2023-07-28 08:00:00 ET
Summary
- AGNC's Q2 results were impressive despite the challenging interest rate environment.
- The company managed to pay its dividend, maintain a stable book value, and achieve strong operating EPS through hedging strategies.
- I review the mechanics of AGNC's changes in book value, which ultimately depends on changes in MBS supply and demand.
- Those supply and demand trends for MBS should be positive creating a significant upside for AGNC's stock price.
AGNC's Q2 - pretty awesome, considering
AGNC Investment (AGNC) is a seriously interest-sensitive company. Its business model is to manage the interest rate risk of fixed-rate mortgage-backed securities ((MBS)). Here is the headwind AGNC has been working against since the start of last year:
The Federal Reserve hasn't increased interest rates this aggressively in a long time. As a result:
The Company's average asset yield on its investment portfolio was 3.72% for the second quarter…For the second quarter, the weighted average interest rate on the Company's repurchase agreements was 5.01%." ( AGNC Q2 '23 earnings press release )
Do the math. Assets yielding 3.7%, and liabilities to fund those assets costing 5.0%. Seems like SIVB all over again, doesn't it? Yet, AGNC:
- Paid $0.36 per share in dividends.
- Had operating EPS of $0.67.
- Keep its tangible book value stable $9.39 a share.
How did AGNC's management pull those furry rabbits out of that shabby hat? Through the magic of hedging. AGNC swaps the variable cost of its short-term repo debt for fixed rate debt to better match its debt maturities with its MBS maturities. As a result, " Inclusive of interest rate swaps, the Company's combined weighted average cost of funds for the second quarter was 0.63%."
This chart shows a history of the percent of its debt that AGNC hedges:
As you can see, AGNC actively adjusts its hedges as the MBS investing environment changes. Remember back in 2021 and 2021 when everyone was refinancing their mortgages because the Fed pushed mortgage rates to record lows? AGNC had to keep its debt maturities short-term also, so it hedged less. Then AGNC anticipated the Fed tightening since 2022, which halted refinancing activity and increased the life expectancy of mortgages.
Yes, AGNC's $0.36 quarterly dividend is below the $0.54 dividend it paid as recently as Q1 2019. But AGNC has survived the Fed's wild swings to take advantage of better days. And better days very likely lie ahead. Several years ahead.
Why I am so optimistic about AGNC. Its earnings mechanics in 3 charts
The first chart is this history of AGNC's price-to-book value:
Over time, AGNC's stock price is about equal to its book value. The discerning reader should now ask, "So what drives book value?" I'm glad you asked. Your question is answered by this second chart. It compares AGNC's book value to the "mortgage spread", which is the difference between the 30-year fixed rate mortgage yield and the 10-year Treasury bond yield:
AGNC is essentially long MBS and short Treasuries. A wider spread between their two yields means the longs are doing worse than the shorts, which reduces the book value. And vice versa. You can see that at present, this long/short trade is doing about as badly as it ever has.
Back to you, the discerning reader. Your next question obviously is, "OK, I see the importance of the mortgage spread for AGNC's stock price. So what factors drive changes in that spread?"
I have the answer! Or at least the main answer. It is based on good old supply and demand, in this case for MBS. The supply of MBS is measured by changes in the amount of MBS outstanding. Demand comes from a wide range of fixed income investors, but two stand out - the Federal Reserve and banks.
The Fed is a "non-economic" MBS investor. And it is a big investor - at present it owns a remarkable 34% of all MBS outstanding. It doesn't buy or sell because of expected returns on investment, but to support its economic agenda. In fact, it often buys or sells MBS in order to impact housing demand. At present it is selling MBS in order to cool off housing demand.
Banks are not natural MBS investors because the long maturities of fixed rate mortgages don't match with the short-term nature of their deposits. MBS flows therefore are typically tied to the banks' amount of excess deposits sitting around. For example, the huge inflow of deposits from COVID checks encouraged banks to raise their MBS holdings from $2.4 trillion at the end of 2019 to $3.5 trillion at the end of 2021. A bad idea, when the Fed started raised interest rates. Right, managements at SIVB and First Republic? They have been sellers since then.
To put supply and demand together, I measure the last four quarters' new supply of MBS and subtract the last four quarters' change in Fed and bank MBS holdings. This third chart compares the result of that calculation to the mortgage spread:
Clearly my supply/demand measure is a major driver of the mortgage spread.
To summarize the mechanics, the main driver of AGNC's stock price is the change in the supply of new MBS and demand from the Fed and banks.
The exciting supply/demand outlook
In this section I have taken a number of quotes from AGNC's Q2 earnings conference transcript because thankfully AGNC management knows a lot more about its business than I do. I start with their summary of the supply/demand outlook:
We are at the forefront of one of the most compelling investment environments that we have experienced in our 15-year history."
AGNC is excited for a number of reasons.
Reason #1: Slow new supply. I'll handle this one. This chart shows the trend in MBS outstanding growth:
Growth should remain quite slow for at least several years for three reasons:
- Housing is not very affordable because of the post-COVID surge in home prices and high mortgage rates.
- The bulk of homeowners have 4% or lower mortgages, so moving and giving up that mortgage is expensive.
- Taking cash out of home equity is also very expensive because of high mortgage rates.
Slowing supply should narrow the mortgage spread.
Reason #2: Fixed income investments are getting more attractive, on an absolute basis…
"The Fed has neared an inflection point in monetary policy and interest rates and perhaps has already reached its cyclical high point. Fixed income investments are therefore an increasingly attractive asset class. Consistent with this more favorable interest rate outlook, bond funds have continued to experience substantial inflows."
Reason #3: …And MBS is attractive on a relative basis.
"Agency MBS also look compelling relative to investment grade corporate debt. From 2010 to 2022, the average spread differential between Agency MBS and the Bloomberg Investment Grade Corporate Bond Index was negative 75 basis points, which is to be expected given the superior credit quality of Agency MBS. However, at today's spread differential of positive 15 basis points, Agency MBS are about 90 basis points cheap to the historical average."
Reason #4: Bank MBS selling should be nearing its end.
"The stresses in the regional banking system have largely abated and further forced bank liquidations are unlikely."
The odds therefore favor a narrowing in the mortgage spread from the 300 bp range today towards its historical norm of about 175 bp. That normalizing could take AGNC's book value from about $10 today to something like $15. This would not be unprecedented. The same thing happened following mortgage spread compression following the Great Financial Crisis , as the book value/mortgage spread chart above shows.
Three other reasons to be confident about the dividend
So far, I have argued that AGNC's book value should surge. Now I'll give three reasons why the current $1.44 annual dividend appears quite safe and could even be increased.
Reason #1: Those current wide mortgage spreads. They stink for book value, but are great for earnings, as AGNC explained:
"If you look at new current coupon mortgages, you're probably in the neighborhood of 180 basis points [in interest margin]. If you lever that something like 7.5 times, given our operating expense of a percent, you should come out in the high teens in terms of an economic return on the portfolio on a go forward basis."
A high teens return on book value is nearly $2.00 a share, amply covering the $1.44 dividend.
Reason #2: Lower hedging costs. I showed above that AGNC's hedging position today is well above normal. Hedges cost money. So this is a welcome comment from AGNC:
"In a scenario where the Fed is shifting toward an easing policy, we will likely operate with a lower hedge ratio, perhaps well under 100% at some point, which would be another source of earnings potential on our portfolio."
Reason #3. More financial leverage. AGNC's current financial leverage - debt outstanding to equity - is 7.5. When it has been confident in the past that Fed policy is stable, it has increased its leverage to 8 and even 9 times.
Wrapping up
An attractive dividend yield with big capital appreciation potential.
If I am close to right in my views above, AGNC should at least maintain its 14% dividend yield and have the capacity for a 50% or so stock price upside.
For further details see:
Buy AGNC Stock, The Turn Gets Ever Closer