Annaly Capital: Poised to Break Higher in Rate Cut Cycle (Technical Analysis) (NLY)

Annaly Capital Management, Inc. (NYSE: NLY) is a mortgage real estate investment trust (“mREIT”) that invests primarily in agency mortgage-backed securities and other mortgage-related documents. 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 perform well in the coming quarters. While certainly a riskier investment than owning agency MBS or Treasuries without the use of leverage, Annaly should track their performance. I think Annaly will likely rise as the Federal Reserve initiates its rate cut cycle, which will likely begin next month.

Annaly Capital’s primary business model is to acquire mortgage-backed securities either to hold to maturity or when they issue. Annaly also intends to capture an interest rate spread, or margin, between payments on those securities and their borrowing costs. mREIT performance is closely correlated with interest rate fluctuations as well as a reasonable interest rate to take advantage of. When interest rates rise, the value of existing mortgage-backed securities will generally decline, and when interest rates fall, the value of these securities should rise.

Annaly offers a high dividend yield by holding a leveraged portfolio of mortgage-backed securities. This has generally made Annaly an attractive investment for income-oriented investors. That appeal has likely diminished in recent years as the value of its portfolio has declined along with most bond ratings and more compelling yields have come to market.

Now, it looks increasingly likely that interest rates will start falling again, and possibly at an accelerated pace. This depends on many factors, including overall market performance, the state of the economy and geopolitical risk, but the most likely driving force appears to be a likely cut in lending rates by the Federal Reserve. If that happens, the value of Annaly Capital’s mortgage-backed securities should increase.

At the end of the second quarter of 2024, Annaly’s 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 specified high-quality coupon pools” and that “60% of the portfolio was in coupons of 5.0% and above , slightly higher than in the previous quarter. (.)” Annaly also maintained a conservative duration position with a 98% hedge focused on replacing maturity swaps with Treasury futures.

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

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

“Despite the modest increase in Agency MBS spreads, Annaly produced a positive economic return in the second quarter, supported by our diversified capital allocation, balanced hedging portfolio and responsible leverage position. In particular, Annaly has generated an economic return of 5.7% year to date, demonstrating the strength of our housing finance model,” noted David Finkelstein, Chief Executive Officer and Chief Investment Officer of Annaly. “During the quarter, we opportunistically added to our agency MBS portfolio given attractive spread levels as we continue to expand our complementary residential credit and MSR platforms.

“We are encouraged by recent inflation data and signals from the Federal Reserve that suggest a short-term interest rate cut is increasingly likely. As interest rate volatility appears to be moderating and a more accommodative monetary policy is on the horizon, we remain well positioned. for further growth given our substantial liquidity, prudent leverage and agile capital structure.”

Technical analysis

Annaly stock has been in a fairly tight trading range for most of 2024. It’s also been at roughly the same valuation for the first three quarters of 2023 and appears to have hit a capitulation low along with bonds in the fourth quarter of last year.

In recent weeks, NLY shares have remained fairly limited despite yields falling steadily. These diminishing returns should result in higher valuations for Annaly’s portfolio. The tight range that NLY stock has been stuck in indicates reasonably strong potential for the stock to appreciate over the next few weeks, and especially if a rate cut cycle begins in September.

In fact, NLY stock has been slowly moving higher since the spring and has seen a series of slightly higher highs as well as higher lows, but both within a fairly tight range. The stock is now basically in the middle of NLY’s tight trading range and is also just above the stock’s 50-day simple moving average. From here, it looks like stocks will soon test the top of this trading range and potentially break higher at the start of a rate cut cycle.

With the Federal Reserve essentially admitting that the rate cut cycle could begin in September, it is reasonably likely that NLY stock will appreciate ahead of the official announcement expected on September 18th. Additionally, analysts are likely to start raising their price estimates for Annaly after this event.

Annaly’s leveraged holdings are likely to benefit substantially from rate cuts and not only from portfolio appreciation but also from the reduced cost of borrowing that should occur. A large institution like Annaly has the ability to borrow at the lowest rates available in the market, and a rate cut cycle is likely to give them higher margins by reducing costs. Additionally, an increased likelihood of further future rate cuts should decrease the risk associated with Annaly’s leverage. These lower rates should also make Annaly’s comparatively higher yield more compelling as an investment.

risks

Increases in interest rates would have a negative impact on the valuation of Annaly’s portfolio as well as the dividend payout. The clearest risk to Annaly’s portfolio is rising interest rates. Rising rates have a negative effect on the value of mortgage-backed securities, and hedging against accelerated changes in interest rates is often difficult.

There is also a risk of default on Annaly’s underlying mortgages. This risk is borne primarily by the part of the portfolio without agency support, as well as by the service activity in general. However, risk could also extend to agency MBS during times of political uncertainty and default. After all, agency paper has an implied warranty, but not an express warranty, 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 them. Unlike Treasuries, agency debt can be called back for early redemption, and higher-yielding debt is more likely to be called as rates fall. If such debt were acquired below 100, a capital gain would result, but any such debt acquired above the issue value would result in a capital loss on 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 the stock’s valuation to decline to or below the offering price.

Conclusion

Annaly’s core business of holding a leveraged portfolio of mortgage-backed securities is likely to benefit from a rate cut cycle. Annaly’s ancillary business lines should similarly benefit from reduced rates and the support it would provide to its real estate and mortgage businesses. Moreover, a reduction in the risk-free rate offered by the Treasury should provide an advantage to income alternatives like Annaly. With the Federal Reserve having just signaled that the time has come to start cutting interest rates, it’s increasingly likely that Annaly will bounce back higher as its portfolio gains value and its dividend becomes more attractive to investors.