Over the last week or so, increasing anxiety about the potential for "Brexit" has been weighing on the market. Returns across the indexes were largely negative and international ETFs got hit pretty hard. Despite mortgage REITs having little in common with the broader equity market when it comes to fundamentals, Annaly Capital Management (NYSE:NLY) occasionally exhibits a significant correlation with the S&P 500.
As of the morning of 06/20/2016, the Brexit anxiety eased significantly, and broad market indexes were moving materially higher. The mortgage REIT sector also saw increases for many names, so it seemed like a good opportunity to look at the factors that would really impact the performance of the underlying assets.
Treasury Rate Movements
On Monday morning (6/20/2016), the treasury yield curve steepened slightly with the two-year yield up about 3.5% and the 10-year yield up about 6.5%. Those values are likely to change some throughout the day.
When the yield curve steepens, it is generally favorable for the prospect of future earnings for mortgage REITs because it indicates a bigger difference between the short-term borrowing rates and the longer-term "lending" rates. The lending rate in this case is simply the yield on assets.
The 30YR FNMA 3.0 fell about 16 basis points in price, the 30YR FNMA 3.5 fell by about 9 basis points in price, and the 30YR FNMA 4.0 fell by about 6 basis points in price.
If you compare the 3.0 to the five year, the 3.5 to the four year (approximated as the average of 3 and 5), and the 4.0 to the three year, it gives us a rough idea of the relative movement. Price movements on the treasuries would be about 25 basis points for the five year (compared to 16 on the MBS), 18 to 19 basis points on the four year (compared to 9 on the MBS), and 11 basis points on the three year (compared to 6 on the MBS).
Assuming the LIBOR swap rates are moving in very close correlation to the treasury rates, the result would be a slight shrinking of the MBS to LIBOR spread. Over the weekend, I highlighted that the MBS to LIBOR spread was at exceptionally high levels.
Even after this minor tightening, the spreads seem pretty big.
The non-agency MBS should be performing very well today in terms of price. While treasury yields are up and prices are down, the opposite can be said for junk bond funds. The SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) was up almost 1% after the first few hours of trading. While I don't believe anything fundamentally changed in the level of performance that should be expected on non-agency MBS, the prices are probably moving a little higher.
I did some more thorough work on the movements in rates and prices across the different instruments in a subscriber piece. It also details the impact on book value for ARMOUR Residential REIT (NYSE:ARR), American Capital Agency Corp. (NASDAQ:AGNC), Orchid Island Capital (NYSE:ORC), CYS Investments (NYSE:CYS), and another mortgage REIT I think may be priced just as attractively as ARR. I am long common shares of ARR.
Brexit should not be expected to have a direct impact on Annaly Capital Management, but the fears around it may still cause mortgage REITs to sell off or gain with the rest of the market. The slight steepening of the yield curve is a positive factor for mortgage REITs, but the bigger issue is the spread between LIBOR swaps and MBS. The widening of the spreads we've seen over the last year or two has hurt book values, but created a better situation for using higher leverage and more hedges. When the spreads tighten slightly, as they did so far today, it is generally positive for book value, but more difficult for future earnings.
I don't believe the modest tightening of spreads we've seen so far is material to the investment thesis, but I'm not surprised to see mortgage REITs exhibiting the correlation to the rest of the market again. A more substantial tightening or widening of spreads would be material to the investment thesis.
My outlook on Annaly Capital Management is moderately concerned about current prices being too high. I would be much more optimistic at prices under $10. I believe when the broader equity market declines, it may drag NLY down in correlation.
Disclosure: I am/we are long ARR.
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