For investors who want to know what's really in store for Annaly Capital Management (NYSE:NLY), you need to go right to the source, and that's management. Annaly conducted its fourth-quarter conference call last Wednesday; here's what you need to know.
5. Annaly did some smart things in 2014
According to Annaly's head of agency portfolio, David Finkelstein: "First, we added nearly $10 billion of assets early in the year. Second [...] we lifted a significant portion of our shorter dated hedges."
Annaly's currently owned securities decline in market value when interest rates rise, and hedges lock in the company's borrowing costs to protect against rising rates. By adding assets and reducing hedges, Annaly was betting on rates to fall.
Considering that interest rates spiked in 2013, the Federal Reserve was tapering its massive bond-buying program, and the Fed was potentially going to increases short-term interest rates, this was a fairly bold assumption at the time. But Annaly was right, as interest rates fell over the course of 2014.
Shareholders depend on the insight and decision-making of Annaly's management team. That team made the right calls in 2014, and the company performed well.
4. The Fed will increase rates in 2015
Unlike last year, however, President Kevin Keyes suggested, "[W]e view lift-off as inevitable this year."
An increase in short-term rates would not only increase Annaly's borrowing costs and squeeze earnings, but Keyes also believes the Fed's actions will be accompanied by more volatile long-term interest rates. Since the market value of Annaly's securities are highly sensitive to the movements of long-term rates, that kind of climate could make Annaly's life difficult.
To help insulate the company, Annaly is going to continue to be cautious. Doing so means holding hedges in place to protect borrowing costs, and keeping leverage low. Leverage is a measure of how much debt compared to equity Annaly is using. By keeping this ratio low (using less debt), the swings in the value of Annaly's assets are less dramatic.
3. Is volatility a good thing?
Most investors view volatility as bad, and rightfully so. If long-term interest rates rise, it lowers the market value of Annaly's currently owned securities and also lowers the company's book value, and Annaly's stock price will almost always fall.
Contrary to this belief, Keyes said, "I will put it simply: Volatility equals opportunity for Annaly."
As mentioned, Annaly has been keeping its leverage low to protect against rising interest rates, but this approach comes with a second benefit: the ability to ramp up borrowing. According to Keyes, Annaly is currently using 40% less leverage than its peers, so if interest rates do rise, Annaly has more ammunition to buy new, higher-yielding assets that can help improve returns. Keyes believes Annaly has a significant competitive advantage here, and I agree.
2. Staying balanced is key
According to Annaly's CEO, Wellington Denahan: "[I]n a perfect world we would love it if we could time these things perfectly. ... Unfortunately, that is not how it goes."
If Annaly was 100% convinced interest rates would rise, it would make sense to add more hedges. If it's wrong, however, and interest rates fall, Annaly would take massive losses. For instance, during the fourth quarter of 2014, interest rates fell by 6.2%, or about 0.2 percentage points, and Annaly took $873 million in losses on its hedges.
Annaly's management team suggested that while it believes rates will rise, it's going to remain balanced in case it's wrong.
1. Diversifying the business is just as important
Since Annaly's inception in 1997, the company has focused exclusively on assets guaranteed against default by Fannie Mae and Freddie Mac. This approach has been key to Annaly's durability.
But that approach changed in January 2013 when Annaly acquired CreXus and started adding commercial mortgage debt and equity (physical properties) to its portfolio. Though it generated attention, these investments have accounted for well below 25% of the company's equity. But that may not be the case forever.
According to Bob Restrick, Annaly's head of commercial real estate group, the company has closed, or is in the process of closing, $450 million in commercial investment in the first quarter of 2015 -- more than in all of 2014.
Also, in an effort to reduce its credit risk, Fannie Mae and Freddie Mac have designed risk-sharing deals, in which investors, such as Annaly, would absorb some of the credit losses if the mortgage securities Fannie and Freddie guarantees start defaulting -- as they did during the financial crisis in 2008. According to Finkelstein, "[W]e have entered into that space, albeit in limited size thus far."
Despite the added risk, I'm excited to see Annaly take on some more unique assets. I think it diversifies the company, creates new opportunities, differentiates Annaly from its peers, and could help develop a more lasting competitive advantage.
The potential for rising or more volatile interest rates is likely to create a difficult environment for Annaly, which could lead to tighter earnings and a strained dividend. However, I think management is doing what's necessary to put itself in a position to be successful. I believe diversifying assets is making Annaly a more attractive, albeit riskier, business, and despite the difficulties ahead, I see Annaly as among the best high-yield stocks you can own over the long term.