Annaly Capital (NYSE:NLY) has been a name I have covered in depth. After the company recently reported its third quarter earnings, I decided to pen an article to argue why I am not backing away from the stock. Sure it is a cyclical business. Timing buys in this stock over the long term is key. We buy stock in mREITs for one of two reasons: to reinvest dividends over time to compound our investments, or to generate a source of income. Despite the stock shedding 40%-plus since its highs, management remains effective and the current dividend is safe. The company is on the mend and is out-competing many of its mREIT brethren. Its quarter was quite strong, with few weak points, as I discussed in my most recent article. However, few have discussed the actual portfolio holdings of the company and how they have changed over time. I feel this is an important topic because an mREIT's success can hinge on its asset mix and subsequent performance. Thus the purpose of this article is to discuss this rather dry, but critical topic to understand what management is up to and how that can potentially impact future earnings. In other words, just how does this company makes it money?
As you know, NLY has investment securities in both Agency mortgage backed securities and Agency debentures. It recently moved into commercial real estate as well. It also protects its portfolio and book value (or should I say attempts to) by undergoing so-called hedging strategies. Sometimes this pays off, other times it doesn't. Why are interest rates so important? It's because the value of NLY's holdings is directly impacted by the values of mortgage holdings. As rates rise, it's due to the value of underlying securities falling. Further, it can narrow the spread, which mREITs rely on to generate income. The asset mix will dictate the impact that fluctuating rates might have.
Let's start with the company's investment in Agency mortgage backed securities and Agency debentures. The value of these investments has essentially been flat for the past few quarters. The investments were $82.8 billion at the end of Q3 2014, compared to $82.4 billion at the end of Q2 2014 and $83.0 billion at the end of Q3 2013. It's important to note that all of these investments are in Fannie Mae, Freddie Mac and Ginnie Mae mortgage backed securities and debentures. Like many competitors, much of the portfolio is in fixed rate Agency mortgage backed securities and debentures. In fact 95% of these investments were in fixed rate Agency mortgage backed securities and debentures at the end of Q3 2013, while adjustable rate Agency mortgage backed securities and debentures comprised the other 5%
Another important consideration is what duration are the fixed rate investments? I prefer a weighting toward longer-term holdings (i.e., 30 years). Well, 82% of Annaly's fixed rate investments are 30 years or higher. Over time the company has weighted more to longer term than short term, which I feel is a smart play. Further, just 8% of fixed rate securities were riskier short-term holdings of 15 years or less. While the adjustable rate holdings are just 5% of the portfolio (a good thing), I will also highlight that the bulk of them are in short-duration maturities of two years or less.
Figure 1. Agency and Mortgage Backed Securities Debentures Overview At The End of the Third Quarter, 2014
Source: Annaly Capital Q3 Stockholder Supplement
One of the big issues that can impact earnings potential is an mREIT's constant prepayment rate. This is the rate at which principal is expected to be prepaid in the given time period. That is, if a certain mortgage loan pool has a constant prepayment rate of 15%, then 15% of the existing pool principal outstanding is expected to prepay. The constant prepayment rate did tick up in the quarter but remains below 10%. I personally start to be uneasy when it crosses this threshold. Some of the best in the business in this category come in around 5%, whereas those failing in this category tend to be around 20%. For Annaly for the constant prepayment rate ticked up to 9% from 7% last quarter, following the general trend of the sector.
What about the commercial portfolio? I have been adamant that I like this diversification. So where is the company putting its money? Well Annaly's commercial investment portfolio consists of commercial real estate investments and corporate debt (figure 2). Commercial real estate debt and preferred equity, including securitized loans, totaled $1.6 billion and investments in commercial real estate totaled $73.8 million at the end of the quarter. The weighted average yield on commercial real estate debt and preferred equity was 9.23% in the quarter. Annaly has also recently expanded its commercial holdings. It just most recently closed the acquisition of a portfolio of grocery anchored shopping centers. The new portfolio addition consists of eleven properties totaling 1.48 million square feet. While the commercial portfolio has been around 11% of the portfolio, I wouldn't be surprised to see Annaly ramp up a bit here, given that more residential mREIT companies are now getting in the commercial real estate game. I take this as a sign that these companies see a turn in commercial real estate market. Further, a survey of commercial property executives indicates that sentiment is very positive, with commercial activity expected to increase heavily over the next few years. I suspect Annaly may want to take advantage.
Figure 2. Annaly Capital's Commercial Real Estate Investments, As of the End of the Third Quarter, 2014
Source: Annaly Capital Q3 Stockholder Supplement
Finally, what about the all-important hedging approach? Recall hedging is done to protect net asset value. Further understand that interest rate swaps and swaptions are used by mREITs to offset the damaging impact of general rises in interest rates. The company pays a fixed rate and then receives a floating rate on the notional amount of the swaps, and the intended effect of these swaps is to lock in a cost of financing. At the close of Q3 2014, Annaly had outstanding interest rate swaps of $31.5 billion and interest rate swaptions of $1.9 billion, which only made up 48% of its existing repurchase agreements. This percentage was unchanged from Q2 2014, but is down substantially from the 85% of repurchase agreements at the end of Q3 2014. This is a direct reflection of the portfolio rebalancing efforts that I have discussed in numerous articles since 2013 on the company.
In summation, this article provides necessary information to better understand the risks that management may or may not be taking. The reduction in hedging reflects confidence in the interest rate stability in the near future by management. The percentage of the portfolio dedicated to commercial real estate remains at 11%, but I suspect this could creep up in the future. Further, the company is primarily invested in Agency securities that are fixed rate, and has increased its bias toward longer duration (i.e., 30-year-plus) holdings, which I think is a conservative but wise play. I reiterate that I am long the stock and feel it is well-positioned and able to adapt to changing environments to continue providing shareholders with income for years to come.
Disclosure: The author is long NLY.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.