2023-09-21 03:08:45 ET
Summary
- AGNC Investment Corp. has suffered from a steepening of the yield curve, resulting in a rise in funding costs and a decline in portfolio and book value.
- The risk of a net interest spread contraction has decreased due to easing inflation and less pressure on the central bank to hike interest rates.
- A reversal in the path of interest rates could provide substantial relief for AGNC Investment's net interest spread.
AGNC Investment Corp. ( AGNC ) has suffered from a steepening of the yield curve since 2022, which resulted in both a rise in funding costs as well as a decline in portfolio and book value for the mortgage real estate investment trust.
Though I don't consider AGNC Investment to be a bargain just yet, I think that the risk of a net interest spread contraction has decreased as of late, primarily because inflation has eased and the central bank is now much less under pressure to hike interest rates.
A reversal in the path of interest rates moving forward could result in substantial relief for AGNC Investment's net interest spread.
My Rating History
I warned about investing in AGNC Investment over the last year, most recently in May 2023 , primarily because of the risk of ongoing book value declines and a contraction in the net interest spread in a rising rate environment.
With the central bank raising interest rates, heavily leveraged investment trusts saw growing pressure on their portfolio book values. With that being said, though, with inflation easing, the central bank could soon lower interest rates, which could be a kicker for earnings growth at the mortgage trust.
Furthermore, AGNC Investment's book is no longer in freefall, leading to a stock classification of Hold (as opposed to Sell). In March , I still warned against buying the drop given the unfavorable risk/reward.
Series Of Book Value Declines And BV Stabilization
The biggest concern for me when investing in mortgage REITs is that they are highly leveraged: mortgage trusts borrow short term and invest long term, which creates a mismatch that, during periods of higher rates, hurts operating performance.
AGNC Investment, for instance, has suffered a shrinking portfolio and book value related to the central bank's present rate-hiking cycle, which, in turn, has weighed heavily on the trust's market valuation.
AGNC Investment's Agency portfolio shrank 34% within the last two years, and the total portfolio value has declined from $87.5 billion in 2Q-21 to just $58.0 billion in 2Q-23.
With that said, however, AGNC Investment's book value appears to have stabilized as of late, and the times of horror QoQ book value declines also seem to be a thing of the past.
In the second quarter, AGNC Investment's book value was $9.39 per share, down 42% from $16.39 per share in 2Q-21, but the rate of decline has moderated a lot in 2023. In the same quarter, AGNC Investment only lost $0.02 per share of its tangible book value, suggesting that the mortgage trust's book value has stabilized.
Changing Outlook For Capital Costs
What is driving my upgrade to Hold, primarily, is that AGNC Investment faces an improved outlook for its borrowing costs. AGNC Investment's borrowing costs decreased from 1.02% in 1Q-23 to 0.63% in 2Q-23, providing relief in terms of capital costs and boosting the trust's net interest spread above 3% again.
I can see this trend continuing moving forward, under the condition that the central bank eases up on rate hikes, which is likely when taking into account that the long-term inflation trend is declining. Inflation has been the key driver of higher funding costs and book value pressures for leveraged mortgage REITs.
Inflation heated up marginally in August, rising to 3.7%, but the long-term trend is indicative of easing consumer price pressures in the economy, which, in turn, should point to interest rate decreases in the short term, or at least in the medium term.
Little Margin Of Safety
AGNC Investment is selling at a discount of 2% to book value, which for me personally is not a big enough discount to make an investment worthwhile.
I would probably have to see at least a 10% discount to book value in order to find the risk/reward attractive. Annaly Capital Management, Inc. ( NLY ) is already selling at full book value, meaning a discount valuation is no longer to be had.
Why AGNC Could See A Lower Or Higher Valuation
If, against all odds, inflation was to make such a comeback that the central bank was forced to once again hike interest rates, then pressure on AGNC Investment's borrowing costs as well as book value might increase. Taking into account the long-term inflation trend, I think that the odds are in favor of decreasing interest rates in 2024.
My Conclusion
I still think that AGNC Investment's 14.2% dividend yield is risky, but the return situation has improved, primarily because of shrinking inflation.
AGNC Investment has only seen a very small decline in its book value in the second quarter, and the large book value haircuts witnessed last year seem to be a thing of the past. Granted, inflation increased two months in a row, but the long-term trend is still favorable and indicates that the market will soon see rate decreases.
In a lower-rate environment, AGNC Investment's capital costs can also be expected to normalize, which, in turn, could be a catalyst for a higher net interest spread and higher earnings.
Though I don't own AGNC at the moment, I can see myself becoming a shareholder if shares were available at a 10% (or higher) discount to book value.
For further details see:
AGNC Investment Corp.: Scary Times May Be Over For This 14% Yielding Trust (Upgrade)