“How will your portfolio perform if rates rise?” We are always asked this question—and rightly so—because our sensitivity to interest rate movements is perhaps the key investment concept for an investor in our strategy to understand. And, given the recent volatility and extreme readings in rates, it is also a timely one. In the past 12 months, the yield on the 10-year Treasury, which we often use as a proxy for the yields on our assets and as a canary in a coal mine on prepayment speeds, has been as high as 5.28% (on May 14, 2002) and as low as 3.56% (on March 10, 2003). Currently, the 10-year yield has risen off its lows and is trading around 4%.

The short—and very general—answer to the question is that in the event rates rise, the coupons on our adjustable-rate and floating-rate assets will reset to reflect the higher rates, our fixed-rate assets may rise in value as prepayments slow but ultimately will perform like any other fixed-rate security in a rising rate environment. Moreover, our cost of funds will rise. The effect on returns will depend on a long list of variables, such as which rates rise, how fast they rise, how short rates change in relation to long rates, how long the changes last, which assets we own and what we paid for them and, not least, what actions the portfolio managers take in response to the rate shift.

Impatient readers can stop right here, but in managing a leveraged portfolio of mortgage- backed securities—an amortizing asset—the answer is in the nuance. In a leveraged fixed income strategy like ours, the primary source of return is spread income. Our goal as managers of this strategy is to maximize that income throughout a range of economic environments, while limiting interest rate risk and credit risk. As for the latter risk, we have virtually none. The unique investment aspect of the mortgage-backed securities we buy is that the guarantee provided by Fannie Mae, Freddie Mac and Ginnie Mae effectively removes credit risk from our portfolio. These agencies guarantee that any defaults or delinquencies on the part of the mortgagee result in zero loss to the mortgage- backed security holders: the credit risk is borne by the Agencies, and holders like us are made whole and paid 100 cents on the dollar. The Agencies have never failed to make good on this guarantee. In any event, holders of MBS are protected by the secured structure of mortgage-backed securities. The MBS holder has multiple levels of protection. Besides the actual (in the case of Ginnie Mae) or implied (in the case of Fannie and Freddie) guarantee of the US Treasury, the MBS holder is secured—protected by the actual loan-to-value rating of the home, mortgage insurance, the income verification and maintenance of the homeowner, property/casualty and life insurance, the rights of foreclosure and the settlement process, and the reduction in principal amount from monthly amortization.

Interest rate risk is the greatest risk we have to manage. In general, this risk evidences itself when interest rates rise and the duration of our assets extends, when rates fall and the returns on our premium securities is reduced by prepayments, or when the alignment of short-term and long-term rates narrows, compressing the spread between what we earn on our assets and what we pay on our liabilities. We manage this risk through the composition of our assets. Our portfolios are constructed to be a blend of floating-rate, adjustable-rate and fixed-rate assets, with some expected to perform better in a rising interest rate environment via increased spread income and lower NAV volatility and some that perform better in a falling interest rate environment via capital gains. Further, while we don’t match the duration of our assets and liabilities—to do so completely would remove any profit—we do strive to keep them as close as possible while earning an acceptable rate of return.

When asked about interest rate risk in meetings, we usually begin by introducing the images of “flexible" and "brittle” when thinking about portfolio strategies. A strategy like ours, which relies on actively managing the duration of highly liquid, triple-A rated, easily fungible securities with conservative amounts of leverage, is one that has the flexibility on the asset and liability side of the balance sheet to perform in a variety of interest rate environments. A brittle strategy, on the other hand, makes a stronger “bet” on one outcome over others; while this strategy may produce relatively superior returns in the event that the “bet” works, the brittle strategy breaks if the outcome is not the one desired. For example, the challenge in 2000 was an inverted yield curve and the raising of the Fed Funds rate, with short term rates higher than long-term rates. In that environment, investments in floating rate assets were the more flexible trade because they provided a consistent spread over funding and helped maintain returns. The inverted yield curve would put more pressure on spread income for a strategy that relied on fixed-rate assets and floating rate liabilities. (In all environments, our position as low-cost provider ensures that we have lower return hurdles.)

In the public filings for our publicly-traded vehicle, Annaly Capital Management, there is excellent disclosure on interest rate risk contained in the Management’s Discussion and Analysis section. We include in this section a snapshot sensitivity analysis taken at the end of the period, in which we stress test the portfolio for 25, 50 and 100 basis point movements in rates, up or down. The excerpted section below is taken from our December 31, 2002 10K:

Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equity prices. The primary market risk to which we are exposed is interest rate risk. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on interest- earning assets and the interest expense incurred in connection with our interest- bearing liabilities, by affecting the spread between our interest-earning assets and interest-bearing liabilities. Changes in the level of interest rates also can affect the value of our mortgage-backed securities and our ability to realize gains from the sale of these assets….

Our profitability and the value of our portfolio may be adversely affected during any period as a result of changing interest rates. The following table quantifies the potential changes in net interest income and portfolio value should interest rates go up or down 100 basis points, assuming the yield curves of the rate shocks will be parallel to each other and the current yield curve. All changes in income and value are measured as percentage changes from the projected net interest income and portfolio value at the base interest rate scenario. The base interest rate scenario assumes interest rates at December 31, 2002, and various estimates regarding prepayment and all activities are made at each level of rate shock. Actual results could differ significantly from these estimates.

The dry recitation of the facts as set forth above is useful, but the stress test that we are required to present is not particularly so. We would be hard-pressed to point to an example in history in which there was an instantaneous, parallel shift in the yield curve as described above. Moreover, the exact same shift at different points in time could yield vastly different results depending on the composition of the portfolio. It does not take into account possible buy or sell decisions by portfolio managers in response to the shift. Last, it requires us to make an assumption on prepayment speeds. In fact, when we are asked “How will your portfolio perform if rates rise or fall?”, we typically answer the question with a question: “Which rates? How far? How fast? How long will it last?” The yield curve is a fluid, ever-changing phenomenon with different investors, technical factors and fundamental influences at different points along the curve. Providing an exact answer, while possible with our portfolio management models, relies on assumptions that are mere educated guesswork.

We use our ‘barbell strategy’ to manage interest rate risk. Instead, we prefer to address the question by describing the strategy and not any particular outcome. We utilize what we call a ‘barbell strategy’ in compiling a portfolio that performs well in a wide variety of interest rate environments. We use the ‘barbell’ metaphor to describe the hedging process that occurs when, in general, a portion of our portfolio will outperform in times of rising rates, while a different portion will outperform in times of falling rates. The two portions of the portfolio—the ends of the barbell—thereby complement each other to maintain current income while minimizing NAV volatility as rates go up or down. What allows us to do this without using any derivatives is the unique characteristics of mortgage-backed securities.

A simple explanation of our composition includes an examination of the two sides of the barbell. In our composition, at one end of the barbell we have ARMs and floating rate CMOs. These securities tend to outperform when interest rates rise because their yields will increase as interest rates rise due to the adjustable nature of the coupons associated with them. On the other end of the barbell we have the fixed rate securities. These securities generally experience capital gains when interest rates are falling and these gains help to offset the lower yields associated with falling interest rates.

What’s Next? Once investors understand the flexibility of our barbell strategy, the questions then turn to the future. “What do you think will happen to rates? How will it affect your portfolio?” As we have stated before, we believe that conditions are in place for higher long-term rates and a continued steep yield curve (please see “A case for a steep yield curve” on our website). The combination of concerted and forceful fiscal and monetary stimulus, large and growing federal and municipal budget deficits and the prospect of increased spending from the war in Iraq and the war on terrorism will make it more likely for long rates to rise than fall. Further, we believe that the Fed’s hand is stayed from engaging in any restrictive policy.

As Chart 1 below illustrates, refinancing activity, as measured by the Mortgage Bankers Association Refinancing Index, tends to rise as rates fall and slow down as rates rise. Currently, with rates at 40-year lows, refi activity is at an all-time high. There has been some ebbing as rates have ticked up in the last two weeks, but refi activity is still very fast.

To give a more precise look at how this works, Chart 2 illustrates an important indicator. The graph plots on the left-hand Y-axis the average coupon on outstanding mortgages versus the current mortgage rate. The right-hand Y-axis plots the difference between those two rates in red, the “mortgage gap”. It is a rough look at the incentive to refinance. As the spread widens, mortgagees will take advantage of the lower rate on current mortgages and, all other things being equal, refinance into lower rates and thereby force the spread to narrow as the coupon on outstanding mortgages comes down relative to the current mortgage rate. The spread is now at the wide end of the cycle.

Chart 3 graphs the “mortgage gap” against the MBA Refinancing Index. The correlation between the two since January 1990 is fairly weak, about 0.41. However, since June 2000, the correlation has become quite convincing at 0.85. Our take on this is that the average mortgagee has become much more aware of the process and willing to go through it in order to take advantage of the benefits of refinancing as rates have continued to fall. For its part, the mortgage refinancing industry has become much more adept at processing the requests quickly. The resulting efficiency in this process leads us to believe that as the “mortgage gap” narrows, either due to rising rates or a decrease in the rate on the average mortgage outstanding, the refi index will fall.

So if rates rise, and if the refinancing wave slows down, then what? The first way to look at this is to illustrate the yield change in the event of a different prepayment speed. Higher rates will improve the yield on securities priced at a premium, because prepayments will slow and the amortization of that premium will be spread over a longer period of time. (See “Refinancing and MBS Returns: A Slippery Slope” on our website for definitions and further discussions.) For example, the current Fannie Mae 7% mortgage-backed security is priced at 105-11/32 and, using the consensus estimate for prepayment speed of 948 PSA, yields 2.622%. Holding the price constant and varying the prepayment assumption will result in a different yield. An increase of 100 basis points would result in a reduction in prepayment speeds to 570 PSA and an increase in yield to 4.471%. An increase of 200 basis points would result in a reduction in prepayment speeds to 234 PSA and an increase in yield to 5.792%. In other words, if mortgage rates rise 100 or 200 basis points, all other things being equal, a holder of this security would pick up about 185 or 317 basis points, respectively, just because of the change in prepayment speeds.

Let’s bring this process down to the level of a portfolio. The publicly-traded Annaly Capital Management files quarterly 10Qs, in which we disclose all the information about our portfolio that an investor might need to know. Chart 4 graphs the historical average prepayment speed of the securities—measured in CPR—of the portfolio in blue. In red, we have plotted the ratio of amortization expense to earnings. Recall that amortization expense will rise as prepayments rise, and that this expense eats into earnings. The chart shows that as CPR rises, amortization expense as a percentage of earnings will also rise, hurting profitability. As we would expect CPR to fall as rates rose, we would expect the deleterious effects of amortization expense on earnings to also fall.

This scenario of rising long term rates and a steep yield curve is by no means automatic. There are many uncertainties hanging over the market, not the least of which is the true state of the economy, i.e., unclouded by the war in Iraq. If the economy remains weak once there is a resolution in Iraq, the Fed could not only lower short-term rates further, but there is also much discussion that it would take unconventional steps to keep long- term rates down as well, such as buying longer-term securities. As such, we would expect to see more fiscal and monetary stimulus in the future, not less. Combined with the weight of the debt issuance to fund the deficit, the war on terror, homeland security and the war and reconstruction in Iraq, we believe that conditions are in place to favor a continued steep yield curve, although perhaps at lower nominal rates. In the event, we will trust in the barbell strategy to continue to generate compelling returns for investors.

April 11, 2003
By Jeremy Diamond, Executive Vice President
Annaly Capital Management/FIDAC