Annaly Series F Preferred: I Backed Up The Truck Today (NYSE:NLY.PF)

On September 30, the Annaly Capital Cumulative Fixed-to-Floating Rate Preferred Series F (NYSE:NLY.PF) converts to 3-month LIBOR plus 4.99 percentage points. That will be a 23% dividend increase with current LIBOR at 3.6%. Even higher after the Fed raises rate again.

Yet the NLY.PF traded below $22.50 today against its par value of $25 per share. That’s 10% call protection to the upside if Annaly replaces this issue any time after September 30.

It would appear Annaly is in really big trouble based on these values. Is that true or is the market throwing money at us?

Under The Hood

First, let’s look at the Annaly mortgage portfolio. Is that about to hit trouble? If by trouble we mean interest rates will continue to climb through at least Q1 2023, then there’s trouble. That trouble is not fatal, though. Annaly managers have been here before, probably know how to play the interest rate cycle and will likely bring the portfolio through this downturn, too. Remember, Annaly is one of the MREITs that survived 2008.

If you want a deeper dive, I strongly recommend Scott Kennedy’s most recent analysis of Annaly’s book value a couple of weeks ago. He found Annaly has pulled in its horns for the recession ahead – that’s very good news for the preferred stocks.

Of its current $59BN assets, Annaly has $55BN in quasi-US government-guaranteed loans. While default risk is low in general, this portfolio will be in very good shape over the coming recession.

Next, will there be income to pay the preferred stock? This is the beautiful part because Distributable Income is rising. That rise comes from two sources: (1) Annaly purchased a mortgage servicer which produces lots of cash when mortgages are not being prepaid in droves, and (2) widening spreads between borrowing and lending costs.

All that income cannot fully offset capital losses while rates are rising, but it creates income Annaly has to distribute or lose its REIT tax status. So even as the common stock is sinking due to shrinking asset values, the preferred dividends for all classes after interest obligations are covered more than 50 times by TTM Distributable income!

That sounds a lot better than junk credit at the preferred level, but what about equity coverage? We calculate more than 6 times common equity supporting the preferreds which feels pretty cushy.

Speaking of junk, general high-yield credit spreads are about 5% today. That’s equal to NLY.PF’s floating rate margin; but show me a junk credit covered 50 times by cash flow because I’ve never found one.

I think the answer is maybe that the market considers the common equity as worse than CCC risk, which has a 12%+ credit spread today. If that’s true, how could the preferred trade like good high-yield credit?

When investors fail to consider the Distributable Income effect on preferred dividend payments, they miss the whole deal, in my opinion.

To me, this is just crazy. So crazy, I doubled my position today. NLY.PF represents about 15% of my portfolio at an average $22.90. From here, I expect the NLY.PF to tether over the coming months close to $25 per share, where I can sell when I see the next good move.