2023-04-20 15:22:29 ET
Summary
- NLY's book value has been pressured by rising interest rates and widening mortgage spreads.
- I believe the firm has the ability to leverage up into a market turn if it can time it right.
- Investors can nibble at the stock but should expect the stock to remain volatile.
Like other mortgage REITs, Annaly Capital Management (NLY) is facing a difficult MBS market. But I think there could be a nice opportunity in the stock when the market turns.
Company Profile
NLY is a capital manager that engages in mortgage finance. It is taxed as a real estate investment trust, and as such it pays no taxes at the corporate level as along as it pay out 90% of its taxable earnings to shareholders in the form of dividends.
The firm primarily invests in agency mortgage-backed securities that are collateralized by residential mortgages that are guaranteed by government agencies or government-sponsored agencies such as Fannie Mae, Freddie Mac, or Ginnie Mae. NLY also invests in residential credit, mortgage servicing rights, commercial real estate, and corporate debt.
The firm employs three investment groups. The Agency Group invests in agency MBS, TBA (to-be-announced) future contracts, and agency commercial MBS. It Residential Credit Group invests in residential MBS that is not backed by agencies. Meanwhile, its Mortgage Servicing Right Group invests in mortgage servicing rights, which are the rights to service a pool of residential mortgage loans in exchange for a portion of the interest payments made on the loans.
The firm can use up to 10 times leverage to further boost returns. Since 2007, however, it has typically been below 8x, and below 7x since Covid.
At the end of 2022, NLY's investment portfolio consisted of 90% agency-backed MBS, 7% residential credit, 2% MSR, and 1% commercial real estate.
Its investment portfolio was valued at $80.6 billion, and $72.9 billion of that was with its Agency portfolio.
Opportunities and Risks
Similar to AGNC Investment (AGNC), which I recently wrote up , NLY operates a spread business, where it funds its MBS and other investments through repurchase agreements and then leverages up to bolster its returns.
With 90% of its portfolio backed by agencies, it takes on a little more credit risk than AGNC. However, the vast majority of its portfolio carries little credit risk.
Similar to AGNC, NLY has also been experiencing the pain of rising interest rates on its book value. As interest rates rise and new MBS coupons become higher, the current value of older fixed-rate MBS becomes less, reducing the value of NLY's portfolio and by extension its book value. At the end of 2022, 94% of NLY's agency MBS portfolio was in 30-year fixed mortgages.
Also similar to AGNC, NLY has also employed a strategy of rotating its portfolio into higher coupon securities. At the end of the year, 52% of its 30-year portfolio had a coupon of 4.5% or more.
NLY has also seen a big drop in book value, with it falling -35% from $31.88 at the end of 2021 to $20.79 at the end of 2022. That was slightly better than the -38% drop experienced by AGNC. Its Q4 book value also rose, similar to AGNC, rising 4%, although that is half of the 8% gain AGNC saw. Portfolio composition and lower leverage play a role in the differences.
Discussing the current state of the market on its Q4 earnings call , CEO and CIO David Finkelstein said:
"We feel good about the state of the housing market as long as the labor market remains strong, consumer balance sheet and lending standards are sound and the shortage of supply supports prices, all else equal. Now shifting to our portfolio activity during the quarter. Within Agency, we continued to shift modestly up in coupons to take advantage of wider spreads and improved carry in production coupons. We grew our allocation of 4.5 and higher, which now represent over 50% of our portfolio, up from 40% last quarter. We believe historically wide nominal spreads in these coupons provide more than adequate compensation for taking on the incremental convexity exposure relative to lower coupons.
"In addition, we reduced our exposure to TBAs as rolled specialists dissipated over the quarter, and we are likely to favor pools over TBAs going forward given their better return profile. Regarding prepayments, the mortgage universe remains firmly out of the money and even with mortgage rates trending lower towards 6%, only 1% of borrowers have an incentive to refinance, leaving our convexity risk near the lowest levels we've seen over the past 5 years."
Now mortgage REITs can also face risks in a dropping rate environment through prepayment risk. But as the above quote notes, this is really the least of these firms' worries at this time, as so few borrowers currently have a reason to refinance.
These firms also face spread risk. If the spread between its borrowing costs and its MBS investments tightens, it can hurt its earnings power. At the same time, widening spreads can negatively impact the book value of mortgage REITs. Spreads have been historically high, which should at some point allow book value to recover when they return to more historical levels.
Earnings Preview
In mid-March , NLY said its estimated book value was between $20.60 and $20.80. It was $20.79 at the end of 2022.
The company also announced a reduced dividend of 65 cents. That was down from the 88 cents it paid out in Q4 of 2022.
NLY doesn't typically give an estimated book value when it announces its dividend payment, so this shows a steadying market in Q1. With the Q1 dividend being paid after the quarter, I would assume that it won't impact the book value, even though the ex-date is before the quarter end.
Overall, there shouldn't be any big surprises with NLY's Q1 numbers. The mortgage market remains volatile, with rates bouncing between 6-7%. The 10-year Treasury, meanwhile, is down from start of the year and up slightly from the end of the month. However, it seems that spreads currently have widened even more, which is something to watch with for Q2, although we are still early in the quarter.
Valuation
The current environment remains difficult for mortgage REITs. Interest rates need to stop going up and mortgage spreads need to tighten for them to really work. At some point that is going to happen, and the market does typically like to react months before it expects something to happen. That said, it's still not a good environment for these firms, and I'd like to see some signs of the MBS market bottoming before getting in.
NLY is a solidly run firm, and it smartly has used less leverage than AGNC, while looking to boost leverage a bit more recently into a more attractive market. If it can leverage up a bit just before the market turns, the stock can really benefit. Trading slightly below book value (0.9x) with less leverage (6.0x), I think it is a bit more attractive than AGNC at the moment, which trades at book value with nearly a turn and half more leverage.
I'm going to rate the stock a "Hold," but investors can nibble in the stock as we look for bottom in the MBS market. Just be prepared for some more potential volatility in the stock.
For further details see:
Annaly Looks Well Positioned For When The MBS Market Turns