2023-11-09 08:30:00 ET
Summary
- AGNC Investment Corporation reported a 14% decline in net book value due to high-interest rate uncertainty and widening mortgage-backed security spreads.
- The stock is now selling at a larger discount to book value, improving the risk/reward relationship.
- AGNC Investment is a speculative position representing 1% of the author's passive income portfolio.
AGNC Investment Corporation (AGNC) reported a substantial increase in its funding costs in the third quarter and the mortgage REIT reported a 14% decline in its net book value in light of consistently high interest rate uncertainty and widening mortgage-backed security spreads.
AGNC Investment’s stock is now selling for a larger discount to book value than last time I looked at the trust and I think, taking into account that the market now widely expects interest rates to fall in 2024, that the risk/reward relationship has improved.
AGNC Investment’s stock is selling for a 7% discount to book and the trust is a speculative position for me only, representing 1% of my passive income portfolio.
My Rating History
AGNC Investment was a Hold due to a shrinking investment portfolio and an unattractive valuation based on book value in September. Since market expectations seriously skew towards rate cuts next year and the stock is available to passive income investors at a larger discount to book value, I am risking a small investment in AGNC Investment and modifying my stock classification to Buy.
Large Agency Portfolio
AGNC Investment is a mortgage REIT that invests primarily in agency mortgage-backed securities (AGNC also invests in non-agency products but to a lesser extent).
Like other investors in the mREIT segment, the mortgage trust uses a lot of debt to buy mortgage securities with borrowed money. At the end of 3Q-23, AGNC Investment’s agency portfolio was valued at $59.3 billion, reflecting a $1.3 billion growth compared to the prior quarter.
Book Value Under Pressure But Interest Rate Expectations Are Favorable
Mortgage trusts like AGNC Investment have gotten pummeled in the last year as interest rates rose and the yield curve steepened. Due to uncertainty about short-term interest rates and a widening spread in the mortgage-backed security market, AGNC Investment’s book value has come under pressure.
AGNC Investment’s book value declined a whopping 14% QoQ to $8.08 per share in the third quarter which reflected the third consecutive decline in the mortgage trust’s book value in 2023. In the second quarter, AGNC Investment’s book value declined only 2 cents per share to $9.39.
With that being said, I think the interest rate outlook for the market is quite favorable, particularly for leverage mREITs. The CME FedWatch Tool shows us the probabilities of future rate increases and decreases and despite a very robust third quarter in terms of GDP growth (economic growth was up 4.9% on an annualized basis in the third quarter), the market overwhelmingly expects a retreat of interest rates towards the 4% range in 2024.
The majority of expectations imply that investors expect a fall from a present rate range of 5.00-5.25% to a range of 4.00-4.50% (more than half of estimates fall into this range) for December 2024.
For AGNC Investment this change in the interest rate trajectory would mean relief in terms of funding costs which continued to surge in the third quarter.
AGNC Investment’s average cost of funds increased from 0.63% in 2Q-23 to 1.17% in 3Q-23, reflecting an increase of 86%. However, interest rates are set to decline and the mortgage trust would profit enormously from lower borrowing costs.
Now Selling At A Large Discount To BV
AGNC Investment is now selling at a 7% discount to book value, despite last week’s recovery rally. Previously, the mortgage trust’s stock was selling close to book value and the lack of a sizable discount was the reason why I have stayed on the sidelines with respect to AGNC Investment so far.
Last week, however, I took a risk and gobbled up a number of shares of the mortgage trust at a 10% discount to book value which I think reflects a decent margin of safety for the trust.
Annaly Capital Management, Inc. ( NLY ) , the largest mortgage REIT in the industry, is currently priced at a 6% discount to book value. Days ago I wrote that I considered NLY to be an extreme bargain as well. The same arguments essentially apply to AGNC Investment.
Why AGNC Could See A Lower/Higher BV Discount
The central bank is the determining factor as to whether AGNC Investment and other mortgage REITs will see pressure on their net interest spreads and book values or not.
Higher inflation would strongly skew the odds in favor of additional rate hikes which would not be good news for leverage-intensive businesses like AGNC Investment.
With present interest rate expectations, however, I am more confident that AGNC Investment, as well as Annaly Capital Management, offer passive income investors much better risk/reward relationships.
My Conclusion
AGNC Investment suffered from widening mortgage-backed security spreads and interest rate uncertainty in the third quarter and the mortgage trust reported that significant decrease of 14% in its net book value as a consequence.
However, the rate picture has substantially improved for AGNC Investment and for passive income investors in the mREIT sector. Since rate expectations for 2024 now imply that interest rates are going to get at least moderately cut next year, I think the 7% discount to book value that is still available after AGNC Investment reported quarterly results makes AGNC a buy.
For further details see:
AGNC Investment: This 17% Yielding Mortgage Trust Can Rebound (Upgrade)