Description

There have been numerous mortgage REITs written up on VIC in the past, both common stock and preferred stock. Two very well timed recent recommendations of preferred stock of mREITs, such as IVR and TWO, have generated great IRRs. Congrats on those brilliant recommendations!

This may seem somewhat prosaic compared to those stellar recommendations. This is a recommendation for a long position in AGNC, the leading agency mortgage REIT.  The upside from here is not as juicy as those previous recommendations but still attractive on a risk-adjusted basis.  A long position in AGNC offers a “pure-play” opportunity to take advantage of the unlimited backstop of the agency mortgage market offered by the Fed, collect a low double digit annual yield, and capture upside as book value accretes and the valuation rerates upward.  While a leveraged investment vehicle like AGNC is not without risks, now that we’ve been through a huge washout cycle in March and the Fed has opened the spigot of unlimited liquidity to purchase agency mortgages, we feel this is an opportune time to consider AGNC, which is trading at about .83x of book value with a 12%+ yield after a recent dividend cut. While there are other mREITs trading at a lower valuation, we don’t mind owning something at a higher relative valuation for a higher quality asset because there’s still good upside.

Background

AGNC is the leading agency mortgage REIT (although it does own a very small percentage of non-agency assets).  There have been plenty of mREITs written up on VIC before, so please refer to the previous writeup to get a sense of the asset class. More information about AGNC can be found in their recent presentation: https://ir.agnc.com/static-files/dbccd1e6-03d7-4a8c-b96f-353acf5d4370

Investment Considerations

1. After the recent washout cycle in the mREIT space, AGNC presents an opportunity to take advantage of the unlimited backstop of the agency mortgage market offered by the Fed

As a result of the financial crisis of 2008-2009 and the recent COVID-19 pandemic, the entire financial market is becoming nationalized by the FED.  The speed and the extent to which the Fed implemented asset purchases and policies to save the economy has been breathtaking. Mortgage REITs were one of the first asset classes to experience severe distress as a result of the pandemic as liquidity dried up, repo loans were called, MBS asset prices plunged and forced liquidations resulted.  As many mREITs crashed to prices signaling imminent insolvency (some did functionally default), the Fed stepped in with unlimited purchases of agencies mortgages and repo support. As a result of the Fed’s actions, the agency MBS prices including the price of pre-pay protected pay ups mortgages have retraced a significant portion of the decline experienced in March. The Fed has a strong incentive to support the mortgage market, as a well functioning mortgage market is a key pillar of the financial system and the housing market, which are important to the economy.

Fed will err on the side of overstaying its welcome in the mortgage market rather than pulling out of the market too early. Despite the Fed intervention and the big drop in the 10 year Treasury rates, consumers have not seen much of a drop in the 30-year and 15-year mortgage rates due to a variety of factors. It’s not implausible to think that the Fed may continue to expand the type of mortgage assets (including non-agency mortgages) it is willing to purchase to support the economy. It’s possible that the Fed continues to backstop the agency mortgage market for many years.

Over the last 10 years, the age-old mantra of “don’t fight the Fed” served investors who owned equities in general as the Fed’s QE filtered into financial assets broadly. However, in the case of AGNC, the benefit is not secondary or tertiary as was the case with stocks and bonds. Fed is literally buying the assets that AGNC owns (albeit with some exceptions as AGNC owns a small percentage of non-agency mortgage assets). There are very few assets that provide a double digit yield trading at a discount to NAV and effectively have the backing of the Fed’s unlimited printing press. The Fed’s intervention means the downside risk - risk of permanent loss of capital in another major risk off event - going forward has been truncated, and investors can capture the attractive yield and upside as valuation rerates over time. 

As we saw in the post-2009 Great Recession era, owning the post-crisis mortgage REITs ended up being good investments. There’s no way to know if there will be additional drawdowns in the near term, but we feel that there is a good chance of generating attractive risk-adjusted returns in a 2-3 year horizon. 

2. Top Notch Management

Gary Kain, the CEO of AGNC, is a top notch CEO and considered one of the best investors and executives in the agency MBS industry. He was formerly the CIO before he became the CEO. He is straight forward, well-respected by peers and investors and has been a savvy manager who has been able to navigate the ups and downs of the mREIT business (such as the Taper Tantrum in 2013 and the interest rate scare in 2015/2016) since 2009. While his track record is not perfect, we’ve been following him for much of the previous decade and found him to be very capable and shareholder friendly. The company’s disclosure and transparency are quite good. It’s also internally managed unlike many of the other mREITs. Gary is one of the reasons that AGNC has historically garnered a premium valuation in the market, has been able to access the capital markets to raise capital accretively, and consistently been able to retain attractive repo market funding.

While the recent performance has been disappointing, AGNC has performed well on a relative basis given the severe dislocation in March. The company issued a press release on April 8 (updating a previous press release on March 31) providing disclosure about its book value and its current financial conditions. It disclosed that it was able to meet all of its margin calls and had sufficient access to repo funding: 

https://ir.agnc.com/node/16001/html#agnc8kexhibit9914820.htm

The company’s ability to survive this recent liquidity crunch is a testament to Gary and his reputation in the market. Some of the other mREIT players have not been so fortunate and have seen their stocks crater as a result of their inability to meet margin calls and entering into forbearance arrangements with their lenders.

In the April 8 press release, the company also noted that it has $900mil left on its share repurchase program. Gary has been strategic in using share buybacks and acquiring competing mREITs over time to generate returns for investors. It wouldn’t be surprising if he uses his access to capital to do something accretive during this COVID-19 crisis.

3. Attractive Yield and Upside to Book Value

On April 8, AGNC announced a cut its monthly dividend to $0.12/share. A $1.44/share annual dividend on $11.65 is a 12.4% yield. In the same April 8 press release, AGNC announced its estimated 3/31/20 book value of $13.60, which is a drop in YTD book value of about 23%. While the book value decline is unfortunate, the decline is not bad relative to other mREITs that have seen much larger decreases. Since the 3/31/20 book value disclosure, the underlying assets have traded up and the current estimated book value is approximately $14.10 per share based on a recent analyst report from JMP Securities:

As the market continues to recover and the Fed continues to support the mortgage market, AGNC’s book value should continue to increase over time. There are great opportunities to generate alpha by repositioning the portfolio in the current environment. Unlike a number of other players in the space, AGNC is in a position to take advantage of the pockets of value in the mortgage market as one of the strong players to emerge from the recent crisis.

Historically, AGNC was considered the leading agency mREIT (along with NLY), and thus it consistently traded at a premium to other mREITs and periodically traded above book value (as high as 1.2x - 1.3x book value). In periods when the stock traded above book value, AGNC strategically raised capital accretively to take advantage of the high book value.  At some point when the COVID-19 pandemic recedes and the market returns to some semblance of normalcy, there’s a good chance investors will be clamoring for yield with the Fed anchoring the short end of the curve at zero (or possibly below zero). It wouldn’t be surprising for AGNC to trade above book value at some point in a ZIRP environment like it did in the post-Great Recession ZIRP environment.

Conclusion

With a long position in AGNC, investors can collect at 12%+ yield with an opportunity to capture a valuation rerating to 1x book value of $14 (which will likely accrete higher as the market recovers) once the COVID-19 situation gets resolved. The base case total return potential in 1 year is 32% and 44% in 2 years (12% dividend yield + rerating to $14/share book value). 

The upside case would be significantly higher returns.  It’s possible that the market rerates to even 1.2x book value in a yield-starved environment. There’s additional upside as a top-notch management team can generate alpha through asset repositioning, M&A, and share buybacks in this dislocated market environment as one of the strong survivors of the recent carnage in the mREIT space. With the Fed purchasing unlimited amounts of agency mortgages, we feel that the downside risk has been curtailed and we have an opportunity to realize an attractive return on the upside.

Risks

• Leverage. Mortgage REITs are levered assets, usually levered on the order of 7-1 to 10-1 for agency mREITs - not unlike banks. You have to be comfortable that the management team will be able to manage the short term funding risk and the leverage risk.

• Interest rate risk. There are a number of risks associated with interest rate volatility including hit to book value, higher CPRs, lower NIM/dividends, etc. Although AGNC actively hedges interest rate risk, if there’s a large move in rates, AGNC will experience a hit to book value and/or NIM compression. Again, you have to trust that the management team is capable of managing the interest rate risk.

• Now that we’ve been through a major washout cycle in March and the Fed has introduced the agency mortgage put, we feel that the downside risk of AGNC has been truncated.

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author and/or his employer has a position in this stock and may trade this stock. 

Catalyst

Dividends

Investors seek yield in a zero interest rate environment

COVID-19 situation eventually gets resolved