Annaly Capital Management, Inc. (NYSE:NLY) Q3 2023 Earnings Call Transcript

Annaly Capital Management, Inc. (NYSE:NLY) Q3 2023 Earnings Call Transcript October 26, 2023

Operator: Good morning and welcome to the Third Quarter 2023 Conference Call for Annaly Capital Management. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Sean Kensil, Director of Investor Relations. Please go ahead, sir.

Sean Kensil: Good morning, and welcome to the third quarter 2023 earnings call for Annaly Capital Management. Any forward-looking statements made during today’s call are subject to certain risks and uncertainties, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date hereof. We do not undertake and specifically disclaim any obligation to update or revise this information.

During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. Content referenced in today’s call can be found in our third quarter 2023 investor presentation and third quarter 2023 supplemental information, both found under the Presentations section of our website. Please also note this event is being recorded. Participants on this morning’s call include David Finkelstein, Chief Executive Officer and Chief Investment Officer; Serena Wolfe, Chief Financial Officer; Mike Fania, Deputy Chief Investment Officer and Head of Residential Credit; V.S Srinivasan, Head of Agency; and Ken Adler, Head of Mortgage Servicing Rights. And with that, I’ll turn the call over to David.

David Finkelstein: Thank you, Sean. Good morning, everyone, and thanks for joining us today. I’ll begin with a discussion of the macro and interest rate landscape, and then I’ll review the current operating environment, including our portfolio activity and positioning. Now as all are aware, the third quarter was characterized by a sharp rise in interest rates as the 10-year treasury yield rising nearly 75 basis points. The move was in part driven by strong economic data, the Fed’s messaging of hire-for-longer, rising commodity prices and the sell-off in global yields. The main driver for higher yields, however, has been a shift in perception around U.S. government debt that began with the August treasury refunding announcement as after increasing issuance following the debt ceiling deal in early June, treasury began to term out debt above market expectations in August, all while signaling further increases in coming quarters.

This higher supply has been met with limited demand as the Fed continues to run down its balance sheet, banks remain sidelined given the sizable unrealized losses on their bond portfolios and foreign central bank buying has been lukewarm at best. Consequently, money managers, pensions and ultimately, households are the main source of demand for treasuries and by extension Agency MBS. However, thus far, households are saving less than historical averages, and savings are largely being allocated to short-term fixed income instruments, best seen through the record $6 trillion in money market mutual fund holdings, contributing to the sharp sell-off and curve steepening in rates markets in recent weeks. Now as it relates to the broader U.S. economy, growth has been supported by strong consumption and sound investment activity, while the labor market remains very healthy.

Inflation has continued to moderate. And looking forward, it appears that a number of headwinds are building for the economy, including household shrinking excess savings, geopolitical risks and the tightening in financial conditions as of late. However, hard economic data has shown little evidence of a meaningful slowdown thus far. Now all told, higher term premium and the continued elevated volatility contributed to significant underperformance in Agency MBS during the quarter, which was exacerbated by a pullback in demand from the money manager community who remain the primary buyers of MBS. As a result, spreads widened roughly 15 to 20 basis points on the quarter, with higher coupons outperforming lower coupons as investors sought to optimize carry-in duration profiles.

These factors weighed on our performance, resulting in a negative 8.8% economic return for the quarter, and our leverage ended Q3 at 6.4x. With respect to portfolio activity, the notional value of our Agency holdings was relatively unchanged given the flexibility from our reduction in leverage heading into the third quarter. We continued to migrate up in coupon, and we favored specified pools over TBAs in order to improve the convexity profile while benefiting from lower financing costs. We also grew our Agency CMBS portfolio by roughly $500 million. And from a relative value perspective, Agency CMBS provide attractive and stable cash flows without the negative convexity of MBS, not to mention a more favorable technical backdrop. As it relates to hedging, as the hiking cycle comes to an end, we anticipated the shift from protecting the front end to protecting the long end.

And therefore, over 75% of our hedge duration remain in the 7- to 20-year part of the curve, matching our asset duration profile. We were active in adding longer-end treasury features early in the quarter. And also to note, as front-end swaps matured, we replaced a portion of those hedges further out the curve. We anticipate we’ll reach a point in the near future where it will be advantageous to add interest rate exposure. But for the time being, we remain conservatively positioned. Now MBS valuations look very attractive relative to other high-quality fixed income alternatives as well as on a stand-alone basis, which we expect will improve investor sentiment and help to normalize spreads over the medium term. However, our intention is to remain disciplined in terms of managing leverage as MBS find their equilibrium in the current environment.

Turning to residential credit; spreads across the sector were resilient during the quarter, driven by limited issuance, supportive housing fundamentals and a still generally healthy borrower. Benchmark CRT below investment grade spreads tightened 50 to 70 basis points on the quarter and AAA Non-QM spreads were flat to 10 basis points tighter, with Non-QM securitization cost of funds relatively stable. Our resi portfolio ended the quarter at $5.3 billion in market value, up approximately $315 million, predominantly attributable to an increase in our whole loan portfolio as we settled $1.5 billion of expanded credit loans in the third quarter, of which 80% was sourced directly from our correspondent channel. The continued expansion of the Onslow Bay correspondent channel allowed us to more than double our Q2 whole loan production while maintaining our conservative lending standards.

Q3 settlements are characterized by a 752 average FICO, a 69% LTV and limited layered risk. Our securitization platform issued 2 Non-QM transactions totaling $812 million during the quarter, which generated $98 million of retained assets. In post quarter end, we closed another Non-QM deal, continuing our programmatic issuance while locking in term financing and generating a mid-teens ROE. Now OBX remains the largest non-bank securitizer of new origination collateral with 2023 year-to-date issuance of nearly $4 billion. And with over $3.5 billion of dedicated facilities across Annaly in our joint venture, we can efficiently finance our whole loan position via securitization or warehouse financing, which Serena will expand on. Now lastly, within mortgage servicing rights, our portfolio grew by $90 million in the third quarter and $480 million year-to-date, ending September at $2.3 billion in market value and $153 billion in principal balance.

And Onslow Bay is now a top 10 non-bank servicer, servicing roughly 2% of the agency market. While bulk trading levels declined in the quarter, the MSR market remains active, and we expect supply to be elevated over the next few quarters, given broad activity in the sector and continued pressure on non-bank originator profitability. As we’ve discussed in the past, Annaly is uniquely positioned to acquire MSR from originators given our certainty of capital as well as our non-competitive business strategy. Now our holdings continue to benefit from our low no rate, high credit quality asset profile, which drove the expansion of our valuation multiple in the year. Our MSR cash flows remain highly stable as evidenced by below 4 CPR prepayment speeds and minimal delinquencies, both consistent with the prior quarter.

Our capital allocation MSR as of quarter end was 19%, which brings us close to our long-term target allocation, though we maintain capacity to increase our holdings further given minimal leverage currently in our additional warehouse capacity. We’ve also expanded our MSR acquisition capabilities, and we can now participate in GSE flow programs to supplement our bulk execution strategy when attractively priced. Now before handing it off to Serena, I wanted to provide one final note as it relates to where we sit today. Yields and notably real yields are at their most attractive levels in more than 15 years and Agency MBS spreads are historically wide. Our residential credit and MSR strategies are fully scaled and established leaders in their respective sectors and provide strong complementary returns to our core agency business, as has been exhibited over the recent past.

Now given the interest rate and spread backdrop in similar periods throughout this company’s history, Annaly has generated very strong returns, and we have the size, scale and liquidity to successfully navigate this environment and capitalize on opportunities as they arise. And now with that, I’ll hand it over to Serena to discuss the financials.

Serena Wolfe: Thank you, David. Today, I will provide brief financial highlights for the quarter and 9-month period that ended September 30, 2023. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. Due to factors as David mentioned earlier, our book value per share for Q3 decreased from the prior quarter to $18.25. And with our third quarter dividend of $0.65, we generated an economic return for the quarter of negative 8.8% and negative 2.8% for the first 9 months of the year. A further increase in rates for the quarter drove gains in our hedging portfolio of roughly $3.76 and our MSR book of $0.16.

While spread widening and increased volatility significantly impacted our Agency portfolio, resulting in losses of approximately $6.16 for the quarter. Additionally, our resi credit assets were down 20% [ph] for the quarter, primarily related to mark-to-market changes on the portfolio. We generated earnings available for distribution of $0.66 per share for the third quarter. Consistent with the prior quarter, EAD was adversely impacted by the continued rise in repo expense. Our portfolio positioning enhanced our average yield ex PAA, which rose again quarter-over-quarter, 24 basis points higher than the prior quarter at 4.46%. Yields also improved by 9 basis points due to lower amortization with long-term CPRs decreasing from 8.6% in Q2 to 7.1% in the third quarter.

Impacted by the same factors as EAD, NIM declined 18 basis points from Q2 to 148 basis points of NIM ex PAA in the third quarter. Net interest spread declined 27 basis points quarter-over-quarter to 1.18% versus 1.45% in Q2 as the rate increases on our financing agreements modestly exceeded the increase in asset yields. The aforementioned rise in repo rates impacted our total cost of funds for the quarter, rising by 51 basis points to 328 basis points in Q3, and our average repo rate for the quarter was 544 basis points compared to 515 basis points in the prior quarter. The beneficial impact of swaps on the cost of funds was tempered in Q3 due to the maturity of certain contracts, resulting in a net interest component of interest rate swaps declined by 7% to approximately $395 million for the quarter compared to $425 million in Q2.

Now, turning to details on financing. Funding markets remain ample and liquid. We continue to see strong demand for funding for our Agency and non-Agency security portfolios. Our financing strategy is consistent with prior quarters, and our Q3 reported weighted average repo days were 52 days, up from 44 days in Q2, as we look to find opportunistic longer-term trades in the market, adding $2.5 billion of floating rate repo with terms exceeding 12 months during the quarter. We continued our disciplined approach to adding and extending existing warehouse capacity for our credit businesses during the quarter. As we previously mentioned, the appetite for credit by lenders has also been robust, and we renewed 2 facilities for approximately $700 million, upsizing 1 facility by $100 million since the beginning of Q3 at tighter spreads to SOFR and improved advance rates.

We continue to expand our suite of financing options available to us and have various additional funding initiatives underway for Q4 and beyond for both our resi and MSR businesses. As of the end of Q3, the $1.8 billion of unused warehouse capacity across our resi credit and MSR financing facilities provided us with a very comfortable liquidity position for these businesses. Impacted by the volatility experienced during the third quarter, our liquidity profile declined compared to prior quarters. However, it remained healthy with unencumbered assets of $4.7 billion compared to $6 billion in Q2, including cash and unencumbered agency assets of $2.8 billion for the quarter. The decrease in unencumbered assets primarily came from higher on balance sheet leverage for Agency MBS securities, offset by MSR purchases during the quarter.

That concludes our prepared remarks, and we will now open the line for questions. Thank you, operator.

Operator: [Operator Instructions] And the first question will come from Bose George with KBW.

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Q&A Session

Bose George: Can I get an update for book value quarter-to-date?

David Finkelstein: Sure, Bose. So I have as of Tuesday evening, which was off 11% for the quarter. So we’re still trading well below book value.

Bose George: Okay, great. And then, just switching to your MSR. So it’s not 19% of capital. Can you just talk about the levered — so the unlevered yield and I guess, the levered yield now that you have some asset-level leverage? And how large do you think the MSRs could get just given the opportunity that looks pretty attractive over the next year?

David Finkelstein: Sure. I’ll start with the capital allocation, and Ken can talk about returns. So as we show, we have 1/3 of a turn of leverage on the MSR. What we’ve talked about in the past is that with the current composition of our MSR, which is deep, deep out of the money and relatively benign cash flows, you can apply leverage to that. And so the way we think about it is you could incorporate a turn of leverage into that. And if we did today — if we did that today, you’d have roughly $1.15 billion in capital and $1.15 billion of debt. And so that would be a much lower capital allocation. And so as a consequence, thinking about it through that lens, we do have capacity to increase the MSR portfolio should the opportunity arise, and we have ample warehouse capacity to do so. And with that, Ken can talk about returns.

Ken Adler: Yes, sure. Returns on the sort of MSR we’ve been participating in on an unlevered basis are in the 9.5% to 10% range and adding leverage to that, we get to the up to the 12% to 13% sort of level. More generic MSR has higher stated returns because it’s more negatively convexed.

Operator: The next question will come from Crispin Love with Piper Sandler.

Crispin Love: First off, can you just speak to how you and the Board are thinking about the dividend right now? We have earnings coverage right now on the dividend, but the dividend yield and yield on book value has increased as book value has been under pressure and those are — the same reasons that warranted your last decrease in the dividend earlier this year. So curious on how you and the Board are balancing earnings coverage plus a higher dividend yield on book value. And then, what all those mean for the sustainability of the dividend?

David Finkelstein: Sure, Chris. So as we’ve talked about in the past, the Board evaluates our dividend every quarter. And we have 3 criteria by which we set it. We want it to be a competitive dividend yield with the peer set. It should be consistent with our historical payout and it should be sustainable to the extent we have line of sight into earnings in the future. Now as you mentioned, we did modestly out earn our dividend in the third quarter. In terms of Q4, we expect EAD to be contextual with the dividend. Beyond that, a lot depends on, for example, how the Fed behaves and other factors, and we don’t have guidance beyond 2023. But rest assured, it’s always a conversation for our Board, and we feel good about this quarter.

Crispin Love: Appreciate the comments there. And David, you made some comments earlier in the call about Agency MBS valuations looking attractive and how investor sentiment should improve here and we could see some tightening over the medium term. I’m curious if you could just expand on that a little bit. What type of tightening do you think would make sense? Or said differently, how far do you think we are from fair value? And kind of what do you mean by medium term and how long that could be just given the rate volatility we’re seeing currently?