American Capital Agency's 2nd quarter 2014 earnings: Key points (Part 3 of 5)
Leverage increases risk by magnifying returns
Agency REITs like American Capital Agency (AGNC), Annaly (NLY), MFA Financial (MFA), Hatteras (HTS), and Capstead (CMO) invest in mortgage-backed securities, which are guaranteed by the Federal government either directly or indirectly. So these REITs bear little to no credit risk on their portfolio. Principal is guaranteed, but the amount of interest is uncertain.
Because there’s no risk of principal loss—not to be confused with mark-to-market issues—the rate of return for mortgage-backed securities is generally low. They tend to trade at a spread to Treasuries, which compensate you for their additional interest rate risk. This additional risk is called “negative convexity.” A REIT parlays a portfolio that may have a coupon payment of 3.7% into a 13% dividend yield through leverage.
American Capital Agency adjusts its portfolio
The company’s balance sheet shrunk from $67.3 billion in assets to $66.9 billion in assets as the company unwound part of its MBS portfolio. The company bought about a billion dollars worth of Treasuries. While AGNC is still primarily in fixed-rate mortgage-backed securities, about half the book is invested in 15-year fixed-rate MBS. The company still held about $200 million in stocks of other mortgage REITs.
American Capital Agency adjusted its leverage from 7.6x at the end of the first quarter to 6.9x at the end of the second quarter this year. The company funded its balance sheet with nearly $49 billion in repurchase agreements.
A repurchase agreement is basically a secured loan. The borrower pledges the MBS as collateral for a loan. Instead of paying periodic interest, the borrower sells the MBS to the lender and agrees to buy them back at a specified price.
AGNC’s repurchase agreements (or “repos”) had a weighted average maturity of 170 days with a weighted average interest rate of 0.41%. During the quarter, the company extended the maturity from 124 days while decreasing the interest rate.
Given the mismatch between the expected maturity of the company’s MBS portfolio and the maturity of its repo lines, American Capital Agency would be exposed to significant duration risk absent some hedging activity. In fact, it uses interest rate derivatives (primarily swaps), which hedge mortgage-backed securities’ interest rate risk.
As of the end of the quarter, the company had $48 billion in swap agreements. It pay a fixed rate of about 1.61% as of the end of the quarter and received a floating rate of around 0.20%. The average maturity is just under five years. If interest rates rise, the floating rate the company receives will increase, while the rate it pays will stay the same. This makes the swap worth more, which offsets the mark-to-market hits the company takes on its MBS portfolio. It also has options on swaps (called “swaptions”), which are used to hedge outsized moves in interest rates.
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