The past three years have been a difficult period for Annaly Capital Management (NLY 1.11%), a real estate investment trust (REIT) that invests in mortgage-backed securities (MBS) that are backed by government-sponsored agencies such as Fannie Mae and Freddie Mac. Over the stretch, Annaly's total return, including dividends reinvested, is about a negative 20%, while its market capitalization has been slashed by nearly half.
However, as is commonly quoted for stocks that have performed well, past performance is not necessarily indicative of future performance. The same holds true for Annaly, and the stock could outperform over the next three years.
Why did Annaly have a difficult past three years?
The reason for Annaly's poor performance over the past three years is actually quite simple. At its core, the company is an investment firm that holds a leveraged portfolio of agency MBS, which are essentially bonds that are secured by residential houses and guaranteed by a government-backed agency against default. The securities, being backed by the likes of Fannie Mae, eliminate most of the credit risk involved with these investments, but it doesn't reduce the firm's interest rate risk, which is only magnified by the leverage it employs.
When interest rates increase, mortgage rates also tend to rise, which lowers the current value of the securities Annaly holds. Starting in March of 2022, the Federal Reserve began to aggressively tighten, hiking rates 11 times. The federal funds rate target went from a range of 0.25% to 0.50% to the 5.25% to 5.50% it remains at today.
In addition to rising rates, widening spreads between 10-year Treasury yields and agency MBS yields put pressure on Annaly's MBS portfolio. Over the last three years, spreads widened to double the historic average. As such, mortgage rates increased more than Treasury yields over this period, hurting the value of MBS securities even more.
Mortgage REITs like Annaly are typically valued based on the value of their investment holdings. This makes sense, as when you buy Annaly stock, you are essentially buying the MBS portfolio it holds.
Given the pressure Annaly saw with rising interest rates and widening spreads, the value of its portfolio not surprisingly declined. The value of the firm's portfolio is reflected in its book value, which dropped from a split-adjusted $35.68 at the end of 2020 to $19.44 at the end of 2023.
So, over the last three years, Annaly's stock just basically followed its book value down.
Image source: Getty Images.
Better days ahead
The good thing for Annaly moving forward is that the Fed has stopped hiking rates.
While some Fed officials have recently said that there is no rush to cut rates, the majority of Fed officials are still expecting to see a 75 basis point rate cut this year based on the March Fed Dot Plot chart. This chart shows where each FOMC member projects interest rates will be over the coming years.
Image source: Federal Reserve.
More importantly, the chart indicates that Fed officials are looking for the federal funds rate to drop to a range of 3.00% to 3.25% by the end of 2026 from its current rate range of 5.25% to 5.50%.
This would bode well for Annaly's portfolio, which is concentrated in 30-year fixed mortgages with coupons between 4 to 6%. This mix will allow the company to benefit from lower rates while avoiding prepayment risk, which tends to happen when a lot of homeowners start to refinance. The mortgage REIT also has moved nearly 8% of its portfolio into high-quality non-agency MBS to help bolster returns. Another 4% of its portfolio is in mortgage service rights (MSRs), which should be less impacted by rates. The biggest risk to these assets tends to be prepayments, which is why Annaly has invested in low-coupon MSRs.
Annaly should also be able to increase its leverage when the MBS market starts to improve. The company ended 2023 with an economic leverage of 5.7 times. Before the pandemic, the company had leverage of 7.2 times at the end of 2019 and 7.0 times at the end of 2018. Added leverage will allow Annaly to generate more net investment to help support its dividend.
Where Annaly is headed
While there haven't been too many periods of rate cuts in recent years, Annaly's book value and stock price performed very well during the rate cut cycles of 2001 to 2003, and 2007 to 2008.
NLY Book Value (Per Share) data by YCharts.
The rate cuts over the next few years aren't projected to be as steep, but Annaly will still greatly benefit from this shift. As seen in the chart above, the stock nearly doubled during both rate-cutting periods. If the Fed cuts rates by about 2% over the next three years, Annaly should see its stock comfortably above the levels it trades at today. Throw in a current robust dividend yield of 14% and the stock looks like an attractive buy at current levels.
