2023-11-27 07:30:38 ET
Summary
- Annaly Capital Management has faced challenges with mark-to-market losses in mortgage-backed securities due to a difficult interest rate environment.
- Analysts are optimistic about the MBS sector in the coming year, citing factors such as the Federal Reserve nearing the end of its hiking cycle and more appealing MBS valuations.
- The timing of potential rate cuts remains uncertain, leading to differing opinions among market participants and caution in the overall outlook.
Annaly Capital Management, Inc (NLY) has faced recent challenges, marked by substantial mark-to-market losses in mortgage-backed securities (MBS) due to a challenging interest rate environment. While the majority of its portfolio, consisting mainly of agency-linked assets, suffered from widening spreads and market volatility, analysts express optimism for the MBS sector in the coming year. Positive factors include the Federal Reserve approaching the end of its hiking cycle, reduced interest rate volatility, and more appealing MBS valuations. However, the timing of potential rate cuts remains uncertain, leading to varied opinions among market participants.
Amidst these challenges, analysts provide a glimmer of hope for the MBS sector in the upcoming year. Positive indicators include the Federal Reserve approaching the conclusion of its hiking cycle, a reduction in interest rate volatility, and more attractive MBS valuations. However, the uncertainty surrounding the timing of potential rate cuts has led to differing opinions among market participants, adding an element of caution to the overall outlook.
While optimism exists for the potential alleviation of mark-to-market losses at Annaly, ongoing volatility in the agency-backed MBS market may necessitate shareholders to exhibit patience as the narrative surrounding interest rates unfolds. Despite concerns about the potential for a dividend cut, Annaly's high dividend yield, currently hovering around 15%, remains an attractive feature.
Interest Rate and MBS Outlook
The rising rate environment has not been kind to most mREITs such as Annaly. The mREIT reported yet another quarter of declines in book value per share as spreads on most fixed-income assets continued to widen requiring further mark-to-market write-downs in this area. Agency-backed MBS was among the worst impacted by these trends, with management observing that -
…higher term premium and the continued elevated volatility contributed to significant underperformance in Agency MBS during the quarter, which was exacerbated by a pullback in demand from the money manager community who remain the primary buyers of MBS. As a result, spreads widened roughly 15 to 20 basis points on the quarter, with higher coupons outperforming lower coupons as investors sought to optimize carry-in duration profiles… spread widening and increased volatility significantly impacted our Agency portfolio, resulting in losses of approximately $6.16 [per share] for the quarter."
The MBS market has also been impacted by concerns over the Federal Reserve's reduction in its balance sheet including fears over potentially selling some MBS positions. Wellington Management has indicated that speculation on this matter has been quelled by Fed Chair Powell's statement during the September FOMC meeting. Powell explicitly stated that the outright sale of mortgages is not presently under consideration and is not expected to be in the foreseeable future.
Merrill, in its Capital Market Outlook , expresses the opinion that the MBS sector is poised for improvement in the coming year. The factors contributing to this positive outlook include the Federal Reserve nearing the conclusion of its hiking cycle, a reduction in interest rate volatility, decreased duration-extension risk, and notably, more appealing MBS valuations. The ICE BofA U.S. Mortgage-Backed Securities Index's option-adjusted spread (OAS) has risen to approximately 70 basis points, up from the initial 40 to 50 basis points at the beginning of the year.
Merrill anticipates U.S. banks, which currently hold around 30% of the agency MBS market, to gradually re-enter the sector, potentially leading to slightly tighter spreads for MBS, assuming other factors remain constant. Furthermore, Merrill notes that, despite U.S. banks staying cautious due to significant unrealized losses on existing MBS portfolios totaling $558.4 billion as of Q2, they expect banks to slowly reintegrate into the MBS market over time. This reintegration is anticipated to contribute to modestly tighter spreads for MBS. Additionally, Merrill suggests that in the event of rising credit concerns in the corporate market, MBS should exhibit less volatility compared to investment-grade bonds.
This view also enjoys support from another analyst such as Brij Khurana with Wellington Management, who expressed the view that agency MBS could experience significant advantages during a cycle of interest rate cuts, particularly with the potential for increased participation from banks. He notes that if the Federal Reserve ultimately decides to lower rates, banks are likely to feel more assured that the costs of their liabilities, such as deposit rates, won't experience substantial increases. Simultaneously, a period of rate cuts could alleviate concerns about duration extension in agency MBS. He also suggests that in a declining rate environment, the U.S. economy is likely to have slowed down, diminishing the attractiveness for banks to engage in lending and providing stronger incentives for them to allocate excess cash towards securities.
I agree with these views. However, it is not yet clear when the Fed will begin cutting rates. There is also quite a bit of disagreement among market participants and analysts over when exactly rate cuts are likely to take place. While some analysts foresee a series of rate cuts starting as early as March 2024 others warn that prices remain elevated which makes these types of deep interest rate cuts unlikely to occur. Nevertheless, the risk of further mark-to-market losses at Annaly is likely to reduce substantially amidst greater optimism over the end of the rate hike cycle in the market and a potential increase in demand for MBS.
The reversal of some of the recent mark-to-market losses would certainly be highly beneficial for shareholders of Annaly. However, there might still be quite a bit more volatility in the agency-backed MBS market as investors react to the indications given by the Fed. This also means that Annaly shareholders may need to be patient as the rates' story plays out.
The dividend and earnings
Annaly currently offers a forward dividend yield of almost 15% and a TTM dividend yield of 16.13%. This is the highest dividend yield of any of the major mREITs considered in the peer comp chart below. It's also well above its 5-year average forward dividend yield of around 7.5%. This wide difference to its historic trading levels likely arises at least in part from investors' fear that another dividend cut could be on the horizon for Annaly.
The high-interest rate environment has also had a negative impact on Annaly's net interest spread, as the rise in the cost of funds has exceeded the rise in asset yields. This again underscores how strongly the future direction of the stock and its earnings potential is linked to the interest rate environment. This outlook is unlikely to change meaningfully unless the interest rate environment stabilises.
Despite the decline in net interest spread, the mREIT generated earnings available for distribution per share of $0.66 which was slightly higher than its quarterly distribution of $0.65 per share. This leaves somewhat limited scope for further earnings declines before the mREIT may have to consider another dividend cut. In its most recent earnings call, management indicated that -
…the Board evaluates our dividend every quarter. And we have 3 criteria by which we set it. We want it to be a competitive dividend yield with the peer set. It should be consistent with our historical payout and it should be sustainable to the extent we have line of sight into earnings in the future. Now as you mentioned, we did modestly out earn our dividend in the third quarter. In terms of Q4, we expect EAD to be contextual with the dividend. Beyond that, a lot depends on, for example, how the Fed behaves and other factors, and we don't have guidance beyond 2023."
These comments suggest that earnings available for distribution is not the sole factor in determining the dividend. Nevertheless, management clearly envisages that the dividend would broadly track earnings available for distribution, but a dividend cut would not necessarily take place if the dividend is not fully covered in a particular quarter. This would particularly be the case if the future earnings outlook looks better. I am of the view that a likely reduction in volatility in the MBS market would substantially reduce the likelihood of a dividend cut. However, the rate environment is far from certain despite the early signs of cause for optimism.
Valuation
Annaly is currently trading at a discount to NAV of around 13% which is the lowest discount to NAV of the mREITs considered in the peer comp chart below. Nevertheless, it is well below the mREITs historical average valuation levels with the stock having traded at an average premium of 6.7% to NAV over the course of the past 5 years.
The discount can partially be justified by the recent declines in book value as it does not make sense for a stock with a declining book value to trade at a premium. However, I am of the view that an improvement in the agency-backed MBS market would see an increase in book value as some of the mark-to-market losses are reversed. While there might still be some volatility in the near term, I am of the view that the eventual decline in interest rates will create substantial opportunities for capital appreciation for Annaly shareholders.
Conclusion
Annaly Capital Management has faced challenging times in recent months, marked by significant mark-to-market losses in MBS, particularly due to the adverse impact of a rising interest rate environment. The majority of NLY's portfolio, consisting of agency-linked assets, suffered amid widening spreads and continued market volatility.
Analysts, such as Merrill and Brij Khurana with Wellington Management, share a positive outlook for the MBS sector in the coming year. Merrill highlights factors such as the Federal Reserve approaching the end of its hiking cycle, reduced interest rate volatility, decreased duration-extension risk, and more attractive MBS valuations. However, the timing of potential rate cuts remains uncertain, with varying opinions among market participants.
While there is optimism regarding the potential reduction of mark-to-market losses for Annaly, the agency-backed MBS market may experience continued volatility as investors react to Federal Reserve signals. Shareholders might need to exercise patience as the rates story unfolds.
Annaly's high dividend yield, currently around 15%, is particularly attractive despite ongoing concerns about the potential for a dividend cut. Valuation-wise, Annaly is trading at a discount to NAV, which may be partially justified by recent declines in book value. Nevertheless, book value will see improvement with a recovery in the agency-backed MBS market. The potential for capital appreciation for Annaly shareholders is seen in the eventual decline in interest rates, though some near-term volatility may persist.
For further details see:
Annaly Capital Management: Cautiously Optimistic Over This Near 15% Yielder