E Annaly Capital Management Is A Value Trap

Declining Income

Investors wouldn’t know NLY’s core business was suffering. They could easily look past those issues. NLY hasn’t cut their dividend in a few years and the company’s “Core EPS” remains stable. However, that masks the underlying problem. The ability of a residential mortgage REIT to earn net interest income on a continual basis relies on their ability to fund the portfolio at a rate below the yield on assets.

The Federal Reserve has increased interest rates several times already and we are expecting 2 or 3 increases in 2018. It is possible that we could even see hikes this year.

That’s a huge problem for Annaly Capital Management because it drives their cost of funds higher. Their hedges will protect part of their cost of funds, but it isn’t possible to hedge out all duration exposure. A mortgage REIT hedging out all of their risk would end up hedging out all of their returns as well. The question is how well investors get paid for the risk they do take.

The relevant earnings metrics can be seen in the slide below, from the same presentation:

I’ve added the red box to highlight the cost of funds. Investors should expect this to continue climbing over the next several quarters. I’ve also put an orange box around the net interest spread excluding PAA. Investors should expect this to gradually decline over the next year unless NLY either modifies their hedging strategy or reallocates more of their portfolio into a different sector.

How Well are Investors Paid?

Currently, NLY’s dividend yield is materially higher than what they can reasonably expect to earn on book value in this environment. Consequently, a chunk of the current dividend is effectively a return of capital rather than a return on capital.

A better option in this scenario would be to look at the preferred shares for Annaly Capital Management.

 While Annaly’s common stock dividend isn’t sustainable, the preferred shares are covered several times over. The yield on the preferred shares isn’t bad, about 7% to 7.7% depending on which series of preferred stock. The F series and G series both carry floating rates when call protection ends, so investors who expect further rate hikes may find them preferable.

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I am currently long NLY-F and actively trade in the preferred shares of mortgage REITs to capitalize on relative mispricing between preferred shares. I have no position in the common stock and do ...

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