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Here’s Why Passive Income Seekers Should Start Thinking About AGNC Investment

Mortgage real estate investment trusts (REITs) have been a highly out-of-favor sector for the past year as markets have anticipated the Federal Reserve’s rate hikes. Rising interest rates are generally bad news for financial assets in general, and the mortgage REIT industry has taken it on the chin.

The Fed has been increasing the fed funds rate at an aggressive pace, however if you look at the fed funds futures, we are probably in the late innings of this rate-hiking cycle. The economy is weakening, and the 10-year Treasury has a lower yield than the two-year bond. This is a signal that long-term interest rates have probably increased as far as they are going to this year. If rates are stabilizing, then it is time to take a fresh look at the mortgage REIT sector. 

Image source: Getty Images.

Mortgage REITs will benefit from the end of the Fed’s hiking cycle

AGNC Investment (NASDAQ: AGNC) is a mortgage REIT that invests almost exclusively in mortgage-backed securities, which are guaranteed by the U.S. government. If you refinanced your home last year into a Fannie Mae or Freddie Mac loan, there is a good chance that it ended up in a mortgage-backed security similar to the ones that AGNC holds. Since these mortgage-backed securities are guaranteed by the U.S. Government, AGNC will get its principal and interest even if the economy goes into a recession and borrowers default. An environment of economic weakness and stable interest rates is the ideal situation for AGNC, as government-guaranteed mortgage-backed securities are considered a pretty safe investment. 

The business model for a mortgage REIT resembles a bank. Instead of taking deposits, it borrows money via repurchase agreements, which are collateralized loans. It then uses that borrowed money to purchase a large portfolio of mortgage-backed securities. This use of borrowed money (or leverage) is how AGNC can turn a portfolio of bonds that yielded 3.09% on average into a dividend yield of more than 11%. Like a bank, its profits are the difference between what it makes on its portfolio and what it costs to borrow the money. The company’s cost of borrowing in the repurchase market last quarter was 0.74%. 

Mortgage REITs have big dividend yields

An 11% yield would ordinarily be a red flag for most common stocks — a too-good-to-be true dividend yield usually is — however for mortgage REITs, that is typical. Mortgage REITs are highly vulnerable to interest rate volatility, which will sap book value over time. When rates stabilize, book value will rebuild and the company will continue to earn its interest spread and pay dividends. AGNC pays a monthly dividend of $0.12 per share, and has maintained that level since cutting it from $0.16 in the early days of the COVID-19 pandemic. 

Mortgage REITs are still licking their wounds from the rapid rise in rates over the past quarter. Tangible book value per share fell 12.9% to $11.43 per share during the quarter. The stock, as the chart below shows, is down considerably over the past year. That said, with rising rates the supply of mortgage-backed securities from mortgage originators is falling (simply because lenders are making fewer loans) and the Fed is reducing its portfolio more slowly as fewer borrowers prepay their loans. The supply and demand situation is improving and management believes agency mortgage-backed securities are highly attractive on a historical basis. 

AGNC data by YCharts

Not an investment for those with a weak stomach

AGNC Investment is not for the faint of heart. Interest rate volatility remains high, however the markets are predicting that the Fed will be done with rate hikes by the end of the year — in fact the markets are handicapping rate cuts in 2023. A stable bond market could be just what the doctor ordered for this highly out-of-favor stock. Income investors looking for passive income should put this name on their shopping list, especially if they can pick up the stock at a discount to book value.

Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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