Annaly Mortgage (NYSE:NLY) and AGNC (NASDAQ:AGNC) are the 2 largest and best known mortgage REITs. AGNC is mostly GSE mortgage carry trade and NLY owns a mix of mortgage assets to include commercial mortgages, GSE mbs and non-GSE mbs. So be aware NLY is both credit and rate risk.
Both companies buy assets and fund them in repo markets, and employ hedges to reduce rate risk, and attempt to lever up the carry trade. I have owned both on and off over last 10-20 years and rarely have I suggested to sell them but I do now.
Mortgage REIT Valuation Metrics
Mortgage REITs (mREITs) tend to trade somewhere around book value. If they trade over book value, management usually does a secondary issuance since selling shares above book value actually increases BV, which is a desirable event. Doing so would also grows AUM which increases their management fees. Thus in general, one should seek to buy mREITs at discounts and sell ones at premiums to BV as typical secondary can knock price lower 3-5% and sometimes more.
In general, I value mREITs on a variety of factors but ability to maintain or grow book value is the top valuation metric. Net interest margins and amount of leverage used and history of management’s hedging ability all equally important .
Both these mREITs have traded as cheaply as 20% discounts to book value in last 5yrs and as high as 3-5% premiums to BV, and both have actively done secondaries over the last 12 months when their stocks trade above BV.
Non-Economic Secondaries Getting Done
Wednesday night, AGNC announced yet another secondary at a price of $17.27 vs an $18 BV as of 9/30/18 - 4% under book value. This is pure destruction of shareholder value in my opinion, and was enacted to increase assets under management. The last NLY secondary was mid-September at around $10.17 vs last reported BV of $10.20 at end of Q2
In short, these guys are pumping out deals that primarily benefit management's own wallets
But it gets worse than that.
Both companies talk about using sophisticated hedging models to preserve book value. But their BV history tells another story:
Q3 2013 Q3 2015 Q3 2018 5yr loss 3yr loss
NLY 12.59 11.88 9.99 21% 16%
AGNC 25.29 23.00 18.00 29% 22%
Clearly, the hedging is not working. Truth be told, nobody is running a traditional mortgage carry trade in a REIT and fully hedging out rate risk because to do so requires reducing the dividend to a level many retail buyers will run from. As well, retail is very focused on dividend yield and tends to ignore book value losses, leverage, etc .
As of Friday after noon, NLY is at just 99+% of BV and AGNC already recovering off its latest secondary and probably 2+% below BV.
I'm not sure why investors would want to own these names when they are losing BV like crazy, and at same time using that BV loss as a reason to pump out secondaries ? It's as if buyers are rewarding management for losing book value!
The story still gets worse. Due to 20yrs of declining rates, these names (as well as all traditional mREITs) are paying out their lowest cash dividends in their history in most cases. We also have the additional whammy of a flat yield curve which compresses NIMs (net interest margins), putting further pressure on earnings/ dividends .
It’s a toxic mix. Book values falling non-stop, earnings barely covering dividends, and nothing but dividend cuts in past 3 years for most part.
Yet despite all this, both these names are trading close to book value and have been doing secondaries (recently doing them UNDER book value). Long investors are set to never see their stock rise more than 2-3% before a big secondary is performed, while possibly seeing book value continue to drop 1-3% a quarter given we are still in rate hiking mode.
I see why retail investors might get lured in on the double digit yield, but look at the huge institutional holders of these names? I wonder what are their analysts thinking. Why would they keep buying the secondaries?
Investors looking for names to swap to would be advised to buy Ellington (NYSE:EARN). EARN is trading at 80% of BV, with almost all FNMA and FHLMC GSE bonds (no credit risk), and with support that Blackstone / Blackrock has quietly accumulated 26% of the shares.
A better idea might be to buy New Residential (NYSE:NRZ). They have grown BV almost 70% in last 5yrs since their IPO and have never cut their dividend. Their main asset (MSR’s) go up in value as rates rise & as mortgage refi’s decline
With Fed’s Evans out today calling for 4 more rate hikes, that will likely cause additional BV erosion at NLY and AGNC. Get out of them. Wait til rate hikes are over, and buy back in at cheaper levels later, or just buy far better names that are demonstrating abiilty to preserve book value.
Disclosure: I am/we are long NRZ EARN. 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.