AGNC : No Free Lunch : Smoothing Volatility On Mortgage REITs For Lower Returns

FYIThis is a trading strategy discussion, not a fundamental analysis of AGNC.

Mortgage REITs can generate significant yields (15% +) that are very attractive in a low interest rate environment. However they can have systematic risks (e.g. rising interest rates), asymetric risks on individual names (e.g. bad management) and can lose significant principal very quickly over a few trading sessions. Before acquiring a position an investor would typically have to do significant due diligence on individual names as each mortgage REIT has its own special quirks.

So is it possible to get a less volatile equity curve by hedging using OTM put/call options on a major mREIT ? (with an associated reduced return)

Here are the main components that form this strategy:

1) Initial stock position : We will invest with AGNC with an initial position at 29.84 (average price) acquired between 20th June and 1st July 2011.

2) Dividend income stream : $1.4 per quarter for 2011, is now $1.25 for Q1 2012.

3) OTM put options : Buy 10% OTM put contracts for each quarter (3 month to expiration) to cover the stock position. The number of contracts is calculated as stock position (shares) / 100, so if you have 500 shares, hedge with 5 OTM put contracts. For example on Feb 22nd AGNC is at 30.57, so buying a Put at strike 27 for June 2012 (4 month) would cost 5 contracts x $0.43 = $215.

The following table summarises the strategy returns :


Buy Date Buy Price Shares Price Today Days held Type Gain/Loss Actual % return Annualised % return*
AGNC Long Stock 1-Jul-11 29.84 500 30.7 21-Feb-12 168 Unrealised $430 2.88%
Dividends (see “Dividends” schedule below) Realised $1,680 11.26% 16.89%
Hedges (see “Hedges” schedule below) Realised -$727 -4.87% -7.30%
TOTAL STRATEGY RETURN $1,383 9.27% 9.59%
* Excludes stock gain/loss as trying to assess as an income stream of “dividends minus cost of hedging” (rather than total strategy return)

The following table gives a more detailed breakdown of the dividend income stream and the cost of the OTM put options (summarised in the strategy return table above):

Year Dividends Hedges
Q1 Q2 Q3 Q4 Total Q1 Q2 Q3 Q4 Total
2011 - $280 $700 $700 $1,680 - - -201 -315 -$516
2012 $0 -$211 -$211
TOTAL $1,680 -$727

When compared to “buy n hold” it merely appears as if we have reduced a 15%+ yield for a 10% yield. (i.e. lost money by hedging). This is true, but does not tell the full story – take a look at this price chart action :

AGNC 2011 chart - panic low

AGNC 2011 chart – panic low

Comparing a price chart from the purchase date to now, would show an equity curve swing from 25.89 (-13.3% on close 3rd Oct 2011 – but it spiked lower intraday) to 30.70 (4% on close 21st Feb 2012). Although -13.3% would be within some investors tolerance levels, the question has to be asked what happens if it keeps going lower – what’s the exit strategy ? Using OTM puts helps remove this uncertainity, by providing a defined price beyond which the investor cannot lose any more money (put strike price minus put premium paid). For example, during this price dip a 29 put was already owned (strike 29.0 – put premium 1.37 giving protection beneath 27.63). This enabled AGNC to be held with no risk losing principal beneath 27.63. In the end the put was held and bought back for 1.35 (for a 0.02 loss) as the price quickly recovered – but the price recovery was not guaranteed (it could have kept going down).

Conclusion : Using this strategy “loses” some dividend returns because of expiring OTM put options, but gives a smoother ride to the destination. A 15%+ return is reduced to approximately 9.5%, but we would argue with an improved risk profile (making it a more attractive proposition). We will continue to run this strategy in 2012.

Final random thoughts on selling OTM call options : You can also sell calls to get more income, but they need to be carefully timed. We actually dont like to be short call options in between dividend payments typically in the middle of the AGNC trading range (say $25 to $30), because the return is very low and you are (potentially) reducing the upside significantly for not much payout. e.g. if you sell a call for $0.15 say $1 above current price, but underlying goes up $3 in 3 months, then you just got only $0.15 for missing $2 worth of upside ($1.85 of “missed opportunity”). Also because they are originally sold for so little value ($0.15) there are very painful to buy back once they go “in the money” – basically one bad experience could wipe out many months of previously sold premium. Covered calls are great, just not on this type of mREIT (obviously this is personal preference).

However one short call strategy we have used sparingly is 6 months or 1 year out, about 3% OTM, and just before a dividend payment so that if you are assigned at least you get (somewhat) compensated for missing the dividend payment. For example : sell call at $0.30 on Sept 2012 strike 31. If AGNC is at 30.57 and you are assigned just before the next dividend payment, your “compensation dividend” is $31 – $30.57 + $0.30 = $0.73 (versus dividend of $1.25). However you can then immeadiately repurchase AGNC directly after dividend payment, which has historically been a good time to get in. If you get lucky, you may get to keep both dividend and call premium.

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