AGNC: 10%-Plus Yield, Beat Earnings, Best Stock To Own In A Recession


  • We have been very bullish on AGNC since September.
  • Already up 22%, there's plenty of room to run.
  • Q4 earnings confirm that many of our predictions were spot on.
  • This is a great pick that can actually go up in a bear market.
  • Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »

Co-produced with Beyond Saving

Back in October, we published our first report on AGNC Investment Corp (NASDAQ:AGNC), explaining how the agency MBS market was poised to turn around. In that article, we stated:

We believe the market is overly fearful of prepayments. It's the cost of debt that has the largest impact on net interest margin and with the Fed cutting the target rate, AGNC's debt costs are coming down.

Our outlook received a lot of criticism, mostly based on the fact that AGNC was trading near all-time lows and that they had previous cut their dividend. Just as we did with another mREIT Annaly Capital Management (NLY), which also yields more than 10%, we maintained that past price performance was secondary to the substantial improvement in fundamentals.

As recently as Jan. 19, we reiterated our positive outlook as AGNC continued to rally. The market was finally taking notice that the environment is favorable for mREITs.

While the details of agency mREITs can be very complex, what they benefit from is very clear: Their profit is a function of their cost of debt, relative to the performance of the assets they hold. Since their cost of debt is very closely related to the Federal Funds rate, when the Federal Reserve cuts the rate, they benefit.

Today, we want to take a deeper look at Q4 earnings which were just released and the specific factors that we believe will continue to drive AGNC to outperform the market from here.

Earnings Home Run

AGNC's earnings were a "home run," wiping out an entire year of losses in just one quarter.

Source: AGNC Presentation

They recorded their highest book value since Q3 2018. With conditions favorable, AGNC is well positioned to see further improvements. Note that this book value does not reflect any improvement that was likely realized in January.

Factors that drive book value are increased stability in Treasury rates, improving prices in agency MBS and an expanding net-interest margin.

In addition to improved book value, AGNC has seen an improvement in cash flow. Their net interest margin is the difference between their average yield and their average cost of funds.

Source: AGNC Presentation

Yield decreased 7 bps from the prior quarter, while the average cost of fund decreased 9 bps. While this doesn't sound significant, across $100 billion-plus in assets it makes a difference. Here's a look at the history of their net interest spread - higher is better.

Source: AGNC Presentation

After falling off a cliff in late 2018 and early 2019, this impacted AGNC's returns and their ability to sustain the dividend. Now that it has recovered, AGNC is on much more stable ground.

We made the prediction that this would happen, and it did. So now we need to consider whether AGNC has room to improve from here.

Effective Yield

One of the headwinds we identified in 2019 was prepayments of mortgages. When a mortgage is prepaid, AGNC gets the principal, but they lose future interest payments and their effective yield is impacted since they are paying above par value for MBS.

The CPR (constant prepayment rate) is a measure of the speed that mortgages are being prepaid. It peaked at 17% for AGNC in November of 2019, which means that if the rate was maintained for an entire year, 17% of principal would have been prepaid.

Source: AGNC Presentation

Fortunately, that rate has been slowing down considerably. Q1 2020 is already off to a much better start than Q4. This will have a positive impact on effective yield. We expect that average asset yield will continue to decline slightly due to rising MBS prices, but not as quickly as we saw in Q3 and Q4.

Cost of Funds

As we predicted, the cost of funds has declined dramatically. AGNC utilizes "repurchase agreements," these are short-term lending agreements that utilizes the agency MBS they are buying as collateral.

Source: AGNC Presentation

This rate dropped significantly from 2.48% to 2.17%. Note that the bulk of these agreements expire in less than three months. So as those mature, AGNC will be able to roll them into lower rate borrowings.

The other factor that impacts the cost of funds is AGNC's hedging activity, specifically their interest rate swaps. AGNC pays the "pay rate" and they receive the "receive rate."

Source: AGNC Presentation

These swaps are currently providing positive income, which offsets the interest they pay on their repurchase agreements. If interest rates continue dropping, the "receive rate" will drop as well and it can go below the pay-rate. However, if interest rates start going up, then these swaps will start producing even more income and help offset increases in the repurchase agreements. Currently, AGNC has nice low pay rates on their swaps, so there is plenty of room for their cost of funds to decrease before these hedges start working against them.

AGNC already has benefited from the big drop, but their cost of funds will continue to incrementally improve as long as the Federal Reserve's target rate remains unchanged. If we see a cut later this year, that would improve their borrowing costs even more.

2020 Outlook

We expect that AGNC will continue to see incremental improvements in their net interest spread. This will result in larger earnings, improving book value and we believe it's very likely that AGNC will raise their dividend before the end of the year.

This improvement will come from two sources - a decline in prepayments will stabilize their effective yield. We expect some compression as the cost of MBS increases, though rising MBS costs is a positive for book value.

Their cost of debt will improve steadily as their repurchase agreements mature and are refinanced at lower rates. Additionally, there could be some more room for improving their interest rate swaps.

Book value will improve as AGNC is now underpaying their dividend, and also their short positions on treasuries are likely to be more profitable. We note that despite the turmoil of the past week, the 10-year Treasury remained above 2019 lows.

Source: CNBC

We continue to believe that long-term rates are going to continue to be biased toward moving upwards and will resume their march toward 2.5% when the near-term fears toward the coronavirus are resolved.


One of the most misunderstood things about agency mREITs is that investors are used to watching historic trends. Companies build infrastructure, prove a business concept and grow it over time.

These mREITs are making a very specific type of investment, they are buying agency MBS, borrowing short-term money to buy securities full of long-term loans. The can leverage up and down very quickly, and the success of their underlying investment is going to drive performance.

So instead of looking at what happened before, we can profit much better by focusing on what's happening right now. Is the agency MBS investment improving or deteriorating right now? We contended in August through October that the answer was clearly improving. All it took was the simple recognition that the Federal Reserve had cut the target rate and that agency MBS would see substantial margin improvement just for the reduction in borrowing costs. As a result, we were buying AGNC at all time lows and NLY at decade lows.

Today, we believe the answer is still that agency MBS is improving. Prepayments are slowing down, Treasury rates are more stable and very unlikely to see a 150 bps shift down like they did last year, and while we might or might not see another cut for the Fed's target rate, at a minimum we are not seeing a raise early in the year. This provides plenty of time for agency mREITs to lock in hedges and be well positioned to handle an increase if it does come.

2020 is going to be a huge year for mREITs, and we are off to a great start. The prices might look expensive compared to what they were in Q3, but there's still plenty of upside left for those who missed out.

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Disclosure: I am/we are long AGNC, NLY. 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.

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