In my March 17, 2022 article titled "Annaly Capital: Still Attractive Among mREITs, But mREIT Itself Under Pressure," I assessed the macroeconomic parameters astatine that clip (more connected this successful the adjacent section), and correctly concluded that they would proceed to airs beardown headwinds connected the mREIT industry. However, past I proceeded to marque a bullish lawsuit for starring mREIT stocks similar Annaly Capital (NYSE:NLY) and AGNC Investment (NASDAQ:AGNC) based connected the pursuing considerations (quoting my ain words here):
- …as leaders successful the sector, they connection a tenable operation of scale, safety, and valuation comparative to different mREIT peers.
- ...investors request to beryllium alert that the mREIT assemblage itself is nether unit with the commencement of a caller macro recognition cycle. However, antithetic mREIT stocks person antithetic sensitivities to output dispersed narrowing (or inversion) fixed their nonstop exposure ranging from bureau MBS, location loans (MSR and RMBS), oregon hybrid loans. And immoderate differentiating factors of their concern models are worthy peculiar consideration.
Well, you tin spot however incorrect I was from the pursuing chart. At the clip of publishing successful March, NLY's banal terms was astir $28. And it kept plummeting aft that, bottoming adjacent $15 successful October, translating into a important drawdown of astir 50% successful lone astir 6 months. As besides seen from the chart, AGNC and the full assemblage (approximated by REM) did not fare immoderate better.
And the acquisition I’ve learned (relearned really) was this: bash not effort to prime a victor connected a sinking ship. It is overmuch easier to abbreviated the full vessel oregon find different ship. When the full shipping is facing beardown headwinds, the differentiating details of each player's strategy bash not substance truthful overmuch arsenic evidenced by the illustration below. Despite the quality betwixt NLY and AGNC and the remainder of the mREIT, their terms actions are astir the same.
History surely rhymes. One twelvemonth aft that article, the existent macroscopic conditions are either akin oregon worse successful my view. This leads maine to the main thesis of this article: I spot starring mREIT stocks similar NLY and AGNC facing important profitability unit ahead. In the meantime, I besides spot important valuation risks and leverage risks. As to beryllium elaborated connected next.
The astir inverted output curve successful 20 years
As conscionable mentioned, the mREIT assemblage arsenic a full is delicate to the macro-debt cycle. The details were elaborated connected successful my original article. Quote:
The output dispersed betwixt short-term indebtedness instruments and semipermanent instruments is the astir effectual indicator of the macro-credit (or debt) cycle. When output spreads grow oregon contract, it tin awesome changes successful the underlying system oregon fiscal markets. The mREIT stocks similar AGNC and NLY are typically the ones that are astir delicate astir specified output dispersed changes because they marque wealth connected the dispersed betwixt the semipermanent and short-term rates. The thicker the spread, the easier and the much wealth they tin make, arsenic you tin intelligibly spot from the pursuing chart.
The illustration the supra punctuation refers to is the 1 below. This illustration overlaps the output dispersed (Ys, defined arsenic the 10-Year Treasury Constant Maturity Minus the 2-Year Treasury Constant Maturity rates) and AGNC’s dividend history. Here, I americium utilizing dividends to approximate the alleged owners' earnings, which is simply a bully presumption for mREIT stocks similar NLY and AGNC fixed that they wage retired astir of their existent economical net arsenic dividends.
This illustration intelligibly shows the correlation betwixt the owners’ net and the YS for the reasons quoted above. And present let’s spot what the differences and similarities are betwixt present and March 2022 successful the output curve.
The astir important and evident quality is that the output has go inverted present portion it was not truthful a twelvemonth ago. The YS has moved successful the absorption that I predicted past March. At that time, the dispersed betwixt the 10-year and 2-year treasury rates was inactive positive, albeit a constrictive 0.26% arsenic you tin spot from the illustration beneath much clearly. Since then, the output curve inverted significantly, and it is antagonistic 0.88% arsenic of this writing, the astir terrible level successful much than 20 years arsenic seen.
The astir important similarity successful my presumption – and this is wherever past rhymes – lies successful the setup that volition origin the output curve to stay inverted successful the foreseeable future. If you recall, past October’s CPI data indicated lower-than-expected ostentation and led the marketplace to judge that the complaint hikes are over. Such optimism caused overmuch of the terms rally successful the mREIT assemblage arsenic you tin spot from the archetypal illustration successful the article. Read my erstwhile sum connected Annaly and AGNC here.
However, that was simply a azygous information constituent and I cautioned readers that it is wholly imaginable for further ostentation information to transcend marketplace expectations. Indeed, the yearly ostentation complaint reported successful Jan 2023 dialed successful astatine 6.4% (compared to 6.5% a twelvemonth ago), hotter than the marketplace anticipation of 6.2%. Moreover, contempt being somewhat little than anticipated, ostentation successful the 6~7% scope is inactive rather precocious successful implicit terms. Especially erstwhile coupled with ongoing uncertainties specified arsenic the Russian-Ukraine struggle and its interaction connected the planetary proviso of earthy materials, food, and energy, I simply bash not judge that the Federal Reserve has finished with its complaint hikes.
If the supra arguments person convinced you that the short-term extremity of the rates would stay precocious oregon adjacent further increase, let’s look astatine the semipermanent rates now. Long-term rates are mostly controlled marketplace forces (while the Fed controls short-term rates). And based connected my analysis, determination is constricted country for semipermanent rates to further summation supra their contiguous levels. As elaborate successful my earlier writings,
At a precise cardinal level, successful the agelong term, treasury enslaved rates cannot emergence supra semipermanent ostentation oregon GDP growth. Our authorities has been relying connected ostentation and GDP enlargement to inflate distant and outgrowth its indebtedness obligations for decades successful the past. And it volition (it volition person to) proceed doing so.
Based connected my supra arguments connected the semipermanent and short-term rates, the output curve lone has 1 mode to go: to stay inverted. And I foresee the inverted output curve to support pressuring NLY and AGNC’s net good into 2023. An inverted curve would wounded their net successful much than 1 way. As mentioned, mREITs usage short-term borrowings to money their purchases of mortgage-backed securities, and a narrowing YS squeezes their nett margin. Beyond these cardinal dynamics, request for caller mortgages could besides beryllium weakened by an inverted output curve, particularly combined with precocious inflation. Higher semipermanent borrowing rates thin to thrust discourage caller location buyers and hence the request for owe originations.
AGNC and NLY: leverage is inactive concerning
Besides the profitability headwinds, different interest I person is that their existent leverages are inactive higher than I’d similar to see, particularly successful the lawsuit of NLY.
As seen from the illustration below, some of them had deleveraged substantially successful aboriginal 2020, knowing that the Fed's casual wealth proviso couldn't past indefinitely. For example, AGNC's leverage ratio had dropped from 12+ successful aboriginal 2020 to astir 8.0x by the extremity of 2021. And NLY had reduced its leverage ratio from astir 10x to 6x successful the aforesaid period. However, their leverages reversed the inclination and accrued substantially during 2022.
In AGNC’s case, its leverage accrued to astir 12x again successful 2022. And successful the astir caller quarter, acknowledgment to an 11% betterment successful its tangible publication worth (“TBV”), its leverage ratio present sits astir 9x. Close to its semipermanent mean of 9.2x. It reported an summation of TBV to ~$10.80 per stock arsenic of Feb. 9, 2023, up from ~$9.8 arsenic of the extremity of 2022, according to its latest SEC filing. Given the headwinds ahead, I would consciousness amended if the leverage is beneath the humanities mean by a bully margin.
In NLY’s case, the representation is adjacent much concerning arsenic seen from the bottommost sheet of the chart. Its leverage ratio has surged during 2022 and presently hovers supra the 10x level, astir the highest level successful a decade.
AGNC and NLY: valuation risks
Finally, valuation. My appraisal is that these stocks are presently trading astatine a important premium contempt the issues analyzed above. To me, the astir applicable metric for evaluating mREIT stocks is the price-to-tangible publication worth ("TBV") ratio, arsenic shown below. Historically, some stocks person been trading adjacent to oregon somewhat beneath TBV connected average. To wit, AGNC's mean P/TBV ratio has been 0.95x, but it is presently priced astatine 1.045x TBV, representing a 10% premium compared to its humanities average. And successful NLY's case, its mean T/PBV ratio successful the past has been 0.996x, but it is presently trading astatine 1.23x, which is an adjacent ample premium of 24% compared to its humanities average.
Upside risks and last thoughts
As 2 of the fashionable mREIT stocks, risks (both upside and downside) associated with NLY and AGNC person been thoroughly debated by different SA articles. And here, since I’ve spent the full nonfiction truthful acold analyzing their downside risks, I volition analyse an upside risk. Especially, since the article’s taxable is to comparison the changes since past March, I privation to absorption connected the quality betwixt their existent conditions and the conditions successful 2022 March. And that involves their dividend yields.
Their dividend yields person go a spot much charismatic present compared to March 2022. Both companies were capable to stabilize their dividend payouts since the cuts successful 2020. AGNC’s payout has been unchangeable astatine $0.12 per stock and paid monthly, translating into a TTM output of 13.6%. And its existent output is ~16% supra its humanities mean implicit the past 4 years. And NLY’s existent output is adjacent much attractive. NLY’s payout has been unchangeable astatine $0.88 per stock and paid quarterly, translating into a TTM output of 17.4%, which is simply a whopping 30% supra its 4-year humanities average. These yields are besides substantially higher than the assemblage mean approximated by REM and MORT.
However, I americium cautious against specified yields fixed the risks entailed. I bash not judge specified yields adequately relationship for the risks. Furthermore, the existent level of output whitethorn not beryllium sustainable owed to the profitability challenges analyzed. Lastly, it is imaginable that they could endure a nonaccomplishment of publication worth (which has been astir a chronic occupation to them successful the past) fixed the headwinds ahead. The nonaccomplishment of publication worth could trigger a banal terms diminution much than the dividends tin compensate for.
To close, past does not precisely repeat, but it decidedly rhymes. I spot today’s macroscopic conditions arsenic either akin oregon worse than those I’ve analyzed a twelvemonth ago. The output curve is astatine the astir severely inverted level successful much than 20 years. And fixed the ostentation information and geopolitical risks, I spot a akin setup that volition origin the output curve to stay inverted. On apical of the macroscopic headwinds, I americium besides acrophobic astir the leverage and valuation premium for some stocks.
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