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Time to Buy Oversold Annaly Capital Management, Inc. (NLY)

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A lot of bearish opinions float around, especially regarding rising interest rates and their impact on the agency mREITs. However, I am becoming bullish on the agency mREITs sector as I believe the agency mREITs, including Annaly Capital Management, Inc. (NYSE:NLY) have been oversold. Let me offer you my thoughts on why I believe the current interest rate environment suits Annaly Capital Management.

Before digging deeper, let me explain what an agency mREIT is and what a hybrid mREIT is. An agency mREIT invests exclusively in the mortgage-backed securities for which a government agency guarantees the principal and interest payments. In contrast, hybrids invest in both agency and non-agency MBS. At times, they also have investments in commercial MBS and other asset-backed securities. So, in short, hybirds have a more diverse asset portfolio compared to their agency-only counterparts.

Bearish opinions

Let me quickly take you through the widely circulated bearish sentiments first.

Annaly Capital Management, Inc. (NYSE:NLY)Analysts and investors are of the view that the rising interest rates will tend to discourage home borrowers to take out more loans. So, fewer mortgage originations would mean lower supply of mortgage backed securities, which would increase their prices given a stable demand. Second, the prices of the existing MBS held by mREITs will fall as the rates continue to increase. Basically, the net effect is increased volatility that will hurt the agency mREITs like Annaly Capital Management, Inc. (NYSE:NLY).

While these opinions are not completely flawed, there is a flip side of the coin which leads me to believe that Annaly Capital Management, Inc. (NYSE:NLY) is a buy. Let’s see why.

Oversold

Given the fundamentals, I believe the agency mREITs sector is oversold. Yesterday alone, we saw more carnage in the agency mREITs space as the 10-year Treasury yield soared above 2.7% following June’s non-farm payroll report. Annaly Capital Management, Inc. (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) fell 6.9% each, while Invesco Mortgage Capital Inc (NYSE:IVR) fell 2.7%. Let’s look at three agency mREITs individually.

Annaly Capital Management, Inc. (NYSE:NLY), the largest agency mREIT that invests exclusively in the fixed rate paper is currently trading in proximity to its 52-week low. With regards to its most recent quarter’s book value, the stock is trading at a 20% discount. Even after an 11% dividend cut, the stock is still yielding 13.9%.

Same is the case with the second largest agency-only mREIT, American Capital Agency Corp. (NASDAQ:AGNC). Exchanging hands at $20.76 per share, the stock is trading in proximity to its 52-week low. With regards to its book value, the stock is trading at a significant discount of 24%. American Capital Agency was forced to cut its dividend distribution by 16%. It is currently yielding 20.2%.

Invesco Mortgage Capital Inc (NYSE:IVR) is currently trading at a 22% discount to its first-quarter book value. Meanwhile, it’s yielding 17% after maintaining its second quarter dividend at $0.65 per common share. Now you must be wondering , “Invesco Mortgage is a hybrid mREIT, so why is it being compared to the agency-only players and why did it experience a somewhat similar decline?” The answer is the nature of its investment portfolio, which has abundance of long-term fixed rate agency paper.

Let’s see why I believe there is a flip side to the widely circulated bearish sentiments about the mREITs.

Why I am bullish

The latest Mortgage Bankers Association weekly survey shows that as a consequence of the rising interest rates, the refinancing activity has slowdown. The increase in rates gives homeowners fewer incentives to refinance and as a result the refinance applications declined 15%, the lowest in two years.

This is actually encouraging for Annaly Capital Management, Inc. (NYSE:NLY) and its peers considered for this investment thesis. Accelerated prepayments have remained a key risk for mREITs. With the rise in rates and the slowdown in refinancing, mREITs will face fewer prepayments on their existing loans. That way Annaly and its peers can report higher income.

Another report stated some even more encouraging facts. It states that while the refinance applications were down, the new purchase applications were moderately up by 10 bps. So, the original concern about a decline in the new production mortgage originations due to the hike in rates is flawed.

These facts coupled with the strategic efforts made by both Annaly Capital Management, Inc. (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) places them in a better position.

The largest mREIT

As part of strategic moves, Annaly Capital Management, Inc. (NYSE:NLY) acquired CreXus Investments, which is largely an mREIT that invests in commercial MBS. The acquisition is now complete and Annaly’s investors can expect the elevated returns coming from CreXus to provide a solid support in the second quarter. Besides, the book value volatility at Annaly will remain low due to the presence of CRE loans and a relatively low level of leverage in the capital structure.

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