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.