2023-10-30 17:08:27 ET
Summary
- AGNC Investment Corp is a mortgage REIT that focuses on agency-backed mortgage securities and collateralized mortgage obligations.
- There appears to be a huge misconception that AGNC is a risk-free investment because it invests in government-guaranteed instruments, but this misconception could be costly.
- AGNC is heavily leveraged, with a leverage ratio of almost 8x, and its dividend payments have significantly decreased over the past decade.
- If you are heavily leveraged in a "risk-free" investment, it becomes not quite "risk-free" anymore as we already saw with some regional banks blowing up while holding treasuries.
AGNC Investment Corp. ( AGNC ) is a mortgage REIT company that focuses on agency-backed (also known as government-guaranteed) mortgage securities and collateralized mortgage obligations. I believe one of the biggest misconceptions about this company is that it is a risk-free investment in the same way treasury bonds are because it only invests into agency-backed assets, but this is a dangerous way of thinking and could cause investors to potentially lose a lot of money in my opinion.
First, let us define what "agency-backed" means for mREITs. When a mortgage security is agency-backed it is considered that its "principal and interest payments are guaranteed by the United States government". This sounds like a great thing and it looks like any asset that's guaranteed by the US government should be as safe as a US treasury so it should be virtually risk-free, which would also make AGNC risk-free since it's investing into these assets, right? Not quite so.
There are 2 things investors should truly understand before investing into AGNC. First, the government guarantee only applies to debt servicing of these mortgage bonds as well as their principal retrieval at the time of maturity. What this means is that if you buy an agency-backed mortgage bond that yields 6% with maturity of 30 years, the government guarantees that you will receive those 6% interest payments for 30 years and get your full money back at the end of 30 years at maturity. What the government doesn't guarantee is that those bonds will hold up their value throughout those 30 years. This is a HUGE difference.
Why? Even though you are getting all of your interest payments every single month without a miss, your bond can still lose value over time due to a variety of reasons such as a rise in interest rates. So the bonds you bought for $100 could drop to a value of $60 in 2-3 years and there is no government guarantee in the world to stop that from happening. In fact, even the government's own bonds (which are considered risk-free) drop significantly in value from time to time. The government offers no guarantees that those bonds will hold up their value over time as it is only guaranteeing that you will get your full money at maturity (in about 10-30 years).
Then why is this distinction so important for investors and companies like AGNC? Well AGNC is heavily leveraged just as most mREITs. We will get back to this in a bit but let me demonstrate how it can affect an investment including those "risk-free" and "government-guaranteed" investments. Let's say you are holding a package of government treasuries and government-backed mortgage bonds. Since those are considered "risk-free" you also decide to use 100% leverage to boost your returns. Nothing can go wrong with that right? Well, if these bonds lose 50% of their value, you could potentially lose 100% of your investments because you are leveraged. Now those risk-free investments suddenly became extremely risky.
This concept is very simple but it left many people puzzled last spring when a number of regional banks went bankrupt and several others faced bankruptcy risks. People wondered how it is even possible for those banks to go bankrupt when they were holding risk-free treasury bonds which are guaranteed by the US government. It turns out that they are not risk-free if you are leveraged because your position can get wiped out completely if bonds lose 30-50% of their value (depending on how leveraged you are).
So, being leveraged in risk-free bonds pretty much negates their "risk-free" nature. At that point you might as well stop calling them risk-free because they are not anymore. There are no government protections and no guarantees about bonds losing value over time and they can lose about 30-50% of their value in some environments (such as the one we are facing today).
Now let's get back to AGNC. Have you ever wondered how the company is able to afford a dividend yield of 20% when mortgage rates ranged from 3% to 7% throughout most of the last decade? Well, the company is heavily leveraged. Below statement is from the company's latest earnings statement :
As of September 30, 2023, AGNC's tangible net book value "at risk" leverage ratio was approximately 7.9x.
Yes, we are looking at a leverage ratio of almost 8x. At this point, there is no point talking about government guarantees or the risk-free nature of government-backed bonds. This is also evident in the company's book value which declined more than 35% in the last 3 years.
Many people say that they only care about dividends and that they don't care about things like book value, NAV, share price or total return. After all they are only invested for income generation and they only want to receive those checks in the mail (or deposits in their bank account). They look at this investment like how a landlord looks at houses that he or she owns and leases out. When you lease out a house for rental income you might not care if your house value dropped, rose or stayed the same as long as that rental income keeps rolling in. That's a fair argument but there is one problem with this. Unless your rental property is located in a really bad area facing economic collapse (or your property is in really bad shape and lacking maintenance), rental income tends to stay stable or even rise over time along with inflation.
Meanwhile, we can't say the same about AGNC's dividend income. In the last decade, AGNC's dividend payments dropped from $5 per share (annually) to $1.44 per share per year. It's a very steep drop even if you ignore inflation. It wasn't a one-time drop either. Dividends kept shrinking year after year and the overall trend remains downward in the long term. So if you are one of those investors who completely ignore things like book value, NAV, share price or total returns and only focus on dividend income alone, this picture should still tell you something.
Now some people look at AGNC's total return since inception and see that it's been up about 220% if you received and reinvested all dividends. It looks great, right? Maybe AGNC wasn't a bad investment after all. But look at the left side of the graph. It turns out that practically all of AGNC's total return gains happened between 2008 and 2013. Back then the company was buying up mortgage bonds that were selling for a fraction of their maturity value due to the recent panic of the 2009 recession. That pretty much explains almost all of the company's good performance since 2008.
When you look at the company's performance since then (since 2013), it's been down -5.6% while S&P 500 has been up 180% even with reinvestment of dividends. So the best time to buy AGNC was in 2008-2009 but it hasn't done much since 2013.
What if you bought $10k of AGNC 10 years ago and you reinvested all your dividends, would your income grow significantly? Well it turns out that it wouldn't. If you bought $10k worth of AGNC in 2013, your annual income in 2013 would have been $1,364, a yield of 13.64%. If you reinvested all your dividends and kept for 10 years, your income would stay mostly flat at the end of 10 years so all that reinvesting dividends would only help you with keeping up with the distribution reductions. Remember how the company cut distributions from $5 to $1.44 during this period.
So regardless of whether you are an income investor, dividend investor, "book value" investor, you have to pay attention to an investment's book value. You have to pay attention to its NAV as well even if you are not planning on ever selling your investment. Finally, you have to pay attention to risk factors and how your dividends are trending over time. You can't assume an investment is "risk-free" just because it is holding risk-free assets especially if it is highly leveraged. Any leverage usage will effectively negate the risk-free nature of an investment. We've already seen this with regional banks invested in treasuries in a leveraged way and we may also find it out in mortgage REITs if things get bad enough in my opinion.
For further details see:
AGNC: 'Agency-Backed' Doesn't Mean Risk-Free Investment