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AGNC: I Keep Buying This 10% Yield (NASDAQ:AGNC)

Co-produced with Beyond Saving

Agency mortgage REITs are perhaps the best deal in the market right now. Two months ago, we highlighted AGNC Investment Corp. (AGNC).

While AGNC has outperformed the market since then, the price increases have failed to keep pace with their book value growth. AGNC reported that their tangible net book value grew 6.1% in August to $15.74, their share price is up less than 3%. The stock is trading at a greater than 10% discount to tangible book value.

The stars have aligned for agency MBS (Mortgage-Backed-Securities). Their cost to borrow is incredibly low thanks to the Federal Reserve’s target rate being set at 0-0.25%. The Federal Reserve has been a major buyer of MBS, uplifting and providing stability to MBS prices. US Treasuries have been trading in an incredibly narrow range. Finally, the Federal Reserve has stated they intend to keep rates low for at least several years.

All of this adds up to an environment where the agency MBS trade should outperform. Despite these ideal conditions, AGNC, along with other agency mREITs, is trading at a discount to book value. We are very happy to be buying up more.

AGNC will be reporting earnings on Monday Oct. 26 after hours. They announced their dividend as unchanged last week, but declined to update the market on book value, which will be announced at earnings. In the second quarter, they reported the largest net interest spreads seen in over two years. This quarter they will be even higher.

How AGNC Makes Money

To understand why conditions are ideal for agency MBS, it’s important to understand how AGNC makes money to pay its 10% dividend yield. AGNC is essentially a pass-through investment vehicle. They take investor capital, leverage it up and invest in agency MBS. The net profit from that then benefits shareholders in one of two wayseither through dividends paid out to shareholders or through rising book value.

Therefore, the two most important numbers for those looking to buy AGNC is “average asset yield” – this is the return on the assets they are investing in, and “average cost of funds” – this is the amount that AGNC pays for the leverage that they use.

Source: AGNC Presentation – July 28

So in the second quarter, AGNC was earning a yield of 2.56% and paying 0.88% for the leverage they were using.

Source: AGNC Presentation – July 28

As a result, AGNC enjoyed the largest net interest spread they have made in more than two years. The larger the spread, the larger the gains that AGNC has. Here is a look at AGNC’s net interest spread over the years:

Note that in 2010 and 2011 it was well over 2%. This was the golden years for agency MBS as the cost of borrowing was low and MBS prices were stabilized by significant asset purchases from the Federal Reserve. Spreads were high, dividends were high and agency mREITs traded at premiums.

It’s not a coincidence that when spread declined in 2012 and 2013, dividends were cut. The MBS trade was less profitable. It also is not coincidence that in 2014, AGNC outperformed the S&P 500:

ChartData by YCharts

Nor is it a coincidence that AGNC’s performance has been mediocre since then, as the declining spread tightened, reducing cash flow and ultimately the dividend.

Our investment thesis is very simple, the larger AGNC’s net interest spread is, the more money they are making for each dollar of equity they have. That spread is getting wider, mostly thanks to the cost of funds diving dramatically. It was at 1.68% in Q2 – for Q3 it will be pushing closer to 2%, a level not seen since 2012. AGNC’s share price is still not reflecting the reality that their underlying trade has become much more profitable.

Cost Of Funds

As noted above, the two main metrics for AGNC are “cost of funds” and “effective yield.” The cost of funds is directly impacted by the Federal Reserve’s target rate, which the “repo” market correlates with very strongly.

Source: DTCC – Oct. 5

So when the Fed cut the target rate in March, repo rates fell off a cliff. Down from nearly 2% at this time last year, and stabilizing around 0.13%. AGNC’s cost of funds always will be slightly higher than DTCC reports for two reasons – first they use 30-90 day repurchase agreements and DTCC is reporting the overnight rate, second AGNC uses “interest rate swaps.”

Source: AGNC Presentation – July 28

These swaps are agreements for AGNC to pay a fixed interest rate, and receive a floating interest rate. When the fixed rate is higher than the floating rate, then AGNC is a net payer and the swaps increase their cost of funds. If rates rise, then AGNC pays the same fixed rate, but the counter-party pays the higher floating rate and AGNC would become the net receiver and the hedges would lower the cost of funds.

So looking at the table above, AGNC is paying an average of 0.39% and is receiving an average of 0.13%. So on average, their swaps are increasing their cost of funds by 0.26% on $42 billion. While an expense now, this will be very helpful for AGNC when rates do rise.

Still, with repos at 0.13%, there’s plenty of room for the cost of funds to come down from the 0.88% reported the second quarter. Additionally, AGNC was only hedging 66% of their debt at the end of Q2.

Source: AGNC Presentation – July 28

As time goes on, we expect AGNC will take advantage of the low-rate environment and put in some more longer-term hedges. But with all indications that the Federal Reserve intends to keep rates low, there’s no hurry. They can be opportunistic and enter hedges only when the prices are favorable.

Effective Yield

AGNC’s average asset yield is the other number in the equation, and it dropped to 2.56% in Q2. This despite the fact that the majority of AGNC’s assets have coupons above 3.5%.

Source: AGNC Presentation – July 28

The effective yield is impacted by two things, the premium that the MBS trade at and prepayments. Agency MBS tends to trade at a premium, if you buy MBS that pays 3.5% at a price of $106, then instead of getting a yield of 3.5%, you are actually getting $3.50/$106 = 3.3% on your investment.

The second factor is prepayments. Mortgages are written as 30-year contracts, but the vast majority of mortgages never mature. Instead, people frequently sell their houses and pay them off or refinance them. In both cases, the mortgage is paid in full long before the 30-year maturity date. With the principal paid off early, the investor receives less total interest, and if a premium was paid, that reduces the effective yield.

Naturally, the higher rate a person is paying relative to current mortgage rates, the more incentive there is to refinance. So when mortgage rates decline, we see a spike in prepayments.

However, these spikes are not long lasting. Mortgage rates decline, and people who are inclined to refinance rush out to do so. Many people either cannot refinance or will not refinance and as rates remain low prepayments will trend down to long-term averages. This was the experience in 2008-2012, note how each time prepayments spiked when mortgage rates fell, and then slowed until rates fell again.

We already are seeing that today as among the older mortgages with higher coupons, prepayment rates were down in August compared to July. This is why on AGNC’s chart above they reported a July 2020 prepayment rate of 24% but a lifetime projected CPR of 17%. “CPR” is “Conditional Prepayment Rate” and is the percentage of mortgages that would be prepaid if the pace was maintained for an entire year. So a 24% CPR suggests that if that pace is maintained, 24% of the existing mortgages will be prepaid in a year.

This is a headwind to effective yield for AGNC, they get the principal back, but they have to reinvest it and new issued mortgages have lower yield than their older mortgages. However, the decline in effective yield has been minimal compared to the crash in their cost of funds.

Additionally, Fannie and Freddie are changing their policies on when mortgages are removed from the MBS pool. Historically, when a mortgage becomes “seriously delinquent” and the mortgage was not paid for four months, Fannie/Freddie would buy the mortgage back for the principal amount. For mREITs, this was the same as a prepayment. Going forward, Fannie/Freddie will not buy the mortgage back for 24 months. In the meantime, principal and interest will still be paid to the MBS owner regardless of whether or not the mortgage borrower is paying. While the majority of prepayments come from refinances, this is going to reduce the number of prepayments caused by serious delinquencies, which will provide a modest benefit for AGNC in the next few years.

Conclusion

With earnings around the corner for what was certainly a very strong quarter for agency MBS, now is the time to top off allocations to agency mREITs. AGNC is one of our favorites and is one of the leaders in the sector. We know that their net interest spread is at multi-year highs, we know that AGNC’s book value is up for the quarter and we know that means cash flow for Q3 will be better than cash flow from Q2.

There’s also very good reason to believe that conditions are going to remain positive for AGNC for the foreseeable future. The cost of funds is going to remain very low as the Federal Reserve has made it clear they are committed to a low rate policy. Their prepayment rates will slow down as mortgage rates remain low and are less likely to drop another material amount considering that they are already at record lows. Those who want to/can refinance have been doing so. That will provide some stability for their effective yield.

Last time we saw conditions like this was back in 2008/2009, when agency mREITs were increasing their dividends. We cannot be positive that AGNC will reach their former heights, but we can be very confident that their returns are going to be remarkably better than they have been for the past five years. This is a company with a current yield more than 10% that’s very likely to experience dividend growth within the next six months. The current price is a unique buying opportunity for income investors! Their next earnings report is scheduled for Oct. 26 (released after market close).

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Disclosure: I am/we are long AGNC AND NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities.

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