Annaly Capital Management (NYSE:NLY) is one of the largest mREITs in the world. Their size and long history has allowed them to amass a fairly large number of shareholders. I've found retirees are often particularly interested in holding the mREITs due to their very high dividend yields. The idea of buying some high yielding investments makes sense, but I want to ensure that investors understand the fundamentals. After writing my latest piece with my thoughts on a handful of mREITs, I wanted to go deeper into assessing the movements of Annaly Capital Management specifically.
I expanded on a previous chart and incorporated the treasury yields at the 1, 2, 7, and 10 year maturities. Then I extended it again to incorporate a section for NLY's share price. The result is demonstrated below.
Labeling the Time Periods
I'll refer to the first orange segment as "period 1" and it runs through January 21st. The second period is "period 2" and it runs through February 12th, 2016. The third period is, obviously, "period 3" and runs through March 28th. Ironically, despite that organization there is still one flaw. Three of the periods have very simple names, but the very first period is Q4 of 2015.
Changes Over Time
If this next bit is a little hard to read, I put together another simple chart right underneath it.
At the end of the year prices seemed fairly reasonable in terms of measures like discount to book value. Some plays were more attractive than others at that point, but if we use Annaly Capital Management as our default measuring stick we can say that discounts were fairly normal relative to the last few months.
During Q4 of 2015 (before Period 1) we saw falling MBS prices and NLY's share value declined by around 5%.
During Period 1 we saw MBS prices rise and reverse most of the changes from the previous quarter. NLY's share value responded by falling again. This time it fell by about 7.5%.
During Period 2 the prices on MBS increased significantly again. It wasn't quite as large, but it was fairly significant. NLY responded by rallying 12%.
During Period 3 the prices on MBS fell, though by relatively moderate amounts. Shares of NLY responded by rallying another 7.2%.
To put that in a simple matrix, it would look like this:
What It Means
Benjamin Graham encouraged investors to remember that price and value are different. The market functions as a voting machine in the short term and a weighing machine in the long term. If the market were being efficient, you wouldn't expect to see combination in the chart above. Yes, Annaly Capital Management is hedging a substantial amount of their exposure to changes in interest rates, but these were fairly substantial price movements.
The other factor we need to bring in is the changes in treasury rates. Technically the mREIT isn't dramatically exposed to "treasury" rates. They are exposed to agency MBS and to LIBOR swaps, but it is common to use the treasury yield curve as a substitute for assessing whether the yield curve is steep.
When the yield curve is flat, it generally indicates that it will be more difficult for an mREIT to make money off borrowing short and lending long. I put together a quick chart that demonstrates the rough steepness of the yield curve at the end of each period. It is fairly rough since it just uses the 7 year treasury minus the 1 year treasury and 10 year treasury minus the 2 year treasury:
In a nutshell, shorter bars are worse for mREIT fundamentals. Do you see the bars getting taller or shorter?
What Spreads Tell Us
The declining spreads here are telling a story of a flattening yield curve. This is a problem for future earnings. The lower long-term rates are indicating weaker interest income in future periods (assuming reinvestment of proceeds in the same assets) and the occasionally higher short-term rates are indicating higher expectations for the interest cost on repo agreements.
As I referenced in my weekly series, the increasing prices on MBS combined with the prices on lower coupon MBS rising faster tells investors that the MBS traders expect higher levels of prepayments. With the 10 year treasury rates falling significantly, it shouldn't be too surprising that prepayments would increase.
Quick and Easy
Asset yields are struggling and there are some challenges to the interest cost on repo agreements. The result is less income unless other changes are made to the portfolio. Annaly Capital Management is working to incorporate more assets into their portfolio and I do believe some of those assets are fairly attractive, but this is still primarily an agency RMBS mREIT at this point.
Weak MBS yields and higher costs should be a sign. For most businesses a decrease in revenue with an increase in costs would indicate a significant problem ahead. When discounts are large, then the costs are effectively priced into the stock and there isn't a big problem. On the other hand, when I see those signs and shares keep moving higher it suggests that investors are willing to overlook some very serious problems. That might be fine if it were always the case, but January certainly proved otherwise.
The way metrics like Core EPS work, the level of core earnings will be significantly influenced by rates on MBS and swaps in past periods. The way the metrics are structured, a problem inherent to the entire industry, can keep the numbers looking stronger and encourage paying out higher dividends in the short term. Over the longer term it leads to declining book value per share. In my view, most mREIT dividends are currently including a return of capital regardless of the tax classification on the dividends. Fortunately NLY's dividend yield as a % of book value is lower than some peers and their operating expenditures as a percentage of equity are lower. The combination means that most of the dividend can be earned. There is significant risk here, but there is less risk in NLY than in many of the other mREITs. However, it is important to point out that if the yield curve continues to flatten then NLY's dividend would also be in significant jeopardy unless they move into higher yielding assets and take on even more risk.
Getting More Specific
At the deepest levels it is not directly the slope of the yield curve that will matter to the mREITs. It is the difference in the rates they can earn and the rates they must use to finance their portfolio. To the extent that the rate on swaps and MBS diverge from the treasury rates it would become possible to focus on exploiting the difference in those rates despite a weak yield curve. If those rates materially diverge in a way that is favorable to future earnings, it would be expected to significantly damage book values across the sector.
If you are interested in further analysis of Annaly Capital Management, I would suggest checking out my latest estimates of unreported book value. I'll try to follow this up with new estimates for book value soon.
My current outlook for NLY is bearish on assessment of decline in share price. I have nothing against NLY, but I do believe materially better (lower) prices will be available in the future. With the flattening yield curve, I would need to see prices around $9.50 to $9.65 to be neutral and under $9.10 to be bullish.
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.
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