Earnings Labs

Annaly Capital Management, Inc. (NLY)

Q3 2023 Earnings Call· Thu, Oct 26, 2023

$22.78

-0.28%

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Transcript

Operator

Operator

Good morning and welcome to the Third Quarter 2023 Conference Call for Annaly Capital Management. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Sean Kensil, Director of Investor Relations. Please go ahead, sir.

Sean Kensil

Analyst

Good morning, and welcome to the third quarter 2023 earnings call for Annaly Capital Management. Any forward-looking statements made during today's call are subject to certain risks and uncertainties, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date hereof. We do not undertake and specifically disclaim any obligation to update or revise this information. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. Content referenced in today's call can be found in our third quarter 2023 investor presentation and third quarter 2023 supplemental information, both found under the Presentations section of our website. Please also note this event is being recorded. Participants on this morning's call include David Finkelstein, Chief Executive Officer and Chief Investment Officer; Serena Wolfe, Chief Financial Officer; Mike Fania, Deputy Chief Investment Officer and Head of Residential Credit; V.S Srinivasan, Head of Agency; and Ken Adler, Head of Mortgage Servicing Rights. And with that, I'll turn the call over to David.

David Finkelstein

Analyst

Thank you, Sean. Good morning, everyone, and thanks for joining us today. I'll begin with a discussion of the macro and interest rate landscape, and then I'll review the current operating environment, including our portfolio activity and positioning. Now as all are aware, the third quarter was characterized by a sharp rise in interest rates as the 10-year treasury yield rising nearly 75 basis points. The move was in part driven by strong economic data, the Fed's messaging of hire-for-longer, rising commodity prices and the sell-off in global yields. The main driver for higher yields, however, has been a shift in perception around U.S. government debt that began with the August treasury refunding announcement as after increasing issuance following the debt ceiling deal in early June, treasury began to term out debt above market expectations in August, all while signaling further increases in coming quarters. This higher supply has been met with limited demand as the Fed continues to run down its balance sheet, banks remain sidelined given the sizable unrealized losses on their bond portfolios and foreign central bank buying has been lukewarm at best. Consequently, money managers, pensions and ultimately, households are the main source of demand for treasuries and by extension Agency MBS. However, thus far, households are saving less than historical averages, and savings are largely being allocated to short-term fixed income instruments, best seen through the record $6 trillion in money market mutual fund holdings, contributing to the sharp sell-off and curve steepening in rates markets in recent weeks. Now as it relates to the broader U.S. economy, growth has been supported by strong consumption and sound investment activity, while the labor market remains very healthy. Inflation has continued to moderate. And looking forward, it appears that a number of headwinds are building for the…

Serena Wolfe

Analyst

Thank you, David. Today, I will provide brief financial highlights for the quarter and 9-month period that ended September 30, 2023. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude PAA. Due to factors as David mentioned earlier, our book value per share for Q3 decreased from the prior quarter to $18.25. And with our third quarter dividend of $0.65, we generated an economic return for the quarter of negative 8.8% and negative 2.8% for the first 9 months of the year. A further increase in rates for the quarter drove gains in our hedging portfolio of roughly $3.76 and our MSR book of $0.16. While spread widening and increased volatility significantly impacted our Agency portfolio, resulting in losses of approximately $6.16 for the quarter. Additionally, our resi credit assets were down 20% [ph] for the quarter, primarily related to mark-to-market changes on the portfolio. We generated earnings available for distribution of $0.66 per share for the third quarter. Consistent with the prior quarter, EAD was adversely impacted by the continued rise in repo expense. Our portfolio positioning enhanced our average yield ex PAA, which rose again quarter-over-quarter, 24 basis points higher than the prior quarter at 4.46%. Yields also improved by 9 basis points due to lower amortization with long-term CPRs decreasing from 8.6% in Q2 to 7.1% in the third quarter. Impacted by the same factors as EAD, NIM declined 18 basis points from Q2 to 148 basis points of NIM ex PAA in the third quarter. Net interest spread declined 27 basis points quarter-over-quarter to 1.18% versus 1.45% in Q2 as the rate increases on our financing agreements modestly exceeded the increase in asset yields. The aforementioned…

Operator

Operator

[Operator Instructions] And the first question will come from Bose George with KBW.

Bose George

Analyst

Can I get an update for book value quarter-to-date?

David Finkelstein

Analyst

Sure, Bose. So I have as of Tuesday evening, which was off 11% for the quarter. So we're still trading well below book value.

Bose George

Analyst

Okay, great. And then, just switching to your MSR. So it's not 19% of capital. Can you just talk about the levered -- so the unlevered yield and I guess, the levered yield now that you have some asset-level leverage? And how large do you think the MSRs could get just given the opportunity that looks pretty attractive over the next year?

David Finkelstein

Analyst

Sure. I'll start with the capital allocation, and Ken can talk about returns. So as we show, we have 1/3 of a turn of leverage on the MSR. What we've talked about in the past is that with the current composition of our MSR, which is deep, deep out of the money and relatively benign cash flows, you can apply leverage to that. And so the way we think about it is you could incorporate a turn of leverage into that. And if we did today -- if we did that today, you'd have roughly $1.15 billion in capital and $1.15 billion of debt. And so that would be a much lower capital allocation. And so as a consequence, thinking about it through that lens, we do have capacity to increase the MSR portfolio should the opportunity arise, and we have ample warehouse capacity to do so. And with that, Ken can talk about returns.

Ken Adler

Analyst

Yes, sure. Returns on the sort of MSR we've been participating in on an unlevered basis are in the 9.5% to 10% range and adding leverage to that, we get to the up to the 12% to 13% sort of level. More generic MSR has higher stated returns because it's more negatively convexed.

Operator

Operator

The next question will come from Crispin Love with Piper Sandler.

Crispin Love

Analyst

First off, can you just speak to how you and the Board are thinking about the dividend right now? We have earnings coverage right now on the dividend, but the dividend yield and yield on book value has increased as book value has been under pressure and those are -- the same reasons that warranted your last decrease in the dividend earlier this year. So curious on how you and the Board are balancing earnings coverage plus a higher dividend yield on book value. And then, what all those mean for the sustainability of the dividend?

David Finkelstein

Analyst

Sure, Chris. So as we've talked about in the past, the Board evaluates our dividend every quarter. And we have 3 criteria by which we set it. We want it to be a competitive dividend yield with the peer set. It should be consistent with our historical payout and it should be sustainable to the extent we have line of sight into earnings in the future. Now as you mentioned, we did modestly out earn our dividend in the third quarter. In terms of Q4, we expect EAD to be contextual with the dividend. Beyond that, a lot depends on, for example, how the Fed behaves and other factors, and we don't have guidance beyond 2023. But rest assured, it's always a conversation for our Board, and we feel good about this quarter.

Crispin Love

Analyst

Appreciate the comments there. And David, you made some comments earlier in the call about Agency MBS valuations looking attractive and how investor sentiment should improve here and we could see some tightening over the medium term. I'm curious if you could just expand on that a little bit. What type of tightening do you think would make sense? Or said differently, how far do you think we are from fair value? And kind of what do you mean by medium term and how long that could be just given the rate volatility we're seeing currently?

David Finkelstein

Analyst

Yes. That's a great question, Crispin. So as I mentioned in the prepared remarks, we are reliant on the money manager community to be the support for Agency MBS. Obviously, the Fed is running off their portfolio and banks are on the sidelines. So a lot will depend on flows in the money managers. And one of the considerations that I think will be required for consistent durable flows is a decrease in volatility and hopefully an end to the Fed hiking cycle. But with levels of current volatility in the market, we do think there should be some tightening just given we're at historically wide levels, and we think a fair value would be roughly 20 basis points tighter than the current level. And should volatility decline, then you would expect to see even more incremental tightening from there. But look, it's an uncertain time. There is still a lot of volatility and the technicals are somewhat daunting insofar as banks and the Fed, obviously, net sellers. So we're being patient. We're managing leverage judiciously, and we're optimistic on mortgages, but we got to be disciplined here.

Operator

Operator

The next question will come from Trevor Cranston with JMP Securities.

Trevor Cranston

Analyst

A follow-up to the comment you made about the book value movement so far in October. Can you comment on any changes you made alongside that to the portfolio in terms of asset composition or the size of the agency book? And also maybe comment on where your leverage stands today.

David Finkelstein

Analyst

Sure. So look, we are very disciplined when it comes to managing liquidity and leverage. And so as a consequence, we have reduced the portfolio to maintain leverage consistent and actually even maybe a tiny bit lower than we ended the fourth quarter. Does that help?

Trevor Cranston

Analyst

Yes.

David Finkelstein

Analyst

Sorry, third quarter. So we manage leverage. We sold assets, but we feel good about where the portfolio sits, particularly from a liquidity standpoint now.

Trevor Cranston

Analyst

Okay, great. And then obviously, you guys have been pretty successful growing the non-Agency conduit. Can you talk generally about how you think the movement higher in rates will impact that business sort of over the coming couple of quarters?

David Finkelstein

Analyst

Yes. So I'll start and then Mike can hand it off. We've been very pleasantly surprised with the growth in the correspondent channel, particularly as mortgage rates have increased and originations have slowed quite a bit. But the fact of the matter is we have taken a lot of market share. We've expanded our partnerships across the originator community, and it's been a welcome development for the resi business. And Mike, do you want to add to that?

Michael Fania

Analyst

Sure. Thanks for the question, Trevor. I think in terms of kind of where we're at with the correspondent build, we're probably 65% to 70% there. We have 180 approved correspondents. We have 30 to 40 correspondents that are in our pipeline that want to be Onslow Bay approved sellers. So I think the stability of our capital, the stability of our operations with our counterparts I think over the last number of years have led our reputation that to be involved in this market, being involved with Onslow Bay is something that makes sense. In terms of momentum, we had over $900 million of locks in August. We had over $800 million of locks in September. And I think in October, we'll probably have close to $750 million to $800 million of locks. A lot of that volume ultimately is coming from gaining market share, but a lot of it also, too, is we have a number of exclusive relationships with very large non-bank originators that don't partner with that broad of a universe. So I think synergies with the MSR portfolio, our MSR business, buying MSR from a number of these counterparties also helps on the relationship on the correspondent side. And lastly, I'll say that the borrower is a little bit different borrower than the conforming market. I think on the conforming side, about 90% of the volume right now is purchased. What we are seeing through our correspondent channel, about 20% is cash out and 10% is still rate and term refi. So it is less dependent on the purchase market, which is at close to 30-year lows.

Operator

Operator

The next question will come from Rick Shane with JPM.

Rick Shane

Analyst

There were some comments about incremental investments in the agency CMBS business. And when we look at Slide 6, it's actually -- the economic returns aren't mentioned there. I'm curious if you could help us understand that a little bit better. I'm assuming the attractiveness is the lack of prepayment optionality and the lack of negative convexity that you see in the Agency book at this point. Can you just sort of walk through how you approach that business a little in more detail?

V.S. Srinivasan

Analyst

This is Srini. Thanks for the question. Basically, Agency CMBS is almost like a bullet cash flow and with spreads north of 110 basis points. you will earn all of that. It's like OAS or MBS. So at 110 basis points of trend [ph], you assume like a 7x leverage, it gets you to about SOFR plus 10%. So it's in the high -- mid- to high teens. But the advantage of that over MBS is just that you don't have slippage, you generally tend to earn the entire amount. And if you just go back 2 years, these spreads were at 15 basis points. So this is at a pretty attractive level for a cash flow that is very little optionality or very little risk.

David Finkelstein

Analyst

And also, as I mentioned, Rick, the technical landscape for Agency CMBS is better than Agency MBS.

Rick Shane

Analyst

Got it. And is that consistent with your strategy of hedging further out on the curve? Or is it, I guess, tied to because of the longer, more predictable duration of the agency CMBS?

V.S. Srinivasan

Analyst

I think we -- when we buy the CMBS, we think of it as buying it on a swap basis. So we would hedge the duration completely and own it on a swap basis.

Rick Shane

Analyst

Okay. And what are the durations that you're assuming associated with them just so we understand how to think about how that's going to impact the hedge book?

V.S. Srinivasan

Analyst

I mean the duration on these will be right around 8 years. They're very similar to 10-year treasury cash flows.

Operator

Operator

The next question will come from Eric Hagen with BTIG.

Eric Hagen

Analyst

So first question here, I mean how are you guys feeling about the shape of the capital structure, just the mix of common and preferred? How much leverage to common stock you're willing to tolerate at these spread levels?

David Finkelstein

Analyst

Yes. So look, we entered this period with very little capital structure leverage. We average around 12% to 13% of our capital in preferreds. With common deterioration, we're up to 15%, which is still quite low, certainly relative to the sector and particularly when you consider the alternative businesses that are less levered from a balance sheet standpoint. And the way we look at it is we do have a floating rate preferreds, obviously, now. And the fact that the curve steepened as much as it did, the cost of our preferreds on a forward basis didn't increase much at all, while the asset side of the equation actually became a lot more ample. And so from a cost of capital standpoint, preferred actually looks more reasonable today than it did, say, at the end of the second quarter. We do have capacity to increase it, but that market has been closed really. There's been a couple of bank deals and not much else. To the extent we can refi at some point, we would look at it, but it's not there now, and we'll see how that market develops.

Eric Hagen

Analyst

Right. No, that's helpful. And so how are we also thinking about hedging your cost of funds at the short end of the yield curve, especially if it looks like the Fed could really cut rates next year, and that begins to get embedded into the forward curve even more?

David Finkelstein

Analyst

Yes. You bet, Eric. So we're keeping our repo profile relatively sure. We do think -- although there's 1/3 of a probability of another hike, we think it's somewhat unlikely. And so we're -- pivoting to a point where the next move, to your point, would be cut. And so we're managing it very nimbly and most of our focus is on hedging out the curve because we do think that's really where the risk is given just the amount of supply coming to the market, particularly from the treasury market next year. I think there's projected to be $1.7 trillion in net treasury issuance. And then you also have fed runoff to the tune of $900 billion between treasuries and Agency MBS. So a lot of the focus is out the curve as you see in the change in composition in our hedge profile quarter-over-quarter.

Operator

Operator

[Operator Instructions] Our next question will come from Matthew Erdner with JonesTrading.

Matthew Erdner

Analyst

David, you just mentioned the composition of the hedge portfolio. Could you talk a little more about the added use of futures and kind of if you're still sitting in that 7-year to 20-year part of the curve there?

David Finkelstein

Analyst

Yes, we are. So in terms of the additions in the futures, look, at the end of the day, the way we looked at it was we wanted the liquidity of the futures market. We wanted to add hedges. We did a lot of that early in the quarter. And our composition of hedges was underweight futures relative to where we have historically been. So now we're up to 24% of the hedges in the futures, which we're comfortable with. And now one point to note is that swaps have generated really the vast majority of the income just given the shape of the curve, and you don't get that benefit from futures. And so it does dampen EAD to some extent, but we're okay with that.

Matthew Erdner

Analyst

Got you. And then do you expect to kind of increase or decrease futures? Or are you guys kind of comfortable with the level that you're at right now?

David Finkelstein

Analyst

We'll see how the market evolves, but we're comfortable with where we're at.

Operator

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. David Finkelstein for any closing remarks. Please go ahead, sir.

David Finkelstein

Analyst

Thank you, Chuck, and thanks for joining us today, and good luck, everyone.

Operator

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.