2023-05-11 14:20:44 ET
Summary
- In investment (and in life too), it’s never too late to learn from our mistakes. However, it’s always way better to learn from other's mistakes.
- This article dissects a painful misjudgment I had regarding Annaly and AGNC about 1 year ago in March 2022.
- If you are attracted by their current dividends (in a mouthwatering range of ~14% to ~16%), my lessons might be timely.
- I see the current macroeconomic setup as very similar to or even worse for these mREITs compared to that back in 2022.
- Their current dividends, even assumed to be sustainable, won’t be able to compensate for the risks of book value loss and/or valuation risks.
Thesis
I contributed an article to Seeking Alpha about 1 year ago (March 17, 2022, to be exact). The article's title , "Annaly Capital: Still Attractive Among mREITs, But mREIT Itself Under Pressure", already shows how wrong I was. I suppose the saving grace is that I correctly foresee the challenging macroeconomic setup that adversely impacted the mREIT industry in the next few quarters (see the chart below).
Nonetheless, I went ahead to argue for a bullish case for leading mREIT stocks such as Annaly Capital ( NLY ) and AGNC Investment ( AGNC ) based on the following factors. I am quoting my exact words here:
- …as leaders in the sector, they offer a reasonable combination of scale, safety, and valuation relative to other mREIT peers.
- Investors need to be aware that the mREIT sector itself is under pressure with the start of a new macro credit cycle. However, different mREIT stocks have different sensitivities to yield spread ("YS") because their specific exposures differ and can range from agency MBS, home loans (MSR and RMBS), or hybrid loans. Moreover, differentiating factors of their business models are worth consideration too.
Reality (see the next chart again) shows how wrong I was with brutal honesty. Both stocks have performed miserably compared to the overall market, approximated by the S&P 500 Index.
Today, you might be tempted to do some bottom fishing here. Indeed, with their large price drops, their dividend yields have climbed to mouth-watering levels as shown in the chart below. AGNC and NLY are offering FWD dividend yields of 15.38% and 13.88%, respectively.
As such, I think it is timely that I caution potential investors by reviewing the mistake I've made before. And you will see that my core argument is that their current dividends, even assumed to be sustainable, don't probably compensate for the risks of book value loss and/or valuation risks. In fact, their yields are not that attractive to start with when contextualized. For example, NLY's FWD yield is only on par (within 1%) compared to this its 4-year average. And their valuation discounts, measured by the ratio between their current yield and their 4-year average, are far lower than the sector average as approximated by [[REM]] and [[MORT]].
And next, let's dissect my painful misjudgment more closely, and see its relevance to today's conditions. I will explain why the current macroeconomic conditions are similar to or even worse for both companies compared to what I saw back in March 2022.
Stay away from a sinking ship!
The crucial here lesson is simple: do not try to predict who has the best chance of survival on a sinking ship. This is precisely what I did last year: I saw the trouble for the whole mREIT sector but still went on to identify the stocks with the best chances of survival. Even though my picks were successful in the sense that both AGNC and NYL outperformed the whole sector (approximated by either REM or MORT) in relative terms. But in absolute terms, they suffered large losses. The right thing to do is to just find another ship altogether to bet on.
I see the current situation as similar compared to last March for the REIT sector. As such, I anticipate significant profitability pressure to continue for the mREIT sector, including leading stocks like NLY and AGNC. Specifically, for AGNC and NLY, I also see considerable risks in terms of valuation and leverage, which I will elaborate on in the following sections.
The sector is very sensitive to the macro-debt cycle and my original article provided the detailed dynamics as recapped below.
The YS between short-term and long-term rates is good measure for the stage of the macro-debt cycle. When the YS expands or contracts, it signals changes in the underlying economy or financial markets. Unfortunately, mREIT stocks like AGNC and NLY typically responds most sensitively to such changes because the YS is precisely how they make their money. The thicker the spread, the easier it is for them to make money, as evidenced by the data in the following chart.
The chart referred to above was reproduced here. It shows the correlation between the yield spread (YS between 10-year and 2-year treasury rates) and AGNC's dividends (used to approximate its owners' earnings). And just by visual examination, you can see that the correlation is quite clear and strong here.
At that time, I projected that the yield spread would further narrow and eventually invert. The reasons are to be provided a bit later. And indeed, the yield curve has inverted subsequently as we all know. In fact, with a yield spread of -0.48%, the yield curve is currently among the most inverted levels in the past 3 decades since 1993, as seen in the chart below.
Now back to the reasons that led me to the above projections a year ago. And I will also explain why I see the same dynamics are still in play now to keep the YS inverted and continue pressuring mREIT stocks. The reasoning is quite straightforward and involves two straightforward chains of logic.
First, I do not see too much space for the long-term rates to go up from here anymore. As detailed in my original article :
At a very fundamental level, in the long term, treasury bond rates cannot rise above long-term inflation or GDP growth. Our government has been relying on inflation and GDP expansion to inflate away and outgrowth its debt obligations for decades in the past. And it will (it will have to) continue doing so.
Second, for the short-term rates, I do not see it going down anytime soon. The latest CPI data (shown below) still reported elevated inflation (in the 4.9% to 5.5% range), effectively rendering the current near-term rates close to zero or even negative. And many of the fundamental forces that caused high inflation are still in play, ranging from the Russian-Ukraine war, and also the interruptions of global supply for essential resources like raw materials and food.
As such, I see the yield curve has nowhere to go but to be stuck inverted in the near future. Next, I will elaborate on the implications for NLY and AGNC.
Profitability and leverage risks
An inverted curve can have detrimental effects on NYL and AGNC's earnings in multiple ways. As aforementioned, a narrowing YS reduces their profit margin. But the pressure extends well beyond that. An inverted yield curve, particularly in conjunction with high inflation, also has the potential to weaken the demand for new mortgages.
To make things worse, both companies are sitting on high leverage as their profitability faces large uncertainties. As evident from the chart below, both companies underwent significant deleveraging in early 2020 - a smart move, since the Federal Reserve obviously cannot provide easy money at near-zero rates indefinitely. To wit, AGNC reduced its leverage from a peak of 12.8x in early 2020 to 7.9x in about a year, and NLY reduced its leverage from 10x to 6.6x.
Given the inverted yield curve and economic uncertainties ahead, I'd feel more comfortable if their leverage stayed at these low levels. But unfortunately, their leverage has shown a reversal and climbed back again. As shown, AGNC's leverage rose to the current level of 9.1x, slightly below its historical average. And NLY's leverage rose to 9.2x, slightly above its historical average leverage.
And it is very likely that they will suffer book value loss in the near future, as detailed next, which leads to a further stretched balance sheet.
Valuation and balance sheet risks
Due to a combination of market sentiment and also book value losses (as you can see from the following two charts), there is no discount in the valuation of AGNC and NLY, leaving no obvious margin of safety.
The first chart shows their price-to-tangible book value ("TBV") ratio, which is one of the most relevant valuation metrics for mREIT stocks in my mind. Historically, both stocks have traded near or below TBV on average. For instance, AGNC's average P/TBV ratio has been 0.97x in the past and NLY's average has been 1.07x. And AGNC is presently priced at 0.95x TBV, essentially on par with its historical average. Similarly, NLY's current P/TBV ratio of 0.995x is also on par with its historical average.
It is in general a bad idea to invest without a margin of safety. And in the case of AGNC and NLY Here, potential investors can use a good amount of margin of safety. Besides the profitability uncertainties analyzed above, both stocks have also suffered book value losses almost chronically. As seen in the second chart below, over the past 10 years, AGNC's TBV has always stayed below its starting value in 2013, and it's currently a whopping 43% below. NLY's picture is slightly better, but not by that much, either. With all the economic uncertainties ongoing and their relatively high leverage, even a relatively mild glitch in the real estate market could deteriorate their TBV substantially.
Upside risks and final thoughts
As two popular mREIT stocks, risks with NLY and AGNC have been debated by plenty of other SA authors. As a bearish article, this article has focused on the downside risks only so far. Hence, here I will devote the risk section to being on its upside risks. An encouraging sign for AGNC is that its dividend payouts have been stable since my article a year ago. As seen, its dividends have been stable at $0.36 per share per quarter (note it actual dividends are paid out on a monthly basis). And it has just announced that its next monthly dividend payout will be $0.12 per share also. With the combination of price corrections and stable dividends since last March, AGNC's current yield is about 30% above its historical average, representing a potential upside risk to my thesis. Sensing the uncertainties ahead, both AGNC and NLY are implementing risk management strategies. These risk management practices, such as hedging against interest rate fluctuations or carefully selecting mortgage-backed securities, could help these companies better navigate the challenges ahead. These strategies could mitigate potential losses and enhance their financial performance.
To conclude, the goal of this article is to caution potential investors who are attracted to AGNC and NLY's dividends. Their yields are indeed mouth-watering. However, based on my interpretation of the undergoing economic forces, I am pessimistic about the sustainability of their dividends, their book value, and their current valuation. In a nutshell, I am ultimately pessimistic about the odds that the dividends can make up the losses for TBV and valuation deterioration.
For further details see:
My Annaly And AGNC Lesson: Don't Bite The Dividends