Annaly Capital Management, Inc. (NLY) Is Down, But Not Out

The sharp move higher in interest rates post the Federal Open Market Committee meeting presented a tough week for most mortgage REITs’ book value and stocks including Annaly Capital Management, Inc. (NYSE:NLY) and Capstead Mortgage Corporation (NYSE:CMO). Therefore, I continue to favor hybrids over the entire agency space. However, just like Two Harbors Investment Corp (NYSE:TWO), the aforementioned agency-only names present some potential for better book value preservation in the face of rising interest rates.

Annaly Capital Management, Inc. (NYSE:NLY)

Book value risk

In a recent research note on mortgage REITs, Credit Suisse states that estimating book value presents more of a challenge in the current environment than usual given the magnitude of moves in mortgage and interest rates. Mortgage REITs have de-risked as rates have increased, but the timing and magnitude of the timing is not known yet.

Duration extension risk

During the second quarter, the 30-year MBS durations have extended by 0.7-2.0 years, given the 70 bps increase in rates. Credit Suisse expects another 50 bps move in the rates would cause a further extension, although at a slower pace. The duration extension is a key reason why mortgage REITs require the need to reduce the duration by selling or by extending the duration of liabilities through additional swaps.

Valuations

On average, the mortgage REITs are trading at a 10% discount to the book values estimated by Credit Suisse. While the sector is viewed as cheap relative to book value, it’s still considered too soon to start buying the sector until some stability in the rates is seen, which would lead to some book value stability.

With regards to its first-quarter book value, Annaly Capital Management, Inc. (NYSE:NLY) is trading at a 16% discount. Credit Suisse estimates a book value of $13 for the company, which means it’s trading at 2.7% discount to its estimated book value.

Similarly, Credit Suisse estimates a book value of $23.72 for American Capital Agency Corp. (NASDAQ:AGNC), which means it’s trading at 3.8% discount. ARMOUR Residential REIT, Inc. (NYSE:ARR) is trading at 14.5% discount to its estimated book value. Therefore, within the largely followed Agency players, ARMOUR Residential REIT, Inc. (NYSE:ARR) is trading at a discount larger than the entire market.

Annaly Capital not out

Annaly Capital Management, Inc. (NYSE:NLY) utilizes less leverage that most of its peers in the Agency mREIT space, and thus, declines in its book value should likely be lower than the group average. Barclays, in its research note, expects Annaly Capital Management, Inc. (NYSE:NLY) to still generate 9%-10% return on equity, which is less than the peer group average.

The company is expected to benefit from lower compensation expense due to the externalization of its management structure. Besides, the presence of CRE loans and additional return available from its recent CreXus Investment acquisition will lead the company to preserve its book value and provide support to the book value.

Portfolio rebalancing is the key for this mREIT

American Capital Agency Corp. (NASDAQ:AGNC) is another well-managed agency-only mREIT. The company experienced around 9% decline in its book value, and a similar decline had already occurred when it presented at the Morgan Stanley (NYSE:MS) investor conference.

For American Capital Agency Corp. (NASDAQ:AGNC), portfolio rebalancing was the key under the given situation. Therefore, its management was not late in taking the decision. Management decided to get rid of some of its exposure in the 30-year fixed rate Agency MBS in order to reduce its exposure to interest rate moves. Further, management decided that it will continue to manage its assets and hedges actively.

While this will create attractive opportunities for the company, it will also increase costs. Therefore, American Capital Agency’s investors must keep a close eye on costs and the resultant lower earnings potential in the coming quarters.

Another measure American Capital Agency could take is to add some adjustable rate securities to its portfolio, like Capstead Mortgage Corporation (NYSE:CMO).

Adjustable rate securities safer

Given the volatility in the mortgage rates, the longer-term fixed rate agency securities are most vulnerable to moves in interest rates. However, adjustable-rate agency securities are the least vulnerable. That’s because their interest payments are adjusted on the most recent reset date to the most current rates. So, the book value fluctuations are least.

Capstead Mortgage Corporation (NYSE:CMO) is one such Agency-only mREIT that is exclusively invested in the adjustable-rate securities. It’s considered a safer option under the given situation. Capstead Mortgage benefits from lower book value fluctuations and higher asset yield.

For Capstead, asset yields adjust to the more current interest rates, causing the company to benefit from the current higher rates. Since the asset yields adjust the more current market rates, fluctuations in the book value of Capstead are only minimum, that too between the reset dates only.

Conclusion

Annaly Capital Management, Inc. (NYSE:NLY) is no doubt the best in agency mREITs league. It has a strong earnings potential and is best positioned to preserve its book value within fixed rate agency mREITs. Therefore, I am bullish on the stock. While American Capital Agency has rebalanced its portfolio, these efforts might lead to lower earnings potential for the company. Capstead Mortgage is another safer option due to the design of its investment portfolio.

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The article Annaly Capital Is Down, But Not Out originally appeared on Fool.com and is written by Adnan Khan.

Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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