Co-produced with Beyond Saving
We have been talking about agency mREITs until we turned blue in the face and kept talking about them. Why? They might be one of the most straight-forward opportunities in the market today.
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.
Specifically, we predicted that their net interest spreads would be even higher than they were in Q2, primarily due to their cost of funds being lower. Sure enough, across the board, agency-focused mREITs produced earnings higher than they have seen in several years. Net interest spreads went from below 1% to exceeding 2%.
This was predictable because it’s straight-forward math. AGNC borrows at the repo-rate and buys agency MBS. Their profit comes from the spread between the yield they receive from agency MBS and their cost of funds based on repo rates.
Agency MBS carries very little credit risk because the “agencies” – Fannie Mae and Freddie Mac – guarantee the principal of the mortgages. Even when a borrower defaults, investors in agency MBS will receive the principal. mREITs like AGNC take advantage of the relative safety of agency MBS and use high levels of leverage to boost returns, making the cost of funds their largest expense and the largest determinant of how profitable their investments will be.
So when repo rates fell off a cliff, it was clear that agency mREITs would see greatly-improved returns. Sure enough, their cost of funds collapsed down below 1%. AGNC managed an incredible improvement to just 0.15%. In other words, for every $1 billion they borrow, they are only paying $1.5 million in annual interest. Just one year ago, the same borrowing would have cost AGNC $18.5 million in annual interest. That’s cash saved going directly to the bottom line.
The best part is that the Federal Reserve has been very blatant that zero-interest-rate policy (ZIRP) is going to remain in place for at least a couple of years. This means that Q3 was not an anomaly. We can expect agency mREITs to continue putting up earnings much stronger than anything they have seen since 2011.
Let’s take a look at some specific results:
Crushing It With AGNC
If anything, AGNC performed even better than we were expecting:
Source: AGNC Q3-2020 Presentation – October 27th
AGNC’s core earnings were an incredible $0.81/share, more than 32% higher than they have been any quarter for the past two years. AGNC had the best cost of funds compared to their peers at a mere 0.15%. Their low cost of funds drove their net income per share despite the yield on their assets drifting lower.
AGNC managed this impressive feat mainly thanks to their large “To Be Announced” (TBA) portfolio. TBAs are forward contracts, agreements to buy MBS on a specific future date. The TBA market offered negative implied funding costs. Even without that, AGNC’s cost of funds was only 0.46%.
The sizable benefit from their TBA portfolio is likely to subside, however, their cost of funds from their repo agreements will decline as AGNC has some “high” interest repo agreements maturing in the next 3-6 months:
Source: AGNC Q3-2020 Presentation
That 1.27% interest rate will be refinanced at something closer to 0.2-0.3%. AGNC is going to continue to see very strong earnings.
We, as income investors, are dividend centric. One of the main reasons we invest in AGNC is to collect the current dividend and we believe that AGNC is likely to raise their dividend in the not so distant future.
In their earnings call, AGNC appears to be more intent on increasing their book value for 2020. However, REITs are required to pay out 90% of their taxable income and AGNC took the step of providing us details of what their taxable income is.
Source: AGNC Q3-2020 Presentation
In Q3, AGNC earned $0.92 per share in taxable income dwarfing the $0.66 they had earned the trailing 12 months. This is because during this period interest rates were falling and AGNC was realizing losses on their hedge positions.
Through the first three quarters, AGNC paid out $1.20 in dividends, and their taxable income was only $1.11. This is why AGNC has not yet been forced to increase their dividends.
However, it’s important to note that going into 2021, AGNC has no tax loss to carry forward. They will be ending 2020 with significantly positive taxable income. Therefore, in 2021, their dividend will need to reflect current earnings.
We expect to see a substantial dividend increase for AGNC in 2021. We will see much stronger earnings and higher dividends until the cost of funds starts to rise.
What About When Rates Rise?
When talking about “rates” it’s easy to get confused about which rates we are talking about. AGNC makes their money from borrowing short-term funds through repos, usually 3-6 months, and buying MBS that generally have a life expectancy of 5-7 years. Agency MBS prices generally correlate most strongly with 10-year treasury rates. So the higher the 10-year Treasury yields, the higher yield AGNC is likely going to be making on new investments. The lower the short end of the curve, the cheaper AGNC’s cost of funds is likely to be.
Therefore, long-term Treasury rates (10-year+) going up is generally positive for AGNC. While it means the value of their MBS holdings are going down, yields on reinvestment are going up and their cash flow goes up. AGNC controls the decline in book value by shorting US Treasuries.
The risk for AGNC is the Federal Reserve’s target rate being raised. Especially if it’s raised at a rate faster than the 10-year+ yields rise. This is because their cost of funds is closely related to the target rate, so their interest expense increases, and since repo contracts are only for 3-6 months, that expense goes up relatively fast. This could squeeze their spreads, and in an extreme scenario, if the cost of funds exceeded the yield received, then they would actually lose money.
AGNC protects themselves from this risk through “interest rate swaps.” These are agreements where they pay a fixed rate, while receiving a variable rate. So when variable rates are below the fixed rate, AGNC is a net payer. If variable rates increase, then AGNC is a net receiver. These contracts are separate from their debt agreements, but the net result is an increase or decrease of their interest expense based on whether they are a net payer or net receiver.
Hedging With Interest Rate Swaps
With interest rates currently very low, AGNC is taking the opportunity to enter into a number of interest rate swaps. Currently, they pay an average of just 0.15% on just under $43 billion. The counterparty is in turn paying them the variable rate, which is 0.08%. So right now, AGNC is a net payer on these agreements, which has the effect of increasing their cost of funds by 0.07%.
AGNC is willing to pay this extra amount because it protects them if interest rates rise. If short-term rates interest rates increased 0.5%, AGNC would still be paying 0.15%, but they would be receiving 0.58%. Instead of being a net payer, they would be receiving 0.43% on $43 billion. This would offset the increase in the cost of their repo debt. Paying an extra 0.07% today is cheap insurance.
These swaps help ensure that the cost of funds does not go higher than the effective yield of the MBS they hold. Currently, AGNC is only hedging 71% of their outstanding debt since the risk of repo rates going up materially is very low. Over time, they will increase their hedge position – it could even be higher than 100% of their debt since these are completely separate contracts.
When rates start rising, these hedges will ease the impact, allowing AGNC to reduce leverage and reinvest at higher yields. Even when the Federal Reserve starts increasing the target rate, AGNC will still have significant profits for a long time afterwards.
The bottom line is that right now conditions are ideal for agency MBS and the risks are very low. Agency mREITs have their loans guaranteed by government institutions which removes the credit risk. Another factor playing in their favor is that the Fed is very unlikely to hike interest rates soon. The Fed will keep rates stable for at least 2-3 years. This means that AGNC’s cost of funds will remain very predictable, along with other agency mREITs, such as NLY (NLY), DX (DX), ARR (ARR), TWO (TWO), and CHMI (CHMI).
Similarly, 10-year Treasury rates are very low, and are just coming off of all-time lows. It is more likely that the 10-year yield remains flat to rising than going below the current yield of 0.98%. There isn’t very far for these yields to go down unless the Federal Reserve pursues a negative interest rate policy. Negative interest rates will probably never happen in the United States.
With near-zero borrowing rates, and the yield on AGNC’s assets more likely to increase or stay the same means that AGNC’s current spread will match or exceed its current levels. AGNC has a tangible net book value of $15.88, so it’s trading at more than a 8% discount. With a 9.9% dividend yield, AGNC’s earnings are very likely to get even better. We expect AGNC to increase its dividends soon due to higher taxable income. AGNC is one of the best 10% yielders to buy in the market today. Buy AGNC with its big discount today to lock in the high yield and capital gains potential!
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Disclosure: I am/we are long AGNC, NLY, CHMI.PA, DX.PB, TWO.PC, AND TWO.PE. 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.