These Mortgage REITs Are Poorly Hedged

Includes: AGNC, ARR, HTS, NLY
by: Illuminati Investments

mREITs are Real Estate Investment Trusts that invest in mortgage backed securities, using leverage to maximize profits from the spread between low short term borrowing costs and interest income from higher yielding long term mortgage backed securities. These are currently among the most polarizing stocks in the market today. Since REITs have to pay out 90% of their income, they are applauded by proponents for their hefty dividends in the current low interest rate environment, while skeptics warn of decreased profitability and a drop in book value if the yield curve tightens or interest rates rise.

Critics warn that mREITs' borrow short, lend long strategy makes them particularly vulnerable to increases in interest rates, since this would make their current holdings less valuable and lead to large drops in book value because of leverage. Many people argue that most of this effect can be hedged with Interest Rate Swaps or other derivatives, but obviously companies can never hedge out all risk without cutting into their profits, as illustrated in a table in the latest quarterly report of one of the largest and most well respected mREITs, Annaly Capital Management (NYSE:NLY), which outlines how their models predict the company would be affected by changes in interest rates, even including the effects of their hedging strategy:

Change in Interest Rate Projected Percentage Change in Economic Net Interest Income (1) Projected Percentage Change in Portfolio Value, with Effect of Interest Rate Swaps
-75 Basis Points 7.01% 0.96%
-50 Basis Points 4.78% 0.69%
-25 Basis Points 2.11% 0.39%
Base Interest Rate - -
+25 Basis Points (0.48%) (0.49%)
+50 Basis Points (2.05%) (1.07%)
+75 Basis Points (4.17%) (1.75%)
Click to enlarge
  (1) Economic net interest income includes interest expense on interest rate swaps.
Click to enlarge

As expected, NLY would be adversely affected by rising interest rates, with both Net Interest Income and Portfolio Value decreasing if rates go up. This change in Portfolio Value would also be amplified by the leverage they use, with each 1% drop in Portfolio Value corresponding to a 6.8% decrease in book value with Annaly's current 5.8 to 1 leverage. While investors may be able to live with this possibility if they think the Fed will continue to keep interest rates low, they should certainly be aware of the company's own warnings.

Another mREIT that is even more vulnerable to rising interest rates is Armour Residential REIT (NYSE:ARR), which has the following exposure to changes in interest rates:

Change in Interest Rates     Percentage Change in Projected Net Interest Income     Percentage Change in Projected Portfolio Value Including Derivatives  
  1.00 %     (18.67) %     (2.63) %
  0.50       (7.71)       (1.49)  
  (0.50)       5.70       (0.09)  
  (1.00)       (2.41)       0.12  
Click to enlarge

These large decreases in Projected Portfolio Value are exacerbated by their higher leverage, which currently sits at 9.2 to 1. When coupled with the drop in the equity portion of their portfolio, it would lead to a 27% decrease in book value if interest rates were to rise 1%. The company certainly does not appear to be adequately hedged against rising interest rates.

In contrast, there are several other mREITs, including American Capital Agency Corporation (NASDAQ:AGNC) and Hatteras Financial Corp (NYSE:HTS), that appear to have the opposite hedging problem. These companies share Annaly and Armour's exposure to rising interest rates but appear to be totally unprepared for any change in interest rates. Case in point is AGNC's own interest rate risk table from their latest 10Q:

  Percentage Change in Projected
Change in Interest Rate Net Interest Income (1)   Portfolio Value (2)   Net Asset Value (2) (3)
+100 Basis Points -16.5%   -1.1%   -10.7%
+50 Basis Points -8.6%   -0.4%   -4.0%
-50 Basis Points 0.2%   0.0%   0.4%
-100 Basis Points -7.6%   -0.4%   -4.0%
Click to enlarge

1. Includes the effect of periodic interest costs on our interest rate swaps that are not designated as hedges under U.S. GAAP, but excludes costs associated with our other supplemental hedges, such as swaptions and short U.S. Treasury or TBA positions.
Click to enlarge

2. Includes the effect of derivatives and other securities used for economic hedging purposes.
Click to enlarge

3. Calculated as the percentage change in projected portfolio value multiplied by a factor of our leverage as of March 31, 2012 of 8.4:1 plus one.
Click to enlarge

We again see that Net Interest Income, Portfolio Value, and Net Asset Value are all projected to decrease if rates rise, but shockingly we also see that they are all expected to drop if rates decrease as well! AGNC appears to possibly be "overhedged" to mitigate risk from rising interest rates, leaving them in peril from the endless assault on interest rates by the Federal Reserve. This should certainly be a bit worrisome to investors, who might rightly think they're better hedged against rising interest rates than Annaly or Armour, but only at the expense of exposing themselves to loses if rates move the other way as well, which sounds like a hedge only JP Morgan's London trading desk would love.

Hatteras Financial also shares this double-edged danger from changes in interest rates, with their models predicting the following:


Change in Interest rates


Percentage Change in Projected Net Interest Income


Percentage Change in Projected Portfolio Value

+ 1.00%

  (8.83%)   (0.84%)

+ 0.50%

  (3.54%)   (0.02%)

- 0.50%

  1.54%   (0.28%)

- 1.00%

  (5.76%)   (0.76%)
Click to enlarge

While it could be argued that all these companies appear to be exposing their investors to unneccessary risk by striving to be as profitable as possible in only the current interest rate environment by using excessive leverage, these two latter companies seem to compound this mistake with a misguided hedging strategy that seems to guarantee losses no matter what interest rates do. If you really need to reach for yield in this low interest rate environment, do so with a proven leader like Annaly while being well aware of the potential downside from rising interest rates, and avoid or potentially short some of the more leveraged and poorly hedged ones like ARR, AGNC and HTS.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.