Annaly Capital Management (NYSE:NLY) just announced their latest dividend. As I've mentioned a few times, Annaly Capital Management has one of the more sustainable dividends despite yielding a fairly strong 11.27%. That doesn't mean the mortgage REIT is without pressure on the dividend though.
Since the end of 2015, the treasury yield curve has flattened out significantly, which is generally a bad sign for mortgage REITs. If the yield spread is fairly flat, then it is difficult for a mortgage REIT to lend long and borrow short while creating a significant net interest margin. Without a strong net interest margin, it is extremely difficult to support a solid dividend. However, Annaly Capital Management is fighting that problem through a few different techniques.
By moving out of strictly investing in agency MBS Annaly Capital Management was able to gain exposure to securities that have a much higher effective yield. The result is higher levels of net interest income and a diversification of the risk factors for the mortgage REIT. On the surface, I consider this a positive development but I would become concerned if they transitioned a substantial portion of the portfolio to this type of asset. The credit risk in small amounts is a reasonable way to diversify risk and increase yield but in large amounts it can create nasty losses if the market falls and that decreases the ability of the mortgage REIT to diversify the investor's portfolio.
One of the ways Annaly Capital Management seeks to improve net interest income is to perform some of their hedging with very long duration hedges. They have a portion of their hedge portfolio that includes swaps with a maturity of 10 to 30 years. The average maturity in that section has been around 19 to 20 years when I check it, but it could be composed of 20-year swaps or a combination of 10-year swaps and 30-year swaps.
Using a very long duration swap provides a dramatic amount of negative duration for the portfolio, which protects the mortgage REIT against book value loss when rates rise. The hedge also has a much lower net interest cost than if a mortgage REIT tried to hedge for 5 years with a notional balance that was 4 times higher. As a result, Annaly Capital Management can generate materially higher levels of net interest income by reducing their swap cost with the use of a long duration swap rather than using more short duration swaps.
The big drawback to this strategy is the way it functions when the yield curve flattens out with lower rates dominating the yield curve. The fair value losses have been dramatic as long-term yields plunged and long-term LIBOR rates moved substantially lower than long-term treasury rates. The net result is the hedges hammering away at book value.
The best case scenario for Annaly Capital Management's hedge use here would be for the long duration yields to increase while the short part of the yield curve remained relatively flat.
MBS to LIBOR
One development that has been positive for earnings, though negative for book values, was a shift over the last year or two towards a larger spread between the yields available on new MBS and the yields on the 5-year and 7-year LIBOR swap. The increase in the spread hammered away at book values but it also allows mortgage REITs to enter new positions with more attractive spreads.
Annaly Capital Management sustained their dividend at $0.30. While some mortgage REITs have cut their dividend during the last year or already in 2016, it shouldn't be a surprise to see Annaly Capital Management sustain theirs. The big risks that would concern me would be a significant increase in the prices for lower coupon agency MBS. That kind of price increase would go hand in hand with new mortgage being written at lower rates and the lower rates would encourage more refinancing activity.
Absent a hike in the short-term rates or a decline in the MBS rates, Annaly Capital Management is looking fairly strong. I still want to see larger discounts to book value to ensure a solid margin of safety, but for the short-term future things are still looking good for the next dividend. I'd love to project more than one dividend into the future, but it just isn't feasible given the way the interest rate environment can change.
The short press release can be seen here.
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