Annaly Capital Management, Inc. (NLY), Crexus Investment Corp (CXS): Will Diversification Help This Mortgage REIT?

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%.