values and valuations of mortgage REITs (mREITs). Since the start of 2014, treasury yields have dropped and interest rate volatility has reduced, which has positively affected the financial performances and valuations of mREITs. The federal fund rate is likely to remain unchanged until 2H2015. However, a systematic end to the Fed's bond purchases by the end of 2014 could increase interest rate volatility. In the current interest rate environment, mRIETs are consistently altering their investment portfolios to protect their book values and support their EPS. Annaly Capital Management (NYSE:NLY) has taken an aggressive approach to boost its EPS by terminating its swaps exposure in anticipation of a stable interest rate environment. By extending the duration of its portfolio and termination of short-term swaps, the company's interest rate risk has increased. I believe the additional upside in EPS and ROE as a result of lower hedge positions is more than offset by the risk to book value if the interest rate volatility increases. However, the company's bottom-line results in the future will benefit from an expected increase in commercial mortgage business exposure. Also, NLY's liquid balance sheet and lower leverage provides the company with an opportunity to deploy capital as an attractive opportunity arises in the future.
Financial Performance and Portfolio Repositioning
NLY delivered a healthy financial performance for 2Q14. The company reported core EPS of $0.30, beating consensus estimates of $0.27 per share. Better-than-expected results for the quarter were mainly due to an improvement in net interest spread, driven by lower funding costs, as the company decreased hedges from 94% of repo balances in 1Q14 to 48% in 2Q14. The company is anticipating the interest rate environment to remain stable, which is why it has reduced its hedges, which will reduce its funding costs and positively affect EPS in the near term. NLY's cost of funds decreased from 2.31% in 1Q14 to 1.94% in 2Q14, which resulted in a 39 basis points increase in net interest spread. Also, the company's book value increased by 8% quarter-on-quarter to $13.23 in 2Q14. The company's leverage in 2Q14 increased to 5.3x, slightly up from 5.2% in 1Q14; still, NLY has the lowest leverage in the mREITs space.
Also, the company has been increasing its exposure to longer maturity mortgage securities to improve its asset yield. By the end of 2Q14, NLY had 89% of its capital allocated to its Agency MBS portfolio, as compared to 88% in 1Q14. Moreover, 95% of its Agency MBS portfolio is invested in fixed rate securities, out of which 81% is invested in 30-year securities. In the near term, the company's earnings will be positively driven by a higher asset yield and lower leverage. However, in the medium-to-long term, I believe that as the company's interest rate risk has increased due to a reduction in hedges and increase in exposure of 30-year MBS, it will more than offset the upside to EPS and ROE.
The company currently offers a dividend yield of 10.70% and a quarterly dividend of $0.30 per share. Dividends offered by the company are currently covered by its core EPS, as the company has been aggressively reducing swaps, which in return is helping NLY lower its funding costs. However, if the interest rate environment turns more volatile in the coming quarters, it could adversely affect core EPS and dividends.
Despite the fact that mREITs are naturally interest rate risk-taking businesses, I believe NLY is taking excessive risk. NLY estimates that a 25 basis points parallel increase in interest rates would adversely affect its book value by 3.5%, as compared to approximately a 2% drop in book value in 1Q14. Therefore, I believe NLY remains one of the most rate-sensitive companies in the mREIT space, as the Fed will end its bond purchases by the end of 2014, which could increase interest rate volatility.
Increasing Commercial Mortgage Exposure = Positive
In efforts to improve its asset yield, NLY plans to increase its commercial mortgage business exposure; commercial mortgage presents a higher yield with lower rate risk as compared to other MBS. The company has plans to increase its commercial investments to 25% of equity from the current level of 11%. As the company plans to increase its commercial business exposure, it will positively affect its risk profile, as it will have a diverse asset base. Also, instead of a pure-play mREIT, the stock will look more like a hybrid mREIT.
NLY has a competitive advantage due to its liquid balance sheet and lower leverage, which allows the company to deploy capital efficiently when an attractive opportunity arises. I believe that if the spread widens, the company will quickly deploy capital and improve levered returns.
The company has opted for an aggressive approach to improve its asset yield and core EPS in the near future by reducing its shorter-term swaps, which have increased its rate sensitivity. If the rate environment becomes volatile in the future, it would adversely affect the company's core EPS and book value. Moreover, I believe NLY has taken excessive risk, and needs to increase its swaps exposure to protect its book value in case of an increase in rate volatility. However, the company has rightly planned to increase its commercial exposure, which will portend well for its asset yield and book value in the future.
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