Call Risk Ruins This Annaly Capital Management Preferred Share (NYSE:NLY.PR.I)

We cover many mortgage REITs, and among them is Annaly Capital Management (NLY). The common stock carries a material amount of risk and spends a lot of time outside of our buy range. That being said, mortgage REITs should be considered trading securities. We believe that investors generally should not use mortgage REIT common shares as buy-and-hold investments. Occasionally, a thesis can take a long time to play out, but it still comes down to when to enter and exit an mREIT common stock.

We cover NLY’s earnings every quarter at The REIT Forum. With Annaly Capital being one of the “less risky” mortgage REITs, we view their preferred shares as carrying minimal risk. If an investor did want to buy-and-hold within the mortgage REIT sector, then they should be looking at the preferred shares. Keep in mind that just because preferred shares carry minimal risk, it doesn’t mean that they can’t have significant risk. To show how a preferred share can carry a material amount of call risk, we will be looking at NLY’s preferred share NLY-I (NYSE:NLY.PR.I).

In most cases, preferred shares will oscillate around $25. There are scenarios where this won’t be the case. For instance, if a preferred share were to carry a significant amount of credit risk, you may find them trading well below $25. Since NLY preferred shares carry minimal risk (vs. most of the sector), they will generally trade around $25. This is because companies can call the preferred share with a 30-day notice for the issuance price of $25. You wouldn’t want to pay $35 for something that the company can then take back from you for $25. Additionally, depending on the dividend rate, shares may trade above or below their call value.

NLY-I is currently trading over $25:

As you can see, the recent price is $25.87. This is where the risk comes into play. If you were to purchase shares today, the company could then call them back for $25. That would leave you with less than you paid for them even after accounting for dividend accrual. The call value of a share tends to put a soft ceiling on the price. Still, the price here has gone materially over the call value. If you were to purchase shares today and NLY called them immediately, the annualized yield-to-call would be negative 28.6%. On a per share basis, you’d be losing about $0.71 per share of NLY-I:

Because of the material loss investors would have on an immediate call, we believe investors should wait on the sidelines to invest in NLY preferred shares. Annaly Capital could issue a preferred share at a lower rate and then call one, or all, of their preferred shares. Probably not NLY-G (NLY.PR.G) though. NLY-G has a low spread and I don’t see why they would ever call it.

Sometimes (especially now), the biggest risk to preferred shares is the call risk. This can be completely avoided by purchasing shares that don’t have a negative call value. Sometimes, especially in a tax advantaged account, it’s worth trading in and out of preferred shares as they oscillate around their call value. Since investors stand to lose $0.71 per share at recent prices, it’s worth selling out of NLY-I and reallocating cash. Investors can always buy back into NLY-I if the “worst cash to call” rises to near zero.

My rating for NLY-I is currently neutral because bearish ratings on preferred shares are usually terrible. I don’t like the risk/reward profile here, but the biggest concern is a potential loss of less than 3%. Using a bearish rating, even if the shares were called immediately with a 3% loss, would dilute the effectiveness of our ratings.

The risk of losing on these shares happens if the company calls shares. If they wait for a while to call, the investor could still have a positive investment even though they would’ve been better off investing in short-term Treasuries. It would be highly unusual for me to have a sell rating on a preferred share.

Final Thoughts

While Annaly Capital Management remains one of the “less risky” mortgage REITs, the recent price of its preferred share carries significant risks for investors. The potential for an immediate call creates a scenario where investors are out $0.71 per share after accounting for dividend accrual. Consequently, we recommend staying on the sidelines and waiting for a better entry point. Investors should exercise caution when considering NLY-I at current prices, as the call risk is substantial.

We covered NLY common shares recently in 15% Yields Want to Mug Your Dividends. I don’t see a reason to reiterate the rating, especially since shares have been declining.

Thanks for reading and have a great weekend.

PS. Prices change. It took a little bit to get this uploaded, so there’s a bit more accrual (and a slightly lower price). But the worst-cash-to-call is still too negative for me to stomach.

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