2024-01-02 12:00:15 ET
Summary
- Annaly Capital Management has been hit hard by rising interest rates as this has caused net interest margins and ultimately book value per share to fall.
- Management has placed hedges to position the company for an end to the rate hiking cycle, and has managed to gain market share in key segments amid a challenging environment.
- Now, Annaly is expected to benefit from potential rate cuts, leading to a revival in net interest income yields and increased activity in the agency mortgage-backed security business.
- Annaly is trading at fair P/B multiples. I believe upside can come from upticks in book value per share.
- Besides the Fed's interest rate decisions, mortgage prepayment rates are a key risk to watch out for as this may increase as rates fall.
Thesis
A year ago, I had a bearish outlook on the mortgage REITs sector. But now, that has changed. I am bullish on Annaly Capital Management ( NLY ):
- Annaly has been hit hard by rising rates
- Management has wisely positioned themselves in the challenging environment
- Annaly is now set to benefit from likely rate cuts
Annaly has been hit hard by rising rates
Net Interest Margin (Company Filings, Author's Analysis)
Annaly's net interest margins ((NIM)) have eroded over the last 2 years as the Fed started their hiking cycle in 2022 .
I will note however that the business' NIMs have outperformed the net interest spread, which has eroded further in recent quarters:
Net Interest Spread (Company Filings, Author's Analysis)
The deterioration in the net interest spread has occurred because interest cost has risen far higher than interest yield:
Net Interest Spread Drivers (Company Filings, Author's Analysis)
This is because Annaly's interest yields are geared more to longer-term rates compared to their sources of funding, which are geared to shorter-term rates. And the rate hikes arising from inflation concerns have led investors to be more cautious in the short term compared to the longer term, which has led shorter term rates to rise faster than longer term rates (more on this later).
Ultimately, these headwinds have resulted in declines in book value per share:
Book Value per Share (Company Filings, Author's Analysis)
Management has wisely positioned themselves in the challenging environment
In the Q3 FY23 earnings call , CEO David Finkelstein shared how Annaly is positioning for an eventual end to the hiking cycle:
As it relates to hedging, as the hiking cycle comes to an end, we anticipated the shift from protecting the front end to protecting the long end . And therefore, over 75% of our hedge duration remain in the 7- to 20-year part of the curve , matching our asset duration profile.
- Author's bolded highlight
From an operations perspective, the business has also been able to gain market share in segments such Residential Credit, which makes up 7% of the overall investment portfolio and 17% of invested shareholder equity.
Annaly is now set to benefit from likely rate cuts
I have discussed rate cuts in more depth in my earlier articles . The key takeaway is the following:
Target Rate Probabilities for January 2024 Federal Reserve Meeting (CME FedWatch)
The target rate probabilities for January 2024's Federal Reserve Meeting imply a 0% chance of a rate hike and a 17.57% chance of a rate cut.
I anticipate this to undo some of the fall in the differential between long-term rates (such as the 10-yr yield) and shorter-term rates (such as the 3-yr yield), which currently stands at -137bps, representing an inverted yield curve:
US10Y - US03Y yield differential (TradingView)
As the yield curve normalizes and the interest rate differential between longer-dated bonds and shorter-dated bonds increases, I believe Annaly will see a revival in net interest spreads and net interest income yields.
The falling rates would lead to a moderation in agency mortgage backed security ((MBS)) spreads, which can be viewed by looking at the difference between mortgage rates (the source of yield) and the US10yr (the source of financing):
The MBS spread is currently near decadal highs at +2.74%. According to The Hamilton Project , a key reason for the rapid rise in the MBS spreads has been because MBS durations are usually held for less than 10 years (typically 7 years). And hence, the MBS spread widening profile moves inversely with the interest rate differentials between long-dated bonds and front-end bonds. This context helps makes sense of management's commentary about a demand slowdown by the money manager community who are the primary buyers of MBS; naturally, these buyers would have preferred to hold treasuries instead.
As the yield curve normalizes with falling rates, I anticipate the MBS spreads to also contract in response to higher demand from the money management community. This could turnaround Annaly's economic return, which had taken a hit due to these headwinds posting -8.8% in Q3 FY23.
Valuation
Annaly P/B (Capital IQ, Author's Analysis)
Annaly is trading at a P/B of 1.06x, which is very close to the longer term median P/B of 1.04x. I believe the valuation multiple is in the fair value range currently.
However, I do anticipate a revival in the net interest margins to lead to upticks in the book value per share. This is where I see further upside potential in the stock.
Key Risks
My thesis, like Annaly's business performance is highly dependent on the Fed's policy decisions. Therefore, it goes without saying that that is a key monitorable.
Another business-relevant factor I am keeping an eye on is the degree of mortgage prepayments. The long-term constant prepayment rate is the relevant indicator of future prepayment behavior:
Long-Term Constant Prepayment Rate (Company Filings, Author's Analysis)
A fall in rates may induce homeowners to repay their mortgage principals faster, which would reduce the interest streams received by mortgage backed security holders such as Annaly. This is a key risk to monitor for my thesis.
Takeaway
I am changing my stance on mortgage REITs and specifically Annaly from bearish (a year ago) to bullish now. The primary reason is that I believe potential rate cuts in 2024 will alleviate pressure on net interest margins and lead to expansions in book value per share, which is where I see the case for price appreciation. Easing rates is also likely to lead to increased levels of activity particularly in the agency MBS business as money managers' demand for MBS assets increase again.
Rating: 'Buy'
How to interpret Hunting Alpha's ratings:
Strong Buy: Expect the company to outperform the S&P500 on a total shareholder return basis, with higher than usual confidence
Buy: Expect the company to outperform the S&P500 on a total shareholder return basis
Neutral/hold: Expect the company to perform in-line with the S&P500 on a total shareholder return basis
Sell: Expect the company to underperform the S&P500 on a total shareholder return basis
Strong Sell: Expect the company to underperform the S&P500 on a total shareholder return basis, with higher than usual confidence
For further details see:
Annaly Capital: Set To Rise From Falling Rates