Times are tough in the mortgage space right now. Rising interest rates led to a collapse in mortgage originations, and mortgage-backed securities have been out of favor among investors for the past 15 months or so. Mortgage real estate investment trusts (mREITs) were beset by declining asset values and have had to cut dividends. These factors explain mREITs' massive share price underperformance since the Fed started hiking rates last year.
Under these circumstances, is AGNC Investment (AGNC -0.11%) -- the best known mortgage REIT -- a buy?
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Mortgage REITs are different than traditional REITs
Most REITs invest in physical properties like office buildings, malls, or apartment complexes, and then lease out space to tenants. It is an easy-to-understand business model. Mortgage REITs use a different model: Rather than investing in properties, they invest in real estate debt -- in other words, mortgages. Instead of collecting rent payments, they collect interest payments. In many ways, they look more like banks or hedge funds than landlords.
AGNC Investment focuses on mortgage-backed securities (MBS) that are guaranteed by the U.S. government, so it has minimal credit risk. If a borrower fails to pay their mortgage, the government ensures that AGNC Investment gets paid on its investment. These securities tend to pay low interest rates because of the government guarantee -- low risk equals low returns. This means that mortgage REITs generally must borrow a lot of money to turn a bunch of securities that pay interest rates in the mid-single-digit percentages into dividend yields in the teens.
Mortgage-backed securities are under pressure
Over the past year, mortgage-backed securities have underperformed Treasuries as benchmark interest rates were raised. You can see the effect in the chart below, which looks at the difference between the prevailing mortgage rate and the yield on Treasuries. The higher the line goes, the greater the underperformance ("widening MBS spreads" in trader parlance) and the higher the risk of a dividend cut.
Fundamental Chart data by YCharts.
The underperformance of mortgage-backed securities results in the book value per share of mREITs declining, which puts them at risk of needing to cut their dividends. There have been three main drivers of MBS underperformance recently:
- The Fed's ongoing policy of fiscal tightening.
- The exit of the Fed as a regular buyer of the securities.
- The supply of mortgage-backed securities from banks that saw big regional banks get into trouble because they held MBS that were underwater.
AGNC Investment held onto its portfolio of MBS, so their declines in value will translate into higher returns going forward. On the first-quarter earnings conference call, Chief Executive Officer Peter Frederico said that the expected return on its portfolio was a percentage in the mid-teens, and asserted that the company can support its dividend. That said, AGNC cannot ignore declines in book value per share, so, at some point, it might have to cut the dividend if mortgage-backed security underperformance continues.
The dividend is no sure thing
Investors who look at AGNC Investment now are probably going to be attracted to its dividend, which yields 15.2% (based on its current share price and recent distributions). However, the continuation of payouts at that level is no sure thing. The stock trades at a premium to book value per share. However, with the MBS spread increasing, its book value per share is probably declining. With mortgage REITs, it is important to remember that book value per share is a moving target.
Mortgage-backed securities are the cheapest relative to Treasuries they have been since the mid-1980s. There is no doubt that valuations are attractive. The problem is that the fortunes of AGNC Investment are tied to Federal Reserve policy, and while most strategists believe the central bank is near the end of its rate-hiking period, that is no sure thing either. Investors considering buying AGNC for the dividend should keep all of that in mind.
