Leverage increases risk by magnifying returns
Most REITs, but especially agency REITs like American Capital Agency (AGNC), Annaly Capital Management (NLY), MFA Financial (MFA), and Capstead Mortgage (CMO), use leverage to increase their returns. As a general rule, the big agency REITs use more leverage than non-agency REITs like Two Harbors Investment (TWO).
Investors interested in trading the mortgage REIT sector as a whole could look at the iShares Mortgage Real Estate Capped ETF (REM).
American Capital maintains its leverage ratio
American Capital Agency increased its “at risk” leverage ratio from 7.0x to 7.2x in 1Q16. The company funded its balance sheet with ~$41.9 billion in repurchase agreements.
Given the volatility in interest rates over the fourth quarter and the poor performance of MBS (mortgage-backed securities) overall, American Capital Agency decided to add to its leverage. It’s still underleveraged compared to the past few years, so it can add assets if they become attractive enough.
American Capital Agency’s repurchase agreements had a weighted average maturity of 184 days. They had a weighted average interest rate of 0.78%. That was 2 basis points higher than the last quarter. It reflects the Fed’s rate hike and also the upward creep in LIBOR.
Considering 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 without some hedging activity. Duration risk is caused by mismatches between the interest rate sensitivity of a REIT’s assets and liabilities.
Investors interested in making directional bets on interest rates should look at the iShares Barclays 20+ Year Treasury Bond ETF (TLT). In fact, it uses interest rate derivatives, primarily swaps. These hedge the interest rate risk for the MBS.
At the end of the third quarter, American Capital Agency had $35.1 billion in swap agreements. It paid a fixed rate of about 1.5% at that time and received a floating rate of around 0.64%. The average maturity is four years.