Annaly Capital Stock: 14% return Trap or opportunity? (NYSE: NLY)


Thesis article

Annaly Capital (NYSE: NLY) has, like many of its peers, fallen significantly over the past year. This boosted its yield to a very high 14%. If the company manages to maintain the dividend at current level forever would be very attractive. But the company’s declining book value and past performance suggest the dividend may not be very safe, which is why investors shouldn’t hunt Annaly for its yield.

Significant Price Drops in the mREIT Space

Mortgage REITs hold long-term assets that are sensitive to changes in interest rates. When interest rates rise, longer term fixed income assets lose value, which is true for mortgages, treasury bills, etc. In the recent past, interest rates have risen in the United States and around the world, primarily as decades-long high inflation rates force central banks to tighten and become more hawkish.

This rise in global interest rates has caused the assets of mREITs such as Annaly Capital to decline, which is why NLY and many of its peers have seen their book values ​​plummet over the past year:

NLY vs AGNC vs RITM book value per share
NLY Book Value Data (per share) by YCharts

Over the past year, Annaly Capital has seen its book value drop by 30%. AGNC Investment (AGNC), a close peer, saw its book value decline almost as much. The chart above also shows Rithm Capital (RITM), called New Residential in the past, which is an outlier among mREITs as it has seen its book value increase over the past year, thanks to its unique business model which benefits from rising interest rates as it increases the value of its (excess) mortgage servicing rights due to the decrease in the number of refinanced mortgages.

But traditional mREITs are clearly impacted by rising rates that weigh on their book value. Over the past five years, Annaly Capital has seen its book value drop by almost 50%.

This had an impact on the stock prices of Annaly, AGNC, etc. peaks seen at the end of last year. On a 5-year basis, Annaly has fallen around 50%, as the company has seen its shares fall over 60% over the past decade. This should give investors pause, I think, as it suggests that buying Annaly purely for its yield is not a good idea – the high yield may be what some call a “sucker yield”.

What is the sustainability of the dividend?

Income-oriented investors typically value multiple metrics. The dividend yield is very important, of course, but the safety or reliability of the dividend, as well as the growth rate of the dividend, are also important parameters. Buying a company solely for the high dividend yield it offers without considering the sustainability of that dividend is a risky choice, as a cut in the dividend can lead to lower income stream and capital depreciation at the same time.

When we look at Annaly’s past dividend payouts, we find the following:

NLY dividends

Looking for Alpha

There have been ups and downs in the dividend per share, but overall the trend is down. In 2010, at its peak, Annaly offered a quarterly dividend of $0.75. Over the next 12 years, that dividend was cut by more than two-thirds, as Annaly now pays just $0.22 per share. Worse, it’s less than Annaly paid 20 years ago, when the dividend was $0.68 a share. Whether investors like it or not, Annaly hasn’t been an overly reliable dividend investment in the past. Of course, the company has always paid dividends, but these have not increased over time (which would be ideal) and they have not even remained stable over time. Instead, there has been a downward trend that has resulted in several dividend cuts over the past two years, with the last occurring in 2020.

NLY price and dividend yield
NLY data by YCharts

Twelve years ago, when Annaly’s dividend was at its peak, the company was trading with a dividend yield of over 15%. It is even higher than today. And yet, those who bought back then saw their investment erode in value. An investment of 1,000 shares was worth $18,000 back then, but that investment has fallen to just $6,500 today. Sure, dividend payouts along the way have provided returns, but even when we include dividends, Annaly hasn’t been a great investment over this period, as total returns have hit 55% over the past few years. past 12 years, which works out to 3.7% per year. The broader market generated a 350% return over the same period, more than 6 times what Annaly generated, despite the fact that Annaly’s dividend yield was at an extremely high level 12 years ago. year. Buying solely for the dividend yield has therefore not worked well in the past.

How sustainable is the dividend at the current level? Currently, analysts are predicting that Annaly will earn $1.07 this year. The company has already earned $0.56 in the first half, so earnings in the second half may drop about 10% from the first half, and the company would still meet analysts’ expectations. This clearly covers the $0.88 dividend, so the risk of a dividend cut this year seems quite low. But interest rate movements don’t just impact Annaly’s book value, they also impact NLY’s ability to generate profits. Like many other financial stocks, Annaly makes money by borrowing and lending/investing at higher rates. But while many banks are seeing their net interest margins rise right now, a trend that will likely continue in the future, that doesn’t apply to most mortgage REITs. Annaly does not borrow money the way banks do, that is, through customer deposits. Instead, Annaly’s funding costs, and those of its peers, are tied to short-term market rates that exploded in 2022:

10 to 2 year Treasury yield spread
10-2 Year Treasury Yield Spread Data by YCharts

The chart above shows the spread between 10-year Treasury yields and 2-year Treasury yields. It’s not a perfect representation of what’s going on with Annaly, but it’s a pretty good analogy. The short-term interest rate has risen significantly relative to longer-term rates. In the case of treasury bills, shorter term bonds offer a higher yield than longer term bonds. This is not the case with Annaly, as its spreads are always positive. But the gap has narrowed and it looks like this trend will continue over the next few quarters. Annaly will therefore most likely become less profitable over time, which is why the current rate of return of over $1 per share per year is unlikely to be sustainable in the long term.

Of course, recent interest rate moves could return at some point, which could lead Annaly to see higher spreads and higher earnings going forward. But at least for now, the macro environment is tough for Annaly. In the event of a drop in profits, the company could be forced to cut its dividend – as it has done on several occasions in the past. A dividend reduced to $0.80, $0.70, or $0.60 per year wouldn’t wipe out the yield, of course. In fact, based on current prices, the dividend yield would still be at a fairly high level. But if history is any guide, then Annaly may be forced to cut the dividend further in the longer term – that is, at least, what has happened in the past.

What does that mean?

Annaly is currently trading with a very intriguing yield of almost 14%. But such returns are rarely sustainable, except in cases where the market irrationally sells off quality companies during times of panic (e.g. EPD offering a rock-solid return of 15% during the COVID panic sell-off in the spring 2020). The market seems to assume that Annaly will cut its dividend in the future, and that seems like a realistic scenario. Annaly’s book value continues to decline and its earnings will be under pressure due to the fact that short-term rates have risen much faster than long-term rates. Last but not least, Annaly has a history of cutting its dividend, and chasing yield has not been a winning strategy with this stock in the past.

For these reasons, I don’t think Annaly’s high dividend yield makes it a great investment here. I choose to stay away as long as the interest rate chart remains murky.

Sallie R. Loera