Should you buy an AGNC investment when it is below $10?

With a forward yield of 15%, it is not surprising that AGNC Investment (AGNC 0.42%) often finds itself on the radar of income-oriented investors looking to supplement their income with dividends. Best of all, the real estate investment trust (REIT) pays a monthly dividend, providing investors with a regular monthly payment each month. It has paid the same monthly dividend of $0.12 since April 2020.

That said, the stock has struggled in recent years, with the price down about 44% over the past five years. Taking into account the stock’s dividends, its total return over this period is approximately 3%. And even though the dividend was paid, it hasn’t changed since April 2020. While it has always generated a positive return, it’s not a good return given the strength of the market over that period.

That said, better days should be ahead for the REIT.

What are mortgage REITs and why have they struggled?

Before considering an investment in AGNC, investors should first understand exactly what the company does. Sure, it’s a little complicated, but let’s try to break it down 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 agencies, such as Fannie Maé, Freddie MacAnd Ginnie Mae. More simply, it has a portfolio of mortgage loans. Since these mortgages are essentially guaranteed by the government, they carry no risk of default.

AGNC makes money using short-term funding, usually in the form of repurchase agreements, and then purchases longer-term MBS. It then makes money from the difference between the interest rate spread between its financing costs and the income generated by its MBS investments. This income is then used to pay its dividend.

Short-term funding 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 widely used hedging strategies, such as the use of interest rate swaps.

Hedging has been particularly important for mortgage REITs in recent years because there has been a historically long inverted yield curve, which only recently returned to normal earlier this year. An inverted yield curve occurs when short-term rates are higher than long-term rates.

Even though AGNC’s financing expenses have increased over the past year, the company has still managed to maintain a healthy net interest spread, which is the difference between its financing costs and the yield of its MBS portfolio. Hedging managed to reduce its funding costs by 2.9% last quarter. Without hedging, the return on its portfolio would have been lower than its financing costs.

Although mortgages have faced some pressure due to narrowing net interest spreads this year, 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 Treasuries have widened, the current book value of MBS has fallen.

The reason is quite simple. If you invested in a fixed income security, such as a Treasury bond or MBS, with a yield of 4% and current rates for newly issued similar securities were now 7%, you would not be able to sell the security that you own at its face value. and turn around and buy the new security with the highest yield. Instead, you will need to sell the security you own at a discounted price so that it closely matches the yield of the newly issued security.

So, as newer MBS began to have higher coupons, the value of older MBS issued with lower coupon rates fell. This shows up 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 drop 45%, from $15.75 per share to $8.70 per share. At the end of the last quarter (Q3 2024), it was at $8.82, so it stabilized in 2024.

Why AGNC should perform better in the future

The decline in AGNC stock is directly correlated with the decline in its TBV, driven both by rising rates and the widening spread between MBS and Treasuries. Currently, everything indicates that rates will fall while spreads should at least remain stable.

On the interest rate front, the Fed has already cut rates twice this year, lowering them by 50 basis points in September and another 25 basis points in October. Meanwhile, Fed officials generally expect rates to continue falling over the next two years.

Meanwhile, the spread between mortgage rates and Treasuries is currently around 2.5%, which is historically high. The gap widened largely because the Fed stopped buying MBS after its period of quantitative easing during the pandemic, then let its MBS run out and replaced them with Treasuries. At the same time, many banks and other financial institutions have also given up on buying MBS, but there are signs they could return with rates expected to fall, the yield curve no longer inverted and less volatility in the market. As rates fall, these institutions are expected to start moving toward higher-yielding instruments such as MBS.

If spreads narrow, AGNC will be a big beneficiary by increasing its TBV, but even if they stay around current levels, which its management expects, this should make for a very good investment environment for the REIT by compared to recent years. . At the same time, as the Fed lowers short-term rates, it is expected to begin reducing its funding costs over the coming years. High long-term rates and low short-term rates create a good investment environment for mortgage REITs.

As such, with a 15% yield and a much better investment environment, AGNC appears to be a solid buy option with its shares priced under $10. It should provide strong dividend income with the potential for moderate stock price appreciation in the future.