AAIN - Annaly Capital's BV Sector Valuation And Dividend Sustainability Versus 19 MREIT Peers - Part 1 (Includes Recommendation For All Covered Peers As Of 6/9/2023)

2023-06-14 13:28:58 ET

Summary

• Part 1 of this article compares NLY’s recent investment composition, leverage, hedging coverage ratio, quarterly BV, economic return (loss), and current valuation to 19 mREIT peers.
• Due to what has occurred during the second quarter of 2023 (fluctuating rates/yields), understanding the composition of NLY’s MBS/investment and derivatives portfolio is crucial in understanding current/future performance.
• My current NLY BV projection and updated price target is in the “Conclusions Drawn” section. With the anticipated move higher in price, NLY is now deemed appropriately valued.
• I also provide a list of the mREIT covered stocks I currently believe are undervalued (a buy recommendation), overvalued (a sell recommendation), or appropriately valued (a hold recommendation).
• Providing sector-wide metrics allows readers to better understand which mREIT companies will likely outperform (or underperform) peers during specific types of interest rate environments.

Focus of Article:

The focus of part 1 of this article is to analyze Annaly Capital Management Inc.’s ( NLY ) recent results and compare several of the company’s metrics to 19 mortgage real estate investment trust (mREIT) peers. This analysis will show past and current data with supporting documentation within four tables. Table 1a will compare NLY’s mortgage-backed securities (“MBS”)/investment composition, recent leverage, hedging coverage ratio, and change in investment portfolio size to the 19 mREIT peers. Table 1b will compare NLY’s BV, economic return (loss), and premium (discount) to estimated current BV using stock prices as of 6/9/2023 to the 19 mREIT peers. Table 2 will show a quarterly compositional analysis of NLY’s agency MBS portfolio while Table 3 will show the company’s recent hedging coverage ratio over the prior 5 quarters (only contributor/team to provide continuous detailed hedging metrics).

I'm writing this two-part article due to the continued requests that such an analysis be specifically performed on NLY vs. its mREIT peers at periodic intervals. This article also discusses the importance of understanding the composition of NLY’s MBS/investment and derivatives portfolios regarding projecting the company’s future quarterly results as interest rates/yields fluctuate. Understanding the characteristics of a company’s MBS/investment and derivatives portfolios can shed some light on which companies are overvalued or undervalued strictly per a “numbers” analysis. This is not the only data that should be examined to initiate a position within a particular stock/sector. However, I believe this analysis is a good “starting point” to begin a discussion on the topic.

At the end of this article, there will be a conclusion regarding the following comparisons between NLY and the 19 mREIT peers: 1) trailing 24-month economic return (loss) ; 2) leverage as of 3/31/2023 ; 3) hedging coverage ratio as of 3/31/2023 ; and 4) premium (discount) to my estimated CURRENT BV (BV as of 6/9/2023) . My BUY, SELL, or HOLD recommendation and updated price target for NLY will be in the “Conclusions Drawn” section of this article. This includes providing a list of the mREIT stocks I currently believe are undervalued (a buy recommendation), overvalued (a sell recommendation), or appropriately valued (a hold recommendation).

Overview of Several Classifications within the mREIT Sector:

I believe there are several different classifications when it comes to mREIT companies. For purposes of this article, I'm focusing on four. It should be noted in light of several prior acquisitions and certain changes in overall investment strategies, some mREIT companies have minor-modest sub-portfolios outside each entity’s main concentration. However, I have continued to group certain mREIT companies in each entity’s main classification for purposes of this article. Some market participants (and even some mREIT companies) have different classifications when compared to Table 1a. Some market participants/companies base classifications on the percentage of capital deployed in each entity’s investment portfolio. However, my preference is to base a company’s classification on the monetary “fair market value” (“FMV”) of each underlying portfolio which, for a fact, is what drives valuation fluctuations. In my professional opinion, there's no “uniform” methodology when it comes to classifying mREIT companies but more of an underlying preference. Readers should understand this as the analysis is presented below.

First, there are mREIT companies that earn a majority of income from investing in fixed-rate agency MBS holdings. These investments consist of commercial/residential MBS, collateralized mortgage obligations (“CMO”), and agency debentures for which the principal and interest payments are guaranteed by government-sponsored enterprises/entities (“GSE”). This is extremely important to understand (especially when markets incorrectly priced in this notion at the onset of COVID-19 in early 2020). Since these investments typically have higher durations vs. most other investments within the broader mREIT sector, companies within this classification typically utilize higher hedging coverage ratios in times of rising mortgage interest rates/U.S. Treasury yields (or a projected rise over the foreseeable future). NLY, AGNC Investment Corp. ( AGNC ), ARMOUR Residential REIT Inc. ( ARR ), Cherry Hill Mortgage Investment Corp. ( CHMI ), Dynex Capital Inc. ( DX ), Invesco Mortgage Capital Inc. ( IVR ) (moved to an agency mREIT back in 2020), Orchid Island Capital Inc. ( ORC ), and Two Harbors Investment Corp. ( TWO ) are currently classified as a fixed-rate agency mREIT. Out of these eight agency mREITs, currently CHMI and TWO have a large mortgage servicing rights (“MSR”) sub-portfolio as well.

Second, there are mREIT companies that earn varying portions of income from investing in agency MBS holdings, non-agency MBS holdings, other securitizations, and non-securitized mortgage-related debt and equity investments (including residential whole loans/properties). This type of company is known as a “hybrid” mREIT. With regard to non-agency MBS, this includes (but is not limited to) Alt-A, prime, subprime, and re/non-performing loans where the principal and interest are not guaranteed by a GSE. Since there is no “government guarantee” on the principal or interest payments of non-agency MBS and residential whole loans (or rental income on properties), coupons are generally higher when compared to agency MBS of a similar maturity. However, borrowing costs (including repurchase agreements) for these specific investments also are higher (no government guarantee; credit risk). Due to the subtle yet identifiable differences between agency and non-agency MBS/residential whole loans/properties, I like to differentiate between an agency and a hybrid mREIT company. Since there's credit risk when it comes to non-agency MBS and residential whole loans/properties, leverage ratios are typically lower when investing in these securitizations/investments when compared to agency MBS (even when credit risk remains low). Arlington Asset Investment Corp. ( AAIC ), Chimera Investment Corp. ( CIM ), Ellington Financial Inc. ( EFC ) (converted to a REIT in 2019), MFA Financial Inc. ( MFA ), AG Mortgage Investment Trust Inc. ( MITT ), and New York Mortgage Trust Inc. ( NYMT ) are currently classified as hybrid mREITs. It should be noted, during July 2022, AAIC was moved from a fixed-rate agency mREIT to a hybrid mREIT due to the company’s recent gradual shift away from fixed-rate agency MBS into a greater proportion of non-agency MBS, non-securitized mortgage-related investments, and mortgage servicing rights (“MSR”) financing receivables. AAIC exited the company’s single-family residential (“SFR”) sub-portfolio late last year.

Third, there are mREIT companies that invest in (but are not limited to) a combination of agency MBS, non-agency MBS, credit risk transfers (“CRT”), other mortgage-related investments (including direct originations of mortgages and/or correspondent production), non-securitized debt investments (including residential, multifamily, and commercial loans), and MSRs. There also are mREIT companies that have underlying subsidiaries who originate mortgage-related/debt products. I currently believe Rithm Capital Corp. ( RITM ), PennyMac Mortgage Investment Trust ( PMT ), and Ready Capital Corp. ( RC ) should be classified as an “originator and servicer” mREIT. Since RITM and PMT currently have at least a modest portion of the company’s investment portfolio in MSR and MSR-related investments, which act as an “indirect” hedge (the same can be said regarding interest only [IO] securities), these companies do not need to utilize as high of a hedging coverage ratio when compared to the agency mREIT sub-sector (some could even argue to not have derivative instruments in place; if anything, “contra” hedges to counter a drop in rates/yields). Indirect hedges are not calculated within each company’s hedging coverage ratio within this analysis (not the main purpose of these investments). As I have pointed out in the past, these investments actually benefit, from a valuation standpoint, in a rising interest rate environment as prepayment risk (and in a majority of scenarios credit risk) decreases while there is an increase in projected future discounted cash flows (and vice versa).

Finally, there are mREIT companies that basically solely invest in non-securitized, commercial whole loans with underlying collateral (real estate) tied to offices, multifamily units, hotels, retail stores, industrial complexes, and other miscellaneous types of properties. Regarding the three commercial whole loan mREIT peers I currently cover, Ares Commercial Real Estate Corp. ( ACRE ), Blackstone Mortgage Trust, Inc. ( BXMT ) and Granite Point Mortgage Trust Inc. ( GPMT ), these companies typically originate/invest in variable-rate, interest-only senior secured (typically first lien) debt. Since ACRE, BXMT, and GPMT all had 98%+ of its investment portfolio in variable-rate debt as of 3/31/2023, these companies currently do not need to utilize a high hedging coverage ratio (some could even argue to not have derivative instruments in place; LIBOR floors are a good substitute as well). This is the first quarter I/we are providing full coverage of ACRE.

Now let us start the comparative analysis between NLY and the 19 mREIT peers.

Leverage, Hedging Coverage Ratio, BV, Economic Return (Loss), and Premium (Discount) to Estimated Current BV Analysis - Overview:

Let us start this analysis by first getting accustomed to the information provided in Table 1a and 1b below. This will be beneficial when explaining how NLY compares to the 19 mREIT peers in regards to the metrics stated earlier.

Table 1a – mREIT Asset Composition, Leverage, Hedging Coverage Ratio, and Change in Investment Portfolio Size

Table 1a above provides the following information on NLY and the 19 mREIT peers (see each corresponding column): 1) generalized MBS/investment portfolio composition as of 3/31/2023 ; 2) on-balance sheet leverage ratio as of 3/31/2023 ; 3) at-risk (total) leverage ratio as of 3/31/2023 ; 4) hedging coverage ratio as of 3/31/2023 ; 5) quarterly change in hedging coverage ratio (3/31/2023 versus 12/31/2022) ; 6) hedging weighted average tenor/maturity ; and 7) change in investment portfolio size (excludes off-balance sheet transactions) . Some readers may notice some mREIT peers have “two sets” of leverage ratios. This is due to the fact I break out both non-recourse and recourse leverage. Within the two sets of leverage ratios within one column, recourse leverage ratios are represented by the lower figure on the right-hand side and are deemed more important.

Table 1b – BV, Economic Return (Loss), and Premium (Discount) to Estimated Current BV Analysis

Table 1b above provides the following information on NLY and the 19 mREIT peers (see each corresponding column): 1) BV per share at the end of the fourth quarter of 2022 ; 2) BV per share at the end of the first quarter of 2023 ; 3) BV per share change during the first quarter of 2023 (percentage) ; 4) economic return (loss) (change in BV and dividends accrued for/paid) during the first quarter of 2023 (percentage) ; 5) economic return (loss) during the trailing 24-months (percentage) ; 6) my estimated CURRENT BV per share (BV as of 6/9/2023) ; 7) stock price as of 6/9/2023 ; 8) 6/9/2023 premium (discount) to my estimated CURRENT BV (percentage) ; 9) 2/21/2020 valuation assessment (pre market sell-off due to coronavirus [COVID-19]) ; 10) 4/3/2020 valuation assessment (post majority of market sell-off due to COVID-19) ; 11) 6/11/2021 valuation assessment (post majority of market rally due to COVID-19 epidemic and prior to more “hawkish” interest rate and monetary policy rhetoric) ;and 12) 6/9/2023 valuation assessment .

Analysis of NLY:

As of 3/31/2023, NLY’s investment portfolio consisted of 74% and 1% fixed- and variable-rate agency MBS holdings, respectively (based on FMV). When compared to 12/31/2022, NLY’s percentage of fixed- and variable-rate agency MBS remained unchanged. NLY also had 2% allocated to both multifamily agency MBS and MSR investments, respectively. When calculated, both sub-sectors also remained unchanged. Finally, NLY continued to invest in non-agency MBS and non-MBS holdings which accounted for 21% of the company’s investment portfolio balance as of 3/31/2023 which was also unchanged. This included NLY’s investments in preferred equity, corporate debt, residential whole loans, and seniors housing. During the first quarter of 2023, NLY basically expanded all sub-portfolios to a proportionately similar amount when compared to allocations as of 12/31/2022. NLY basically sold the company’s entire commercial real estate sub-portfolio to Slate Asset Management L.P. (“Slate”) for $2.33 billion. This sale closed/was finalized during the third quarter of 2021. NLY’s middle market lending portfolio was fairly recently sold to Ares Management Corp. ( ARES ) for approximately $2.4 billion. ARES (including all subsidiaries) is the external manager of another stock I cover, Ares Capital Corp. ( ARCC ). This sale closed during the second quarter of 2022.

Using Table 1a above as a reference, when excluding borrowings collateralized by assets held in “securitization trusts” (non-recourse debt), NLY had an on-balance sheet leverage ratio of 5.2x while the company’s at-risk (total) leverage ratio, when including its off-balance sheet net long “to-be-announced” (“TBA”) MBS position, was 6.4x as of 3/31/2023. NLY had an on-balance sheet and at-risk (total) leverage ratio of 5.4x and 6.3x as of 12/31/2022, respectively. As such, NLY very slightly decreased the company’s on-balance sheet leverage during the first quarter of 2023 while very slightly increasing its at-risk (total) leverage. This was mainly due to a minor-modest increase in NLY’s investment portfolio size and a minor-modest increase in total equity due to the company’s “at-the-market” (“ATM”) common stock equity offerings during the quarter.

As of 3/31/2023, NLY had the third highest at-risk (total) leverage ratio when compared to the seven other agency mREIT sub-sector peers within this analysis. Due to the notable impacts from the COVID-19 pandemic to the mREIT sector when it came to the quick “spike” in leverage and liquidity risk (rising credit risk more of a longer-term impact regarding all non-agency investments), outside the commercial whole loan mREIT peers (BXMT and GPMT), all sector peers I currently cover had various strategies at play when it came to investment portfolio composition and risk management strategies. Even when several mREIT peers had very similar MBS/mortgage-related investments, 2020 strategies notably differed from company-to-company. Directly dependent on the amount/percentage of margins calls on certain outstanding borrowings (and the underlying investments pledged as collateral) and derivative instruments, most mREIT peers had a notable change in 2020 leverage ratios. Due to NLY’s overall size and asset composition, this company was not “forced” to de-lever to the same extent as some of the smaller-capitalized agency mREIT peers (more “cushion” when it came to its existing capital base).

Previously, management implied NLY had a fairly “defensive posture” in regards to leverage during 2017 - 2018 due to the risk of widening spreads/lower MBS prices as Fed monetary policy dictated broader market dynamics (in particular, the Fed Funds Rate and the Fed Reserve’s non-reinvestment of U.S. Treasuries and agency MBS). However, with the Fed’s more “dovish” rhetoric in 2019 regarding U.S. monetary policy over the foreseeable future, I previously correctly anticipated NLY would increase leverage which was consistent with agency mREIT sector trends as net spreads narrowed. This benefited most mREIT peers during late 2019.

However, this led to more severe BV declines during the first quarter of 2020 when the COVID-19 “pandemic panic” occurred across all financial markets (especially March). This was partially offset during the second quarter of 2020 as MBS pricing/valuations (and most other mortgage-related investments outside some CMBS and commercial whole loans) rebounded in price/valuation as financial panic/stress eased (mainly due to the Fed’s swift response regarding financial assistance and monetary policy). This general trend continued into the third and fourth quarters of 2020 as broader market pricing/valuations (outside isolated pockets) rebounded further. As such, most mREIT peers reported BV increases during the third and fourth quarters of 2020 (including NLY).

During the first quarter of 2021, even though severe agency MBS price decreases occurred within lower coupons, spreads notably tightened when compared to most derivative instruments which led to outperformance within certain agency mREIT peers (and broader sector peers) who utilized higher hedging coverage ratios (especially with higher duration hedges). However, during the second quarter of 2021, I believe markets finally started to begin pricing in the eventual announcement of the Federal Open Market Committee’s (“FOMC”) end to its asset tapering program and eventual increase in the Fed Funds Rate. Remember, the market is always “forward thinking” in its processes. As such, speculation appeared to be on the rise in my opinion. The Fed was previously purchasing $80 billion of U.S. Treasury securities and $40 billion in agency MBS each month. This fear/speculation directly resulted in a widening of spreads within fixed-rate agency MBS relative to derivative instrument valuations during the summer of 2021 (increase in spread/basis risk).

During the first two weeks of June 2021, along with the first couple weeks of July 2021, markets experienced a modest widening of spreads between most agency MBS coupons (including specified pools) versus interest rate payer swaps, net (short) U.S. Treasury securities, and Eurodollar futures.As such, derivative valuation decreases “trumped,” in basically all coupons and characteristics, MBS price fluctuations. Simply put, this negatively impacted BVs within the agency mREIT sub-sector (and to a lesser degree other mREIT peers who invest in agency MBS and utilize derivative instruments designed to combat interest rate risk) during the second quarter of 2021.This trend continued into July-August 2021 to some extent (just not as severe). Some of this risk temporarily abated in September-October 2021 but “re-announced itself” beginning in November 2021. This 2022 rise in spread/basis risk was previously correctly anticipated and continuously pointed out to subscribers of the REIT Forum during 2021. This is important to understand. I believe this was mainly the result of economic indicators/reports showing strong inflationary data. Typically, strong inflationary data results in an increase to rates/yields as we saw in September 2021 and again in early November 2021.

Moving to more very late 2021-early 2022 trends, FOMC Chairman Powell stated there was strong data to quicken the Fed’s asset tapering program due to strong inflationary data (mainly via the Consumer Price Index; CPI). This led to a faster “lift-off” of the Fed Funds Rate vs. previous 2020-2021 expectations. This was a bit of a “curveball” for markets as this was a new Fed narrative. The change in monetary policy directly impacted the shorter-end of the yield curve with all rates/yields with 1-, 2-, and -3-year maturities modestly increasing during the second half of 2021. This narrative “shifted” the timing for the both the end of the Fed’s quantitative easing program (“QE4”) and the “lift-off” of the Fed Funds Rate. Instead of the Fed’s asset tapering program ending in June 2022, events “pegged” QE4 to end by March 2022 (3 months earlier). This was all but confirmed by Mr. Powell during his press conference after the FOMC’s December 2021 and January 2022 meetings. This, in turn, led to market participants accelerating the dates for when the Fed Funds Rate will increase from its 0-25 basis point (“bp”) range (and multiple subsequent raises).

As global economies sporadically opened back up for business during 2022, consumer demand for all sorts of goods quickly increased. However, pockets of the globe continued to experience the direct impact of the COVID 19 pandemic via sporadic shutdowns which notably disrupted supply chains. Simply put, this was one of the leading factors to rapid price increases (basic supply and demand reasoning) in a wide array of goods; including a “competitive” labor force which wanted stronger wage price hikes. Many businesses had very little choice but to give in the most demands. This cycle basically caused a “snowball” effect which has directly led to the fairly recent 40-year high inflation. In direct response to this worrying inflationary data, the FOMC increased the Fed Funds rate by 50, 75, 75, 75, 75, and 50 bps in May, June, July, September, November, and December 2022.

So far, during 2023, the FOMC increased the Fed Funds rate by 25 bps in early February (technically the January meeting), March, and May 2023. My personal projection is the Fed Funds Rate will be in a range of 5.00% - 5.50% by December 2023. This is also my projection for the Fed Funds “terminal” rate (plateau) this hiking cycle. This projection is unchanged when compared to last quarter’s analysis.

Bringing this back to the stock market, this has recently caused a notable increase in borrowing costs throughout financial markets. I believe a good portion (but not all) of this increase was “baked” into financial markets. However, this has (and will continue) put some pressure on financial markets/equity valuations/multiples in my professional opinion. Last quarter, we witnessed what happened when Silicon Valley Bank Financial Group (“SIVB”) quickly ran into trouble directly due to depressed asset pricing, poor interest rate/risk management, and a run on deposits (a simple mention here should suffice). As such, even outside this specific and general sector event (regional banks), some general caution remains warranted regarding stock market performance as a whole. I believe the first half of 2022 was a great example regarding how markets will typically react to the perception of rising interest rates in general (lower market multiples; especially in high growth sectors like technology). Something I/we have pointed out since the summer of 2021.

Rising short-term interest rates have recently had a growing negative impact on repurchase (“repo”) agreement borrowing costs, especially on agency MBS. Average agency MBS repo rates remained in a tight range of 0.10%-0.25% from the spring of 2020 – early 2022. More recently, “spot” /current agency MBS repo rates are north of 5.00%. As a remainder, there's a very strong, direct relationship between the Fed Funds Rate and agency repo agreement rates. As such, the recent accelerated Fed Funds Rate timeline have caused modestly - notably higher agency repo agreement rates during late 2022 – early 2023. However, there has (and will likely continue to be) some “relief” on conditional/constant prepayment rates (“CPR”) which would lead to lower premium amortization expense which would help alleviate rising borrowing costs from a net spread perspective. In fact, markets are already experiencing a growing proportion of mortgage-related investments trading below par which technically switches premium amortization expense to discount accretion income (on new purchases). Furthermore, with likely agency MBS price decreases and higher available coupons with new supply, new purchases would likely have a better overall yield versus purchases during 2020-2021. Companies who “locked in” some very low-low interest rate payer swaps/swaptions would also record less of an expense/more income with rising short-term interest rates for some time.

So, there was 2022 pressure on most mREIT BVs (and some earnings) but an EVENTUAL GRADUAL enhancement to most peer’s earnings; especially for agency mREITs (as long as management teams correctly formulate and act upon a correct investment and derivative portfolio strategies) should occur. We are NOT there yet so readers have to be patient. As I have always stated, the mREIT business model is always a balancing act. Management teams just have to correctly identify which type of economic cycle is likely to occur over the foreseeable future and set up strategies to both mitigate risk and accelerate earnings. Each company’s prospects are factored into mREIT’s recommendation ranges and general risk rating.

Tying this trend back to spread/basis risk, wider spreads persisted during most of January-early May 2022. These movements were directly in relation to U.S. short- intermediate-term monetar y policy. May-very early June 2022 experienced a temporary “plateau” in spread/basis ris k which was an encouraging sign (especially when it comes to the agency mREIT business model). That said, at the time, I previously correctly projected we were not out of the woods yet with spread/basis risk regarding the mREIT business model. I stated spreads will remain under pressure with the FOMC/Fed monetary policy and economic indicators such as price indices and consumer sentiment surveys (which directly impacts the FOMC’s/Fed’s Fed Funds Rate decisions). Also, the whole Russia/Ukraine situation has added to market uncertainty/volatility and spurs global inflation; most notably certain agriculture products (in particular, but not limited to, wheat). Again, we expect this “ebb and flow” will continue for some time. Spread/Basis risk abated some during July 2022 which was encouraging. However, spread/basis risk quickly increased, once again, during August-October 2022.

During the second week in November 2022, spreads quickly, and notably, tightened. This momentum continued heading into early December 2022, paused the remainder of December, but notably picked back up during January 2023.However, BV gains during January 2023 have mostly “evaporated” during February – early March 2023. Most sector BVs moved lower during April – May 2023 but have partially rebounded the past 2 weeks (early June 2023).

Moving on, NLY had a BV of $20.79 per common share at the end of the fourth quarter of 2022. NLY had a BV of $20.77 per common share at the end of the first quarter of 2023. This calculates to a quarterly BV decrease of (0.08%). When including NLY’s recently reduced quarterly dividend of $0.65 per common share, the company had an economic return of 3.05% for the first quarter of 2023. When compared to fixed-rate agency mREIT peers like AGNC and DX, a modest – notable quarterly BV outperformance. In fact, NLY recorded the least severe quarterly decrease out of the 8 agency mREIT peers I currently cover.

I correctly projected most agency mREIT companies would experience a minor - modest BV decrease during the first quarter of 2023. I also correctly projected most agency mREIT sub-sector peers would underperform most hybrid, originator and servicer, and commercial whole loan mREIT sub-sector peers regarding BV fluctuations during the first quarter of 2023. Each mREIT’s earnings results were previously discussed with Marketplace subscribers in “real time” through earnings chat notes and subsequent earnings articles.

Let us now discuss NLY’s MBS and derivatives portfolios to spot certain characteristics which will impact future results. Table 2 below provides NLY’s proportion of fixed- and variable-rate agency MBS holdings as of 3/31/2023 versus 12/31/2022 (the vast majority of the company’s investment portfolio).

Tables 2a + 2b – NLY Agency MBS Portfolio Composition (3/31/2023 Versus 12/31/2022)

Using Table 2 above as a reference, NLY continued to maintain a portfolio heavily invested in 30-year fixed-rate agency MBS holdings during the first quarter of 2023. NLY’s proportion of 15-year fixed-rate agency MBS holdings very slightly increased from 3.4% to 3.5% during the quarter (based on par/face value). NLY’s proportion of 20-year fixed-rate agency MBS holdings very slightly decreased from 1.2% to 1.1%. As such, NLY’s proportion of 30-year fixed-rate agency MBS remained unchanged at 95.4%. Most agency sub-sector peers continued to have an extremely high proportion of 30-year fixed-rate agency MBS holdings during the first quarter of 2023.

NLY’s on-balance sheet fixed-rate agency MBS holdings had a weighted average coupon (“WAC”) of 4.11% as of 3/31/2023 which was a 15 basis points (“bps”) increase when compared to 12/31/2022. This should be considered a minor - modest quarterly rise in WAC. Continuing to reverse a trend during 2020-2021, NLY’s TBA MBS position had a higher WAC of 5.21% which was consistent with a few other fixed-rate agency mREIT peers regarding forward/generic MBS strategies (moved up in coupon). In addition, NLY’s weighted average three-month conditional prepayment rate (“CPR”) decreased from 7.5% to 5.5% which also was a fairly consistent trend across the sector as mortgage interest rates rapidly increased during 2022 (a bit of a “delayed” impact to this metric; including seasonal trends). NLY’s quarterly CPR should continue to remain suppressed during 2023. Let us now move on to NLY’s derivatives portfolio.

While management has, in the past, diversified the company’s investment portfolio into less interest rate sensitive holdings (lower durations), a majority of the company’s investment portfolio (from a valuation standpoint) was still in fixed-rate agency MBS as of 3/31/2023. Along with the “plummet” in the Fed Funds Rate to near 0% in March 2020 (which also caused a proportionately large decrease to the London Interbank Offered Rate (“LIBOR”) across all tenors/maturities and all other applicable short-term funding/interest rates) and subsequent margin calls in certain derivative instruments, NLY notably reduced the company’s hedging coverage ratio during the first quarter of 2020. However, as NLY entered into new interest rate swap contracts during the second, third, and fourth quarters of 2020 (at notably more attractive terms), management gradually “rebuilt” the company’s derivatives portfolio. NLY basically maintained this previously built-up derivatives portfolio during the first, second, and third quarters of 2021 (slight alterations within several sub-accounts). With the risk of continued higher mortgage interest rates/U.S. Treasury yields heading into 2022, management became more defensive during the fourth quarter of 2021 and first quarter of 2022. NLY basically maintained the company’s hedging coverage ratio during the second quarter of 2022, became even more defensive during the third quarter of 2022, and became less defensive during the fourth quarter of 2022. NLY remained defensive during the first quarter of 2013. To highlight the recent activity within NLY’s derivatives portfolio, Table 3 is presented below.

Table 3 – NLY Hedging Coverage Ratio (As of 3/31/2023 Versus Prior 5 Quarters)

Using Table 3 above as a reference, NLY had a net (short) interest rate swaps and swaptions position of ($45.9) and ($2.1) billion as of 12/31/2021, respectively. NLY also had a net (short) U.S. Treasury futures position of ($22.5) billion. When calculated, NLY’s hedging coverage ratio modestly increased to 92% as of 12/31/2021. This was now slightly-modestly above the agency mREIT average hedging coverage ratio of 79% as of 12/31/2021.

NLY had a net (short) interest rate swaps and swaptions position of ($46.5) and ($3.1) billion as of 3/31/2022, respectively. NLY also had a net (short) U.S. Treasury futures position of ($27.7) billion. When calculated, NLY’s hedging coverage ratio modestly increased to 106% as of 3/31/2022. This was now slightly above the agency mREIT average hedging coverage ratio of 100% as of 3/31/2022.

NLY had a net (short) interest rate swaps and swaptions position of ($35.2) and ($3.1) billion as of 6/30/2022, respectively. NLY also had a net (short) U.S. Treasury futures position of ($36.0) billion. When calculated, NLY’s hedging coverage ratio slightly decreased to 104% as of 6/30/2022. This remained slightly above the agency mREIT average hedging coverage ratio of 100% as of 6/30/2022.

NLY had a net (short) interest rate swaps and swaptions position of ($40.9) and ($2.3) billion as of 9/30/2022, respectively. NLY also had a net (short) U.S. Treasury futures position of ($42.3) billion. When calculated, NLY’s hedging coverage ratio modestly increased to 120% as of 9/30/2022. This was now modestly above the agency mREIT average hedging coverage ratio of 106% as of 9/30/2022. Simply put, a majority of agency mREIT peers remained defensive regarding their hedges during the third quarter of 2022.

NLY had a net (short) interest rate swaps and swaptions position of ($52.3) and ($1.8) billion as of 12/31/2022, respectively. NLY also had a net (short) U.S. Treasury futures position of ($21.2) billion. When calculated, NLY’s hedging coverage ratio modestly decreased to 106% as of 12/31/2022. This was now very slightly below the agency mREIT average hedging coverage ratio of 111% as of 12/31/2022.

NLY had a net (short) interest rate swaps and swaptions position of ($64.7) and ($1.8) billion as of 3/31/2023, respectively. NLY also had a net (short) U.S. Treasury futures position of ($13.0) billion. As such, a fairly large “swap” from net (short) U.S. Treasury futures into interest rate payer swaps. When calculated, NLY’s hedging coverage ratio slightly increased to 108% as of 3/31/2023. This was now modestly above the agency mREIT average hedging coverage ratio of 94% as of 3/31/2023. This was mainly the result of the very large quarterly decrease in net (short) derivative instruments implemented by CHMI and TWO.

Once again using Table 1b above as a reference, as of 6/9/2023 NLY’s stock price traded at $20.70 per share. When calculated, NLY’s stock price was trading at a (3.38%) discount to my estimated CURRENT BV (BV as of 6/9/2023). Simply put, NLY’s stock price traded at a minor (less than a 5%) discount to my estimated CURRENT BV and at a slightly - modestly higher valuation when compared to most other agency mREIT peers within Table 1b. When tracking historical trends, NLY typically trades at a slightly - modestly higher valuation (less of a discount/more of a premium) to the company’s agency mREIT peers. I continue to believe NLY “deserves” to trade at a slightly - modestly higher valuation (which has been explained in various mREIT sector articles and through the REIT Forum discussions ).

I believe the 24-month total economic return (loss) metric is a great tool in spotting each mREIT’s historical performance. A great tool when also considering future general expectations versus peers. As such, as stated later in the article, I currently believe NLY is now appropriately undervalued (a HOLD recommendation) from a stock price perspective. Only a couple months ago, I/we had an undervalued classification (BUY recommendation) on NLY (and most of the broader mREIT sector) which quickly “paid off” to readers/subscribers who deeded our advice with the recent rally.

Comparison of NLY’s Recent Economic Return (Loss), Leverage, Hedging Coverage Ratio, and Valuation to 19 mREIT Peers in Ranking Order:

The REIT Forum Feature

Conclusions Drawn (PART 1):

PART 1 of this article has analyzed NLY and 19 mREIT peers in regards to the following metrics: 1) trailing 24-month economic return (loss) ; 2) leverage as of 3/31/2023 ; 3) hedging coverage ratio as of 3/31/2023 ; and 4) premium (discount) to my estimated CURRENT BV .

First, NLY’s trailing 24-month economic loss of (23.60%) was slightly more attractive (less severe decrease) vs. the agency mREIT sub-sector average of (29.89%). However, this loss was notably less attractive when compared to the hybrid, originator + servicer, and commercial whole loan average of (3.81%), 12.40%, and 7.82%, respectively. NLY outperformed most of the company’s agency mREIT sub-sector peers regarding this metric and slightly - modestly outperformed one of its closest sector peers, AGNC. This was mainly due to the recent composition of NLY’s MBS/investment and derivatives portfolio and the net movement of mortgage interest rates/U.S. Treasury yields during this timeframe. I would point out DX modestly - notably outperformed all agency mREIT sub-sector peers regarding this specific metric but the company gave up some earnings to achieve this notable 24-month outperformance (to remain non-bias since I currently own DX).

Second, NLY’s at-risk (total) leverage as of 3/31/2023 was modestly above the broader mREIT sector average. However, when compared to the company’s fixed-rate agency mREIT peers within this analysis, NLY’s at-risk leverage ratio average. Over the prior several years, NLY typically ran below average leverage versus the company’s fixed-rate agency mREIT peers so a bit more aggressive on NLY’s leverage more recently.

Third, NLY’s hedging coverage ratio was now modestly above the agency mREIT average as of 3/31/2023. With the risk of continued higher mortgage interest rates/U.S. Treasury yields heading into 2022, management became more defensive during the fourth quarter of 2021 and first quarter of 2022. NLY basically maintained the company’s hedging coverage ratio during the second quarter of 2022, became even more defensive during the third quarter of 2022, and became less defensive during the fourth quarter of 2022. NLY remained defensive during the first quarter of 2013. That said, spread/basis risk quickly elevated during the first, second, and third quarters of 2022 which led to notable BV losses within the agency mREIT sub-sector (even within companies who have utilized higher hedging coverage ratios). Agency mREITs who utilized MSRs typically had less severe losses when compared to peers who did not invest in MSR investments.

Finally, NLY’s current valuation, when compared to my estimate of each mREIT’s current BV (BV as of 6/9/2023), was at a slightly - modestly higher valuation vs. the mREIT peers within this analysis. Through the metrics provided within this two-part sector comparison article (including factors/metrics not directly discussed), I believe NLY “deserves” to trade at a slight - modest premium valuation to most mREIT peers. As such, I currently believe NLY’s level of premium, versus sub-sector peers, is justified. As such, this is one of the reasons why I believe NLY is currently appropriately undervalued (as opposed to being overvalued in January 2023 and undervalued in April 2023). I would strongly suggest readers consider current BVs (as opposed to prior period BVs) when assessing whether a stock is attractively valued or not. The REIT Forum subscribers have access to weekly BV projection updates.

Dependent upon the metrics laid out in the tables above, results across the broader mREIT sector will slightly - notably vary from peer-to-peer; dependent upon specific asset classifications and risk management strategies put into place. The relationship between MBS/investment pricing and derivative instrument valuations needs to be constantly monitored (which I continually perform throughout the quarter). If I start to see a more notable positive/negative relationship unfold, I will inform readers through several avenues within Seeking Alpha (through articles, the live chat feature of The REIT Forum, and/or comments).

My BUY, SELL, or HOLD Recommendation:

From the analysis provided above (using Table 1b as a direct reference), including additional catalysts/factors not discussed within this article, I currently rate NLY as a SELL when I believe the company’s stock price is trading at or greater than a 2% premium to my projected CURRENT BV (BV as of 6/9/2023; $20.70 per share), a HOLD when trading at less than a 2% premium through less than a (8%) discount to my projected CURRENT BV, and a BUY when trading at or greater than a (8%) discount to my projected CURRENT BV.

Therefore, I currently rate NLY as APPROPRIATELY VALUED from a stock price perspective .

As such, I currently believe NLY is a HOLD recommendation.

My current price target for NLY is approximately $21.10 per common share. This is currently the price where my recommendation would change to OVERVALUED/a SELL recommendation. The current price where my classification/recommendation would change to UNDERVALUED/a BUY recommendation is approximately $19.05 per common share. Put another way, the following are my CURRENT BUY, SELL, or HOLD per share recommendation ranges (the REIT Forum subscribers get this type of data on all 20 mREIT stocks I currently cover on a weekly basis):

$21.10 per share or above = SELL

$19.06 - $21.09 per share = HOLD

$16.96 - $19.05 per share = BUY

$16.95 per share or below = STRONG BUY

Along with the data presented within this article, this recommendation considers the following mREIT catalysts/factors: 1) projected future MBS/investment price movements ; 2) projected future derivative valuations ;and 3) projected near-term (up to 1-year) dividend per share rates. As discussed earlier, this includes all recent, current, and projected macroeconomic indicators and FOMC monetary policy.

mREIT Sector Recommendations as of 6/9/2023:

Once again using Table 1b above as a reference, I want to highlight to readers what I/we are conveying to subscribers when it comes to sector recommendations as of 6/9/2023 (last Friday’s close).

As of 6/9/2023, I/we had a STRONG BUY recommendation (notably undervalued) on the following mREIT stocks analyzed above (in no particular order): 1) CIM; 2) MITT; 3) RITM; 4) RC; and 5) GPMT.

As of 6/9/2023, I/we had a BUY recommendation (undervalued) on the following mREIT stocks analyzed above (in no particular order): 1) EFC; 2) MFA; 3) PMT 4) ACRE; and 5) BXMT.

As of 6/9/2023, I/we had a HOLD recommendation (appropriately valued) on the following mREIT stocks analyzed above (in no particular order): 1) DX; 2) IVR; 3) NLY; 4) ORC; 5) TWO; 6) AAIC; and 7) NYMT.

As of 6/9/2023, I/we had a SELL recommendation (overvalued) on the following mREIT stocks analyzed above (in no particular order): 1) AGNC; 2) ARR; and 3) CHMI.

So, as of 6/9/2023 I/we now have 5 mREITs rated as a STRONG BUY, 5 rated as a BUY, 7 rated as a HOLD, 3 rated as a SELL, and 0 rated as a STRONG SELL. Simply put, more bullish when compared to the summer of 2021 – early fall of 2022 and December – February 2023 but a bit less bullish when compared to April 2023.

PART 2 of this article will cover dividend metrics and projections for the second quarter of 2023.

Readers looking for my/our mREIT dividend projections for the second quarter of 2023 can look in last quarter’s article.

Recent NLY/AGNC Stock Disclosures:

On 3/18/2020, I initiated a position in NLY at a weighted average purchase price of $5.05 per share (large purchase). This weighted average per share price excluded all dividends received/reinvested. On 6/9/2021, I sold my entire NLY position at a weighted average sales price of $9.574 per share as my price target, at the time, of $9.55 per share was surpassed. This calculates to a weighted average realized gain and total return of 89.6% and 112.0%, respectively. I held this position for approximately 15 months.

On 3/18/2020, I once again initiated a position in AGNC at a weighted average purchase price of $7.115 per share (large purchase). This weighted average per share price excluded all dividends received/reinvested. On 6/2/2021, I sold my entire AGNC position at a weighted average sales price of $18.692 per share as my price target, at the time, of $18.65 per share was surpassed. This calculates to a weighted average realized gain and total return of 162.7% and 188.6%, respectively. I held this position for approximately 14.5 months.

On 10/11/2022, I once again initiated a position in AGNC at a weighted average purchase price of $7.445 per share. On 10/24/2022, I increased my position in AGNC at a weighted average purchase price of $7.500 per share. When combined, my AGNC position had a weighted average purchase price of $7.473 per share. This weighted average per share price excluded all dividends received/reinvested. On 11/9/2022, I sold my entire AGNC position at a weighted average sales price of $8.750 per share as my price target, at the time, of $8.75 per share was surpassed. This calculates to a weighted average realized gain and total return of 17.1% and 18.7%, respectively. I held this position for approximately 3 weeks.

Final Note: All trades/investments I have performed over the past several years have been disclosed to readers in “real time” (that day at the latest) via either the StockTalks feature of Seeking Alpha or, more recently, the “live chat” feature of the Marketplace Service the REIT Forum (which cannot be changed/altered). Through these resources, readers can look up all my prior disclosures (buys/sells) regarding all companies I cover here at Seeking Alpha (see my profile page for a list of all stocks covered). Through StockTalk disclosures and/or the live chat feature of the REIT Forum, at the end of May 2023 I had an unrealized/realized gain “success rate” of 86.4% and a total return (includes dividends received) success rate of 93.9% out of 66 total past and present mREIT and business development company ( “BDC”) positions (updated monthly; multiple purchases/sales in one stock count as one overall position until fully closed out). I encourage other Seeking Alpha contributors to provide real time buy and sell updates for their readers/subscribers which would ultimately lead to greater transparency/credibility. Starting in January 2020, I have transitioned all my real-time purchase and sale disclosures solely to members of the REIT Forum. All applicable public articles will still have my “main ticker” purchase and sale disclosures (just not real-time alerts).

Table 8a – The REIT Forum NLY + AGNC Seeking Alpha Recommendations (November 2019 – March 2023 Timeframe)

Table 8b – NLY Public Seeking Alpha Recommendations (June 2022 – June 2023 Timeframe)

I just want to quickly highlight my/our AGNC and NLYSeeking Alpha recommendation ranges over the past several years. In my personal opinion, a stock with a BUY recommendation should increase in price over time, a SELL recommendation should decrease in price over time, and a HOLD recommendation should remain relatively unchanged in price over time (pretty logical). Simply put, my/our “valuation methodology” has correctly timed when both AGNC and NLY have been undervalued (a BUY recommendation; bullish), overvalued (a SELL recommendation; bearish), and appropriately valued (a HOLD recommendation; neutral).

Using Table 8a above as a reference, I believe we have done a pretty good job in my/our AGNC and NLY recommendation ratings. For NLY, both pricing charts should really be viewed as 1 combined chart since CO and I are part of the same Marketplace service team. Not only do I/we want to provide guidance/a recommendation that enhances total returns for subscribers, I/we also want to protect these generated returns by subsequently minimizing total losses. I personally believe this methodology/strategy is very important. In other words, correctly spotting both positive catalysts/trends and negative factors/trends as economic and interest rate cycles fluctuate.

This methodology/strategy was extremely useful/accurate when going back to very late 2019 and early 2020 (both pre-COVID-19) where I/we had a SELL recommendation on both AGNC and NLY. For some reason, this S.A. pricing chart does not show my AGNC SELL recommendation pre-COVID-19 but one can simply look back to past public articles in early 2020 (just an omission on S.A.’s end in this particular case). As an alternative, simply look at the NLY SELL recommendation highlighted in CO’s pricing chart (AGNC and NLY typically have very similar recommendation ranges when considering similar time periods). Furthermore, after the initial “pandemic panic” , I/we had a STRONG BUY recommendation on both AGNC and NLY later in the spring of 2020.

Simply put, a contributor’s/team’s recommendation track record should “count for something” and should always be considered when it comes to credibility/successful investing. You will not see most (if not all) other contributor teams use this type of factual, recommendation-driven price chart because the results are not nearly as “attractive” when compared to our own.

Understanding My/Our Valuation Methodology Regarding mREIT Common and BDC Stocks:

The basic "premise" around my/our recommendations in the mREIT common and BDC sectors is value. Regarding operational performance over the long-term, there are above average, average, and below average mREIT and BDC stocks. That said, better-performing mREIT and BDC peers can be expensive to own, as well as being cheap. Just because a well-performing stock outperforms the company’s sector peers over the long-term, this does not mean this stock should be owned at any price. As with any stock, there is a price range where the valuation is cheap, a price where the valuation is expensive, and a price where the valuation is appropriate. The same holds true with all mREIT common and BDC peers. As such, regarding my/our investing methodology, each mREIT common and BDC peer has their own unique BUY, SELL, or HOLD recommendation range (relative to estimated CURRENT BV/NAV). The better-performing mREITs and BDCs typically have a recommendation range at a premium to BV/NAV (varying percentages based on overall outperformance) and vice versa with the average/underperforming mREITs and BDCs (typically at a discount to estimated CURRENT BV/NAV).

Each company’s recommendation range is "pegged" to estimated CURRENT BV/NAV because this way subscribers/readers can track when each mREIT and BDC peer moves within the assigned recommendation ranges (daily if desired). That said, the underlying reasoning why I/we place each mREIT and BDC recommendation range at a different premium or (discount) to estimated CURRENT BV/NAV is based on roughly 15-20 catalysts which include both macroeconomic catalysts/factors and company-specific catalysts/factors (both positive and negative). This investing strategy is not for all market participants. For instance, not likely a “good fit” for extremely passive investors. For example, investors holding a position in a particular stock, no matter the price, for say a period of 5+ years. However, as shown throughout my articles written here at Seeking Alpha since 2013, in the vast majority of instances I have been able to enhance my personal total returns and/or minimize my personal total losses from specifically implementing this particular investing valuation methodology. I hope this provides some added clarity/understanding for new subscribers/readers regarding my valuation methodology utilized in the mREIT common and BDC sectors.

Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader’s current investing strategy. The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions. Please disregard any minor “cosmetic” typos if/when applicable.

For further details see: