2023-06-14 11:42:33 ET
Summary
- AGNC is a stable company with a whole slate of preferreds.
- Among them AGNCO looks highly opportunistic.
- We see 22% potential upside in 16 months.
I believe AGNC Investment Corp. ( AGNC ) Preferred E (AGNCO) presents a 16 month total return of 22.2%. This consists of 9.5% from dividends and 12.7% from capital appreciation to par value. The move will be catalyzed by its conversion to floating rate dividend on 10/15/24 at which point the dividend yield jumps up to the SOFR equivalent of 3 month LIBOR plus 499.3 basis points. At today’s interest rates and today’s price that would be a yield of 11.88% which is far too high of a yield for a company of AGNC’s stability. This buy thesis contains 4 parts:
- Evidence of similar moves in recent history
- Evidence of mispricing
- Intracompany arbitrage
- Fundamental stability of preferred dividends and liquidation preference
- Interest rate risk
Evidence of similar moves in recent history
On September 29 th, 2022, Annaly ( NLY ) Preferred F ( NLY.PF ) traded at $22.32. By October 4 th it traded at $24.41. In just 3 market days the stock spiked over 9% as the preferred converted to variable rate from its former fixed rate. The dividend increased significantly and the market price followed.
On October 14 th , 2022 AGNC Investment Corp. Preferred C (AGNCN) traded at $22.17. By December 22 nd it was at $25.26. This 14% move occurred as the preferred converted to variable rate from fixed rate. Again, the dividend increased and the market followed.
This behavior can be seen on the charts below.
The aspect I find remarkable about these price surges is that no new information was released.
The dividend change was a pre-scheduled event and the knowledge of it was readily accessible to anyone who read the preferred offering documents. The information was there, yet the market simply failed to respond until AFTER the dividend change took place.
Remarkably, it is happening again, and an opportunity of similar obviousness and similar magnitude is again available.
AGNCO converts to its much higher floating rate yield on 10/15/24 which using today’s levels will take it to a yield of 11.88%.
2nd Market Capital Portfolio Income Solutions Preferred Tracker
The market is not pricing that in. The market only sees the fixed coupon of 6.50% and is trading it at a current yield of 7.33%.
A 7.33% current yield is appropriate for this interest rate environment given the stability of AGNC, but trading it as such ignores the rather sizable increase scheduled for October 2024.
Evidence of mispricing
AGNCN has pari-passu risk with AGNCO because they are issued by the same company and get identical priority in both dividends and liquidation waterfall. Yet the 2 issues trade at widely disparate valuations.
- AGNCN is trading correctly at $25.47 which represents a 10.46% yield and a slight premium to par.
- AGNCO is trading incorrectly at $22.17 as that price represents an 11.88% yield upon conversion.
The difference here is that AGNCN is currently paying variable yield so the market is aware of its dividend yield. As evinced by both NLY-F and AGNCN prior to going variable, the market is somehow blind to what is coming and does not see AGNCO as its variable yield.
Let me walk you through a little exercise to demonstrate the arbitrage between AGNCN and AGNCO.
We can begin by adjusting for the slight difference in variable yields. AGNCN has a slightly higher variable coupon at the SOFR equivalent of LIBOR + 511.1 versus AGNCO at LIBOR +499.3
To account for this difference, AGNCO should trade at a lower price such that the yields roughly match. Thus, I posit fair value on 10/15/24 for AGNCO is slightly above $25 compared to AGNCN’s $25.47 as that would equate its yield to that of AGNCN. For simplicity let’s call it $25 even.
Given that AGNCO trades at $22.37 today, the market is implying that the dividend difference between AGNCO’s fixed yield and AGNCN’s variable yield over the next 16 months is going to be $2.63.
Thus, for the 2 securities to be fairly valued with respect to one another, 3 month LIBOR would have to immediately jump to 930 basis points immediately and stay there for the entire 16 months as per the calculations below.
2MCAC
Even the most aggressive Fed forecasts don’t suggest LIBOR even getting above 6.5%.
Therefore, there is severe mispricing within AGNC’s preferred capital stack and a clear arbitrage. Anyone who owns AGNCN can sell it, buy AGNCO in its place and net a significantly better result in any world where short term interest rates don’t immediately go to 930 basis points.
Mathematically, the mispricing between the AGNC preferreds is clear. It behooves us to consider whether AGNCN is overpriced or AGNCO is underpriced. Fundamental analysis suggests the latter.
Fundamental stability suggests full par value is appropriate
AGNC owns a large portfolio of what are inherently low risk securities.
As these are backed by the U.S. government agencies, AGNC is effectively guaranteed par value when the loans are paid off by the borrowers or even if the borrower defaults. In a vacuum, such a portfolio is “riskless”, but since spreads are low, AGNC does have to lever up to generate a total return sufficient to please equity markets. As of most recent quarter, AGNC has about 7.2X leverage.
This introduces some risk into the equation.
AGNC hedges certain types of risks extensively. Through the use of swaps and other interest rate hedges, they are largely immune to parallel shifts to the yield curve. Even large changes to interest rates result in fairly tame changes to book value.
A bigger risk exists in the spread between MBS and similar duration treasuries tightening or widening. This risk is harder to hedge and has a fairly large impact on book value.
It is worth noting that spreads recently blew out and if one were to plot the spreads relative to history on a bell curve it reached a Z score over 2X.
In other words, spreads got extremely wide. This hurt book value and AGNC common share price fell in sympathy. Spreads have moderated somewhat, but remain quite wide relative to history.
I view this as a good thing because going forward the path of least resistance is reversion to a more normal spread which would result in significant gains to book value. Assuming some level of rationality in capital markets, the spread between a government backed security and treasuries can only get so wide given they have very similar risk profiles.
The sort of jostling in capital markets described above happens from time to time and makes the common shares a somewhat volatile high yield investment. Although I think shares are somewhat cheap now, I am still not a huge fan of the common.
Preferreds operate in a very different fashion. Since preferreds have a fixed liquidation preference, in this case $25 per share, and sit above the common in the capital stack, the entire common equity serves as a cushion.
I have no doubt there will be jostling in the future, but it strikes me as highly improbably that it would be so severe as to make it through the cushion. One of the reasons I like AGNC preferreds in particular over those of other mREITs is that it has a huge equity base.
S&P Global Market Intelligence
As AGNC trades at a slight discount to book value, the actual amount of equity capital beneath the preferreds is above $6B.
Value destruction of that magnitude would require something catastrophic. AGNC is well managed and owns assets that are inherently stable. As such, I consider its preferreds to be reasonably low risk preferreds.
I consider par value of $25 per share to be roughly fair value for AGNCO. Even at par, AGNCO would provide a 10.54% dividend yield at today’s interest rates once it goes variable (assuming today’s interest rates).
I actually think that sort of yield would cause it to trade well above par except that it will be callable. Thus, it will probably float somewhere slightly above par as investors weigh call risk against the outsized yield.
Interest rate risk or lack thereof
The variable rate nature of AGNCO perpetually starting on 10/15/24 makes it largely immune to changes to interest rates.
At first it might seem like investors would want rates to be higher because the higher SOFR gets the higher one’s yield gets, but remember that all investments are relative. With its variable yield set to 3 month LIBOR +499.3, AGNCO will always yield 5% more than short term interest rates.
That is a big spread which makes it a good yield regardless of the environment. In an extremely low interest rate environment with LIBOR/SOFR at 1%, AGNCO would yield about 6%.
6% is good in a zero interest rate environment.
In a higher interest rate environment where LIBOR/SOFR is 7% then AGNCO yields about 12%.
12% is good in a 7% interest rate environment.
The point is that regardless of where interest rates move, AGNCO is roughly equally attractive on a relative basis. As the 499.3 basis point premium to prevailing yields is generous relative to the risk level of the preferred, I think AGNCO will trade at or slightly above par regardless of interest rate level.
Summary of opportunity
AGNCO trades today at $22.15.
In 16 months it converts to a much higher variable yield which I believe will catalyze its move to $25 per share. That $2.85 gain on top of the dividends results in a 16 month total return just north of 22%.
That is an outsized return for a lower-than-normal risk security as the preferred of a well-capitalized large cap company.
Similar opportunities abound
The preferred space is wrought with mispricing. Despite being fixed income securities whose valuations should be calculable with bond-like precision, market prices bounce all over the place. On a weekly basis, new opportunities pop up similar to the present one with AGNCO discussed in this article.
The best way to spot these is to build out a spreadsheet with API feeds updating to live data. Determine the fair values of the various preferreds and watch as the spreads between fair value and market price bounce around.
We did this and made our spreadsheet available to Portfolio Income Solutions subscribers. It is quite fun to watch the erratic market. Essentially what happens is that these preferred shares are very thinly traded, sometimes just a few hundred shares per day, so when someone foolishly puts in a market order instead of a limit order it can wildly swing prices.
There is also a lack of price discovery as so few entities are tracking these preferreds that the mispricing can compound upon itself resulting in some crazy situations like that time when Innovative Industrial ( IIPR ) Preferred A was trading at a negative 22% yield to call .
It is a great sandbox in which to play. Opportunities abound.
For further details see:
AGNC Preferred About To Yield 11.88% Upon Conversion To Floating