With a forward yield of 15%, this is no surprise AGNC investment (NASDAQ: AGNC) is often on the radar of income-oriented investors looking to supplement their income with dividends. Even better, the Real Estate Investment Trust (REIT) pays a monthly dividend, giving investors a fixed monthly payment each month. The same monthly dividend of $0.12 has been paid since April 2020.
That said, the stock has struggled in recent years, with the price down about 44% over the past five years. When the stock’s dividends are taken into account, the total return over that period is about 3%. And while the dividend has been paid, it has not changed since April 2020. While it still had a positive return, that’s not a great return considering the strength of the market during this period.
That said, better days should be ahead for the REIT.
Before investors consider investing in AGNC, they should first understand exactly what the company does. Admittedly, it’s a bit complicated, but let’s try to explain it as simply as possible and explain why mortgage REITs have struggled in recent years.
AGNC is a mortgage REIT that invests in mortgage-backed securities (MBS) backed by government or government-sponsored entities, such as Fannie Mae, Freddie MacAnd Ginny Mae. Simply put, it owns a portfolio of mortgages. Because these mortgages are mainly backed by the government, there is no default risk.
AGNC makes money by using short-term financing, usually in the form of repurchase agreements, and then buys longer-term MBS. It then makes money through the difference in the interest rate spread between its financing costs and the income its MBS investments generate. This income is then used to pay out the dividend.
Short-term financing rates can fluctuate, so mortgage REITs also hedge these rates to better match the duration of the MBS in their portfolios. This is done through commonly used hedging strategies, such as the use of interest rate swaps.
Hedging has been particularly important for mortgage REITs in recent years as they have a historically long inverted yield curve, which only recently returned to normal earlier this year. An inverted yield curve occurs when short-term interest rates are higher than long-term interest rates.
Although AGNC’s funding costs have risen over the past year, it has still been able to maintain a healthy net interest rate spread, which is the difference between its funding costs and the return on its MBS portfolio. Hedging managed to reduce financing costs by 2.9% last quarter. Without hedging, the portfolio return would have been lower than the financing costs.
While mortgages have seen some pressure this year due to narrowing net interest rate differentials, the biggest problem they have faced in recent years has been the decline in the value of MBS. As interest rates have risen and spreads between MBS and government bonds have widened, the current book values of MBS have fallen.
The reason for this is quite simple. If you had invested in a fixed income security, such as a government bond or an MBS, with a yield of 4%, and the current interest rate for comparable newly issued securities was now 7%, you would not be trading the security you have at face value can sell and turn around and buy the new security with the higher yield. Instead, you should sell the security you own at a discount so that it closely matches the return of the newly issued security.
As new MBS began to receive higher coupons, the value of older MBS issued with lower coupon rates declined. This is reflected in a mortgage REIT’s tangible book value (TBV), which represents the current value of its portfolio. Between the end of 2021 and the end of 2023, AGNC saw its TBV per share decline by 45%, from $15.75 per share to $8.70 per share. At the end of the last quarter (Q3 2024) it was $8.82, so in 2024 it has stabilized.
The decline in AGNC shares is directly related to the decline in TBV, which was caused by both higher interest rates and the widening of the spread between MBS and government bonds. Currently, there are good indications that interest rates will fall, while spreads should at least remain stable.
On the interest rate front, the Fed has already cut interest rates twice this year: by 50 basis points in September and by another 25 basis points in October. Meanwhile, Fed officials generally expect rates to fall further over the next two years.
Meanwhile, the difference between mortgage rates and government bonds is currently around 2.5%, which is historically high. The spread has widened largely because the Fed stopped buying MBS after the period of quantitative easing during the pandemic and then dumped them and replaced them with Treasuries. At the same time, many banks and other financial institutions have also retreated from buying MBS, but there are signs they could return as interest rates move downward, the yield curve is no longer inverted and there is lower market volatility . With interest rates falling, these institutions should start looking at higher yield instruments such as MBS.
If spreads tighten, AGNC will be a big beneficiary as it increases its TBV, but even if they remain around current levels, which management expects, it should be a very good investment environment for the REIT compared to the past few years . At the same time, as the Fed cuts short-term interest rates, it should begin lowering its borrowing costs in the coming years. High long-term rates with low short-term rates create a good investment environment for mortgage REITs.
As such, with a 15% yield and a much better investment climate, AGNC seems like a solid option for buying stocks under $10. It should deliver solid dividend income, with the potential for moderate share price appreciation in the future.
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Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
Should You Buy AGNC Investment While It’s Below $10? was originally published by The Motley Fool
