With a forward yield of 15%, it's no surprise that AGNC Investment (AGNC -0.53%) often finds itself on the radar of income-oriented investors who are looking to supplement their income with dividends. Even better, the real estate investment trust (REIT) pays out a monthly dividend, giving investors a steady monthly payment each month. It has paid out the same $0.12 monthly dividend since April 2020.
That said, the stock has struggled the past several years, with its price down about 44% over the past five years. When taking into account the stock's dividends, its total return over that period is about 3%. And while the dividend has been paid, it hasn't changed since April 2020. While it still managed a positive return, that's not a great return given the strength of the market over this period.
That said, better days should be ahead for the REIT moving forward.
What is a mortgage REIT, and why have they struggled?
Before considering an investment in AGNC, investors first need to understand exactly what the company does. Admittedly, it's a bit complicated, but let's try to break it down as simply as possible, as well as explain why mortgage REITs have struggled the past few years.
AGNC is a mortgage REIT that invests in mortgage-backed securities (MBS) that are backed by government or government-sponsored agencies, such as Fannie Mae, Freddie Mac, and Ginnie Mae. More simply, it owns a portfolio of mortgages. Since these mortgages are essentially backed by the government, they carry no default risk.
AGNC makes money by using short-term financing, usually in the form of repurchase agreements, and then it buys longer-dated MBS. It then makes money through the difference in the interest rate spread between its financing costs and the income its MBS investments generate. This income is then used to pay its dividend.
Short-term financing rates can fluctuate, so mortgage REITs also hedge out these rates to better match the duration of the MBS in their portfolios. This is done through widely used hedging strategies, such as using interest rate swaps.
Hedging has been particularly important for mortgage REITs in recent years, as there has been a historically long inverted yield curve, which only just recently returned to normal earlier this year. An inverted yield curve is when short-term rates are higher than long-term rates.
While AGNC's funding expenses have risen over the past year, it still has been able to maintain a healthy net interest spread, which is the difference between its funding costs and the yield of its MBS portfolio. Hedging was able to reduce its funding costs by 2.9% last quarter. If not for hedging, the yield of its portfolio would have been less than its funding costs.
While mortgages have faced some pressure with narrowing net interest spreads this year, the biggest issue they have faced over the past few years has been the decline in the value of MBS. As interest rates have risen and spreads between MBS and Treasury bonds have widened, the current carrying values of MBS have fallen.
The reason for this is quite simple. If you invested in a fixed-income security, like a Treasury bond or MBS, with a 4% yield, and current rates for similar newly issued securities were now 7%, you would not be able to sell the security you have at face value and turn around and buy the new security with the higher yield. Instead, you would have to sell the security you own at a discount so it would closely match the yield of the newly issued security.
As such, as new MBS started to have higher coupons, the value of older issued MBS with lower coupon rates fell. This shows up in a mortgage REIT's tangible book value (TBV), which represents the current value of its portfolio. Between the end of 2021 and the end of 2023, AGNC saw its TBV per share sink 45%, going from $15.75 per share down to $8.70 per share. At the end of last quarter (Q3 2024), it was at $8.82, so it has stabilized in 2024.
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Why AGNC should perform better moving forward
The decline in AGNC shares is directly correlated to the drop in its TBV, which was spurred both by higher rates and the widening of the spread between MBS and Treasuries. Currently, there is a good indication that rates will fall while spreads should at least remain stable.
On the interest rate front, the Fed has already cut rates twice this year, lowering rates by 50 basis points in September and another 25 basis points in October. Meanwhile, Fed officials are generally expecting rates to continue to head lower over the next two years.
Meanwhile, the spread between mortgage rates and Treasuries currently sits around 2.5%, which is historically high. The spread has widened largely because the Fed stopped buying MBS after its period of quantitive easing during the pandemic and then let its MBS run off and replaced them with Treasury bills. At the same time, many banks and other financial institutions also backed away from buying MBS, but there are signs they could return with rates set to move lower, the yield curve no longer inverted, and lower volatility in the market. As rates head lower, these institutions should begin to look toward higher-yielding instruments such as MBS.
If the spreads narrow, AGNC will be a big beneficiary as it boosts its TBV, but even if they just remain around current levels, which its management is expecting, it should be a very good investment environment for the REIT compared to the last few years. At the same time, with the Fed lowering short-term rates, it should begin to lower its funding costs over the next few years. High long-term rates with low short-term rates create a good investment environment for mortgage REITs.
As such, with a 15% yield and a much better investment environment, AGNC looks like a solid option to buy with its stock under $10. It should provide solid dividend income with the potential for moderate stock price appreciation moving forward.
