The US housing and labor markets are feeding investors with all sorts of mixed signals, and now it’s the Fed’s turn. Ben Bernanke’s most recent speech gave an impression that the Fed might be tapering its Agency MBS purchases as early as the second half of the current year. Therefore, the markets started pricing in the Fed’s exit, causing the Agency MBS spreads to widen 18 bps to 67 bps.
While the widening of Agency MBS spread is a welcome sign for Agency mortgage REITs in general, the rise in mortgage rates causes erosion in their book values. Therefore, the securing the book value remains a key challenge for mREITs today.
Lower leverage to cushion book value decline
I believe Annaly Capital Management, Inc. (NYSE:NLY) is well positioned to take advantage of the current market conditions and improve returns. Annaly Capital’s recent acquisition of CreXus Investments, coupled with relatively low leverage levels employed by the company will lead it to outperform in the prevailing environment.
Given the expectation for continued volatility, you should not expect Annaly Capital Management, Inc. (NYSE:NLY) to add significant leverage to its current levels of 6.7 times in the near term. Also, the CreXus Investment can add low double digit returns in the commercial real estate space for Annaly Capital Management, Inc. (NYSE:NLY).
Less sensitive book value
Further, the addition of CRE loans into the portfolio should help minimize book value sensitivity to interest rates. However, their impact will be small as they represent only 5% of the total equity. More access to capital can result in more CRE debt at a faster pace, which could further reduce Annaly Capital Management, Inc. (NYSE:NLY)’s book value sensitivity.
Reduced compensation expense
Further, the company has been able to decrease its compensation expense by 13 bps due to the externalization of its management. After the board’s approval, Annaly Capital is now being managed by an external manager, Annaly Capital Company. Annaly Capital Management, Inc. (NYSE:NLY) will now pay its external manager a 1.05% management fee, compared to a 1.18% average compensation expense over the past five years. This is also below the industry standard of 1.35%. The reduced expense will further provide support to the Annaly Capital Management, Inc. (NYSE:NLY) bottom line.
Now let’s look at a couple of mREITs that compete directly with Annaly to purchase the Agency paper. American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are the other two mREITs that are exclusively invested in Agency residential mortgage backed securities.