The US housing and labor markets are feeding investors with all sorts of mixed signals, and now it’s the Fed’s turn. Ben Bernanke’s most recent speech gave an impression that the Fed might be tapering its Agency MBS purchases as early as the second half of the current year. Therefore, the markets started pricing in the Fed’s exit, causing the Agency MBS spreads to widen 18 bps to 67 bps.
While the widening of Agency MBS spread is a welcome sign for Agency mortgage REITs in general, the rise in mortgage rates causes erosion in their book values. Therefore, the securing the book value remains a key challenge for mREITs today.
Lower leverage to cushion book value decline
I believe Annaly Capital Management, Inc. (NYSE:NLY) is well positioned to take advantage of the current market conditions and improve returns. Annaly Capital’s recent acquisition of CreXus Investments, coupled with relatively low leverage levels employed by the company will lead it to outperform in the prevailing environment.
Given the expectation for continued volatility, you should not expect Annaly Capital Management, Inc. (NYSE:NLY) to add significant leverage to its current levels of 6.7 times in the near term. Also, the CreXus Investment can add low double digit returns in the commercial real estate space for Annaly Capital Management, Inc. (NYSE:NLY).
Less sensitive book value
Further, the addition of CRE loans into the portfolio should help minimize book value sensitivity to interest rates. However, their impact will be small as they represent only 5% of the total equity. More access to capital can result in more CRE debt at a faster pace, which could further reduce Annaly Capital Management, Inc. (NYSE:NLY)’s book value sensitivity.
Reduced compensation expense
Further, the company has been able to decrease its compensation expense by 13 bps due to the externalization of its management. After the board’s approval, Annaly Capital is now being managed by an external manager, Annaly Capital Company. Annaly Capital Management, Inc. (NYSE:NLY) will now pay its external manager a 1.05% management fee, compared to a 1.18% average compensation expense over the past five years. This is also below the industry standard of 1.35%. The reduced expense will further provide support to the Annaly Capital Management, Inc. (NYSE:NLY) bottom line.
Competition
Now let’s look at a couple of mREITs that compete directly with Annaly to purchase the Agency paper. American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are the other two mREITs that are exclusively invested in Agency residential mortgage backed securities.
American Capital Agency Corp. (NASDAQ:AGNC) is currently leveraged at 6.5 times, below the 2Q12 7.5 times. This means both American Capital and Annaly Capital have the same level of leverage in their capital structures but, unlike Annaly Capital, American Capital Agency will face adverse effects on its net interest rate spread if the long-term mortgage rates keep climbing up. At the end of the first quarter, American Capital Agency Corp. (NASDAQ:AGNC) reported a spread of 1.52%, down 1.62% at the end of the linked quarter. If the spread drops below 1.3%, it would be marked as a multi-year low.
The 30-year fixed mortgage rate has climbed 54 bps since the start of the first quarter, and American Capital Agency estimates at least a 4.3% contraction in its projected net interest spread in such a scenario. ARMOUR Residential REIT, Inc. (NYSE:ARR) estimates a similar 4% contraction in its net interest income for the current quarter. Besides, the new production MBS, which ARMOUR purchased, perform worse when the rates go up. Therefore, for ARMOUR Residential REIT, Inc. (NYSE:ARR) higher mortgage rates mean a definite strain on its bottom line.
Foolish Takeaways
I believe out of the three aforementioned pure-play mREITs, Annaly Capital is best positioned to take advantage of the prevailing situation. The company’s low leverage, coupled with the higher returns available from its recent acquisition will provide some cushion to its book value. And, more CRE debt opportunities will make the book value less sensitive to changes in interest rates. The coming quarter’s bottom line will also be supported with low compensation expense.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article Time to Buy Annaly Capital Management originally appeared on Fool.com is written by Adnan Khan.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
