No, not these types of hedges... Photo: Tony Hisgett

With rising interest rates looming over the bond market, Annaly Capital Management (NYSE:NLY) and many of its mortgage REIT brethren have been less focused on growth, and more focused on conservatively protecting their assets with large amounts of hedging. 

Hedging is any action or tool that defends against financial loss. A company's ability to effectively hedge assets is essential to preserve shareholder value. 

Let's dig into the most common hedge Annaly uses, how it works, and why investors should care.

Interest rate swaps
Annaly funds its investments using repurchase agreements or REPO loans (a form of collateralized borrowing). These loans have a floating interest rate roughly tied to the London Interbank Offered Rate (LIBOR). 

On the asset side, Annaly mainly buys fixed-rate mortgage-backed securities. If interest rates rise – which increases their cost of funds -- it squeezes the gap between borrowing costs and asset yield. In the worst case scenario, borrowing costs could exceed asset yield, and Annaly would start losing money hand over fist.

To solve this problem Annaly uses interest rate swaps.

This allows two counter-parties to trade interest rates payments for an agreed-upon amount of time. Annaly pays a fixed interest rate, while the counter-party pays Annaly's floating rate. The principal is never exchanged, only the interest rate payments. 

How much does Annaly use?
As of the first quarter of 2014, 94% of Annaly's REPO loans were swapped for fixed interest rates (this include swaptions). This is compared to just 48% in the first quarter of 2013.

Displayed in the chart below (from left to right) is the: "current notional" or principal, the "pay rate" or the fixed interest rate Annaly swapped for, and the "receive rate" or the floating rate Annaly traded.

Interest Rate Swaps Q

Pluses and minuses 
A quick glance at the chart and it may seem insane to pay 2.16% on average when the company could be paying 0.19%. Add in expenses to set up the swaps, the possibility interest rates don't rise, and the potential for the counter-party to default on their payments, and it seems even more lopsided. 

However, despite the numerous downsides to swaps, there's one big positive. It locks in financing costs, and puts a cap on the maximum amount Annaly will have to pay for funding. And since Annaly's major asset (mortgage-backed securities) has a fixed rate, it makes sure that borrowing costs don't exceed asset yields -- which, as mentioned earlier, would be a disaster. 

Why you should care
Annaly was founded in 1997, and since that time interest rates have steady risen only once. That was in 2005 around the time of the housing bubble. During that year Annaly entered into swap agreements with a face value of approximately $500 million. This is compared to about $17 billion in borrowings -- so, not a big percentage. 

That year Annaly's net interest rate spread (difference between borrowing costs and yield on assets) shriveled to just 0.53%.

Annaly has since used swaps more heavily. Though, never exceeding 50% of the company's total borrowings -- that is until recently. The chart below shows the percentage of interest rate swaps compared to total repurchase agreements. 

Pic Swaps As A Percent Of Borrowing

Ultimately, we're in uncharted waters. Annaly is making a big bet on rising rates, and considering interest rate can't go much lower, I think that's a pretty good one. So, while earnings may look rough right now, much of that is due to the costs associated with swaps. And I believe Annaly is doing what is necessary to put itself in a position to be more successful in the future. 

The last word 
It's important to remember that hedging can be both good and bad. But ultimately, it's more of a testament to management's view of the environment and the potential opportunities that exist. 

By having a better understanding of hedges you can more aptly recognize what management is attempting to accomplish, while helping you read past the bottom line to more readily spot opportunity, where others may see misfortune.

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Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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