2023-05-22 12:50:00 ET
Summary
- Annaly Capital saw a large contraction in its net interest spread in the first quarter.
- The trust’s book value declined marginally. The dividend pay-out ratio improved, however, thanks to Annaly Capital’s dividend cut in 1Q-23.
- Annaly Capital may trade at too low a discount to book value.
Short-term interest rate volatility and tightening mortgage-backed security spreads contributed to a significant decline in the trust's book value last year, and these trends unfortunately continued in the first quarter.
Annaly Capital Management, Inc. ( NLY ) was harmed by a sharp increase in funding costs, and the trust's book value fell again in 1Q-23, though not as steeply as it did last year.
Even though the mortgage real estate investment trust cut its dividend in the last quarter as expected, I believe the risk/reward tradeoff remains unfavorable until the central bank stops raising interest rates.
Dangerous Net Interest Spread Trajectory
Over the last year or so, I have pointed out a significant risk that Annaly Capital was facing, which I believe was related to the leverage-driven nature of the mortgage trust business model. Mortgage trusts, such as Annaly Capital, borrow heavily in order to purchase high-yielding mortgage securities. This model works well until the central bank starts raising interest rates.
Annaly Capital has seen a concerning compression in its net interest spread since the central bank began aggressively raising interest rates last year. For example, the mortgage trust reported a negative net interest spread of 0.56% in the first quarter, indicating that Annaly Capital's financing costs exceeded the trust's average yield on interest earnings assets. The net interest spread has decreased from 3.13% in 1Q-22, almost entirely due to the rise in borrowing costs as a result of the central bank's rate-hiking cycle.
Annaly Recently Cut Its Dividend And Dividend Coverage Has Improved
The big mistake that I believe many passive income investors make is being too easily seduced by a high dividend yield. Annaly Capital's stock currently has a dividend yield of 13.7%, but investors should keep in mind that Annaly Capital has been a serial dividend cutter, and the high dividend yield that attracts passive income investors has frequently proven to be a trap.
Annaly Capital recently slashed its dividend by a whopping 26% in the first quarter, reducing its payout to just $0.65 per share. In 1Q-23, the mortgage trust earned $0.81 per share in earnings available for distribution, implying an 80% dividend payout ratio. Annaly Capital distributed 99% of its earnings in the previous dividend payment of $0.88 per share. The lower dividend has improved the coverage (pay-out) ratio, but it was not Annaly's first dividend cut, and it is unlikely to be the last.
One Thing That I Like About Annaly Capital
The trust's primary business is the acquisition of agency mortgage-backed securities, which is the trust's primary focus. However, Annaly Capital also invests in Mortgage Servicing Rights, which provide investors with income and valuation upside by moving in the same general direction as interest rates. In this sense, Mortgage Servicing Rights enable Annaly Capital to hedge against an increase in interest rates.
The mortgage market, on the other hand, is relatively small, with a total market value of $1.83 billion, whereas the agency MBS business had assets valued at $77.6 billion at the end of the first quarter.
Rithm Capital Corporation (RITM), which I believe offers better exposure to MSRs, is one of the best mortgage trusts passive income investors can own.
Discount To Book Value Doesn’t Properly Account For Annaly Capital’s Risk
Annaly Capital is currently valued at 0.91x book value, which appears to be an unjustifiably high valuation given the massive amount of book value lost in the last year. Annaly Capital's book value has dropped 23% in the last year, from $27.08 per share at the end of 1Q-22 to just $20.77 per share at the end of 1Q-23. Annaly Capital's book value fell only $0.02 per share in the first quarter, but it was a drop nonetheless.
Annaly Capital's main competitor in the mortgage trust sector, AGNC Investment Corporation ( AGNC ), is trading at a P/B ratio of 0.88x. Given the narrowing of the net interest spread in 1Q-23, I believe Annaly could, and perhaps should, trade at a higher discount to book value.
Why Annaly Capital Might See A Lower Valuation
The obvious and immediate risk for Annaly Capital and other mortgage REITs is that the central bank will continue to raise interest rates, putting additional pressure on Annaly Capital's net interest spread. As a result, I see ongoing risks with Annaly Capital's dividend coverage ratio and book value.
My Conclusion
I think passive income investors should reconsider any decision to put their money at risk with Annaly Capital's eye-popping 14% dividend yield. Annaly Capital has a history of dividend cuts, most recently reducing its payout by 26% to account for lower distributable earnings from its investment portfolio.
Anally Capital's book value fell 23% YoY, and I'm not convinced that the central bank's current rate-hiking cycle has ended.
The risks still appear to outweigh the rewards in this case, and I would be cautious about purchasing Annaly Capital solely for its high dividend yield.
For further details see:
Annaly Capital: Things Could Get Worse For This 13.7% Yielding Mortgage Trust