American Capital Agency's 1Q14 earnings: Important takeaways (Part 3 of 5)
Leverage increases risk by magnifying returns
Because 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), they bear little to no credit risk on their portfolio. Principal is guaranteed, but the amount of interest is uncertain.
Because there is 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 compensates the investor for the additional interest rate risk they exhibit (called negative convexity). The way a REIT parlays a portfolio that may have a coupon payment of 3.7% into a 13% dividend yield is through leverage.
American Capital Agency adjusts its portfolio
The balance sheet shrunk from $76 billion in assets to $67 billion in assets as the company unwound a part of its MBS portfolio and used cash to buy back common stock. While AGNC is still primarily in fixed-rate mortgage-backed securities, about half the book is invested in 15-year fixed-rate MBS. It still held about $350 million in stocks of other mortgage REITs.
American Capital Agency adjusted its leverage from 7.5x at the end of 2013 to 7.6x at the end of the first quarter this year. The company funded its balance sheet with nearly $50 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. The repurchase agreements (aka repos) had a weighted average maturity of 162 days with a weighted average interest rate of 0.43%. During the quarter, they 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, they utilize interest rate derivatives (primarily swaps), which hedge the interest rate risk of the mortgage-backed securities. As of the end of the quarter, they had $46 billion in swap agreements. They pay a fixed rate of about 1.57% as of the end of the quarter and receive a floating rate which was around 0.21%. The average maturity is just under five years. If interest rates rise, the floating rate they receive will increase, while the rate they pay will stay the same. This makes the swap worth more which offsets the mark-to-market hits they will take on their MBS portfolio. They also have options on swaps (called swaptions) which are used to hedge outsized moves in interest rates.
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