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![Green arrow up over wooden houses. Increasing cost of housing concept. High demand for real estate. Growth of mortgage rates. Sale apartments. Price increase. Maintenance cost. Raising property taxes](https://static.seekingalpha.com/cdn/s3/uploads/getty_images/1370323333/image_1370323333.jpg?io=getty-c-w750)
Andrii Yalanskyi
Again in April, I wrote that Annaly Capital Administration (NYSE:NLY) regarded nicely positioned for when the MBS market turns. From a complete return perspective, the inventory is up about 5% since then. Let’s take a more in-depth look.
Firm Profile
As a fast reminder, NLY is mortgage REIT that invests in company mortgage-backed securities (MBS) which are collateralized by residential mortgages which are assured by authorities or government-sponsored businesses. It additionally invests in residential credit score, mortgage servicing rights (MSR), business actual property, and company debt.
The agency has three funding teams, that largest of which is its Company Group, which purchases MBS, TBA (to-be-announced) future contracts, and company business MBS. Its Residential Credit score Group invests in residential MBS not backed by businesses, whereas its Mortgage Servicing Proper Group invests in mortgage servicing rights.
On the finish of Q1 2023, NLY’s funding portfolio was valued at $85.5 billion, with $77.6 billion of that Company MBS. Roughly 91% of its portfolio was in agency-backed MBS at quarter finish, whereas ~2% was in MSRs and over 2% in non-agency mortgage property.
E-book Worth Enchancment
Just like different mortgage REITs, declining e-book worth was the large story for NLY in 2022, with the agency seeing it drop -35% from $31.88 in the beginning of the 12 months to $20.79 on the finish of the 12 months. As fastened revenue buyers are nicely conscious, an increase in rates of interest causes the worth of fastened revenue securities to drop to assist shut the hole in yield between legacy securities and newly issued securities. Whereas there are definitely completely different dynamics between Treasuries and the company MBS that NLY invests in, the underlying principals are related, and rising mortgage charges have hampered the e-book worth of mortgage REITs. As well as, mortgages have additionally seen their spreads versus Treasuries widen.
NLY noticed a reversal in This fall, with its e-book worth rising 4% sequentially. In Q1, the corporate noticed its e-book worth per share keep comparatively flat at $20.77. It paid out a dividend of 65 cents, and its financial return for the quarter was 3%. That was higher than the -0.7% return for rival AGNC Funding (AGNC) and -3.6% for Two Harbors Funding (TWO). E-book worth was down about one other -1% in April after the quarter as nicely.
![NLY MBS Portfolio](https://static.seekingalpha.com/uploads/2023/6/12/906212-1686593229675593.png)
Firm Presentation
NLY credited its outperformance to its portfolio make-up and hedge e-book. On its Q1 call, CEO David Finkelstein mentioned:
“Over 50% of our portfolio is in what we outline as intermediate coupons, 3.5s to 4.5s, which stay extra insulated from potential financial institution gross sales whereas avoiding the provision strain greater up the coupon stack. This dynamic drove buyers to shift into these coupons, resulting in marginally constructive hedge efficiency inside this portion of our portfolio regardless of headline MBS spreads widening over the quarter. Wanting ahead, we proceed to favor these intermediate coupons, and we’ll additionally opportunistically make investments up the stack into 5s and better as these property present traditionally engaging nominal spreads. Along with our balanced positioning throughout the company market, our period administration and hedging selections have been essential in serving to us navigate the volatility in March. Over [7] consecutive buying and selling classes starting on March 9, the 2-year word moved in extra of 20 foundation factors per day. And all through this era, our portfolio was nicely positioned and we have been capable of reap the benefits of the surface strikes by including short-end hedges at engaging ranges, which changed swap runoff skilled over the quarter. And moreover, we proceed to rotate hedges out of treasury futures within the SOFR swaps, which we see as a extra environment friendly hedge and extra intently tracks our repo funding prices.”
Throughout troublesome occasions, mortgage REITs are solely nearly as good as their administration groups and the way they place their portfolio and hedges. On that entrance, NLY appears to be doing job. It continues to lift the coupon price of its portfolio, wanting largely at medium price coupons, that are much less risky than the extra ample low coupon MBS.
Just like AGNC, NLY additionally issued inventory in Q1 via an at-the-market program. The agency raised $563 million promoting widespread inventory in the course of the quarter via its ATM program. Primarily based on its internet proceeds, it appears like NLY was capable of promote the shares at a mean worth of round $22.20, which is properly above its end-of-quarter e-book worth of $20.77.
Elevating fairness for mortgage REITs above e-book worth helps improve e-book worth per share, whereas issuing shares beneath e-book worth decreases e-book worth per share. Given how NLY has traded, these gross sales look to have been at an opportune time. It could actually additionally funnel the proceeds into greater coupon MBS than most of its portfolio.
NLY hasn’t gotten the identical unfold carry as AGNC, and actually it has drifted decrease from 1.73% a 12 months in the past to 1.62% in Q1. Nevertheless, the corporate, as famous above, has performed a greater job of defending e-book worth. And e-book worth is the true key for these shares going ahead.
Similar to AGNC and others, NLY noticed the identical Q1 headwinds due to sturdy financial and jobs knowledge in addition to financial institution failures. This precipitated quite a lot of volatility, as Silicon Valley Financial institution and Signature offered off their MBS portfolios.
In the meantime, mortgages charges have continued to maneuver greater. Whereas the Fed appears poised to pause its rate of interest hikes, the continued solid jobs data might imply extra hikes later this 12 months. Economists are typically searching for two more rate increases, however suppose the Fed might start to decrease charges in 2024.
NLY has performed job of defending e-book worth with its shift to intermediate coupons, in addition to diversification into MSR and non-agency loans. If it may well proceed to take action, the inventory ought to dangle in there regardless of potential price hikes. Mortgage charges additionally might not transfer as a lot with further price hikes given the already vast unfold between mortgages and Treasuries.
Conclusion
After tough 12 months and a half for mortgage REITs as a result of rising rates of interest and widening spreads, the Fed tightening cycle ought to be coming nearer to an finish. NLY has performed job taking part in protection the previous couple of quarters, and it ought to profit as soon as the cycle shifts.
MBS spreads stay vast, so the mixture of spreads narrowing and the potential of the Fed reversing course and reducing charges subsequent 12 months may very well be enormous increase to a reputation like NLY and different mortgage REITs. For mortgage REITs, I normally have a look at a worth to e-book as the easiest way to worth them. On that entrance, NLY trades at 0.96x. By comparability, AGNC trades at 1.05x e-book whereas ARMOUR (ARR) is at 0.94x. TWO trades at 0.83x.
NLY is a well-run firm, so the low cost to e-book with its e-book worth settling into a variety is changing into engaging. Whereas it could be somewhat early, I’m going to lift my ranking on NLY to a “Purchase” because it has sturdy upside as soon as the Fed shifts its techniques.
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