NLY - Preferreds Weekly Review: Agency mREITs Kick Off Earnings

2023-11-06 14:10:25 ET

Summary

• We take a look at the action in preferreds and baby bonds through the fourth week of October and highlight some of the key themes we are watching.
• Preferred stocks were slightly lower as Treasury yields fell, driving yields above the COVID period.
• Mortgage REIT preferreds kicked off earnings and saw double-digit drops in book value.
• Our positioning in the Agency mREIT preferreds space favors NLY.PR.I, DX.PR.C, and AGNCL.

Welcome to another installment of our Preferreds Market Weekly Review, where we discuss preferred stock and baby bond market activity from both the bottom-up, highlighting individual news and events, as well as the top-down, providing an overview of the broader market. We also try to add some historical context as well as relevant themes that look to be driving markets or that investors ought to be mindful of. This update covers the period through the fourth week of October.

Be sure to check out our other weekly updates covering the business development company ("BDC") as well as the closed-end fund ("CEF") markets for perspectives across the broader income space.

Market Action

Preferreds were slightly lower on the week as Treasury yields managed to fall, driven by a lower than expected PCE reading which registered the slowest quarterly pace of core inflation since the fourth quarter of 2020. Rate rises earlier in the month, however, did take their toll and all sectors are in the red, month-to-date.

The combination of the rise in both Treasury yields and credit spreads means retail preferreds now yield more than they did during the COVID episode - a very attractive proposition for income investors and a far cry from the sub-4% level in 2021.

Market Themes

Mortgage REIT preferreds remain a staple of many income portfolios which is one reason we like to follow their earnings announcements. So far, results have not been great, to say the least. The headline figure is the sharp drop in book values which has continued past the end of the quarter.

AGNC Investment Corp ( AGNC ) issued a press release prior to the full earnings release highlighting not only the Q3 14% book value drop to $8.08 which looked to be priced in (the stock closed at $8.11 prior to the announcement) but another 15% drop since the end of the quarter. The announcement took the market by surprise, driving the stock down 10% overnight before recovering somewhat.

Dynex Capital ( DX ) saw its book value fall around 14% - about what we saw for AGNC. The company issued some stock so equity fell less - by around 9%, resulting in equity / preferred coverage of 7.2x.

The earnings call was interesting - the company mentioned that the Agency OAS of their portfolio (which has a focus on higher coupons - similar to AGNC) widened 0.15% over the quarter and another 0.15% since the end of the quarter. A similar move post quarter end explains the weakness in book value sustained by AGNC.

The pure spread move, however, does not fully explain the drop in book value. According to DX, a 0.15% widening in spreads leads to an 8% drop in book value vs. the 13.5% drop they sustained.

What’s useful is that they also break down their yield curve position which more mREITs should do. If we look at the numbers published in the Q2 presentation what we have is that for a 25bp bear steepener (i.e., longer-term rates rise more than short-term rates) there is a 4% drop in book value. Obviously, the actual risk position can change through the month but this should give a decent guide.

This yield curve exposure, together with the Agency spread sensitivity, largely explains the drop in book value. It's odd that DX would have a position on that lost money if the yield curve normalized given how unusually inverted the curve has been this year.

At the end of Q3 they reduced the flattener position however they would have already incurred a 2% book value loss on it since the end of the quarter plus a similar 8% or slightly larger drop in book value from wider Agency spreads (larger as their leverage increased from Q2).

Annaly Capital Management ( NLY ) had a 12% drop in book value - a bit less than that of AGNC and DX. They haven’t issued a lot of shares in the last couple of quarters unlike AGNC and DX so this remains a potential equity coverage support for them.

Stance And Takeaways

In terms of positioning across the Agency mREIT preferreds space, we like NLY.PR.I, DX.PR.C and AGNCL. Since the rotation from NLY.PR.F to I in August in the Income Portfolios, I has outperformed. There is a bit more juice left there and we should see further outperformance as we approach the NLY.PR.I Jun-2024 reset date.

Equity coverage is the one big difference versus AGNC whose coverage is about half that of DX and NLY. If the CMT-linked preferred AGNCL didn't exist there would be little reason to hold any AGNC preferred over DX or NLY preferreds which tend to have a lower book beta, much higher equity / coverage and similar yields.

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