In my March 17, 2022 article titled “Annaly Capital: Still Attractive Among mREITs, But mREIT Itself Under Pressure,” I assessed the macroeconomic parameters at that time (more on this in the next section), and correctly concluded that they would continue to pose strong headwinds on the mREIT industry. However, then I proceeded to make a bullish case for leading mREIT stocks like Annaly Capital (NYSE:NLY) and AGNC Investment (NASDAQ:AGNC) based on the following considerations (quoting my own words here):
- …as leaders in the sector, they offer a reasonable combination of scale, safety, and valuation relative to other mREIT peers.
- …investors need to be aware that the mREIT sector itself is under pressure with the start of a new macro credit cycle. However, different mREIT stocks have different sensitivities to yield spread narrowing (or inversion) given their exact exposure ranging from agency MBS, home loans (MSR and RMBS), or hybrid loans. And some differentiating factors of their business models are worth special consideration.
Well, you can see how wrong I was from the following chart. At the time of publishing in March, NLY’s stock price was approximately $28. And it kept plummeting after that, bottoming near $15 in October, translating into a significant drawdown of almost 50% in only about 6 months. As also seen from the chart, AGNC and the entire sector (approximated by REM) did not fare any better.
And the lesson I’ve learned (relearned really) was this: do not try to pick a winner on a sinking ship. It is much easier to short the whole ship or find another ship. When the whole shipping is facing strong headwinds, the differentiating details of each player’s strategy do not matter so much as evidenced by the chart below. Despite the difference between NLY and AGNC and the rest of the mREIT, their price actions are about the same.
History certainly rhymes. One year after that article, the current macroscopic conditions are either similar or worse in my view. This leads me to the main thesis of this article: I see leading mREIT stocks like NLY and AGNC facing substantial profitability pressure ahead. In the meantime, I also see significant valuation risks and leverage risks. As to be elaborated on next.
The most inverted yield curve in 20 years
As just mentioned, the mREIT sector as a whole is sensitive to the macro-debt cycle. The details were elaborated on in my original article. Quote:
The yield spread between short-term debt instruments and long-term instruments is the most effective indicator of the macro-credit (or debt) cycle. When yield spreads expand or contract, it can signal changes in the underlying economy or financial markets. The mREIT stocks like AGNC and NLY are typically the ones that are most sensitive about such yield spread changes because they make money on the spread between the long-term and short-term rates. The thicker the spread, the easier and the more money they can make, as you can clearly see from the following chart.
The chart the above quote refers to is the one below. This chart overlaps the yield spread (Ys, defined as the 10-Year Treasury Constant Maturity Minus the 2-Year Treasury Constant Maturity rates) and AGNC’s dividend history. Here, I am using dividends to approximate the so-called owners’ earnings, which is a good assumption for mREIT stocks like NLY and AGNC given that they pay out most of their true economic earnings as dividends.
This chart clearly shows the correlation between the owners’ earnings and the YS for the reasons quoted above. And now let’s see what the differences and similarities are between now and March 2022 in the yield curve.
The most important and obvious difference is that the yield has become inverted now while it was not so a year ago. The YS has moved in the direction that I predicted last March. At that time, the spread between the 10-year and 2-year treasury rates was still positive, albeit a narrow 0.26% as you can see from the chart below more clearly. Since then, the yield curve inverted significantly, and it is negative 0.88% as of this writing, the most severe level in more than 20 years as seen.
The most important similarity in my view – and this is where history rhymes – lies in the setup that will cause the yield curve to remain inverted in the foreseeable future. If you recall, last October’s CPI data indicated lower-than-expected inflation and led the market to believe that the rate hikes are over. Such optimism caused much of the price rally in the mREIT sector as you can see from the first chart in the article. Read my previous coverage on Annaly and AGNC here.
However, that was merely a single data point and I cautioned readers that it is entirely possible for further inflation data to exceed market expectations. Indeed, the annual inflation rate reported in Jan 2023 dialed in at 6.4% (compared to 6.5% a year ago), hotter than the market expectation of 6.2%. Moreover, despite being slightly lower than anticipated, inflation in the 6~7% range is still quite high in absolute terms. Especially when coupled with ongoing uncertainties such as the Russian-Ukraine conflict and its impact on the global supply of raw materials, food, and energy, I simply do not believe that the Federal Reserve has finished with its rate hikes.
If the above arguments have convinced you that the short-term end of the rates would remain high or even further increase, let’s look at the long-term rates now. Long-term rates are largely controlled market forces (while the Fed controls short-term rates). And based on my analysis, there is limited room for long-term rates to further increase above their present levels. As detailed in my earlier writings,
At a very fundamental level, in the long term, treasury bond rates cannot rise above long-term inflation or GDP growth. Our government has been relying on inflation and GDP expansion to inflate away and outgrowth its debt obligations for decades in the past. And it will (it will have to) continue doing so.
Based on my above arguments on the long-term and short-term rates, the yield curve only has one way to go: to remain inverted. And I foresee the inverted yield curve to keep pressuring NLY and AGNC’s earnings well into 2023. An inverted curve would hurt their earnings in more than one way. As mentioned, mREITs use short-term borrowings to fund their purchases of mortgage-backed securities, and a narrowing YS squeezes their profit margin. Beyond these fundamental dynamics, demand for new mortgages could also be weakened by an inverted yield curve, especially combined with high inflation. Higher long-term borrowing rates tend to drive discourage new home buyers and hence the need for mortgage originations.
AGNC and NLY: leverage is still concerning
Besides the profitability headwinds, another concern I have is that their current leverages are still higher than I’d like to see, especially in the case of NLY.
As seen from the chart below, both of them had deleveraged substantially in early 2020, knowing that the Fed’s easy money supply couldn’t last indefinitely. For example, AGNC’s leverage ratio had dropped from 12+ in early 2020 to about 8.0x by the end of 2021. And NLY had reduced its leverage ratio from about 10x to 6x in the same period. However, their leverages reversed the trend and increased substantially during 2022.
In AGNC’s case, its leverage increased to nearly 12x again in 2022. And in the most recent quarter, thanks to an 11% improvement in its tangible book value (“TBV”), its leverage ratio now sits around 9x. Close to its long-term average of 9.2x. It reported an increase of TBV to ~$10.80 per share as of Feb. 9, 2023, up from ~$9.8 as of the end of 2022, according to its latest SEC filing. Given the headwinds ahead, I would feel better if the leverage is below the historical average by a good margin.
In NLY’s case, the picture is even more concerning as seen from the bottom panel of the chart. Its leverage ratio has surged during 2022 and currently hovers above the 10x level, almost the highest level in a decade.
AGNC and NLY: valuation risks
Finally, valuation. My assessment is that these stocks are currently trading at a significant premium despite the issues analyzed above. To me, the most relevant metric for evaluating mREIT stocks is the price-to-tangible book value (“TBV”) ratio, as shown below. Historically, both stocks have been trading close to or slightly below TBV on average. To wit, AGNC’s average P/TBV ratio has been 0.95x, but it is currently priced at 1.045x TBV, representing a 10% premium compared to its historical average. And in NLY’s case, its average T/PBV ratio in the past has been 0.996x, but it is currently trading at 1.23x, which is an even large premium of 24% compared to its historical average.
Upside risks and final thoughts
As two of the popular mREIT stocks, risks (both upside and downside) associated with NLY and AGNC have been thoroughly debated by other SA articles. And here, since I’ve spent the whole article so far analyzing their downside risks, I will analyze an upside risk. Especially, since the article’s theme is to compare the changes since last March, I want to focus on the difference between their current conditions and the conditions in 2022 March. And that involves their dividend yields.
Their dividend yields have become a bit more attractive now compared to March 2022. Both companies were able to stabilize their dividend payouts since the cuts in 2020. AGNC’s payout has been stable at $0.12 per share and paid monthly, translating into a TTM yield of 13.6%. And its current yield is ~16% above its historical average over the past 4 years. And NLY’s current yield is even more attractive. NLY’s payout has been stable at $0.88 per share and paid quarterly, translating into a TTM yield of 17.4%, which is a whopping 30% above its 4-year historical average. These yields are also substantially higher than the sector average approximated by REM and MORT.
However, I am cautious against such yields given the risks entailed. I do not believe such yields adequately account for the risks. Furthermore, the current level of yield may not be sustainable due to the profitability challenges analyzed. Lastly, it is possible that they could suffer a loss of book value (which has been almost a chronic problem to them in the past) given the headwinds ahead. The loss of book value could trigger a stock price decline more than the dividends can compensate for.
To close, history does not exactly repeat, but it definitely rhymes. I see today’s macroscopic conditions as either similar or worse than those I’ve analyzed a year ago. The yield curve is at the most severely inverted level in more than 20 years. And given the inflation data and geopolitical risks, I see a similar setup that will cause the yield curve to remain inverted. On top of the macroscopic headwinds, I am also concerned about the leverage and valuation premium for both stocks.