Leverage increases risk by magnifying returns
Because agency REITs like CYS Investments (CYS), American Capital Agency (AGNC), Annaly (NLY), MFA Financial (MFA), 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’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. This tendency compensates you for the additional interest rate risk they exhibit, called negative convexity. A REIT parlays a portfolio that may have a coupon payment of 3.7% into a 13% dividend yield is through leverage.
CYS increased its assets
The company’s balance sheet increased from $13.3 billion in assets to $14.2 billion in assets. The company benefited from mark-to-market gains on its portfolio. While CYS is still primarily in fixed-rate mortgage-backed securities, just under half the book is invested in 15-year fixed-rate MBS. Another quarter is held in 30-year MBS, and the rest is in ARMS and Treasuries.
The company’s leverage ratio stayed more or less constant at 6.35x. The company funded its balance sheet with nearly $10 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 (repos) had a weighted average maturity of 93 days with a weighted average interest rate of 0.30%. During the quarter, they extended the maturity from 74 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, CYS Investments would be exposed to significant duration risk absent some hedging activity. In fact, it uses interest rate derivatives, primarily swaps, which hedge the mortgage-backed securities’ interest rate risk.
As of the end of the quarter, CYS had $7.3 billion in swap agreements. They pay a fixed rate of about 1.34% as of the end of the quarter and receive a floating rate, which was around 0.22%. The average duration of the swaps was 3.63 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, offsetting the mark-to-market hits the company will take on its MBS portfolio.
CYS also has options on swaps, called “swaptions,” which are used to hedge outsized moves in interest rates.