Why 1 Analyst Just Downgraded Annaly Capital Management

On April 8, FBR & Co. analyst Daniel Altscher released a research report on agency mREIT Annaly Capital Management, Inc.

, "Stuck between a Large Rock and a Hard Place; Downgrading Annaly to Underperform." Essentially, the FBR thesis is that the only interest rate scenario that appears favorable for Annaly's portfolio is if interest rates stay the same. In fact, a rate change as little as 25 bps (basis points), could have a significant negative effect on NLY. In contrast, FBR maintains an Outperform rating on Two Harbors Investment Corp.

, noting that "positive momentum in TWO's value-add, platform-driven business that should drive valuation back above book…" Tale Of The Tape

Annaly has traded in a 52-week range of $10.00 to 11.03, and previously closed at $10.42 per share. FBR noted that Annaly's 2013 purchase of commercial real estate focused CreXus has not resulted in NLY being viewed as a "hybrid" mREIT, given the size of its agency residential portfolio. FBR & Co. - Annaly: Market Perform to Underperform, PT Lowered $12 to $10 The FBR $10 PT "represents an approximately 80% target multiple on [FBR's] estimated 1Q15 book value for Annaly of $12.78." FBR & Co. - Annaly: Deeper Dive Interest Rate Risks: This is the major reason that FBR describes Annaly as being "somewhat uninvestable, or at least a relative underperformer to other residential mREITs that are perceived to be less of an interest rate–driven bet."  If short-term rates move higher, FBR sees Annaly's earnings and dividend likely "disproportionately at risk."  If long-term rates begin to fall, or if the market believes they will, this will accelerate prepayments of existing mortgages, and narrow the spread for subsequent investment.  If long-term rates move higher, NLY shares could be under pressure due to decrease in book value. FBR - Annaly: Under-Hedged Relative To Peers FBR noted that Annaly only hedges 47 percent of its short-term financing costs, significantly lower than its agency mREIT peer group.

FBR - Annaly: Additional Hedge Protection Costs FBR acknowledges that at any point Annaly could increase its interest rate hedges, however that comes a price, depending upon which strategies NLY chose to pursue.

The good news is that many hedging strategies come at a lower cost than an unhedged 25 bps move, but it would still impact earnings negatively. FBR - Annaly: Accelerated Mortgage Prepayments Agency MBS (mortgage backed securities) currently trade at a premium, but when a bond is prepaid the mREIT only receives par, or face value.

Additionally, the investor no longer is receiving interest payments at the higher rate, and must reinvest in a lower interest rate environment. FBR - Annaly Bottom Line FBR estimates that "1Q15 book value for the agency mREIT group is down around 1.5% on average." However, FBR analysts calculate that "Annaly's book value is down 2.5%, underperforming the group as agency MBS has underperformed interest rate swap hedges during the quarter."