This year has been especially tough for the mortgage market and housing in general. The press talks about a housing recession, builders have slowed home construction, mortgage origination volume has been cut in half, and the mortgage real estate investment trusts (REITs) have been hammered by rising rates and underperforming portfolios.
As the year has worn on, the dividend yields on many mortgage REITs have reached levels where dividend cuts have occurred in the past. AGNC Investment (AGNC -0.17%) recently reported earnings and gave some color on its thinking regarding the dividend, which now stands at about 17.7%.
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Mortgage REITs are different than the typical REIT
AGNC Investment is a bit different than the typical REIT. Instead of owning properties and charging rent, AGNC Investment owns mortgage-backed securities (MBSs) and collects interest. For the third quarter, AGNC Investment reported a loss and a huge 20.6% decrease in book value per share. The decline in book value per share was due to distress in the mortgage market.
On the earnings conference call, AGNC explained what has been going on in the mortgage-backed securities market, which drove the decline in book value per share. Mortgage-backed securities have underperformed Treasuries, which means that they have fallen in value faster than Treasuries. Since AGNC Investment uses Treasury derivatives to hedge its portfolio, the gain from the Treasury hedge has been insufficient to offset the losses from the MBS portfolio.
The reason for the underperformance has to do at least partially with the way bond fund managers handle outflows (or when investors decide to liquidate their holdings in the fund). Agency mortgage-backed securities are the most liquid non-Treasury bond market out there. Liquidity matters because fund managers want to be able to sell holdings with the smallest impact on prices. In other words, a bond fund manager may be able to sell $500 million worth of mortgage-backed securities without pushing down the market too dramatically. The manager might not be able to do the same thing in a corporate bond issue or other securitized product. This means that agency mortgage-backed securities are the first to take a hit during a downturn and they will also be the first to recover.
Mortgage-backed securities have underperformed by record amounts
AGNC pointed out on the conference call that mortgage-backed security spreads (in other words, the difference in yield between a mortgage-backed security and the 10-year bond) is about 1.9 percentage points, which is the largest difference since 2008. This means that if the 10-year bond yields 4.1%, an investor would be able to get a government-guaranteed mortgage-backed security that pays 6%. Historically, the difference has been about 0.8%.
This increase in MBS spreads has driven the underperformance of the portfolio. When asked about the dividend on the conference call, Chief Executive Officer Peter Federico talked about how wider spreads mean declining book value today, but on the flip side it implies higher returns in the future. He went further to say that the expected return on the portfolio matches the dividend, implying that the dividend will remain covered. He did make the caveat that things can always change, but he didn't suggest that a dividend cut was coming.
Despite assurances, the dividend yield is in dangerous territory
If you look at this historical dividend yield of AGNC, the last two times dividend yields were in the high teens, AGNC Investment was forced to cut its payout.
AGNC Dividend Yield data by YCharts
While the CEO is sanguine about the dividend, the market is clearly pricing in some chance of a reduction in the dividend. On the earnings call, the company said that book value per share was down another 15% from the beginning of October. If mortgage-backed security spreads continue to widen, I think a cut is possible. That said, if the Federal Reserve signals that it is close to winding up its tightening cycle, the underperformance in the MBS market should reverse, which would support the dividend and higher book value per share. AGNC Investment is a highly speculative stock right now, but there should be some more clarity by the end of the year.
