2023-07-03 01:31:30 ET
Summary
- Annaly Capital Management has underperformed the broader market since our bear call.
- The stock has had a decent bounce from the lows.
- We show you why the distribution looks unsustainable over the medium term and why risks are far higher today than at the beginning of 2023.
At the beginning of 2023, we gave you three reasons why Annaly Capital Management Inc. ( NLY ) should not be a stock to be considered for your investments. NLY has concurred with our thesis so far and has lagged the broader markets on price and total returns.
Seeking Alpha
The REIT has kept up (or down, if you will) with its mortgage REIT peers like Dynex Capital Inc. ( DX ), PennyMac Mortgage Investment Trust and AGNC Investment Corp ( AGNC ).
We look at why are call is working and what lies ahead for this poor performing mortgage REIT.
The Fundamentals
NLY is a mortgage REIT focused on the agency side of assets. Like all mortgage REITs, the company uses extraordinary levels of leverage to achieve its objectives. This is no secret and the information is often found in the first couple of slides in the company presentations.
This leverage has also been the centerpiece of our disdain for these companies over the last 2 years. While they have always had, and always will, use massive amounts of leverage, the past few years were the worst possible time to do so. They came at the end of the ZIRP (zero interest rate policy) era and these companies were loaded with the highest levels of risk for the lowest possible returns. Our contention was that they had locked in assets yielding very poor returns while their borrowing costs were set to rise and kill their margins. This has played out from the dividend cut we predicted back in September 2022 all the way to now, where the stock continues to lag. Here is why things can get far worse.
Q1-2023
NLY's Q1-2023 had a lot of data showing the trend that has been place for a long time. Unlike the bull contention which continues to stress of what a great time it is to be a mortgage REIT, NLY's presentation has heavy dose of reality. The first key thing to focus on here is the book value per share which has lost $6.31 over the five quarters.
Loss in tangible book value is very real and impacts ability to generate future returns. Income focused investors constantly brush this aside as if this is simply an accounting gimmick. Whereas in reality, it is the strongest correlator to price, dividend paying ability and total returns.
The next thing to focus on here is the compression in net interest margin. Yes, as the bulls have contended repeatedly, mortgage backed securities make more money than in the past. What is not mentioned though is that NLY bought and held the bulk of its portfolio at extremely low interest rates. It cannot dump these at huge losses. An extension of that is that NLY can only buy new higher yielding assets as paydowns occur. These prepayment speeds have slowed drastically since mortgage rates have risen.
NLY Q1-2023 Presentation
Any sane investor with extra cash would park it in a Treasury bill that has a higher rate than their mortgage rate, rather than pay extra mortgage amounts down. The cumulative impact has been that NLY is not being able to invest in higher yielding assets as quickly as the bulls would like to believe. Note below just how slowly the average yield on interest earning assets has been rising. Over the last 5 quarters it has moved up 35 basis points (from 3.61% to 3.96%).
In contrast, interest bearing liabilities cost has gone up from 0.48% to 4.52%. Net interest margin is now at 0.09%, down 97% from 5 quarters ago.
The one surviving grace here is that "earnings available for distribution" metric which while falling, has held up far better than other metrics. The key question to ask here is why are the two sets of numbers below so drastically different.
The answer lies in the hedges being employed. You can see in the work through from GAAP interest income and GAAP interest expense below. It is the huge amount of hedge benefits which reduce GAAP interest expense, that is what is saving the day.
Outlook
Hedges are for a given timeframe. NLY has some good hedges in place but two things need to be very clear about this. The first being that they will run-out. Over time the "net interest margin (excluding PAA)" category will converge on "net interest margin". To that you have to add the interest rate hikes that are still flowing through and the potential for 2 more rate hikes in 2023. In two to three quarters, all measures of net interest margin will fall drastically. Why would this surprise anyone? After all, we have one of the most inverted yield curves we have ever seen since the 1970s. Borrow short, lend long models are not really designed for this.
The second aspect here is that hedges are marked to market. So in other words the book value reflects the gains in hedges. As we roll through the year, the hedges will protect the income statement but that will be offset on the balance sheet side of things. There is no further money to be made on those hedges.
Verdict
Given this knowledge of where NLY stands, the biggest question over the next 6 -9 months is how you want to price this for the current environment. Our contention is that core inflation has proven more sticky than most have expected and in a "higher for longer" scenario, NLY's model does not work. We would also add that in such a climate, we would price NLY at a large discount (25-30%) to tangible book value. This is no different than pricing some of the office REITs, at huge 50% plus discounts to consensus NAV. If NLY's model reaches a point of negative returns, who exactly is going to want to own it? While trading at 70%to 75% of tangible book value may sound bleak, NLY traded under 80% of tangible book value even during benign times with a sloping yield curve in 2015 and 2016. So our call can hardly be considered harsh, all things considered.
If you find mortgage backed securities appealing, you can go and hold mortgage backed securities. Certainly their spreads relative to risk-free rates of the same duration (this is key, same duration) Treasury bonds are appealing. But they are not cheap relative to short term borrowing costs and that is the problem. We think NLY will provide negative returns over the next 12 months including dividends and we see a potential for another significant dividend cut in 12 months.
Preferred Shares
NLY has three classes of preference share classes outstanding.
1) Annaly Capital Management, Inc. 6.95% PFD SER F ( NLY.PF ).
2) Annaly Capital Management, Inc. 6.50% PFD SER G ( NLY.PG )
3) Annaly Capital Management, Inc. 6.75% PFD SER I ( NLY.PI )
NLY.PF is floating at LIBOR + 4.993% and is a very expensive source of financing for NLY. This could be called, especially if two more rate hikes pan out. NLY.PG is also floating at LIBOR +4.172%. This is least likely to be called as NLY will have bigger fish to fry. If interest rates stay stubbornly high, NLY.PI will turn out to be expensive for NLY starting about a year from now when it floats at LIBOR plus 4.989%. At present none of the securities are very appealing and other mortgage REIT preferred shares are better priced .
For further details see:
Annaly Capital: Broken Model, Downside Is As Low As 70% Of Tangible Book