The past 18 months have been extraordinarily difficult for companies in the mortgage market. As the Federal Reserve hiked interest rates to defeat inflation, mortgage bankers saw origination volume collapse and mortgage real estate investment trusts (mREITs) saw the values of their holdings erode. Now that the worst appears to be over, is AGNC Investment (AGNC -0.53%) worthy of a buy?
Mortgage REITs are different
Mortgage REITs are different from typical REITs, which invest in properties and lease them out to tenants. Mortgage REITs don't buy properties; they buy property debt. Instead of collecting rent, they collect interest on mortgage-backed securities (MBS).
AGNC Investment is a mortgage REIT that focuses almost entirely on MBS that are guaranteed by the U.S. government. If you recently bought a house and used a mortgage backed by the Federal Housing Administration or by Fannie Mae/Freddie Mac, chances are it ended up in a mortgage-backed security that might be held by an mREIT like AGNC Investment. These securities have no credit risk, but they have a lot of interest rate risk, and that was the problem for mortgage REITs last year.
Image source: Getty images.
The Federal Reserve has been a headwind for the sector
Ever since the Fed started hiking interest rates, mortgage-backed securities have underperformed Treasuries. You can see that in the chart below, which shows the difference between the mortgage rate and the 10-year Treasury. The bigger the number, the bigger the underperformance. This translates into decreases in book value now, but large potential returns on the portfolio in the future.
Data source: YCharts
The driver of that underperformance was volatility in the bond market, fueled by Fed interest rate increases. The Fed appears to be close to wrapping up its tightening cycle, and this should end all the doubt that has been driving mortgage-backed security underperformance. As Chief Executive Officer Peter Federico mentioned on the company's second-quarter earnings conference call, AGNC is "at the forefront of one of the most compelling investment environments that we have experienced in our 15-year history." Right now, the company can buy mortgage-backed securities guaranteed by the U.S. government at 5.5% yield. AGNC uses leverage (i.e., borrowed money) to magnify returns, which is how it turns a bunch of securities paying 5.5% into a 14.4% dividend yield. When asset prices are going the right way, leverage helps improve returns. It also works the other way, as AGNC (and the rest of the mortgage REIT sector) has seen over the past 18 months.
The company is comfortable with the dividend
On the earnings call, management was asked about the dividend. Federico said that AGNC was very comfortable with the dividend, which yields more than 14%, and indicated the projected return on the portfolio was in the mid-to-high teen percentages. While most other mREITs have been forced to cut their dividends, AGNC has been one of the very few that has not, and Federico's language implies that a dividend cut isn't really in the cards, assuming that mortgage-backed securities don't underperform Treasuries further.
At the end of the quarter, AGNC's tangible book value per share was $9.39, which means the stock is trading at a slight premium to book value per share. As a general rule, mortgage REITs tend to stick around book value per share, at least if they have easy-to-value assets like AGNC does. I tend to like mortgage REITs at a discount to tangible book. Note that book value per share is $10.26 if you add back the $0.87 in goodwill the company carries on its balance sheet.
AGNC's dividend yield is about where it should be given the expected returns on the portfolio. If mortgage-backed securities begin to outperform Treasuries, we should see an increase in book value per share, which will push up the stock. However, most investors buy mREITs for income, not capital appreciation. At current levels, the risk/reward trade-off for AGNC is attractive, and investors that get a chance to pick it up at tangible book per share should grab it.
