Annaly Capital Management, Inc. Shares Slip as Treasury Yields Rise: Should You Worry?

Shares of Annaly Capital Management took a hit this week. The trigger appears to be worries that the economic recovery is gaining steam and interest rates will spike. Last May, quickly rising rates tanked mREITs. These fears appear overblown.

Jul 13, 2014 at 8:00AM

In the last several trading sessions, Annaly Capital Management (NYSE:NLY) common share have been pounded down about 4%. Is something fundamentally wrong?

Probably not.

Last week, the 10-year Treasury yield was about 2.50%, but it's been on the rise. After a strong July 3 jobs report, and a drop in the unemployment rate to 6.1%, the benchmark popped to nearly 2.7%. Since that time, it's eased just a little.

Apparently, some traders fret about a May 2013 repeat, when interest rates spiked 130 bps in four months.  That threw the mREIT business model into a tizzy. Indeed, rapidly rising interest rates spell trouble for these investments. Essentially, mREITs make money on the "spread", or the difference between short and long rates. In addition to the spread, mREITs have various tools to mitigate rising rates or narrowing margins. These include interest rate hedging techniques, leverage, and security duration. Recently, Annaly's portfolio has added commercial real estate, traditionally a less-volatile asset class.

Here's a chart illustrating the movement in the 10-year Treasury note over the past year:

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courtesy of ameritrade.com

Note the sharp rate rise in May 2013, the subsequent fall, and the current blip up this week. No question the 2013 spike whipsawed management.  But does the current rise appear earth-shattering? Indeed, rates have fallen back again this week.

Reading the tea leaves
Short term, no one knows where interest rates are headed. However, over the medium term, there isn't much reason to expect rates to rise quickly. While the US economy has been on the mend, the recovery has been sluggish. Inflationary signals have been modest, and Fed chief Janet Yellen is dovish.

She's espoused a moderate stance on rates. Ms. Yellen has insisted that unless the economy begins to overheat or signal inflation clearly, she's unlikely to boost short rates. Within the jobs report, it's noted that year-over-year wage growth was only 2%, and the labor participation rate was flat. 

The Annaly sell-off looks hot-headed.

The Annaly Capital calendar
On June 27, Annaly went ex-dividend by $0.30. The payable date is July 31. The payout was inline with the previous two declarations. While the second-quarter books closed on June 30, the quarterly earnings report shouldn't come out until early August. Investors will have little new hard data for a month.

At that time, investors should watch for two key items: the price-to-book ratio and the net interest margin. These metrics provide a quick take on share valuation and earnings quality.

Annaly's P/B ratio was 0.87 after the first quarter earnings release. It's edged up to about 0.90 now. As long as the net book is below 1.0, the shares appear below their fair value; just experiencing volatility before  reaching equilibrium. Indeed, it's difficult to envision a scenario whereas the BV didn't rise during the second quarter from $12.30 in the first quarter.

The 1Q net interest spread was 0.90%. This figure is expected to improve, too. In May, Annaly management reported they had de-leveraged the portfolio to take advantage of new opportunities. Since April, long rates dropped about 30 basis points from 2.8% to 2.5%. This should translate into good news.

Final thoughts
A most compelling argument for Annaly shares being undervalued is highlighted in the following chart:

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Since Annaly Capital Management was organized in 1998, the relationship between the 10-year / 2-year Treasury spread and the common share price was linked. Last year, the correlation unhinged completely.

This would seem to be an anomaly. The Fed has signaled little intent to raise short rates. Therefore, Annaly should continue to have easy access to cheap capital. If long rates rise, it will increase the interest rate spread, and Annaly will make more money. Even if interest rates were to advance, pressing book value, Annaly management can make adjustments to protect it. Unless rates skyrocket quickly, the business can react.

Investing is about probabilities. Plausibly, one may argue that the historical spread and share price correlation are more likely to revert to the mean than begin a "new normal" relationship.

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Raymond Merola owns shares of Annaly Capital Management. Please do your own careful due diligence before making any investment. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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