Deep Dive – $NLY

Annaly caught my attention this morning when I saw the headline that the COO and the Co-Chief Investment officer were both resigning from the firm.  That would be major news for any company, but more interesting when it’s NLY, a controversial mortgage REIT that has been pummeled over the past 18 months.

Annaly is a $10 billion market cap mortgage REIT, the largest among such stocks, and one of the most popular given the company’s 17 year track record.  The stock has generally paid a 10-15% annual dividend yield throughout that history (depending on interest rates, leverage, and the company’s hedging), while the stock itself has been flat:

While the stock is flat, most investors in NLY have generally been satisfied with the dividend yield in the stock.

So what’s the reason for the recent severe decline, and is it a solid investment opportunity going forward?  

Annaly’s business is essentially to borrow short-term financing from banks, and use those proceeds to invest in agency mortgage-backed securities (Freddie Mac and Fannie Mae).  Through a good bit of leverage, NLY is able to produce strong cash flow yields as a result of this borrow short, lend long strategy.  It passes on that cash flow to investors in the form of dividends.

That’s how NLY is a $10 billion market cap company with only 150 employees in New York.  It’s a large financial operation run by mortgage-backed security investors.

As a result of this strategy, NLY has gotten hurt over the last year as interest rates have risen.  The rise in interest rates has reduced the value of the company’s existing inventory (higher rates equals lower bond prices, all else equal), and reduced book value as a result.  As that has occurred, management has reduced its leverage over the last year, taking down its liability to equity ratio:

The Total Liabilities to Total Stockholders’ Equity ratio is down from (15.9/117.5) = 13.5% at the end of 2012 (right column) to (12.9/80.5) =16.1% at the end of the Sept. 30th, 2013 (left column).

Management outlined the company’s primary risk as interest rates:

The primary risk to the Company is interest rate risk. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond the Company’s control. Changes in the general level of interest rates can affect net interest income, which is the difference between the interest income earned on interest earning assets and the interest expense incurred in connection with the interest-bearing liabilities, by affecting the spread between the interest earning assets and interest-bearing liabilities. Changes in the level of interest rates can also affect the value of the interest earning assets and the Company’s ability to realize gains from the sale of these assets.  A decline in the value of the interest earning assets pledged as collateral for borrowings under repurchase agreements and derivative contracts could result in the counterparties demanding additional collateral pledges or liquidation of some of the existing collateral to reduce borrowing levels.

…

Weakness in the mortgage market, the shape of the yield curve and changes in the expectations for the volatility of future interest rates may adversely affect the performance and market value of the Company’s investments.  This could negatively impact the Company’s net book value.  Furthermore, if many of the Company’s lenders are unwilling or unable to provide additional financing, the Company could be forced to sell its Investment Securities at an inopportune time when prices are depressed. The Company has established policies and procedures for mitigating market risk, including conducting scenario analyses and utilizing a range of hedging strategies.

As a result of the rapid rise in interest rates in the second half of 2013, investors in NLY became more nervous about the value of the company’s existing mortgage-backed securities portfolio.  That portfolio consists of agency backed securities, with the majority of the bonds in 1-5 year duration assets:

Management has gradually moved some of the company’s inventory from the 1-5 year bucket to the 5-10 year bucket (now around 15% of the portfolio, vs. around 2% of the portfolio at the end of 2012).  That is one signal that management thinks long-term interest rates might head lower again.

Annaly’s stock has traditionally not been highly correlated to interest rates, as rates are a push/pull factor for the company.  When rates are moving higher, it’s bad for the existing portfolio, but good for future potential yield of the portfolio, especially if management moves from shorter-duration to longer-duration bonds at higher rates.  When rates are moving lower, it’s good for the existing portfolio, but bad for the future potential yield of the portfolio, with lower potential reinvestment rates going forward.

However, NLY’s stock has become quite depressed in the past year, trading at around 0.86x Price/Book, near the lowest level in its history:

[caption id="attachment_36332" align="alignnone" width="503"] NLY Price/Book ratio, Courtesy of Bloomberg[/caption]

In this depressed state, investors are much more concerned with how interest rates impact the value of the current investment portfolio, rather than concern themselves with the future impact of rates on reinvestment.  That’s why NLY’s stock has become much more correlated to U.S. long-term rates in the past year.  The correlation between NLY and longer-dated Treasuries is much more positive today than it has been over the past 5 years, essentially moving in lockstep in the past year:

[caption id="attachment_36333" align="alignnone" width="514"] NLY vs. TLT, Courtesy of Bloomberg[/caption]

This increased correlation makes sense given NLY’s distressed valuation.  At this point, if rates do move lower, book value is going to move higher, which will relieve investors of some of the fears built into NLY’s stock price related to higher rates.

NLY is at this point a cheap way to play for lower rates.  With an 11% annual dividend yield (though that might be cut to 7.5-9% over the next year), you are getting paid better than in Treasuries.  The risk, of course, is NLY’s leverage.  Higher rates from here would hit book value once again.

Returning to the news of the departures of the COO and Co-CIO yesterday, the concern is that the company’s recent hedging activities to protect against higher rates might have back-fired.  NLY stock was up almost 10% in 2014 as of yesterday’s close (down 1%+ today), and the company reports earnings on February 25th.

While the risks for NLY are clear, the stock’s low implied volatility could offer an opportunity for a defined-risk way to play for upside over the next 6 months, likely a better way to play for lower rates than buying Treasuries or the stock itself.  Here is 30 day implied volatility over the last year:

[caption id="attachment_36334" align="alignnone" width="600"] NLY 30 day implied volatility, Courtesy of Bloomberg[/caption]

Implied vol moved higher in May and June as rates rapidly rose.  But implied vol is now near 9 month lows.

No position in NLY for now, but we have this one on our radar if we like the setup and the options pricing in the future.