AGNC: A Less Attractive Investment With A Massive 14% Yield

Article Thesis

AGNC Investment Corp. (NASDAQ:AGNC) is a very high-yielding mortgage real estate investment trust. Higher interest rates have hurt its book value, however, and there are some questions about the company’s ability to maintain the dividend at the current level in the long run. While the yield is hefty, I believe that this alone is not a great reason to buy this stock.

AGNC Investment: The Macro Picture

AGNC Investment Corp. is a mortgage REIT that, as the name suggests, primarily invests in agency mortgages. These are lower-risk investments when it comes to credit defaults, but there are some other risks to consider, mainly duration risk. A fixed-income investment that is traded on the market will see its market value move up and down, depending on where interest rates are moving. The following chart shows this pretty well:

When interest rates move lower, which was the case in early 2020 during the beginning of the pandemic, for example, then treasuries and treasury ETFs (IEF) are moving up. But when interest rates climb, treasuries and treasury ETFs are heading lower, as the market value for these fixed-income assets declines during times of rising interest rates. The same holds true for mortgages and related assets, such as mortgage-backed securities.

AGNC Investment, which owns a large number of fixed-income assets, was negatively impacted by the downward move in the fair market value of these assets. Not surprisingly, AGNC’s book value dropped harshly over the last one and a half years or so, a time of rising interest rates:

While book value and tangible book value were relatively stable in the 2019 to early 2022 time frame, both have fallen like a rock over the last year and a half. The big decrease in the market value of AGNC Investment’s long-duration fixed-income assets is to blame for that. Of course, the fact that AGNC Investment employs considerable leverage plays a role as well: When leverage is used, declines in a company’s gross asset value are amplified once translated into net asset value. If, for example, a company uses $4 in debt for every $1 in equity, a 10% gross value decline in the company’s assets translates into a 50% net asset value decline. While leverage can, of course, work in favor of investors during good times, when yield spreads are positive and when gross asset values are rising, leverage can work against investors during tough times, when gross asset values are declining and when funding costs for the leverage that the company or investor employs are rising.

AGNC Investment’s use of considerable leverage, in combination with a relatively high dividend payout ratio, explains why AGNC Investment has not delivered any share price gains in the past. Instead, shares are currently trading at almost exactly half the IPO price ($20 per share) from 15 years ago. Leverage, high payouts, and interest rates moving in an unfavorable direction hurt AGNC’s book value, and that, in turn, translated into substantial share price losses — those that bought in 2008 are down 50% today (not accounting for dividends).

Inflation remains well above the Fed’s target rate of 2%, as the core CPI increase remained at 4.8% on a year-over-year basis during June — more than twice the broad inflation target rate. Interest rates are thus unlikely to decline in the near term, and the market believes that the Fed will increase rates again this summer — at least that’s what the market expects. According to the CME Fed Watch tool, the likelihood of an interest rate increase in July is pretty high:

With a 96% chance, the market is pretty convinced that interest rates will be increased again later this month. At least in the very near term, financial conditions are thus not easing up, which could further pressure AGNC Investment’s book value. During the first quarter of the current year, tangible book value declined by 4.4% or almost 1.5% per month. This will not continue forever, of course, but at least for now, the macro environment remains tough for AGNC Investment.

The path for interest rates beyond summer will depend on how inflation changes over time. If inflation heads lower, the Fed will stop raising rates, and will (presumably) eventually lower interest rates again. But that is not guaranteed — so far, inflation has moved down at a slower pace than many had projected, and inflation has not been very transitory. If high inflation persists, the likelihood of declining interest rates in the foreseeable future is not very high. And there are some items that could keep inflation high. Oil prices are not very high right now, but have recently moved upwards, due to production cuts by Saudi Arabia and production declines in Russia. At the same time, we have seen big inventory draws in the United States, as consumption is very strong. If that persists, then it wouldn’t be surprising to see oil prices head higher over the coming months — projections by OPEC and other market watchers see global oil demand growing to a new record high next year, after all. Higher oil prices could put upwards pressure on inflation, as higher oil prices feed into all kinds of products due to higher transportation costs etc. Decoupling from China and increased manufacturing in higher-cost countries including the US could also put upwards pressure on inflation. Stubbornly high inflation that will force central banks to remain hawkish is thus an important risk factor to consider when looking at AGNC Investment. Although it should be noted that the reliance on inflation could also work in the other direction: If inflation heads lower much quicker than expected in the coming months, then central bank easing is possible, which would be positive for the market value of fixed-income assets. This, in turn, would positively impact AGNC’s book value, and thus ultimately also its share price, assuming the book value multiple remains more or less the same.

AGNC Investment: Upcoming Q2 Earnings, Dividends, Earnings Outlook

AGNC Investment will report its second-quarter earnings results on July 24, or around a week from now. Wall Street analysts expect that the company will report earnings per share of $0.63. This would be enough to cover the dividend of $0.12 per month, or $0.36 per quarter, easily. On the other hand, the projected earnings per share for the second quarter would represent a decline of around 25% versus the previous year’s quarter — which isn’t great, of course. Importantly, AGNC Investment is forecasted to experience further earnings per share declines in the following quarters, as sequential earnings per share declines are forecasted for Q3 and Q4. Looking beyond the current year, analyst estimates see AGNC Investment experience further profitability declines in the coming years, as earnings per share are forecasted to head below $0.50 per quarter in 2025. While that would still be enough to cover the dividend, it is not guaranteed that AGNC would keep the dividend intact — the company has a pretty clear history of lowering its payout over time. Declining earnings are not too surprising, considering the hefty book value decline the REIT has experienced — under the assumption that returns on book value remain more or less the same over time, declining per-share book value means declining earnings per share. This, in turn, results in a rising dividend payout ratio, which could eventually cause a dividend reduction — it wouldn’t be the first for AGNC Investment, as the company has cut its dividend by more than three-quarters from the peak seen in 2009.

AGNC Investment currently trades at a small premium compared to how the company was valued in the past, as we can see in the following chart:

AGNC trades at 10.7x tangible book value, which is around 10% higher than the 5-year median tangible book value multiple. Of course, we don’t know yet how book value has changed during the second quarter — if it declined again, then the valuation would be higher, while a book value improvement would mean a smaller premium versus the historically normal valuation.

Thanks to its pretty high yield of around 14%, AGNC Investment looks intriguing at current prices. But with shares trading at a valuation that is higher than it used to be, I do not think that AGNC is especially attractive today.

Takeaway

AGNC Investment does, like many other mREITs, offer a hefty yield today. But rising interest rates are a headwind, and if inflation remains higher than it should, further interest rate increases could result in additional book value declines. Those will likely result in declining earnings, which naturally isn’t positive for AGNC.

With shares trading at a premium to the historic valuation average, I believe that AGNC is not a buy right here, despite the pretty high dividend yield.