Unlocking the Potential of AGNC Investment: A 16% Yield and Smart Move for Anticipated Rate Decrease (NASDAQ:AGNC)

AGNC Investment Corp. (NASDAQ:AGNC) offers a very high-dividend yield and is also a good play on probable lower interest rates in the coming months.

As I’ve covered in a previous article, I see both AGNC and Annaly Capital Management (NLY) as good yield plays in the mortgage REIT sector. However, interest rates continued in an upward trend until mid-October, which is not positive for the business model of both companies, but this landscape has changed recently, being an important support for higher share prices in recent weeks.

As shown in the previous graph, both AGNC and Annaly share prices have recovered strongly since their bottom at the end of last October, supported by prospects that long-term rates have likely reached their peak and a new downtrend may lie ahead. This is a positive backdrop to AGNC and Annaly, which have very similar business models, thus after updating my investment thesis on Annaly some couple of weeks ago, in this article, I update AGNC’s investment case to see if it remains a good yield play or not.

Interest Rates

AGNC is a REIT that invests primarily in agency-backed mortgage securities (agency MBS), which usually have long durations and are therefore sensible to long-term interest rates. To finance these purchases, the company borrows largely in the repo market, which means its funding is more sensible to short-term interest rates.

AGNC’s goal is to generate a profit from the difference between interest received and paid, which is measured as net interest income. This business model usually works well when the interest rate curve has an upward slope, which means long-term interest rates are higher than short-term rates, which is also the usual setup.

However, roughly over the past eighteen months, the interest rate has had an inverted slope, given that short-term rates have been higher than long-term rates. This happened because due to abnormally high levels of inflation, short-term rates were raised rapidly across the globe and that trend was also present in the U.S.

The Federal Reserve entered into a hiking pace in its effective rate from a near zero interest rate level at the beginning of 2022, to more than 5.3% since last July, as shown in the next graph.

This setback was quite negative for mREITs, as short-term rates hurt their cost of funding, while its asset rates did not climb the same, as the market was not convinced that high levels of inflation would last long. This expectation resulted in an inverted yield curve, a profile that has somewhat recovered in recent months, as inflation figures are declining considerably from its peak reached in 2022.

This market landscape also led to a negative spread between 2Y rates and 30Y rates since the middle of 2022, which are the rates that can be considered better proxies for funding and asset rates for mREITs, showing that the investment environment for AGNC and its peers was quite negative since the beginning of 2022.

As shown in the previous graph, this spread has been consistently negative since July 2022, and currently is negative by around 40 basis points (bps). However, its most recent bottom was reached last July at about -107 bps and has since recovered considerably. Therefore, it’s not surprising to see that AGNC’s book value declined by 14% during Q3 to $8.08 per share, but it should recover during Q4 as the spread is now less negative.

Taking into account that AGNC’s asset base is mainly consisted of agency MBS, this makes the company very exposed to interest rate risk. While this is positive in a period of declining rates, it hurts the company’s economic value during periods of rising rates, like the one experienced since mid-2022. Not surprisingly, both AGNC and Annaly have reported lower book values during this period, with AGNC’s book value declining from $16.76 per share in 2021, to about $8 in the last quarter, representing a decline of more than 50% during this period.

While this is a negative outcome, it could be even worse if AGNC management didn’t use financial derivatives to hedge interest rate risk. By using interest rate swaps and swaptions, AGNC reduces its sensitivity to interest rates and protects its cost of funding, which has allowed it to protect to some extent its balance sheet from rising rates.

Indeed, due to this hedging policy, its net duration gap was only 0.4 years at the end of last September, a slight increase from 0.2 years at the end of June. This increased exposure to interest rates did not play out given that rates maintained an upward trend during Q3 but have since reversed and could be a tailwind for better results in Q4.

Moreover, given that long-term interest rates are likely to reach their peak and the Federal Reserve is expected to cut rates next year, despite its current talk of ‘higher for longer’, AGNC seems to be well positioned to benefit from lower rates ahead.

Furthermore, while the company’s hedge position makes it nowadays not much geared to rates, this profile can change meaningfully in a relatively short period of time, given that a good part of AGNC’s interest rate swaps matures in the coming three years, as shown in the next table.

I also expect the company to cut some hedges as the interest rate environment changes from a headwind to a tailwind, something that is likely to be already visible when it reports its 2023 results, expected to be released at the end of next January.

Compared to Annaly, AGNC can benefit more from declining interest rates because its balance sheet leverage is higher, at about 7.9x its tangible net book value at the end of last September, compared to 6.4x for Annaly. While a more conservative leverage position was desirable during a rising interest rate environment, the opposite happens now in a declining rates environment, and AGNC can benefit more from lower rates in the short term than Annaly. I think this is a major reason why AGNC’s share price has outperformed its peer since its bottom at the end of last October, a trend that is likely to maintain over the coming weeks.

While management is likely to maintain leverage at current levels, its goal is to be between 6-12x throughout the cycle, thus it may decide to increase leverage in the coming quarters if interest rates enter a clear downtrend path, which would boost even further its book value, as the company business model is clearly geared to declining interest rates.

On top of the potential book value upside from declining rates, AGNC’s investment case is also quite attractive for investors due to its high-dividend yield. When I last covered the company, it was yielding some 15%, but due to a slightly lower share price, it’s now offering a dividend yield of more than 16%.

This yield is based on its monthly distribution of $0.12 per share, which has been unchanged since May 2020, which can be considered a positive outcome considering the negative landscape for mREITs since mid-2022. As shown in the next graph, its dividend has been remarkably stable despite the company’s earnings volatility, showing that its dividend can be considered risky and a potential dividend cut cannot be ruled out.

Despite that, looking at its cash flow statements, AGNC has been able to generate cash to cover its dividends in the past few years, even though during the past couple of quarters it has borrowed money to maintain its dividend. While this does not bode well for dividend sustainability over the long term, the fact that the interest rate environment has changed considerably over the past few weeks makes me more comfortable that AGNC can maintain its dividend in the short term.

This is also expected by the street, given that the current dividend consensus is for AGNC to maintain its annual dividend unchanged until 2025, thus while a high-dividend yield is clearly a warning sign that investors shouldn’t overlook in the long term, AGNC’s dividend seems to be supported in the short to medium term.

Conclusion

Having declined by more than 54% since its peak reached in mid-2021, I see AGNC’s current high-dividend yield as a reflection of undervaluation rather than a potential income trap. Moreover, given that the interest rate environment is likely to reverse to a downward trend in the coming months, this would be a strong tailwind for a higher book value ahead.

Given this profile, I see AGNC has a very interesting income and value play right now, being a good way to benefit from lower interest rates in 2024. As usual, its shares are currently trading near book value, and I expect upside potential coming from an increasing book value rather than a re-rating of its shares in the coming quarters.