Annaly Capital Management, Inc. (NYSE:NLY) Q1 2024 Earnings Call Transcript

Annaly Capital Management, Inc. (NYSE:NLY) Q1 2024 Earnings Call Transcript April 25, 2024

Annaly Capital Management, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning. And welcome to the First Quarter 2024 Annaly Capital Management Earnings Conference. [Operator Instructions] Please note that today’s event is being recorded. I would now like to turn the conference over to Sean Kensil, Director, Investor Relations. Please go ahead, sir.

Sean Kensil: Good morning, and welcome to the First Quarter 2024 Earnings Call for Annaly Capital Management. Any forward-looking statements made during today’s call are subject to certain risks and uncertainties, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date hereof. We do not undertake and specifically disclaim any obligation to update or revise this information.

During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. Content referenced in today’s call can be found in our First Quarter 2024 Investor Presentation and First Quarter 2024 Supplemental Information, both found under the Presentations section of our website. Please also note this event is being recorded. Participants on this morning’s call include David Finkelstein, Chief Executive Officer and Chief Investment Officer; Serena Wolfe, Chief Financial Officer; Mike Fania, Deputy Chief Investment Officer and Head of Residential Credit; V.S. Srinivasan, Head of Agency; and Ken Adler, Head of Mortgage Servicing Rights. And with that, I’ll turn the call over to David.

David Finkelstein: Thank you, Sean. Good morning and thank you all for joining us on our first quarter earnings call. Today, I’ll briefly review the macro and market environment along with our first quarter performance, then I’ll provide an update on each of our three businesses and conclude with our outlook. Serena will then discuss her financials, after which we’ll open the call up to Q&A. Now, beginning with the macro landscape. First quarter of 2024 was characterized by surprisingly resilient economic data, a healthy labor market, and an uptick in inflation. Consequently, interest rates sold off modestly on the quarter as the market priced out roughly half of the rate cuts that were expected at the beginning of the year.

Now despite rising rates, risk assets performed well over the quarter as volatility declined and money flowed into both equity and fixed income markets. Banks also reemerged as modest buyers of Treasuries and Agency MBS in the first quarter, a welcome development given their absence over the past couple of years. In addition, the Federal Reserve made it clear that it considers policy rates and balance sheet management to be separate tools as they have begun discussing slowing the pace the Fed’s Treasury securities run off. We are encouraged by this development as this approach allows for more gradual decline in bank reserves, thereby stabilizing liquidity, potentially reducing treasury supply to the private sector, and strengthening banks’ deposit growth, all positive for fixed income and Agency MBS.

Now, against this supportive backdrop, all three of our housing finance strategies perform well in the quarter, with production coupon Agency MBS spreads roughly five basis points tighter, credit spreads 25 to 100 basis points tighter, and the MSR market experiencing modest multiple expansion. As a result, we delivered a 4.8% economic return for the quarter with EAD of $0.64 and leverage a quarter end of 5.6 turns. Now, as the second quarter has unfolded, continued strong economic data coupled with stalled progress on disinflation has driven a further repricing of forward rate expectations, as well as an increase in volatility. This current risk-off tone has led to marginal spread widening across Agency and Credit, and justifies our leverage profile, which is at its lowest level of the cycle.

Now, notwithstanding lower leverage, prevailing return environment gives us confidence in the durability of the portfolio earnings profile, and we believe that our current dividend is appropriately set for 2024, given our expectations for earnings this year. Now shifting to the businesses, and beginning with Agency, the portfolio ended the quarter modestly lower to accommodate growth in the Residential Credit and MSR businesses. We continue to gravitate up in coupon, with our weighted average coupon increasing 20 basis points to 4.76%, reducing our holdings of 4% coupons and lower by over $5 billion, in favor of, predominantly, 5.5% and higher. We continue to favor production coupons, as they provide the widest nominal spreads, and as evidenced by their performance this past quarter, the best returns in a range-bound rate environment.

They also stand to benefit from potential spread tightening, should option costs decline due to a steeper yield curve or lower implied volatility. Our Agency CMBS portfolio was largely unchanged over the quarter, spreads in the sector tightened 10 to 15 basis points on continued broad-based demand, outperforming Agency MBS and providing incremental excess returns while improving our overall convexity profile. As it relates to interest rate management, the notional value of our hedge portfolio declined slightly as we moved hedges out the curve, leading to a modest decline in our hedge ratio. As our existing front-end swap position has been rolling off, we have replaced that risk with hedges in the intermediate and long-end part of the yield curve, closely aligning our hedges with the interest rate risk of our assets.

In addition, our increased allocation of swaps relative to Treasuries that we discussed last quarter benefited our overall return, given the widening of swap spreads during the quarter. The short-term outlook for Agency CMBS has become somewhat more challenging. As recent inflation reports have delayed the start of the cutting cycle and led to a pickup in volatility. However, we remain constructive on the sector, given the potential of sustained bank demand and the expected upcoming reduction in Fed Treasury runoff, factors that should be supportive of Agency CMBS and were absent in the prior widening episodes. Meanwhile, hedge carry remains attractive with historically wide nominal spreads. Now turning to Residential Credit, the portfolio ended the quarter at $6.2 billion in market value and $2.4 billion of equity, with a rise in 21% of the firm’s capital at quarter end.

Residential Credit spreads tighten meaningfully to start the year, given the support the fundamental backdrop with AAA9 non-QM spreads 35 basis points tighter than below [IGCRTM2] 70 basis points tighter. The credit curve continued to flatten as the issuance and supply of subordinate assets remained limited. Now, the growth in our portfolio was driven by our organic Onslow Bay strategy through increased whole loan purchases and retention of OBX securities. Given tightening spreads, we opportunistically reduced our CRT portfolio and other segments of our third party securities holdings into strong demand. In Onslow Bay correspondent channel had another record quarter as we registered $3.7 billion of expanded credit locks in Q1, up 40% quarter-over-quarter.

We settled $2.4 billion in loans, the vast majority of which were sourced directly via our correspondent channel. And our pipeline remains robust with $2 billion of locks at quarter end and continued momentum into the spring selling season. Most importantly, our credit discipline remains strong as our current pipeline is characterized by a 68 LTV and a 753 FICO with only 3% of our locks greater than 80 LTV. We were able to take advantage of the supportive capital markets by pricing seven securitizations, totaling $3.3 billion in Q1, generating $328 million in assets for Annaly’s balance sheet and low to mid double digit returns. And subsequent to quarter end, we priced an additional non-QM transaction with retained assets exhibiting similar expected returns.

Now looking forward, the further expansion of the Onslow Bay channel is positioned Annaly as a market leader in the Residential Credit market, allowing us to manufacture our own credit risk while retaining control over all aspects of the process. Now Shifting to our MSR business, our portfolio ended the first quarter at $2.7 billion in market value, representing $2.3 billion in the firm’s capital. MSR transaction volumes continue to be elevated in the first quarter given challenging originator profitability while demand and pricing remain firm. And despite elevated supply, we were disciplined, finding better opportunity and relative value post quarter end and in early April, we committed to purchase just over $100 million in market value for bulk package, which we expect to close in the second quarter.

We’re confident we’ve constructed one of the highest quality conventional MSR portfolios in the market, characterized by our industry lower 3.07% note rate and exceptional credit quality. Fundamental performance of our MSR portfolio has continued to outpace our initial expectations with our holdings realizing a three month CPR of 3%, rising float income given increased escrow balances and minimal borrower delinquencies and all of these factors have contributed to our MSR portfolio exhibiting highly stable cash flows at double digit returns. Now given Annaly’s diversified strategy and ample liquidity position, we currently do not utilize a significant amount of recourse leverage on the MSR portfolio as it is advantageous to supplement leverage with lower cost agency repo.

However, with $1.25 billion of committed warehouse facilities, we are positioned for additional MSR growth should pricing be favorable. Now looking ahead, we are optimistic about the outlook for our three businesses and we continue to see attractive risk adjusted returns across each of our investment strategies. However, bouts of volatility remain a key risk as we have been reminded in recent weeks and we remain vigilant. We continue to be well prepared given our conservative leverage position and capital structure, our ample liquidity and a diversified capital allocation strategy that can outperform across different interest rate and macro landscapes. And while we continue to make progress in allocating incremental capital towards our Residential Credit and MSR strategies, we like our current capital allocation and are disciplined in pricing and selected in the sourcing of assets.

And overall, we are proud of the unique platform we built with three established and fully skilled businesses on our balance sheet and we believe this model can continue to deliver superior returns relative to sector just as we have over the past couple of years. Now with that, I will hand it over to Serena to discuss our financials.

Serena Wolfe: Thank you, David. Today, I will provide brief financial highlights for the first quarter ending March 31, 2024. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics which exclude the PAA. Our book value per share as of March 31, 2024 increased from the prior quarter to $19.73, based largely on asset spread appreciation with minimal interest rate exposure. And with our first quarter dividend of $0.65, as David mentioned earlier, we generated an economic return of 4.8%. Rising rates and spread timing for credit assets resulted in gains on our hedging portfolios of $2.19 and gains on our ready MSR investments of $0.17.

Outpacing losses on our Agency investment portfolios of $2.04 as implied volatility declines in asset spread times. Earnings available for distribution decreased by $0.04 per share to $0.64 in the first quarter compared to Q4, 2023. EAD declined on lower swap benefits and some of our positions matured. Gross interest expense increased as average repo and securitized debt balances increased by approximately $3.6 billion. The net financing impact on the EAD was mitigated by continued improvement in asset yields and the average asset yields ex-PAAs further rose quarter-over-quarter, 23 basis points higher than in the fourth quarter at 4.87%. Asset yields benefited from the Agency MBS portfolio continuing its up and keep on strategy and the Onslow Bay correspondent channel experiencing record growth and hold on purchases as attracted yields.

Net interest margin reflected the changes to EAD in the first quarter with the portfolio generating 143 basis points of NIM ex-PAA, and 15 basis points decreased from Q4. Similarly, net interest spread decreased 13 basis points quarter-over-quarter to 109 basis points. Total cost of funds increased quarter-over-quarter rising 36 basis points to 3.78%. As I previously highlighted, swap benefit continues to normalize as positions expire reducing net interest on swaps by $49 million and increasing cost of funds by 33 basis points accounting for much of the quarter- over-quarter impact. On the other hand, average repo rates were stable through the quarter declining nominally by one basis point. Turning to details on financing, we continue to see strong demand for funding for our Agency and non-Agency security portfolios.

Our repo strategy is consistent with prior quarters with a book positioned around Fed meeting dates as we look to take advantage of any future rate cuts. As a result, our Q1 reported weighted average repo days were 43 days down just one day compared to Q4. During Q1, we continued to obtain additional funding capacity for our credit businesses. To increase financing optionality for our Onslow Bay platform, we closed additional warehouse facilities approaching $1 billion in size, which included expanded product offerings and non- market features at two-year terms. As of March 31, 2024, we had $3.9 billion of MSR and hold on warehouse capacity at a 34% of utilization rate, leaving substantial availability. Annaly’s unencumbered assets increased to $5.3 billion in the first quarter compared to $5.2 billion in the fourth quarter, including cash and unencumbered Agency MBS of $3.5 billion.

In addition, we have approximately $900 million in fair value of MSR that has been placed to committed warehouse facilities. They remain undrawn and can be quickly converted to cash, subject to market advance rates. We have approximately $6.2 billion in assets available for financing unchanged compared to last quarter. We believe that our disciplined approach to liquidity and credit leverage leaves us well prepared to confront market risk, such as the volatility of the previous few weeks. Lastly, we have continued to efficiently manage our expenses, resulting in a decline in our OpEx-to-equity ratio to 1.35% of the first quarter, compared to 1.41% for the fourth quarter of 2023. That concludes our prepared remarks, and we will now open the line for questions.

Thank you, operator.

Operator: [Operator Instructions] Today’s first question comes from Bose George with KBW.

See also 14 Strongest Military Forces in the Middle East and 15 Best Perfumes For Teenage Girls.

Q&A Session

Bose George: Hey, everyone, good morning. Could I get an update for book value quarter to date?

David Finkelstein: Sure, Bose, good morning. So, as of our last flash, which was Tuesday’s close, net of our dividend accrual, we were off just inside of 3% inclusive of that dividend just inside of 2% off.

Bose George: Okay, perfect. Thank you. And then I noticed the targeted return on your MSR increased to 12 to 14 from 10 to 12. Is that sort of just better yields in the market or is there like a different leverage assumption or just curious what drove that?

David Finkelstein: It’s predominantly the increase in float income associated with higher short rates projected, but Ken, you want to elaborate?

Ken Adler: Yes, as you may know, ownership of the MSR asset involves the MSR owner and the benefit of the float income maintaining those extra accounts. So the higher for longer change in rates just translates to a much higher yield at the exact same multiple. So it’s really just the math on that.

Operator: The next question comes from Doug Harder with UBS.

Doug Harter: Thanks. Can you talk about how MSRs are performing kind of in this, as rates continue to increase and their effectiveness of hedging the MBS portfolio?

Ken Adler: Yes, absolutely. This is Ken. Thanks for the question. In terms of spot performance, I mean, the speeds you can see in the presentation, extremely stable, delinquency is extremely stable. And as the prior question alluded to, we have an increase in cash flow. Expected cash flow over time as the earnings on the flow are not expected to decline, given the Fed rate cuts coming out of the market in terms of the expected pricing. In terms of hedging the MBS portfolio, slower speeds are good for the MSR. And the mortgage universe trading in discounts, slower speeds are not a good outcome for mortgage backed security. So we do have that hedging property.

David Finkelstein: Yes, Doug, I’ll just add to Ken’s point. Look, when we buy MSR, standard speaking, it’s often a hedge for the duration of the portfolio. When it’s deep out of the money, there’s two other hedge benefits we get as Ken discussed. First are the higher float income hedges, the higher for longer and short rates in financing associated with the Agency MBS. And secondly, the turnover, which is lower in a higher rate environment, is better for MSR. So those two factors have led to a shift in the benefits associated with MSR for our portfolio.

Doug Harter: Thanks. And then the increase in the Onslow Bay correspondent activity is how much — is that kind of adding new customers? Is that getting deeper with existing customers kind of if you could give a little more color behind the increased activity there?

Mike Fania: Hey, Doug. Thank you. This is Mike. Thanks for the question I think a lot of it is that the correspondent channel is not yet mature. We still believe that there’s over a 100 correspondence that are originating non-QM and VSCR loans that are not currently our captive customers so we’ve been very aggressive in trying to build it the correspondence so some of that volume is just through the maturation of the correspondent channel, some of it is spring seasonals right so we’ve certainly benefited from that it’s one relative to Q4 and I think a lot of it is also the growth in the actual market itself , larger non-banks have rolled out these programs and they have been very active participants and not only potentially taking market share from some of the smaller niche specialty finance players but they’re building market share as well and the borrower in the non-QM VSCR market is also a little bit less sensitive than an Agency or jumbo market two rates about a quarter of the volume that we’re doing right now is cash outs that numbers 7% to 8% within the Agency market.

So I think there’s a number of factors that are leading to the increase in volumes but I’ll say one of the largest drivers is just the actual build of the correspondent adding new originators to the platform.

Operator: Our next question comes from Rick Shane with JPMorgan.

Rick Shane: Thanks everybody and good morning. Look, I’m looking at slide 6 and I know Bose had ask a question here as well. There’s convergence between the returns on the three strategies and I’d love to explore in the current environment, sort of the base case, higher for longer, what you think the right tactical approach is. And then if you could sort of lay out if we saw the tail scenarios, one tail scenario being additional hikes, the other being cut sooner than we thought, how you would position yourself in the context of these three choices. Basically, I want to understand how you’re thinking about things now and what the risks are or what the opportunities are if you make a strategic call.

David Finkelstein: Sure, thanks Rick. So just in terms of overall capital allocation, as I mentioned in our prepared remarks, so we do very much like where we are at today. We think the three sectors are all fully scaled, obviously, and the portfolio is in a good balance right now. And I think it shows up in our economic returns over the past many quarters. So we’re happy with where we’re at. In terms of relative value, Agency looks perfectly fair here. We’re certainly sensitive to higher volatility that could materialize, albeit we don’t expect to see anything like we saw last fall. But nonetheless, some we’re sensitive to. So we’re a little bit under levered on the Agency side. But our allocation is nearly 60%. And that’s the core of the portfolio, and that’s where our liquidity is.

So we like it there. In terms of the other two sectors, both are adding accretive returns, both in terms of book value, and they’re supporting the dividend. So we like where we’re at. And then when we look at, from a relative value and a capital allocation percentage in terms of expected returns under various scenarios, this allocation here today gives us the best bang for a buck when we stress the portfolio with shock rates up or down. Now, in terms of how we would position in the scenario you mentioned, whether it’s higher for longer versus or even hike potentially versus the potential for cuts. Look, the way we look at it is we are carrying a very small amount of interest rate risk, but you’re not getting paid for it. The rates market is, we think, to be relatively fairly priced.