2023-11-03 11:39:01 ET
Summary
- Stock price weakness in Annaly Capital Management presents an attractive entry point into the largest mortgage real estate investment trust.
- Despite weak Q3 results, the 11% discount to book value offers a reasonable margin of safety.
- The expectation of lower interest rates in 2024 and improving economics could make the stock a compelling investment.
Stock price weakness with regards to Annaly Capital Management, Inc. ( NLY ) is creating a potentially attractive entry point into the largest publicly-traded mortgage real estate investment trust.
The trust reported results for 3Q-23 that were widely seen as weak: Annaly Capital Management suffered a 12% QoQ book value decline for its most recent quarter and saw a higher negative interest rate spread, which in turn led to weakening dividend coverage.
Annaly Capital Management's pay-out ratio increased 8% percentage points QoQ. Despite the drop in book value as well as softening pay-out metrics due to an unexpected widening in mortgage-backed security spreads, I think that we are near peak rates and that the 11% discount to book value presents a reasonable margin of safety.
My Rating History
Not long ago, I moved the rating classification for Annaly Capital Management from Sell to Hold in light of easing inflation and the potential for spread improvements in the mortgage trust's business.
These improvements have not revealed themselves in the third quarter, and Annaly Capital Management instead reported a rather steep drop in book value and deteriorating dividend pay-out metrics.
With that being said, I think that the stock has a much more compelling valuation and fears over a dividend cut might not be justified.
Negative Net Interest Spread, But Interest Rate Expectations Indicate Rates Are Near-Peak
Higher interest rates and higher financing costs continued to hurt Annaly Capital Management in the third quarter, which I guess was sort of anticipated.
The mortgage trust experienced yet another QoQ increase in its average GAAP financing cost to 5.27%, reflecting a 27 basis point increase compared against the prior quarter. Because of higher costs to carry debt, the trust's net interest spread declined again, to negative 0.78%. The force of the incremental deterioration, however, has moderated quite a bit (the net interest spread declined only 5 basis point QoQ) and I would think that Annaly Capital Management could soon see net interest spread pressures easing.
The thinking behind this assumption is that inflation, broadly speaking, has moderated since last year (it was down to 3.7% in September) and the central bank should soon follow up by lowering interest rates. The market widely expects a decline in interest rates in 2024, a view that I share and think will help improve Annaly Capital Management's economics.
While there is, of course, considerable uncertainty about the exact timing when interest rates will decrease, there is a broad consensus that interest rates have peaked, or are very near their peak, in 2023.
If inflation roars back, the interest expectation curve might shift into 2024, but with inflation generally being on a good trajectory (pointing south on a QoQ basis), I think we are approaching a point (my estimate: 2Q-24) at which the central bank will end its tightening policy and push interest rates lower again.
Dividend Pay-Out Metrics Deteriorated In 3Q-23
Annaly Capital Management witnessed a rather substantial increase in its dividend pay-out ratio in the third quarter as its net interest spread declined, which in turn resulted in lower distributable earnings.
The mortgage REIT paid out 98.5% of its distributable earnings in the last quarter, which is the highest dividend pay-out ratio since the fourth quarter of 2022. Annaly Capital Management's LTM pay-out ratio is 92%, but with that said, the 3Q-23 pay-out ratio closing in on 100% is not a good sign in the near term as it makes, hypothetically, a dividend cut probable.
Annaly Capital Management's 11% BV Discount Translates Into High Margin Of Safety
Annaly Capital Management's book value plunged from $20.73 per share in 2Q-23 to $18.25 per share in 3Q-23, reflecting a decline of 12% QoQ, due to rising yields as well as a widening of mortgage-backed security spreads in the Agency market. AGNC Investment Corporation ( AGNC ) suffered a 14% QoQ decline in its net book value in the third quarter.
Annaly Capital Management is now selling for an 11% discount to book value, whereas AGNC Investment Corp is priced at an 14% discount to book value.
These book value discounts indicate higher margins of safety than when I covered both of these trust before. And though I acknowledge that MBS spread risks and higher financing cost risks exist in the market, driven by uncertainty about the interest rate path, I think that a speculative position could potentially reward passive income investors here.
Why Annaly Capital Management Could See A Higher Discount To BV
If, against consensus expectations, the central bank continues to hike interest rates next year, this would be set to lead to a higher-for-longer pressure scenario for the trust's net interest spread and pay-out ratio. There is also a certain risk related to the increase in the 3Q-23 pay-out ratio, which has moved closer to 100%.
Right now, I don't expect a dividend cut, buy Annaly Capital Management has historically been a dividend cutter, so passive income investors might see another dividend cut in 2024, if conditions (spreads) don't substantially improve.
My Conclusion
Annaly Capital Management did not have a particularly great quarter in 3Q-23, just like AGNC Investment didn't, and the stock price reflects concerns about a QoQ decline in the net interest spread, uncertainty about Agency MBS spreads and a rather large decline in the mortgage trust's book value.
The pay-out ratio also moved dangerously close to 100% in 3Q-23, a potential indicator that the trust might slash its dividend again. Against this backdrop of concerns, however, I think that we are near peak rates in the market and that Annaly Capital Management and other mortgage trusts will soon gravitate into a lower yield environment.
With inflation easing, I think the odds are in favor of a substantial rate decline in 2024. The stock is now selling at a large, double-digit discount to book value, which improves passive income investors' margin of safety. Trading at just 0.86x book value, I think NLY is a steal.
For further details see:
Annaly Capital Management: This 16.6% Yielding Trust Is A Bargain (Upgrade)