Annaly Capital: Ready To Break Higher On The Rate Cut Cycle (Technical Analysis) (NLY)

Annaly Capital Management, Inc. (NYSE:NLY) is a mortgage real estate investment trust (“mREIT”) that primarily invests in agency mortgage-backed securities, and other mortgage-related paper. Given the current economic environment, and the increasing likelihood that the Federal Reserve will soon initiate a series of interest rate cuts, Annaly’s leveraged agency MBS portfolio should be expected to perform well in coming quarters. While certainly a riskier investment than holding agency MBSs or Treasuries without the use of leverage, Annaly should follow their performance. I believe Annaly is likely to move higher as the Federal Reserve initiates its rate cut cycle, which is likely to begin next month.

Annaly Capital’s primary business model is to acquire mortgage-backed securities to either hold them until maturity, or when called by the issuer. Annaly also intends to capture an interest rate spread, or margin, between the payout on those securities and their borrowing costs. The performance of mREITs is highly correlated to interest rate fluctuations, as well as there being a reasonable interest rate spread off of which to profit. When interest rates rise, the value of existing mortgage-backed securities will generally decline, and when interest rates decline, the value of these securities should increase.

Annaly provides a high dividend yield by holding a leveraged portfolio of mortgage-backed securities. This has generally made Annaly an attractive investment to income-oriented investors. This attraction was likely lessened over the last few years, as its portfolio’s value declined along with most bond valuations, and more compelling yields came to market.

Now, it appears increasingly likely that interest rates will begin to decline again, and potentially at an accelerated pace. This is dependent upon many factors, including broad market performance, the state of the economy and geopolitical risk, but the most likely driving force appears to be a probable reduction of borrowing rates by the Federal Reserve. If this happens, the value of Annaly Capital’s mortgage-backed securities should increase.

At the end of the second quarter of 2024, Annaly’s agency portfolio consisted of $66 billion in assets. In Annaly’s Q2 2024 investor presentation, it noted that the company “continued to rotate the portfolio into higher coupon high-quality specified pools,” and that “60% of the portfolio was in 5.0% coupons and higher, slightly higher than the prior quarter[.]” Annaly also maintained a conservative duration position with a 98% hedge ratio that was focused on replacing maturing swaps with Treasury futures.

Annaly also has a residential credit portfolio that was worth about $5.9 billion at the end of Q2, 2024. This was a decrease of about four percent compared to Q1 2024. Annaly’s mortgage servicing rights (or MSR) portfolio was worth about $2.8 billion at the end of Q2 2024, which was an increase of about five percent compared to Q1 2024 and about 29% year-over-year. These business segments are also likely to benefit from lower interest rates, as a reduction in rates is likely to increase market activity and support existing mortgage paper valuations along with the value of the underlying real estate.

Annaly’s Q2 2024 earnings press release included commentary that:

“Despite modest widening in Agency MBS spreads, Annaly produced a positive economic return in the second quarter, supported by our diversified capital allocation, balanced hedge portfolio and responsible leverage position. Notably, Annaly generated a 5.7% economic return year-to-date, demonstrating the strength of our housing finance model,” remarked David Finkelstein, Annaly’s Chief Executive Officer and Chief Investment Officer. “During the quarter, we opportunistically added to our Agency MBS portfolio given attractive spread levels, while we continue to expand our complementary Residential Credit and MSR platforms.

“We are encouraged by recent inflation data and signaling from the Federal Reserve, which suggest a near-term rate cut is increasingly likely. As interest rate volatility appears poised to moderate and more dovish monetary policy is on the horizon, we remain well- positioned for further growth given our substantial liquidity, prudent leverage and nimble capital structure.”

Technical Analysis

Annaly’s shares have been in a fairly tight trading range for most of 2024. They were also at roughly the same valuation throughout the first three quarters of 2023, and appear to have reached a capitulatory bottom along with bonds in the fourth quarter of last year.

In the more recent weeks, NLY shares have remained fairly rangebound despite the fact that yields have been consistently declining. These declining yields should result in higher valuations upon Annaly’s portfolio. The tight range within which NLY shares have remained stuck indicates a reasonably strong potential for shares to appreciate in the next few weeks, and especially if a rate cut cycle starts in September.

NLY shares have actually been slowly trending higher since the spring, and making a series of slightly higher highs, as well as higher lows, but both within a fairly tight range. Shares are now basically in the middle of NLY’s tight trading range, and also sitting just above the stock’s 50-day simple moving average. From here, it appears likely that shares will soon test the top of this trading range and potentially break higher upon the start of a rate cut cycle.

Given that the Federal Reserve essentially acknowledged that the rate cut cycle is likely to begin in September, it is reasonably probable that NLY shares will appreciate in advance of the formal announcement that is expected to occur on September 18th. Further, it is likely that analysts will begin to raise their price estimates for Annaly after that occurrence.

Annaly’s leveraged holdings are likely to substantially benefit from the rate cuts, and not solely from portfolio appreciation, but also due to the reduced cost of borrowing that should occur. A large institution like Annaly has the capacity to borrow at among the lowest rates available in the market, and a rate cut cycle is likely to provide them with higher margins by reducing their costs. Further, an increased probability of additional forthcoming rate cuts should lower the risk associated with the leverage utilized by Annaly. Those lower rates should also make Annaly’s comparatively higher yield more compelling as an investment.

Risks

Increases to interest rates would negatively impact Annaly’s portfolio valuation, as well as its dividend payout. The clearest risk to Annaly’s portfolio is that of spiking interest rates. Increasing rates have a negative effect upon the value of mortgage-backed securities, and hedging against accelerated changes to interest rates is often difficult.

There is also a risk of default on Annaly’s underlying mortgage loans. This risk is primarily borne by the part of its portfolio without an agency backing, as well as the servicing business in general. Nonetheless, the risk could extend to agency MBSs in times of political uncertainty and grandstanding. After all, agency paper has an implied guarantee, but not an express guarantee as is the case with Treasuries.

It is also likely that some of the company’s agency debt holdings will be called by the government agencies that issued it. Unlike Treasuries, agency debt may be called back for early redemption, and higher yielding debt is more likely to get called as rates decline. If such debt were acquired below 100, it would result in a capital gain, but any such debt acquired above issuing value would result in a capital loss upon prepayment.

Annaly has a long history of issuing secondary offerings. This is a common financial maneuver for mREITs in an effort to raise capital. Such a secondary offering is generally dilutive and likely to cause a decrease in share valuation to or below the offering price.

Conclusion

Annaly’s core business of holding a leveraged portfolio of agency mortgage-backed securities is likely to benefit from a rate cutting cycle. Annaly’s ancillary business lines should similarly benefit from reduced rates, and the support they would provide to real estate and mortgage related businesses. Further, a reduction to the risk-free rate offered by Treasuries should provide a benefit to income alternatives like Annaly. Given that the Federal Reserve just indicated that the time has come for it to begin cutting rates, it appears of increasing likelihood that Annaly should reprice higher as its portfolio gains value, and its dividend becomes more attractive to investors.