2023-08-29 18:12:47 ET
Summary
- Income investors have good reasons to like AGNC Investment Corp.
- The mREIT stock now features a yield close to 15%.
- It is not only higher than most other alternatives (such as treasury bonds or high-yield corporate bonds) but also higher than its own historical average (around 12% in the past.
- However, potential investors need to be aware of the risks involved.
- Fed Chair Powell’s speech at Jackson Hole implies that higher rates could persist, which would create considerable risks for AGNC's cost of funds, leverage, and profitability.
Thesis
Income-oriented investors have good reasons to like AGNC Investment Corp. ( AGNC ). This mortgage real estate investment trust, or mREIT, stock currently provides a dividend yield as high as 14.75% on an FWD basis. And to sweeten the deal, its dividend payouts were made every month. Such a yield is not only much higher than other alternatives (such as high-yield bonds) but also higher than its close peers and its own historical track record. As seen in the chart below, its close peer, Annaly Capital Management, Inc. (NLY), currently yields 13.19%. And its 4-year average yield is about 12.04%, about 19% below its current FWD yield. Thus, judging by the dividend yields, the stock is currently trading at a substantially discounted valuation.
Despite the above draws (high yield and possible valuation discount), the thesis of this article is to analyze the potential risks. The mREIT sector is a sector that is very sensitive to interest rates and therefore my analysis will focus on the impacts if the current interest rates persist, which is a very likely scenario in my mind based on Fed Chair Powell's speech at Jackson Hole last Friday. In the speech, Powell stated that inflation is currently "too high" and cautioned the market that the FED is "prepared to raise rates further."
In the remainder of this article, I will explain why the current interest rates are high enough to create strong headwinds for AGNC, let alone a further increase. More specifically, I will elaborate on the risks from three aspects: AGNC's cost of funds, its leverage, and profitability.
Rising cost of funds and negative economic return
As most mREIT investors already know, this sector makes its profit on the spread between short-term borrowing rates and long-term lending rates. As the Fed keeps the short-term rates (which is what the Fed can actually control), the cost of funds remains at an elevated level for AGNC, as you can see from the following chart (taken from its Q2 2023 earnings report , ER). It enjoyed essentially zero cost of funds amid the epic quantitative easing shortly after the pandemic broke out. It actually got paid to borrow money during Q3 2021 and Q4 2021 as the cost of funds became slightly negative.
However, as the Fed reversed its gears and started monetary tightening, its cost of funds kept climbing up. In tandem, its economic returns tanked, as you can see from the second chart below. Next, I will explain that the rising borrowing cost is not the only headwind that AGNC will face, and the negative economic return could create worse implications than on the surface.
Source: AGNC Q2 ER Source: AGNC Q2 ER
Housing affordability and profitability headwinds
As aforementioned, rising Fed fund rates have caused AGNC's borrowing cost to rise dramatically already. However, this is not the only way that a higher rate could hurt AGNC's profitability. As treasury rates persist at a higher level and with a good chance for further hikes, mortgage rates are now at a multi-year peak level. To wit, the chart below shows that currently, the 30-year fixed rate increased to 7.23%, the highest level since at least 2018. In my view, such mortgage rates are high enough to severely suppress refinance and origination activities, creating a strong headwind for the mREIT sector and AGNC.
Loss of book value
Also, as just mentioned, the negative economic return shown above is worse than on the surface. As clarified in the footnotes from the ER, the economic return is defined as "the change in tangible net book value per common share plus dividends per common share declared." As a result, if the tangible book value ("TBV") remains, then a declining economic return simply means declining profit, and it hurts investors "only" once. But if the TBV also declines at the same time, then a shrinking economic return is worse than on the surface. And that is precisely the case with AGNC as seen in the next chart. Its TBV has been in steady decline in recent years, shirking from $16.39 per share in June 2021 to the current level of only $9.39 per share. Broadening our horizon does not change the picture. As seen in the second chart below, its TBV loss is chronic in the long term, also.
Source: AGNC Q2 ER Source: Seeking Alpha
Other risks and final thoughts
Besides the above issues, there are a couple of other risks worth mentioning. As mentioned earlier, judging by the dividend yields, AGNC is currently trading at a valuation discount. However, other metrics send a mixed signal. For example, the next chart shows its valuations in terms of the P/TBV ratio. To wit, its average P/TBV ratio has been about 0.95x historically. The current P/TBV ratio of ~1.06x is actually about 10% above the historical average.
Its leverage is another concern. As seen in the next chart below, AGNC started deleveraging in 2020, probably sensing that the rock-bottom interest rates won't last for too long. Its leverage (in terms of total asset/TBV) decreased from an alarming level of ~13x to a level of around 8x by late 2021. However, its leverage has climbed back since then and currently hovers around 10.6x. It is substantially above its average level of 9.3x in the past 10 years, and bear in mind that the current interest rates are higher than the average in the past 10 years.
All told, there are good reasons to like AGNC. Its 14%+ yield is higher than most alternatives, close peers, and also its own historical average. My thesis, however, is to point out the risks. My key concerns with AGNC Investment Corp. are threefold: cost of funds, leverage, and profitability. As detailed above, I am concerned that its profitability will be hurt in multiple ways if the benchmark rate persists at the current level or even further increases (which is likely based on my reading of the message from the Jackson Hole meeting). Borrowing costs would remain high or even further climb and demand for new mortgage or refinancing would soften. These issues could also cause further TBV erosion, both pressuring its stock prices (especially considering the current P/TBV multiple is above the historical average) and shrinking its capital base to generate income.
For further details see:
AGNC Investment: Not Out Of The Woods Yet After Jackson Hole