2023-08-09 14:16:55 ET
Summary
- NLY recently released its Q2 numbers, which provide a good opportunity to revisit the company in the context of its 7-10% yielding preferreds.
- NLY preferreds remain our favorite choice in the Agency mortgage REIT preferreds sector.
- After enjoying a great run with NLY.PF for over a year, we are now rotating to sister preferred NLY.PI which we expect to outperform over the next year.
With the latest quarterly earnings release from mortgage REIT Annaly Capital ( NLY ) out, we take the opportunity to revisit its preferreds shares. The suite remains very attractive for income investors due to high single-digit/low double-digit yields as well as the company's strong and stable credit metrics. In this article we discuss the company's metrics that are most relevant to preferreds investors, how it stacks up in the suite and where we see value in its trio of preferreds.
Why We Favor Agency MBS Preferreds
Within the broader income space, we find the Agency MBS sector quite attractive at present. The chart below shows that Agency option-adjusted spreads are elevated historically. This provides a significant margin of safety for agency mortgage REIT investors as a reversion to the longer-term average would support book values and, hence, equity/preferred coverage for holders of the preferreds.
This is in contrast to the corporate credit space where valuations are quite rich at present as the following chart of high-yield corporate credit spreads shows.
Why We Favor NLY
There are three reasons why we tilt to NLY preferreds in the Agency mREIT sub-sector (which also includes DX, AGNC, ARR and IVR). First, we like the positively convex behavior of share issuance exhibited by NLY with respect to its preferreds. This has to do with how it responds to large book value drops.
The company has typically issued additional shares in response to drops in book value. For example, in Q3 NLY issued 16% more common shares in response to its book value drop. The net result is that while book value fell 15%, equity, which is the thing that actually matters to preferreds, fell only 1.2%. As the book value fell over 2022, the company grew its common shares by a huge 29%.
The chart below shows the outstanding common share profile of NLY. Over the last five years the share count has grown by 50%. In other words, a large book value drop causes NLY to issue common shares, softening the impact on preferreds. And if we see a big rise in book value, NLY will likely do nothing (i.e. they won’t buy back their recently issued shares), leaving preferreds much better off from an organic rise in equity.
This convexity of little equity coverage loss to the downside, and a big potential equity coverage gain to the upside, is a nice profile for preferreds to have. There is no guarantee NLY will keep being so bold with common equity issuance to the downside, but the fact is they have been so far, leaving their preferreds much better off than others in the sector.
What all this means is that while book value (blue line) has fallen sharply over time, the equity/preferred coverage has been very stable (red line). Common share investors have seen about half of book value lost while preferred investors are no worse off than they were at the end of 2019.
Systematic Income Preferreds Tool
Another reason we like NLY in the sub-sector is because NLY tends to be somewhat more conservative . For example, while DX and AGNC have kept leverage stable or increased it, NLY has pushed it lower recently. Its latest leverage of 6.4x is well below the other higher-quality mREITs such as AGNC and DX which feature leverage of 7.2x and 7.7x respectively.
A higher level of leverage is now more attractive for investors in common shares as Agency MBS valuations are attractive. However, preferred holders are much more interested in downside risk than upside gains so, all else equal, they prefer lower leverage levels as it makes book value more resilient.
Finally, the company's equity/preferred coverage level is very high and among the highest in the sector (in close second place after DX). The net result of these two factors is that NLY features a very attractive combination of leverage (y-axis) and coverage (in parenthesis). And while it's level of Agencies (x-axis) is not as high as the rest of the sub-sector it's still very high at 92%.
NLY Preferreds
In this section we discuss the NLY preferreds suite which looks like this:
Systematic Income Preferreds Tool
We initially added NLY.PF to our Income Portfolios in the middle of last year with the view that the upcoming switch to floating-rates would significantly boost its yield and, hence, likely return. Since then we have moved between NLY.PF and NLY.PG and the total return of the pair since our initial allocation is shown below in the context of the broader mREIT preferreds sector.
This kind of relative value rotation is quite common in our allocation for securities of the same issuer. We find that it adds a significant amount of additional return on top of the base return of the original holding. The chart below shows what we've done with red lines highlighting rotations between NLY.PF and NLY.PG.
Systematic Income
Specifically, we added NLY.PF at the end of June 2022, then switched to NLY.PG in early November and moved back to NLY.PF at the end of November. The chart shows that the total return of the strategy (blue line) is quite a bit above the original allocation to NLY.PF.
And although NLY.PG has narrowly outperformed the rotation strategy, it's because it has run up to a very expensive valuation which doesn't make a ton of sense. The chart below shows that the yield of NLY.PG is dominated by that of NLY.PF and will also be dominated by NLY.PI after its own reset next year.
Systematic Income Preferreds Tool
NLY.PF and NLY.PG are floating-rate stocks that are currently based off Libor. They will move to SOFR in Q4 as the following website extract explains.
The chart above also makes it clear that in the middle of next year NLY.PI yield (blue line) will rise above the rest. If all the stocks are redeemed, NLY.PI will outperform as it trades well below the other two stocks.
It's very likely the yield between NLY.PI and NLY.PF will converge as we approach the NLY.PI call date next year, causing NLY.PI to outperform. There is no iron rule of markets that demands yield convergence (after all NLY.PG has been happily trading well below the yield of NLY.PF for a while) however even if yields don't converge, NLY.PI holders will enjoy a higher yield and compounding at higher yield which by itself will drive outperformance in the suite over time.
The price differential between NLY.PF and NLY.PI of close to $2 is on the high side outside of a weird spike during the last big market drawdown in October. This suggests it's a good time to rotate to NLY.PI. Investors will have to settle for a lower yield of about 3% however this will be either made up through capital gains and through higher longer-term yield at the current price.
Systematic Income
For further details see:
Annaly Capital: Our Latest Move In The 7-10% Yielding Preferreds