The U.S. economy has been struggling to deal with an unusually high level of inflation, which is something that hasn't been an issue for decades. If anything, the Federal Reserve has been unhappy because inflation has been too low for too long in the past.
The latest inflation bout has been blamed on supply chain issues, product shortages, labor shortages, and rising wage growth, and the Fed is being forced to take action to address the problem. To address the coronavirus pandemic the Fed ramped up the purchase of Treasuries and mortgage-backed securities. To address rising inflation, the Fed recently announced plans to begin tapering its purchase of these assets.
This move could potentially mean bad things for agency-mortgage investors like AGNC Investment (AGNC 1.65%).
Mortgage REITs are different than the typical REIT
AGNC is a mortgage real estate investment trust (REIT), which is different from most REITs. The typical REIT develops real estate assets and then rents them out. It might develop apartment complexes, office buildings, or shopping malls.
Mortgage REITs don't invest in property, rather it buys up real estate debt. If you recently refinanced your mortgage, chances are it ended up getting guaranteed by Fannie Mae or Freddie Mac, and then securitized. A common investor for these mortgage-backed securities is a mortgage REIT like AGNC Investment. These securities are guaranteed by the U.S. government, so there is almost no risk of default.
The Fed's actions could negatively affect the sector
The other big investor for these mortgage-backed securities is the Federal Reserve, which has been buying them since the early days of the pandemic. The Fed stepped into this market as the broader financial markets became illiquid early on in the pandemic. This stabilized the financial markets, and now the Fed is beginning to reduce its footprint. Beginning in November, it will reduce its purchases of mortgage-backed securities and Treasuries with the goal of ending the excess purchases completely by next summer. The term for this program is "tapering."
So far, the mortgage-backed securities markets are taking the Fed's announced plans in stride, which is good news for mortgage REIT investors. In 2013, the Fed began to reduce its purchases of mortgage-backed securities in the aftermath of the Great Recession. Interest rates increased so rapidly that mortgage REITs like AGNC saw big declines in book value per share and were forced to cut their dividends. The Fed seems eager to prevent a recurrence, and it has therefore been much more transparent in its plans.
AGNC is positioned conservatively
While we aren't seeing a big increase in interest rates, AGNC Investment is still maintaining a conservative risk approach, by operating at a low leverage level (average debt divided by average equity) of about 7.5 times. Leverage is another term for borrowed money, and it is how AGNC Investment turns a portfolio of mortgage-backed securities paying 3% into a 9% dividend yield. It is the same concept as using margin on your stock trades. If your stock is going up, it magnifies your gains. If your stock is falling, you might be subject to margin calls, or demands that you put up additional cash.
AGNC reported that third-quarter tangible book value per share (which is one of the most important numbers for mortgage REIT investors) was $16.41, an increase of $0.02 per share. Mortgage REITs generally trade right around book value per share, and at current levels, AGNC is trading at a small discount. Tangible book value will be driven by earnings and the prices of mortgage-backed securities.
The other crucial number for mortgage REITs is dividend yield, which is 9% currently. AGNC pays a monthly dividend of $0.12 per share. So far, the mortgage-backed securities markets are sanguine about the changes in Fed policy, but mortgage REIT investors should be cautious, and be price sensitive. Investors should step in only when the stock is trading with a high single-digit discount to tangible book value per share.