This year has been a period of feast and famine for the mortgage real estate investment trust (REIT) industry. March and April were characterized by extreme bond market volatility, which prompted margin calls and a massive de-leveraging for the sector. Every company in the mREIT space reported big declines in book value and a dividend cut. Subsequently, the Fed began to buy mortgage-backed securities, which steadied the markets and turned around earnings.
Annaly Capital Management (NYSE:NLY) just reported that its recent earnings could be its best for a while. What is going on?
Big increase in book value per share
Annaly reported net income of $0.70 for the third quarter, which was an increase from $0.58 in the second quarter. Book value per share increased from $8.39 to $8.70. On the earnings conference call, CEO David Finkelstein characterized third-quarter core earnings as a "near-term peak," although the company expects to cover the dividend in the fourth quarter. Annaly was able to generate a 6.3% economic return during the quarter, all while reducing leverage, which fell from 6.4 times to 6.2 times.
The Fed is driving the higher returns
The prime driver of the improved earnings picture was a widening of spread income, which is the difference between what Annaly earns on its assets and what it pays to finance them. Over the past year, mortgage-backed securities yields have decreased, but not by much. A year ago, Annaly's assets paid 2.89%. In the second quarter, that fell to 2.77%, and in the third, to 2.7%. On the other hand, the cost of financing these positions fell massively, from 2.58% last year to 0.96% in the second quarter and 0.6% in the third. This means the net interest spread (or the difference between what the assets make and what it costs to finance them) rose from 0.31% a year ago to 2.1% today. The Fed is forecasting that short-term rates (which drive the financing costs) will be on hold through 2023, which means that spreads should remain wide.
Interest rate volatility has been depressed due to the Fed's tight control over the bond markets. The Fed is keeping short-term rates close to 0% and is actively supporting the mortgage-backed securities market. As a general rule, low volatility bond markets are extremely helpful for investors in mortgage-backed securities (MBS). When bond markets get volatile, like they did in March and April, mortgage-backed securities suffer. Prepayment assumptions (a critical input into MBS valuation) become difficult to predict, and that uncertainty gets priced into the MBS price. Conversely, when rates are stable, that uncertainty diminishes, which means stronger MBS prices.
Credit exposure is at the low end of Annaly's historic range
Annaly's credit portfolio is struggling somewhat with the economic environment, especially on the commercial real estate side. The commercial real estate environment appears to be showing signs of improvement, with improving sales and leasing activity. However, the environment is still stressed. The residential loan portfolio will be supported by the technicals of the housing market (high demand and limited supply). Forbearance seems to be decreasing, although the non-QM space still has the highest forbearance numbers.
Annaly is exiting the third quarter with higher agency (i.e. government-guaranteed) exposure and credit exposure toward the low end of its historical target range. The company is looking to add credit exposure; however, opportunities are somewhat intermittent. Annaly bought back $200 million in stock over the past six months and is always weighing building its portfolio versus returning capital to shareholders.
Annaly is trading at a 19% discount to book value and a 12.4% dividend yield. While some of Annaly's discount could be due to fears about its credit portfolio, even mREITs like AGNC Investment Corp., which invest almost exclusively in mortgages backed by the government, are trading at sizable discounts to book. The sector is out of favor at the moment, and Annaly is trading at a historically large discount to book value.
Investors who prefer value and also income should consider Annaly Capital. With a 19% discount to book value and a 12% dividend yield at recent prices, the stock has a margin of safety that should allow investors to sleep at night. With the Fed on hold for the foreseeable future, interest rate volatility should remain low, which will support the stock.