Annaly Capital Management (NYSE:NLY) trades at a substantial discount to book value. The number usually runs in the range of 18% to 25%. Because the discount to book value is an important part of the analysis of an mREIT, it warrants frequent discussion. Rather than simply analyzing the amount of the discount at the moment, I want to look at why Annaly Capital Management trades at a discount. It is critical for investors to fundamentally understand why the discounts to book value exist so they can move past the appearance of a market failure.
Discounts To Book
I believe discounts to book are often viewed in an isolated sense. The problem with analyzing the discount for a single mREIT is that it creates a misleading image that suggests that each individual mREIT is substantially undervalued. While the market for mREITs does make material pricing mistakes, it would be absurd to suggest that the market has thoroughly mispriced the entire sector for over a year.
The most useful applications of discount to book are to look for liquidation opportunities or to find relative mispricing so we can predict corrections in some of the smaller mREITs. The smaller mREITs tend to be less efficiently priced by the market, which results in better opportunities for risk-adjusted returns. The challenge with using liquidation opportunities as a smaller investor is the inherent problem in extracting the book value. To actually get liquidation, investors will generally require an activist to run their own slate of directors. Unfortunately such an event includes both a chance of failure and the cost of management fees to terminate the management contract. The combination means the discount to book must be fairly substantial before the activists are attracted to the opportunity.
Sometimes Different Discounts Are Appropriate
Since we know that as investors we won't be able to forcefully extract the book value from an investment, the real value in the mREIT must be determined by something beyond book value. In the short term, we can look for pair trades to generate profits from the relative mispricing of mREITs, but over the longer term, we (investors) are dependent upon the dividends.
If investors had the ability to extract the book value, there would be very little argument for shares ever trading below book value since shareholders would simply force a liquidation with the proceeds going to their account rather than selling the shares below book value.
I want to emphasize that this is a hypothetical example using rough figures from the current macroeconomic environment.
Let's say the expected yield on fixed-rate MBS assets is 2.5% with a short-term cost of financing of .5%. The unhedged spread between the two would be 2% and the mREIT would expect to earn an additional 2.5% off the assets funded with equity. If the mREIT were expected to run with 5 turns of leverage (5:1 debt to equity), we would expect the net interest income before hedging costs to be 12.5% of equity. If we assume some fairly significant hedges for assets that are funded with debt, we might suggest that the hedges would add another 1% to our funding costs for each turn of leverage. That would bring the spread between the two to a mere 1% and give us an expectation for net interest income after hedging costs to only run 7.5% of equity. If we assume a fairly standard 1.5% of equity going to operational costs, then the result would be 6% of equity.
Valuing The Return
Would you consider 6% return on equity to be a satisfactory return for investing in mREITs? I think most people would say that the level of expected return here would simply be too low. If the expected returns are too low, investors will simply avoid buying the mREITs until they see a more appealing opportunity. This is where the discount to book value comes in. If we assume book value of $10.00 in this scenario, then our expected income after all hedging costs and operational costs is simply going to be $.60. Since that is not satisfactory for investors, they sell off shares and the mREIT trades at a 20% or so discount to book value. The result is earning $.60 on an investment of $8.00 despite book value being $10.00.
Looking At Annaly Capital Management
By my estimates, at the end of the fourth quarter, book value per share should have been about $11.86. Rather than hedging all of their repurchase agreements, they were hedging 58% of the agreements. The ratio seems a little bit low, but Annaly Capital Management was using longer-duration swaps that allowed it to have a lower notional balance. The weighted average pay rate on the swaps was 2.26%, and the weighted average receive rate was .42%. The result was a net rate of 1.84%. In other words, that should add roughly 1.067% to the total net interest expense. That isn't too far off from the 1% figure I was ball parking earlier.
The simple math here is 1.84% * .58 = 1.0672%.
In a search for better net interest spreads, there will be several tactics employed by the mREITs. Some will take on material amounts of credit risk to get stronger yields on their assets. Those credit-sensitive assets are also less sensitive to rates, so they won't require as much hedging. This technique shows strong net interest spreads and allows substantially smaller levels of leverage. However, there are some unique challenges here. For instance, the necessary due diligence in this process will often require higher operating expenses than the typical 1.5% for an agency mREIT.
This is one of the areas that Annaly Capital Management is looking into for additional yield. By incorporating a small amount of non-agency MBS, it would be able to push the yield on the portfolio higher and justify closing out some swap positions. The spread would be larger, but it would be reasonable to expect lower levels of leverage under this strategy.
Another option many mREITs have considered is designing their hedge structure to reduce net interest payments. By avoiding a net interest payment on swaps, the mREIT is able to avoid passing these costs through "Core EPS," which makes it appear that their position is stronger. There are no free lunches, and the hedging costs must still show up somewhere else. This is one of the major reasons for the year I'm predicting declines in book value across the industry.
I've examined NLY quite a few times for this kind of hedging technique. In my opinion, Annaly uses these tactics less than many comparable mREITs.
Light On Hedges
Another option is for the mREITs to simply run light on hedges. This can materially improve the net interest income that would be available for shareholders, but it also means substantially more duration risk which will make portfolio values more volatile. Keep in mind that the volatility is not simply a short-term event. In this case, it would be entirely possible for the book value to be dramatically damaged. When the mREITs are concerned about short-term rates being increased, it forces them to use higher levels of hedges.
This is one area where I think we might see a little more risk taken. If the sector starts to believe that "lower for longer" is the real future of short-term rates, then I wouldn't be surprised to see hedging levels reduced at least moderately.
Alternative Hedging Techniques
Some mREITs use other methods such as IO strips, MSRs (mortgage servicing rights) and eMSRs (excess mortgage servicing rights) to generate negative duration for the portfolio. Each of these investments is expected to increase in value when rates move higher. Therefore, the mREIT could invest in these areas to generate more value. Ironically, the excess MSRs have done fairly well for Nationstar Mortgage Holdings (NYSE:NSM). It produced surprisingly solid yields while having negative duration.
Meanwhile most mREITs that are investing directly in MSRs have simply created an asset that losses cash in every single quarter. It is ironic that book value increases for the regular MSR as rates decrease. The argument is that a longer weighted average life for the assets means more cash flows, but how highly can investors value something that consistently loses money.
Two Harbors Investment Corp. (NYSE:TWO) is the one mREIT that appears to generate some positive income from their positions. It is worth noting that this is an area where analysts can disagree as it will depend on how costs are allocated. I think TWO is beating other mREITs in this area because of the economies of scale and keeping a fairly material margin on the MSRs.
How Annaly Capital Management Can Reach $.30 For Core EPS
Since Annaly isn't pushing a substantial portion of its costs around the Core EPS formula, it has to rely on some other factors. One of those factors is a normalized asset yield that ran between 2.8% and 2.9% over the last three quarters. Compared to 2.5%, this is materially better. To get to a 2.5% yield while using primarily agency MBS, the mREIT has to use some substantial exposure to the 30-year MBS because adjustable rate agency MBS and the 15-year fixed-rate agency MBS wouldn't provide high enough yields. If we adjust for adding .35% to the yield on assets with the 5 turns of leverage, the result is adding 6 times .35%, or 2.1% to the expected return on equity. That would bring us to expecting 8.1%, but Annaly Capital Management has been reporting around 9.6% to 10.3%. The extra yield comes from additional leverage which was often established using TBA securities.
Annaly Capital Management is looking at a few potential ways to improve their yield, but so far it still looks like both Annaly and the rest of the industry will need to continue trading at material discounts to book value. It still has a good shot of hitting around $.30 for normalized Core EPS figures. I'm expecting a trend of declining book values in 2016. NLY has a decent shot to have a smaller decline in book value than many peers since its dividend and normalized Core EPS are similar while Core EPS is incorporating most of the hedging costs. For the mREITs that are paying out around 100% of normalized Core EPS while passing hedging costs through book value, I would expect the decline in book values to be faster.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.