AGNC is a mortgage REIT that offers a tempting 18.5% Yield. We typically don’t invest in mortgage REITs (because of the risks), unless they offer a particularly compelling opportunity, like AGNC seems to be right now. In this report, we review the business, the market environment, the current valuation, dividend safety and risks. We conclude with our strong opinion on investing.
Overview:
AGNC is a mortgage REIT. But unlike typical REITs that own physical real estate properties, AGNC invests in mortgage securities. Specifically, AGNC invests in mortgage securities guaranteed by US government agencies. This makes the business sound safe (i.e. the US government agency backing), but in reality the risk is not related to default, the risk is related to the leverage (or borrowed money). Specifically, AGNC currently has about 8x leverage on its books (slightly high by historical standards). This leverage magnifies the income it earns (i.e. how it supports the big dividend payments), but also magnifies the risks (volatility), as we will discuss later in this report.
For a little perspective on the company, at the end of the most recent quarter (Sept 30th) AGNC had a $59.3 billion investment portfolio, consisting of $55.9 billion in Agency MBS, plus $2.4 billion is other mortgage positions and $1.1 billion in credit risk transfer ("CRT") and non-Agency securities and other mortgage credit investments.
AGNC makes money by borrowing at a lower interest rate, and then investing the money (in mortgage securities, as described above) that pay a higher rate. Essentially, AGNC makes money on the spread between the rate they borrow at and the return they earn on mortgage securities, as you can see in the following graphic.
Current Market Environment:
As you are likely aware, interest rates have been rising rapidly over the last year, and that causes bond prices to fall (such as the mortgage-backed securities AGNC owns). And compounding the falling price issue for AGNC is the leverage (or borrowed money) which magnifies losses for the company (AGNC shares are down more than 25% this year).
For perspective, here is a look at the company’s sensitivity to interest rates. For example, if rates rise by 75 basis points, the market value of the company’s portfolio could fall (0.4%) and the value of the company’s tangible common equity could fall by 4.2%.
Furthermore, the spread between mortgage-backed securities and treasuries has an even more pronounced impact on the company’s value, as you can see above (i.e. a 25 basis point increase could cause common equity to fall by 14.8%—that’s a lot!).
AGNC Management Outlook:
From AGNC’s standpoint, they believe the steep decline in mortgage-backed securities has arguably created more compelling investment opportunities going forward. For example, according to Christopher Kuehl (Executive Vice President and Chief Investment Officer) on the last earnings call:
Looking forward, our outlook for Agency MBS is very favorable. Spreads have decoupled from treasuries and corporates due to supply and demand technical factors that we expect will ease over time.
and
This is especially remarkable given that the fundamentals for Agency MBS have rarely looked as compelling as they do today. Organic agency supply is minimal, prepayment risk is deeply out of the money and repo markets for Agency MBS are deep and liquid. With spreads as wide as they are today, we believe investors in Agency MBS are well compensated for elevated rate volatility.
Current Valuation
One of the most common ways to value a mortgage REIT is the price-to-book-value ratio. Anything above one is often considered to be a premium price, whereas below one is often considered an attractive discount. Obviously, there is a lot more too it than simply price-to-book value, but on that metric, AGNC is currently trading at a discounted price of 0.86 price-to-book (as per our earlier chart).
Notably however, the book value per share has been declining, as you can see in our earlier chart and in this next chart too.
A declining book value is bad because it reduces the capital base upon which AGNC can earns returns going forward. The recent declines are related to the challenges created by sharp increases in interest rates over the last year.
Dividend Safety
The main reason most people invest in AGNC is for the big dividend, which has remained fairly consistent over time.
However, the dividend payment has contributed to a decline in book value (i.e. tangible common equity). For example, here is what Bernice Bell - Executive Vice President and Chief Financial Officer, had to say on the most recent quarterly call:
Economic return on tangible common equity was negative 10.1% for the quarter comprised of $0.36 of dividends declared per common share and a decline in our tangible net book value of $1.31 per share.
And even though economic returns have been challenging in recent quarters (see chart below), AGNC believes the dividend is still prudently aligned with the returns the company expects going forward.
According to Peter Federico - President and Chief Executive Officer, on the most recent quarterly call”
“One of the primary factors that we evaluate in setting our dividend is the economic return that we expect to earn on our portfolio at current MBS valuation levels.
and
“Our common stock dividend remains well aligned with the return that we expect to earn on our portfolio at current valuation levels and operating parameters. That said, we continuously evaluate our dividend as market conditions, expected returns and risk management considerations are always changing.”
Also noteworthy, AGNC has over $1.6 billion of preferred shares outstanding, which pay lower yields. This is important (according to AGNC) because when you factor in the lower rate paid on the preferreds that makes the total yield paid out more reasonable and achievable versus the company’s economic returns. Note, AGNC’s total common equity market cap is around $4.8 billion.
So while the dividend has been consistent, and AGNC continues to monitor it closely, it’s still quite large and it has contributed to book value declines. Going forward, AGNC needs to realize some of the gains it is expecting (from softer monetary policies) to make the dividend more sustainable.
Risks:
AGNC faces a lot of risks to its business. First and foremost, as we have discussed, is the combination of volatile interest rates and high leverage. If rates move too far too fast, this can force the company to sell some of its securities at unfavorable prices (just to meet liquidity needs) and this will do damage to the future earnings power of the company.
Hedging is another risk factor. AGNC attempts to hedge out various interest rate and volatility risks, however this is expensive and not precise. For example, according to Peter Federico - President and Chief Executive Officer:
The sharp steepening of the yield curve also caused Agency MBS performance to vary significantly across the yield curve. Agency MBS hedged with short and intermediate term instruments perform materially worse than Agency MBS hedged with longer-term instruments.
Yield curve shifts (or changes in interest rates at various terms to maturity) can also create expensive challenges to the company in terms of its hedging activities.
Declining book value is another risk. As mentioned, as book value continues to decline, it reduces the future earnings power of the company, all else equal.
Liquidity is another risk. The company must maintain an adequate level of liquidity to operate. Noteworthy, AGNC was recently able to raise capital by issuing more shares at favorable prices. According to Bernice Bell:
During the quarter, we also issued $432 million of common equity through our at-the-market offering program, which at a significant price-to-book premium was accretive to our net book value.
The Bottom Line
Mortgage REITs are a risky proposition considering the high leverage, market volatility and the potential for forced sales at unfavorable prices to raise liquidity (but to the detriment of book value and thereby destroying future earnings potential).
We only consider investing in mortgage REITs at highly depressed prices, as appears to be the case for AGNC right now. In fact, if the fed lightens up on interest rates and monetary policy in general, AGNC could rebound dramatically in the quarters ahead.
Of course, trying to predict market interest rate moves is a risky (highly uncertain) proposition, and for that reason AGNC remains a risk. We don’t currently own shares of AGNC, but it is tempting at these depressed prices, and we wouldn’t fault anyone too much for taking a nibble at these prices (but only within the constructs of a prudently diversified, long-term income-focused portfolio, such as our High Income NOW portfolio.
Every investor needs to invest according to their own personal situation and goals. Disciplined goal-focused long-term investing continues to be a winning strategy.