Last year was awful for the mortgage industry. Rising interest rates crushed mortgage originators, and mortgage real estate investment trusts (REITs) suffered from mortgage-backed security (MBS) underperformance. Many of these REITs were forced to cut their dividends, and every one reported declines in book value per share.
But it's beginning to look as if the Federal Reserve is easing up on its tightening policy for the U.S. economy. AGNC Investment (AGNC 1.32%) recently reported earnings and showed why things might be looking up for this sector of the market.
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Mortgage REITs are different from typical REITs
Most REITs invest in physical real estate: They develop shopping malls, office towers, or apartment buildings and then rent out individual units to tenants. Theirs is an easy-to-understand business model.
But mortgage REITs don't invest in properties. Instead, they invest in property debt -- in other words, mortgages. Mortgage REITs use borrowed money (called leverage) to buy mortgage-backed securities, and the difference between what they earn on their portfolio and the interest they pay on their debt is their gross profit. In many ways, mortgage REITs operate similarly to banks.
AGNC Investment is an agency mortgage REIT, which means it invests almost all of its balance sheet in mortgage-backed securities that are guaranteed by the U.S. government. If you recently bought a home and used a mortgage backed by Fannie Mae or Freddie Mac, chances are your mortgage ended up in a mortgage-backed security, which might have been bought by a mortgage REIT like AGNC Investment. Even if you stop paying your mortgage, thanks to that guarantee, AGNC will still get its principal and interest payments.
MBS spreads drive book value per share
Even though AGNC Investment doesn't bear credit risk, it still has risk, particularly interest-rate risk, and that's what really hurt the mortgage REITs last year. If interest rates increase, the value of a mortgage REIT's investment portfolio will fall. In order to protect against this risk, mortgage REITs use interest rate hedges, which increase in value when rates rise. The idea is that any losses in the portfolio will be offset by the gains on the hedge.
Last year, that didn't happen as intended. Mortgage-backed securities fell in value, and the profit AGNC earned on its hedge portfolio wasn't enough to cover the losses. This was because mortgage-backed securities underperformed Treasuries -- or, in trader parlance, MBS spreads "widened."
In AGNC's earnings presentation, the company laid out how much MBS spreads have widened over the past year (and have reversed in Q4). The book value per share shows the relationship between MBS spreads (in basis points, which are 1/100 of a percent) and book value per share. When the spread widens, tangible book value per share falls; when it shrinks, book value rises.
| Q4 2021 | Q1 2022 | Q2 2022 | Q3 2022 | Q4 2022 | |
|---|---|---|---|---|---|
| MBS spread in basis points | 56 | 115 | 136 | 185 | 151 |
| Tangible book value per share | $15.75 | $13.12 | $11.43 | $9.08 | $9.84 |
MBS spreads have farther to fall, which means higher book value per share
The big question for investors is whether the current MBS spread is big or small. If it is big, then AGNC should see continued increases in book value per share. If it is small, the risk is that MBS spreads could widen again.
MBS spreads at the end of the third quarter of 2022 were the highest since the Great Recession, and they have only begun to recover. This indicates that AGNC should continue to earn outsized returns (basically reverse 2022's losses) as spreads revert to the mean.
This trend also indicates that the dividend is safe for now. AGNC is trading with a 12% dividend yield. As long as earnings begin returning to a more normal level, AGNC can weather a short-term above-average yield. But if this trading way above book value per share continues for several quarters, the chance of a dividend cut rises.
I generally like to purchase mortgage REITs below book value, and AGNC is trading at a 21.6% premium to book. That is too rich for me. But if you can get AGNC at book value per share, it is a buy.
