2023-11-29 06:43:48 ET
Summary
- Annaly Capital Management is a good play on potential lower interest rates ahead, despite the Fed's rhetoric of 'higher for longer'.
- Annaly's business model is negatively impacted by rising interest rates, but the company may benefit from a potentially declining interest rate environment.
- Annaly offers a high-dividend yield that seems sustainable in the short term, making it an attractive income and value play.
Annaly Capital Management ( NLY ) is a good play on potential lower rates ahead despite the Fed’s rhetoric of ‘higher for longer', plus it offers a high-dividend yield that seems sustainable in the short term.
As I’ve covered in previous articles , Annaly’s investment case is highly geared to its high-dividend yield, as the company’s business model does not work well in a rising interest rate environment. Even though inflation has cooled in recent months and the Fed has stopped its hiking campaign last July, long-term interest rates continued its upward pace until mid-October, being a negative backdrop for Annaly.
Not surprisingly, its shares have been quite weak over the past couple of years and have underperformed the market by a large margin, like its peer AGNC Investment Corp. ( AGNC ), a trend that seems likely to reverse in the near future.
This happens because long-term rates have likely reached their peak and, potentially, rate cuts ahead will be a strong tailwind for book value growth in 2024, as the company’s business model is highly geared to declining interest rates.
Interest Rate Risk
Annaly’s business model is quite straightforward, as the company raises money to invest in high-quality securities. Its goal is to generate a profit from the difference between income generated and interest expense, which usually works well when the interest rate curve has an upward slope.
This happens because, generally speaking, Annaly borrows at shorter-term maturities and invests on longer-dated securities, making a profit from the difference between these rates. In normal times, the interest rate curve has an upward slope, and Annaly is able to generate profits, but this has changed considerably since the end of 2021.
Due to abnormal high levels of inflation following the global supply chain disruption due to the pandemic, central banks around the world entered into a hiking pace. The Fed was no exception, and the Fed’s Funds effective rate went from near zero at the beginning of 2022, to more than 5.3% since last July, as shown in the next graph.
However, while short-term rates increased rapidly during this period, the market was not so convinced that high levels of inflation would be durable, and long-term rates did not increase at the same pace. That led to an inverted yield curve, where short-term rates are higher than long-term rates, a profile that usually is a good indicator of an economic recession ahead.
That was also a reason why so many analysts were expecting a recession in 2023, which did not happened yet. These expectations also led to a negative spread between 2Y rates and 30Y rates since mid-2022, as can be seen in the next graph. Currently, this spread is still negative by 28 basis points (bps), but has recovered significantly since July when it was close to -100 bps.
Given that the vast majority of Annaly’s asset base is agency mortgage-backed securities (MBS), which have long durations, this asset profile makes Annaly quite exposed to interest rate risk. To reduce its sensitivity to rates, the company uses financial derivatives, including futures, options, or swaps, to hedge some part of this risk, but nonetheless its business is negatively impacted by rising rates and a negative spread between short and long term rates.
Taking into account this backdrop, it’s not surprising to see that Annaly’s net interest margin has declined in recent quarters, from more than 2% in 2021 to 1.48% in Q3 2023 . Moreover, its book value per share has also been on a downward trend, impacted negatively by higher rates and due to the inverted yield curve, to $18.25 per share in Q3, representing a decline of 12% on a quarterly basis.
Given its relatively low NIM, compared to banks for instance that are currently enjoying NIMs in excess of 3%, Annaly generates an acceptable return on equity ((ROE)) by leveraging up its balance sheet. Indeed, at the end of Q3, its total investment portfolio was around $76 billion, while shareholders’ equity was only $10.6 billion, showing that Annaly’s financial leverage is considerable.
Its reported economic leverage ratio was 6.4x in Q3, up from 5.8x in the previous quarter, due to an increase in its hedge portfolio from $73 billion to $79 billion in the last quarter, to manage portfolio duration extension. This means that Annaly increased its hedges during the last quarter, a sensible move considering that rates increased markedly from September to mid-October.
However, recent inflation figures have shown a gradual declining trend, even though the inflation rate is still above the Fed’s desired target, but the need for further rate hikes seems to be quite low. While the Fed is currently managing expectations and saying that rates are likely to stay ‘higher for longer’ , in my opinion, the Fed is likely to be wrong again, like it was in late 2021 when it called the surge in inflation ‘temporary’ and was quite slow to react.
Taking into account this background, interest rates have declined over the past month, with the 2Y rate, which is more sensitive to the Fed’s actions, declining from a peak of 5.22% in mid-October, to about 4.77% currently, as can be seen in the next graph.
Given that there are some expectations for rate cuts in 2024, if inflation continues to subdue and move towards the Fed’s 2% goal, short-term interest rates are likely to remain on a downward path in the coming months, even if the Fed maintains its rhetoric of ‘high for longer’ rates.
This completely changes Annaly’s operating backdrop, which has been quite negative over the past eighteen months, to benefit from a potentially declining interest rate environment. While the company was fully hedged at the end of Q3, Annaly is quite experienced regarding interest rate risk management and, most likely, has reduced its hedges in recent weeks to be more geared to lower rates.
Not surprisingly, due to this improved outlook for its business ahead, its share price has rebounded nicely since its bottom a few weeks ago, being up by more than 19% over the past month.
Despite that, much more upside may lie ahead if rates continue, as I expect, in a downtrend over the coming months, which will be a positive tailwind for a higher book value and share price in the near future. Based on its Q3 book value, Annaly is currently trading at 0.96x book value, more or less in-line with its historical average of 1x book value over the past five years, thus I expect upside potential from a rising book value in the coming quarters, rather than a re-rating of its valuation multiple.
On top of potential upside from an increasing book value, Annaly also pays a quarterly dividend of $0.65 per share, which were covered by earnings available for distribution of $0.66 per share in Q3. While the current payout is quite high at close to 100% of earnings, this is likely to reduce in the next few quarters as declining rates are a tailwind for its earnings, thus I don’t see a big risk of a dividend cut in the near term. Therefore, Annaly’s current dividend yield of nearly 15% seems to be quite attractive, making Annaly an income and also a value play on lower interest rates ahead.
Conclusion
While the Fed is currently managing market expectations regarding rates saying that they will remain ‘higher for longer’, the prospects of lower rates ahead are good and this should have a positive effect on Annaly’s operational performance in the coming quarters.
This means its investment case is no longer reliant solely in its high-dividend yield, being now also a good bet on potential lower rates ahead. While its shares have already rebounded somewhat in recent weeks, there is still plenty of upside ahead if rates maintain a downward trajectory. Thus, investors should consider current levels as a good entry point, while also receiving a high-dividend yield in the meantime, to fight the Fed in its current rates outlook.
For further details see:
Annaly Capital Management: Receive A 15% Yield To Fight The Fed