2023-11-21 02:14:39 ET
Summary
- AGNC Investment has managed to maintain its dividend during the current Fed tightening cycle, unlike most mortgage REITs.
- Widening mortgage backed security (MBS) spreads have been a major issue for mortgage REITs, leading to declining book value per share.
- AGNC Investment is trading at a slight discount to book value per share and is expected to benefit from a decrease in interest rate volatility and tightening MBS spreads.
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The past year and half has been absolutely miserable for companies in the mortgage space. Mortgage originators have seen volumes collapse, while mortgage REITs have seen their portfolios underperform Treasuries, which has translated into lower book values. Most mortgage REITs have cut their dividends already.
AGNC Investment (AGNC) is one of the few mortgage REITs that has managed to maintain its dividend during the current Fed tightening cycle. Rithm Capital (RITM) is the other. Despite one of the most hostile environments for mortgage REITs, the company has been resolute in maintaining the dividend. While AGNC did cut its dividend during the margin call fiasco in the early days of the COVID-19 pandemic, it admitted after the fact that it probably could have avoided it.
Thesis
The headwinds that have faced the mortgage REITs over the past 18 months are about to dissipate which will make the sector investible. The big issue facing mortgage REITs over the past 18 months has been widening mortgage backed security ((MBS)) spreads. The chart below shows the difference between the 30 year fixed rate mortgage and the 10 year bond yield. MBS traders will quibble that this isn't a true MBS spread, and they are correct, however this chart is a close enough representation.
Interest Rates And The Fed
Ever since the Fed started tightening MBS spreads have widened, which has translated into declining book value per share. Widening MBS spreads have been attributed to quantitative tightening, however if you look at the chart below, MBS spreads before real estate bubble and MBS spreads during the age of QE weren't materially different. MBS spreads also demonstrate mean reversion, so spikes generally don't last long.
It is hard to make the argument that MBS spreads will remain at ultra-wide levels as the Fed lets is MBS portfolio run off. Given that the vast majority of the Fed's MBS portfolio is in coupons of 5% or less, runoff will be slow.
In their earnings presentation , AGNC showed that MBS spreads had widened considerably. MBS spreads have widened considerably from the beginning of the 2023, rising from 151 basis points to 179 basis points.
To put those numbers into perspective, here is a chart from AGNC's presentation a year ago. The current level of 179 basis points is not quite as high as a year ago, but is historically extremely wide. Note that spreads tend to be volatile and mean-reverting. Aside from Q3 2022, MBS spreads are comparable to the Global Financial Crisis.
AGNC Investment earnings presentation Q322
The Dividend Appears Safe
At current levels, AGNC yields over 17%, which is on the high side for a mortgage REIT and is often the level where the dividend is at risk for a cut. Is the dividend covered going forward? Given that wider MBS spreads generally mean higher expected returns going forward, this should support the dividend. On the third quarter earnings conference call AGNC CEO Peter Federico said that he expected high-teens to low 20s levered return on the MBS portfolio and that the " common stock dividend remains well aligned with the return that we expect to earn on our portfolio at current valuation levels and operating parameters ."
Discount To Book Value
Widening MBS spreads have caused AGNC's book value per share to steadily decline ever since the Federal Reserve started hiking the Fed Funds rate. This caused the value of mortgage backed securities to decline, while quantitative tightening removed one of the biggest buyers of new mortgage production. You can see the trend in book value per share in the chart below, taken from the third quarter presentation.
These declines in book value per share can be reversed either by tightening MBS spreads or declines in interest rates. Given that the latest inflation data has been falling, the Fed Funds futures are now pricing in the assumption that rate hikes are done. The 10-year bond yield is falling as a result, which is supportive of MBS prices.
A Deeper Look Into AGNC's Balance Sheet
As of September 30, AGNC's portfolio of mortgage backed securities was primarily concentrated in the 4.5% - 5.5% coupon range. With mortgage rates still around 7.5%, rates have to fall quite a bit in order for these bonds to have any meaningful prepayment risk.
AGNC finances its portfolio of agency mortgage backed securities using repurchase transactions, which are basically a secured loan. These loans cost 5.47% at the end of the third quarter, however AGNC hedges these with swaps, which have made money as short term rates have increased. Between the swaps and the repos, AGNC's cost of funds is 1.17%, while the portfolio average asset yield was 4.2%, which gives a spread of 3.03%.
Interest Rate Volatility Matters
At the November Federal Open Market Committee ((FOMC)) meeting, the Fed chose to maintain the Fed Funds rate at its current level. Later that week, the jobs report came in weaker than expected, which shows the economy is weakening. The 10 year bond yield has fallen dramatically recently as investors take down their bets on further rate hikes.
Once the Fed is out of the way, we should see a decrease in interest rate volatility. While this is a somewhat esoteric concept, it is good to understand. Mortgage backed securities are highly sensitive to interest rate volatility due to the inherent prepayment option that borrowers own. If the borrower is long that option, that means the lender is short that option. If the option increases in value, the mortgage becomes worth less. Since volatility increases the value of that option, and the MBS holder is short that option, interest rate volatility is bad for MBS investors. Conversely, as volatility decreases, the value of that option decreases, which makes the MBS worth more. Certainty about Fed policy going forward will go a long way towards reducing interest rate volatility, which will support MBS prices and AGNC's book value per share going forward.
Peer Comparison
One thing that separates AGNC Investment from a lot of mortgage REITs is the fact it doesn't rely on mortgage servicing rights. Mortgage servicing rights have been one of the best-performing assets over the past year as they increase in value as interest rates rise. That said, mortgage servicing rights are priced for perfection, and will only decline in value as interest rates peak and delinquencies begin to rise. Mortgage servicing rights are an illiquid asset, and when valuations are falling they can be hard to sell, which will impact valuations. This will be a headache for competing mortgage REITs but not for AGNC.
The best comparable for AGNC Investment is Annaly Capital Management. Both companies trade close to book value per share, while AGNC has a better dividend yield by 200 basis points. Both companies have large agency MBS portfolio, however Annaly also has non-guaranteed MBS. Most other big mREITs have credit exposure and servicing. If the US economy ends up in a recession, credit risk losses will almost certainly increase. This will impact servicing values as well. AGNC is the most conservative mREIT out there, and should outperform if the US enters a recession.
Risks To The Dividend
AGNC Investment is trading at a small premium to its $8.08 tangible book value per share. As a general rule, the agency REITs trade at or close to book while the non-agency REITs with lots of hard-to-value assets often trade at a discount. Finding a target price is difficult because it involves forecasting interest rate moves. That said, people buy mortgage REITs for the dividend more than they do for capital appreciation. On the third quarter call, CEO Peter Federico indicated the portfolio covers the dividend, and as things improve, the dividend should be sustainable. This means investors should be comfortable that the 17.6% dividend yield is a good probability bet. I think that once the Fed wraps up its tightening regime we will see a marked drop in bond volatility, which will tighten MBS spreads. This will support AGNC's dividend going forward, and tightening spreads will translate into higher book value per share.
Conclusion
AGNC is probably a buy once we get the all-clear signal from the Fed, and income investors looking for an entry might want to target a discount to book value per share.
For further details see:
AGNC Investment Is A Buy Below Book Value Per Share