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Two years ago, I focused on how the rise in mortgage rates would harm the value of mortgage REITs. My bearish outlook on the giant Annaly (NYSE:NLY) was established at the beginning of the year. Mortgage rates had just begun to rise then, and I believe they’d increase significantly due to prolonged inflation. As that occurred, I expected NLY and its peers to lose value as mortgage-backed securities declined, exacerbating book value losses due to its high leverage.
Since then, NLY has declined by 43%, with a 20% net loss after dividends. I last covered the stock in May 2022, with a total net return after dividends of -7%. I avoided taking a strong position in mortgage REITs in 2023 as it seemed mortgage rates had begun to stabilize around the 6-7% range.
Investors often like mortgage REITs because most pay double-digit dividend yields. NLY, among the “higher quality” mortgage REITs, pays a ~14.5% forward dividend yield today. The yields of these REITs have risen in recent years with higher mortgage rates.
However, those increases are offset by a massive decline in their book values due to the rise in mortgage rates. Unlike banks, mortgage REITs always mark their MBS positions at their fair value. Since many are highly invested in ~30-year fixed-rate mortgages, they’d need to hold those securities to maturity to recoup losses on their fair value. Of course, if mortgage rates reverse lower, then Mortgage REITs like NLY could regain much of those losses.
Since it’s been nearly two years since I’ve covered Annaly and the mortgage market is starting to see higher volatility, now seems to be an excellent time to examine its valuation and outlook.
Annaly’s Exposure to the 2024 MBS Market
Annaly’s portfolio has changed since I last covered it, but it remains similar. At the end of Q4, 62% of its capital allocation was in agency mortgage-backed securities. Of those, 93% had a 30-year maturity and were mixed between residential and commercial. These securities have theoretically low credit risk because US government agencies back them. However, I doubt the US has the credit stability to bail out the entire market if need be (as it had in 2008). These securities are backed by agencies like Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) that are critically undercapitalized. Still, interest rate increases are these funds’ primary risk, given their high maturity increases in their duration.
About 18% of its capital allocation is invested in Mortgage Servicing Rights. These assets are critical. Unlike MBS assets, they rise in value with interest rates because their refinancing risk falls with higher rates. Annaly invests in them for this reason. There is no way to directly hedge mortgage rates (as opposed to Treasury rates), so MSRs are an increasingly common strategy mortgage lenders use.
The remaining ~20% of its capital allocation is in residential credit. As noted in its presentation, the company is the largest non-bank lender of prime jumbo and “expanded credit” MBS. These are usually non-conforming residential loans to properties of high value or loans with high LTV’s. As noted in its annual report (pg. 65), some of these segments, such as subprime, carry loans with rates over 3% above their agency peers and boast delinquency rates of nearly 9%.
The credit risk in this segment of its portfolio is notable. However, as long as there is appropriate compensation for that risk, it may not be a huge issue. Further, many of those loans were likely made before 2022, meaning the actual rate paid on the mortgage may not be much higher than mortgage rates today. In my view, the risk of a 2008-credit crisis in mortgage is low today, but will likely rise significantly over the coming years on those subprime mortgages created now, given borrowers may be paying over 10%.
Still, there has been a rise in late mortgage payments in recent quarters, combined with a massive decline in pending home sales:
If these trends continue, I believe Annaly may suffer from loan losses. The company operates at a 5.7X leverage ratio, magnifying losses greatly, mainly if property prices fall. Still, I think the most significant risk lies in commercial properties today. Residential properties may be overvalued, but do not face the same extent of low-quality borrowers as in the past.
Mortgage Rate Increase Risks
In 2022, Annaly’s most significant issue was the rise in long-term interest rates. Most of its assets are long-term fixed rates, so higher rates lower their fair values. Crucially, changes in the Federal Reserve’s interest rate are not directly essential, but instead, the long-term rates on Treasuries with maturities close to thirty years. The Fed has no direct control over long-term interest rates aside from the indirect impacts of QE and QT. To be very clear, rate cuts and rate hikes have no immediate effect on the value of long-term bonds (such as its agency MBS), which are instead more tied to inflation expectations.
The company calculates its net impact of rate changes after accounting for its hedge positions and MSRs. See its last data below:
Annaly Capital Interest Rate Sensitivity (Annaly Capital Q4 Investor Presentation)
The company’s risk to Treasury rates is low, given that it hedges most of that risk through swaps. A vast rise or decline could cause a small change to its NAV, but that impact is unlikely to be greater than 10%. However, even with its MSR, a 25 bps increase in mortgage spreads would lower its NAV by 12%, and vice versa. Comparing the two charts below, note the inverse correlation between the spread on mortgages to Treasuries of equal maturity vs. its book value:
In 2020, the spread declined as the Fed purchased agency MBS assets through QE. During that period, many borrowers obtained mortgages for rates below 3%, causing a massive increase in property prices. However, in 2022, that reversed as the Fed began to sell those assets, causing mortgage rates to rise much faster than long-term Treasuries. As a direct result, NLY’s book value collapsed proportionally:
At the end of last quarter, NLY had a $18.73 book value, which is close to its price today. Significantly, the spread between long-term mortgages and long-term Treasuries has declined, meaning NLY’s book value may have risen recently. The mortgage spread figure has dropped by around ~15 bps since the end of 2023, implying a ~7.3% increase to its NAV.
The Bottom Line
Overall, I upgraded my outlook on NLY and other mortgage REITs to neutral, though I continue to believe they are too risky to be a good investment. Fundamentally, mortgage spreads are more likely to decline than rise, even if Treasuries decline as I expect. Some mortgage REITs do not hedge at all, and those remain at high risk as I believe long-term treasuries have yet to bottom and may fall soon as inflation expectations rebound with oil.
However, Annaly hedges that risk is primarily exposed to a rise in mortgage spreads, associated with increased risk perception in mortgages. If mortgage spreads continue to reverse, NLY may rise by 20-30% as its book value improves. In this case, a decline in mortgage rates should not dramatically harm its value because most MBS assets were minted before the rise in rates, giving them low refinancing risk. Only borrowers who made a loan since 2022 are likely to refinance if mortgage rates decline. Overall, this may be potentially great news for Annaly.
However, I remain uncomfortable with mortgage credit risk. Yes, the situation does not appear as bad as it did in 2006-2008, but the residential property market is becoming very illiquid with low sales. Homes are highly unaffordable compared to the past, and they only look reasonable if we compare them to rents, which are also exceptionally high today compared to income. NLY’s 14%+ dividend yield does offset that risk. However, if mortgages fail to decline soon, then I expect LTVs will rise excessively.
Still, compared to 2022, NLY’s outlook appears greatly improved. Investors interested in mortgage REITs may want to look for similar ones. Namely, those with Treasury hedges and avoid excess commercial loans.
