2023-08-15 07:35:00 ET
Summary
- AGNC Investment Corp. is a mortgage REIT that offers a 14.6% yield and has historically low leverage.
- AGNC's portfolio of agency MBS is currently mispriced, providing an excellent investment opportunity.
- Annaly Capital Management, Inc. reported in-line Q2 earnings and has been steadily growing its agency MBS portfolio, positioning it for future recovery.
Co-authored with Treading Softly.
To this day, I can still remember the feeling I had the first time I got paid for a job. I can tell you that it wasn't a lot, but what I can also tell you was that I had a sense of accomplishment. I had done hard work and had been paid for it, something that had never happened to me previously. Interestingly, the love for payday never seems to go away. Whenever I've spoken to the richest and wealthiest individuals, or those who are living hand to mouth, every single one of them loves payday.
Why is that? I think the answer is simple. We simply love to get paid. We love having money come into our account. It's enjoyable.
When it comes to the stock market, so many eschew getting paid by the market as if it's some fool's errand, and yet we wonder why so few retirees save for retirement. Perhaps, if more people spent time focusing on helping people enjoy their retirement savings instead of trying to belittle them for enjoying it, there may be more success to be found.
Today I want to take a look at two companies that pay you an outstanding income from owning mortgages tied to people's homes. So many misunderstand these companies and are missing out on excellent income. So let's take a look at their most recent quarterly earnings and see if we can uncover some more information about both.
Let's dive in!
Pick #1: AGNC – Yield 14.6%
AGNC Investment Corp ( AGNC ) is a mortgage real estate investment trust, or mREIT, that invests in agency MBS (mortgage-backed securities). It hasn't been an easy year for agency MBS, as its prices have underperformed other types of debt. In its presentation, AGNC provided an illuminating graph that shows how extreme the mispricing of agency MBS is today. Source .
What this graph shows is the spread of investment-grade corporate debt over Treasuries, compared to the spread of agency MBS over Treasuries. The normal condition for bonds is that the higher the risk, the higher the spread should be. A high-risk bond should have a higher spread than a low-risk bond because investors need a higher return to justify taking the risk. Agency MBS carries zero credit risk. So even when the market is very optimistic towards IG-rated debt and believes it is very safe, IG-rated bonds should still pay at least a little bit more.
You can imagine how even the greatest company might have the smallest risk of default. Silicon Valley Bank (SIVBQ) had an "A" credit rating before its collapse, so it happens – and it happened just four months ago. Agency MBS has never defaulted, and if it did, it would be the economic equivalent of a nuclear bomb blowing up half the country. That's why the U.S. Government stepped in during the GFC to ensure that Fannie and Freddie were able to honor their guarantee. If the underlying borrowers default, the agencies buy back the loan at par, creating zero credit risk for investors, and ensuring the very foundation of the entire U.S. financial system. So agency MBS should have a lower spread than even highly-grade corporate debt. Today, it doesn't. And this is thanks to a number of technical factors, such as the Federal Reserve reducing its balance sheet, banks pulling back from buying agency MBS because they need more cash, and the FDIC liquidating the agency MBS that were held by failed banks.
Agency MBS are historically cheap right now relative to other debt investments. AGNC ended the quarter with leverage at 7.2x, this is very low compared to their history and AGNC can operate very comfortably at 8-10x leverage.
Last quarter, AGNC increased the amount of par value it holds from $56.9 billion to $58.8 billion, while also rotating up in coupon.
AGNC's average coupon is now 4.42%, this compares to 3.89% in Q2 last year. The difference between par value and market value amounts to approximately $4.04/share. That is a value that will be realized in time since agency MBS will always pay par and assumes that AGNC does not leverage up and buy more MBS before prices increase. In the earnings call, AGNC disclosed that they have been buying, and increased leverage to 7.5x quarter to date.
For Q2, AGNC reported net spread and dollar roll income of $0.67, easily covering its $0.36 dividend. Its book value was essentially flat, down $0.02 to $9.39.
The big news, from our perspective, came from the earnings call. When asked a question about the dividend, CEO Federico discussed an outlook expecting a "mid to high teens" return on equity from current prices after hedging costs. In prior earnings calls, he discussed an outlook for "mid-teens". From last quarter:
"If you think about our portfolio on a go-forward basis, if you're buying into our portfolio today, you're buying in at a fully mark-to-market portfolio at really attractive valuation levels. So, the earnings expectation of the portfolio on a go-forward basis is really strong. As I talked about, it's mid-teens. It can support our dividend. And that's obviously encouraging from a price-to-book perspective."
Late last year, they were discussing 12-14% ROEs. As MBS spreads have widened, the forward-looking earnings have improved even as book value has remained fairly flat. In the most recent earnings call, he said:
"If you look at new current coupon mortgages, for example, hedged with a mix of 5 and 10-year swap, and Treasury hedges, you're probably in the neighborhood of 180 basis points, which is historically very attractive. That's why we're so excited about this environment. If you lever that something like 7.5 times, given the current coupon spread, and 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."
Note that this is assuming operating at a leverage ratio of 7.5x, if AGNC decides the coast is clear to increase leverage to 8-9x, as they have in the past, then returns will be higher.
The CEO of peer Dynex Capital ( DX ) described today's agency MBS environment as a "historic investment opportunity" – we agree. The forward returns for agency MBS are massive when spreads start reverting to the mean and the market has some certainty regarding interest rates. Forward returns if rates remain high are in the high teens, if interest rates decline, that could provide the potential for substantially higher returns.
Pick #2: NLY – Yield 13.1%
Annaly Capital Management, Inc. ( NLY ) reported Q2 earnings that were in-line with what we have seen with peers like AGNC. Earnings Available for Distribution ("EAD") slipped down to $0.72 (down $0.09 from Q1), while book value came in at $20.73, down $0.04 from $20.77 in Q1 – although management indicated book value was up approximately 1% quarter to date.
Some investors see EAD decline and assume that means another dividend cut is in the offing. For those paying attention, the lower EAD shouldn't be a surprise. In the Q1 earnings call , management said (emphasis added):
"TBA dollar roll continued to decline, offsetting the benefit to EAD of higher yields on the spec pools experienced during the quarter. In previous earnings calls, we communicated our expectation that earnings would moderate as demonstrated this quarter. And the driving factors that we had referenced previously still hold. That is the continued increase in financing costs, swap runoff, the decline in the specialness of rolls and the mismatch between economics and earnings related to futures. Therefore, we expect some further moderation of EAD in the near term, but continue to be comfortable with our current dividend level, given the economic earnings of the portfolio, all things equal. "
Let's translate this into plain English. TBAs are future contracts for MBS. Companies like originators will look to sell mortgages before they actually originate them. This is why a mortgage originator is able to "lock in" a customer's rate long before they actually fund the mortgage. Like any futures market, the TBA market provides an avenue for producers to hedge and to guarantee they are getting a price that makes production profitable, while also providing an avenue for investors to speculate on future prices. The "dollar roll" strategy involves NLY entering into two simultaneous contracts, buying and selling futures at the same time, and profiting from the spread. A TBA dollar roll is "special" when the implied financing costs of the trade are lower than using repo financing. Thanks to the combination of an active housing market and rapidly rising interest rates, there has been an elevated level of specialness over the past year. Something that is now fading away, and if anything probably lasted longer than most expected.
When we look at NLY's portfolio, we can see a dramatic shift. Here is NLY's current portfolio as of the end of Q2: Source .
Note NLY had $69.6 billion in agency MBS (by par value) and $3.7 billion in TBAs. Going back to Q1: Source .
We see that the par value of agency MBS was only $66.6 billion, so NLY added about $3 billion in par value of agency MBS during the quarter. However, the TBA portfolio shrunk from $11.9 billion to $3.7 billion. That's a very significant shift, and the main driver in NLY's decline in economic leverage from 6.4x to 5.8x over the quarter. When the portfolio shrinks, it isn't a surprise that earnings decline. Management telegraphed this in Q1, so it isn't something to panic over, it is part of the plan.
Today, NLY is sitting with low leverage. Its TBA strategy has shrunk dramatically as it is no longer profitable. We can see that most of the impact came from Q1 to Q2 as the amount of TBAs decreased by nearly 70%. Like most of its peers, NLY has been adding to its agency MBS portfolio, but has been buying methodically. In the earnings call, management indicated that they want to maintain a high level of liquidity and lower leverage, allowing the flexibility to be opportunistic with buys.
If we go back one year to Q2 2022, we can see that NLY has grown its MBS portfolio slowly and meaningfully over the past year: Source .
NLY's agency MBS, by face value, increased from $56.9 billion to $69.6 billion! This happened as some commentators were claiming that NLY was being "forced" to sell its portfolio. In reality, NLY has been buying all along, transitioning from a strategy of short-term TBA investments to a strategy of long-term agency MBS that can be held to maturity.
Management has been consistent in its messaging that it is not in a hurry. They view the current high spreads as something that is likely to continue for a period of time, so they have opted for a slow and steady building process. So far, they have been right.
Agency MBS stands to be one of the greatest winners from interest rate stability, as mortgages sold off more aggressively than other types of debt. When fixed-income recovers, agency MBS is positioned to recover much more strongly, and NLY owns about 22% more agency MBS by par value at a much higher average coupon for the trip up than it held on the trip down. While agency MBS prices dipped, NLY has been slowly and methodically "averaging down", which provides the opportunity for immense upside when MBS prices recover.
Conclusion
At the end of the day, owning a mortgage is a simple proposition. You buy the mortgage, you get paid the interest and some principal back with each payment, and you earn a return. If people can be enticed to not prepay their mortgage more rapidly, then your return is greater than if people do prepay their mortgage more rapidly. For MREITs, the biggest question is the spread of profitability between the leverage they use to buy more mortgages and the returns they see on the mortgages they've purchased. The larger that spread, the greater income that they can pay you, and the smaller that spread, the smaller income that they can pay you.
If I had my personal way and if I was on the board of these two companies, I would switch over to a completely variable dividend scheme, one in which only the required amount of money was paid out each quarter, and everyone recognized that it would change quarter to quarter. The larger the spread got, the more shareholders would be paid, and the smaller it got, the less they would be paid, but at least everyone would understand that that was the case. Unfortunately, these companies try to provide a steady stream of predictable income, but in doing so, they sometimes cause confusion over the long run.
When it comes to your retirement, you should have no shame in loving being paid great income from your holdings. Ironically, those who often eschew getting paid strong income turn around and have to sell their possessions – their shares – to unlock money. They claim that they're creating their own "dividend," but really what they're doing is selling their possessions. One day you're going to run out of something to sell instead of receiving strong income.
As a professional income investor, your goal should be to never have to sell anything ever and receive strong income to cover all of your expenses. The difference between a novice income investor and a professional income investor is their ability to continue to hold something that is paying them excellent dividends and not be swayed by market sentiment while fundamental performance is strong. The day you unlock that ability is the day that your retirement becomes exponentially more secure than it was before.
That's the beauty of my Income Method. That's the beauty of income investing.
For further details see:
We All Love Big Income: 2 Great Picks