Rising interest rates can cause big problems for mortgage REITs like Annaly Capital (NYSE:NLY), ARMOUR Residential (NYSE:ARR), and American Capital Agency (NASDAQ:AGNC). Because mREITs hold fixed-rate securities, any increase in interest rates would cause the securities the companies currently hold to be worth less then what the market can readily offer.
All three companies reported depressed full-year results in 2013, suggesting the culprit was both rising and volatile interest rates. While analysts are mixed on how the Fed's Quantitative Easing taper will affect rates moving forward, some, such as Keplinger, suggest we could see rates on 10-year Treasuries rise from their current rate of 2.7% to as high as 3.5% by the end of 2014.
As a result, this is why it's so important to focus on finding strong management that has a strategy for managing such an environment. Let's look at three ways that these companies can manage the risks caused by increasing (and volatile) interest rates.
Increases in hedging
One of the first lines of defense against rising interest rates are hedges. While these defensive tools come in a number of different flavors, their purpose is widely the same. It works a little like playing roulette: instead of wagering all your money on black, you can protect yourself by betting some on red. You can't win as much, but -- more importantly -- you won't lose as much either. In this manner, betting the opposite way through hedging helps to smooth out some of the volatility of interest rates.
To increase profit, ultimately, mREITs would like to bet as little as possible the opposite way -- or, at least keep it fairly consistent. A great example of this this may not always work is seen through American Capital Agency's "hedge ratio", or the size of its hedge portfolio relative to total liabilities. Just over the course of two years, this ratio jumped all over the place:
The silver-lining for investors is that after the spike in early to-mid 2013, the ratio began to taper off. This is a great sign that, perhaps, the interest rate environment is showing signs of stabilizing. More importantly, this could lead to more normalized results.
Annaly Capital, American Capital Agency and ARMOUR all buy Agency Residential Mortgage-Backed Securities, or RMBS. In essence, these are securities backed by loans owned by Fannie Mae and Freddie Mac. Due to the low yield on these securities, mREITs will borrow against its equity to increase returns. This is referred to as leverage. While leverage has the potential to multiply returns, it can conversly multiply losses.
In a volatile or rising rate environment mREITs can protect its book value – or the value of the company's assets – by decreasing leverage. Below, leverage can be displayed through each company's debt-to-equity ratio.
While it was a much bumpier ride for American Capital Agency and ARMOUR when compared to Annaly Capital, all three companies finished the year with lower leverage than the prior year. On the negative side, the less borrowed, the fewer securities each company is able to buy. This will reduce short-term returns for shareholders. More importantly, however, it protects these companies from more significant losses.
Out with the old, in with the new
In 2013, American Capital Agency and ARMOUR sold $80 billion and $15 billion of its securities, respectively. To put that in perspective, each company basically turned over its entire portfolio. This is perhaps why we saw such volatility in these companies debt-to-equity ratio.
All three companies seem to be on the same page with which MBS look the most desirable. Long-term loans, like 30-year MBS, have the best interest rates -- but due to the rising rate environment, these lower-rate securities will be sitting ducks on the company's balance sheet.
Instead, there's been a move to buy more middle-duration securities. For instance, American Capital Agency increased its exposure to 15-year MBS from 39% of its portfolio in 2012 to 51% in 2013. ARMOUR, similarly, sold off a majority of its 30-year MBS in favor of 15-year MBS.
The bottom line
Analysts from Bankrate.com and Wells Fargo seem to agree that long-term interest rates will rise in 2014. Whether or not this comes to fruition, investors should be focused on those companies with a strategy they can understand, and proven management.
With that said, I believe Annaly Capital best fits that description. It's strategy of significantly lowering leverage in a volatile environment makes the most sense to me.This also gives the company a financial cushion to be a major player when rates normalize. Annaly's CEO and co-founder Wellington Denahan-Norris has a ton of experience, and has led the company toward being one of the top performing mREITs post financial crisis.
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.