Annaly Capital Management (NYSE:NLY) is the largest mortgage REIT and there is usually stronger demand for their preferred shares than for those of smaller mortgage REITs. Over the last couple weeks, there has been a market failure in pricing the preferred shares and it came to a head over the last couple of days. The beauty of this small subsector of the market is the way market failures appear and become corrected.
The difficulty of watching each stock makes it too much work for most individual investors. I'm going to break from tradition and publicly post an updated version (updated to 10-12-2016) of a chart I provide to subscribers:
This chart covers the preferred shares for every mortgage REIT except Chimera Investment Corporation (NYSE:CIM) because their preferred shares are not fully established yet. The table includes AGNC Investment Corp. (NASDAQ:AGNC), Apollo Commercial Real Estate Finance (NYSE:ARI), ARMOUR Residential REIT (NYSE:ARR), Capstead Mortgage Corporation (NYSE:CMO), CYS Investments (NYSE:CYS), Dynex Capital (NYSE:DX), MFA Financial (NYSE:MFA), AG Mortgage Investment Trust (NYSE:MITT), MTGE Investment Corp. (NASDAQ:MTGE), New York Mortgage Trust (NASDAQ:NYMT), Five Oaks (NYSE:OAKS), and Resource Capital Corporation (NYSE:RSO).
What Investors Need to Know
Using this chart allows me to track the prices of preferred shares each week. I calculate the stripped yield each week, which adjusts for the impact of dividend accrual. Over the last weekend, preferred share prices on average had moved to more attractive levels. With higher interest rates in the economy, yield sensitive instruments tend to decline a bit. However, the current decline is not even remotely efficient.
Two Major Bargains
The biggest two bargains right now are shares of AGNCP and shares of NLY-D. When I covered NLY-E, the piece brought in high page views and NLY-E corrected to remove the persistent discount it was holding relative to the other shares.
Now NLY-D trades at an absurd discount compared to the rest of the options in the preferred sector for mortgage REITs.
At a most recent price of $24.82, the shares are now trading at a discount to par value. Since the preferred shares for Annaly Capital Management pay their dividends almost a month before most of the preferred shares, they have a higher level of dividend accrual. The resulting stripped price came in at $24.59.
The shares become callable in a little under a year, but the yield to call would be excellent since calls include any dividend accrued through the date of the call.
Just how cheap is Annaly Capital Management's D series? In measuring the shares each week, the average stripped price was $25.43. The stripped price at the end of last week was $25.00. Since then, it fell another $.41. The shares are effectively about $.84 cents below their average weekend stripped price. How does that compare to the rest of the sector? It blows them away.
There is only one other share more than $.60 below the average. That is RSO-B. I'm not particularly interested in the risk there. The third largest discount to normal stripped prices goes to AGNCP, which was $.56 below the average value I recorded. On average, stripped prices recorded at the end of 10/12/2016 were $.19 lower for each share than the average values recorded for that share over the last few months.
The weak pricing on NLY-D appears to be the function of a motivated seller trying to exit a large position. Volume moved dramatically higher over the last few days. The average volume for NLY-D is around 28,000 shares. The following screenshot of the Google trading history demonstrates prices and volumes:
It appears some entity owns a large volume of these shares and needs liquidity. The reason is unclear, but the result is NLY-D trading at a substantial discount to its normal trading range. By posting this publicly, the opportunity to acquire the bargain shares may be blown up. Getting a great deal on preferred stock is usually a function of combining solid analysis with poor liquidity.
The other shares I want to highlight in this article are AGNCP. The biggest risk factor for these preferred shares was the potential of rates moving lower and causing AGNC to decide to call the shares when the call protection ended. AGNC is very well capitalized and has excellent coverage of their preferred shares combined with a portfolio of agency securities. The risk of AGNC going under should be obscenely low.
Despite the major risk being call risk with lower interest rates, the shares have sold off as interest rates moved higher. The result is a materially better value for "worst cash to call." I think an immediate call is unlikely, but the potential damage from one has been materially reduced as prices declined. Now the stripped yield runs 7.87% on a financially strong mortgage REIT with a larger market capitalization and internal management. These shares were a good deal at $25.65 and are an exceptional deal at $25.51.
Other Things You Can See
The High and Low values were built based on the trading range from the end of Q2 2015 to the end of Q2 2016. This period included both very optimistic market prices and extremely bearish views. Consequently, I believe it set an excellent example of the potential volatility in each case. As the pink highlighting shows, some of these shares were above their previous highs and even as of 10-12-2016, some were still above the top of their prior ranges.
The coloring on each share is based off my opinion using the pricing for 10-07-2016, not 10-12-2016. If I didn't feel I had a strong enough read on an issue to project the way it was going to move, I simply left the shares in white. There are often several shares that are white. Investing is somewhat like baseball, except investors can view hundreds of pitches without swinging. Swing with confidence. No need to reach on a pitch without confidence.
The market is not particularly bearish on mREIT preferred shares. Most of these investments were still trading above 85% the previously established range, and in many cases, the shares recently went ex-dividend. Consequently, it is incredibly ironic that NLY-D is trading at only 75% of the range despite having nearly a month and half since it went ex-dividend.
Investors thinking they need to wait for shares to hit 50% of the range could be waiting for a very long time. The absolute lows for a year are usually set when a general market panic perfectly coincides with poor liquidity on a specific preferred share. The shares should usually spend most of their time trading in the top quarter or so of the range.
To avoid any confusion with readers missing the disclosure: I am long NLY-D, NLY-E, AGNCB, and AGNCP.
The challenge with publishing on preferred shares, which are inherently less liquid, is that solid analysis leads to corrections more reliably than in the common stock. Consequently, I keep most of this analysis to the weekly subscription piece covering these issues and the occasional real-time alert I send to subscribers. An annual subscription to the Mortgage REIT Forum is $240/year. On a monthly basis, it is equivalent to buying lunch for me once a month and receiving my best ideas and real-time alerts when I find a market failure. Subscribers received this article on the evening of 10-12-2016. I requested delayed publication on the public site to give subscribers time to get their orders in first.
Disclosure: I am/we are long AGNCB, AGNCP, NLY-D, NLY-E.
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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