What Just Happened To Annaly Capital Management?

| About: Annaly Capital (NLY)

Summary

The biggest mortgage REIT invests heavily in the 30 year fixed rate MBS which is fairly flat on the morning.

Treasury yields are falling with bond prices jumping higher.

The flatter yield curve represents a real problem but for mortgage REITs with heavy hedging the spread between MBS and LIBOR swaps may be more important.

The change in the environment is more favorable for reinvestment but book values should be taking a small hit in early bond price movements.

Annaly Capital Management (NYSE:NLY) is the biggest mortgage REIT and they are up slightly about an hour after the market opened despite some fierce volatility in the bond markets. The treasury bond yields are falling and the yield curve continues to flatten. This is a bit of a problem because flat yield curves can reduce earnings for mortgage REITs and they signal a higher probability of recession as there is a known correlation between inversion of the yield curve and recessions. Remember that the market can be heavily influenced by expectations since expectations about future scenarios can drive marginal levels of spending. For instance, when consumers are confident that their job will still be there in a few years or that they have a decent shot at a promotion with a raise, they will be more likely to take that family vacation, buy the car, or otherwise "stimulate the economy".

With several mortgage REITs cutting their dividends, such as Capstead Mortgage Corporation (NYSE:CMO) from $.26 to $.23 and CYS Investments (NYSE:CYS) from $.26 to $.25, anything positive for earnings could help. The bond movements are a bit of a mixed bag because the flattening aspect of the yield curve is bad but MBS prices are not moving in high correlation with treasury prices. The 30YR FNMA 4.0, one of the most widely traded securities, as precisely flat at the time the treasury measurements were taken.

The 30YR FNMA 4.0 and Annaly Capital Management

The following chart shows the positions in agency RMBS for Annaly Capital Management:

Click to enlarge

The green box highlights the largest single position which is the 30 year fixed rate with a weighted average coupon of 3.87%. That means their portfolio is going to be pretty heavily weighted towards the 30YR FNMA 4.0. They aren't gaining much book value off their MBS, but they will get a little bit because the 3.5 is up slightly on the day. The bigger issue is that falling treasury yields, if accompanied by falling LIBOR swap rates, will reduce book value temporarily but provide a much better scenario for new investments with new hedges.

MBS to LIBOR Spread

The major key to net interest income for a mortgage REIT in this environment, particularly for a mortgage REIT carrying a heavy hedge portfolio, is the spread between the rate on hedges and the rate on MBS. Even if the yield curve is flattening out a mortgage REIT can handle the flattening if they get the right assets and hedges in place. While the curve keeps getting flatter, the spread between the LIBOR swaps and MBS is the saving grace for the sector right now. It may not prevent price declines the next time the market gets scared but it does give mortgage REITs a viable way to continue earning net interest income even if the yield curve is fairly flat.

To take advantage of the MBS to LIBOR spread requires running a fairly heavy amount of leverage and then hedging heavily with LIBOR swaps. The normal choice would be a portfolio emphasizing swaps with 3 to 7 years to maturity.

Reinvestment

The ideal time for a mortgage REIT to be reinvesting proceeds is when the spread between the MBS and the LIBOR swap is as high as possible - assuming the mortgage REIT intends to hedge heavily. If they were going to skimp on hedges then the steepness of the yield curve would be more important.

ARMOUR Residential REIT (NYSE:ARR)

I currently have a short term position in ARR. It is not a long term investment for me, it is simply a play on the difference in discounts to book value so I may exit the play in the near future if I see a better opportunity or if the spreads between the mortgage REITs shrinks a little.

To be exceptionally clear, the position is "Long ARR" but my investment timeframe is measured in days or weeks rather than months or years.

Book value for ARR seems like it would be positive on the day because their net position in swaps had a positive duration. Essentially the mortgage REITs book value should increase when yields are falling. Given the difference in the movements between treasuries and the MBS (which hardly moved) I would expect swaps to be hurting book value slightly and given the fall in credit sensitive assets so far this morning I would expect the non-agency MBS to also be down slightly in fair value.

Conclusion

The flatter yield curve represents a challenge for the mortgage REITs but the REITs emphasizing heavy leverage with hedging can try to capitalize on the MBS to LIBOR swap spread as a way to counteract the flattening of the yield curve. In early trading the treasury yields moved materially lower and prices moved higher. Normally the fixed rate agency MBS will follow the treasury for movements but there can be a delay and that delay seems to be more pronounced when interest rate volatility is higher or when there is more uncertainty regarding the future path of interest rates.

I don't like the flattening of the yield curve since it indicates an increase in prepayments, but I do like the resulting spreads for reinvestment.

I'm concerned that most mortgage REITs are trading at relatively high valuations on correlation with the S&P 500 as investors simply seek a home for their money. Therefore, I'm not thrilled with the investment prospects for buying NLY at the current price, but a small pull back in the share price could certainly change my mind. At this point most of the strategy is simply finding the right entry prices.

Disclosure: I am/we are long ARR.

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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