Last year was the worst of all possible worlds for the mortgage sector. The Federal Reserve began hiking rates in order to rein in inflation, which wreaked havoc on the mortgage market. Mortgage rates rose rapidly, which all but eliminated refinancing activity and drove several large mortgage originators out of the business. Mortgage-backed securities were under pressure all year, which caused losses for mortgage real estate investment trusts (REITs) and forced many to cut their dividends.
Now that the worst appears to be over, investors are taking a fresh look at the mortgage REIT sector, especially AGNC Investment (AGNC -0.11%). Is it a buy?
The Federal Reserve building in Washington, D.C. Image source: Getty Images.
Mortgage REITs are different than the typical REIT
Mortgage REITs are a different animal than the typical REIT. Most REITs invest in physical real estate and then rent out units. The building could be a shopping mall, apartment building, or office tower. Mortgage REITs don't invest in physical real estate -- they invest in real estate debt (in other words, mortgages). The typical REIT business model looks more like a landlord/tenant relationship. Mortgage REITs look more like banks or hedge funds.
AGNC Investment focuses on mortgage-backed securities that are guaranteed by the U.S. government. Almost all of its portfolio is guaranteed by either Fannie Mae or Freddie Mac. If you recently bought a house using a Fannie Mae or Freddie Mac mortgage, chances are it ended up in a mortgage-backed security held by a mortgage REIT like AGNC Investment.
AGNC also invests in credit risk transfer securities, which are kind of a reinsurance product for Fannie Mae and Freddie Mac, and has a small position in commercial mortgage-backed securities.
Mortgage-backed securities had a rough 2022
Mortgage-backed securities struggled last year as the Federal Reserve initiated an aggressive policy of monetary tightening in order to defeat inflation. The federal funds rate was hiked from zero to a range of 4.25% to 4.5% at the end of 2022. Mortgage-backed securities react badly to interest rate volatility, and this caused them to underperform Treasuries by a wide amount. The difference between the prevailing mortgage rate and the 10-year Treasury reached levels last seen during the financial crisis in 2008. This effect (often referred to as "widening spreads") caused AGNC Investment's book value per share to fall from $15.75 at the end of 2021 to $9.84 at the end of 2022.
The macroeconomic backdrop is getting better
Now that the Fed seems to close to wrapping up its tightening cycle, mortgage-backed security spreads are reversing the widening from 2022. This should translate into higher profits and book value per share in 2023. The mortgage business is highly cyclical, and 2022 represented the bottom of the cycle. AGNC should benefit from a benign environment where interest rate volatility declines and rates don't fall enough to trigger a refinancing wave. The macroeconomic environment for mortgage-backed securities should be supportive for the asset class in general.
The big fear for the mortgage REITs has been the specter of the Fed selling off its portfolio of mortgage-backed securities. This is not something the Fed is contemplating at the moment, and it is easier said than done. Liquidity in the mortgage-backed security space is spotty and concentrated in the active coupons where origination is currently occurring (think in the 6% to 7% range), which are much higher than the Fed's portfolio (which is in the 3% to 4% range).
AGNC is trading at a sizable premium to its $9.84 book value per share. Mortgage REITs generally trade pretty close to book, and I like to pick them up when they are trading at a discount to book. At current levels, AGNC has a dividend yield of 12.7%. The company pays a monthly dividend of $0.12 per share and it earned $1.17 in the fourth quarter, so the dividend was well covered. There have been lots of dividend cuts in the mortgage REIT space over the past year, but AGNC has been one of the few to maintain the dividend. Income investors who are looking for yield should take a look at AGNC Investment.
