What does the yield curve tell us about AGNC Investment’s portfolio?

The COVID-19 pandemic has been downright terrible for the mortgage real estate investment trust (mREIT) industry. At the start of the pandemic, mortgage market liquidity dried up and companies were plagued by margin calls. This forced them to shrink their portfolios and cut their dividends. After interest rates fell to zero, a wave of refinancing caused their portfolios to prepay, costing them years of expected income. Finally, the rise in rates since the beginning of the year has depressed book values.

Finally, the sector could benefit from a more favorable environment. Interested in double-digit dividend yields? Next, pay attention to the mortgage REIT sector.

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Mortgage REITs have a different business model

Mortgage REITs like AGNC Investment (AGNC 8.88%) have a different business model than most REITs. Most REITs invest in properties and follow an owner/tenant model. They develop properties and finance them with long-term debt. They then rent out the properties and earn a spread between their rent and their interest cost. It is a relatively easy to understand approach.

However, mortgage REITs do not invest in properties – they invest in real estate debt, aka mortgages. AGNC specializes in US government-backed mortgages. If you recently bought a house and took out a mortgage, chances are it was secured by Fannie Mae Where Freddie Mac then securitized into a mortgage-backed security. AGNC specializes in these titles.

The Fed has been a headwind, but will be less of a problem going forward

The mortgage REIT market took a beating as interest rates rose amid fears the Federal Reserve would start selling off its holdings of mortgage-backed securities it has bought since the start of quantitative easing around 2008. He currently holds around $2.7 trillion in mortgages, i.e. more than 100% of mortgage production forecast for 2022. This expected supply weighed on the sector.

Mortgage-backed securities are very sensitive to interest rate volatility. In other words, when rates are all over the place, mortgage-backed securities tend to be unattractive compared to Treasuries. Mortgage-backed securities carry the same level of credit risk as treasury bills (i.e. no credit risk), but they pay higher yields. This extra return is not “free” – it represents the extra sensitivity to interest rates. When rates rise, mortgage-backed securities fall faster than treasury bills. When rates fall, they underperform Treasuries. Indeed, borrowers can always prepay their mortgage loan. To offset this risk, mortgage-backed securities offer higher yields. Mortgage REITs like AGNC Investment are experts in managing this risk (known as convexity risk).

Mortgage-backed securities are the most attractive in years

As the Fed raised the fed funds rate, the yield curve (the difference between long-term and short-term interest rates) inverted. This means that short-term interest rates are higher than long-term rates. Although the inversion is often a signal of recession, it also seems to indicate that long-term interest rates have stabilized. This is good news for investors in mortgage-backed securities like AGNC Investment.

For AGNC, the potential returns of its portfolio are quite attractive. Yields on mortgage-backed securities relative to Treasuries, or the spread, are the most attractive in years. This means that revenues should increase, all other things being equal. As the Federal Reserve wraps up its rate hikes by the end of the year, a big cloud over AGNC’s head should dissipate. The end of the bullish cycle should dampen interest rate volatility in general, which means that mortgage-backed securities should outperform Treasuries.

Mortgage REITs are not yet a buy, but should be considered in late 2022 or early 2023

Mortgage REITs pay exceptionally high dividend yields. At current levels, AGNC’s stock is yielding 13.1%. Mortgage REITs are not for the faint of heart, as they are very susceptible to financial upheaval. That said, the market environment for the sector has been dire since the start of the pandemic. The outlook is beginning to brighten. Investors should start watching the sector now, with an eye on buying towards the end of the year as the Fed completes its tightening cycle. Mortgage REITs aren’t a buy yet (definitely wait for Q3 earnings), but they should be on an income investor’s radar screen.

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