There has been a sea change in investor sentiment in the bond market lately as inflation has picked up. The consumer price index rose 7% on an annualized basis in December, which was the highest rate since 1982. Investors have increased their bets that the Fed will be more aggressive, with many expecting it to hike the federal funds rate by 125 basis points in percentage this year.
In addition, the Fed signaled that it would begin to reduce its holdings of mortgage-backed securities. While this means a rough road ahead for agency mortgage real estate investment trusts (REITs) like AGNC Investment (AGNC 0.61%), the worst may be behind it.
The Federal Reserve building. Image source: Getty Images.
Mortgage REITs are different
As a mortgage REIT, AGNC Investment is different from the typical REIT. The most-common REITs develop properties and then rent out the units. These properties could be anything from office buildings to shopping malls to even cellphone towers. Mortgage REITs don't invest in property; they invest in real estate debt. If you recently refinanced your mortgage, it was probably securitized and may have ended up in AGNC's portfolio.
The Fed owns a lot of mortgage-backed securities
Ever since the 2008-09 financial crisis, the Federal Reserve has supported the economy by purchasing Treasuries and mortgage-backed securities. Prior to the financial crisis, the Fed held roughly $850 billion in such assets. Today, it owns $8.9 trillion, more than a tenfold increase.
US total assets held by all Federal Reserve Banks. Data by YCharts.
Of the current $8.7 trillion in assets, roughly $2.8 trillion is in mortgage-backed securities. Since the early days of the pandemic, the Fed has bought approximately $1.3 trillion in mortgage-backed securities. This represents about 15% of the total mortgage origination in the record years 2020 and 2021. Origination volumes are expected to shrink as rates rise, which will mean any impact from the Fed's activity will be magnified.
Investor sentiment in the mortgage-backed securities market has become more negative as the Fed prepares to begin hiking rates. This sentiment has been reflected in what investors call wider spreads, which are the difference between the rate an investor earns on a mortgage-backed security and what they would earn in a similar Treasury. Widening spreads mean losses now for higher earnings later. In other words, the expected coupon payments remain the same, but the starting price is lower. To illustrate this, consider a stock that pays a 5% dividend. If its price falls 10%, the dividend yield increases to 5.6%, widening the spread. Spreads widened in the fourth quarter of 2021 and continued to widen in January.
The worst is probably over
During the earnings conference call, AGNC Investment management indicated that spreads were within 10 basis points of where they were in 2018, the last time the Fed tried to reduce its holdings. Given how much widening has already occurred, we are closer to the end of the underperformance than the beginning, assuming at least that mortgage-backed securities behave as they did in 2018 and 2019.
In the fourth quarter, AGNC Investment reported a 4% decrease in book value per share, but it maintained its monthly dividend of $0.12 per share. This gives the stock a dividend yield of about 9.5%, which is still one of the highest yields in the market. On the earnings call, CEO Peter Federico said, "And if you look at our dividend today based on the current stock price at around 9.5%, I think that the agency MBS [mortgage-backed security] market can be very supportive of a dividend in that level." This indicates the dividend isn't at risk, at least as far as things stand now.
Mortgage REITs generally trade with very high dividend yields, so a 9.5% yield is not a sign of financial distress. A bank with a yield of 9.5% is probably in trouble in terms of being able to maintain its dividend payout longer term, while a mortgage REIT is not. Investors who want yield and are willing to accept some near-term volatility should keep an eye on AGNC Investment.
As long as inflation remains high, it is hard to get too excited about the stock. But once inflation returns closer to the Fed's target level of 2%, the stock might be a buy if you can pick it up at a high-single-digit percentage discount to book value per share.
