The past 12 months have been absolutely terrible for companies in the mortgage space. With the sudden and steep rise in interest rates, mortgage originators watched volumes collapse as refinance activity dried up, and mortgage real estate investment trusts (REITs) saw their portfolios of mortgage-backed securities drop in value.
AGNC Investment (AGNC 0.54%) kicked off the earnings season for mortgage REITs and said that the Silicon Valley Bank situation dented its portfolio.
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Mortgage REITs are different than the typical REIT
AGNC Investment is a mortgage REIT, a type of REIT that focuses on mortgage-backed securities that are guaranteed by the U.S. government. Mortgage REITs are somewhat different than the typical REIT, so it makes sense to understand the difference. Most REITs invest in physical real estate, whether it is office buildings, apartment buildings, or shopping malls. They develop properties and then lease out the individual units. It is a relatively easy-to-understand business model; it is basically a landlord-tenant model.
Mortgage REITs don't invest in real estate, they invest in real estate debt. These are generally mortgage-backed securities or whole loans. This makes them look more like a bank or a hedge fund. They use leverage (i.e., borrowed money) to turn a portfolio of mortgage-backed securities paying 5% into a 14% dividend yield.
The Fed's interest rate hikes have wreaked havoc on the MBS sector
In 2022, mortgage REITs struggled as the Federal Reserve hiked the fed funds rate in order to beat inflation. Rising rates caused mortgage-backed securities to fall in value. Unlike SVB Financial's Silicon Valley Bank, AGNC Investment did hedge its interest rate risk. However, the gains on the hedge did not fully offset the losses on the mortgage-backed security portfolio.
The big reason for the mortgage-backed security underperformance is interest rate volatility. Mortgage-backed securities really do not like interest rate volatility. Intercontinental Exchange's MOVE Index, which tracks interest rate volatility (think of it as a volatility index, or VIX, for bonds) hit a 15-year high. Just about every mortgage REIT reported big decreases in book value per share and almost every mREIT aside from AGNC Investment was forced to cut its dividend.
Mortgage-backed security underperformance is quantified by the term MBS spreads. MBS spreads are the difference in yield between a mortgage-backed security and the Treasury of a corresponding maturity data. MBS spreads peaked in the third quarter of 2022 and have been decreasing ever since. That was until the Silicon Valley Bank situation. MBS outperformance in the first part of the quarter gave way to underperformance, and AGNC ended up reporting a small decline in book value per share for the quarter.
Mortgage-backed security spreads are probably going to stay wide until the FDIC liquidates Silicon Valley Bank's MBS portfolio. AGNC believes the FDIC is probably going to be mainly concerned with maximizing value, so chances are it will go slow.
The dividend appears safe
Wide mortgage-backed security spreads imply higher potential returns going forward. On the earnings conference call, AGNC CEO Peter Federico reassured investors about the book going forward:
So, the earnings expectation of the portfolio on a go-forward basis is really strong. As I talked about, it's mid-teens. It can support our dividend. And that's obviously encouraging from a price-to-book perspective.
This probably means that unless MBS spreads widen further, the dividend can be maintained.
AGNC pays a monthly per-share dividend of $0.12, which gives the stock a dividend yield of 14.7%. For the quarter, book value per share fell from $9.84 to $9.41. At current levels, AGNC is trading at a 4% premium to book value per share. I generally like to pick up mortgage REITs at a discount to book value per share. Given the uncertainty about monetary policy, I wouldn't pick at the mortgage REIT sector quite yet, but once the Fed signals it is done hiking rates, the mREIT sector will become investible.
