Should Retail Investors Hedge Their Mortgage REIT Positions?

Includes: AGNC, MTGE
by: Jack Rice

A mortgage REIT is rather unique. An mREIT's management is the investor's proxy in the active trading of the underlying mortgage-backed securities (MBS) assets. In the latest earnings call of American Capital Agency Corporation (NASDAQ:AGNC), management speaks of trading billions of dollars of securities in a single day. So, the retail investor might regard the mREIT as a hedge fund, in which good management, such as that of sector-leading AGNC or American Capital Mortgage Investment Corporation (NASDAQ:MTGE), is actively protecting the investor by protecting their portfolio.

Examples of the mREIT's protecting the investor's position are AGNC's and MTGE's utilization of "swaptions" to hedge against rate spikes and, more recently, "TBA dollar rolls" to profit from the Federal Reserve's Quantitative Easing (QE) program, which has the otherwise negative effect of narrowing mREIT spreads. How many individual investors have the sophistication and resources to effect these solutions, to profit in the current rate environment? When I asked my broker what a "tee-bee-ay dollar roll" is, he said it's something you order at a sushi bar.

A look at conventional hedging by the retail investor, through options, reveals how poorly puts and calls protect against pricing swings.

AGNC Option Chain from February 11, 2013
(Click to enlarge)

Data from February 11, 2013

When the investor reads of a particular put/call strategy for an mREIT, it should be noted that though attractive in theory, the trading support, hence liquidity, for the given option is usually not there, and the "slippage," the bid-ask spreads, are high. "Shorting against the box," is lower-cost, but shorting against a position has the inherent downside of freezing the price and the risk of wiping out the dividend.

This is not to say the retail investor should toss his or her AGNC stock in a box and forget it, as one might do with KO. But once management is scrutinized by the investor's due diligence, a major virtue of mREITs is their direct relation to the macroeconomy. Thus, a prognosis for the mREIT stock would closely follow the prognosis for the economy, particularly the housing market. If the investor believes the economy is slowly picking up, then he or she would expect to see rates rise, mREIT spreads widen and book values decline. This is precisely what happened in the case of AGNC and MTGE in 4th-quarter 2012. (The converse occurred in previous quarters, as rates fell.) And since spreads are the mREITs' bread and butter, the investor in an mREIT like AGNC or MTGE would regard this trend as positive and be gratified by management's agility in profiting through tough times.

It is evident that short-term QE is not good for mREIT spreads, but long-term QE is good for mREITs, because the economic recovery QE aims to promote will inevitably lead to rising rates and wider spreads. QE also has brought rate stability, which again is good for the mREIT sector, where the Goldilocks scenario is steady rates, or rather slowly rising rates, and a steepening yield curve. This stability should mitigate the sector swings which may tempt the retail investor to look for hedges. And despite talk of "QE Infinity," QE will end eventually, as confirmed by Federal Reserve governor Dennis Lockhart.

In summary, hedging by the retail investor of actively-managed mREITs, such as AGNC and MTGE, is redundant. Furthermore, taking into account individual mREIT management performance, as interest rates stabilize and with them mREIT share prices, the paltry benefits of hedging inherently low-beta and high-dividend mREIT positions will further erode.

Disclosure: I am long AGNC, MTGE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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