As highlighted in previous articles, we are generally still very bullish on agency mortgage REITs. Despite stagnant employment growth and a weak housing market, agency mREITs should continue to offer retirees (and other income investors) compelling risk-adjusted returns for the foreseeable future.
One agency mREIT in particular, American Capital Agency (AGNC), has really separated itself from the pack over the past few years and we believe that it should be a core holding in your retirement portfolio. This is not just a blind recommendation either...AGNC has been our largest mREIT holding for well over a year now.
We have written many articles highlighting AGNC as an investment opportunity and a common question that we often get from readers (through comments and emails) is "what makes AGNC different from other agency mREITs?" That said, we decided to write a series of articles that will help answer that question.
- In Part 1, we gave you a brief overview of the company and discussed how AGNC's management team has consistently created value for shareholders;
- In Part 2, we highlighted how AGNC's asset selection has lead to stable prepayment rates across their portfolio; and
- Part 3 (below) discusses the current interest rate environment and some of the strategies the company uses to manage/hedge interest rate risk.
The Yield Curve
There is a misconception about interest rate risk as it relates to the mortgage REIT space. Contrary to popular belief, higher interest rates are not necessarily a bad thing for mREITs. A mortgage REIT's principal business objective is to generate income for distribution to its stockholders from the interest rate spread (i.e., the spread between the interest income received on its mortgage-backed securities and the cost of borrowing to finance its acquisition of mortgage-backed securities). In other words, the slope of the yield curve is a primary factor that drives mREIT profits.
Even though interest rates are slightly lower than they were 3 months ago (i.e., the yield curve has shifted to the right), the current yield curve is still very steep, which is positive for mREITs.
Looking Ahead - 3 Scenarios to Consider
During the Q1 Earnings Call, CIO Gary Kain highlighted 3 potential economic scenarios that the company is focused on, including the impact of each on AGNC's mortgage portfolio.
1. Moderate Growth Continues / Inflation Remains Near FED Target
- Probability - most likely
- 10-Year Rate - moderate increase
- Yield Curve - steepens
- QE3? - unlikely
- Prepayment Rate Impact - organic prepays decrease; HARP 2.0 speeds could increase
- Expected Agency MBS Impact - prices decline modestly; spreads perform reasonably well
- Potential Implications for AGNC - returns on existing portfolio improve; steeper yield curve leads to wider spreads
2. Economy Weakens / Inflation Below FED Target
- Probability - medium
- 10-Year Rate - flat to lower
- Yield Curve - flattens
- QE3? - likely
- Prepayment Rate Impact - materially accelerate
- Expected Agency MBS Impact - prices increase
- Potential Implications for AGNC - prepayment protection will be critical to returns; new purchases will be less attractive; book value will increase in response to QE3
3. Economy Rebounds Strongly / Inflation Increases Significantly
- Probability - low
- 10-Year Rate - large rapid increase
- Yield Curve - steepens
- QE3? - none
- Prepayment Rate Impact - slow significantly
- Expected Agency MBS Impact - prices fall; extention risk increases; spreads widen
- Potential Implications for AGNC - effective hedges critical to performance; new purchase very attractive; book value likely decreases
As an investor, it is great to hear the management team address the "elephant in the room" directly. Clearly a few of these scenarios are not ideal for AGNC, but the company believes in its ability to change directions based on evolving market conditions. Gary Kain concluded the earnings call with the following statement:
We feel our portfolio is well positioned to produce attractive returns over a range of market outcomes. We also hope that by summarizing our thought process in this manner, it helps give investors some transparency into management's approach to the current environment. But remember, as our performance over the past few years has demonstrated, against the backdrop of a QE1, QE2, operation twist, the GSE buyouts, the delinquent loans, multiple HARP program enhancements and several European debt flare ups, just to mention a few of the things that have gone on, it is going to be the ability to change direction based on evolving marketing conditions and then to implement appropriate strategies around asset selection and hedging that's going to be the real driver of market-leading performance.
The Other Elephant in the Room - Leverage
As part of its investment strategy, AGNC borrows against its investment portfolio using repurchase agreements. Borrowings generally have maturities that range from 30 to 90 days, but may have maturities up to 364 days. The company expect its leverage will range between 5.0x and 10.0x stockholder's equity.
While AGNC's current leverage of 8.4x is slightly higher than recent history (see chart below), it is consistent with its long-term investment strategy.
Mr. Kain also addressed the company's current leverage policy during the recent call:
With respect to leverage, our bias in Q1 was toward increasing leverage as mortgage valuations were attractive and we didn't want to be underinvested. However, as the prices in mortgages have appreciated significantly over the last few months, we now believe a more moderate stance toward leverage is warranted. But we are still currently biased against running at leverage levels below, say, 7 times as the risk of having to compete with the Fed in a QE3 scenario for overpriced mortgages is just too great. Moreover, we do not expect to be able to buy mortgages cheaper, net of hedges of course, in the base case moderate growth scenario.
As the company has stated, future leverage levels or strategies can change quickly and will primarily be a function of perceived risk/return tradeoffs, liquidity considerations and changes in the market value of AGNC's equity.
Interest Rate Hedging Policy
The company's primary objective with interest rate hedges is not to eliminate risk or to lock in a particular net interest margin, but to maintain its book value within reasonable bands under a wide range of interest rate scenarios.
As of 3/31/12, AGNC had interest rate swaps in place for $38 billion of notional principal, which covers 55% of repo and other debt balances. In addition, the company took advantage of lower option prices to buy a material amount of protection against the risk of a large spike in interest rates (like in scenario 3 above). The swaption portfolio is designed to increase in value in response to rapid increases in rates, providing a partial offset against a decline in asset values.
We believe that agency mREITs will continue to offer investors compelling risk-adjusted returns for at least the next 18-24 months (we also believe that the moderate growth scenario discussed above is the most likely case). AGNC is our largest mREIT holding based on the reasoning that we provided in this three-part series. That said, investors should consider buying a basket of agency mREITs to help mitigate the portfolio biases of specific managers. We also own Annaly Capital Management (NLY) and Hatteras Financial Corp. (HTS).