2023-12-16 04:24:49 ET
Summary
- Mortgage REITs AGNC and Annaly could benefit from a change in interest rates in 2024.
- Major mortgage REITs have experienced large declines in book value in the last three years.
- Lower interest rates imply an increase in the value of AGNC's MBS assets as well as a reversal in the net interest income trajectory.
- Buying mortgage REITs ahead of a downturn in interest rates may be a wise move.
A few days ago, I made a case for investing in fixed income assets such as those that are included in the PIMCO Dynamic Income Fund (PDI). Fixed income-focused funds like PDI are set, in my opinion, to benefit from an expected change in the interest rate landscape in 2024. Other investments that could benefit from the end of the Federal Reserve's tightening policy are mortgage REITs like AGNC Investment (AGNC).
In October, I aggressively acquired shares in rival mortgage REIT Annaly Capital Management (NLY) because I thought the spread/income situation was set to improve in the short term, given a changing inflation trajectory. Since AGNC is one of the two largest mortgage REITs in the U.S. with a large portfolio of mortgage-backed securities, I see revaluation potential for AGNC as well as a catalyst for the REIT's book value growth in a rising-rate world!
Previous coverage
I covered AGNC more than two years ago -- A Strong Quarter For This MREIT But Risks Are Growing -- which is when I rated the mortgage REIT as a hold, chiefly due to growing inflation risks. With interest rates now apparently being on the verge of falling, I believe mortgage REITs that own large mortgage-backed security portfolios are set to see a valuation recovery.
MBS investments have not done well in the last year
Mortgage-backed securities are fixed income assets whose values are inversely correlated to interest rates. The values of mortgage-backed securities (and those of other fixed income assets) fall during periods of rising rates and vice versa. The only exception I am aware of are mortgage servicing rights whose values increase during rate-rising periods.
AGNC's portfolio chiefly includes MBS of different maturity dates, the majority of which related to 30-year fixed mortgages. AGNC's portfolio value has been under pressure from rising rates in the last year, as one would expect, and the REIT's combined MBS value declined from $61.5B in Q3'22 to $59.3B in Q3'23. AGNC's portfolio also includes commercial and residential credit assets, but with an assigned value of only $1.0B, this part of the portfolio is small relative to the MBS portion.
What makes AGNC stand out from other mortgage REITs, however, is that it is one of the two largest MBS investors in the market, meaning the company has especially been hurt by rising interest rates in the last year or so. The Federal Reserve indicated that it would cut the federal fund rate three times in 2024 ( Source ), potentially delivering a powerful book value catalyst to AGNC.
Mortgage REITs tend not to do well during high-rate periods which pressure the values of MBS and lead to a deterioration of the spread picture. The chart below shows that the mortgage REIT has suffered a rather large drawdown in its asset base since FY 2021, although the MBS portfolio as a whole has started to grow again in the last three quarters...
High interest rates don't only pressure the value of fixed income assets like mortgage-backed securities. They also have the effect of making debt much more expensive which is exactly what investors have seen play out in the last year.
AGNC's net interest income, a key measure of profitability for mortgage REITs, flipped from positive $177M in Q3'22 to negative $53M in Q3'23, largely because interest expenses grew much faster than interest income. AGNC suffered three straight quarters of negative net interest income in FY 2023.
The driving force behind the changed net interest income trajectory for AGNC has been the inflation trend which the Federal Reserve tried to control in 2022 by raising interest rates at the fastest speed in decades.
Since inflation has been in a down-trend in the last year, however, it is now widely expected for the Federal Reserve to end its tightening policy in 2024... which could then reverse AGNC's net interest income trajectory again. U.S. inflation fell to 3.24% in October and I believe we are going to see a continuation of this trend heading into 2024. Since inflation rates have now fallen below long term U.S. interest rates, the Federal Reserve is all but guaranteed to start lowering interest rates next year, in my opinion.
Balance sheet
Mortgage REITs use a lot of debt to invest in mortgage securities and AGNC had a leverage ratio (based off of net book value) of 7.9X in Q3'23 compared to 8.7X in Q3'22. The leverage trend is therefore positive, but the firm's total leverage remains high nonetheless. The biggest asset on the company's balance sheet were agency securities with a fair market value of $55.8B, making up 80% of the REIT's investments.
Potential for a book value recovery
The most recent book value trends for major mortgage REITs reveal a challenged picture, largely because growing spreads in credit markets have pressured the value of mortgage-backed securities which, despite diversification efforts, remain a key holding for AGNC and Annaly. These two mortgage REITs have disclosed major book value declines in the last three years and both of them lost about half of their book values.
These book value declines pressured the valuations of both mortgage REITs, resulting in serious draw-downs in their market caps.
Currently, AGNC trades at 1.03X book value, but the mortgage REIT has traded as high as 1.12X book value in the last three years. Lower interest rates are set to improve AGNC's net interest income and reverse unrealized losses on MBS which could be a catalyst for both mortgage REITs to see their book values grow again. I see a fair value of $10 for AGNC (implying 1.1X BV), but this is a dynamic number and the Federal Reserve will likely be a driving force of AGNC's book value going forward. That said, AGNC throws off a very decent dividend which comes in addition to any price return. I see strong potential for price appreciation in the next twelve months as the Federal Reserve adjusts its tightening policy and guides the market towards lower rates.
Risks with AGNC
As an MBS-focused mortgage REIT, AGNC has a considerable amount of interest rate risk. Higher rates would hurt AGNC's income profile and MBS valuation... and result in a decline in the mortgage REIT's tangible common equity, the extent of which depends on the size of the rate change. By far the biggest risk factor is an unexpected change in interest rates because it will drastically change the value of AGNC's core MBS holdings.
Final thoughts
I see revaluation potential for AGNC (and Annaly) in a lower-rate world and this revaluation potential could come from two sources: 1) Lower interest expenses which are set to take pressure off of AGNC's net interest income, and 2) AGNC's MBS portfolio is set to gain in value in a lower-rate world, thereby creating a catalyst for book value per-share and tangible common equity growth. I believe it can make sense for higher-risk investors to start a speculative buy position relating to mortgage REITs AGNC or Annaly -- which are loaded with rate-sensitive fixed income assets -- ahead of a down-turn in interest rates!
For further details see:
AGNC: A Top Mortgage REIT Buy For 2024 (Rating Upgrade)