Residential mortgage REITs have been rocked since May 1, 2019. It’s been brutal throughout the sector, but the sale on Annaly Capital Management (NLY) caught our eye. We’ve seen two events occurring at roughly the same time, each of which is pressuring share prices:
Dividend cut previews
We discussed the dividend cut previews in our prior article on NLY.
The analysis here comes from our recent Residential Mortgage REIT Sector Update for subscribers of The REIT Forum.
Before getting into this article, we want to highlight a couple of terms. Specifically, you will see terms like “widen” and “tighten” used extensively. These terms refer to the difference between the expected yield on assets at recent prices and the cost to hedge those assets.
These metrics do not have to do with the shape of the yield curve. The shape of the yield curve can become “flatter” or “steeper,” but it does not “widen” or “tighten.” We will not be discussing the shape of the yield curve at any point in this piece as it has not changed substantially in the last couple of months.
What Does Spread Widening Do?
When spreads widen, book value declines. However, the mortgage REITs gain a much better environment for reinvesting their cash flows. If spreads are wide, a mortgage REIT can hedge most of their “Duration” risk.
Duration risk is the risk of interest rates moving higher or lower. A REIT can hedge against duration risk through a handful of derivatives. The most widely used is the “LIBOR Swap.”
If the spreads are wide, it means the REIT can enter into LIBOR swaps where they pay a fixed-rate that is materially lower than the expected yield on their assets.
During Q4 of 2018, we witnessed spread widening. It significantly reduced book value for many mortgage REITs.
During Q1 2019, we witnessed spread tightening. It brought book values higher for most mortgage REITs.
During Q2 2019 - so far, we witnessed spread widening again. Consequently, we expect book values to be lower.
That's OK, we are willing to buy shares after book value falls if spreads are wider and the price-to-book ratio is lower. That's precisely what we have. Consequently, this looks like a great time to be bullish.
We Weren't Always Bullish
We took a significant deal of criticism for prior bearish stances. This separates us from authors who simply maintain a bullish stance. Investing is a matter of finding value, and that's where we have succeeded repeatedly.
On 10/25/2017, we wrote:
The following chart demonstrates returns with dividends reinvested and the change in the share price (excludes dividends). It starts with the day prior to publication:
Even if the investor reinvested all their dividends, the position value would be down 10.6%. The dividends were great, but the price declined by 24.67%.
Remind me: Has 2019 been a pretty strong market?
Using Preferred Shares as the Primary Choice
We also had an article about the same time suggesting investors:
We only go into the common shares of the mortgage REITs when we spot an opportunity where the price should back higher. If we don't have a solid reason to believe that we will earn a significant return for taking on that risk, we stick to the preferred shares. Earning a couple of extra points of yield isn't worth it.
Since the common dividend was reduced from $.30 to $.25 per quarter, investors who ignored our advice and bought the common shares at $12.40 now have an 8.06% yield on cost ($1.00/$12.40). They had a higher income for 18 months, but now most of that is gone.
If the investor had purchased NLY-C (NLY.PC) or NLY-D (NLY.PD) instead, they could be swapping for NLY today and have about 23% more shares of NLY than an investor who bought in October 2017 and reinvested all their dividends.
NLY's book value should be down for Q2 2019, but it shouldn't be down near as much as the price. We witnessed NLY plunge following their "surprising" announcement of a dividend cut. It wasn't a surprise to investors who genuinely understood precisely how mortgage REITs work. Expect a reduction in book value and expect the new dividend at $.25 to be maintained for at least a year, probably two. Beyond that, there's too much that can change for a residential mortgage REIT for projections to carry much weight. With shares trading around $9, they've entered value territory.
We've been bearish before, but we're in the bull camp today.
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Disclosure: I am/we are long NLY, NLY.PF. 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.