What's The Compelling Reason For Owning Annaly Capital Management?

Apr.11.12 | About: Annaly Capital (NLY)

Today's project is to try to come up with an answer to the above question regarding Annaly Capital Management (NLY), one of the mortgage REITs that we have been analyzing lately - all of which have been receiving interest from investors because of their high dividend yield in an era where CD rates are low and returns in the stock market, in general, are questionable.

To arrive at the answer, I will start by comparing Annaly Capital Management to American Capital Agency (AGNC), which has been one of the favorites in this industry. All of this information came from the most recent 10K for each of the companies, which can be found on the company websites here and here.

Here are the current prices and dividend yields:

Price Div Yield
American Capital Agency AGNC 30.08 16.6%
Annaly Capital Management NLY 15.75 14.1%
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Here is a recent price chart:

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Both of these companies are engaged in the business of originating mortgage money. Annaly's stated strategy is to invest in at least 75% of its portfolio in high-quality mortgage loans, and its portfolio is currently about 92% agency-backed mortgages, 95% of which have a maturity of greater than three years. AGNC is chartered to have a portfolio of 100% agency-backed mortgages, and most of its portfolio is the fixed rate, 30-year variety. The reason this is that the shorter term the mortgage, the easier it is to use hedging to reduce the portfolio risk, and also, if interest rates change, it is easier to manage

Agency 100% 93%
Non Agency 0% 0%
Comm/Other 0% 7%
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These are among the two largest of the mortgage REITs, NLY is about twice as big as AGNC.

Portfolio ($B) 54.6 104
2011 Int Income ($M) 1108 3579
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Portfolio Value ($B) 2008 2009 2010 2011
AGNC 1.5 4.3 13.5 54.6
NLY 55.96 58.55 66.9 96.6
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Both companies have been around for a long time, the growth curves for both have flattened. This is important for the following reason: In this industry, growth is good, because it is easier to manage both the leverage and the quarterly dividend payout for a smaller, and more rapidly growing company.

Interest Rate Spread is the difference between the interest rate of borrowed funds and the interest income of the company. Of the two, AGNC had the higher, as of its 2011 10K. Leverage is the ratio of the portfolio value to the paid in stockholders equity, and of the two, AGNC is slightly more highly leveraged. In general, leverage is risk, but in this industry, the bigger more mature companies tend to have the higher leverage because they are more stable.

Interest Spread 2.3% 2.1%
Leverage 7.90 6.90
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So, both of these companies are basically in the same business, are mature, and you have to say the minor differences in portfolio maturity and leverage are not really compelling reasons to choose one over the other.

Both of these companies are engaged in the practice of hedging, which is the use of derivatives and other financial instruments to either reduce risk or if possible, make a little money. The smaller, aggressive funds can do this to a much greater extent than the bigger ones. In some of these cases, the amount of money made on hedging is a substantial percentage of the income of the company, which is useful information to a prospective investor.

Hedging gains or losses show up on the income statement in two ways: "realized", which means that the company has already exited the derivative position at either a profit or loss, or "unrealized", which means that the position is still open.

Here are the realized and unrealized derivative profits and losses as of the last 10K for both of these funds. As you can see, there was nearly $1B in realized derivative losses for NLY at year-end, and unrealized losses of nearly $2B on the books. AGNC did much better, its derivative positions were positive, and a relatively small portion of its overall income.

Realized Derivative Income/Loss ($M) 26.4 -882
Realized Derivative/Interest Ratio 2.4% -24.6%
Unrealized Derivatives Income($M) 378.9 -1815
UDR/Interest Income 34.2% -50.7%
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In the Qualitative and Quantitative Discussion of Risk in the quarterly reports, the management discloses the hedging strategy for reducing the risk of a change in interest rates. Here is a summary of the effects of a change in interest rates on the operating income of these two funds. The source of this information is page 60 of the AGNC 2011 Annual Report, page 56 of the NLY 2011 Annual Report, and page 55 of the NLY 2010 Annual Report:

Basis Point Change NLY 2011 NLY 2010 AGNC
100 -3.1
75 -8.47 -4.11
50 -4.89 -2.16 -0.4
25 -1.87 -0.65
0 0 0 0
-25 3.58 1.94
-50 7.88 4.35 -2
-75 11.9 6.4
-100 -13.2
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It is a bit easier to visualize by producing a graph:

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Here is how it works: The derivative instruments for NLY are set up in such a way that if interest rates go down, it will have an increase in net income, and the bigger the decrease, the more it will benefit. However, if interest rates go up, the opposite will be true. The farther away from the "zero" line, the more the risk, so you have to say NLY got more risky in the last year.

The strategy in the case of AGNC is based on the idea that interest rates will stay about where they are: They will lose a little income if the interest rates go either up or down, and they are, overall, less risky in the up direction versus NLY. So, one compelling reason for owning NLY might be that if interest rates go down, it does stand to benefit.

What a lot of us found out in the last year is that these high yielding mREITs look good when they pop up on a stock screener, but the dividends are not guaranteed. In fact, both of these companies have cut their dividend in the last year. Here is the dividend history for NLY:

NLY Dividend History

Year Ex-Dividend Date Dividend ($)
Q1 03/28/12 0.550000
Q4 12/27/11 0.570000
Q3 09/28/11 0.600000
Q2 06/28/11 0.650000
Q1 03/29/11 0.620000
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Here is the dividend history for AGNC:

AGNC Dividend History

Year Ex-Dividend Date Dividend ($)
Q1 03/05/12 1.250000
Q4 12/20/11 1.400000
Q3 09/21/11 1.400000
Q2 06/21/11 1.400000
Q1 03/21/11 1.400000
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So, it is quite true that entering the investment right now with a 14%-16% dividend is looking good, it will be much less good if they company cuts its dividend in the next year and the stock price goes down. Here is the calculation of what will your rate of return be if the dividends of each of these stocks declines at the current rate, using the beginning of 2010 as the starting point, and assuming the market will adjust to give a comparable yield:

Current Price 30.08 15.75
Current Div Yield 16.6% 14.1%
Dividend, Q1 2010 1.4 0.65
Dividend, Q1 2012 1.25 0.55
Shrinkage Rate (Per Year Avg) 0.15 0.075
Expected Dividend, Q4 2012 1.1 0.475
Q4 2012 price at current yield 26.51 13.48
ROR at Projected Div Change 3.7% -1.4%
4Q 2011 EPS 1.2 0.48
Payout Ratio 104% 115%
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As you can see, either of these two investments is looking uglier given the assumption that company dividends will continue to go down at the same rate as they now are. You'd be better off after one year in XOM or any other more stable investment.

Also, note at the bottom of the chart the payout ratio: This is the ratio of the dividend payout compared to the company earnings in the fourth quarter. In this industry, companies are required to pay out at least 90% of earnings to maintain their favorable tax status. Both of these companies paid out more than their earnings, which they can do temporarily, but the one-quarter sampling of data suggests that NLY of the two is much more likely to cut their dividend again in the next quarter.

One more piece of information: In the last month AGNC has announced the issuance of additional stock. In a normal world, this would mean dilution of shares for the current stockholders, but in this case it means that they intend to use the money plus their leverage to grow, and as we mentioned before, growth is good as are share issuances. NLY's last share issuance was in February of 2011 although they are currently converting some of their long term debt to equity.

So, what are we to make of all of this?

In the case of Annaly, you have a mature mREIT at the flat part of their growth curve, with substantial unrealized derivatives losses on the books, and an apparent higher likelihood of dividend cuts, based on its payout ratio in the last quarter. If the likelihood of a further interest rate decrease is enough to offset all of these headwinds, that may be a reason for going long on the stock.

Other than that, you'd be better off with AGNC.

As I am so fond of saying, the world is chaotic, and there are no guarantees on anything, much less the projected dividend of a mortgage REIT a year from now. Do with this information what you will.

Disclosure: I am long AGNC, ARR, CYS, TWO, IVR.

Additional disclosure: I exited CIM just before the dividend.