On Tuesday, after the markets closed, Annaly Capital Management (NLY) announced plans to repurchase up to $1.5 billion of its outstanding common shares over a 12-month period. This is a noticeably different and quite contrary move compared to the standard serial secondary stock offerings made by most mortgage REITs. The news is likely to immediately benefit Annaly's shares, as there is a new buyer in town.
Due to prepayments and the high dividend payouts that the REIT model necessitates, mortgage REITs like Annaly usually go to the market and sell additional shares in order to raise funds and expand their operation. This move could indicate that Annaly is not interested in such expansion in the near term. Another basis for the repurchase could be that Annaly's management believes the market is not appropriately evaluating its book of agency mortgage-backed securities. Annaly was trading at nearly a 5% discount to its last reported book value, though its book value may have changed during the third quarter. The company should report Q3 results in a few weeks.
During the last few quarters, as interest rates declined, most mortgage REITs have noticed declining spreads and rising prepayment rates. This makes it difficult for an mREIT to maintain its dividend, or it forces the management to buy riskier securities and/or institute higher leverage rates in order to increase profits. Such endeavors generally substitute one risk for another.
It is likely that Q3 mortgage prepayment rates were even higher than prior levels, as homeowners continued to refinance while borrowing costs hover at or near historic lows. According to Lender Processing Services, prepayments during August were at their highest rate since 2005. Mortgage bond investors risk losses when buying debt for more than par, or the call rate if it is above par. Most agency RMBSs are trading at premiums to par, so most agency mREITs have exposure to prepayment-related losses. Prepayments also generally force these mREITs to investo in other paper, though Annaly has come up with another option.
Annaly's Constant Prepayment Rate for Q2 was 19%, which is the same prepayment rate it reported for Q1 2012. Though Annaly did not recognize a significant prepayment spike in Q2 compared to Q1 2012, its prepayment rate was 11% in Q2 2011 and a prepayment rate of 19% is significant. American Capital Agency (AGNC), the second largest agency mREIT, reported a constant prepayment rate during Q2 of 10%, which was unchanged from the first quarter. AGNC noted that it "repositioned the portfolio during the quarter into lower coupon MBS and lower loan balance and HARP securities, which are less susceptible to prepayment risk, reducing the impact of the decline in long-term interest rates on the company's prepayment forecast."
Here and now, whether or not Annaly's prepayment rate increased, the company may have also simply come to the conclusion that acquiring more agency paper is risky and that the company is better off holding onto what it can from its own already existing portfolio. If it is true that Annaly is at a discount to book, or even less of a premium than the paper available through the market, buying its own shares could be the cheapest option.
Moreover, repurchasing shares may allow Annaly to maintain its dividend by reducing the number of shares to which it must pay out. Not only will this purchases create additional demand for Annaly's shares, but also each share of NLY that NLY acquires becomes treasury stock that is not eligible for a dividend. With Annaly paying nearly 13%, repurchasing $1.5 billion in equity would mean that maintaining the dividend for one year would decrease the total payout to shareholders by $195 million. This means that even if Annaly earned less income in the future due to continuing spread narrowing, its yield could stay the same or even increase.
In all, NLY investors should be happy with this decision by NLY management. This plan should immediately result in some share price appreciation, while simultaneously reducing agency RMBS related risks to shareholders and also adding stability to the dividend.