2023-06-12 22:13:16 ET
Summary
- AGNC Investment's book value has continued to decline due to rising interest rates, with tangible book value falling over -4% sequentially to $9.41 in Q1 2023.
- Rising mortgage rates are likely to further pressure book value in Q2.
- As the end of the Fed tightening cycle approaches, AGNC is becoming a buy.
Back in April, I wrote that AGNC Investment ( AGNC ) was getting close to “Buy” territory, but it wasn’t there yet. From a total return perspective, the stock is about breakeven since then. Let’s take a closer look.
Company Profile
As a quick reminder AGNC is mortgage REIT that primarily generates earnings from the spread between the interest income on the mortgage-backed securities ((MBS)) it owns and its borrowing costs. It generally leverages up to boost return.
It mainly invests in MBS backed by Fannie Mae, Freddie Mac, and Ginnie Mae, which as gives it virtually no credit risk. A small portion of its portfolio can be invested in non-agency residential mortgage backed securities ((RMBS)), commercial mortgage backed securities ((CMBS)), and credit risk transfer ((CRT)) securities.
At the end of Q1 2023, AGNC's investment portfolio was valued at $56.8 billion, with $55.5 billion of that Agency MBS and TBA securities. Approximately 92% of its portfolio was in 30-year fixed rate MBS and TBA securities at quarter end.
Book Value Declines Again
As I noted in my original write-up, the decline in tangible book value ((TBV)) was the main story for AGNC and other agency mortgage REITs in 2022. Last year the company saw its TBV go from $15.75 to start the year to $9.84 by year-end, a substantial -38% drop. This was largely due to increasing interest rates, because as rates rise on new mortgages, the current value of fixed MBS securities issued at lower rates declines.
AGNC saw the tide shift a bit in Q4, as its TBV increase 8% sequentially to $9.84. However, TBV once again declined in Q1, falling over -4% sequentially to $9.41. Now the company did pay out 36 cents in dividends in the quarter, so the overall economic return was only -0.7%. Book value was down about another -1% in April after the quarter as well.
Notably, AGNC issued $171 million in common stock during the quarter through its ATM program. While with most stocks issuing equity is dilutive and often frowned upon, when a mortgage REIT issues equity above book value it actually helps increase this important metric. AGNC was able to issue the shares when its stock was trading above TBV per share, selling 17.1 million shares at $9.95 per share. With an end-of-quarter book value of $9.41, the ATM was nicely accretive. So this was a good move by management to take advantage of its share price and boost book.
Discussing its ATM strategy on its Q1 earnings call , CEO Peter Federico said:
And we have consistently traded at a premium to our book value. And I expect that to continue. And I think it's consistent with the environment that we're in because it's such a favorable earnings environment, if you think about our portfolio on a go-forward basis, if you're buying into our portfolio today, you're buying in at a fully mark-to-market portfolio at really attractive valuation levels. So the earnings expectation of the portfolio on a go-forward basis is really strong. As I talked about, it's mid-teens. It can support our dividend, and that's obviously encouraging from a price-to-book perspective. The way I would describe our appetite for capital is just sort of going back to the principles that I laid out before, we're not trying to raise capital for the sake of being larger. ….. But there's no need to simply raise capital and buy assets for the sake of being larger. But we will certainly try to use it opportunistically as long as it's accretive for our existing shareholders.”
Now with higher rates, AGNC has been able to get some solid spreads in Q1. It had a 2.88% annualized net interest spread and TBA Dollar Roll Income in the quarter. That compares to 2.19% a year ago and 2.00% two years ago. So on that front, AGNC is doing an exceptional job, highlighted by its use of swaps that have kept its funding costs down. This is one area where AGNC has really stood out.
The biggest issue is increasing mortgage rates and where they are headed.
Mortgage Rates (Google)
In Q1, the company said it saw headwinds from stronger-than-expected economic data, as well as bank failures from Silicon Valley Bank and Signature Bank. This caused a lot of volatility in the quarter, with lower coupon mortgages taking the biggest hit. So far in Q2, it appears mortgages rates have continued to move higher since the end of Q1 and the jobs data continues to put the Fed in a tough position. While the central bank has currently decided to pause its increased rates, economists are generally looking for two more rate increases .
Financial Times
If that occurs, AGNC’s book value will likely continue to drift lower throughout the year. However, there is an expectation among economists that the Fed could start cutting rates in the second quarter of 2024. You’ll want to get in AGNC before that starts happening, as the market often reacts many months in advance.
Conclusion
A rising rates environment wreaked havoc on AGNC’s book value last year, and things haven’t improved thus far this year. The current environment will likely remain difficult for the rest of the year, but the closer we get to the end of rate hikes is when you want to jump into AGNC. That might be a few to several months way, but when the cycle eventually turns, the firm is going to be in a really good spot. It’s methodically been taking the coupon profile of its portfolio up, and raising equity above book value to purchase higher coupon MBS could turn out to be a very good move when the cycle turns.
For mortgage REITs, I usually look at a price to book as the best way to value them. On that front, AGNC trades at 1.05x. By comparison, Annaly ( NLY ) trades at 0.96x book while ARMOUR ( ARR ) is at 0.94x. Two Harbors ( TWO ) trades 0.83x. Note that trading above book does have some advantages, as discussed above.
I’m going to increase my rating on AGNC to a “Buy.” It may be a bit early, but we are getting closer to the end of the Fed tightening cycle and that should be around the time you want to own it. And if the Fed does indeed start to cut rates next year, it would be a huge boost to AGNC. The combination of tightening spreads (mortgages vs Treasuries spreads have been very wide) and lower overall interest rates would create some really nice gains in the stock.
For further details see:
AGNC Investment: Buy Before The Turn (Upgrade To Buy)