2023-04-20 10:52:24 ET
Summary
- Annaly is an mREIT with high exposure to agency MBS, a business model that does not work particularly well in a rising interest rate environment.
- Its earnings are volatile and interest rate sensitivity is still significant, thus its growth prospects aren’t particularly good over the next few quarters.
- Its high-dividend yield is the main reason to consider its shares.
Annaly Capital Management ( NLY ) offers a very high-dividend yield, that seems to be sustainable in the short term. However, for long-term investors its dividend is quite risky.
Company Overview
Annaly Capital Management is a capital management company, being focused on investing and financing residential and commercial assets. It operates as a real estate investment trust ((REIT)) for tax purposes, having the goal of generating sustainable income to provide recurring dividend distributions for shareholders over the long term. It was founded in 1996, and its current market value is about $9.5 billion, and its closest peers include AGNC Investment Corp. ( AGNC ), Starwood Property Trust ( STWD ) and Rithm Capital Corp. ( RITM ).
While the vast majority of REITs own real estate, Annaly does not own physical property, and instead of its core activity is investing and managing a portfolio of mortgage-backed securities (MBS). Its investment portfolio is highly exposed to high-quality MBS, issued or guaranteed by agencies, and backed by single-family residential mortgages. This means its exposure to credit risk can be considered to be relatively low, while on the other hand it has exposure to interest rate risk, which the company actively hedges considering its interest rate outlook.
At the end of 2022, its investment portfolio amounted to more than $80 billion, of which the largest segment was agency MBS, followed by residential credit, and mortgage servicing rights. Due to the rising interest rate environment in recent quarters, the portfolio was fully hedged ($76 billion), while the company also had about $4 billion in liquidity.
Portfolio (Annaly)
Business Strategy
Annaly’s business model is relatively straightforward, given that its goal is to generate a profit to shareholders by investing in high-quality securities that generate a recurring and to a large extent predictable income, which should be above the company’s cost of funding.
This means that its business model is similar to retail and commercial banks, which generate the vast majority of its earnings from the difference between its asset yields and funding costs (usually highly exposed to deposits).
While banks have a more diversified asset base, which can include mortgage, consumer or auto loans, beyond others, Annaly has a much more concentrated asset base, as agency MBS represents the vast majority of its assets. To generate a positive net interest income, the difference between interest received and interest paid, Annaly usually borrows in the short term, which have lower interest rates, and borrows by investing in mortgage-backed securities, which are typically of longer term and carry higher interest rates.
Taking this business model into account, not surprisingly, Annaly’s average yield on interest earnings assets was 3.82% at the end of 2022 , while the average cost of funds was only 2.11%. This means that its net interest margin was close to 1.71%, which is an acceptable margin considering that Annaly invests mainly in low-risk assets. For instance, Wells Fargo’s ( WFC ) net interest margin was 2.68% in 2022, but large U.S. banks have a more diversified loan mix and lower funding costs, thus it’s not likely that Annaly will be able to increase much its NIM in the near future.
Considering that its business margin, measured by its NIM, can be considered low in absolute terms, Annaly finances most of its assets through liabilities, and like banks it uses a relatively low level of shareholders’ equity compared to total assets, leading to high levels of financial leverage. Indeed, at the end of 2022, its shareholders equity amounted to only $11.3 billion, while total assets were above $80 billion, showing that its balance sheet leverage is considerable.
This is not much different from the banking business model, with the difference being that Annaly’s assets are much more concentrated in a few asset classes and on the liabilities side it does not take deposits.
Moreover, high balance sheet leverage is what makes it possible for Annaly to have a good level of profitability, measured by the return on shareholders’ equity ratio, and also what explains the difference between return on assets ratio (usually very low single-digit) and return on equity ratio (usually above double-digit). Annaly is not different, and has reported a ROA of 2.18% in 2022, while its ROE was above 15%, which is basically explained by the company’s financial leverage.
Another important factor of Annaly’s business model is its exposure to interest rate risk, given that it’s highly exposed to agency MBS. Therefore, a more balanced business mix is positive for the company to have less interest rate sensitivity, with a rising interest rate environment being usually negative for its financial performance.
This happens because its assets have longer duration than liabilities, declining more in value through rising rates, a risk the company manages by using interest rate swaps, swaptions, and futures. While this risk can be sometimes overlooked, it’s very important to have experience managing this type of risk in a balance sheet, something that was recently quite clear to investors in the failure of Silicon Valley Bank (SIVBQ).
Hedges (Annaly)
Despite hedging a great part of its interest rate risk, a rising interest rate environment is negative for its book value and not surprisingly Annaly’s book value decreased by 34% during 2022, to $20.79 per share at the end of the year. This shows that Annaly’s balance sheet interest rate sensitivity is quite significant, which does not bode well in the short term as the Federal Reserve should continue to raise rates for some more time.
While there are some prospects of rate cuts ahead, potentially in 2024 if inflation starts to moderate, I think is still too early to consider that and for the time being Annaly’s book value is likely to remain under pressure from a rising interest rate environment.
Financial Overview & Dividends
Regarding its financial performance , Annaly’s operating performance was impacted by rising interest rates during the past few quarters, given that its liabilities have shorter duration than assets, being negative for its net interest income ((NII)).
Indeed, Annaly’s NII amounted to $1.47 billion in 2022, a decline of 15% YoY, while on the other hand its revenues related to servicing increased to $221 million (vs. $57 million in the previous year). Regarding operating expenses, Annaly showed a good cost control and was able to reduce its annual costs by 13% YoY, to $163 million.
Its net income was higher than $1.7 billion, a significant decline from the previous year (-26% YoY), justified by much lower ‘other income’ related to gains from the sale of securities. Its EPS was $3.92, down by 38% YoY, due to higher number of shares outstanding. Regarding its profitability, its ROE was close to 15% in the past year, still a good level of profitability, even though it declined from 17.45% in the previous year.
Going forward, its business prospects aren’t particularly impressive, given that its business is expected to remain under pressure from rising interest rates. Indeed, according to analysts’ estimates , its total revenues are expected to increase slightly in 2023 to $1.57 billion, but its net income should decline to $1.45 billion and its ROE is expected to drop to about 13%.
Given that Annaly’s growth prospects aren’t particularly strong, one of the key reasons to own its shares is its high-dividend yield.
Annaly’s current quarterly dividend is $0.65 per share, following a recent dividend cut of about 26%, which leads to an annual dividend of $2.60 per share. At its current share price, Annaly offers a dividend yield of 13.5%, which is very high compared to other REITs and other financial companies.
However, investors should note that Annaly’s dividend history is not fantastic and the risk of further dividend cuts should not be overlooked. Therefore, while Annaly’s high-dividend yield is quite attractive to income investors, it also shows that the dividend cut risk is substantial. Moreover, taking into account its REIT status, Annaly must distribute dividends equaling at least 90% of its REIT taxable income for each year to shareholders, thus its dividend is directly reliant on its earnings stream and no minimum payment level is defined.
Following its recent dividend cut, Annaly’s dividend is now much more supported by its earnings, given that its payout ratio is now 84% of its estimated 2023 EPS, while its previous dividend was not covered by earnings. This means that Annaly’s dividend looks to be sustainable over the next few quarters, but visibility regarding its dividend sustainability over the medium to long term is quite low.
Conclusion
Annaly’s investment case is highly reliant on its high-dividend yield, given that its business model does not work well in a rising interest rate environment. Not surprisingly, this backdrop led to a dividend cut recently, but its rebased quarterly dividend seems now to be sustainable over the coming quarters.
Therefore, Annaly may be an interesting income investment right now for some type of investors, even though for long-term investors that want recurring and safe income over the long term this is a stock to avoid.
For further details see:
Should You Buy Annaly For Its High-Dividend Yield?