2023-05-08 09:47:36 ET
Summary
- Relative valuation model for all LIBOR preferred stocks of the two companies.
- Exposing the overvalued ones and defending the undervalued ones.
- Possible double-digit "Alpha" returns based on the mispricing.
This article was first published to members of our service on the 30th of April 2023
With this short article, we would like to bring your attention to Annaly Capital Management ( NLY ) and AGNC Investment Corp.(AGNC) and their preferred stocks. Both companies are mortgage REITs, and both of them have exchange-traded preferred stocks. Mortgage REIT preferred stocks have stood the test of time as one of the great opportunities for the dividend-based income-seeking investor. The main purpose of the mREIT is to generate profit on the spread between the interest on the mortgages/MBS they invest in and the cost of the equity and debt they finance with. These types of companies leverage the long-term yield of their underlying securities, thus attracting a lot of investors with the high distribution rates they offer. As a rule of thumb, their fixed-income vehicles receive less attention. The low interest in these financial products sometimes creates mispricings that give the investors the opportunity for even greater profit. In this article, we will shed light on the exchange-traded preferred stocks of NLY and AGNC and try to show that AGNCP and AGNCO are relatively undervalued to AGNCN and NLY-G at the moment.
Preferred vs. common stocks
There are some important aspects that every self-respecting investor needs to keep in mind when comparing preferred to common stocks. Preferred stocks stay higher than common ones in the capital structure of the companies. Moreover, the companies need to pay their preferred stock dividends before they can make common stock distributions. These factors make the preferred stock dividend safer than that of the common stock.
AGNC and NLY similarities
These two companies have very similar models and portfolios. Even though their cumulative returns are not identical:
NLY, AGNC, SPY Returns (Fast Graphs)
This does not affect the credibility of their preferred stocks. The mREITs are obligated to distribute their earnings and sooner or later both companies try to keep up with their long-term leverage ratios by offerings of common stock. Historically, the yields of NLY and AGNC preferred stocks have traded with very small deviations in normal times. The clearest example of this would be the IPO valuations of NLY-I and AGNCO:
NLY-I and AGNCO similarities (proprietary software)
These preferred stocks are created equal. 2 days before the IPO date of NLY-I the 5-year treasury was at 1.83% and the fixed (for 5 years) coupon of NLY-I was 4.93% higher, while 2 days before the IPO of AGNCO, the 5-year treasury was at 1.52% and AGNCO was issued with a spread of 5%. The floating rate of both securities is surprisingly identical at 4.99% (rounded). You rarely find 2 securities from different companies being treated in such a manner by market participants. Based on those we assume that all else being equal, the market is supposed to treat AGNC and NLY preferreds identically (which is the case for AGNCN and NLY-F at the moment).
AGNC and NLY preferred stocks
Both companies have exchange-traded LIBOR-based Fixed-To-Floating preferred stocks that are the main focus of our article. Given the fact that AGNC and NLY have the same structure and through the years they have issued preferred stocks with very similar characteristics, it is very easy for us to compare them in search of the best picks.
When comparing securities with floating interest rates, the gold standard is to use swap rates. An interest rate swap is a derivative contract that typically trades over the counter and exchanges a floating interest rate payment for a fixed interest rate one over a set period of time. One side of the contract is the payer, and the other is the receiver of the fixed rate. The swap rate represents the fixed-rate payment that the receiver requires from the payer in exchange for the uncertainty of having to pay the short-term floating rate. At the time the swap deal is undertaken, the total cash flows of the fixed-rate leg of the contract will be equal to the sum of the expected floating rate cash flows implied by the forward floating rate curve.
In the particular case that is of interest to us, NLY has three and AGNC has four exchange-traded, three-month LIBOR-based fixed-to-floating preferred stocks:
NLY and AGNC preferred stocks(LIBOR) (proprietary software) AGNC and NLY preferred stocks(model parameters) (personal spreadsheet)
NLY-F, NLY-G, and AGNCN are already floating-rate securities as they are trading past their call dates while NLY-I, AGNCP, AGNCO, and AGNCM are soon to be, with the farthest being the AGNCP call date on April 15, 2025. As all seven preferred stocks, in focus, today are perpetuities, we are using the USD 30 Years Interest Rate Swap for three-month LIBOR (USDSB3L30Y=), which is 3.30% as of the moment the calculations are made. For each preferred stock, we exchange the LIBOR rate with this swap rate when taking into account the future dividend flows after their corresponding call date.
We chose one of the preferred stocks - AGNCN (for the calculations we made it doesn't really matter which one), as being fairly priced. Using the swap rate, we determine the future cash flows for AGNCN up until the last call date for the group - April 15, 2025, and the terminal value for the stock for all the payments made after that:
AGNCN cashflows estimate (personal calculations)
Since AGNCN is the highest LIBOR spread, we assume it will be the one trading at Par on the terminal date.
The internal rate of return we find for AGNCN is used as a discount factor for the rest of the preferred stocks in the group. Using the same technique for the future cash flows for each stock in the set, we calculate the preset value of every one of them:
Model calculations of all preferred stocks (personal calculations)
Thus, their present values represent "fair prices" with AGNCN set as a benchmark. As stated earlier, it doesn't matter which stock will be taken as a basis, as the calculations that follow only give us relative pricing to one another inside the group.
At this point, one should be able to pinpoint the big market mistake inside the group:
All preferred stocks fair value vs market price (Model calculations)
AGNCP and AGNCO are clearly undervalued by 4 points in comparison with NLY-G (should you agree with the model). Should the trader/investor is uncomfortable with taking cross-company trades or simply prefer to play it safe, AGNCP/AGNCO vs. AGNCN and NLY-I vs. NLY-G give rather decent intra-company 2-point arbitrage opportunities.
How to trade this?
This certainly depends on many personal factors. The average investor who is holding preferred stocks from the NLY and AGNC families has to consider the logic presented in the article and decide whether he wants to be invested in the highest PV instruments of the group. As long as our calculations are correct and you like the model then a switch to AGNCP or AGNCO is a must. If one believes AGNCM will have the same faith as NLY-G and will be as overvalued as NLY-G, then AGNCM might be a choice to consider. Ironically the highest current yields temporarily presented by AGNCN, NLY-F, and especially NLY-G seem to be quite overvalued and uninvestable if one has any alternative financial thinking.
Conclusion
It is (not)surprising that the current high LIBOR rate attracts interest in LIBOR-based instruments. The sophisticated investor has to always consider the whole valuation rather than the current distribution yield. Very often the higher distribution yield is misleading and creates simple opportunities to benefit from. AGNCO and AGNCP are two of the most mispriced preferred stocks on the exchange at the moment based on very simple and clear logic.
For further details see:
Annaly And AGNC Preferred Stocks - Crazy Mispricings Create An Opportunity