The mortgage REIT industry is a favorable sector for income seeking investors, because of its high dividend yields. However, with the Federal Reserve’s continuous intervention into the market in recent times, there are concerns whether these companies will continue to provide higher dividend yields or not. Let’s discuss the biggest player in this industry, Annaly Capital Management, Inc. (NYSE:NLY), which recently posted first-quarter results. Let’s look at the highlights of its first quarter, and how it is planning to avoid the Fed threat.
In the first quarter, Annaly Capital Management, Inc. (NYSE:NLY)’s non-interest rate spread income benefited from its market backed securities, or MBS sales. It sold securities worth around $17 billion, which resulted in a GAAP income of $182 million. This sale has reduced its portfolio of MBS to $108 billion, down from $123 billion quarter over quarter. Even after this large decline in its portfolio, the company showed a very slight increase in its leverage. It increased to 6.6 times from 6.5 quarter over quarter. However, one of the important points to be considered here is that, Annaly Capital Management, Inc. (NYSE:NLY)’s leverage level is still the lowest among all publicly traded agency mortgage REITs.
Its portfolio spread once again proved to be a headwind for the company. Its net interest spread declined to 91 basis points from 95 basis points quarter over quarter. The major reason of this decline in spread income was declining asset yields from 2.45% to 2.37%. This was partially offset with the lower funding cost of 1.46% against 1.5%.
Prepayment risk
One of the most important drivers of the agency REIT market in recent times is the Federal Reserve’s Operation Twist. Under this operation, Federal Reserve is buying long term MBS and selling short term MBS securities in order to lower the yields on the securities. In September 2012, it came up with its third round of bond purchasing, under which it is buying an additional $40 billion of MBS per month, which brought the total purchase to $85 billion in a month.
This has increased higher prepayment for the company. In this quarter, the conditional prepayment rate or CPR was 18%, which is less than 19% from previous quarter, but still remains at the higher level. With the recent interest rate cuts, mortgage refinancing will speed up and force consumers to increase prepayment of their mortgage portfolio. This will ultimately pressure Annaly Capital Management, Inc. (NYSE:NLY)’s spread income. However, the company sold some of the securities in this quarter, which had CPR of 34%.
Prepayment risk remains for the majority of agency mortgage REITs, but Annaly Capital Management, Inc. (NYSE:NLY)’s peer company CYS Investments Inc (NYSE:CYS) has made a smart move by focusing on 15-year fixed rate securities. These securities are not immune to prepayment risk, but have much lower risk in comparison to 30-year fixed rate notes, which Annaly is mostly holding. In the first quarter, CYS Investments Inc (NYSE:CYS)’ average CPR was 17.5%, but it dropped to 13.4% at the end of the quarter. It reported that in April CPR further dropped to 12.1%. Looking at lower prepayment risk, CYS Investments Inc (NYSE:CYS) has also bought 30-year fixed rate securities, as these have a higher spread of 1.5% against the 1.2% of the 15-year fixed rate securities. With lower prepayment risk and a recent portfolio shuffle, CYS Investments Inc (NYSE:CYS) will see increased earning in future.
Diversification – a key to success?
Annaly Capital Management, Inc. (NYSE:NLY) recently announced that it will complete its merger of Crexus Investment Corp (NYSE:CXS) on May 23rd. Annaly already holds around 12.4% of Crexus Investment Corp (NYSE:CXS) . This merger will expand its portfolio from agency MBS to non-agency MBS and commercial mortgage loans. Crexus Investment Corp (NYSE:CXS) has around $1 billion of assets, which are focused on commercial mortgage. This merger is considered to be the beginning of a transformation process, as over time, Annaly will transform itself into a hybrid REIT, which includes both agency and non-agency MBS. Annaly can invest up to 25% of its equity into non-agency securities and, even after this merger, Annaly will only have around 6% of its equity allocated in non-agency assets. So there is still room for additional investment into non-agency assets. On the other hand, Crexus Investment Corp (NYSE:CXS) will have more capital flexibility and prepayment, which Annaly would be getting from agency assets, but the company will be invested in commercial assets. It is estimated that this merger will add in EPS of around $0.10.
Bottom line
With the Federal Reserve active in the market, there is very little chance that yields will improve in the near future. However, Annaly’s merger with Crexus Investment Corp (NYSE:CXS) will enhance its portfolio of non-agency assets and reduce its prepayment risk. Also, Crexus Investment Corp (NYSE:CXS) will enjoy greater availability of funds. Overall, this merged entity will reflect increased earnings in the future. Hence, I recommend holding Annaly’s stock, considering its good dividend yield of 11.8%.
The article Will Diversification Help This Mortgage REIT? originally appeared on Fool.com is written by Madhu Dube.
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