Co-produced with Beyond Saving

If you are an income investor, mortgage REITs (mREITs) are consistently among the highest yielding options. Some people pay interest, other people like to collect it. At High Dividend Opportunities” we think it’s much better to be one of net interest collectors. However, one of the major risks of owning debt is if the borrower is unable to pay. Debt is only worth what the borrower can eventually pay or the value of any collateral.

Perhaps one of the most intriguing mortgage assets to own today is “agency mortgage-backed securities” (agency MBS). This unique asset removes the risk of the underlying borrowers defaulting on the mortgages.

Banks that originate mortgages are not interested in waiting for decades to get their capital back – they want to originate more mortgages to new customers. So when an individual gets a mortgage, as long as the loan qualifies, the loan is quickly sold to “Government Sponsored Enterprises” (or GSEs) Fannie Mae or Freddie Mac. Those agencies then repackage the mortgages into MBS and sell them to investors who are willing to sit back and collect the interest payments – hence the term “agency MBS.” In order to ensure investor demand, the GSEs include a principal guarantee. If the borrower defaults, the GSE will buy back the mortgage for the amount of principal still owed.

This creates a unique asset where investors can receive mortgage interest with very minimal credit risk. Whether the borrower defaults or not, the investor is getting the principal. So regardless of the credit ratings of the underlying borrowers, agency MBS always is AAA rated. Agency MBS is known as one of the most conservative investments outside of US Treasuries.

Agency mREITs like Annaly Capital (NLY) provide investors an opportunity to take advantage of this very strong asset class.

Leverage Up!

Since we last wrote about it (on July 5), NLY had a nice run and is up nearly 20%, however it still has an impressive yield of 11.6%. Wait, didn’t we say that agency MBS was very low risk? How do you get a such a high yield from a very low risk asset?

The answer is leverage. Agency MBS currently has yields in the 2%-3% range. NLY borrows a significant amount of debt on their agency portfolio. Since agency MBS has very little credit risk, lenders are willing to lend a substantial portion of the buying price. It’s not uncommon for mREITs to use leverage at 8-10x equity on agency MBS.

As a result of utilizing so much leverage, the primary determinant of profitability of agency mREITs is the spread between the interest they pay and the interest they receive.

READ ALSO  "This Kind Of Thing Is Enough To Make One Go To The Pub. Oh, We Can't: It's Past 10pm..."

This spread already was improving in Q4 2019 thanks the declining interest rates, but it was kicked into overdrive in Q2 of 2020 as a result of the Federal Reserve dropping their target rate to 0.00%-0.25%.

NLY’s spread increased dramatically as a result:

The best part is that there’s still plenty of room for improvement as NLY’s cost of funds will continue to trend down as of quarter end, the rate NLY pays on all of their debt was lower than the average throughout the quarter. Particularly on their largest source of debt, repurchase agreements.

Source: NLY Q2 2020 Supplement

Declining rates on their debt is going to continue to improve their cash flow.

What The Fed Is Doing

The Federal Reserve has a lot of impact on the agency MBS market. On the cost of funds side, the repurchase agreements that NLY uses for the bulk of their borrowing are heavily tied to short-term Treasury rates. The Federal Reserve recently announced that it would allow inflation to exceed its 2% target before raising the Federal Funds Rate again. This change in policy means that interest rates are likely to remain near zero for a very long time.

The Fed also has a huge impact on the asset side, announcing in March that it would buy “unlimited” amounts necessary to stabilize the market. While we understand that many have various opinions on the politics of whether or not the federal government should play such a strong role in the mortgage market, the reality for investing is that it does and that tie is not one that will be easily undone.

The Federal Reserve can, and will, step into the agency MBS market to support it. We can see the impact it had in March.

Source: Mortgage News Daily

The Fed continues to buy billions of dollars worth of agency MBS. For NLY, this means that the values of their MBS holdings are going to remain very stable. Stable asset values combined with a declining cost of debt is a homerun type of environment for NLY. Their net interest spread is headed toward 2% and might even exceed 2% in future quarters, meaning they will have twice the cash flow they were earning last year on the same assets.

READ ALSO  How Trump’s Supreme Court pick could reshape law on abortion and guns

Hedging

For agency mREITs, they have no credit risk. That’s not the same as saying they have no risk at all. The primary risk for NLY is interest rate risk. The debt that NLY buys is generally short term, with 60% of it maturing within 90 days – while 90% of the mortgages they own have maturities of 30 years. So the largest risk to NLY is that the interest rate on their debt rises, possibly to be even higher than the yield they receive.

To protect themselves from that risk, NLY engages in a series of hedging transactions. They buy interest rate swaps, which are agreements to pay a fixed interest rate and receive a floating interest rate over a period of time. Currently, their average pay rate is 1.01% and the average receive rate is 0.75%, so holding the hedges costs NLY 0.26% on $28.8 billion. If interest rates rise above 1.01%, say to 1.20%, then NLY would be receiving 0.19% from the counterparty.

Additionally, they will directly short US Treasuries, so if rates rise, those positions will have gains.

Source: NLY Q2 2020 Supplement

Having hedges is necessary to protect the company from unexpected interest rate increases. However, the downside is that when Treasury rates quickly move down, existing swap contracts become far less valuable, short positions on treasuries lose value and that leads to losses on book value. This was the main factor driving the book value loss in March.

Fortunately, with short-term interest rates near zero, and the Federal Reserve unlikely to consider a negative interest rate policy, another sharp move down is very unlikely. Additionally, with the Federal Reserve being very consistent about not raising interest rates anytime soon, NLY and their peers have an environment where they can expect a lot of stability. This has allowed them to reduce their hedging, while the hedges they have been getting are at very attractive prices and are far more likely to improve in value than decline in value.

Conclusion

Agency MBS is a premium asset class because with the “Government Sponsored Enterprises” guaranteeing the principal, they carry very little credit risk. NLY takes advantage of that security to use significant amounts of leverage to convert a low yield into a double-digit yield.

READ ALSO  Optimism in the Time of COVID

The risk for NLY has little to do with whether or not people pay their mortgages, it has everything to do with the actions of the Federal Reserve. The absolute ideal conditions is interest rates on the short end of the curve being very stable, with interest rates at the long-end gradually climbing. These are the conditions that we are experiencing right now.

These conditions also are not likely to go away as the Fed has reiterated their intention to maintain the current 0%-0.25% target rate, even if inflation exceeds 2%.

NLY’s last reported book value was $8.39, and in the earnings call management indicated that it was approximately 1% higher at the end of July. This means that today, investors can buy NLY at a 10%-plus discount to book value in an environment where we can expect book value and cash flow to climb.

As investors, we can collect a +11% yield today, and for the next few years the interest rate environment is ideal for NLY’s strategy. Book value will climb back up and it’s very likely that the dividend will be increased as well.

A +11% yield with dividend growth ahead? Yes, it’s possible and it’s name is NLY.

Thanks for reading! If you liked this article, please scroll up and click “Follow” next to my name to receive our future updates.

Which Dividend Stocks To Buy?

High Dividend Opportunities is the #1 service on Seeking Alpha for the 5th year in a row. We are the most exciting community of income investors and retirees with over 4400 members. Our Immediate Income Method generates strong returns, regardless of market volatility, making retirement investing less stressful – simple and straightforward.

Invest with the Best! Join us to get instant-access to our model portfolio targeting 9-10% yield, our preferred stock portfolio, bond portfolio, and income tracking tools. Don’t miss out on the Power of Dividends! Start your free two-week trial today!

Disclosure: I am/we are long NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities.



Via SeekingAlpha.com