Annaly Capital Management (NLY) is approaching an attractive valuation level. Annaly is the largest market capitalization name in the agency mortgage real estate investment trust (mREIT) sector. Annaly has a $15.58 billion market cap. Agency mREITs are popular due to their high current dividend yields. The company currently yields a 14.30% dividend. This article will focus upon Annaly in terms of valuation versus the agency mREIT sector.
Fourth Quarter Conference Call Expectations
Agency mREIT investors want to learn how Annaly management is addressing the mortgage backed security yield compression. This directly relates to the Treasury Bond market. The U.S. Treasury 30 Year Bond is at 3.02%. As the Federal Reserve has bought back mortgage backed securities, the yields have compressed per the below table. In addition, foreign investors are flocking to the U.S. Treasury market for capital preservation.
The yield compression will reduce Annaly's net interest margin. The company's recent 10-Q highlights Annaly's leverage at 5.5x. This is low compared to the mREIT competition.
Annaly's constant prepayment rate, per page 25, highlights the change in voluntary prepayments:
The conference call will ideally provide insight on Annaly's focus to reduce the constant prepayment rate. For example, a low mortgage balance is less likely to be refinanced by the home owner. The costs to refinance make more sense if the balance is higher.
Annaly's book value per share will be a key reflection point. Due to Treasury Bond's decreasing interest rates, the company's mortgage backed security portfolio should possess a higher book value compared to the third quarter.
The fourth quarter dividend was 57 cents. This figure will change based upon Annaly's use of leverage, strategy in developing the mortgage portfolio composition, and the degree of voluntary prepayment. The yield remains a compelling 14.3%.
Agency mREIT Background
Agency mREITs derive their profits between the short term borrowing rate and the longer duration mortgage bonds' interest rates. Agency mREITs own government sponsored entity [GSE] mortgage backed securities. The duration can range between two to thirty years. The agency mREIT borrows money at short term rates. One short term borrowing option is the repurchase agreement with a third party.
The agency mREIT borrows at the short term rate to purchase the government sponsored entity mortgage backed securities. The difference in yield spread is a positive yield. The company will then use leverage to increase the profit margin. Annaly will have a hedging cost to reduce the exposure of the Federal Reserve hiking interest rates or lowering interest rates. Since the middle of 2011, however, Fed Chairman Bernanke has maintained a policy of a low interest rate environment.
Short Lived Rumor
There have been a handful of national mortgage refinance plans in the past year. In the weakest rumor I have witnessed, a story was put forth about a nationwide refinancing plan. The rumored plan caused Bank of America (BAC) to jump in common share appreciation. The rumor was promptly put to its peaceful end by the White House. The U.S. Federal Government does not, by all accounts, have $1 trillion in excess Federal budget spending to fund the program.
As with all stocks, portfolio management is key. American Capital Agency Corp. (AGNC) was the clear star with a 23.1% annualized performance over the past five years. Chief Executive Officer Gary Kain continues to be the sector's leading manager. Annaly does not compete when looking at the historical investor returns.
CYS Investments (CYS) has a terrific annualized 13.9% return over the past four years. The 15.1% yield is worthy of new investment dollars. Per the below table, the mREIT trades with a 2.31% premium to book value per share.
Hatteras (HTS) is the third name which has out performed the sector. The mREIT is externally managed and has been consistent with solid returns quarter in and quarter out. They are a sleeping giant in terms of out performance in the mREIT sector.
Government sponsored entity mortgage backed securities have an implicit 100% guarantee from the U.S. Federal Government. I recommend investors continue to hold these out performing stocks until the interest rate environment changes. The double digit yields, versus a 3.02% 30 year Treasury Bond, are highly seductive.
Credit Default Swaps
The Sovereign Credit Default Swaps highlight, as of January 9th, price drops in several countries. The Euro Sovereign Debt crisis, in my opinion, still requires a focus upon France and Italy. Here are the current prices to swap the risk in country specific debt. The listed number is the price, in thousands, to insure $10 million in debt for five years:
The U.S. Treasury Bond market continues to bring in foreign dollars and foreign investments. France, Germany and Italy do not have the debt issue under control. Debt simply does not go away. I would steer clear of any closed end funds, mutual funds, or asset classes which have extensive or levered foreign exposure to the Euros Sovereign debt crisis.
Valuation Metrics Annaly is trading slightly below its September 30th book value per share.
Anworth (ANH) is trading at 90.33% of its book value per share. The constant prepayment rate is at a high level of 28.00%. The leverage appears to be at industry levels. I want to know why the stock is under performing despite a stock buy back in place.
ARMOUR Residential REIT (ARR) is trading at a sector high 5.75% premium to book value per share. The higher the premium to book value per share, the more likely a secondary could be announced. Secondaries, when completed at premiums to book value, are accretive to current share holders.
Action Investors can only rely upon the facts. American Capital Agency is the clear winner in reviewing the mREIT peer group. The company has provided the best returns in a five year analysis. A new mREIT portfolio, in my opinion, must contain American Capital Agency because their business model appears to be head and shoulders above its peers.
The best valuations, everything being equal, are those agency mREITs trading below book value per share.
Annaly provides a compelling valuation when trading below its book value per share. The 14.3% annual dividend yield is strong. The data highlights Annaly has not matched the returns of the out performers in its peer group.
I presume the cause and effect is due to portfolio composition. The mREIT balance sheet contains mortgage securities, borrowing obligations, and hedging derivatives.
The conference call will hopefully discuss the mortgage portfolio's attributes. As a new investor, I would prefer to establish an Annaly position at 95% of its current book value per share. This would be a $15.40 price per share. This may require patience as high yield investments are sought after by income investors.