Annaly Capital Management: The Safety Premium Of Preferred Stock

Sep.10.12 | About: Annaly Capital (NLY)

There were a couple of press releases this week by Annaly Capital Management (NYSE:NLY), the largest mortgage REIT, and it is worth a little digging to try to understand the ramifications.

Since the declaration of the last dividend, the fund has had a good month. This is a comparison of NLY and American Capital Agency (NASDAQ:AGNC), another widely held fund.

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Side note: I went on record a while back expecting AGNC to do a little better than NLY, but I see that both are doing about the same since that prediction.

The project of the day is to figure out the effects of the two announcements by NLY.

The first one was a buyback of some of NLY's long term debt: $281M of 4% debt will be repurchased. Here is a calculation of the effects of this on NLY's bottom line:

Debt Repurchase ($M) 281
Interest Rate (%) 4
Incremental Interest Decrease ($M) 11.24
Leverage 6
Incremental Portfolio Decrease ($M) 1686
Interest Spread (%) 1.54
Incremental Income Decrease ($M) 25.96
Net Effect on Income ($M) -14.72
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The $280M of debt was costing the company $11M per year, at 4% interest. They are leveraging this money at 6:1, and so it translated into an incremental portfolio value of about $1.7B.

The value of this portfolio to the company's net income at a spread of 1.54% is roughly $26M. So in effect, the company walked away from $15M per year by buying back the debt.

The company had about $1.4B of interest income over the last six months, according to its most recent 10Q, and so in the grand scheme of things, this amount is small relative to the size of the rest of the company.

The company also announced the issuance of some Series D Preferred Stock.

Here is the calculation on that transaction:

Preferred Stock Issuance
Proceeds from Issuance $M 400
Interest Rate % 7.5
Incremental Interest Expense ($M) 30
Leverage 6
Portfolio Increase ($M) 2400
Interest Rate Spread (%) 1.54
Incremental Income Increase ($M) 36.96
Net Effect on Income 6.96
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Using the $400M at 6:1 leverage would give the company an additional $2.4B in portfolio, which at the company's current average spread of 1.54% would break it just about even on the transaction. It is possible that it will not be that good, if the incremental portfolio is added at a lower average spread than the rest of the portfolio. There has been a decline in interest rates over the last six months, so any incremental mortgages will probably be added at a lower coupon.

So these two announcements represent a swapping of 4% debt for 7.5% Preferred stock. It will probably cost the company a little money to do this, and there will be a "small" net increase in cash of about $120M.

So, why did the management do it?

The face value explanation by management in the recent press release is probably the most plausible. The company traded debt, with a maturity date of 2015, for preferred stock, with no shelf life. This is consistent with the overall strategy of lengthening the maturity of their portfolio. It allows NLY to lock in financing at what the management sees as a historically low rate. Neither of these announcements in and of themselves are reasons to buy or sell the stock, except to the extent that it reaffirms the management strategy of conservative leverage levels, and reasonable growth.

The final question: Are you better off being a buyer of the Series D preferred stock or the regular common stock?

The answer is: It depends on your risk tolerance. Here is the chart of the NLY Series C shares, which were first issued at $25 per share in early May:

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Currently, the Series C Preferred stock is trading at $25.50 per share. The stock was originally issued at $25 with a face value of 7.625%, and so the 50-cent per share increase in the price represents a premium in the marketplace. This is because the Series D was issued with a lower face value, 7.5%.

Current Price $/share 25.5
Original Price $/share 25
Increase since issuance 2.00%
Dividend Yield 7.63%
Dividend Rate $/share 1.90625
Effective Yield at Current Price 7.48%
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The lower-risk but lower-reward Class C Preferred Stock was originally priced at $25, and was paying up to $26 in the marketplace a month or so ago. To buy that issuance today would give an effective interest rate yield of 7.48% which is essentially the same as the new issuance.

The fact that the Class C shares were trading higher briefly is the premium for safety. The effective yield of the Class C shares was only 7.33% at that moment.

The NLY common stock is currently paying about 12.5% dividends, nominally, but the common dividends of these mREITs are always vulnerable to being cut if the company has a bad quarter or two.

In both cases, the fact that the preferred shares are trading at or near their original issue value suggests that the shareholders are willing to settle for a greater than 5% lower return in exchange for a little more safety.

You could also see a scenario where the company did another issuance later on, at an even lower rate, and that would benefit both the C and D preferred shareholders.

So, to summarize: The retirement of debt and issuance of more preferred stock in and of itself is not a reason to trade the stock, because the transactions are small relative to the rest of the company, and amount to just a swap of debt for preferred equity.

The management has reaffirmed the strategy of extending the portfolio farther into the future.

The preferred shares (either the Class C or Class D) represent a lower risk way to participate in NLY's business. It does not matter at this point which one you buy because the effective yield is the same, but if interest rates continue to fall, as they have between May and now, the Preferred Shareholders do have an opportunity for a little capital appreciation if, and it is a big if, the company continues with this strategy of an occasional preferred issuance at lower face value interest rates.

Do with this information what you will. As usual, I would remind you that the world is chaotic, and there are no guarantees on anything.

Disclosure: I am long AGNC. 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.