Co-produced with Beyond Saving and PendragonY for High Dividend Opportunities
Summary
In June, we looked at Annaly Capital Management (NYSE:NLY) in "Annaly Capital: An 11% Yield Today, That Could Double In A Recession". NLY is an mREIT that primarily focuses on Agency MBS- residential mortgage-backed securities that are issued and guaranteed by government-sponsored enterprises (GSEs). We observed how during previous recessions, agency MBS had performed exceptionally well, causing NLY to experience rising prices and rising dividends when the general market was experiencing losses.
In that article, we said,
With recent declines, we believe now is the time to invest in this potentially powerful hedge. We can reasonably expect market-matching performance as the bull market enters its twilight and in 2-5 years, whenever the bear market starts, we can expect it to experience price and dividend growth as the rest of the market pulls back.”
Since that article, NLY common has had a total return of 0.36%, while the S&P 500 has declined by 3.09%. It has been a crazy couple of months for Mr. Market and especially crazy for interest rates and interest rate sensitive investments.
Source: US 10 Year Treasury Yield CNBC
The Federal Reserve reduced target rates 25 bps at their July meeting, hopes for some stability were soon dashed as rhetoric over the trade war heated up and US treasuries had a very strong rally.
Agency MBS utilize a lot of leverage, which necessitates the use of a lot of hedging. As a result, the ideal environment of mREITs is one where interest rates are relatively stable. Preferably, with the short end of the curve (where they borrow) low and the long-end of the curve (the yield they receive) slightly increasing.
So with interest rates coming down, we have some good impacts on NLY, as well as some negative impacts. While short-term there will be turbulence, the long term will be very beneficial. We remain bullish on NLY common shares and continue to hold the belief described above, that it will experience generally market-matching performance as the bull market continues and will outperform when we enter a full bear market.
In addition to the common shares, we like the preferred stock of NLY. They are also well suited for more conservative investors or those who want minimum price volatility. With 87.2 million shares outstanding, preferred shares make up $2.18 billion of NLY's capital structure. With dividends that are easily covered by cash-flow and value that is easily covered by assets, the preferred shares offer a more stable way to enjoy consistent cash-flow.
The Good
Source: NY Fed, Chart HDO
When the Federal Reserve reduced the target rate, it had an immediate impact on Repo Rates, the rates upon which mREIT borrowing is based. After trending between 2.4% and 2.6% for most of the year, they dropped below 2.2%.
Source: NLY Supplemental
NLY has seen their average debt cost increasing as a result of repo-rates remaining inflated. This is the primary driver of their declining core earnings. With borrowing costs reduced, we should see some much-needed relief.
We will see some benefit of this in Q3, and even more in Q4, especially if the Fed cuts rates again before the end of the year. This will be a powerful tailwind for cash-flow and core-earnings.
The Bad
As discussed about, interest rate volatility creates some headwinds for Agency mREITs.
It does this primarily in three ways,
- Declining mortgage rates encourage consumers to refinance.
- The spread between agency-MBS and treasuries tends to widen when treasuries rally quickly. A wide spread usually results in declining BV (book value).
- Cost of hedging also rises in times of high volatility.
#1 is a headwind against core earnings. GSEs guarantee the principal of the mortgages; they do not guarantee the interest payments. So when consumers are refinancing, they pay off the existing mortgage reducing the total amount of interest that will be received.
Source: NLY Q2 10-Q
This impact is calculated as CPR (Conditional Pre-payment Rate), which is the percentage of principal that is expected to be prepaid in a year. As mortgage rates declined, the projected long-term CPR increased from 9.1% to 14.5% over the past year. The impact is that this lowers the effective yield of the portfolio. We expect that the decline in borrowing rates will have a much larger impact than prepayments, but it should be recognized that this factor will be a headwind.
#2 is the decline in book value, which is caused by the hedging that mREITs use to protect themselves from rising rates. As rates decline, agency MBS prices go up. This has been occurring as agency MBS have spent most of the year above their 50-day moving average.
Source: Mortgage News Daily
This results in an increase of NLY's asset values. However, on the other side of the coin, NLY has short positions on US Treasuries.
Source: NLY Supplemental
As Treasuries rally, these short positions decline. Typically, when treasuries rally very quickly, MBS prices fail to keep pace. The result is a net loss, that while mostly unrealized, will cause a decline in book value.
#3 hurts NLY as in times of heightened volatility, hedging costs more as the counterparty assumes higher risk and the spreads are higher as well.
Based on these, we believe that common shareholders should be prepared for another slight decline in BV in Q3. But longer term, the NLY common shares are a great buy-and-hold type of dividend stock. With a yield of 11.1% and a very solid future outlook, the common shares are a very solid buy.
Preferred Options
Over the long-term, we believe that NLY common will more or less keep pace with the remaining bull market and will perform strongly when the Fed becomes more aggressive about cutting the target rate. We believe that the dividend will be maintained and eventually raised as interest rate volatility declines. However, investors could see some volatility.
NLY preferred shares offer an opportunity to avoid some of that volatility, while still getting a strong yield. NLY preferred shares enjoy strong asset coverage of about 7.2x by book value.
Source: NLY Q2 10-Q
NLY's preferred shares are supported by a very large pool of unencumbered assets, currently valued at $7.84 billion. The bulk of NLY's debt is non-recourse, meaning that the lenders can only take the collateral and have no rights to any of NLY's assets beyond that collateral. Unencumbered assets alone provide 3.6x coverage of NLY's preferred shares at par.
The bulk of those unencumbered assets are agency MBS, which are extremely liquid and can be sold quickly in large amounts.
The preferred dividend is only $32.4 million/quarter, easily covered by core earnings, even when there is a disappointing quarter like Q2. In Q2, NLY's core earnings covered the preferred dividends 7.74x, and we expect core earnings to increase substantially.
To put that in perspective, with the reduced common dividend, NLY is still paying $364 million/quarter. An amount that would have to be reduced to $0 before the preferred dividends could be suspended. This provides a very large cash-flow cushion for the preferred shares and ensures that the preferred dividend is very secure.
Which Preferred?
NLY has 4 preferred issues outstanding.
- Annaly Capital Management, 7.50% Series D Cumul Redeem Preferred Stock (NLY.PD) Yield 7.3%
- Annaly Capital Management, 6.95% Series F Fix/Float Cumul Redeem Preferred Stock (NLY.PF) - Yield 6.7%
- Annaly Capital Management, 6.50% Series G Fix/Float Cumul Redeem Preferred Stock (NLY.PG) - Yield 6.5%
- Annaly Capital Management, 6.75% Series I Fixed/Float Cumul Red Preferred Stock (NLY.PI) - Yield 6.6%
NLY.PD is the only one that is currently callable. Earlier this year, NLY redeemed two preferred issues, and we believe there is a very strong possibility that NLY.PD will be called within 1-year or sooner. So while NLY.PD offers the highest immediate yield, we do not believe that it offers the best total return.
The other 3 issues all convert to floating rates if they are not called on the call date.
We slightly favor NLY.PG and NLY.PI .
- NLY.PG is on only preferred stock that trades below par value of $25 a share and is very attractive.
- NLY.PI offers a slightly lower current yield, it offers a superior yield-to-call, as well as a more generous floating rate than NLY.PG. Since we intend to hold this investment for a long time, we like the call date being further out.
Conclusion
When interest rates are highly volatile, it creates headwinds and uncertainty that are usually negative for mREITs. We continue to be confident in our investment in NLY common shares and view the current dip as a buying opportunity. While BV might decline slightly, we expect that lower borrowing rates will improve core-earnings. NLY common shares will be able to easily maintain their 11% yield and as the fed gets more aggressive at cutting rates, they stand to benefit. This is also a resilient investment that could double in price in case we hit a recession.
We also like the preferred shares of NLY which are a very attractive option. With asset coverage and core-earnings coverage both in excess of 7x (or 700%), NLY's preferred equity is very secure, and suitable for conservative investors who are looking for safe income.
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