Why Nomura Likes Annaly & American Capital Agency Right Now

Interest rate concerns appear to be overblown and already baked into the share prices for these two residential agency mREITs.

On August 12, Nomura analyst Brock Vandervliet published a research report upgrading both Annaly Capital Management, Inc. (NYSE: NLY) and American Capital Agency Corp. Real Estate Trust (NYSE: AGNC) from Neutral to Buy.

Vandervliet also increased his target price by $2.00 for both NLY and AGNC, resulting in projected total returns of 32 percent and 31 percent, respectively.

He noted that both of these agency mortgage REITs currently have low levels of leverage, and therefore are well positioned to take advantage of the next interest rate cycle.

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Interest Rates - Damage Done & Forecast

Nomura foresees a slow and steady approach by the Fed moving forward, with gradual rate increases over time.

During 2Q15 the 10-yr Treasury yield rose from 1.92 to 2.35 percent, the largest move during the past two years.

As a result, for agency REITs under coverage by Nomura, "…book values fell 5% while stocks fell 12% in Q2."

More Favorable Rate Environment

Nomura's U.S. Economics & Strategy Team sees a slower cycle moving forward, which "…provides the companies more time to reposition their portfolios, reducing the potential for material book value decline."

Additionally, because of this slow movement, Nomura expects "…the yield curve (2yr versus 10yr UST yields) to pancake or flatten out dramatically from present levels over the next six to 12 months."

This interest rate spread should allow the mREITs to generate improved earnings as they leverage up their balance sheets, according Vandervliet.

In fact, the report pointed out that slightly higher interest rates combined with very gradual increases expected during the coming cycle, will actually serve to help these REITs.

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Share Repurchases

During Q2 AGNC repurchased 4 million shares, ~1 percent of outstanding shares, and the report noted that AGNC "…has a further $900mn in dry powder equivalent to 13% of outstanding shares."

On August 5, NLY authorized a $1 billion share repurchase, equivalent to 11 percent of its outstanding shares. Notably, incoming CEO Kevin Keyes also bought 300,000 shares at $10.08 per share, according to an SEC filing last week.

Nomura "…believe[s] buyback materially improves the risk-reward of holding the shares and puts these management teams on the same side of the table as investors."

Nomura - New Price Targets

The new Nomura price targets reflect an expectation that both AGNC and NLY will be trading at 100 percent of estimated book value in 2016.

American Capital Agency - target price was increased from $21 to $23 per share.

Annaly Capital Management - target price is increased from $10 to $12 per share.

Nomura's report pointed out the agency REITs under coverage were currently trading at 75 percent to 85 percent of book value per share.

Investor Takeaway

It has been a brutal few years for long-term investors of these two agency mREITs, as shown in the chart below.

Vandervliet believes that the timing is now right for investors to jump in and take advantage of what he believes to be the bottoming in price-to-book multiples; with investor total returns augmented by the high dividend yields.

This belief is reinforced by the recent company share repurchase announcements, and insider buying at these price levels.