2023-08-22 17:55:29 ET
Summary
- Mortgage REITs are facing a tough quarter due to increased interest rates and volatility.
- Annaly Capital Management is an agency mortgage REIT with a projected book value per share of $19.60.
- NLY's high hedging ratio may be due to the inverted yield curve, which allows for net interest income from hedges.
- We have a neutral rating currently due to the projected price-to-book ratio.
This quarter is brutal for mortgage REITs.
We're going to look at Annaly Capital Management ( NLY ). We classify NLY as an "agency" mortgage REIT because the vast majority of their capital is invested in agency MBS (mortgage-backed securities).
NLY
By our estimate , as of Friday, Aug. 18, NLY's current book value per share was projected to be around $19.60. Those are not management estimates and you won't find them elsewhere.
We have our own internal estimates for book value per share or net asset value per share across each of the mortgage REITs and BDCs we cover. These are updated most weeks.
Book Value Per Share
For reference, here are the last few weeks:
- July 28: $20.95
- Aug. 4: $20.40
- Aug. 11: $20.10
- Aug. 18: $19.60
That's a decrease of 6.44% since late July.
Are our estimates perfectly accurate every time? No. Sometimes the REITs change their positions during the quarter. If they change their positions during the quarter, it can make our modeling less accurate. Looking back across the last several years, our estimates have been excellent.
Interest Rates Hurting Values
Treasury yields have increased significantly.
FRED
Agency mortgage REITs generally want to see a gradual dip in rates.
There's a simple way to remember that:
- Higher rates are bad.
- Volatility is really bad.
Therefore, you want rates to slowly trend lower.
What Happens To Book Value
Most of the assets (the MBS) contribute "positive duration." That just means they're like bonds. When rates go up, values go down.
Mortgage REITs hedge against their duration using a few tools, such as interest rate swaps and futures. They usually enter those contracts in a way that creates "negative duration." That means when rates go up, value goes up.
This is a pretty simple formula.
- Rates go up: MBS values go down, hedge values go up.
- Rates go down: MBS values go up, hedge values go down.
Why Do You Care About Book Value?
Book value tells us how much equity the REIT has available to invest. Think of it like your own portfolio. If you have a portfolio worth $10 million, you can easily live off the dividends and laugh as it compounds. If you have a portfolio worth $10 thousand, the dividends aren't going to be substantial.
If you were going to buy a share for $18.93, would you rather the REIT have $20.95 or $19.60 in equity per share to invest?
Hopefully, you picked the bigger number. There are no trick questions here.
Assuming the same quality of management and the same macro environment, how much more income could be produced using $20.95 instead of $19.60?
Sorry, that involves too much math. Let me simplify that question a bit more.
Assuming the same quality of management and the same macro environment, how much more income could be produced by a portfolio that is 6.89% larger?
Hopefully, everyone reached an answer between 6% and 8%. Ideally, they picked something close to 6.89%.
Net Interest Expense
I want to teach you a little trick here.
If you've been reading Annaly's presentations, you may notice that they have a really high hedging ratio.
NLY
The hedging ratio was over 100% in the last five quarterly presentations. However, that doesn't make it normal. We can look back on some prior periods:
NLY
Wow, those hedging ratios were lower. Even if we don't do math, we can see that the hedging ratios were only two digits long. Numbers with two digits (below 100%) are smaller than numbers with three digits (above 100%). You can verify this visually, so long as you use the same size font.
To the one guy trying to be creative, no, you may not add decimal places and stop trying to insert negative signs. Just let me finish this article.
Further, I want to point out that most of NLY's hedges were entered into when rates lower. Consequently, the average rate they pay on the swaps is only 2.5%.
One final note here. The hedging ratio doesn't tell you how long the hedges are. Consequently, that one metric isn't enough to say how well positioned a REIT is for higher rates. The damage to book value doesn't reflect NLY hedging poorly or insufficiently. Remember that mortgage REITs don't like higher rates or volatility. Rates were soaring higher, which is volatility. There is no great hedging strategy to handle volatility.
What Happens to Income
If you enter a swap where you pay the five-year fixed-rate and receive the floating rate? The yield curve is inverted, so you'll start out with interest income.
Let's use the following chart from Chatham Financial :
Chatham Financial
The chart doesn't show the 1-month rate for SOFR, but it's around the 5.27% to 5.3% range. That's actually really close to the 1-year rate, so I just circled the 1-year rate.
So as an investor going into this hedge, you would receive about 5.29% and you would pay about 4.19%. Those payments are netted against each other (to reduce risk and pointless cash flows). Consequently, you would get a payment for 1.1% based on the amount of the hedge. Congratulations, you're getting paid net interest income from your hedges.
This income partially offsets the interest you pay the banks for your financing. Consequently, even if you paid the banks 5.29%, you would get 1.1% back from the swap. That would create an effective rate of 4.19%. If you use swaps with a total balance greater than all of the money you're borrowing, your rate would be even lower than 4.19%.
Can you just swap load on swaps to the point of having free money? No. That's really not a thing. Explaining why it isn't a thing would take too many words.
I believe NLY is using such high hedging levels (over 100%) because the inverted yield curve leads to swaps (which are hedges) producing net interest income in the current period.
Conclusion
We estimate NLY's current book value per share to be about $19.60. That's only modestly higher than the share price of $18.93. Consequently, the discount isn't big enough to get bullish. However, there's not a premium big enough to warrant a bearish rating either. Therefore, we're taking a neutral outlook on the stock.
For further details see:
How Annaly Capital Management Generates Extra Income