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Mortgage REITs: So That's How They Hedge Interest Rate Risk

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Includes: AAT, ACC, AGNC, AMH, AMT, BPR, BXMT, BXP, CCI, CORR, CUBE, CXW, DLR, DRE, EDR-OLD, HTA, KIM, MNR, NLY, O, QTS, REG, SLG, SNR, SPG, SRC, SVC, UMH, UNIT, WY
by: Arturo Neto, CFA
Arturo Neto, CFA
Registered investment advisor, REITs, dividend growth investing, portfolio strategy
Summary

Invest in what you know. Very simple advice from Warren Buffett.

The allure of high potential returns can sometimes make us invest in companies we aren't quite familiar how they make money or what the risks are.

This basic review of interest rate hedging sheds some light on how mREITs work, including the high level of complexity involved.

It was a good review for me - I hope it's helpful for investors interested in mREITs.

Let me first preface this article by reminding readers of Warren Buffett’s mantra to

Invest in what you know

That doesn’t mean you have to be able to run a company or replicate the intricate details of its operating strategy – but you should have at least a basic understanding of how a business works.

Mortgage REITs are one of those types of companies that seem to be quite simple on the surface but the operational implementation of the mREIT business model is much more complex. Most investors, myself included, couldn’t manage a portfolio of mortgages as well as the executives that are managing these companies. Insurance companies are another great example - collecting premiums that are determined based on actuarial analysis, investing the proceeds, and paying out claims as they occur. It's simple on the surface but not so simple to implement – and a minor miscalculation could be the difference between profitability and bankruptcy.

That said, Mortgage REITs sport 10% plus yields that are too attractive to ignore, so many investors buy them without really understanding how they work. The rest of this article will try to fill in some of the that knowledge gap.

Leveraging A Spread

Mortgage REITs (mREITs) have increased in popularity over the last several years as investors sought yield in a low interest environment. The attraction is obvious as some mREITs have sported yields in excess of 15%. These attractive dividends paid out by mREITs can be attributed to two factors: Net Interest Income and Leverage. Net interest income is the difference between the amount an mREIT receives on the assets they hold and the cost of funding used to purchase those assets.

Leverage then just multiplies that net interest income by a specific factor. Used effectively, leverage can allow mREITs to generate very attractive returns, by allowing the mREIT to use assets as collateral for additional loans, investing in MBSs, and subsequently using those newly purchased assets as collateral for additional loans. When a REIT is said to have 7x leverage, it usually means that it has repeated the above process seven times.

But leverage can also be detrimental to the success of an mREIT, particularly when prices of the MBSs fluctuate to the extent that a margin call is triggered - forcing the mREIT to either raise additional capital or sell some assets at unfavorable prices.

Mortgage REITs do have a very simple business model on the surface. They borrow capital at low interest rates – typically through repurchase agreements - and reinvest the proceeds into mortgage-backed securities paying interest rates that exceed the cost of borrowing. The spread between the two is their profit. They can then leverage those assets to buy more assets and generate more profit, etc.

The biggest challenge for mREITs is the mismatch of those assets and the liabilities to fund them - the capital they borrow is short term in nature while the investments they make have very long maturities. If interest rates were to rise, borrowing rates would increase – narrowing the spread they earn and more importantly, reducing the value of the mortgage assets they hold. Leverage exacerbates those valuation changes.

The solution, therefore, is to minimize the effect of interest rate changes via hedging, in addition to other strategies used to manage prepayment risk, volatility risk, and mortgage spread risk – which we will not cover here.

I’d like to use AGNC Investment Corp. (AGNC) as an example because it is the second largest mortgage REIT behind Annaly Capital (NLY) and unlike Annaly, still has a majority of its assets in Agency-Backed mortgage securities that do not have any credit risk.

Interest Rate Risk

Interest rate risk is probably the most significant risk faced by investors in mortgage-backed securities. As interest rates rise, the price of the underlying mortgages decline and vice versa. Because mortgages have negative convexity, duration gets longer as rates rise. (Intuitively, this makes sense because as rates rise, prepayments are likely to decline)

The most common way to hedge interest rate risk is using swaps and swaptions. A swap is a simple agreement between two parties where one party agrees to pay a fixed interest rate in exchange for receiving a variable rate that is based on a benchmark rate that fluctuates. The parties then agree to pay each other the net amount that results from the differences in the two rates. As an example, when the variable rate rises above the fixed rate, the variable rate payer will pay the other party the difference between the two rates multiplied by the notional amount.

While interest rate swaps work pretty well for smaller rate changes, they tend to be less effective when rates change dramatically. The chart below shows the P&L for MBS, 10-year swaps, and the sum of the two. In this example, the swap hedge is viewed from the perspective of the fixed rate payer – so that as rates decline, the amount paid remains the same but the amount received declines.

However, if rates decline, losses on the swap will be minimized by the increase in the value of the mortgage assets. As we move from right to left, the price of RMBS rises while the 10-year swap declines. The sum of the two is shown by the light blue line. It’s a good hedge but not a perfect hedge – the P&L still declines as interest rates move beyond +/- 50bps.

Source: Two Harbors Investment Corp

A detailed summary of AGNC’s swaps are shown below. Most of the swaps have a maturity of less than 3 years and in all maturity spectrums, the fixed pay rate is higher than the variable receive rate.

Source: AGNC 2Q Investor Presentation

Recall that I mentioned earlier the typical borrowing mechanism for mREITs is through repurchase agreements or repos. A repo is a form of short-term borrowing where the mREIT sells securities to investors – receives proceeds – and agrees to buy those securities back at some point in the future. The difference in price is essentially the cost of borrowing.

The cost of the repos for AGNC was 1.27% as of the end of 2Q and the majority of them have maturities of less than 3 months. In the event of a spike in rates, borrowing costs could increase and tighten the mortgage spread – so hedging that risk is important. By entering into a swap agreement as described above, AGNC attempts to ‘lock-in’ that spread – or at least keep it within a reasonable range.

The table of mortgage funding is shown below with the breakdown of repos by maturity in the lower section. Notice also the TBA Dollar Roll funding line of $17.2 billion. I won’t cover that here but that is another way to obtain funding. A simple way to explain To-Be-Announced securities is when a contract is entered into between two parties to buy/sell securities at a future date but does not include a specific security or pool of securities.

Instead, it outlines certain characteristics of the securities to be bought/sold. Think of it this way: you let me borrow $100 and I promise to buy ‘something’ from you in 3 months for $101. That something is defined by specific terms – in the case of MBS, it could be interest rate, maturity, price, etc.

Source: AGNC 2Q Investor Presentation

We saw in the swap hedge chart that a swap is not a perfect hedge. To better hedge wide interest rate changes, an mREIT can also use Swaptions - options to enter into a swap agreement similar to options to buy or sell individual equities. A premium is paid to have the option to exercise a swap at a particular price and within a specific time frame. Because of the optionality, Swaptions work better for big rate changes by allowing the holder of the option to smooth out the effects of interest rate changes by exercising the option when it's beneficial, and allowing it to expire when it is not.

The chart below compares the result of a hedge with only swaps – as shown in the chart above – with the result of a hedge that incorporates both swaps and swaptions. Notice that the P&L is further smoothed out with the use of swaptions.

Source: Two Harbors Investment Corp.

Yet another way to hedge interest rate risk is to short Treasuries, shown in the table below as having a notional value of $10.8 billion. The logic there is no different than with other hedging techniques - if rates rise and mortgage prices decline, so will Treasuries – offsetting the declines in mortgages.

Source: AGNC 2Q Investor Presentation

For AGNC, interest rate swaps resulted in a loss of $159 million based on a notional amount of $40 billion. While swaptions resulted in a net loss of $13 million on $4.9 billion notional. What that means is that they paid a fixed rate on swaps and swaptions that was higher than the variable rate they received. See table below.

Source: AGNC 2Q Investor Presentation

The result of all the hedging activity is an interest rate sensitivity that reduces both the impact on portfolio market value and net asset values – provided there is a parallel shift in the yield curve – see below. In other words, both short term and long-term rates adjust equally. If instead the yield curve steepens or flattens, the results will differ.

Source: AGNC 2Q Investor Presentation

Valuations

How are these ‘values’ estimated and how do you take comfort that management is accurately reporting the valuations of assets as rates change?

The values of AGNC’s investment securities are based on a market approach using "Level 2" inputs from third-party pricing services and non-binding dealer quotes derived from common market pricing methods. Such methods incorporate, but are not limited to, reported trades and executable bid and asked prices for similar securities, benchmark interest rate curves, such as the spread to the U.S. Treasury rate and interest rate swap curves, convexity, duration and the underlying characteristics of the particular security, including coupon, periodic and life caps, rate reset period, issuer, additional credit support and expected life of the security. So while management does have input into the process, there is third party involvement that we can assume is unbiased.

Final Note

With all the focus on mREITs and the risks they pose to shareholders and an equal number of mentions touting their attractiveness as income investments, I hope the quick review presented here provides readers with just a tiny bit more knowledge and familiarity with how mREITs work so they can make an educated and informed decision to invest or not invest. And that decision may also depend on how the rest of your portfolio is positioned.

Remember, as investors we don’t need to know how to trade swaps, swaptions, treasury futures, and repos. We should, however, have a basic knowledge of how they work and then trust management’s ability to generate profits and dividends for us.

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