2023-12-20 07:34:46 ET
Summary
- Annaly Capital's dividend yield of around 13% has attracted investors, but its dividends per share have been declining steadily.
- I suggest that income investors seeking reliable REITs should not invest in Annaly Capital.
- I argue that Annaly Capital is an easy sell for investors.
Annaly Capital (NLY) is an mREIT whose dividend yield of around 13% has intrigued many investors. To anyone that looks at the history of their distributions, they will see that these dividends per share have been on a steady trend of decline, as the chart below will show.
It is therefore worth examining what drives this dividend history. I will make the case that, for income investors in pursuit of dependable REITs, they will not find that by being invested in NLY, making it SELL.
Recent Earnings
Here is a screenshot of their income and expenses over the last few years.
As we can see, there is significant fluctuation among their different income sources. Since a REIT's return is primarily and structurally realized by way of the dividend, look at how management discussed their distributable earnings for 2022 in their 10-K :
The change in earnings available for distribution for the year ended December 31, 2022 compared to the same period in 2021 was primarily due to a favorable change in the net interest component of interest rate swaps, lower premium amortization expense, excluding PAA, resulting from lower prepayment speed projections, higher net servicing income from an increase in average MSR balances, and higher coupon income from an increase in interest rates, partially offset by higher interest expense from an increase in average borrowing rates.
For one, I'll note that this description has a lot of complexity to it. When I am looking at a mortgage REIT (or any lender, really), I mainly want to see that they are originating solid loans that provide a high return on equity and little risk of default. Clearly, that's not what Annaly does. It puts its money into related investments which have more obscurity to them, and I think that's important for investors that want a simple income stream to know.
Derivatives
If you peek again at that chart, just look at how much derivatives-not net interest income-move the needle on earnings overall. Sometimes the impact is positive. Sometimes it isn't. Nevertheless, it's concerning to me that its role here is so large. In this slide from their Q3 2023 earnings presentation, they reported a larger hedge portfolio than their actual investment portfolio.
It's amazing to me that so much commitment to hedging exists here. Now, every lender does a little hedging. There are situations where some kind of derivative purchase has an outsized benefit for its cost. The Big Short dramatizes real events that pertain to one such scenario. When hedging becomes as major and systemic to a company's strategy as this, however, that tells me that they don't believe very strongly in their portfolio. After all, that's why it's called hedging. It does not tell me that they are meticulously treating derivatives as situational uses of capital.
Crucially, derivatives are just not a form of durable cash flow. They can be great trades here and there, but when folks buy a REIT, they are looking for that cash flow as an income source.
Portfolio Assets
With the actual loans on their portfolio, the company indicates that its credit quality is lacking in some portions. I've consolidated charts from separate slides that describe their Agency portfolio (left) and their Residential Credit (right).
Both of these display significant portions of lower credit quality. When times are tough (and they have been lately), these are portfolios exposed to risks of delinquency on payments. Delinquencies result in decline of value of assets. Sufficient declines in values of assets result in margin calls, forced sale of these assets, or even share dilution in order to raise liquid capital in a pinch (which will hurt dividend per share over time).
Even for periods where the risk of margin call does not materialize, some of the rise in interest expense that we saw in the earnings table can also be explained by this section of their risk factors:
A significant portion of our assets are longer-term, fixed-rate interest earning assets, and a significant portion of our borrowings are shorter-term, floating-rate borrowings. Periods of rising interest rates or a relatively flat or inverted yield curve could decrease or eliminate the spread between the interest payments we earn on our interest earning assets and the interest payments we must make on our borrowings.
As interest rates went up, their interest expense rose, but not their interest income from these assets quite as much. Personally, I prefer not to invest in a company that would let themselves get squeezed like this.
MSRs
More recently, they've recently been building up a portfolio of Mortgage Servicing Rights (MSRs).
Within the last couple of years, they have gone from almost nothing in MSRs to over $2 billion. This is something that I almost find to be one of the more redeeming parts of the business, as servicing fees for loans tend to be a source of stabler cash flows in the long run. Unfortunately, $2 billion is only a minor portion of their portfolio for the time being.
Considering that, it's important to pay attention when the company mentions in their 2022 10-K's risk factors about MSRs:
Investments in MSR are highly illiquid and subject to numerous restrictions on transfer and, as a result, there is risk that we would be unable to locate a willing buyer or get required approval to sell MSR in the future should we desire to do so.
Lack of liquidity here is concerning, for reasons I mentioned before about margin calls and potential for share dilution. That said, because cash flow is a factor with MSRs, there is potential that it could improve Annaly's fundamentals over time. This will largely depend on the quality of those loans as its grows its position in MSRs, so for now it's something to watch.
Preferred Shares
Another part of this picture when discussing the common shares is to consider Annaly's preferred shares, which have the interesting feature of floating-rate dividends ( NLY.PR.F ), ( NLY.PR.G ), and ( NLY.PR.I ).
If we look at where these preferred shares fit into the earnings, we can see they usually eat up no more than 10% of earnings.
With priority in distributions and not being subject to the same dilutive effects of the common, there is a case for the preferred over the common here. Let's look at each individual issue, however.
The Fs
Not only do these shares pay quarterly, the dividend has not been cut since issuance. Because they were given a floating rate, they actually increased as interest rates rose, another advantage over the common. While the base spread is 4.993%, the shares currently trade around 10%, a fairly attractive yield. Of course, one should keep in mind that this will reverse if interest rates decline. As its Form 8-A indicates as well, these dividends will also accumulate, should they ever go unpaid.
Interestingly, the Fs has also shown relative price stability in light of these features.
Thus, even if interest rates move, investors could enjoy relative capital preservation and thus an opportunity to reallocate if they find better yields elsewhere at that time.
The Gs
The Gs are very similar to the Fs, except that their base spread is 4.172% . As we can see here, their dividend has been consistently paid quarterly and went up after the floating rates triggered.
Similarly, the share prices have been relatively stable.
Unless interest rates fall to near-zero again, investors get a similar benefit between the Fs and the Gs.
The Is
These are a bit different than their cousins. They are still in the fixed-rate portion of their life and are yielding at the 6.75% until June 30, 2024. At that point, they shall shift to floating rates as well, with a base spread of 4.989%. It will depend on what rates are at that time, but if they do not change much by then, investors could expect a yield of around 10% at that time.
Yet, the payout so far has been reliable.
The price has also been relatively stable for its holders.
With these three preferred issues, the yield might not quite be as high as NLY's 13%, but the payouts haven't been in a state of decline, which is part of why NLY's yield is so high right now. I think income investors would therefore find a somewhat attractive yield and more safety of principal in these preferred issues.
Conclusion
Annaly Capital fits into the category of mREITs but doesn't partake in loan origination itself. Rather, they invest in Agency loans, Residential Credit loans, MSRs, and derivatives on these assets. Financed largely by floating-rate debt and preferred equity, their net interest income available to holders of the common has been squeezed in recent years as interest rates went up. Their investments in derivatives also tend to have a larger impact to earnings than net interest income, making the common shares tricky to value from a cash-flow perspective.
Some hope exists with the rise of its investments in MSR, but until this becomes larger, I think that folks who want to be invested in Annaly for income might get a better deal selling any common shares they have and buying the preferred F, G, and I issues, provided they understand how those yields will be impacted by future fluctuation in interest rates.
Because of its history of declining dividends, its lack of clear signals that this will improve, and the safer returns offered by the preferred, it's my view that shares of NLY are a SELL for investors seeking dependable income.
For further details see:
Annaly Capital: Common Is A Dividend Trap, Preferreds Are Better