On November 2, 2022, the central bank is generally expected to raise its benchmark interest rate by another 75 basis points. This would be the fourth increase in the 75 basis point jumbo-sized rate in 2022.
Unfortunately, this means that Pressure on valuation and net interest margin is growing for mortgage real estate investment funds like Annaly Capital Management, Inc. (NYSE: NUMBER).
The real estate investment trust released its results for the third quarter of 2022 last week, and those numbers revealed another sharp quarter-on-quarter drop in book value. Although Annaly was able to pay her dividend with earnings that were available for distribution, the company currently faces challenges that could result in further discounting to book value in the future.
Another rate hike is coming
On Wednesday, the central bank is expected to determine whether to raise interest rates again, with the Federal Reserve expected to raise its benchmark interest rate by an additional 75 basis points.
In 2022, the central bank raised its benchmark interest rate three times by 75 basis points each, marking the most significant rate hike in more than 20 years.
The justification for the sharp rise in interest rates is the need to control inflation, which, despite having cooled down a bit in recent months, is still close to 40-year highs. 8.2% was the rate of inflation in October, and it was probably high during November as well.
The central bank is trying to realign the interest rate level in the US economy with inflation rates, so the interest rate hike may not be the last for mortgage trusts like Annaly and , as a result, could trade lower.
Annaly Book Value Trend: A Trail of Blood
In the third quarter, interest rate volatility and net interest margin pressure caused Annaly’s book value to decline once again. As a result of the mortgage trust’s 1-for-4 reverse stock split that took place in September, Annaly’s per-share book values for prior quarters were revised.
As of the end of the September quarter, Annaly’s book value was $19.94 per share, down from $23.59 per share in the previous quarter, a decrease of 16%.
In a previous article titled ‘Annaly Capital: Don’t Take The 14% Yield Bait’, I raised the alarm about Annaly’s book value and net interest margin issues. Annaly’s book value decreased 38% during the first three quarters of 2022: 15% in the first quarter, 13% in the second and 16% in the third.
Annaly’s net interest margin has started to decline as a result of higher interest rates, which are a death sentence for large leveraged mortgage trusts. The net interest margin for the trust fell 1.22 percentage points to 1.42% from 2Q-22. The trust’s net interest margin is expected to decline further in the future as interest rates are expected to rise further.
The discount to book value could be substantially higher
Currently, Annaly’s discount to book value is around 8%, which may not be enough to offset the tail risks associated with rising interest rates.
As investors price in the likelihood of additional interest rate hikes in 2023, particularly if inflation remains strong, I continue to believe Annaly could see a significantly lower valuation (higher discount to book value).
In the near future, Annaly’s book value discount could expand to 20–25%, at which point the shares could be selling in the $15–16 region.
Why Annaly might see a higher rating
Investors currently don’t appreciate exposure to the mortgage market because the central bank is about to raise interest rates yet again, and as a result, Annaly has lost a sizeable chunk of her book value this year.
Naturally, a slower rate of rate increases would be favorable for Annaly and the larger mortgage market. The probability of this happening is mainly influenced by inflation forecasts. Although inflation has slowed recently, it remains a major concern for both consumers and politicians. Fewer interest rate hikes are expected going forward, which could benefit Annaly and her investor base.
For the foreseeable future, the interest rate environment will remain uncertain for Annaly and other mortgage real estate investment funds.
Despite this, October saw inflation rates rise above 8%, so this week’s anticipated 75 basis point interest rate hike is unlikely to be the last. This means for Annaly that the pressure on her portfolio of mortgage assets and the net interest margin will continue to be high. This could result in an even larger discount to the book value of the shares.
Investors may want to avoid Annaly’s stock until they are certain of the central bank’s interest rate policy due to Annaly’s high yield of 19%, indicating very high risk.