Annaly For The New Year

SUMMARY

Annaly Capital Management trades at nearly a 20% discount to its book value, which is comprised of highly liquid securities. Annaly has recently delevered and hedged, which should limit further losses. The stock is currently priced for a disaster and anything short of that should lead to attractive gains. An end to tax loss selling season or putting the taper behind us could be the catalyst for gains.

BUSINESS

Annaly Capital Management is a mortgage REIT that primarily owns a levered portfolio of agency securities. Through Annaly’s acquisition of its subsidiary, Crexus, Annaly has diversified modestly into CMBS as well. Annaly now deploys 11% of its capital in the CMBS market. Additionally, Annaly owns a small asset management business.

Annaly has been in the agency RMBS business for over 15 years. The way the business works is that Annaly owns a levered portfolio of agency securities. Annaly makes money through two spreads, the spread between longer rates and shorter rates and the spread between agency securities and treasuries. This is a very simplified explanation of the business. Annaly has to choose what securities to own, how much leverage to employ, how to fund the portfolio and how to hedge based on the current environment.

WHAT HAPPENED

For nearly 15 years Annaly had been in a great business with some minor bumps along the way. Over this period Annaly was able to offer a dividend that averaged in the double digits plus capital appreciation. When QE came along it compressed both the spreads that Annaly was profiting off of. QE succeeded in lowering interest rates and the spread between agency securities and treasuries collapsed.

Instead of backing off the trade as the spreads became narrower many agency mortgage REITs increased or maintained leverage in order to sustain returns. When the Fed announced a possible taper in May this caused rates to go higher & spreads to widen. This led to losses across these leveraged portfolios. Most agency mREITs have locked in these losses and delevered their portfolios since.

PRESENT

Annaly’s book value has fallen from $15.85 at the beginning of the year to $12.70 at the end of the most recent quarter. This is partially due to the large dividend they continued to pay out despite losses but mostly due to the increase in rates and spreads. In reaction to these large losses Annaly has delevered and hedged more aggressively. At the end of the latest reported quarter Annaly was levered 5.4 times, which is at the very low end historically. Annaly is 74% hedged, which is at the very high end historically. It is estimated that Annaly would lose 4.4% if yields were to go up by 100bps.

Annaly has historically traded at approximately a 10% premium to book value. After this past years missteps it currently trades at a roughly 19% discount to its book value. The most common response I get when pitching Annaly is that rates are likely to go higher and spreads are likely to widen as the Fed tapers. However, even if rates went up by 125 basis points and spreads widened its unlikely that book value would fall much more than 10%. If that were to occur the Annaly would still trade at a 10% discount to book and the spread would come back into the trade that they do, making it attractive again. All the while one is likely to be paid a 10% dividend to wait (currently the dividend is 14% but likely to go lower). In November four different insiders purchased shares in Annaly at prices higher than current levels.

CATALYST


It is likely that much of the recent selling has been tax loss selling as Annaly is down more than 45% from its highs. Tax loss selling ends at the end of December and these sellers will no longer be present in January, paving the way for a higher share price.  It seems that every time somebody mentions the word taper that Annaly gets hit. Getting the big, bad event behind us will likely be a positive as Annaly is hedged for higher rates and the fear of the taper is likely worse than the taper itself. 

2 comments:

Anonymous said...

How can you write this case with zero mention of Annaly's reliance on repo financing and how that will be impacted by coming regulation on bank's leverage ratios?

Tsachy Mishal said...

Annaly has lower leverage than ever. With such strong collateral and low leverage, financing is simply not an issue. In 2008, with leverage significantly higher financing was not an issue. Might as well worry about a meteor hitting the earth.