Over the past couple of months, I have received a few requests to write a more basic mREIT article detailing risk concepts and definitions in simpler terms. This also brought up the point that much of the mREIT concepts on SA that are simple are oversimplified and based on heuristics or rules of thumb. As another SA member Dividends#1 describes, this creates a lot of myths around what really impacts mREIT risk and return as well as the value that these investment vehicles offer.
In this article, I attempt to provide a basic explanation of what mREITs do and how they manage risk without overly simplifying concepts, and then discuss some of the commonly cited mREIT Myths to determine their validity. For the purpose of this article, the mREIT concepts discussed will relate to the larger fixed-rate Agency mREITs such as American Capital Agency (NASDAQ:AGNC) and Annaly Capital Management (NYSE:NLY).
Note: The section on mREIT myths is at the end of the article. The following section is meant to provide a basic background of concepts and terms to aid in the discussion of each myth.
What is a Mortgage REIT?
A Mortgage REIT is an investment vehicle that is primarily made up of agency mortgage-backed securities ("MBS") that are funded using repurchase agreements ("repo") and equity, and hedged with a derivatives overlay. The amount of repo funding exceeds equity funding several times over to result in leverage ratios ranging from 5x to over 10x. As such, mREITs are essentially portfolios of levered Agency MBS and derivatives. Below, I discussed the key components of a mREIT portfolio, followed by a discussion of the combined portfolio.
Agency Mortgage-Back Securities ("MBS")
Agency MBS are created as mortgage originators sell loans into securities guaranteed by FNMA, FHLMC or GNMA or collectively referred to as government sponsored entities or ("GSEs"). These securities pay cash flow from the underlying mortgages less fees paid to the mortgage servicer and the GSEs, which are deducted from the loan's interest payment. The benefit of having those fees paid out is that Agency MBS are guaranteed by the GSEs and has very little credit risk exposure. For example in the event of a default, an investor will receive the entire MBS principal. As a result, Agency MBS is extremely liquid and has tremendous market depth.
The mechanics of MBS are very similar to residential loans. MBS scheduled principal and interest is typically paid over 15, 20, 30 or 40 years and provides the underlying borrows the option to prepay their loan at any time. On average, the weighted average life of a newly originated 30-year MBS is expected to be around 7-10 years due to principal payments and expected prepayments. Seasoned MBS, shorter tenor MBS such as 15-year or 20-year, or MBS with high expected prepayments will have shorter expected lives. As such, MBS are typically compared to bonds with tenors ranging from 2 to 10 years.
The economics of MBS is such that they are priced to yield a rate that is equal to similar tenor treasury rate plus an additional spread. The additional spread is to compensate the investor for the added risk that prepayments add to the bond as well as the general supply and demand of MBS. The prepayment risk is often referred to prepayment option risk as borrowers own the option and tend to refinance when interest rates are low. If the additional spread or MBS nominal spread increases due to higher prepayment option risk or for supply/demand reasons, the MBS value could decline despite no change in treasury yields. This is often referred to as basis or spread risk.
|Treasury Yield (Similar Tenor)||+||MBS Nominal Spread||=||MBS Yield|
The main takeaway is that the duration of MBS varies across bonds and as prepayments change. The MBS typically held by mREITs will have durations that range from 2 to 10 years. As a result, MBS can be characterized as medium to long term bonds with prepayment option risk and basis risk.
Repurchase Agreements ("Repo")
Repo agreements are collateralized short-term funding agreements, which comprise the majority of mREIT liabilities. A mREIT will pledge their MBS or other high quality securities as collateral against the repurchase agreement to ensure the lender is made whole in the event that the mREIT defaults on the agreement. As a result, mREITs are able to borrow at attractive rates from multiple counter parties. The tenor of these agreements can range from several days to several years. However, the most concentrated tenors are agreements that are less than 6 months in tenor. As a result, repo can be characterized as very short term funding.
mREITs use derivatives for two purposes, to offset risk or in some cases to enhance income at the cost of higher risk. The types of derivatives used include interest rate swaps, swaptions, TBAs and Treasury futures. A definition of each and their uses are described below.
|Pay-Fixed Interest Rate Swap||A pay-fixed swap derivative requires the holder to pay a fixed rate of interest, while receiving a floating rate of interest over a specified tenor.||This "swaps" repo funding from short-term to long-term to match the duration of their MBS.|
|Pay-Fixed Interest Rate Swaption||A pay-fixed swaption derivative allows the holder the option to enter into a swap at a pre-defined rate at a future date.||Provides the ability to swap repo funding from short-term to longer-term in the event that prepayments slow and MBS duration/life increases.|
|TBA Contracts (Long)||Being long a TBA contract allows the holder to purchase "to be announced" securities at a future date at set price. "To be announced" securities are MBS that are expected to be created at a future date.||Economically, long TBA positions behave like an MBS position funded with repo and mREITs use this to increase income and incremental risk.|
|TBA Contracts (Short)||Being short a TBA contract allows the holder to sell "to be announced" securities at a future date at set price. "To be announced" securities are MBS that are expected to be created at a future date.||Economically, short TBA positions behave like selling MBS position and investing in repo and mREITs use this to synthetically reduce MBS exposure without selling securities, which reduces income.|
|Treasury Futures||Similar to TBAs, Treasury futures are contracts to either purchase or sell treasury bonds for a fixed price at a future date.||mREITs use Treasury futures to mitigate the value change in MBS due to moves in the treasury yield curve. This makes up a small portion of their balance sheet.|
Portfolio View of mREIT Risk
When combining all of the moving parts of an mREIT, the mechanics become much more complex as there are many offsetting risks. As we discussed, MBS are very similar to moderate to long duration bonds of let's say roughly 3 to 10 years with prepayment option and basis risk. When MBS is levered and only funded by repo and equity, this creates:
1) Risk to higher interest rates both long and short.
a. If long rates increase, MBS values decline until their yields match market yields.
b. If short rates increase, repo costs rise while MBS yields remain unchanged to result in a compressed spread.
2) Risk to changes in prepayments.
a. If prepayments slow as interest rates rise, MBS investors will be stuck with lower yielding assets for longer periods of time.
3) Risk to wider MBS nominal spreads.
a. If MBS nominal spreads widen, MBS values will decrease such that the asset yields a market rate and spread.
As we can see the risk of a levered MBS position is significant. However, the reality is that hedges offset a significant portion of these risks. The use of interest rate swaps effectively converts short-term funding to long-term fixed funding. The use of swaptions provides mREITs the "option" to swap funding even longer if our MBS extends in term due to lower prepayments. The use of TBAs provides mREITs the ability to quickly add or reduce MBS exposure without actively buying or selling. The use of Treasury futures is similar to TBAs in that they add or reduce certain valuation risks without actively buying or selling securities. So, below we can see how the risks of a levered MBS position changes with hedges.
1) Lower risk to higher interest rates both long and short.
a. If long rates increase, MBS values decline until their yields match market yields, but interest rate swaps increase in value to offset loss.
b. If short rates increase, repo costs rise, but are offset by interest rate swaps that receive a floating rate and pay a fixed rate. Cost of funds will remain fairly matched against the MBS to provide a more stable margin.
2) Lower risk to changes in prepayments.
a. If prepayments slow as interest rates rise, MBS investors will be stuck with lower yielding assets for longer periods of time. However, swaptions can be executed to lock in funding for a longer period of time to preserve interest spread.
3) Unchanged risk to wider MBS nominal spreads.
a. If MBS nominal spreads widen, MBS values will decrease such that the asset yields a market rate and spread. This risk is still high as there is no economically efficient hedge currently accessible by the larger mREITs.
Based on the above, we can see that a large amount of risk from the levered MBS position are offset and reduced by hedges, while other risks such as the spread widening are unchanged. The notion of hedging and dynamically changing risk exposure is also important as a risk that was unhedged and resulted in losses last year may no longer be a risk today if the risk exposure is now hedged. This results in mREIT risk exposures being complex and multi-faceted as well as being dynamic and constantly changing.
This finally brings us to mREIT return and yield. The main point of to know on mREIT yield is that it is a function of the risk that an mREIT takes on. The reason for this is that mREIT balance sheets are for the most part marked-to-market to a price that yields the market rate of return on their respective asset, liabilities and hedges. For example if interest rates increase by 10bps, MBS values will be marked down such that the bond now yields roughly an additional 10bps, now apply this to the entire balance sheet. This is a simplified explanation, but essentially the mark-to-market treatment indicates that a mREITs balance sheet is always yielding a market rate. As a result, if one mREIT is producing a higher yield as a percent of book value than another that indicates that the higher yielding mREIT is taking more risk in one or more areas. This is one of the primary reasons for such a high focus on book value and less focus on purely net interest spread or the dividend.
Conclusion of mREIT Risk Basics
The discussion above basically explains that mREITs are complex investment vehicles made up of MBS, repo and hedges whose risk and return are dynamic and change with balance sheet and hedge composition. As a result, investors need to understand the changes in mREIT balance sheets and risk exposure, instead of extrapolating past book value declines and focusing on the level of dividends. By examining the details, investors will notice that some of the commonly referred to risks are not real risks and rather the real risks are not commonly discussed. As a start, below are common myths that occur in discussions on mREITs.
The second part of this article discusses some commonly mentioned myths about mREITs as they oversimplify the true drivers of risk and return. I believe that the commonly repeated myths create misinformation and are the result of the complexity of mREITS, in which investors attempt to simplify the complexity through the use of heuristics and rules of thumb. My personal opinion is that the use of heuristics and rules of thumb prevent investors from understanding the true value, risk and return of mREITs and when combined with the high concentration of retail investors create mispricing. For more informed investors that embrace the complexity of mREITs this mispricing may result in attractive investment opportunities.
Myth #1 - "mREITs purely borrow short and invest long"
Other variations include:
"mREITs are a levered bet on the yield curve" or "mREITs cannot survive when the short end rises"
False - As discussed in the section above, mREITs utilize interest rate swaps to effectively convert their short borrowings into longer-term borrowing that match the term of their investments. In effect, mREIT economic borrowing and investing are well matched are the yield curve and the "bet" is usually very minimal. Additionally, a rise in short rates will be mitigated by the floating payments receive via interest rate swaps.
Myth #2 - "You cannot trust mREIT hedges"
Other variations include:
"mREIT hedges don't work", "mREIT managers failed at hedging"
False - Undoubtedly hedges do work, which make the statements above false. Banks, mortgage originators/servicers and money managers all hedge with relatively high success, so it seems unreasonable that mREITs fail in this category. The doubt or distrust in hedges seems to stem from the idea that hedging should prevent all declines in value. Rather hedging is about offsetting undesired risks, while keeping desired exposures to generate return. If all value declines were offset one would earn the risk-free rate. I believe certain mREITs such as AGNC to be very transparent in their risk management strategy and as a result I believe it is the responsibility of the investor to understand the risks that are being hedged and get comfortable with the risks that are unhedged rather than attribute hedging to a black box that may or may not work.
Myth #3 - "Hedging becomes too expensive as interest rates rise"
Other variations include:
"mREITs will face higher hedge cost in the future", "The more rates move against you, the more expensive it becomes to hedge"
False - When rates rise, the market value of MBS declines to return the higher market yield. As a result, when matching MBS against a new interest rate swap at higher rate levels, the higher MBS yield will offset the increase in the pay rate on the interest rate swap. So, what this comes back down to is investors are better off focusing on changes in the value of mREIT assets, liabilities and hedges rather than speculate on high hedge costs that will be offset by higher yields in rising rate environments. In other words, the focus is again back on book value and the preservation of book value while generating yield.
Myth #4 - "Higher 10-year rates are the biggest risk to mREITs"
Other variations include:
"mREIT values move with the 10-year treasury", "Recent book value declines were due to increases in treasury rates"
False - It is true that treasury rates are one driver of mREIT value, but there are more dominant factors that could impact book value and have impacted book value in the past quarters. Two of the other factors are swap rates and mortgage rates, which are the main drivers of pricing hedges and MBS. Oddly enough treasury rates do not directly price any of a mREIT's major positions. The impact of MBS yields increasing higher than the increase in swap and treasury rates was very pronounced in the first half of this year and contributed to much of the book value declines, which some seem to mistakenly attribute to higher treasury rates. The divergence in MBS yields and swap/treasury rates is often referred to as spread or basis widening.
Myth #5 - "Investing in mREITs is like gambling on interest rates"
True/False - I opted to say that there is some truth to this if one is purchasing a mREIT without a basic understanding of the risk and return. However, this is much like any other stock in which some type of risk premia is being generated in exchange for a risk that the investor faces. In the equity markets, price risk is taken on by investors in exchange for an equity risk premium, which historically has generated excess returns. In the case of mREITs, the risk faced is interest rate risk in exchange for less well known risk premiums, which also historically has generated excess returns. So, in my opinion as long as you understand the risks you are taking on, investing in mREITs is not like gambling on interest rate risk.