Most financial assets performed poorly in the first quarter of 2022. Investors came to the realization that inflation was not "transitory" and that shortages of labor and materials were likely to be around for a while. The Russian invasion of Ukraine pushed up energy prices, which will in turn push prices of everyday goods and services higher. The Federal Reserve moved up its assessment of inflation, took down its estimates for GDP growth, and penciled in a much higher forecast for interest rates.
One of the harder-hit sectors from all these headwinds was mortgage-backed securities. That's likely to mean rough sledding for first-quarter numbers. The most vulnerable mortgage real estate investment trust (REIT) is AGNC Investment (AGNC 1.85%), whose assets are under direct assault from the Fed's actions. Should investors be worried about first-quarter numbers?
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The Federal Reserve has been removing support for mortgage-backed securities
Mortgage rates moved aggressively higher during the first quarter of 2022. This was driven by sharply higher inflationary readings, which caused investors to raise their estimates for interest rates this year. The Fed had already begun to reduce its purchases of mortgage-backed securities, which generally translates into lower demand.
In addition, the Fed mentioned that it planned on reducing its holdings of mortgage-backed securities at some point in the future. In general, mortgage-backed securities were hit hard from all directions, and this translated into higher mortgage rates since these securities are generally how mortgage rates are set. You can see below just how dramatic the move was.
30 Year Mortgage Rate data by YCharts.
As a mortgage REIT, AGNC Investment holds mortgage-backed securities as a core asset. If mortgage rates are rising, that means that mortgage-backed security prices are falling. This means that AGNC's assets were under significant pressure throughout the quarter. While some of this interest-rate risk can be hedged, some cannot. As a general rule, volatility in the bond market hurts investors in mortgages.
The return on mortgage-backed securities went negative in Q1
Mortgage-backed securities earned a negative 4.8% return in the first quarter, according to the S&P U.S. Mortgage-Backed Securities Index. While this sounds relatively benign compared to the negative return of the Nasdaq Composite in Q1, it is important to remember that mortgage REITs are highly leveraged. This means they use borrowed money to increase the size of their portfolios. It is similar to the concept of a stock investor using margin to amplify returns. When markets are going your way, leverage increases returns. When they aren't, it magnifies losses.
Falling book value puts a dividend cut in play
AGNC pays a monthly dividend and recently declared its normal $0.12 per-share dividend, and announced that tangible book value per share had fallen to $13.48 per share at the end of February from $14.91 at the end of January. This was a big monthly decline, and March should prove to be much worse.
Even though AGNC might appear to be trading at a discount to book, it probably isn't since book value will probably take another hit when the company announces its next monthly dividend on April 10. It is tough to say for certain whether AGNC is at risk for a dividend cut, but with the beating mortgage-backed securities have taken this year, investors should be aware of the possibility.
