New Residential Investment And The Macro Credit Cycle (NRZ) (2024)

Thesis and Background

With a 9.1% dividend yield, New Residential Investment Corp. (NRZ) appears attractive to many income-oriented investors, especially under a low-rate environment. However, you need to understand the macro credit cycles and the role of yield spread before investing in NRZ.

When the yield spreads expand or contract, it can signal changes in the underlying economy or financial markets. And the mREIT stocks are typically the ones that are the most sensitive to such changes. NRZ makes money on the spread between the long-term and short-term rates and this spread is narrowing. And it has enjoyed a thick spread (more than 1.5% at this peak) since the 2020 COVID recession because of the Fed’s hard landing (short-term rates reduced to zero as shown below). Now, with Fed’s hawkish tapering and anticipated interest rate raises, the spread has begun to narrow. And the narrowing is expected to exacerbate and further pressure NRZ’s profitability as you will see next.

The macro credit cycle

The yield spread between short-term debt instruments and long-term instruments is the most effective indicator of the credit cycle. When yield spreads expand or contract, it can signal changes in the underlying economy or financial markets.

The following chart shows the spread between the 10-Year Treasury Constant Maturity yield and the 2-Year Treasury Constant Maturity yield. Both underlying series are published by the U.S. Treasury Department. As you can see, most of the time, long-term bonds have higher yields than short-term bonds, resulting in a positive yield spread.

However, occasionally, the yield spread turns negative (resulting in a so-called Inverted Yield Curve). The exact mechanism of the inverted yield curve is debatable and can vary from situation to situation. Regardless of the underlying mechanism, the end result is that an inverted yield curve is a strong leading indicator of an impending recession. And we’ve just experienced the most recent incident in 2019 as you can see from the chart below. The yield curve started inverting in August 2019, and a recession followed shortly afterward in early 2020.

mREIT stocks like NRZ are typically the ones that are most sensitive to such yield spread changes, as we will see next.

NRZ profit and the macro credit cycle

NRZ makes its money on the spread between the long-term and short-term rates. The thicker the spread, the easier and the more money they can make, as you can clearly see from the following chart.

This chart overlays the yield spread we've just seen above together with NRZ’s dividend payments, which is used as a metric of its profitability. As you can see very clearly, when the yield spread is relatively thick (around 2.5% in 2014 and gradually narrowed), NRZ enjoyed stable and healthy profits. The dividends stayed around $0.5 per share almost all the time (and the corresponding dividend yield was on average 12% during this period of time). However, as the yield spread gradually narrowed, the pressure built upon the business. And when finally the yield spread turned negative in 2019, the profit went through a cliff, and the dividends were cut from $0.5 per share to $0.05 per share, a 10x decrease.

After the recession hit in early 2020, the Fed executed a hard landing move and reduced the short-term rates to essentially 0. (The Fed only has control over the short-term rates. It has no control over the long-term rates.) As a result, the yield curve gradually expanded to a very healthy and lucrative level for NRZ. It peaked at about 1.5% in early 2021.

Now with Fed’s hawkish tapering and anticipated interest rate raises, there are a couple of possible outcomes. Again, remember that the Fed only controls the short-term rates. The long-term rates can change in any fashion (stay put, rise more slowly, or rise more quickly than the short-term rates) and lead to either expanding or contracting yield spread.

Unfortunately for NRZ, the spread is taking the direction of contracting so far as seen. Since its peak of 1.5% in early 2021, it has contracted to the current level of 0.58%, a more than 92 basis points contracting. And according to Fed’s dot-plot, the short-term interest rates will gradually rise to 2.5% to 3% level in a few years. I expect the long-term rate to rise no more than that, i.e., to stabilize in the 2.5% to 3% in the long term also (long-term rates eventually cannot rise above inflation or GDP growth – otherwise, our government would have solvency issues). This means the narrowing is expected to continue and further pressure NRZ’s profitability.

This is why NRZ’s current 9%+ dividend yield, though mouth-watering in absolute terms, is far below the historical average (again, its historical average dividend yield has been about 12%). It is actually near a record low in a decade, precisely because of the governing dynamics of the credit cycles.

NRZ stock price and the macro credit cycle

Finally, you must also be wondering how the stock price responded to the credit cycle. Did the stock price appreciate over the past to make up for the dividend cuts? The answer is, unfortunately, no, as you can see from the following chart.

The stock price responded to the credit cycle pretty much in the same way as the profitability. As you can see, in the first macro cycle between 2014 and 2019, the stock price went through some mini-cycles, but over the macro-level, it stayed flat at $17.5.

This is again because the yield spread has stayed relatively thick during that time. It started around its thickest level of 2.5% in 2014 and only gradually narrowed since then. As the yield spread gradually narrowed, the pressure also gradually built upon the business. And when finally the yield spread turned negative in 2019, the price also went through a cliff and dropped from $17.5 to the $5 level. Many people might think such a drop was due to the COVID outbreak. However, I think the drop would have happened with or without COVID. COVID might just have exacerbated it. The fundamental driving force was the yield spread. And in hindsight, COVID might have helped to save many of the mREITs because COVID triggered the Fed’s hard landing and restored the yield spread to a profitable level for them.

Then during the credit expansion cycle from early 2020 to early 2021, the yield spread expanded from negative to a peak level of 1.5%. And the stock price rallied from $5 to $11, a more than 100% rally, in tandem.

Now looking forward, as the yield spread began to narrow again since early 2021 from the peak of 1.5%, the stock price has also been under pressure. Moreover, as mentioned above, I expect the yield spread to further narrow, which would keep pressuring the stock price, together with the dividends.

Conclusion and final thoughts

If you are looking for income, you may be attracted to a 9%+ dividend yield from NRZ – for very good reasons. The yield is very appealing given the current low-interest-rate environment; it beats even the higher end of inflation projection. However, you need to understand the macro credit cycles before investing in NRZ, or mREITs in general. Specifically,

• NRZ makes money on the spread between the long-term and short-term rates and this spread is narrowing. Unfortunately, the spread is taking the direction of contracting since its peak of 1.5% in early 2021. Moreover, according to Fed’s dot-plot, the short-term interest rate will gradually rise to 2.5% to 3% level in a few years. I expect the long-term rate to rise no more than that, i.e., to the 2.5% to 3% range too. Long-term rates eventually cannot rise above inflation or GDP growth – otherwise, our government would have solvency issues. This means the narrowing is expected to continue and further pressure NRZ’s profitability.
• This is why NRZ’s current 9%+ dividend yield, though mouth-watering in absolute terms, is far below the historical average. It is actually near a record low in a decade, precisely because of the governing dynamics of the credit cycles.
• At the same time, the stock price responded to the credit cycle pretty much in the same way as the profitability. Looking forward, I expect the narrowing yield spread to keep pressuring the stock price too.
• Nonetheless, NRZ is a safer play within the mREIT universe. Its recent Caliber acquisition will enhance the diversification of its income stream and help to hedge earnings in changing rate environments. Its profitability and acquisition are also achieved with stable leveraging, which is lower than the sector average.

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