AGNC’s funding shares have gone opportunistically low cost (NASDAQ:AGNC)

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I’ve all the time been bearish on mortgage REITs. In March 2013, I mentioned that AGNC was not incomes its dividend sustainably and {that a} reduce was probably. In June 2013, AGNC introduced a dividend reduce.

In September 2021, I defined why inventory REITs are typically higher investments than mortgage REITs.

An exception to my downtrend on the sector was a chance in most well-liked mREIT businesses resembling ARMOR Residential (NYSE:ARR) most well-liked C and Annaly Capital (NYSE: NLY) Most popular D which grew to become opportunistically low cost because of a worth dislocation through the pandemic. At this time, these most well-liked shares are all at or above their $25 face worth or have been redeemed, so the chance has largely dried up.

I convey up this historical past to indicate that in writing a bullish thesis on AGNC at the moment, it isn’t from a “yay excessive yield” perspective however slightly a aware evaluation of the precise alternative at this valuation. particular.

Given the overall poor worth efficiency amongst mREITs, a few of them at the moment are low cost sufficient to supply an honest whole return. Specifically, I transfer increased on AGNC Funding Corp. (NASDAQ:AGNC).

The acquisition thesis

The market has bought AGNC a lot that it’s now virtually the most affordable it has been prior to now 10 years.

The sale appears to be associated to 2 issues:

  1. Dividend investor frustration with dividend cuts.
  2. Concern of rising rates of interest.

None of these items have a big affect on its basic worth, so I am assuming that at this decreased valuation it has a powerful return going ahead. The earnings yield is excessive as a result of low market worth and the sustainable earnings totally cowl the 9.5% yield.

Cuts and worry of rising rates of interest made AGNC low cost

The 2013 dividend reduce was simply the tip of the iceberg, with dividends falling precipitously.

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AGNC Dividend Historical past

SNL Monetary

With its monstrous dividend yield, AGNC was very fashionable amongst dividend buyers. Nevertheless, the chart above is the precise reverse of what most dividend-focused buyers wish to see.

Because of this, many bought the title in quest of extra steady dividends.

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AGNC 10-Yr Chart


Given the excessive degree of return on AGNC, the entire return was really optimistic, nevertheless it nonetheless considerably underperformed the market.

The sale of AGNC accelerated in mid-2021 because it started to develop into clear that the Fed was going to should take motion to cope with inflation.

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AGNC share worth


The fundamental thought right here is that rising charges have a tendency to harm extremely leveraged corporations that use short-term debt.

All that promoting strain has left AGNC simply concerning the least expensive in a decade.

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AGNC share worth at ebook worth

SNL Monetary

It now trades at just below 6 occasions ahead earnings and 87% of ebook worth.

This degree of cheapness is justified within the eyes of the market, as many anticipate additional cuts in dividends and earnings because of increased rates of interest.

I see issues slightly otherwise.

Historic dividend cuts will not be a related consider figuring out future dividends

As a REIT, AGNC is required to pay out at the least 90% of its taxable revenue within the type of dividends. For fairness REITs, this isn’t an issue as a result of they’ve depreciation to shelter their money movement, permitting the corporate to retain vital money movement past their dividend payout. Mortgage REITs like AGNC do not have vital amortization, to allow them to’t shelter their revenue and should pay nearly every little thing. There’s nothing fallacious with shareholders receiving the majority of earnings within the type of dividends, however there is a large downside when taxable earnings far exceed precise money earnings.

This was the case for AGNC for a lot of the previous decade and the rationale it needed to reduce its dividend. AGNC subsequently has 2 main revenue brackets.

  1. Web curiosity margin or NIM which is the distinction between what they earn on their belongings and the price of capital
  2. Mark to market of securities

The primary bucket is what I might name true earnings whereas the second bucket is only a matter of market fluctuation.

As rates of interest have fallen considerably over the previous decade, the market worth of RMBS securities has risen such that the yield to maturity would drop to market charges. This worth enhance precipitated AGNC to make large good points available in the market worth vary.

These good points compelled AGNC to pay out a dividend far in extra of their true first bucket earnings. Since rates of interest can not fall endlessly and subsequently optimistic market worth can not final endlessly, a dividend reduce was inevitable.

This is the reason there was a discount and it’s also why historic dividend cuts don’t predict future cuts.

At this time, AGNC’s dividend is roofed by NIM’s precise earnings and subsequently appears to be like fairly sustainable. Actually, NIM has improved significantly and is at a excessive degree.

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AGNC Curiosity variations


Rates of interest – risk or not?

Based mostly on AGNC’s market worth motion, it’s clear that the market perceives rising rates of interest as a risk.

Nevertheless, trying on the mechanics, I see it as non-threatening.

Thus, AGNC’s web curiosity margin operates from their belongings producing a return in extra of their value of capital. Given the present zero rate of interest atmosphere, Repo charges are near 0.

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Desk of pension charges


That is the majority of AGNC’s value of capital.

The worry of an rate of interest hike is that when the Fed rises, repo charges will probably rise in keeping with the fed funds fee. I agree that it’d occur.

Nevertheless, with the speed hike telegraphed by the Fed for a very long time, corporations had been capable of put together. Beneath is AGNC’s hedging exercise.

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AGNC protection


Total, AGNC’s value of capital is 98% hedged. So even when rates of interest rise, AGNC’s value of capital is basically locked in.

The opposite affect of rising charges is that it might result in a unfavourable ranking available in the market. Simply as falling charges shifted one-time revenue from a optimistic mark to the market, rising charges would trigger one-time revenue to be unfavourable. Right here is the sensitivity chart.

I discover the total 75 foundation level hike to be fairly believable and it could drive the ebook worth down by 9.6%.

Nicely, with AGNC buying and selling at lower than 90% of ebook worth, that success is already totally priced in.

The important thing factor to notice right here is that this hit could be one-time in nature and wouldn’t affect their dividend protection. It is coming from the NIM and it appears to be like wholesome whether or not charges are rising or not.

The true danger that buyers ought to take into consideration is an explosion in spreads.

Hedging exercise handles parallel shifts very effectively when all of the monetary components transfer correctly in tandem, nevertheless it doesn’t deal with unfold breakouts.

You’ll discover beneath the desk of sensitivity to unfold variations between RMBS and Treasuries.

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AGNC Unfold Sensitivity


If, for any purpose, market yields for RMBS rise considerably relative to Treasuries, it might lead to substantial losses for AGNC.

Such actions are normally the results of a big enhance in danger premia and I do not suppose that’s probably. Given the overall financial stability and the telegraphed nature of the Fed hikes, I believe the 30-year mortgage fee and Treasuries will rise in tandem.

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30 yr mortgage fee


To date, that has been the case this cycle.

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Yield on 10-year treasury payments


Actually, I believe the unfold will tighten barely because the RMBS is reasonably de-risked.

With rates of interest at 0, refinancing mortgages grew to become very profitable for owners, driving refinance charges as much as 40%.

As rates of interest rise, refinancing turns into much less of a monetary incentive and the tempo of refinancing ought to come down. This motion has already begun.

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Mortgage refinance fee


With extra reasonable rollovers, the length of the RMBS is extra predictable and there will probably be fewer par premiums misplaced within the occasion of early redemption.

I count on the good points from the unfold tightening between RMBS and Treasuries to greater than offset the market worth loss from increased rates of interest.

The general image

Given the sell-off, AGNC is now buying and selling at a lovely valuation. With a powerful earnings yield and a steep low cost to the market, I believe it is a good entry level. A wholesome web curiosity margin and plentiful hedging exercise be certain that the 9.5% dividend is totally lined by sustainable money movement.

One of the best time to take a position is commonly when sentiment is at its lowest, particularly when sentiment is extra bearish than precise fundamentals. Given the overall disdain for AGNC from earlier dividend cuts and fears of rising rates of interest, I believe the market is much too bearish on AGNC.

This has pushed the worth down to a degree the place whole ahead returns look like beating the market.

About Edith J.

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