Annaly Capital’s 14.2% Yield Is Still A Buy, Here’s Why (NYSE:NLY)

It was the turn of Annaly Capital Management, Inc. (NYSE:NLY) last Wednesday to report quarterly earnings for 4Q, and they were better-than-expected.

The mortgage real estate investment trust was able to grow its book value by 7% QoQ and the outlook for the mortgage trust 2024 is generally positive, I would say. The central bank’s shift in interest policy is set to bring down Annaly Capital Management’s funding costs, which should provide a boost to the trust’s net interest spread in 2024.

Yesterday, hotter inflation surprised the market, triggering a minor stock selloff that included Annaly Capital Management, whose price declined 4%.

The trust’s stock sells again at a 6% discount to book value and with the central bank set to kick off a rate-lowering cycle in 2024, Annaly Capital Management has earnings upside related to its funding costs. The dividend was well-covered in 2024 and should not be headed for the chopping block.

My Previous Rating

I was confident enough to call Annaly Capital Management a steal in my article from November, Annaly Capital Management: This 16.6% Yielding Trust Is A Bargain (Upgrade) as the mortgage trust felt the pain from widening spreads and short-term interest rate volatility.

These factors triggered a 12% decline in the trust’s book value. In 4Q-23, however, Annaly Capital Management’s book value came back, and the stock has re-rated to book value.

The central bank has provided clarity with respect to its rate policy in December 2023, and it was this announcement that has been a main catalyst for Annaly Capital Management’s stock re-rating.

The Buy recommendation was since successful, but I continue to see value in NLY due to its well-covered dividend.

Despite news of higher-than-expected inflation, I think the fundamentals, including the pay-out ratio, favor an investment in Annaly Capital Management.

Why Buying Annaly Capital Management’s 14.2% Yield Is A No-Brainer

As was the case with AGNC Investment Corp. (AGNC), Annaly Capital Management’s book value for the fourth quarter was up in light of improving sector fundamentals, particularly easing uncertainty about the central bank’s rate hiking cycle.

AGNC Investment’s book value rose 8% QoQ in 4Q-23 to $8.70 per share. Annaly Capital Management’s book value for 4Q-23 was $19.44, up 7% QoQ, following a 12% QoQ drop in the prior quarter. The increase in book value was registered due to unrealized investment gains on available-for-sale securities. With the book value stabilizing and the interest rate outlook broadly being favorable, I think Annaly Capital Management is a compelling passive income investment.

Though Annaly Capital Management’s book value bounced back nicely in 4Q-23, investors yesterday freaked out about the inflation reading that showed higher-than-expected inflation for the month of January.

Inflation in the U.S. was up 3.1% YoY, reflecting a decline from December’s 3.4%, but the date came in higher than the expectation of 2.9% inflation. So the prevailing market explanation is pushing bets on rate cuts further out into the future, which in turn sparked a stock sell-off on Tuesday that included Annaly Capital Management.

The consensus for rate cuts has now shifted, and investors anticipate the central bank to cut short-term interest rates for the first time in June 2024.

This inflation reading is set to delay the central bank’s rate cuts, which means mortgage trusts like Annaly Capital Management will have to put up with higher funding costs for longer.

Annaly Capital Management is a mortgage trust that buys long duration assets, mortgage securities (mostly of the Agency sort), with debt. The spread between mortgage security income and profits from MBS sales minus funding costs represents the company’s profit.

In 4Q-23, the mortgage real estate investment trust had a net interest spread of negative 0.82% (which was the fourth consecutive quarter of said spread being negative) due to higher funding costs in a high-rate environment.

Annaly Capital Management is poised to profit from lower funding costs, which are now anticipated to benefit the trust in the second half of the year.

Funding costs are a potential lever for earnings growth and play a vital role in returning the mortgage trust to positive net interest income, which I expect to be the case in the latter half of 2023. My thinking behind this is that the central bank has announced that it wants to push short-term interest rates lower, which should provide relief to Annaly Capital Management’s financing costs.

Annaly Capital Management’s net interest margin was also negative for three quarters straight due to higher interest expenses. The mortgage trust did see a 24% YoY increase in total interest income to $990.4 million in 4Q-23 (mostly from its Agency securities), due to higher yields on interest earnings assets in a rising-rate environment, but interest expenses rose even faster, 57% YoY, resulting in negative net interest income of $53.6 million. As short-term interest rates start to fall off in 2023, Annaly Capital Management should be able to return to a positive net interest margin and net interest income.

As far as the balance sheet and portfolio are concerned, mortgage-backed securities make up the lion share of Annaly Capital Management’s investments.

Other assets include Mortgage Servicing Rights and Residential Mortgage Loans, which pale in comparison to the size of the Agency portfolio ($69.6 billion). No transformative change in the balance sheet composition has taken place in the last year, and I don’t expect it moving forward either.

Annaly Capital Management’s 14.2% Yield Is Covered

Though the spread was negative, the mortgage real estate investment trust continued to cover its $0.65 per share per quarter dividend pay-out with distributable earnings of $0.68 per share in the fourth quarter.

In the last twelve months, Annaly Capital Management earned $2.87 in distributable earnings and paid out to $2.60 per share, leading us to a dividend pay-out ratio of 91%. I think the dividend is well-covered here and has sufficient support from the trust’s distributable earnings.

Since the central bank seems on track to lower interest rates in the second half of 2023, Annaly Capital Management could see a higher margin of safety in the latter six months of the year.

You Can Buy NLY Below Book Value Again

Annaly Capital Management’s book value rose to $19.44 per share, up 7% QoQ, yet the stock price is down, which is exactly the way I like it. The stock price movement to the downside can primarily be explained by investors doubting the central bank’s timeline for interest rate cuts.

As an approximation of intrinsic value, I utilize the trust’s GAAP book value, which reflects the sum of Annaly Capital Management’s investments at fair value. I think using GAAP book value is a sensible measure for a mortgage trust which, under normal circumstances, could quickly liquidate its assets.

Annaly Capital Management’s GAAP book value is a reasonable metric to follow moving forward, as is the company’s net interest margin. The market now expects (and so do I) that interest rates are going to fall in the latter half of the year, in which case I anticipate Annaly Capital Management to see positive net interest income again.

While we may deal with higher-for-longer interest rates, meaning the central bank may begin to cut short-term interest rates in June 2024 or later, Annaly Capital Management should be a beneficiary of falling interest rates as it will lower the trust’s funding costs for its mortgage security portfolio.

Right now, Annaly Capital Management’s stock is selling at $18.37, reflecting a 3% discount to the last reported book value. AGNC Investment is selling for a 1% discount to book value.

Why Annaly Capital Management May See Headwinds

The central bank has said that it will shift its interest rate policy in 2024, but when exactly this will be is anyone’s guess. A potential obstacle is the strength of the economy, which created 353K jobs in January, which was also better-than-expected. If the economy gains steam and sees a boatload of job growth in 1Q-24, then the central bank might be tempted to further delay rate cuts, in which case Annaly Capital Management may not experience funding cost relief.

In addition, the mortgage trust carries a substantial amount of interest rate risk, meaning any unforeseen, rapid changes in key interest rates would hurt Annaly Capital Management’s book value.

An unexpected increase in interest rates implies higher valuation pressure on the mortgage trust’s sizable Agency MBS portfolio.

Other risks potentially relate to the trust’s investments in Mortgage Servicing Rights, whose values decrease in a falling-rate environment. So while lower short-term interest rates are good for mortgage-backed securities, they are a negative for the valuation of Mortgage Servicing Rights.

Since Annaly Capital Management owned $2.1 billion worth of MSRs, this particularly asset class may underperform in a market that is dealing with falling interest rates.

My Conclusion

Annaly Capital Management had a pretty good quarter in terms of book value growth, which was an area of serious disappointment in the last two years when the central bank initiated one of its most aggressive rate-hiking cycles ever.

The mortgage real estate investment trust’s book value suffered in 2023 as short-term interest rate volatility spiked and mortgage-backed security spreads widened, but the writing is on the wall for rate cuts this year, even though it may take a couple of months longer than anticipated until the central bank pulls the trigger.

With that being said, though, it seems that the bleeding has stopped for Annaly Capital Management’s book value. Despite the higher-than-expected inflation for January, I still think that we are at or near peak interest rates, and the trust offers passive income investors a well-covered 14.2% yield. Buy.