Hedge cost as a permanent drag versus running unhedged and eating the variance in agency mREITs

Question

Working through the interest rate hedging disclosures on a handful of agency-focused mREITs turns up a wider range of approaches than expected for what is supposedly a commodity business. One group runs a heavy hedge book, swaps and treasury futures against most of the repo funding. The economics are that shareholders give up basis points every quarter to buy stability in net interest income and book value. In a flat environment that cost is pure drag and it shows up as a lower dividend than an unhedged peer. The defense is that the drag is the price of not being a forced seller when the curve moves, and that surviving is the whole business when funding long assets with short borrowing. The other group hedges lightly, on the view that hedges are imperfect anyway. Swaps hedge parallel moves reasonably well and do very little for a steepener or a twist, so a heavy hedger pays full cost for partial protection. That group argues shareholders bought a spread business and should get the spread, and that management claiming it can neutralize rate risk is selling comfort rather than delivering it. What makes this hard to resolve is that both positions look right in different periods, and disclosure is thin enough that it is often unclear what a hedge actually accomplished. Sensitivity tables show parallel shifts of fifty and a hundred basis points, which is the scenario a hedge is best at handling. The scenario that hurts is the one nobody tabulates. Anyone underwriting this sector eventually has to decide where they come down: pay the drag, or take the variance and demand a higher yield for it.

chriswalton8 · Answer

Anchor, the part worth sitting with is that the choice being described isn't really available to a shareholder. A shareholder can pick an issuer whose current hedge posture looks appealing, but hedge policy isn't a covenant. Management can be seventy percent hedged this quarter and thirty next, and that only becomes visible after the fact in a filing. So the real choice is a bet on a management team's judgment about when to hedge, which is a much harder thing to evaluate than a static policy. That pushes toward favoring the heavy hedge side, for a reason that has nothing to do with the math. A team that pays the drag consistently is signaling something about how it thinks about tail risk, and that stated posture can be checked against disclosed positions quarter after quarter. A lightly hedged team might be right that swaps are imperfect, or might simply be reaching for yield with a good story attached. What's harder to judge is whether the drag being observed is a reasonable price or an expensive one. Comparing hedge cost across issuers is close to impossible given how differently each one presents it.

luis_carrera · Answer

Sable's point about policy not being fixed is the one worth sitting with. Take a model comparing hedge ratios against realized book value volatility over sixteen quarters, expecting to find that heavier hedgers produced smoother books. The relationship usually turns out weaker than expected, and the reason is that hedge ratios themselves move around so much within the period that any single average describes almost nobody's actual position. That argues for the higher yield with variance, and the reasoning is close to admitting the analysis can't be trusted. If good hedging can't be distinguished from lucky hedging in the disclosure, paying the drag is paying for something that can't be verified. Holding the unhedged version at least means knowing what's owned, sizing it smaller, and treating the variance as the thing signed up for. Anchor, on the sensitivity tables only showing parallel moves, has anyone here found an issuer that tabulates a steepener? Every table pulled so far runs the same parallel scenarios.

Hedge cost as a permanent drag versus running unhedged and eating the variance in agency mREITs

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