2023-07-18 07:35:00 ET
Summary
- You can earn massive yields from others' misunderstandings.
- Often the simplest approach is best, and when approaching a mREIT, it's best to use the basics of fixed-income investing.
- As a professional income investor, I don't want you running around like a chicken with its head freshly cut off or being stuck in place like a stone statue.
Co-authored with Treading Softly
Have you ever been referred to as someone who is trigger-happy? For many of us, we know that this is the opposite of someone who is careful and well-planned before executing decisions.
A trigger-happy person will be one who responds to the slightest piece of potential information in the news with the most extreme possible actions. They catch a whiff of the breeze being different and decide to sell their stocks because a recession is coming. They smell a fall in the air, and a fall means prices are going to go down.
The opposite can be just as bad, being someone who is so stuck in analysis mode that they never make it to action. This can be called "paralysis by analysis." It's where someone has to think through every possible outcome and decision and ramification that they never actually make it to the big step of making a choice or doing an action.
When it comes to retirement planning, you will meet retirees of both stripes, those who react emotionally and sometimes even with a violent level of emotion at the slightest provocation by the market, and those who are unwilling to do anything until they have seen every potential outcome and thus miss great opportunities due to their lack of motion.
As a professional income investor, I don't want you running around like a chicken with its head freshly cut off or being stuck in place like a stone statue. You need to be one who can make rational, careful decisions that are not emotion-based, using as much information as possible, processing it, and drawing a conclusion and thus making a decision.
Today I want to look at an investment that many have written off because they haven't taken the time to understand it. Others who understand it are too afraid of when to make a choice or make a move to take action. I want to show you how you can get paid handsomely because of both types of investors' lack of understanding of this particular investment.
Let's dive in!
AGNC Investment Corp ( AGNC ) is a mortgage REIT specializing in "agency" mortgage-backed securities, which yields 14%. Agency MBS is a unique investment because the investor does not carry the credit risk; instead, the agencies – Fannie Mae or Freddie Mac – guarantee the mortgages. If a borrower defaults, the agency buys back the mortgage from the investor at par value.
This creates an unusual situation when agency MBS trades below par: investors earn a higher rate of return if defaults rise! For the investor, a default is no different than a repayment because if a loan defaults, the agency pays the investor par. The investor can then take those par dollars and reinvest them into new mortgages that are also trading at a discount to par.
Agency MBS prices tend to correlate with U.S. Treasuries since there is no credit risk. Yet they differ slightly because borrowers can voluntarily repay or default. With a U.S. Treasury, you know the specific date that you will get your principal back. With Agency MBS, you will usually get your principal back well before the maturity date, as most mortgages are repaid early through some combination of refinancing, selling the home, or defaulting.
AGNC invests in agency MBS on a leveraged basis – this means that AGNC borrows money to invest in MBS. Since there isn't any credit risk, AGNC is able to use a substantial amount of leverage relative to other types of investments. Source
AGNC Q1 2023 Presentation
Currently, AGNC is at 7.2x leverage. For every $1 in book value, AGNC is borrowing $6.20. So if AGNC owns an MBS that is trading at $100 par value, approximately $14 is shareholder equity, and $86 is borrowed.
How does AGNC earn money? Take an MBS trading at par value with a coupon of 3.5% – this was the case in March 2022 – and AGNC pays $14 and borrows $86 to buy the MBS. AGNC collects $3.50/year in interest payments, but AGNC also has to pay interest on the $86 it is borrowing. This is where "net interest spread" comes in; that is the difference between the interest rate that AGNC is receiving and the interest rate it is paying.
AGNC Q1 2023 Presentation
So AGNC is earning the coupon on its equity portion, plus the difference between the coupon interest received and interest paid on the borrowed portion. Using the example above, if you assume a 2% net interest spread, AGNC is receiving a 3.5% coupon while paying 1.5% interest on the $86 it is borrowing. $86 * 1.5% = $1.29. $3.50 revenue minus $1.29 = $2.21. On equity of only $14, that is a 15.8% yield on equity – this is how AGNC generates a double-digit yield from an investment that has coupons in the low single digits. Over the past couple of years, AGNC has seen a large increase in its net interest spread, but at the same time, it has been deleveraging from 7.9x to 7.2x. As a result, its earnings have been relatively stable while the size of AGNC's portfolio has declined.
AGNC Q1 2023 Presentation
There is no magic involved here; it is simply the benefit of using leverage. However, leverage also creates some risks. Over the past year, Agency MBS has seen significant price declines. Note the 3.5% coupon MBS was trading near par at $100.21 at the end of Q1 2022, but at the end of Q1 2023 was trading at $92.82
AGNC Q1 2023 Presentation
When you have $14 in equity on a $100 investment, a $7+ decline in price results in a substantial decline in equity. The $86 owed doesn't change; the equity changes.
This is why AGNC has seen a significant decline in book value over the past year, even as its earnings power remained high.
AGNC Q1 2023 Presentation
Scary right? This is why a lot of folks have panicked about agency mREITs. Book values collapsed hard last year, so they panic and sell, despite the fact that AGNC is producing as much cash flow as it was before.
But remember how we started? Agency MBS repays $100 par 100% of the time – the agencies guarantee it. So while a 3.5% coupon MBS might be trading at $92.82, if the borrower defaults, AGNC gets $100; if the borrower refinances, AGNC gets $100; if the borrower prepays, AGNC gets $100, at maturity AGNC will receive $100. The MBS is carried on the books with a value of $92.82, but AGNC will receive $100 for it; it is only a question of when.
AGNC's current portfolio is trading at a discount to par. You can see its "par value" is $56.903 billion, while it is carried at a value of $55.149 billion.
AGNC Q1 2023 Presentation
Just like the unrealized losses come directly out of the equity, the gains will add directly to the equity. That is about $1.75 billion, or $3.02/share, just from MBS prices returning to par. And that is assuming that AGNC doesn't increase leverage when MBS prices start rising.
MBS prices, like all bond prices, have faced significant headwinds due to rising interest rates and declining Treasury prices. This has created downward pressure on AGNC's book value. Yet the unique aspects of agency MBS mean that value will be recovered for those who are patient. While we wait for book value to recover, AGNC's portfolio is generating substantial cash flow and producing earnings that covered the dividend by 194% in Q1. We are being paid very well to wait.
Conclusion
It's a beautiful thing; you don't have to be a quantum physics theorist to understand the basics of fixed-income investing. As long as you can understand that there is such a thing as a par value, and that the trading value and the par value are not always the same – you are already off to a great start. Then you understand that the stated yield at par will move to the stated yield of its trading value. All of this is very simple and basic to understand, yet many analysts will complicate this when they look at an investment like AGNC. AGNC, to many, is a financial black box simply because they don't understand that the basic tenets of fixed-income investing are being applied on a wider and larger scale. Instead of thinking of thousands of dollars for some reason, their mind blanks when it comes to billions. This shouldn't be the case.
The simple thesis behind AGNC is this: currently, they are buying MBS at steep discounts. When these mortgages mature, they mature at par value and are guaranteed by the agencies to do so. So, if they buy something for $92, they're going to get $100 back – guaranteed. The question becomes will AGNC be able to keep buying these great deals while interest rates are high and be able to hold them until interest rates are lower and trading values of MBS go back up to a premium? If you believe in the management's ability to keep the train running on time through a high-interest rate environment until the rate cuts start – AGNC is a blanket buy. If you believe that the management won't be able to keep the music playing, then you shouldn't buy it at all.
While agency MBS are fantastic investments for long-term holding, mREITs, like AGNC, add a new layer of complexity that many investors simply misunderstand. But this layer of complexity is not that complicated when you sit down and look at it from a "basics of a fixed-income investing" point of view.
I expect interest rates to start being cut as early as potentially the end of this year or the beginning of next year. Therefore I see that AGNC will profit strongly as it has in the past, as we've shown in prior articles, once interest rates are falling and the economy is stumbling. So I'm buying here. I'm locking in excellent double-digit yields via monthly dividends because my retirement is going to be paid for by dividends. Yours can too.
That's the beauty of my Income Method. That's the beauty of dividend investing
For further details see:
Buy The Dip And Earn 14%: AGNC