For most of 2020, the mortgage real estate investment trust (REIT) sector followed the arc of a turnaround story. These stocks were beaten up badly in the early days of the novel coronavirus pandemic, and many became insolvent. Some even became favorites of the Robinhood crowd, which was an unusual thing to see for stocks that were normally associated with income investors, not day traders. AGNC Investment (NASDAQ:AGNC) navigated the crisis better than most of its peers, and it has completed its turnaround. How should investors think about the stock going forward?
Mortgage REITs are different from typical REITs
Mortgage REITs have a different sort of business model than a typical REIT. Most REITs build properties and lease out the units, and this model is seen most often for offices, apartments, and retail. Mortgage REITs don't own property; they own real estate debt (in other words, mortgages). If you recently refinanced your home, chances are your loan was put into a mortgage-backed security and sold to a mortgage REIT like AGNC Investment.
Last year was particularly difficult for the entire mortgage REIT sector. This was due to extreme volatility and a lack of liquidity in the mortgage-backed securities market in the first month of the lockdown. The mortgage-backed securities market completely froze for a period, and asset values plummeted as mortgage REITs were forced to raise cash. Even securities that were guaranteed by the U.S. government were impacted. Every mortgage REIT was forced to cut its dividend. However, AGNC's 25% reduction was much smaller than its peer group. This was because AGNC's investment portfolio is almost exclusively mortgage-backed securities that are guaranteed by the U.S. government.
Mortgage-backed securities as an asset class are no longer cheap
AGNC Investment ended 2019 with a tangible book value per share of $17.66. By the end of the first quarter of 2020 (March 31), it had fallen to $13.62. Since then, however, AGNC has been able to rebuild it, reaching $17.22 in tangible book value per share at the end of this year's first quarter. On this basis, AGNC has fully recovered from the damage the COVID-19 crisis did to its balance sheet. AGNC was able to do that via a combination of asset price recovery, income on investments, and stock buybacks. The company purchased around $650 million (or 7.5% of shares outstanding) at a discount to book value.
At this point, AGNC considers the mortgage-backed securities market to be pretty much fully valued. Despite a big increase in the 10-year bond yield, AGNC's mortgage-backed security portfolio was down only modestly. On the other side of the coin, its funding costs are extremely low at the moment. So the company is looking at a situation where asset prices are fully valued, but leverage (i.e., borrowing costs) is almost free. The company has been increasing some exposure to credit risk as a way to source relatively more attractive assets. In the meantime, the net interest margin, which represents the difference between what AGNC earns on its portfolio and its cost of borrowing, was extremely strong at 200 basis points (2 percentage points). So even if assets are fairly valued, they still pay pretty well.
During 2020, AGNC cut its monthly dividend from $0.15 to $0.12 per share. On the recent earnings conference call, the question of the dividend was raised. The company responded that it sees three avenues to reward shareholders: paying dividends, investing in more assets, or buying back stock. It will probably end up doing all three. That said, mortgage REITs generally like to keep their dividend yield in a certain range, and AGNC's is plumbing new lows, which means a dividend hike might be in the cards -- especially since tangible book per share is back to pre-COVID-19 levels.
For investors who got into the stock after the COVID-19 crisis, the easy money has been made, and most of the stock's return at this point will come from dividends, not price appreciation. AGNC is a great mortgage REIT, and certainly a great story for income investors, but the turnaround is complete.