On Sept. 19, Annaly Capital Management (NLY) declared its quarterly dividend for the third quarter of the current year. The company seeks to distribute $0.50 per share to its common shares, which is a 9% cut from its previous quarter's $0.55 per share. With the quarterly new dividend, the new dividend yield comes out to be 11.6%. The new dividend yield is still above the yield of many mortgage REITs. QE3 will have an impact of further eroding net interest spreads, and if that happens, investors should expect a further cut in dividends in the coming quarters. Therefore, we recommend investors hold the stock and closely monitor the twists in the yield curve.
The interest rate spread that Annaly Capital Management earned during the second quarter of the current year was 1.54%, as compared to 1.71% in the first quarter of the current year. During the fourth quarter of the previous year, the company earned a 2.09% interest rate spread. This reflects a declining trend in the interest income that the company earned. With the new round of easing announced, we believe the margins may erode further.
How Do mREITs Make Money?
For quite some time, mortgage REITs have been enjoying record low interest rates from the Fed to decrease their cost of funds. This was part of the stimulus that the Fed provided to support the sluggish U.S. economy. Mortgage REITs invest in long-term U.S. mortgage-backed securities and earn an interest rate on them. They get the required funding to invest in their asset portfolio by borrowing short term. They borrow funds using repurchase agreements. NLY earns the interest rate spread or margin between the interest it receives on its interest-yielding asset and the interest it pays on its interest bearing liabilities. The record low policy rate has been helping these REITs borrow funds at record low costs, enabling them to distribute elevated returns in the shape of dividend distributions to their shareholders.
The Impact of QE3
The Fed, in order to stimulate the economy, further initiated programs like Operation Twist and the Maturity Extension Program. In an earlier article, we pointed out the impact of these operations on the interest rate yield curve, and the resultant impact on the net interest spread earned by mortgage REITs. Operation Twist and the Maturity Extension Program have a tendency to put downward pressure on long-term interest rates. This downward pressure on long-term interest rates means lower interest income for mortgage REITs, and the resultant dividend cuts.
Looking at the country's deteriorating economic situation, the Fed announced the launch of another round of easing (QE3). Under the new round, the Fed seeks to purchase mortgage-backed securities worth $40 billion a month until the Fed feels that the economy doesn't need the required support. The result of this round of easing will be similar. However, the extent of the impact might not be little as compared to the previous rounds of easing. Through the third round of easing, the Fed aims to bring down mortgage rates. This will have a similar impact of depressing the interest rate spreads that these companies earn.
FBR Capital Management, Wunderlich, and Compass Point downgraded the stock to underperform, hold and neutral, respectively. FBR Capital Management cited Annaly Capital's oversized asset portfolio as the reason for its downgrade. FBR believes the company is significantly exposed to higher prepayments than most of its peers. With a price target of $17, analysts at JPMorgan also downgraded the shares of the company from overweight to neutral, citing a balanced risk/reward profile as a major reason. Government intervention through the third round of easing is considered to be another reason for the downgrades. Analysts at JPMorgan believe that the new round of quantitative easing will further squeeze the net interest rate spread that the company earns. Wells Fargo also cut the ratings for the stock from market perform to underperform.
The stock trades at attractive valuations as compared to most of its peers in the U.S. mortgage REITs industry. The stock trades at a 6% premium to its book value. Compared to this, shares of American Capital Agency (AGNC) trade at a 24% premium to its book value, while MFA Financial (MFA) trades at a 9% premium.