2022 was terrible for companies in the mortgage space. Inflation pushed the Federal Reserve to tighten monetary policy by aggressively increasing the federal funds rate. This spelled bad news for mortgage originators and mortgage real estate investment trusts (REITs).
Mortgage REITs have some of the highest dividend yields in the market, but it is important to understand what drives their businesses. AGNC Investment (AGNC 1.62%) is one of the best-known mortgage REITs out there and it has an attractive dividend that is paid out monthly. Is it a buy?
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Mortgage REITs look different than the typical REIT
Mortgage REITs are somewhat different than the traditional REIT. Most REITs are in the business of developing commercial properties and then leasing them out to tenants. It is a pretty easy-to-understand business model, similar to owning a rental property and renting it out to a tenant. Mortgage REITs don't invest in physical real estate as a general rule. They don't buy real estate, they buy real estate debt -- in other words, mortgages. Instead of a landlord/tenant business model the mortgage REIT looks more like a bank or hedge fund. It buys mortgage-backed securities and then uses borrowed money to increase the potential return. This is how mortgage REITs like AGNC Investment can turn a portfolio of mortgage-backed securities that pay 5% into a 13% dividend yield.
AGNC Investment focuses almost exclusively on mortgage-backed securities that are guaranteed by the U.S. government. These are typically mortgages backed by the government-sponsored entities Fannie Mae and Freddie Mac. If you refinanced your mortgage a year ago when rates were low, chances are your mortgage ended up in a mortgage-backed security and was bought by a mortgage REIT like AGNC Investment.
The Fed has been a headwind for the sector
Last year the Federal Reserve began a campaign of aggressive interest rate hikes in order to combat outsized inflation. Interest rates rose rapidly in response. Mortgage-backed securities (MBS) generally react poorly to interest rate volatility, and this effect caused these investments to underperform Treasuries. Mortgage REITs generally use Treasury derivatives to hedge their interest rate risk, and this underperformance (also known as widening MBS spreads) meant that the gains on their hedge portfolios were insufficient to cover the losses on their investment portfolios. This translated into falling book value per share, and many mortgage REITs ended up cutting their dividends last year.
MBS spreads seem to have peaked in late 2022 and are now contracting. In fact, MBS spreads widened to the highest level since the 2009 financial crisis in late 2022. Subsequently, spreads have narrowed, which pushed up AGNC Investment's book value per share from $9.08 to $9.84 in the fourth quarter of 2022. MBS spreads are still quite wide, and this means that AGNC should have the wind at its back as they revert to the mean. If that happens, book value per share should continue to increase.
Wait until the stock is trading below book value per share
At current levels, AGNC Investment is trading with a dividend yield of over 13%. It pays a monthly dividend of $0.12 per share. So is the stock a buy? I like it, but as a general rule, mortgage REITs tend to trade close to book value per share. The uncertainty with the Fed's next intentions has introduced a bit of risk into the interest rate market and AGNC Investment has been falling in sympathy with the financial sector. If you can pick up AGNC Investment below book value per share of $9.84, it is an attractive entry point. AGNC Investment will be subject to the vagaries of interest rate volatility and as long as the Federal Reserve remains front and center the stock will be volatile. That said, the investor is compensated well with the monthly dividend.
