Annaly Capital Management (NYSE:NLY) is an mREIT in transition. It has been moving away from the typical agency mREIT strategy and diversifying into other areas. Lately, the market reaction has been fairly positive as the discount to book value has been respectable relative to peers. While NLY is starting to transition away from the typical agency model, I thought it would be worthwhile to do some testing on its performance in prior periods to establish its performance in different circumstances.
Why Investors Care
The share price performance of an mREIT can be difficult to predict, though there are times when some clear signs show up. For the most part, my estimates on smaller mREITs have revolved around using larger players such as NLY to project how the market will value similar (though smaller) peers. Despite that relative difficulty, it is not as difficult to prepare estimates for factors like "Core EPS" because we can get a fairly reasonable read on asset yields and the cost of funds.
It would be reasonable to say that if MBS had an expected yield of 2% and the expected cost of funds was 2%, the mREIT structure would be fairly useless. It would merely be a way to bet on asset yields being higher or lower than projected rather than expecting the mREIT to arrange the portfolio to create a reasonable net interest spread. Remember that the primary function of an mREIT is to lend long and borrow short to capitalize on the difference in interest rates.
The 2-10 Spread
I was running some numbers lately and decided it would be worthwhile to start recording the rates on different durations of treasuries for each year. I may need to expand this to incorporate the spread for each quarter since having more frequent measurements would increase the sample size and help me identify which price movements may have simply been an irrational market.
As I was recording the values, I decided to calculate the 2-10 spread and the 1-7 spread for the end of each year. For investors that aren't familiar with this concept, we are simply discussing the spread between the 2-year and 10-year treasury rate. The calculation is fairly simple:
10-year treasury yield minus 2-year treasury yield = the spread
In hindsight, it seems like the 10-2 spread might make more sense mathematically. Let's just ignore that oddity and move on.
The following table demonstrates the treasury yields reported by the Federal Reserve for several maturities with measurements recorded at the end of each year:
For a few of the years, the 30-year yield was simply labeled as N/A, so I've left those squares empty.
Using that data, I calculated the spread at the end of each year along with the total return to shareholders (dividends + price change) that NLY had seen during that year.
What We See
The yield curve at the end of 2015 was flatter than at the end of any year since 2007. We can also see that 2013 saw yields spread substantially and the returns for shareholders of NLY were terrible. On the other hand, the returns for 2014 were very solid as the curve was flattening. Keep in mind that this means the total return for the years (arbitrary time measurement) moved in the opposite direction of future earnings power. On the other hand, the change in book value was precisely what we would expect in these scenarios. When the yield curve became substantially steeper in 2013, the book value declined from $15.85 to $12.13. In 2014, when the yield curve flattened, the book value rose from $12.13 to $13.11.
On the other hand, in 2015, the yield curve was getting flatter, but mREITs were losing book value instead of gaining it.
The earlier years include some very substantial price movements that would be excellent for analysis. However, Annaly Capital Management was a smaller mREIT at the time and the market should have been dramatically less efficient. Therefore, the implications should be handled with caution. While NLY appears to be the most efficiently priced mREIT at the present time, it was not efficiently priced in some previous periods.
The next table takes a look at the price to book values to provide investors with a little more context for the movements in share prices:
In 2005, the total return to shareholders was negative 40.58%, but book value only declined by 14% to 15%. The major factor driving those exceptionally terrible returns was shares starting 2015 at $19.62 when book value was only $12.56.
That enormous premium at the start of 2005 (end of 2004) is remarkable given that the 2-10 spread was only 1.16% and the 1-7 spread was 1.19%. These spreads were not large enough to generate substantial amounts of net interest income even if the mREIT ran fairly light on hedging. During 2005, the yield curve flattened out with short-term rates moving dramatically higher and long-term rates moving moderately higher. The higher rates should have hammered book values unless there was an enormous amount of hedging in use. Since we already know that book value declined between 14% and 15%, it looks like things played out quite effectively.
At the end of 2006, the spread was negative and yet NLY had delivered total returns of over 30%. The high pricing at the end of 2006 is an area that particularly interests me because the lack of a reliable way to generate net interest income does not justify an mREIT trading at 126.7% of book value. The following year, 2007, saw the spread increase, which would normally hurt book values but improve earnings potential. However, the increase in the spread was from short rates falling substantially while long-term rates fell moderately. Since mREITs frequently have positive duration, the gain to book value isn't that strange. At that point, the company was back to having a legitimate way to earn net interest income for shareholders, but it was also trading at 148% of book value.
The Other Way To Build Book Value
It isn't just solid predictions on interest rate conditions that help an mREIT generate gains to book value. The ability to issue new shares at a premium to book value helps a great deal. From the end of 2005 to the end of 2007, the "shares outstanding" count at Annaly Capital Management more than tripled. That offers an alternative explanation to book value gains.
It might be appropriate for mREITs to declare the change in book value as a result of issuing/repurchasing shares as a major operating metric. Of course, companies can't report a profit or loss on share buybacks, but it might be worth having some non-GAAP supplementary disclosures becoming commonplace so investors could assess how much of the performance was a direct function of buying back or issuing shares.
The Lesson In A Nutshell
While Annaly Capital Management was a materially smaller mREIT, it appears to have benefited from the inefficient pricing that was favorable to issuing new equity. When the data is broken out to an annual level, it can be difficult to project share price returns even though the net interest spreads should be easier to predict. It would be logical to think that buying mREITs when the yield curve is steep would be the easiest path to profits. A steep yield curve is highly favorable for net interest income. Unfortunately, the results for shareholders have been largely overwhelmed by changes in the premium or discount to book value.
This creates an interesting counterpoint to the relative weak spreads demonstrated at the end of 2015. While the spread remains fairly weak and the exact discount is not yet known, estimates of the discount suggest that it was still fairly high. It is also worth noting that the mREITs may hedge through LIBOR swaps and will be buying agency MBS, which can be priced at different levels than the treasuries. The result is that book value movements may still be materially different than would be projected solely through the treasury curve.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.