In the current market environment, finding income can be incredibly difficult. Short-term interest rates are stuck close to zero, and corporate bonds are paying miserly yields. One of the few asset classes providing some sort of yield is real estate investment trusts (REITs).
REITs are coming off a rough year, as COVID-19 triggered widespread business shutdowns and caused dislocations in the bond market. Mortgage REITs in particular had one of their worst periods ever as liquidity dried up in the mortgage market, which triggered a wave of margin calls. But a year later, these stocks have all regained their footing and are looking at a new investment environment. Over the past month, we have seen a sizable increase in the 10-year bond yield.
What is Annaly Capital Management (NLY 1.76%), one of the biggest mortgage REITs, thinking about this environment, and what does it have to offer investors now?
Mortgage REITs are a little different than the typical REIT
While most REITs have a pretty easy-to-understand business model, mortgage REITs are a bit different. The typical REIT, say an apartment REIT or office REIT, builds properties and then rents them out. Mortgage REITs don't own properties -- they own property debt. For the most part, this means residential mortgages.
If you recently refinanced your home, chances are your loan was pooled into a mortgage-backed security, which ended up being held by a mortgage REIT like Annaly. These REITs then use leverage (borrowed money) to turn a bunch of 3% yielding mortgages into a 10% dividend yield. Leverage allows a company to invest multiple times its equity.
Annaly recently reported its fourth-quarter and full-year earnings. Book value per share (which is one of the most critical metrics for mortgage REITs) rose 2.5% from the third quarter to $8.92 per share. At the end of the year, leverage was down one full point to 6.2 times equity.
Agency mortgage-backed securities (in other words, government-guaranteed) represented 93% of the investment portfolio. Annaly also began increasing its exposure to credit assets, which are not guaranteed by the government.
Agency mortgage-backed securities are becoming less attractive compared to other assets
On its earnings conference call, the company described its economic outlook, which is one where longer-term rates gently rise as the economy recovers. In fact, the company began implementing hedging strategies to mitigate this risk. It views the Federal Reserve as having learned the lessons of the 2013 "taper tantrum," where the Fed began to ease off of mortgage-backed securities purchases and caused a spike in interest rates. The Fed has stressed the need to be transparent and deliberate when reducing its footprint in the mortgage market.
Despite the upward move in the 10-year bond, mortgage rates have only begun to rise. This behavior is called "spread tightening," meaning that mortgage-backed securities have outperformed Treasuries.
For bond investors, extended periods of outperformance in one asset often means there are better relative values elsewhere. Indeed, Annaly sees opportunities in non-guaranteed residential mortgages and middle-market lending. Annaly added about $1 billion in assets in this area last quarter.
The outperformance of government-guaranteed mortgage-backed securities is due, in part, to Federal Reserve buying and also the behavior of commercial banks. The company noted on the earnings call that banks are seeing strong deposit growth while making fewer commercial and industrial loans.
The loan-to-deposit ratio is the lowest in 50 years. Those deposits have to get invested somewhere, and that's the agency mortgage-backed securities market right now. Non-government guaranteed mortgages are beginning to see new issuance as credit eases.
The one area where Annaly is still cautious is in the commercial real estate space. It's still somewhat early in the recovery for that asset class, and Annaly took advantage of an opportunity to sell some of its investment in healthcare facilities.
A high yield and substantial discount to book value
Annaly pays a $0.22 quarterly dividend, which works out to be a 10% dividend yield, more or less in line with its historical yield. In comparison, the yield on the S&P 500 is about 2.5%, which is the lowest in the past decade.
The company describes its investment strategy as counter-cyclical, or acyclical. Given that most of the portfolio is government-guaranteed, it's less at risk in a recession than the typical stock. For that reason, it provides a decent amount of diversification in addition to the yield.
Annaly also trades at a 6.3% discount to its end-of-2020 book value. Book value per share is up about 3.5% since the end of the year, so the discount is really closer to 9.5%.
Given the 10% dividend yield and the discount to book, Annaly is an attractive stock for income investors.