Annaly Capital Management And Yield Spread

| About: Annaly Capital (NLY)
This article is now exclusive for PRO subscribers.

Summary

There are several types of spreads for mortgage REITs, but one most investors ignore is the Treasury to LIBOR swap spread.

For years, analysts believed LIBOR would not fall under Treasury rates, but LIBOR rates are lower and have been lower for quite a while.

The lower LIBOR rates effectively allow the mortgage REITs to lock in financing beneath the “risk-free rate”.

When LIBOR rates move up relative to Treasury yields, it creates an increase in book value, but it weakens the expected savings on hedging.

I’m projecting a significant decline in book value per share, but the Treasury to LIBOR spread is offsetting a small part of the other losses.

Investors in Annaly Capital Management (NYSE:NLY) need to understand the implications of yield spreads. This can be a complicated topic for discussion, but investors that don't understand it are setting themselves up for failure. Because of the huge dividends, many investors may simply think of it as a "buy and hold" investment. That is a fine strategy for them to use, so long as they know how to find a solid entry point. Because I manage my positions more actively, I also look for the strong exit points.

Spreads Upon Spreads

When I start talking about yield spreads, there are several possible areas for emphasis. I could be talking about the net interest spread, the spreads between different asset classes, or even the way an mREIT accounts for interest income since that can have a significant impact on spreads.

This article is going to tackle an area that many investors completely ignore. This piece is going into the Treasury to LIBOR spread. The reason this matters is because of the impact it can have on future earnings and the impact a shift in the spread has on current book values.

Simplifying the Spread

The spread on these two interest rates can be measured at many points along the yield curve, but I'm going to emphasize the 7-year rate because I believe the 7-year swap is a very useful hedge for a mortgage REIT like Annaly Capital Management. The mREITs that allocate heavily to fixed-rate RMBS, especially those with 30-year loans, may create a significant portion of their hedging portfolio using swaps with durations around 7 years.

Bringing Out a Chart

I brought out a chart in the last article to demonstrate when NLY was attractive by looking at the price to book value ratios and the steepness of the yield curve. However, relying on a measure like the steepness of the yield curve can be misleading if we are not accounting for the way the individual mortgage REIT is hedging their interest rate exposure. If the mortgage REIT doesn't want to take on much "duration" risk, then they would hedge heavily and the benefits of a steeper yield curve are much weaker.

The major column for this chart is the one labeled "7 Year Swap Minus 7 Year Treasury". The blue coloring at the end of 2012 is there to indicate that the spread between the two had just fallen significantly.

Analysts assumed that LIBOR rates would not fall under Treasury rates because hedge funds would immediately solve the problem with arbitrage trading. Unfortunately, that theory relied on the ability to borrow at the risk-free rate with unlimited leverage. Clearly, that is not the case.

Economic theories are great in theory and the majority of them work fairly well. However, theories regarding borrowing at the risk-free rate and theories that rely on perfect competition are ripe for errors because in the real world neither of those factors are frequently observed.

So in late 2013, we saw a fairly thin spread, and investors who expected the spread to widen would assume that the book value would gain in the near future.

To an extent, they were right. The spreads did expand in the near future, but the Taper Tantrum in Q2 of 2013 smashed book value and overwhelmed the gains to book value from that spread getting wider.

When LIBOR Rates Fall Below Treasury Rates

The impact of the LIBOR rates going under the Treasury rates was a book value loss for the mortgage REITs. However, it also implies that new hedges can be locked in at lower rates. Theoretically then, the mortgage REIT could borrow at less than the "risk free rate." They would be stuck using repurchase agreements and may need to pay something around the Treasury yield plus 5 basis points, but they would be locking in the longer rate at a level materially below the Treasury rate. If the swap is running 13 basis points below the treasury rate and the mREIT only needs to pay 5 basis points above the short-term LIBOR rate when borrowing, the net result would be borrowing at about 8 basis points under the longer-term Treasury rate. The ability to borrow below the risk-free rate is an example of economic theory being inaccurate, but it is important to point out that unlimited leverage still does not exist.

In a nutshell: LIBOR swap rates were materially higher than Treasury rates; that was a problem for book value. When the rates fell below Treasury rates, it was painful for book value, but positive for future earnings.

The latest values, depending on which source is used, will run around 8 to 10 basis points of spread between the two rates. The shrinking spread here should create a small gain for book value, but it is a negative for future earnings.

Implications

The impact on future earnings from a movement of only a few basis points won't be huge. It should be relatively small unless the mortgage REIT opts to increase leverage in assets and hedge against the duration risk. However, if the rates do expand back to where they were before, it would put some downward pressure on book value. How much pressure? For a change of 5 basis points on a 7-year security, we would be looking at about .35% of the notional value on the hedge. How much does that pressure book value per share? It depends on the level of hedges the mortgage REIT is using, but they usually won't run very heavy on hedges at 7 years or longer. Anywhere in the range of .3% to 1% could be reasonable estimates depending on how the movements spread through the yield curve.

Simple Interpretation

If we really want to boil this down to a simple concept, we can do that. If the LIBOR rate is significantly below the Treasury rate, then all else equal, it would make sense to be paying higher price to book value ratios. Allow me to emphasize that the all else equal clause there is extremely important. This is one factor among several that can influence future returns to shareholders.

Rating

My rating on NLY is sitting at neutral. Based on the latest prices, if book value had not been damaged, I would see a large enough discount to make it an appealing entry point. Due to a significant decline in projected book value, I don't see that discount here.

Want some estimates on the book value? I'll get some public pieces done with more data on current BV estimates. I've already got the numbers and comparable discounts posted in a subscriber article.

Conclusion

There will be a great deal of talk about Core EPS and normalized Core EPS in the months to follow. Investors will have to comprehend the several different types of spreads. In preparation for that coverage, I want investors to understand the concept of the Treasury to LIBOR swap spread and what it means for future earnings and book value movements.

If the LIBOR rate is materially below Treasuries, it means the mREIT is able to effectively reduce their cost of funds below the "risk-free rate" for that period. If the LIBOR rate increases, the mortgage REIT won't be able to initiate new swaps at that old rate, but they would see the gain in book value. Consequently, the lower LIBOR rates are one factor that can help to stack the deck in favor of the investor.

The Mortgage REIT Forum is the most effective way for me to get my research to investors immediately. Due to the costs of running the system and the time required to prepare the pieces, I intend to raise rates in January 2017, but I am still allowing subscribers to automatically lock in their rates when they purchase a subscription. Those subscriptions are only $240/year if you sign up during December 2016. If you're thinking about it, why not check out the reviews from my subscribers. The Mortgage REIT Forum averages 3 articles per week. One provides updated book value estimates for several mortgage REITs and includes my ratings (adjusted each week). The second article rates the different preferred shares and shows investors which ones are offering the best bargains. The third is used to highlight individual stocks and market failures or to provide a sneak preview on the articles I'm planning to publish over the next couple weeks.

Disclosure: I am/we are long NLY-C, NLY-D.

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. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. 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. Tipranks: Neutral on NLY.