AGNC - Annaly Capital: A Maleficent 14% Yield

2023-10-11 04:27:13 ET

Summary

• Annaly Capital Management's stock is down 13.37% since our last article.
• The company is likely to sell assets on the way down to maintain leverage requirements.
• The yield is seductive, but the distribution will be cut again. Chasing the yield will create more harm than good.

Maleficent: doing evil or harm

Source: Dictionary

It is always nice to look at the actual performance card of a trade. Sometimes it looks good and sometimes it teaches you a good lesson. Annaly Capital Management (NLY) has been a good one. The stock is down 13.37% and even that singular distribution did not fluff up that poor return.

With Q3-2023 results coming up soon, we update our thesis and tell you why you should sell this even here.

Throw The Book At Them

With a few exceptions, NLY tends to get priced near tangible book value. Sure, there are those with a reluctance for capital preservation who will buy regardless of the price, but over the long haul, the stock follows the tangible book value up or down.

With the current value of the stock at $18.07, one might be tempted to believe this is cheap. That comes from the fact that NLY, unlike an ETF or a CEF, updates its tangible book value only once a quarter. We will find out soon as to what actually happened to its tangible book value, but based on the absolute blowout in the two metrics things revolve around, we will wager that the book value will be down.

Sure, both the 30-year mortgage rate and the 10-year treasury rate moved in the same direction but the spread widened this quarter slightly. NLY's hedges on its short term funding rates will also flow into income this quarter and be eaten away. Calculating an exact book value is a very complex exercise with enough of a margin for error to make it relatively meaningless. We can give you a range, but that range would be quite wide and not useful for trading. It also assumes that there were notable actions taken during the quarter by management that could make the loss in book value worse or perhaps reduce it a tad. But the move this quarter is so large that it would be surprising if tangible book value dropped less than 10%. So we are likely looking at somewhere near $17.00 when all is said and done.

Deleveraging Once More

As we have pointed out before, NLY and AGNC Investment (AGNC) and pretty much every mortgage REIT that would like to stay in business, will sell assets on the way down. If this sounds like a perverse buy high-sell-low strategy, it is probably because it is. They have to maintain their leverage requirements and that requires selling on the way down. Now how much of their assets they sell on the way down depends on how leveraged they were to begin with. Over the last 4 years, total assets are down about 40% in this group. Those are the assets they sold at losses despite the tidal wave of analysts telling you "it is the best time to buy".

It is the best time for you to buy the stock while the company keeps selling the assets you want to indirectly own. Sounds legit. With NLY you will see this again in this quarter and depending on when they sold these assets, it will make the end result better or worse.

Dividend Getting Cut Once More

The dividend (or distribution for the purists) is a function of the tangible book value. There is almost no other self-evident truth in mortgage REIT land that speaks as loudly as this one. Investors fight and try to deny this at every single turn because it requires them to accept that they put money into this awful asset class. Fair enough. You do you. But from our perspective, you can only pay from tangible book value and money does not grow on trees (Enviva's (EVA) stock performance should seal that debate ). NLY's tangible book value suggests that the dividend is likely to go to about 12% of tangible book or to $1.94 pretty soon.

There is a lot of downside to this forecast as the inverted curve is making it very hard for NLY to even generate normal amounts of income. Distributable earnings is collapsing and net interest margin is imploding.

By end of Q4-2023, we expect this (earnings available for distribution) to be under 55 cents. So the next cut is coming, regardless of what anyone else tells you.

Verdict

Over the last 13 years, NLY's total return has been 23.90%. That works to about 1.65% annually.

Sure there are peaks and troughs there and sure you will find everyone apparently buying at the exact bottom on March 2020 showing up in the comment stream. The counterpoint is that for them to buy someone must have sold at the exact moment. So we really cannot comment on individual returns, just the total return of the stock which has been pathetic. We love the idea that the past is not the future. But the headwinds that NLY faces have been getting worse as we have repeatedly warned about in the last year. Yes mortgage backed securities are getting cheap.

But you are not buying mortgage backed securities with NLY. You are buying 6-7X leveraged investment in mortgage backed securities.

You are explicitly betting that rates will be cut and the yield curve will steepen perfectly. Maybe it works out. Maybe it plays like 2008 where NLY tanked 40% after the Fed started aggressive easing.

Perhaps this plays like the 1970s where the rate cuts were modest even during the recession. We don't know. What we do know is that there is reason that NLY has done so poorly over the last 13 years. There is a reason that mortgage REITs have delivered negative price returns on every single longer term timeframe. There is a reason that over 20 years total returns including distributions has been under 1% for this asset class.

Over the last 40 years, the price returns on the mortgage REIT index have been negative 7.55% annually. That means that if you invested $100, you would have $4.50 left today. Assuming you get a 14% yield on that, it works to a 0.63% yield on your original investment. This is what it probably means to chase pennies in front of a steamroller.

We wish someone would put up calculations for the total returns if you actually paid tax on the large distributions and had large losses on your stock price. None of that would be pretty. But if you are looking at 14% yield right now and it is calling out to you, go ahead and ignore all the evidence. We won't. We rate this a Sell and think total returns will be negative a year out.

The Best Choice

With NLY staying out is always a good choice, but if you really are in it for the yield, the preferred shares offer some interesting choices.

1) Annaly Capital Management, Inc. 6.95% PFD SER F ( NLY.PR.F ) currently floating.

2) Annaly Capital Management, Inc. 6.50% PFD SER G ( NLY.PR.G ) currently floating.

3) Annaly Capital Management, Inc. 6.75% PFD SER I ( NLY.PR.I ) will start floating at the end of June 2024 at 3 month LIBOR plus 4.989%.

All three will be using SOFR.

These dividends are very high but obviously they will get cut if a rate cut cycle starts. So these are better suited for the "higher for longer" crowd. We will note here that all the preferred shares have done far better than the common stock since they came into existence.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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