It's widely assumed that agency mREITs, who buy securities from GSEs like Fannie Mae, Freddie Mac, and Ginne Mae, are most concerned with default risks when evaluating investment opportunities. However, REIT investment managers like Two Harbors (NYSE:TWO) and Annaly Capital Management (NYSE:NLY) are more interested in consistent cash flows -- and interest rate volatility, rather than defaults, has a far greater impact on these cash flows.

Risks in any scenario
As Bill Roth, Two Harbors CIO, explains, "the borrower benefits in both a rising and declining rate environment." When rates fall it creates an opportunity for borrowers to refinance. The lower rates fall the more it encourages prepayment -- or paying off the loans faster than expected -- and this shortens the life of the security. In these cases REITs, ultimately, earn less. This is called prepayment risk. 

On the other hand, if rates go up this creates extension risk. Borrowers are less likely to refinance or prepay, so the lifetime of securities increase. REITs are then stuck holding securities worth less than it could readily find in the marketplace.

How to manage this risk
There are three commonly used options for protecting assets from interest rate risk:

  1. Diversification
  2. Hedging
  3. Reducing leverage 

The first option is a lot like buying a total market index fund. Some classes may do well, others not so much, but over time you'll likely see steady growth. Annaly Capital, for instance, diversifies among various types of Agency securities. The company noted in its most recent 10-K: "We believe that future interest rates and mortgage prepayment rates are very difficult to predict. Therefore, we seek to acquire assets which we believe will provide attractive returns over a broad range of interest rate and prepayment scenarios."

Another common strategy is hedging. This includes, among others, interest rate swaps. This involves trading fixed rates for adjustable rates. The chart below shows how the hedging works.

Hedging With Swaps Two Harbors Webinar

Source: Two Harbors.

As you can see, when interest rates rise, adjustable-rate "swaps" become more valuable and fixed-rate mortgage-backed securities lose value. The opposite is true if interest rates fall. Therefore, by utilizing swaps investment managers can smooth out interest rate volatility.    

Finally, Annaly Capital reduced its debt-to-equity ratio, or leverage, from approximately 7:1 in 2012 to 5:1 in 2013. If loans lose value, it affects the company's ability to borrow, as well as repay loans. By reducing leverage Annaly increases liquidity and protects itself from some of this risk. Two Harbors, however, consistently operates at much lower leverage, normally below 4:1, so this is a much smaller consideration.  

Taking it one step further
There are some REITs, however, that have turned managing prepayment risk into a science -- and Two Harbors is one such REIT. The company is able to do this by buying low loan balance, or LLB, seasoned, and low FICO score securities.

Breakeven Part

When borrowers refinance there are "refinancing costs". The question is: how many years will it take for the lower interest rate to "breakeven" with the cost of refinancing? As the chart above shows, the lower the loan balance, the longer the time period to breakeven. This creates a disincentive to refinance, an assumption that these loans will face less prepayment risk, and a more certain cash flow. 

Similarly, Low FICO score, or even Sub-prime, securities have higher loan-to-value ratios. This makes it more difficult for the borrower to refinance.

The bottom line
A REIT's cash flow, and your return, depend on its ability to manage interest rate risk. For investors, it's critical to understand the strategy the company is implementing, and how successful it's been. 

Annaly Capital's model, mixed with its size and strength, gives it a competitive advantage. Though, Two Harbor's transparent strategy is one that make sense, and I believe allows for growth despite an uncertain environment. For that reason, I'm giving Two Harbors the slight edge over Annaly Capital.

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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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