Because both stocks have heavily sold off, the mortgage real estate investment trust (mREIT) stocks Annaly Capital Management (NLY -0.32%) and AGNC Investment (AGNC -0.11%) became widely discussed tickers this year. The increased interest is because both are currently generating a lot of passive income relative to their stock prices, with Annaly boasting a nearly 16% annual dividend yield and AGNC yielding about 13.6%.
Investors are not likely to be too miffed about stocks' performance if they can guarantee a consistently strong dividend. But the general rule on dividends is that if it looks too good to be true, then it probably is. A big point of focus among investors this year is whether or not Annaly and AGNC can sustain these monster dividends, especially with a challenging backdrop of an economy headed toward a recession.
The stocks recently got a boost when billionaire Bill Gross, who founded the global fixed-income investment firm PIMCO and is also known as the "Bond King," recently said that he has been buying shares of Annaly and AGNC. Should investors follow his lead? Let's take a look.
Struggles this year for mortgage REITs
Both Annaly and AGNC use debt and leverage to generate returns for investors, largely by investing in agency mortgage-backed securities (MBS). These securities are backed by the U.S. government, so there is no inherent credit risk. However, these bonds are still susceptible to interest rate risk.
As bond yields rise, bond values fall due to the inverse relationship. Mortgage rates have soared this year as the Federal Reserve has hiked its federal funds rate and begun to unwind its balance sheet through quantitative tightening. This means the Fed is no longer buying MBS, which had helped keep MBS coupon rates down. As a result, mortgage spreads -- the difference between the yields on a 30-year mortgage and the 10-year U.S. Treasury bill -- had widened to levels not seen since the Great Recession.
10-Year Real Treasury Rate data by YCharts
This has led to billions in unrealized losses on Annaly's and AGNC's MBS portfolios. While the losses are temporary and can revert if the bonds are held long enough, the losses reduce book value, or equity, in the present. Through the first nine months of the year, AGNC has seen its book value decline by roughly 42%, while Annaly's is down about 37%.
Not only do these stocks trade relative to their book value, but equity is used to support the dividend if earnings can't cover it, and to grow the balance sheet. Earnings have also begun to struggle as well, largely due to soaring funding costs, which are moving higher with the federal funds rate.
If you look at earnings available for distribution (EAD), which incorporates hedging activities and mortgage servicing rights amortization, each company can still cover its dividend. EAD is a better way to assess the ability of REITs to cover their dividends, but EAD is on the decline.
Why is the Bond King buying?
Gross specifically said he's buying shares of Annaly and AGNC with the idea that mortgage spreads will tighten as the Fed slows its rate-hiking campaign.
Gross may indeed be onto something here, as mortgage spreads have begun to tighten more recently. If this continues, Annaly and AGNC may be able to pare some of the losses in their bond portfolios.
Gross may also be buying -- and I'm just guessing here -- because he sees a better opportunity for mREIT margins down the line as well. At the core of their business, companies like Annaly and AGNC make money by using debt to fund the purchase of agency MBS and then earn money on the spread.
But with funding costs moving higher quickly now, Annaly's margins have compressed significantly. AGNC has actually managed to grow its margin through a lot of hedging activity. But slowing interest rates and lower funding costs would generally be positive for the industry.
Should you follow the Bond King?
Gross is legendary when it comes to fixed-income investing and certainly knows a lot more than me. But the move is still risky because it's hard to predict what the Fed will do in the future regarding interest rates.
Also, while there's no indication right now that the Fed will do an outright sale of MBS on its balance sheet any time soon, that's still a lingering concern on investors' minds. Ultimately, it does seem like the outlook for mREITs is brightening, and at the end of the day, even if Annaly and AGNC have to cut payments a little bit, they still might carry quite healthy dividends.
But if you are going to invest, just realize that this could be a very volatile investment with a lot of associated risk. You're really making a gamble on the direction of interest rates and mortgage spreads, which is always easier said than done.
