Annaly Capital Management, Inc. (NLY-PF) is a leading diversified capital manager with investment strategies across mortgage finance. The company's principal business objective is to generate net income for distribution to its stockholders and optimize its returns through prudent management of its diversified investment strategies.

Business Overview

Annaly operates in three primary business segments: the Agency Group, the Residential Credit Group, and the Mortgage Servicing Rights (MSR) Group. The Agency Group invests in Agency mortgage-backed securities (MBS) and complementary investments within the Agency market. The Residential Credit Group invests primarily in non-Agency residential whole loans and securitized products within the residential and commercial markets. The MSR Group invests in mortgage servicing rights, which provide the right to service residential mortgage loans in exchange for a portion of the interest payments made on the loans.

Financials

For the full year 2023, Annaly reported annual net income of -$1,643,171,000, annual revenue of -$1,651,591,000, annual operating cash flow of $2,367,203,000, and annual free cash flow of $1,970,397,000. In the second quarter of 2024, the company generated a 0.9% economic return, including a $0.65 dividend. This brings the year-to-date economic return to 5.7%, including $1.30 in dividends declared.

Earnings available for distribution (EAD) increased in the second quarter by $0.04 per share to $0.68. Higher coupon income related to the continued rotation up in coupon on the agency portfolio and $2.8 billion in assets settled via the Onslow Bay Correspondent Channel contributed to the increase in EAD. Consequently, Annaly's average asset yield, excluding premium amortization adjustment (PAA), increased 27 basis points from the first quarter to 5.14% in Q2. Higher coupon income was partially offset by an increase of 12 basis points in the company's economic cost of funds. Taken together, Annaly's net interest spread, excluding PAA, increased by 15 basis points, reaching 1.24% in the second quarter. Net interest margin, excluding PAA, also rose 15 basis points quarter-over-quarter to 1.58%.

Agency Segment Performance

In the Agency segment, Annaly actively managed the portfolio during the quarter as current coupon nominal spreads widened by roughly 10 basis points, driven predominantly by elevated rate volatility. The company tactically reduced its agency holdings early in the quarter as it navigated higher rates and wider spreads, and then gradually added that exposure back over the remainder of the quarter as its outlook and relative value considerations improved, growing the agency portfolio by approximately $1.6 billion notional.

Annaly continued to rotate up in coupon to take advantage of wider spreads offered by production coupons, increasing its holdings of 5.5% and higher by $4 billion. Year-to-date, the average net coupon on the agency portfolio has increased by 30 basis points to 4.87%. Consistent with prior quarters, the company favored high-quality prepayment-protected collateral with durable cash flows.

Residential Credit Segment Performance

Annaly's Residential Credit portfolio ended the quarter at $5.9 billion in economic market value and $2.2 billion in equity, representing 20% of the firm's capital. The modest decline in the resi portfolio was driven by the sale of third-party securities to take advantage of relatively tight credit spreads while increasing exposure to agency MBS.

Residential credit assets were largely range-bound throughout the quarter, with investment-grade non-QM securities trading in a 10-basis point range and the CRT market tightening 10 to 20 basis points. The fundamentals of the residential credit market remain constructive, although the company is closely monitoring the increasing regional disparities in housing and the strength of the consumer given softening labor markets. Mortgage delinquencies, however, remain in near-record low levels.

Annaly's Onslow Bay correspondent channel experienced record growth in Q2 as the company locked $4.1 billion of expanded prime loans and settled $2.8 billion, representing a 22% increase quarter-over-quarter. Year-to-date, Onslow Bay has locked and settled more loans than the entirety of 2023. The current pipeline continues to exhibit strong credit characteristics, including a 754 average FICO and a 68% CLTV.

Mortgage Servicing Rights (MSR) Segment Performance

Annaly's MSR portfolio ended the second quarter with $2.8 billion in market value and $2.5 billion of equity, representing 22% of the firm's capital. The portfolio increased $135 million quarter-over-quarter, driven by purchases, settlements, and a modest increase in value due to the 20-basis point increase in mortgage rates.

The fundamental performance of the MSR portfolio continues to outperform expectations, as prepayment speeds remain muted despite peak seasonals and serious delinquencies are inside of 40 basis points. Increased competitiveness surrounding deposits is driving elevated float income, leading to prospective hedge returns remaining in the 12% to 14% range.

While transactional activity slowed in Q2, the portfolio is nearly 30% higher year-over-year, as Annaly remains firmly entrenched as a Top 10 non-bank holder of servicing rights. The company has focused on enhancing its flow and recapture capabilities to acquire newly originated MSR from its network of partners, as the record amount of bulk offerings over the last two years appears to be normalizing.

Liquidity

Annaly's unencumbered assets increased to $5.4 billion in the second quarter, including cash and unencumbered agency MBS of $3.5 billion. The company also had approximately $900 million in fair value of MSR pledged to committed warehouse facilities, which remained undrawn and can be quickly converted to cash subject to contractual advance rates. Together, Annaly had approximately $6.3 billion in assets available for financing, up $45 million compared to the previous quarter.

As of June 30, 2024, the company had $4.2 billion of MSR and home loan warehouse capacity at a 39% utilization rate, leaving substantial availability. Annaly's weighted average repo days declined seven days compared to Q1, standing at 36 days for the second quarter, as the company continued executing its repo strategy.

Outlook

Annaly is encouraged by the return potential across each of its three investment strategies and is optimistic as the market prepares to enter a more accommodative phase in monetary policy. This should steepen the yield curve, reduce volatility, and ultimately lead to agency outperformance, in the company's view.

While Annaly expects to continue to grow its residential credit and MSR businesses opportunistically, the company feels its current capital allocation and portfolio construction is positioned to generate sustainable returns in an environment that should be favorable to fixed-income investors.

Risks and Challenges

Risks to Annaly's business include interest rate risk, credit risk, counterparty risk, operational risk, and compliance, regulatory, and legal risk. The company actively manages these risks through its comprehensive risk management framework and governance structure.

Conclusion

Annaly Capital Management, Inc. (NLY-PF) is a leading diversified capital manager navigating the shifting market dynamics with its three-pronged investment strategy. The company's performance in the second quarter of 2024, marked by strong earnings, portfolio growth, and prudent capital management, positions it well to capitalize on the anticipated more accommodative monetary policy environment. With a focus on risk management and a diversified business model, Annaly appears poised to continue generating sustainable returns for its shareholders.