Last year was downright awful for the mortgage space. To help combat rising inflation, the Federal Reserve aggressively hiked interest rates beginning in March and going throughout the year, which crushed mortgage originators and mortgage real estate investment trusts (REITs) alike.
As a result, many of the mortgage REITs saw their stock prices fall and their dividend yields reach eye-popping dividend levels. AGNC Investment (AGNC 1.85%) is one of the biggest mortgage REITs in the country and it is now trading with a yield in the mid-teens.
Does that make this stock a buy, or is it one to avoid?
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Mortgage REITs are a different animal
Mortgage REITs are different than the typical REIT. Most REITs invest in properties such as office buildings or shopping malls, and then subdivide the space and charge rent. Mortgage REITs don't invest in properties -- they invest in property debt, in other words, mortgages. Instead of receiving rent, they receive interest.
AGNC Investment is an agency mortgage REIT, which means it invests primarily in mortgage-backed securities (MBSs), which are guaranteed by the U.S. government. If you recently refinanced your mortgage with a loan backed by Fannie Mae or Freddie Mac, your loan was probably pooled into a mortgage-backed security that might have been bought by an investor like AGNC Investment. Even if you skip your mortgage payment, the government will ensure that AGNC Investment gets its money. This means that AGNC Investment takes on almost no credit risk from the MBSs in its portfolio.
Credit risk versus interest rate risk
It is important to understand that no credit risk doesn't mean no risk. It means that AGNC takes a different kind of risk, specifically interest rate risk. Think back to your recent mortgage loan. If you refinanced a year ago, you probably have a 3.5% mortgage rate. How does AGNC turn a bunch of mortgage-backed securities paying 3.5% into a mid-teens dividend yield? Simple: leverage (i.e., borrowed money), and a lot of it.
At the end of the third quarter of 2022, AGNC had a leverage ratio of 8.7 times, which means that the vast majority of its mortgage portfolio has been bought with borrowed money. It is very similar to when you buy a stock on margin. Leverage magnifies potential gains, but it also magnifies potential losses. This was an issue early in the pandemic when the mortgage-backed securities market froze and AGNC's bankers asked for additional margin. AGNC ended up cutting its dividend to preserve cash.
The other issue for mortgage REITs is that their assets have a long maturity and their borrowings are very short-term. Think back to your 3.5% mortgage. If AGNC can borrow money at 1%, everything is great. What happens when it costs 4% to borrow money? AGNC uses interest rate derivatives to help mitigate this risk, but it can't be completely hedged. So interest rate risk is a serious risk for mortgage REITs in general, and investors need to keep that in mind. No credit risk does not equate to no risk.
Much will depend on what the Fed does
Over the past year, the difference between the yield on U.S. Treasuries and the comparable mortgage-backed security has risen past levels seen during the depths of the 2008 financial crisis. This has been driven primarily by fears of quantitative tightening and the possibility that the Federal Reserve might sell off some of its multitrillion-dollar MBS portfolio. This difference (called MBS spreads) seems to have peaked in the fall and is now returning to normal. This represents potential additional returns on AGNC and should translate into higher book values per share.
So is AGNC Investment a buy with a 13.9% dividend yield? The risk is that MBS spreads begin to widen and that the Fed continues to hike interest rates. While the Federal Reserve sees the end-of-2023 federal funds rate between 5.1% and 5.4%, the markets (at least as observed by the Fed funds futures index) consider that to be a long shot. Generally speaking mortgage REITs trade right around book value per share, and AGNC is trading above its end-of-September book value per share of $10.04 per share. If you can get it below book value, it should be a reasonable valuation given that MBS spreads are tightening.
