Annaly (NLY) is one of the largest mortgage REITs -- if not the largest -- by market capitalization and has one of the longest tenured managements in the industry. It currently has a projected yield of 12.9%, and is selling at a price to book value of around 1. That may make it look cheap at first glance, but a closer look may reveal otherwise
Why you should invest
- Yield -- Annaly Capital pays out a yield of about 13%, which is very attractive in an environment where interest rates are so low.
- Management -- in the mortgage REIT industry, Annaly Capital is recognized as being one of the best-run companies. It all starts at the top, with founder Michael Farrell, CIO Wellington Denahan-Norris, and CFO Kathryn Fagan.
- Performance -- while not indicative of future results, for long holding periods, the returns on this REIT have been great. In 2008, Annaly held its own. It did have a 39% loss in 2005, but investors who held on would have recovered their investment by mid-2006.
Why you shouldn't invest
- Valuation -- the current price/earnings multiple is 29, which is above the 5-year average P/E ratio for the company of 19.1. It also sells for 18x sales and 6.4x cash flow, both above the respective long-term averages of 10.1 and 2.5, respectively. So by those metrics, it looks a little pricey.
- Risks -- returns don't come without risks, unfortunately. I, for one, haven't figured out how to separate those two love birds. As an investment, Annaly certainly has its risks.
- Leverage -- risks are magnified when you have leverage. So while leverage could have been lumped in with all the other, several risks, I wanted to stress its importance by listing it separately.
Now, let's look at some of these factors in more detail:
How Annaly Makes Money
Annaly operates by investing in mortgage-backed securities (or similar instruments) and earning interest on these securities that exceeds its cost of borrowing. Its borrowing consists primarily of repurchase agreements, typically between 30-120 days, with the majority on the shorter end of that range. A repurchase agreement is the process of using mortgage-backed securities as collateral for a short-term loan, and an agreement to repurchase those securities at a future date.
In the meantime, Annaly continues to benefit from interest and principal payments on the securities used as collateral, while using the proceeds of the loan to buy additional securities. Since the newly purchased securities can also be used as collateral for additional funding, the process can, in essence, be repeated several times, and explains why mortgage REITs are usually leveraged multiple times.
It sounds risky. And it is. So long as the underlying mortgage securities perform as expected, Annaly collects interest and principal payments, pays the interest on the repurchase agreements, and pays out 90% of the remainder to investors. (I'm simplifying of course.) But what if defaults rise, or interest rates increase, or prepayments accelerate?
We are probably at the end or near the end of the mortgage default debacle that has plagued the industry and our economy for several years. But even in the event that we experience another 2008-like year and borrowers either involuntary default, or as is often the case these days, decide not to pay their mortgage, all of the mortgage securities on the Annaly balance sheet are guaranteed by either Fannie Mae, Freddie Mac, or Ginnie Mae. That effectively makes these securities default-free with an implied rating of AA+ -- a couple of steps above their target of an S&P rating of A.
Interest Rate Changes
For starters, Annaly hedges their interest rate exposure using derivatives and/or interest rate swaps. But if we assume Annaly does not hedge at all, I've estimated the weighted average duration of its portfolio is 2.5 years, give or take 6 months. In its financials, Annaly reports that $98 billion of the $104 billion it holds in securities has a weighted average life of 1-5 years. This includes prepayments as well as maturities, but to simplify, I just used the mid-point.
Since the prepayment rate was 22% through 2011, we can assume that the other 78% of the $98 billion has a weighted average life of 2.5 years. If I then assume that weighted average life can be used as a proxy for duration, we can calculate that for every 1% change in interest rates, the value of the securities Annaly holds will change by roughly 2.5% - 3%.
But Annaly goes further in its financial statements to provide actual sensitivities, including any hedging it does. The following table is taken directly from its most recent 10-K and shows that Annaly is well-insulated to interest rate changes through its interest rate swaps. If you want to be conservative, use the 2.5% calculation mentioned above.
|Interest Rate changes||Change in Portfolio Value|
|-75 basis points||-0.44%|
|-50 basis points||-0.29%|
|-25 basis points||-0.13%|
|+25 basis points||0.10%|
|+50 basis points||0.15%|
|+75 basis points||0.12%|
Prepayment risk is highest in an environment of decreasing dividends. We have just lived through such an environment, and there have been some clear winners and losers in the refinancing boom. But interest rates are quite possibly at all-time lows, and while there may still be some borrowers out there thinking about refinancing, the majority that qualified for refinancing, have already done so.
The challenge for many borrowers has been that the value of their homes is currently below the balance on their mortgages, making it difficult if not impossible to refinance. And since we don't see home prices soaring anytime soon (even though it seems they are starting to pick up), we think the refinancing era is at the end of its run.
In the event that any of these risks cause the value of the securities it holds to decrease in value by a large enough amount, Annaly would then have to sell some of these securities at the lower price in order to meet margin calls. This process can feed itself. As securities are sold to meet margin call, driving the prices down, the lower prices trigger additional margin calls, which leads to additional sales, and so on.
With all the risks I just mentioned, the 12.9% yield may no longer looks as attractive to some investors. Still, I think Annaly has tight risk controls and one of the top management teams in the industry. In addition, we think the risks it faces are increasingly muted, and yet it is conservatively leveraged at only 5.4 times. In good times, they may leverage up to 12 times.
So if you are looking for a nice yield and can withstand some of the volatility inherent in the security, I think Annaly can be a very good income generating asset. But I don't think it looks attractive from a valuation perspective. (For greater upside potential, check out AGNC.)
In other words, I don't see much upside. In fact, I see a bit of downside in the price, but not enough to forego a very attractive dividend that, in a market downturn, still provides a very nice cushion.
Disclosure: I am long NLY.