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Annaly Capital Management (NYSE:NLY) has been around for a long time compared to most mortgage REITs. The company has seen their share of price movements and traded at both large discounts and small discounts, but the thing that may stick out to investors is that their dividend has changed a few times as well.
For the income investor, a change in the quarterly dividend amount is a very serious event. Given the huge increase in interest rates, I recently heard a great question regarding Taper Tantrum from 2013. If a steeper yield curve is positive for the net interest spread, why did Annaly Capital Management have to cut their dividend after the Taper Tantrum?
Prior to the Taper Tantrum, the dividend was $.45 per share. Following the event, the dividend was cut to $.35 and then to $.30. That begs a huge question about the way we understand mortgage REITs. A steeper yield curve should have been positive, despite some damage to book value, but the dividend cut spoke volumes about the state of the industry.
This article is not about the most recent dividend. Screening tools are showing an incorrect yield for Annaly Capital Management because they failed to adequately account for the partial period dividend paid out in July 2016. Counting that partial period dividend, the quarterly rate is still at $.30. To understand why I believe it will stay there, you should understand why it was chopped after the Taper Tantrum.
Setting the Stage
At the end of Q1 2013, the 7-year Treasury was 1.24% and the 10-year Treasury was 1.87%. One year later, the 7-year was at 2.3% and the 10-year was at 2.73%. During that time, the 1-year Treasury remained around 13 basis points (that means .13%) and the 2-year Treasury only climbed from .25% to .44%.
The taper tantrum began late in the second quarter of 2013. The market sold off bonds in a very fierce way on fear the Federal Reserve would change their strategy with bonds.
I built the following chart to show the change in book value over that year:
As bad as that looks, if I had picked different dates, the fall would've been larger. It is fair to say NLY's book value got hammered.
However, that doesn't necessarily explain what happened to the dividend. Since the dividend is driven more by the earnings power of the portfolio than the book value (granted, the two are strongly tied together), what happened to the interest income?
I pulled up one of the old earnings presentations to reach the following chart:
I've added the red box to highlight Q1 of 2014 and the green box to highlight Q1 of 2013. We can clearly see that economic net interest income decreased significantly. We can also see that the economic interest expense was down slightly, but the interest income fell even more.
That should give investors a little pause. As analysts, we keep saying that higher rates reduce prepayments and thus drive up the yield on assets. If the yield on assets is supposed to be going up, why is total interest income down significantly? Perhaps we should also ask what happened to the interest expense.
The answer is simpler than it seems. I edited the chart again to add a yellow box and a blue box:
The yellow box shows the interest expense from repurchase agreements and the blue box shows the interest expense flowing through from the realized losses on interest rate swaps. To oversimplify slightly, the yellow is the cost of borrowing and the blue is the cost of hedging.
Annaly Capital Management spent far less on borrowing but they spent far more on hedging.
How did that happen? I will tackle the questions one at a time. First, we'll deal with the yellow box (cost of borrowing).
To demonstrate the issue, we need to look at the balance sheet at each time. Fortunately, NLY presented charts that covered precisely five quarters of data. Again, the red box shows Q1 2014 and the green box shows Q1 2013:
The major driver for the yellow box was the total value of repurchase agreements. For simplicity sake, I put a yellow box around it in this chart. The repurchase agreements drive the interest expense on… repurchase agreements. Are you still with me?
The leverage during this period also decreased from 6.6x to 5.2x. Since the amount of repurchase agreements declined so dramatically, you could probably guess leverage was lower. However, the book value was also lower, as we mentioned before. The combination of a lower book value per share and lower leverage suggests that assets should have declined significantly assuming the share count was roughly unchanged.
A Quick Look at Assets
Before we go into the hedges, I want to expand on the idea of leverage and debt financing. The following chart follows the same trend with red and green boxes to indicate the quarters. The purple box has been added to highlight the rows for "Total Investment Securities…" and "Total Assets."
Regardless of which asset category we were using, the total value is dramatically lower. That fits into the narrative we've been seeing of a lower book value combined with lower leverage. This is important because we know that interest income decreased modestly during the time span, but now, we can see that the size of the portfolio of assets decreased quite substantially. The assets were providing higher yields, but the total amount of assets just wasn't large enough to provide the same level of interest income.
Back to Hedging
Returning to our discussion of the debts, the increase in hedging costs was the big factor for expenses. The quarterly cost of those hedges went from $225 up to $260. Remember that there was less leverage and a lower book value, so a similar hedging portfolio would have provided dramatically more protection from interest rate movements. However, we won't see a similar hedging portfolio. We will see major changes.
Even though these charts are presented separately, I'm going to stick to the pattern of highlighting with red for 2014 and green for 2013.
The hedges in 2013 were fairly light:
NLY had about $48 billion in the notional balance of hedges with a weighted average years to maturity of 4.89. They also had just over $100 billion in repurchase agreements outstanding. Overall, this is pretty light for an agency mREIT with heavy positions in fixed-rate RMBS. Now we should compare it with the values from 2014:
In early 2014, we can see that the notional balance on the swaps moved higher, nearing $57 billion. The weighted average years to maturity also increased to 5.31. Further, we see that the outstanding repo balance declined to about $64.5 billion.
It is worth noting that the weighted average pay rate on the swaps only moved up from 2.08% to 2.16%, so the increase in hedging costs was driven at least as much by the increase in the total notional balance of the swaps as it was driven by the higher rates. The reason this matters is that it highlights that NLY wasn't paying that much more for the swap protection, it was simply buying substantially more of it.
The decline for Annaly Capital Management's net interest income wasn't driven by the steeper yield curve. It was driven by running light on hedges entering the first period and losing a substantial amount of book value. That loss was compounded when leverage was reduced and the hedge position was dramatically increased. As it stands, Annaly Capital Management is carrying a much more effective hedge portfolio than they had in 2013. I'll demonstrate why in the next article.
That article is already available to subscribers of The Mortgage REIT Forum. For the cost of one lunch per month, you can get access to the research I'm using for managing my own investments. On average, I publish about 3 subscription articles per week. One is for calculating new estimated book value for several mortgage REITs and finding the current discounts to those estimates.
Another covers the preferred shares for each mortgage REIT that has preferred shares. The third is used to either preview articles I'm working on for the public or to provide real-time updates on liquidity failures where prices for a small number of securities detached from other similar stocks.
Disclosure: I am/we are long NLY, NLY-D.
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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