Leveraged Fixed Income offers investors an attractive means to add portfolio diversification. These strategies allow investors to enhance return through borrowed funds and purchasing additional assets with investors seeking to profit from the spread between the asset and cost of borrowing. Depending on the asset, the spread exists due to various factors or combinations thereof. Assets with a risk of default have higher yields due to credit risk. An example of leverage credit fixed income investment is a Collateralized Loan Obligations. ("CLO") Mortgage REITs ("mREIT") , such as American Capital (NASDAQ:AGNC), Hatteras Financial (NYSE:HTS), Annaly (NYSE:NLY), and Two Harbors (NYSE:TWO) are another form of leveraged fixed income investments capturing the spread due to the prepayment risk or in the case of non-agency mortgages the credit risk.
These strategies can add significant value in optimizing an investor's portfolio. The leverage-induced returns add incremental portfolio return while the incremental risk or variance is tied to the spread and is often uncorrelated with other portfolio investments.
In evaluating the opportunity for entering into a leveraged investment investors will evaluate the return on equity (ROE) for that investment. For mREITs they will look at the option adjusted yield on their purchases. Think of this as the yield after deducting the cost of hedging the prepayment risk, frequently through swaptions. Then subtract the cost of funds, including interest rate swaps to mitigate interest rate risk. The result is the net interest spread applied to the leveraged portion of the portfolio. The ratio of leverage to equity is multiplied by the spread to obtain the leveraged net interest rate spread. The asset yield is added on the equity portion and the result is the estimated return on equity from the investment. mREITs will look at the estimated return on equity for marginal purchases and assess whether this is the best use of shareholder capital.
American Capital Agency (AGNC) discloses a similar metric showing the ROE from the existing portfolio. http://seekingalpha.com/article/2025881-american-capital-agency-portfolio-is-brilliantly-positioned (see figure below from AGNC Q4 investor presentation)
Why You Should Not Focus On Dividends
From a capital usage standpoint mREITs have three alternatives. Use available capital to purchase mortgages at the prevailing ROE, return that capital to shareholders as dividends, return the capital to shareholders through repurchases.
From the above investors can estimate the ROE from purchasing new mortgages. AGNC's last investor presentation provides some insight into the ROE on share repurchases. As an mREITs share price declines below book value investors are effectively purchasing the leveraged portfolio at a larger net interest spread than would be available deploying capital directly to mortgages. AGNC highlighted a recent example below estimating a 20% discount to book would ad anywhere from 35 to 55 bps to the spread. When accounting for leverage of 7.6x it would translate to an equivalent return on equity of 3.01% to 4.73% higher than outright mortgage purchases.
mREIT investors should note that both outright purchases and share repurchases are functions of the mortgage option adjusted spread to funding (most frequently LIBOR and referred to as Mortgage OAS spread) As the OAS spreads widen ROE becomes more lucrative and vice versa. Two Harbors recently presented the estimated ROEs and historical OAS spreads in a February presentation seen below.
The final alternative is to return cash to shareholders in the form of dividends. AGNC and other mREITs don't have full flexibility with regard to dividends as they must pay out a statutory minimum else lose significant tax efficiency. However they do have the option to exceed this amount.
From a mREIT shareholder point of view one should first look at the available ROE from both outright leveraged mortgage purchases and repurchasing shares comparing both to the theoretical hurdle rate. The hurdle rate being the theoretical required ROE for mREIT investors. What investors should note is that at times when the Mortgage OAS is sufficiently wide that either share repurchases or outright mortgage purchases exceed the hurdle rate dividends are an inefficient use of capital. Capital that otherwise could be deployed for an attractive rate of return otherwise being returned to shareholders. Whereas at times Mortgage OAS is narrow that the hurdle rate is not met dividends are the most efficient usage and the alternatives are providing a sub optimal return.
At the same time the Mortgage OAS has a significant impact on book value as widening spreads negatively impact book and narrowing spreads increase it.
This phenomenon provides savvy investors an opportunity. As spreads widen the book value will decrease and typically AGNC's dividend declines. Observing the recent market reaction yield focused investors dump the stock pressuring shares. This is exactly the time shareholders want more capital deployed elsewhere. If one were to ignore the tax impact, with attractive ROEs you may not want a dividend at all.
Disclosure: I am long TWO. 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.