2023-08-21 14:19:29 ET
Summary
- AGNC Investment Corp offers a high-dividend yield that appears to be sustainable in the near term.
- The company's business model is focused on generating income from its investment portfolio to provide a regular income stream to shareholders.
- AGNC's financial performance has been impacted by rising interest rates, but there are signs of improvement in the market landscape for mREITs.
AGNC Investment Corp ( AGNC ) offers a very high-dividend yield, that seems to be unexpectedly sustainable in the near term, even though Annaly seems to be a better option in the mREIT sector.
Company Overview
AGNC Investment Corp is an internally-managed real estate investment trust ((REIT)), which invests primarily in agency-backed mortgage securities (agency MBS). The company is relatively young given that it was created back in 2008, to invest in single-family residential mortgages and collateralized mortgage obligations, financed primarily through collateralized borrowings structured as repurchase agreements (repos).
The company performed its IPO in 2008 and trades on the NASDAQ, and its current market value is about $5.8 billion, being smaller by this measure than its closest peer Annaly Capital Management ( NLY ). At the end of 2022, its investment portfolio amounted to $59.5 billion, a decline of 27% YoY, which is explained mainly by general weakness in the fixed income markets during the last year, due to the rising interest rate environment.
AGNC's main goal is to provide shareholders with an easy way to invest in agency MBSs, aiming to create value over the long term both through dividend distributions and net asset value growth. Its business model is quite straightforward, aiming to generate income from its investment portfolio to provide a regular income stream to shareholders. On the liabilities side, AGNC finances its investments mainly through repos, which are borrowings with a short-term duration, usually up to one year, with the company generally speaking making a profit between the difference of short and long-term rates.
To generate a significant return on capital employed, AGNC leverages its balance sheet, which the company defines as total assets to tangible shareholders' equity. Its goal is to maintain this ratio within a range of 6-12x, which has fluctuated over the past few years as shown in the next graph. At the end of 2022, its leverage ratio was about 8x, a level that is acceptable and at the middle of its target range.
Leverage (Finbox.com)
Due to increased market volatility and wider rate spreads (the difference between short and long rates), AGNC took a more conservative approach regarding leverage in recent quarters, aiming to protect its book value during a period of rising rates.
This is important because, as I've analyzed previously on Annaly , mREITs business model does not work well in a rising interest rate environment and AGNC is no exception.
Indeed, AGNC's business model usually works in an upward sloping yield curve, when long-term rates are higher than short-term rates, but this has not been the case over the past few quarters as the Federal Reserve has been aggressively hiking the Fed funds rate. Currently, the 30-year treasury rate is about 4.43%, while the 2-year treasury rate is around 4.95%, showing that in the current yield curve environment, borrowing in the short term to invest in longer maturities is not profitable.
This means that AGNC, and its mREIT peers, are highly exposed to interest rate risk and have to manage this risk actively to protect and profit from changes in interest rates. Not surprisingly, AGNC's share price performance has been negative over the last year, as the company's book value has been impacted negatively by rising rates.
In my opinion, the rising cycle is almost done, and it is quite likely that the Federal Reserve has reached its peak rate, or is close to reach that level. Therefore, I don't expect much upward pressure on rates going forward, especially long-term rates as inflation is also showing signs of strong moderation, which means that the market landscape is likely to improve for mREITs over the next few months.
Having said that, I also don't expect the Fed to start cutting rates in the coming months, thus rates shouldn't be as volatile in the near future, which means AGNC's book value is likely to move sideways in the coming quarters and potentially increase, if eventually inflation moderates to levels near or below 2% in the coming quarters and if the Fed starts to gradually cut rates during 2024. However, it's currently quite uncertain if this scenario will happen during this timeframe and investors should be aware that monetary policy can change more rapidly than expected right now.
Financial Overview
Regarding its financial performance , AGNC has reported somewhat weak and volatile financial figures over the past few years, showing that its business is cyclical and can have large swings in a relatively short period of time.
Indeed, in 2022, AGNC reported a net loss as the company's business was impacted by rising rates, compared to a net income of around $640 million in the previous year, even though the company had most of its portfolio hedged for interest rate risk. Despite that, mark-to-market of securities was quite negative and mostly explains its reported loss for the year, as the drop in market prices was quite considerable for agency MBS.
Reflecting the gradually worse market environment for the company, AGNC's net interest income ((NII)) declined over the year as rates spreads became wider, with quarterly NII dropping from $448 in Q1, to only $25 million in Q4. For the full year, AGNC's NII amounted to $966 million, a drop of 25% YoY.
While its operations have a very low-cost basis (annual expenses of only $74 million in 2022), as the company only has some 50 employees and is therefore quite efficient, its net losses on investments amounted to more than $2 billion and led to a net loss for the year of nearly $1.2 billion. Its tangible net book value dropped from $15.75 per share, to $9.84 at the end of 2022, representing an annual drop of 37% YoY.
During the first six months of 2023, AGNC maintained a conservative approach to its balance sheet management and reduced leverage to a ratio of 7.2x, which seems sensible given that rates continued to rise during this period. At the end of last June, its total assets amounted to $58 billion, a small decline compared to the end of 2022 (-2.5%), remaining heavily invested in the 30-year agency MBS.
Its portfolio remained highly hedged for interest rate risk through interest rate swaps, swaptions, and futures, leading to a small duration risk at the end of Q2 2023.
Rates sensitivity (AGNC)
Despite this conservative approach, AGNC's financial performance continued to be affected by higher rates, leading to negative NII in the first half of 2023. However, due to AGNC's hedging strategy its gains on financial derivatives were higher than losses on securities, leading to net other gains of about $340 million in the first half. As expenses were practically flat in the period, AGNC's net income was $74 million during H1 2023, a positive improvement compared to its recent past. Its comprehensive income per share was $0.25 per share, impacted negatively by the issuance of new equity during the period.
Regarding dividends, AGNC must distribute annually some 90% of its taxable income, like other REITs. Therefore, there is not a minimum dividend level, and its dividend can be volatile over the long term, as theoretically it should be linked to its annual earnings. However, there are differences between GAAP and taxable income, thus AGNC's dividend may be different from what would be expected looking at its reported earnings under accounting rules.
Despite this background and the company's volatile earnings over the past couple of years, its dividend has been remarkably stable at $0.36 per share quarterly, even though its payment frequency is monthly. This leads to an annual dividend of $1.44 per share, which at its current share price leads to a dividend yield of about 15%. This is a very high-dividend yield, but slightly lower than compared to its closest peer Annaly, which is currently yielding around 16%.
Dividend history (AGNC)
As usual, a very high-dividend yield is potentially a sign of poor dividend sustainability, or undervaluation of its shares. In AGNC's case, its shares are currently trading at around 0.9x book value , in line with its historical average and its peers, thus it appears to be fairly valued.
Regarding dividend sustainability, while its dividend has not been covered by earnings, looking at the cash flow statements the dividend seems to be more sustainable than I was expecting at first glance. AGNC's cash position at the end of 2022 was around $2.3 billion, while its annual dividend payments amount to $870 million, plus its operations have been generating net cash above $1 billion over the past three years, boding well for its dividend sustainability over the next few years.
Conclusion
AGNC Investment Corp is an interesting income option, even though in my personal case I already own Annaly and I don't see much benefit of owning both stocks in my income portfolio. The business model of the two companies is quite similar, and they are heavily exposed to the same macroeconomic factors, namely interest rates, thus there isn't much diversification benefit of owning both stocks.
Despite that, AGNC's high-dividend yield can be considered to be risky, given that its operations are volatile and dividends are not covered by earnings, but AGNC's cash position and good cash flow generation capacity are good signs that it can maintain its dividend level in the near future.
For further details see:
Should You Buy AGNC Investment Corp For Its 15% Yield?