While the volatility in the stock market has received a tremendous amount of attention in the press, the drop in interest rates is perhaps even more dramatic. The 10-year bond yield has fallen from 1.92% to 0.77% since the beginning of the year. Falling interest rates are good for bonds, and mortgage-backed securities are bonds, so mortgage real estate investment trusts (REITs) like AGNC Investment Corp. (NASDAQ:AGNC) should be doing great, right? Not so fast. 

The flight to safety has driven rates to record lows

We have seen an unprecedented drop in interest rates over the past two months, which is great news for everyone's bond portfolio. If you owned the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT), you are up over 23% year-to-date between dividends and capital gains. Corporate bonds have participated less, as the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEMKT:LQD) is only up about 5.5%, presumably on recession fears offsetting the change in interest rates. Agency mortgage-backed securities are guaranteed by the government, so there is no credit risk. However, the big companies that invest in these securities have not participated in the rally. Why is that? 

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Image source: Getty Images.

Why mortgage-backed securities don't act like Treasuries

Mortgage-backed securities are different than traditional bonds in one key characteristic, and that is the option of the borrower to repay the bond at any time. This means these securities react differently to changes in interest rates. When rates fall, borrowers will choose to refinance their current mortgages, which means that mortgage-backed securities with higher note rates will be more likely to prepay early. This limits the benefit they receive when rates fall.

At some point, higher-rate mortgage-backed securities become completely insensitive to decreases in interest rates. The weighted average coupon for AGNC's portfolio at the end of the year was 4.26%, with the current 30-year fixed-rate mortgage at 3.26%. A lot of that portfolio is in the money, which means it will make financial sense for the borrower to refinance the mortgage. That means a mortgage-backed security that was trading at 104 or 105 cents on the dollar a week ago might get paid off early at 100 cents on the dollar over the next month. 

AGNC's interest rate risk

In AGNC's most recent 10-K, the company lays out the effect of rate changes on its portfolio. Note that shocks negatively affect the portfolio, although increases in rates have a more severe effect. Also, note that the changes in profit/loss do not scale linearly with the shocks. Finally, these shocks are modeled based on what the company thinks mortgage-backed security pricing will do. Mark-to-market will differ from mark-to-model.

Change in Interest Rate Estimated Change in Portfolio Value Estimated Change in Tangible Book Value
- 100 basis points (0.5%) (6%)
- 50 basis points (0.1%) (0.9%)
+ 50 basis points (0.4%) (4.7%)
+ 100 basis points (1.3%) (14.8%)

Source: AGNC 10-K

As of Dec. 31, 2019, AGNC's tangible book value per share was $17.66. Applying that 6% decrease gives a book value of $16.60 per share. So, while the current price as of Friday, March 5, is $17.10, it is not really trading at a discount to book. Book value is probably closer to $16.60 a share and is falling faster the longer this goes on. That will put the dividend at risk. As a general rule, financials (and especially mortgage REITs) like financial stability. Trying to buy the agency mortgage REITs right now with rates in free fall is like trying to catch a falling knife. The REITs that are more credit exposed will have less exposure to this event, and their performance will depend on whether the novel coronavirus pandemic causes a recession. For the agency REITs, it is all about interest rate risk. Once things stabilize, it will be time to take a look. But not now.