As yield-hungry investors well know, the mortgage REIT sector has been brought to its knees by the low-interest environment and the Fed's quantitative easing policies. The latter has really wounded mREITs like Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), which invest in just the kind of goodies being gobbled up by the Federal Reserve: mortgage-backed securities backed by Fannie and Freddie.
Now that Annaly has reported its fourth-quarter earnings, let's take a closer look at how the REIT has been coping with such headwinds. The company reported earnings of $0.70 per common share, an impressive increase from the year-ago quarter's $0.46, and net income was up 57% year over year. How, we wonder, is the mREIT faring on important issues like spread compression, book value, and leverage?
To see how mostly pure-play Annaly is doing in those areas, let's compare it to hybrid REIT Invesco Mortgage (NYSE:IVR), which also buys agency securities, as well as non-agency and commercial paper.
QE3 giveth and taketh away
On the one hand, the government's QE policy makes mortgage-backed securities scarce, pushing up the value of the securities held by Annaly and other mREITs, thus increasing book value. On the other hand, the long-term interest rates on mortgages have been pressed down to record levels over the past few months, which constricts the spread on which these companies make their money.
For Annaly, both these metrics look a little anemic. Book value per share has decreased by nearly 5% since last quarter, and fell 1.3% from the year-ago quarter. More-diversified Invesco saw its book value per share decrease by only 0.5% from the third quarter, and increase by 27% year over year.
Interest rate spreads were squeezed tighter at Annaly, as well. The company's in-quarter spread dropped to 0.95%, down 76 basis points from the fourth-quarter of 2011, whereas Invesco's spread now sits at 1.62%, down 50 basis points year over year.
Leverage moves up
Annaly has a reputation for being very conservative, and it has served the REIT and its investors very well over the years. Lately, and despite the new CEO Wellington Denahan's promise to remain conservative, the company is taking a new, bolder tack: It has agreed to buy up what it doesn't yet own of Crexus Investment (UNKNOWN:CXS.DL.DL), a REIT which specializes in commercial paper.
In addition to this new foray into diversified investment, Annaly has stepped up its leverage. In an effort to minimize risk, the company has kept its leverage on the low side. But it has increased this metric to 6.5 from the year-ago value of 5.4. This puts it ahead of Invesco, at 6.1.
Variety really is the spice of life
Will diversifying help Annaly achieve the heights it once took for granted? Looking at the Invesco example, management was clear that it had reduced its percentage of agency mortgage-backed securities to 49% of its equity in the last quarter, and this doubtless helped the overall spread. Indeed, Invesco's agency unit has a spread of just a tad more than Annaly's -- 1.1% compared with Annaly's 0.95%. With a yield of 3.09% on its non-agency section, however, the overall rate gets a very nice boost, and that's precisely where the Crexus acquisition will come in handy for Annaly.
What about book value? Normally, you would expect Annaly's book to have increased more than Invesco's, due to QE3 and its resultant rationing of mortgage-backed securities available for sale. But there were a few things that pulled down Annaly's book value, including the share buybacks that the company executed and huge unrealized losses -- a good chunk of which came from the company's swap hedges.
Then, of course, there's the question of dividends. Invesco paid $0.65 per share, unchanged since the end of 2011. Annaly, however, has been steadily chipping away at its payout over the past two years, with no end in sight. Adding a new ingredient to the mix (hello, Crexus) might just be what the dividend doctor ordered.
What does all this mean for other agency REITs, such as American Capital Agency? Unlike Annaly, American has been paying out a plump divvy for the better part of a year now. Does that mean that, unlike Annaly, American will not feel the need to expand into uncharted territory? Or, once it sees how the new business plan works for Annaly, will it, too, be jumping on the diversification bandwagon?