AGNC: I Preserve Shopping for This 10% Yield (NASDAQ:AGNC)

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Co-produced with Past Saving

Company mortgage REITs are maybe one of the best deal out there proper now. Two months in the past, we highlighted AGNC Funding Corp. (AGNC).

Whereas AGNC has outperformed the market since then, the value will increase have didn’t hold tempo with their e-book worth development. AGNC reported that their tangible web e-book worth grew 6.1% in August to $15.74, their share worth is up lower than 3%. The inventory is buying and selling at a higher than 10% low cost to tangible e-book worth.

The celebs have aligned for company MBS (Mortgage-Backed-Securities). Their price to borrow is extremely low because of the Federal Reserve’s goal fee being set at 0-0.25%. The Federal Reserve has been a serious purchaser of MBS, uplifting and offering stability to MBS costs. US Treasuries have been buying and selling in an extremely slender vary. Lastly, the Federal Reserve has said they intend to maintain charges low for at the least a number of years.

All of this provides as much as an atmosphere the place the company MBS commerce ought to outperform. Regardless of these very best situations, AGNC, together with different company mREITs, is buying and selling at a reduction to e-book worth. We’re very completely satisfied to be shopping for up extra.

AGNC shall be reporting earnings on Monday Oct. 26 after hours. They introduced their dividend as unchanged final week, however declined to replace the market on e-book worth, which shall be introduced at earnings. Within the second quarter, they reported the biggest web curiosity spreads seen in over two years. This quarter they are going to be even larger.

How AGNC Makes Cash

To know why situations are perfect for company MBS, it is necessary to know how AGNC makes cash to pay its 10% dividend yield. AGNC is basically a pass-through funding automobile. They take investor capital, leverage it up and spend money on company MBS. The web revenue from that then advantages shareholders in one in all two methodsboth by way of dividends paid out to shareholders or by way of rising e-book worth.

Subsequently, the 2 most necessary numbers for these trying to purchase AGNC is “common asset yield” – that is the return on the property they’re investing in, and “common price of funds” – that is the quantity that AGNC pays for the leverage that they use.

Supply: AGNC Presentation – July 28

So within the second quarter, AGNC was incomes a yield of two.56% and paying 0.88% for the leverage they have been utilizing.

Supply: AGNC Presentation – July 28

In consequence, AGNC loved the biggest web curiosity unfold they’ve made in additional than two years. The bigger the unfold, the bigger the good points that AGNC has. Here’s a have a look at AGNC’s web curiosity unfold over time:

Be aware that in 2010 and 2011 it was nicely over 2%. This was the golden years for company MBS as the price of borrowing was low and MBS costs have been stabilized by vital asset purchases from the Federal Reserve. Spreads have been excessive, dividends have been excessive and company mREITs traded at premiums.

It isn’t a coincidence that when unfold declined in 2012 and 2013, dividends have been lower. The MBS commerce was much less worthwhile. It additionally will not be coincidence that in 2014, AGNC outperformed the S&P 500:

ChartInformation by YCharts

Neither is it a coincidence that AGNC’s efficiency has been mediocre since then, because the declining unfold tightened, decreasing money movement and in the end the dividend.

Our funding thesis may be very easy, the bigger AGNC’s web curiosity unfold is, the extra money they’re making for every greenback of fairness they’ve. That unfold is getting wider, principally because of the price of funds diving dramatically. It was at 1.68% in Q2 – for Q3 it will likely be pushing nearer to 2%, a stage not seen since 2012. AGNC’s share worth continues to be not reflecting the fact that their underlying commerce has develop into far more worthwhile.

Value Of Funds

As famous above, the 2 primary metrics for AGNC are “price of funds” and “efficient yield.” The price of funds is straight impacted by the Federal Reserve’s goal fee, which the “repo” market correlates with very strongly.

Supply: DTCC – Oct. 5

So when the Fed lower the goal fee in March, repo charges fell off a cliff. Down from practically 2% right now final 12 months, and stabilizing round 0.13%. AGNC’s price of funds all the time shall be barely larger than DTCC studies for 2 causes – first they use 30-90 day repurchase agreements and DTCC is reporting the in a single day fee, second AGNC makes use of “rate of interest swaps.”

Supply: AGNC Presentation – July 28

These swaps are agreements for AGNC to pay a set rate of interest, and obtain a floating rate of interest. When the mounted fee is larger than the floating fee, then AGNC is a web payer and the swaps enhance their price of funds. If charges rise, then AGNC pays the identical mounted fee, however the counter-party pays the upper floating fee and AGNC would develop into the web receiver and the hedges would decrease the price of funds.

So trying on the desk above, AGNC is paying a median of 0.39% and is receiving a median of 0.13%. So on common, their swaps are rising their price of funds by 0.26% on $42 billion. Whereas an expense now, this shall be very useful for AGNC when charges do rise.

Nonetheless, with repos at 0.13%, there’s loads of room for the price of funds to come back down from the 0.88% reported the second quarter. Moreover, AGNC was solely hedging 66% of their debt on the finish of Q2.

Supply: AGNC Presentation – July 28

As time goes on, we anticipate AGNC will benefit from the low-rate atmosphere and put in some extra longer-term hedges. However with all indications that the Federal Reserve intends to maintain charges low, there is not any hurry. They are often opportunistic and enter hedges solely when the costs are favorable.

Efficient Yield

AGNC’s common asset yield is the opposite quantity within the equation, and it dropped to 2.56% in Q2. This even though the vast majority of AGNC’s property have coupons above 3.5%.

Supply: AGNC Presentation – July 28

The efficient yield is impacted by two issues, the premium that the MBS commerce at and prepayments. Company MBS tends to commerce at a premium, should you purchase MBS that pays 3.5% at a worth of $106, then as an alternative of getting a yield of three.5%, you’re really getting $3.50/$106 = 3.3% in your funding.

The second issue is prepayments. Mortgages are written as 30-year contracts, however the overwhelming majority of mortgages by no means mature. As an alternative, folks steadily promote their homes and pay them off or refinance them. In each instances, the mortgage is paid in full lengthy earlier than the 30-year maturity date. With the principal paid off early, the investor receives much less complete curiosity, and if a premium was paid, that reduces the efficient yield.

Naturally, the upper fee an individual is paying relative to present mortgage charges, the extra incentive there’s to refinance. So when mortgage charges decline, we see a spike in prepayments.

Nonetheless, these spikes usually are not lengthy lasting. Mortgage charges decline, and people who find themselves inclined to refinance rush out to take action. Many individuals both can’t refinance or is not going to refinance and as charges stay low prepayments will development right down to long-term averages. This was the expertise in 2008-2012, observe how every time prepayments spiked when mortgage charges fell, after which slowed till charges fell once more.

We already are seeing that in the present day as among the many older mortgages with larger coupons, prepayment charges were down in August in comparison with July. For this reason on AGNC’s chart above they reported a July 2020 prepayment fee of 24% however a lifetime projected CPR of 17%. “CPR” is “Conditional Prepayment Charge” and is the proportion of mortgages that may be pay as you go if the tempo was maintained for a complete 12 months. So a 24% CPR means that if that tempo is maintained, 24% of the present mortgages shall be pay as you go in a 12 months.

It is a headwind to efficient yield for AGNC, they get the principal again, however they must reinvest it and new issued mortgages have decrease yield than their older mortgages. Nonetheless, the decline in efficient yield has been minimal in comparison with the crash of their price of funds.

Moreover, Fannie and Freddie are changing their policies on when mortgages are faraway from the MBS pool. Traditionally, when a mortgage turns into “severely delinquent” and the mortgage was not paid for 4 months, Fannie/Freddie would purchase the mortgage again for the principal quantity. For mREITs, this was the identical as a prepayment. Going ahead, Fannie/Freddie is not going to purchase the mortgage again for twenty-four months. Within the meantime, principal and curiosity will nonetheless be paid to the MBS proprietor no matter whether or not or not the mortgage borrower is paying. Whereas the vast majority of prepayments come from refinances, that is going to scale back the variety of prepayments brought on by critical delinquencies, which can present a modest profit for AGNC within the subsequent few years.

Conclusion

With earnings across the nook for what was actually a really sturdy quarter for company MBS, now’s the time to prime off allocations to company mREITs. AGNC is one in all our favorites and is without doubt one of the leaders within the sector. We all know that their web curiosity unfold is at multi-year highs, we all know that AGNC’s e-book worth is up for the quarter and we all know which means money movement for Q3 shall be higher than money movement from Q2.

There’s additionally superb purpose to consider that situations are going to stay constructive for AGNC for the foreseeable future. The price of funds goes to stay very low because the Federal Reserve has made it clear they’re dedicated to a low fee coverage. Their prepayment charges will decelerate as mortgage charges stay low and are much less more likely to drop one other materials quantity contemplating that they’re already at file lows. Those that need to/can refinance have been doing so. That may present some stability for his or her efficient yield.

Final time we noticed situations like this was again in 2008/2009, when company mREITs have been rising their dividends. We can’t be constructive that AGNC will attain their former heights, however we could be very assured that their returns are going to be remarkably higher than they’ve been for the previous 5 years. It is a firm with a present yield greater than 10% that is very more likely to expertise dividend development throughout the subsequent six months. The present worth is a novel shopping for alternative for earnings traders! Their subsequent earnings report is scheduled for Oct. 26 (launched after market shut).

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Disclosure: I’m/we’re lengthy AGNC AND NLY. I wrote this text myself, and it expresses my very own opinions. I’m not receiving compensation for it (aside from from In search of Alpha). I’ve no enterprise relationship with any firm whose inventory is talked about on this article.

Further disclosure: Treading Softly, Past Saving, PendragonY, and Most popular Inventory Dealer all are supporting contributors for Excessive Dividend Alternatives.