Annaly Capital Management Preferred Shares: 7.5% Yield

| About: Annaly Capital (NLY)
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Annaly Capital generates enough income to comfortably cover the preferred dividend.

The Hatteras Financial acquisition will significantly boost income and the equity cushion.

Dilution is not a concern to preferred shareholders. Less cash paid for the acquisition means that more can be used to protect the preferred dividend.

Annaly Capital is returning a lot of cash to common shareholders.

However, the existing equity cushion is so large that preferred shareholders can get out long before the equity cushion completely depletes.

Read my guide to high yield investments for some background on the process.

Today we'll be looking at another preferred stock for the Seven Percenter List. You can find all the securities analyzed to date at the very bottom of the article.

Many investors have chosen to invest in Annaly Capital's (NYSE:NLY) common stock for its yield, which is a whopping 11% right now. With such a high yield, the common stock is subjected to significant risks. You can read more about it in my previous article. But will the preferred dividend be safe? Let's see whether Annaly's preferred shares can hold up to scrutiny (NLY.PRA, NLY.PRC, NLY.PRD).

In many ways, Annaly Capital is very similar to American Capital Agency (NASDAQ:AGNC). Both companies are taking advantage of the carry trade opportunity presented by the yield curve. Long-term MBS assets are financed through cheap repo agreements, allowing Annaly to earn a spread as a result. In the face of rising interest rates, the company recently acquired Hatteras Financial (NYSE:HTS) to shift its asset allocation. As we will find out later, this will have a big impact on the risk of our preferred shares, which are currently yielding around 7.5%.

The first step is to establish the company's profitability. Does Annaly Capital generate profits? Absolutely. In my analysis of American Capital Agency, I mentioned that GAAP EPS is not reflective of an mREIT's earning power due to one-time charges. We'll be looking at the spread instead. Net interest spread was 0.36% in Q1. After adjusting for leverage, the effective spread was 0.58%, translating to $411 million of annual income from the $71 billion investment portfolio. After deducting $192 million of management fees, the final total comes out to $219 million, which comfortably covers the annual preferred dividend of $72 million. Now we know that the preferred dividend is a return on capital.

That was how the company looked like at the end of Q1. As Annaly Capital will absorb Hatteras Financial, it's important for us to look at the impact of that transaction as well. The Hatteras transaction will improve the attractiveness of the preferred shares in two ways: 1) increased earnings and 2) higher equity cushion.

Higher Earnings

With an annual yield of 2.06% and effective cost of funds of 1.44%, Hatteras can generate $91 million of income annually based on the $12.52 billion interest earning portfolio at the end of Q1. Hatteras also earns some income from servicing mortgages, totaling $20 million in Q1, which annualizes to $80 million per year. Operating expenses will cost $70 million per year based on Q1 results. Adding up the above, we get a total income of $101 million per year from Hatteras, making the grand total (Annaly and Hatteras) $320 million.

We also have to make an adjustment to our preferred dividend calculation because Annaly will assume the preferred shares from Hatteras, so we have to add another $22 million, bring the total annual preferred dividend to $94 million. Though this transaction, Annaly has improved both the preferred dividend coverage (3.0x to 3.4x) and the absolute value of the income cushion ($147 million to $226 million).

Larger Equity Cushion

The structure of the deal also greatly increased the equity cushion for preferred shareholders. The price paid was 0.85x the book value and only 35% will be in cash. As far as the interest of a preferred shareholder goes, a dollar that stays in the company is a dollar that can be used to pay the dividend. Note that the same does not apply to common shareholders due to dilution. In exchange for $526 million of cash, preferred shareholders will receive $2 billion of additional padding (net effect of $1.5 billion), bringing the total equity cushion to $12 billion after accounting for the liquidation preference for both companies.


Just like American Capital Agency, Annaly's earnings will deteriorate as Fed raises interest rates. However, unlike American Capital Agency, Annaly has repositioned its portfolio through the Hatteras acquisition to better prepare for future rate increases (read Big Changes Are Coming). While the majority of its portfolio still consists of fixed-rate investments, doing something is better than doing nothing. Because the portfolio is shifting, it's difficult to say how much Annaly Capital will earn in the future. However, I don't think that is something that preferred shareholders need to worry about yet. Because there is a large equity cushion ($12 billion) provided by the common stock and the company isn't losing money, the preferred stocks are investable. Finally, as is the case with American Capital Agency, it's important to keep an eye on the equity cushion as Annaly Capital is also busy returning capital to common shareholders (currently at a pace of $1.6 billion per year). While the equity cushion will deteriorate as time goes on under the current pace of common dividend payouts, it will still take some time to fully deplete given its sheer size ($12 billion), giving preferred shareholders more than enough time to react.


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