2023-11-28 07:35:00 ET
Summary
- The most important bill you'll usually pay? Your mortgage.
- Mortgage-Backed Securities values have swung wildly in 2023 as rates climbed swiftly; currently, they trade as a discount to PAR.
- I am collecting outstanding income knowing MBS values are set to rise swiftly.
Co-authored by Treading Softly.
There is an old adage or belief that when interest rates rise, fixed income dies. The reason behind this is that, as interest rates rise, investors will leave fixed-income investments for the safety of Treasury notes or other higher-yielding opportunities, because their entire risk perspective gets skewed.
Why would I hold a 3% dividend stock when I can get a 5% Treasury note? Indeed, I hear many talking about selling stocks yielding 8% or even 10% to buy Treasuries because of the perceived improvement in safety. For the short-term minded, this makes perfect sense.
Your money market account yielding 5% is a highly attractive place to store cash until interest rates fall again, and then its yield evaporates. Then you'll have to find that yield somewhere else. As a long-term investor, I look at the problem from a long-term angle. I don't want to lock in income just today. I want that income to persist 3, 4, 5, or even 10+ years down the road.
One of the lowest-risk investments outside of Treasury notes that exist in the market is Agency MBS (Mortgage-Backed Securities). If the loan defaults, you could still get the full principal value back. However, as interest rates have risen, MBS values have dropped as investors are selling them at a discount to their par value, seeking yield elsewhere. This makes an outstanding opportunity to buy the dip.
One option to invest in agency MBS is through mortgage real estate investment trusts, or mREITs. These are REITs that invest in various sectors of the mortgage industry. While mREITs that invest in agency MBS carry leverage on these low-risk assets, causing greater volatility in price movements, I can collect great income.
Let's take a look at one of my favorite agency mREITs available in the market today.
Buying the MBS Dip
AGNC Investment Corp. ( AGNC ), yielding 16.5%, didn't have a lot of surprises in their Q3 earnings report because they pre-released their earnings. We already knew net earnings came in at $0.65/share, easily exceeding the dividend, and we already knew that book value was hit hard like it was for all agency mortgage REITs. The price of agency MBS fell in September and kept falling in October. The 6.5% coupon MBS declined from $102 at the end of June to below $99 in October – which in the MBS market, is a large decline. Prices have rebounded a little bit, but there is no certainty whether the bottom is in. Source .
If we look at the big picture over the past decade, we can see how MBS prices have been on a steady downward trend since 2021.
Since AGNC 's primary asset is agency MBS, this has had a meaningful impact on book value. Especially since the hedges AGNC uses is to short U.S. Treasuries, while AGNC enjoyed gains on those short positions, MBS prices have fallen more than Treasury prices. So those gains were not enough to make up for the decline in MBS prices.
However, as we've pointed out before, these are unrealized losses. AGNC did some trading, moving into higher coupon MBS, but they have been actively increasing their MBS portfolio. Essentially it is using a "buying the dip" strategy.
Looking at the par value outstanding relative to the current market value helps us remove the noise of the market. Since MBS will repay at par value, par value is how much money AGNC will receive at some point in the future. If they simply stopped doing everything and sat on their hands, the par value will be repaid to them over time.
Here is a look at Q2 2023, AGNC had $58.8 billion in par value, with a market value of $56.478 billion. Source .
AGNC Investment Q2 Presentation
Here is a look at the same slide for Q3 2023:
AGNC Investment Q3 Presentation
Note how the par value increased to $61.8 billion, while the market value is $57.7 billion. The average coupon also increased from 4.42% to 4.71%. In other words, AGNC is owed more money and is collecting a higher coupon, while book value is representing a larger discount to par.
As we can see, AGNC increased the size of its portfolio. Some have worried about the leverage ratio, which AGNC has increased to 7.9x debt to equity – which is the highest leverage that AGNC has held in years. So they fear that somehow AGNC might be "forced" to sell assets at low prices. True, AGNC is relying on having the ability to continue holding its current assets. Being forced to sell assets at poor prices would be very bad. However, it is a fear that doesn't really hold any water. Why?
- MBS prices have already crashed. See the chart above, Agency MBS prices are trading at the lowest ever seen. Since MBS prices are strongly correlated with U.S. Treasury prices, it is very reasonable to believe that most of the damage has already been done. Mortgage rates have climbed from 3% to 8%. Are they more likely to keep going to 13%? Or is it more likely that they peak and eventually settle somewhere between 6-10%? We certainly can't rule out more downside risk, but it seems a safe bet that whatever downside we see in the next year will be less than we've seen recently.
- AGNC is nowhere close to its historical leverage levels. AGNC is at 7.9x leverage, if we look back, that is where it was in 2017-2018. In 2019, AGNC's leverage climbed up to 9.8x. If AGNC's leverage was 10x today, there would be cause for concern if you expected another significant leg down in agency MBS. But at current leverage, AGNC has the liquidity to manage a big leg down and still have ample cash on hand. Remember, AGNC carried this leverage right before the black swan known as COVID.
So while others are running around worried about AGNC's book value this quarter, we remain focused on the big picture. We own MBS because we don't believe that current conditions will persist forever. A recession is going to happen, and agency MBS prices will go up. We don't know when but we absolutely want AGNC in our portfolio when it does.
Conclusion
With AGNC, I am buying into a massive double-digit yield while recognizing a few very important facts:
- Agency MBS prices have already collapsed and are primed to rise.
- Interest rate hikes have an oversized impact on book value.
- Agency MBS matures at PAR like any other fixed-income investment.
- If the underlying borrower defaults, the agency will buy back the loan at par value.
- AGNC's leverage is not close to historical max levels, providing room to leverage up at these low prices.
Knowing all of this, I am buying up shares of AGNC to enjoy the massive income provided, especially in economically turbulent times. High interest rates are having continued impacts on the U.S. economy, and when rates fall, I want to be positioned to enjoy massive income and capital gains. I am happily collecting great income to wait.
When it comes to retirement, I hope most of us have the opportunity to own our home in full – if we choose to do so. If not, I want your income from your portfolio to readily pay your bills and leave you with a surplus to enjoy a retirement marked by abundance and relaxation. True financial independence and freedom can be found in owning outstanding income opportunities from the market.
I'm willing to bet my income on your house.
That's the beauty of my Income Method. That's the beauty of income investing.
For further details see:
I'm Betting On Your House And Getting 16% Yield: AGNC