AGNC Investment Corp. (NASDAQ:AGNC) reported earnings of $1.59 a share for the fourth quarter, the strongest since the second quarter of 2014. Many of the headwinds that bedeviled the company earlier in the year -- like uncertainty about the Fed and trade -- abated during the quarter, which boosted tangible net book value per share by 6.7% to $17.66.

A benign Federal reserve, and a return to calm

AGNC had a rough start to the year, missing estimates in the first and second quarters, largely due to the Fed tightening cycle that ended in December 2018. A tightening cycle means the Fed is raising interest rates, usually in hopes of controlling inflation. But by the middle of 2019, the Fed embarked on an easing cycle, and in July made the first of three decreases.

Picture of man look at markets

Image source: Getty Images

This change in policy benefited mortgage REITs (real estate investment trusts) in general, and increasing calm in the financial markets added to their returns. AGNC also benefited from improved sentiment in the financial markets. The company's year-end earnings release quoted CEO and CIO Gary Kain as saying:

"Our economic return of 9.6% in the fourth quarter represents AGNC's best quarter since the second quarter of 2014 and drove a total economic return of 18.7% for the year. Looking ahead, we believe AGNC remains extremely well-positioned to continue to generate attractive risk-adjusted returns as a more benign interest rate environment and favorable developments on the financing front should serve as a positive tailwind for levered investors in Agency MBS as we enter 2020."

Brief primer on mortgage REITs

Mortgage REITs can seem like complicated instruments, and investors have to wade through a bunch of bond-geek lingo when they read the earnings releases. That said, they really aren't all that complicated. Mortgage REITs like AGNC borrow money to invest in mortgages guaranteed by the U.S. government. If that sounds a lot like what a bank does, you would be correct.

The main difference is that mortgage REITs borrow money in the money market, while banks generally take deposits. Since mortgages generally pay 4% to 5% interest, the REITs have to use leverage (borrowed money) to pump up the returns. 

AGNC reported 18.7% economic return on tangible common equity in 2019, which encompasses the $2.00 per share it paid in dividends plus its tangible net book value per share. Comprehensive earnings per share were $2.16, so the payout ratio is 92%, which is typical for a REIT.

Double-digit dividend yields are rare these days, so it is worth it to take the time to understand AGNC's business.

In a nutshell, when the Fed is hiking rates, AGNC's cost of borrowing goes up, and the value of the asset portfolio generally falls. This takes a bite out of earnings and can cause the company to cut the dividend -- which AGNC did last spring, lowering it from $0.18 a month to $0.16.

On the other side of the coin, when the Fed is cutting interest rates, the company's cost of borrowing falls, and the value of the assets on the balance sheet increase. In other words, it pays to keep tabs on what the Fed is doing and how things look in the future. Fortunately, there are ways to gather clues about future Fed intentions

A benign Fed means fatter profits and dividends

With the Fed expected to be finished with rate increases for the foreseeable future, the environment is favorable for the mortgage REIT sector as a whole. The market currently anticipates at least one more rate cut by December. These probabilities are based on the trading prices of the Fed Funds futures contracts and are available on the Chicago Mercantile Exchange website. Below is a snapshot of the current state of play:

Graph of Fed funds forecasts

Image Source: Chicago Mercantile Exchange

This graph shows the current level of the Fed Funds rate (it is given in a range, which is how the Fed likes to express things). The market is assessing a 16.5% chance of no further moves by the Fed this year, a 34.4% probability of a 25-basis-point cut -- that is, a cut of 0.25% -- a 30% probability of a 50 basis point cut, and an almost 20% chance of something bigger.

This indicates that the market environment will be favorable for mortgage REITs like AGNC Investment Corp. for the next year. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.