What Just Happened To Annaly Capital Management?

| About: Annaly Capital (NLY)

Summary

Interest rates took off in the middle of Wednesday.

Annaly Capital Management had a delayed response to the hike in rates.

The yield curve has been exceptionally flat, but finally grew a little steeper.

The steepening is challenging for book value, but a steep yield curve is dramatically better dividends.

Annaly's hedges will protect the company from a significant portion of the impact.

Annaly Capital Management (NYSE:NLY) finally had a day with poor stock price performance. The mREITs that are primarily running an agency RMBS portfolio have done fairly well so far this year and seen a huge increase in prices since February. While Annaly Capital Management isn't purely holding Agency RMBS, it is still the vast majority of the company's portfolio. The interesting thing about the weak performance for Annaly Capital Management is the way the market responds. The market as a whole was down for the day, and REITs, including mortgage REITs, were down quite a bit.

The Selling Pressure Started Thursday Morning or Wednesday Night

The following chart demonstrates the change in price for shares of NLY. You'll notice it was fairly flat throughout the previous 4 days.

Click to enlarge

On Thursday, things opened materially lower, but the pressure on rates began about 11:30 AM Eastern time on Wednesday, as demonstrated by the following charts for the 30YR FNMA 4.0 (a pool of 30-year fixed-rate mortgages insured by Fannie Mae, with a weighted average coupon rate of 4.0) and the 10-year Treasury.

Note that the first chart is showing the price of the pool of agency RMBS. The second chart is showing the yield on the 10-year Treasury. Since price and yield move in opposite directions, both charts are telling us the same story regarding interest rates moving higher.

Silly Market

The substantial majority of the change in yields occurred on Wednesday, not on Thursday. Traders weren't taking advantage of it in real time, so there was some additional pressure when the market opened on Thursday.

Was It Actually Bad?

The appearance of higher rates suggests book value losses for the mortgage REITs, but this is an area the market frequently misunderstands. For an mREIT to make money for shareholders, it needs to earn a higher yield on assets than it spends on financing those assets. When MBS prices are exceptionally high, it results in fairly weak yields on assets. The yield on a fixed-rate mortgage doesn't stay directly tied to the 10-year Treasury, but there is some correlation with longer-duration assets moving in the same general direction. Again, I remind readers that the charts are demonstrating prices for one security and yields for the other.

While the 10-year Treasury increased by about 10 basis points in the span of 2 days, the 2-year Treasury only climbed by about 5 basis points. The result is a yield curve that is becoming slightly steeper and indicating a more favorable long-term operating environment for mREITs.

So Far This Year

Previously this year, the yield curve was flattening quite substantially, as demonstrated in the following chart:

Click to enlarge

The 10-year to 2-year spread at the end of 2015 was 1.21. So far in the second quarter, it has been hanging around 1.00. A spread of 1% simply isn't enough for mREITs to be making a strong amount of net interest income from their positions.

The Market's Bias

Over the last several months, the market has shown very little concern about the long-term damage to asset yields from exceptionally low long-term rates. On the other hand, it has shown some fear about short-term rates rising. It is somewhat ironic, since Annaly Capital Management uses a strong enough hedge portfolio to protect itself from most of the damage from rising rates. The thing they wouldn't be protected from is a prolonged period of low rates on the medium- to long-term end of the yield curve.

My Assessment of Annaly Capital Management

I would find Annaly Capital Management very attractive at prices around $9.10. I would be neutral with prices in the middle to high middle of the $9 range. The market has currently discarded risk aversion and sent shares of both the S&P 500 and mortgage REITs much higher. The two investments have pretty much nothing in common, but both rose with oil prices this February. This is just one of the cases where the market perceives some risks and scorns others. Rising long-term rates would hurt book value, but they would be excellent for dividend sustainability.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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