We've been doing an analysis of Annaly Capital Management's (NLY) annual report and comparing it to that of American Capital Agency (AGNC). These are two of the larger mortgage-based REITs, which are of great interest because of their currently high dividend yield.
In the section called "Discussion of Quantitative and Qualitative Risk," these two companies disclose the effects of changes in interest rates on net income. For Annaly, this information is published on pg. 56:
Here is a quote from the discussion that defines more or less what this is:
Changes in the level of interest rates also can affect the value of our Agency mortgage-backed securities and our ability to realize gains from the sale of these assets. We may utilize a variety of financial instruments, including interest rate swaps, caps, floors, inverse floaters and other interest rate exchange contracts, in order to limit the effects of interest rates on our operations. When we use these types of derivatives to hedge the risk of interest-earning assets or interest-bearing liabilities, we may be subject to certain risks, including the risk that losses on a hedge position will reduce the funds available for payments to holders of securities and that the losses may exceed the amount we invested in the
So the only question is Annaly's definition of "economic net interest income," which the discussion goes on to define as follows:
...the difference between the interest income earned on interest-earning assets
and the interest expense incurred in connection with our interest-bearing liabilities, by affecting the spread between our interest-earning assets and interest-bearing liabilities.
The derivative instruments for Annaly are set up in such a way that if interest rates go up 50 basis points, the company will have a 4.49% decrease in net income. If interest rates go down by 50 basis points, Annaly will have a 7.88% gain in net income. It hopes to profit from a decrease in interest rates.
For American Capital Agency, the table is posted on pg. 60:
So, for American Capital Agency, a 50 basis point increase in interest rates will result in a 0.4% decrease in net income and a 50 basis point decrease in interest rates will result in a 2% decrease in net income.
There is some flexibility in the way these numbers are calculated by these two companies, and we are making the following assumptions: both companies are calculating it in the same way, they are equally accurate, and "the net economic income" we are talking about is something approaching the calculation we did in Part 2 of this series, which was actual net interest income plus (or minus) the net effect of the hedging activity.
Given all of this, a 50 basis point interest rate increase will have less effect on American Capital Agency than it will on Annaly. If interest rates decrease by 50 basis points, the effect on Annaly will be positive, an improvement in net income, and the effect on American Capital Agency will be negative by 2%. So, everything else being equal, the scenario of a big decrease in interest rates will favor Annaly.
We want to calculate the potential effects of all of this to try to determine how it might affect the dividend security.
We will start with Annaly:
|Net Interest Income ($M)||3099|
|Total other Income (loss)||(2459)|
|Other Comprehensive Income (loss)||1844|
|Total Comprehensive Income*||2484|
|Shares Outstanding 12-31||874|
|Conversion of Class B Preferred to Common Stock (M Shares)||2|
|New Shares Outstanding||876|
|Current Quarterly Dividend||0.55|
|Amount Needed to maintain Common Dividend ($M)||1928|
|Class A Preferred Shares Outstanding (M Shares)||7.10|
|Current Preferred Dividend ($/share/quarter)||0.49|
|Preferred Dividends Needed ($M)||13.92|
|Total Needed to Maintain Dividend ($M)||1942|
I have taken the net interest income for last year and added back to it the realized and unrealized leverage effects from the income statement to arrive at an approximate comprehensive income. Note that this does not include the administration, taxes, or other items. The comprehensive income here does not equal the comprehensive income on the income statement, which for Annaly is on pg. F2.
Since Dec. 31, Annaly has announced the conversion of the Class B Preferred stock to common shares, resulting in an additional 2.5 million shares of stock outstanding. It also has in existence 7 million shares of Class A preferred stock, on which it announced a .49 per share quarterly dividend.
So, after the negligible adjustments for the preferred stock, Annaly will need approximately $1.92B over the coming year to maintain the dividend, and the adjusted comprehensive net income would be 127% of its dividend distribution. This is consistent with the roughly $2B it paid out last year, which is listed on the company's cash flow statement, so we know our numbers are not too far off.
Here is a table of the potential interest rate scenarios, using Annaly's net comprehensive income as noted above:
|Potential Interest Rate Change||Effect %||Effect $M||Net Income||% Div Coverage|
|75 basis point increase||-8.47||-210||2274||117%|
|50 basis point increase||-4.89||-121||2363||122%|
|25 basis point increase||-1.87||-46||2438||126%|
|25 basis point decrease||3.58||89||2573||133%|
|50 basis point decrease||7.88||196||2680||138%|
|75 basis point decrease||11.9||296||2780||143%|
Given this set of assumptions, the dividend can be paid at these levels in all of these scenarios. The scenario of a declining interest rate would result in Annaly having its dividend covered to a greater extent.
The calculation for American Capital Agency is made more complicated by two announcements over the last six weeks: The issuance of an additional 71 million shares of common stock, with the potential to increase the size of the company by an additional roughly 50%, and the issuance of 8% preferred shares.
|American Capital Agency|
|Net Interest Income ($M)||824|
|Total other Income (loss) ($M)||26|
|Other Comprehensive Income (loss) ($M)||378|
|Total Comprehensive Income ($M)||1228|
|Shares Outstanding 12-31 (M Shares)||153|
|New Common Shares (M Shares)||71.1|
|Proceeds @$30 per share ($M)||2,133|
|Potential Portfolio Increase ($M)||17,064|
|Interest Rate Spread (Est)||0.02|
|Potential Increase in Income ($M)||341|
|New Preferred Shares (M Shares)||6.9|
|Issue Price $/share||25|
|Potential Portfolio Increase ($M)||1,380|
|Interest Rate Spread||0.02|
|Potential Increase in Income ($M)||28|
|Total Potential Income Increase ($M)||369|
|Total Potential Net Income ($M)||1,597|
|New Total Common Shares outstanding (M Shares)||224|
|Current Quarterly Dividend (per share) $/Share||1.25|
|Amount needed to cover Common Dividend ($M)||1120.5|
|Amount needed to cover Preferred dividend ($M)||13.8|
It is important to remember that none of this is going to happen instantaneously; it will take a little time for the company to expand as all of this is a moving target. So this estimate is a way to think of the company after a full year of being bigger.
This calculation uses the two conservative assumptions of an 8:1 leverage rate, turning the new capital into the portfolio, and also using an interest rate spread on the new portfolio of 2.0%, which is lower than the 2.3% that American Capital Agency had in 2011 and is probably more like what is available in the marketplace.
The bigger American Capital Agency may have a comprehensive income of around $1.6B, and the more numerous shareholders would require a dividend of $1.113B, so its cushion could be somewhere around 141%. If things continue the way they are, American Capital Agency's dividend coverage would be greater than Annaly's, which we calculated as 127%.
Now, the interest rate sensitivity. Here it is for American Capital Agency:
|Effects of Interest Rate Changes||Effect on Income %||Effect $B||Potential Net||% Div Coverage|
|+100 Basis Points||-3.1||-49.5||1547.4||136%|
|+50 Basis Points||-0.4||-6.4||1590.5||140%|
|-50 Basis Points||-2||-31.9||1564.9||138%|
|-100 Basis Points||-13.2||-210.8||1386.1||122%|
American Capital Agency's hedging program is set up so as to have a decrease in income if interest rates move in either direction, but obviously it is insured to a greater extent against a small interest rate increase, and has accepted risk if the interest rates change 100 basis points in either direction.
Given this set of assumptions, the American Capital Agency dividend at these levels does not appear to be in jeopardy either.
However, note that if you take the scenario of a big decrease in interest rates, Annaly will have its dividend covered to a greater extent. Annaly's income would be $2.780B, which is 143% of its dividend requirements. With a 100-point decrease in interest rates, American Capital Agency's income of $1.386B would be 122% of its dividend requirement. This is the only scenario in which Annaly's dividend coverage is higher than American Capital Agency's.
It's a bit easier to visualize if we graph it. The crossover point is a 50 basis point decrease.
These companies are basically dealing in a commodity: money. The differentiation from one to the other is how the managers of each of the companies in this industry deal with risk. Reduction in risk comes at some cost, so the "talent" in this business is to balance the risk vs. cost.
That whole balance is based on management's expectations of the future direction of interest rates. They can and do set up and adjust their system of hedging transactions based on those expectations. You can clearly see above the potential ramifications of all of this on the dividend coverage of these two companies. An informed investor with a theory about the future of interest rates can and should adjust his or her portfolio on this basis.
Naturally, every place in the above calculation where there is an "if" or an "estimated" or a "possible" is an opportunity for error. And of course past performance is not an indication of future results.
In Part 1 of this series, we looked at growth, leverage and cash flow. American Capital Agency had the higher growth rate in the difficult second half of last year. As of Dec. 31, American Capital Agency had the stronger cash position, despite being less than half the size of Annaly.
In Part 2, we looked at the income statements of these two companies, and pointed out the higher hedging costs of Annaly compared to American Capital Agency. It is up to the reader to determine if this higher hedging cost represents "insurance," or if it represents expense that could be better distributed to the shareholders. Herein lies the biggest difference of opinion on these two companies, I think.
In Part 3, we looked at the interest rate spread, which was higher for American Capital Agency than it was for Annaly. The portfolio CPR, or constant prepayment rate, was higher for Annaly than it was for American Capital Agency.
Now, using the statements of qualitative and quantitative risk from the annual reports, we have taken a look at the future. We estimate that if things stay the way they are, or if interest rates rise, American Capital Agency will have its dividend covered to a larger extent. If interest rates fall substantially, Annaly will have the better time of it.
The world is chaotic, and there are no guarantees on anything. Do with this information what you will.