I'm now short, via put options, a company that holds liquid bonds trading below book value with an implicit guarantee from the U.S. government. At first blush, that doesn't sound like a solid investment thesis. However, I think the risk/reward ratio of an investment in American Capital Agency (NASDAQ:AGNC) skews negative with a small, limited upside and a larger downside.
AGNC is between a rock and a hard place. Reviewing this week's investor presentation, the rock is the cost of funds at approximately 1.5%. The hard place is the decreasing yield of its investments currently at 2.5%. The result is a spread that is being squeezed to unattractive levels, now at 1.16% including TBAs, down from 1.74% only a year ago. AGNC should have seen large book value increases as agency mortgage back securities rallied. Instead interest rate hedges have limited gains. Additionally, the refinance risk to agency MBS is increasing. The factors leave AGNC with unappealing options of further reducing the dividend or increasing risk. The trade I propose is buying the January 2018 put option with the cost partially offset with interest generated from purchasing preferred shares.
Net Spread is Shrinking
The shrinking spread is not new but it is persistent. Below is a graph of the two-year and 10-year Treasury rates. There has been a rise in short-term rates while the long-term rates decrease.
Similarly, the cost of funds has increased while the asset yield has decreased leaving a paltry spread. This is the core of how AGNC makes money. It borrows money at 1.5% and buys assets yielding 2.5%. Leverage the spread enough times and the yield starts to look attractive.
Leverage is Increasing
Taking a look at the leverage we can see that AGNC has ramped up leverage from 6.1x to 7.2x in the last year. On the conference call, Gary Kain, CEO, stated that as of July 1 the leverage is now 7.7x. To make up for the lower spread, leverage is increasing.
Book Value is Decreasing
Meanwhile the book value is down 7.5% year over year, despite a small increase last quarter. AGNC trades at a 11.8% discount as the market is pricing in further erosion of book value.
Interest Rate Hedges Weigh on Book Value
Book Value decreased primarily because AGNC was heavily hedged against an interest rate increase. The percent of the portfolio hedged has decreased significantly since September of last year. AGNC lost $1.19 per share of book value in Q2 due to hedges. The primary objective of interest rate hedges is to maintain book value, whether good or bad.
70% of outstanding 15- and 30-year mortgages have at least a 50 basis point incentive to refinance. A refinance is particularly destructive to AGNC because it holds a significant portion of its portfolio in mortgages trading above 105 with a par value of 100. AGNC loses 5% on any of those mortgages refinanced. A portion of the portfolio refinanced wouldn't be disastrous, but with 7.7x leverage every loss compounds.
The Bear Case
AGNC is positioning itself for a "lower for longer" interest rate environment. By increasing leverage and reducing hedges, AGNC is vulnerable to a change in sentiment. Furthermore, AGNC is increasing the percentage of its portfolio into 30-year fixed mortgages. A rise in interest rates will lower book value. However, a further decrease in interest rates could trigger a refinancing wave, which would also lower book value. A 1% spread is a bad risk/reward investment. Leveraging a bad investment nearly 8x does not turn it into a good investment. It turns it into a risky investment.
Using prices from midday on Thursday, 100 shares of AGNC preferred series B could be bought for $2,610. Between now and January 2018 those shares will pay $253 in dividends. Those dividends offset the cost of the January 2018 $20 put at $340 for a net cost $97. The upfront cash required is $2,950. At the time of the trade AGNC was $19.50. The breakeven for the put is $16.60. If AGNC has a 0% total return and maintains an $0.18 monthly dividend, the share price will be $16.44 in January 2018. The trade can be scaled up for the size of the portfolio.
That's a very cheap put. It's rare for the put to break even if the share price decreases by the dividends, much less be in the money. That leads me to believe that the market is pricing in more dividend cuts.
Below is a table that shows the potential returns that I see as probable. Since the put is worthless with AGNC above $20, losses largely become limited to the decrease in preferred shares. The best case scenario for this trade would be short-term interest rates continue to rise while long-term rates continue to fall. The interest rate curve goes completely flat and forces AGNC to slash the dividend. Homeowners refinance causing book value to fall. Meanwhile the preferred shares increase as they are interest rate sensitive. The cumulative dividend of the preferred shares helps me sleep at night knowing that even if AGNC gets bit by its 7.7x dividend, I don't see a bankruptcy situation possible. The worst case for the preferred would be deferred dividends that would eventually get paid.
If you found information in this article useful, please follow me.
Disclosure: I am/we are long AGNC-B AND JAN 2018 $20 PUTS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.