Last year was extremely difficult for companies operating in the mortgage market. Mortgage originators saw volumes collapse as home affordability was hit with a double whammy of rising interest rates and home prices. Mortgage real estate investment trusts (mREITs) suffered after mortgage-backed securities (MBS) declined amid rising interest rates. If you bought AGNC Investment (AGNC 1.07%) at the beginning of 2022, you would be nursing some losses.
Mortgage REITs look more like banks than the typical REIT
AGNC Investment is a mortgage REIT that invests primarily in mortgage-backed securities that are guaranteed by the U.S. government. If you refinanced your mortgage last year with one backed by Fannie Mae or Freddie Mac, it was probably securitized and it may have ended up on a mortgage REIT's balance sheet.
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Mortgage REITs are not the same as the typical REIT, which develops commercial properties and rents them out. Mortgage REITs don't buy properties or collect rent; they invest in mortgage assets and collect interest. They look more like a hedge fund or bank than, say, an apartment or office REIT.
AGNC hedged the interest rate risk on its portfolio, while some banks did not
AGNC Investment's portfolio of mortgage-backed securities is pretty similar to the portfolios that took down Silicon Valley Bank and some of the other regional banks. The difference between AGNC Investment and these banks is that AGNC hedged its interest rate risk using derivatives. While the hedges didn't cover all of the losses that mortgage-backed securities experienced last year, they did offset some of it.
If you had invested $500 in AGNC Investment at the beginning of 2022, you would have bought 33 shares at $15.04 a share. At this point you would have $313.50 worth of stock and would have collected $63.36 in dividends. Last year was absolutely awful for the mortgage market, and AGNC Investment was one of the few mREITs that didn't cut its dividend.
The pain of 2022 may translate into gains over the next couple of years
Mortgage-backed securities underperformed Treasuries by a wide margin last year. In trader parlance, MBS spreads widened. The impact to a mREIT investor is that when spreads widen, book value falls, but the potential returns increase. Because the securities AGNC owns are guaranteed, it will get its principal and interest no matter what happens. Investors today are effectively buying these securities at a discount.
On the first-quarter earnings call, Chief Executive Officer Peter Frederico said that current MBS spread levels are double the average over the past 10 years and can support mid-teens return levels without spread tightening. In other words, mortgage-backed securities are very attractively priced, and are poised to generate healthy returns. If MBS spreads return to historical norms, that would represent additional gains.
The mREIT sector has been hard to recommend as long as the Federal Reserve is hiking interest rates. The Fed removed language referring to potential further rate hikes at the May meeting, which is being taken as a signal that it might be done hiking rates for this cycle. If the Fed is stepping back, we should see a decline in interest rate volatility, which should help MBS spreads.
That should mean the headwinds for mREITs are dissipating. MBS spreads may remain wide simply because of concerns that the Fed will liquidate its bond securities portfolio and that the Federal Deposit Insurance Corp. will start selling the MBS it seized recently from failed banks. That said, the risk-reward ratio for mortgage REITs is the best it has been since the Fed started hiking rates early last year. AGNC Investment is trading just about right at book value, and its dividend yield is about 15%. Income investors who are thinking about getting involved in the mREIT space might find AGNC Investment an interesting opportunity.
