2023-12-13 07:35:00 ET
Summary
- We revisit the Mortgage REIT sector to highlight another Agency mREIT opportunity.
- You can earn 14% yields by investing in this opportunity.
- Help make your portfolio less interest rate sensitive.
Co-authored by Treading Softly.
Something often said in Hollywood is that if you have a successful movie, they are almost always going to make a sequel. This is because the sequel will hopefully ride on the fame of the last movie and build that franchise further. Unfortunately, all too often, sequels are mostly money grabs. Usually, each sequel performs worse than the movie before it, even though its budget grows. Yet there are prime examples where a sequel outperforms the original and truly develops the concept or world further.
Yesterday we released an article discussing the insanity contained within the Mortgage REIT, or mREIT, sector. We received comments undoubtedly by some people who simply broke out their chart and pointed to it, missing the entire focus of what we wrote about, while others read and provided very strong opinions for and against these types of investments. I appreciate all the civil conversation we were able to enjoy together. I also appreciate Seeking Alpha's moderating team for removing several comments that may have not been civil as well.
Today, I want to take an opportunity to retread the same ground, but I am looking at a different opportunity that I still find highly attractive within the same sector we were just reviewing in that article. If you haven't read that article yet. I recommend that you take a step back, jump in over there , read through that article to understand the groundwork of what we're doing, and then jump back into this article for the new opportunity.
Let's dive in!
A Second Look, A Second Opportunity
Annaly Capital Management, Inc. ( NLY ) - Yield 14.2%
It is no secret that Q3 was a really tough quarter for agency mortgage REITs. Dynex Capital ( DX ) and AGNC Investment ( AGNC ) both reported significant declines in book value. So, when NLY reported its earnings, the market already knew what was coming. Book value declined to $18.25/share, down 12% from Q2. This compares to AGNC, which saw book value decline 14%.
The primary driver of this difference is NLY's capital allocation has become more weighted towards MSRs (mortgage servicing rights), which increased from 15% to 19% of capital allocation from Q2 to Q3. Source .
The value of mortgage servicing rights tends to go up when interest rates rise, which helps counter agency MBS which tends to go down when interest rates rise.
This is a significant difference from AGNC's strategy, since AGNC has a very small credit portfolio ($1 billion as of Q2) and no MSR portfolio. In Q3, that difference was a positive, given the rapid rise in the 10-year Treasury (US10Y) and the decline in agency prices.
Another difference in NLY's strategy, compared to AGNC's, is that NLY chose not to be an active buyer of agency MBS in Q3. Based on AGNC's pre-release, we know AGNC did a significant amount of buying in Q3. NLY let its agency portfolio decline by about 4%, which is about the same amount that agency MBS prices decreased.
On a par value basis, the portfolio remained roughly the same – suggesting that NLY reinvested principal repayments and possibly did some horse trading, but did not add any new capital to the agency business. Source .
The difference between fair value (which is used to calculate book value) and the par value of MBS is $5.4 billion. That is $10.99/share. As we discussed previously, agency MBS is guaranteed to repay at par value. That is $10.99/share, that will be recovered either through cash flow or through MBS prices returning to par if NLY holds these MBS to maturity. It is that discount to par that will be capable of driving significant upside to NLY's book value if interest rates stabilize or decline.
NLY has been working on increasing the average coupon, with 43% of the portfolio in coupons that are 5%+. This compared to 36% above 5% last quarter.
NLY Q3 2023 Presentation
Meanwhile, the MSR business has continued to grow.
The agency MBS business continues to be the largest portion of NLY, and will continue to explain quarter-to-quarter results but the MSR business is up 27% year-to-date and has grown rapidly over the past 3 years.
As a result, NLY is likely to outperform peers if interest rates are higher for longer. In the event of declining interest rates, the MSR business that is a slight benefit now will become a slight drag on book value.
Agency MBS will continue to see headwinds if interest rates rise, however the potential upside when rates fall is increasing as they rotate into higher coupons. In a typical recession scenario where interest rates decline and the Fed cuts rates significantly, NLY's 5%+ coupon holdings are going to be very valuable and trading at a premium, while their cost of borrowing would also decline causing cash flow to increase significantly as well. The more time NLY has to rotate into higher coupons (now 6.5% and 7% is available), the greater the upside in a rate-cutting scenario. This is why agency mREITs are among the best investments to hold going into a recession.
Conclusion
With NLY, we have a second route to benefit strongly from agency mREIT – a sector that has historically outperformed during recessions, and is capable of producing massive levels of income during all times.
When it comes to retirement, you need a portfolio that's able to generate income, regardless of what's going on in the economy. You don't want a portfolio that's dependent on a vibrant, strong economy at all times, because if you live long enough, you will live through a recession and, most likely, more than one. Likewise, you don't want a portfolio that thrives only in recessionary periods because, fortunately, those are typically shorter than strong economic times. A professional income investor is able to craft a portfolio that can provide outstanding income, regardless of the economic situation or interest rate that we live in. When your portfolio produces outsized income, regardless of what's going on in the world around you, it helps insulate you from the winds of worry and anxiety that so many are blown around by. It could provide you with tangible financial security.
That's the beauty of my Income Method. That's the beauty of income investing.
For further details see:
mREIT Insanity And The Fat Yield Of 14%: Annaly Capital (Part 2)