Annaly Capital Stock: attractive, but mREIT under pressure

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Thesis and background

Annaly Capital Management (NYSE: NLY) is the leader in the mREIT space. Its size is approximately ~14x of the median mREIT by market capitalization. With this size and scale, NLY enjoys good efficiency and profitability of the two fundamental pillars of the American economy: housing and business. With a dividend yield of 12.4%, NLY is very attractive to many income-oriented investors. And you will see that the income is even more competitive compared to other alternatives such as high yield bonds.

In addition, the stock also benefits from better profitability as shown in the graph below. This graph plots the price to TBV (tangible book value) ratio of NLY and a few of its peers (which I wrote about myself) against the return on TBV (EPS divided by TBV). And TBV data was taken as latest quarterly data and EPS as TTM data, and both were taken from Seeking Alpha. As seen, overall, NLY offers a reasonable combination of scale, security, and rating compared to other peers.

In this context, the thesis of this article is as follows:

  • For investors who want exposure to the mREIT sector, we believe that NLY remains an attractive, if not the most attractive, candidate in this space.
  • But investors should be aware that the mREIT sector itself is under pressure with the start of a new macro credit cycle, and NLY additionally has its own unique challenges.
  • So, for investors who don’t need this level of current income, we think there are other more attractive sectors (like the energy sector) that offer better prospects for total return (but still once, at a much lower level of current income) .

NLY action - P/TBV vs selected peers

Source: Author based on Seeking Alpha.

The right one – still competitive revenue generation

For investors seeking high current income, it is natural to benchmark NLY’s performance against a high yield index. And here I’m using Moody’s Seasoned BAA Corporate Bond Yield. The following chart shows NLY’s yield spread over the seasoned yield of Moody’s Baa corporate bonds. As can be seen, the yield gap is bounded and manageable. The spread was between about 4% and 9% most of the time. Which suggests that when the spread is near or above 9%, NLY is significantly undervalued relative to corporate bonds in general (i.e. I would sell BAA corporate bonds and buy NLY). And when the yield spread is close to or below 4%, it means the opposite. The basic reason is that the yield spread measures the risk premium investors are willing to pay for NLY relative to other assets such as BAA bonds.

Moreover, these ranges of yield spread are quite stable for different stocks in the same sector, as I have already analyzed (eg for CIM). The basic reason is that the yield spread measures the risk premium that investors are willing to pay, and this premium should not change too much between similar assets in the same mREIT compartment.

And as you can see, the current NLY offers a return almost 8% higher than the BAA return, close to the widest level compared to its historical spectrum. Such a wide spread over high yield bonds makes NLY’s earnings even more attractive than what’s on the surface, especially considering the interest rate uncertainties ahead.

The second graph in this section illustrates some of these uncertainties. As you can see, since the Fed announced its hawkish dot chart a few months ago, yields on high yield bonds have risen sharply, by more than 131 basis points in the past few months. And interest rate risks continue to unfold and could rise further (causing high yield bond prices to fall further). This is where NLY’s 8% spread yield can help – it provides a thick cushion against further interest rate rises and therefore an attractive alternative to high yield bonds.

Yield NLY vs BAA

Source: author based on Seeking Alpha and FRED data

Moodys Seasoned Baa Corporate Bond Yield

Source: Fred

The bad – loss of chronological book value

NLY stock has had a very turbulent year during the pandemic along with the rest of the mREIT sector. The stock has lost about 13% of its tangible book value (“TBV”) per share and more than 45% of its price during the pandemic. Since then, the price has recovered (by around 70% to its peak in 2022) but the TBV has continued to decline. As a result, at this point, the price movement is a little ahead of the fundamentals, which has resulted in a relatively expansive valuation, as seen in the following chart.

NLY share TBV per share

Source: author and Seeking Alpha data.

The following chart shows historical TBV price ratios for the stock over the past decade. You can see that the stock is valued at 1.0x TBV on average (which makes sense for an mREIT stock). And the valuation has fluctuated only within a narrow range, as evidenced by a relatively low standard deviation of 0.1. The current P/TBV ratio is approximately 1.1x, at the 1-sigma level. Obviously, there is no reason for the valuation to be around the average. But for a stock like NLY, there is also no reason to expect a sudden quantum leap in its valuation. And a big part of being a conservative investor means being aware of the rule of reverse selectivity – I’m more apt to expect something old to repeat itself again than to expect something completely new appears.

Historical NLY share price vs. TBV ratio

Source: author and Seeking Alpha data.

Other risks

In addition to the above risks with its book impairments and valuation, there are a few other risks that are both general to the mREIT industry and also unique to NLY:

  • Macroeconomic risks. The mREIT sector (and NLY is no exception) is making money on the spread between long-term and short-term rates and that spread is narrowing. With the Fed’s hawkish cut and expected interest rate hikes, the tightening is expected to exacerbate and put further pressure on their profitability. The duration and eventual recovery of the COVID pandemic are also uncertain. Although vaccination is progressing widely and the economy is reopening at a steady pace. However, the pandemic is far from over and uncertainties like the delta and omicron variants (and newer variants) still exist. These uncertainties could have a negative impact on the general financial market and also NLY.
  • Specific to NLY, it has enjoyed nearly 0% funding cost (i.e. free access to funds) since mid-2020 when the Fed started injecting a massive amount of liquidity to fight the pandemic and lower the Fed fund to a level close to 0%. . As interest rates rise, the cost of funds will increase and the tailwinds that have benefited NLY will begin to reverse. Also, interest rates could rise faster and more than the current dot chart suggests.

Conclusion and final thoughts

As an industry leader, NLY is relatively more resilient than its peers, as demonstrated by the pandemic. It suffered fewer losses on its tangible book value and lower price volatility during this stress test.

The main takeaways from this article are:

  • For investors who want exposure to the mREIT sector, we believe that NLY remains an attractive, if not the most attractive, candidate in this space. Overall, NLY offers a reasonable combination of scale, security, and rating compared to other peers.
  • Its yield of over 12% is attractive to income-oriented investors, and even more so when compared to high-yield bonds. NLY currently offers a yield nearly 8% higher than the BAA yield, close to the broadest level relative to its historical spectrum.
  • Although investors should be aware that the mREIT sector itself is under pressure with the start of a new macro credit cycle. The flattening of the yield curve will put pressure on profitability. And NLY’s current valuation is expensive in terms of historical price versus TBV multiples.
  • So, for investors who don’t need this level of current income, we think there are other more attractive sectors (like the energy sector) that offer better prospects for total return (but still once, at a much lower level of current income) .

Sallie R. Loera