AGNC: The Power Of Combining The Preferred With Common Equity, Boosting Yield And Upside Potential

Summary

• AGNC focuses on agency MBS which are lower risk than non-agency MBS.
• AGNC common has seen improved fundamentals.
• Today, we look at the preferred offerings as well.
• 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

In 2019, we have focused on expanding our preferred holdings. Today we take a look at a preferred offering from a company for which we already hold the common shares. By combining the preferred shares with the common, we can get more stability, while still maintaining a very high cash yield.

At High Dividend Opportunities, we have been encouraging our members to take advantage of fixed-income investments like preferred shares and bonds. We recommend a 45% allocation of portfolio to high-yield bonds and preferred stocks. When these are combined with higher-yield common equities and funds, they produce very strong immediate income while managing volatility at the overall portfolio level.

Preferred shares come with their benefits, but they also have drawbacks.

For example, a major attraction of preferred shares is that the dividend is fixed and it has priority over all common equity dividends. This means that the company cannot pay a penny to common shareholders until the preferred dividend has been paid in full. This makes the preferred dividend much more secure.

However, preferred dividends are never raised. So investors in preferred equities miss out on improvements that might lead to higher dividends.

Similarly, the price of preferred shares tends to be far more stable. While it might dip or climb a little bit, investors will not see the same upside that they might be able to obtain with the common shares.

In short, preferred shares provide an opportunity for a more secure and steady income stream, but in return they don’t provide the same upside potential of common shares. The best solution for income investors is to diversify. Preferred equity and bonds provide a base of investments providing a stable, fixed income that we can be very confident will continue uninterrupted during any economic conditions. Then, having provided us with a floor, we can invest in common equities which have a higher risk but also provide higher potential reward.

Frequently, we will find what we see as a compelling common equity opportunity that also has a compelling preferred equity opportunity. This is the case with the investment we are discussing today. We bought the common shares a couple of months ago and we already have seen some healthy appreciation. Now we look at adding the preferred equity which will have the impact of providing some stability to our overall position.

AGNC Investment Corp. (NASDAQ:AGNC), yielding 11% per year, is a mortgage REIT which focuses primarily on investing in agency MBS. These are mortgage-backed securities which hold mortgages that are guaranteed by one of the government-sponsored enterprises (GSEs), usually Fannie Mae or Freddie Mac. Since GSEs guarantee the principal of the mortgages, the credit risk (risk of the borrower defaulting) is carried by them.

In our prior article, we explained how AGNC is able to take one of the lowest risk investments in the market and pay out a high dividend yield. The coupons on their investments are only 3-4%, but AGNC currently has a dividend yield of over 11% per year (May 4).

Investors interested in the details should read our prior articles, but the Cliff-notes version is that AGNC uses a substantial amount of leverage. So while there's minimal credit risk, there's interest-rate risk. The cost of debt is very significant to them and throughout the year we saw long-term rates coming down. But it's only recently that we have seen the short-term rates that AGNC borrows at come down. We summed it up predicting:

We expect to see some incremental improvement in borrowing costs in Q3, though we need to remember that July is included and there is a delay as AGNC has to wait for the old contracts to expire. At the end of Q2, their average expiration was 80 days.

So investors will have to be patient for the full benefit of declining borrowing costs to be realized.

Sure enough, when AGNC reported their Q4 2019 and Q1 2020 earnings, they had a significant reduction in their borrowing costs. Looking at recent history, we can see that there was a significant improvement from Q2 to Q3. They continued to see some incremental improvement into Q4 and Q1 2020.

Source: AGNC 1Q 2020 Presentation

Since the peak, AGNC's cost to borrow declined from 2.24% to 1.67%. So while the average effective yield on their investments also declined, the cheaper borrowing had a significant impact on their margin, increasing it from 1.00% to 1.30%. The chart shows this reversal of the downward trend that had been occurring for a year.

The best part is that AGNC's cost of funds will continue to decrease. We will see another huge step-down due to the Fed cutting rates again in response to COVID-19. On their earnings call, AGNC management predicted that their cost of funds would be reduced to 1.10% in Q2. Current funding is available at under 0.50%, but they have interest rate swaps that will continue to inflate their cost of funds until those contracts expire. We will see a big leg down in Q2, and then a more gradual decline in future quarters, much like we saw a big leg down in Q3 2019, and then smaller declines through Q1 2020.

COVID-19 Impact

COVID-19 had a significant impact on mREITs, introducing volatility in agency MBS at a level that has never been seen before. Here's a look at Agency MBS prices - these are the securities that AGNC buys.

Source: MBS Dashboard

In the span of just a couple of days, agency MBS gave up nearly a full year of price gains. The abrupt turnaround was due to the Federal Reserve buying agency MBS.

The pain of that drop was increased by the fact that agency MBS and treasury rates generally move in the same direction. Due to this strong correlation, mREITs frequently initiate short positions on Treasury rates in order to hedge their portfolios. In this case, the short positions were losing as treasury prices rallied strongly, at the same time, their MBS holdings were falling at an unprecedented rate.

This lose-lose situation forced AGNC and other agency mREITs to deleverage and/or realize losses in their hedging portfolio, resulting in losses to their book value.

Preferred Shares

That's the point where the preferred equity comes in. We can buy preferred shares and have the confidence that we can continue to hold them and maintain our income regardless of what economic conditions bring. We want the upside of the common shares, but we also want some stability. Anyone looking at a long-term chart of AGNC can see that it has been somewhat volatile. The impact from the events of March made for even more dramatic swings.

Source: Tradingview.com

Historically, buying AGNC after it falls has been very profitable. With lower interest rates, we believe that AGNC is going to have significant upside and exceed its February 2020 peak, although it will take some time to recover from the damage in March.

AGNC preferred shares, AGNCN, on the other hand, were extremely stable before March, and while they did fall, they have nevertheless regained ground more quickly. While they are not immune to the general panic selling, their superior position in the capital stack allowed for a faster bounce back, as seen in the one-year chart below.

Source: Seeking Alpha AGNCN

Preferred shares offer retirees an investment that's less volatile and that generates high immediate income. The income is stable as the dividend amounts are set at issuance and cannot be changed.

While common dividends can be reduced at the company's discretion, AGNC preferred dividends are cumulative. This means that even if AGNC has a dire financial situation that forces it to suspend the preferred dividends, these dividends continue to accumulate. These preferred dividends must be paid before any dividends are paid to common shares investors.

This means that preferred investors enjoy the luxury of being less concerned with the quarterly oscillations in performance. They can take a broader, more macro view of the company's health and only need to be fearful if there's a material risk of permanent deterioration.

Coverage

AGNC primarily utilizes a debt structure of repurchase agreements. This is a very common debt structure in agency mREITs which uses the MBS bought as collateral for the loan. These loans are non-recourse, which means that collection rights for the lender do not extend to other assets of the company.

For AGNC, their unencumbered portfolio of agency MBS - the portion of their portfolio which has not been pledged as collateral, plus cash, is valued at over $3.7 billion. By comparison, the preferred shares have a liquidation preference of $1.235 billion. That provides very significant asset coverage of nearly 3x, just from the unencumbered portfolio and cash. Note that even with record breaking volatility, agency MBS prices dropped 3.5%, so these unencumbered assets are conservative in even the most panicked environments.

In terms of cash flow coverage, the preferred shares also look very healthy. AGNC's net interest income was $693 million in 2019. This compares to a preferred dividend obligation of $82 million. NII coverage of the preferred dividend is in excess of 8.4x. Preferred investors also enjoy the "cushion" of $200 million in common dividend payments that would have to be slashed to $0 before AGNC could suspend the preferred dividends.

In short, AGNC's preferred shares benefit from:

• A debt-structure where debt is non-recourse
• An unencumbered asset pool that is large relative to the preferred obligation
• Assets that are extremely liquid
• A massive amount of cash flow relative to the preferred dividend obligation

Which Preferred?

AGNC currently has four preferred shares outstanding, having recently redeemed AGNCB.

• AGNC 7.00% Series C Fix/Float Cumulative Redeemable Preferred (AGNCN) - yield 7.8%
• AGNC 6.875% Series D Fix/Float Cumulative Redeemable Preferred (NASDAQ:AGNCM) - yield 8.0%
• AGNC 6.50% Dep Shares Series E Fix/Float Cumulative Redeemable Preferred (NASDAQ:AGNCO) - yield 7.6%
• AGNC 6.125% Dep Shares Series F Fix/Float Cumulative Redeemable Preferred (NASDAQ:AGNCP) - yield 7.5%

All four preferred shares are "fixed-to-floating." This means that they are at a fixed rate and if AGNC doesn't redeem them on the call date, the dividends convert to a floating rate which is calculated as three-month LIBOR + a base rate. Here is the rundown of the currently outstanding preferreds as of April 28.

The first thing we notice is that AGNCO and AGNCP are trading at a lower stripped yield than the others. In exchange, investors get more distant call dates.

AGNCN and AGNCM are much closer in current stripped yield and investors might be lured by the higher floating rate. However, if the shares of AGNCN are called, near the call date, that does not make a difference.

That makes our choice clear, AGNCM is the best option at current prices. It has the highest current yield, and four years before the call date.

Conclusion

The lure of common equities is strong, especially in a case like AGNC where the common equity is yielding more than 11% per year. We have made the case that there's significant price upside as the Treasury market stabilizes and they start to benefit from the low borrowing costs. As their net investment spread increases, it's very likely that AGNC will be raising their dividend by the end of 2020 or in 2021.

Conditions for agency mREITs were very poor for most of 2019, and it's only at the tail-end that there has been a noticeable improvement. Spreads will continue to improve into 2020 as AGNC and other mREITs like the 16% yielding Annaly Capital (NLY) benefit from declining borrowing costs. These are common share positions that we are very bullish on.

On the other hand, investing is all about risk management. It's important for investors to provide some stability in their portfolios. We have seen in the past how common shares for AGNC can be volatile, with large upswings and downswings and last month was competition for the world's largest roller coasters.

The common shares are also exposed to dividend changes when AGNC decides it is best to retain more cash. This happened recently with the fallout of the book value impact from March, AGNC decided to retain more cash to help them rebuild their book value more quickly. In the long run, we anticipate AGNC will have to raise their dividend back up as their taxable income will be growing with larger spreads. Historically, AGNC's common dividends have varied significantly, moving up as spreads improve and declining as they tighten. When they had similar turbulence in 2009, they cut the dividend from $1.20 to $0.85 for a single quarter before raising it back up to $1.40 because their taxable income jumped.

That is why we recommend to our members that they diversify into bonds and preferred shares. These fixed-income securities will provide more secure income and have less price volatility. This provides a solid base that investors can rely on to support their more volatile picks.

AGNC preferred shares have the advantage of a stable dividend and very low volatility. AGNC, on the other hand, has more upside potential as well as a higher dividend. We want the potential growth of the common, but we also like the stability of the preferred.

By mixing the two, with a 55% common position and a 45% preferred position, we can reduce our volatility and still achieve a combined yield between 9%-10%. Additionally, the mixed portfolio preserves exposure to the upside we believe is coming in 2020.

That's the power of diversifying across the capital stack and that's why we believe investors could hold a position in AGNC preferred shares, even if they already have exposure to AGNC common.

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Analyst’s 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.

Comments

[ajspjs60]

I have AGNC common shares and am looking to add preferred shares to my holdings.This will be my first such purchase of such type shares. Looking at the 4 choices, I picked the AGNCM as my pick, meaning I get the reasoning. That is also below par correct, $25.00? So, theoretically the share may rise to Par and collect the dividend, right? Thank you to anyone to take the time and help me understand.

[Hammer1]

Long NLY and watching both closely

[The Value Portfolio]

NLY is definitely one of the best common stocks that are out there.

[Hammer1]

Rida, no mention of payoff risk for a percentage of their mortgages. Yes, principle is agency guaranteed, but should loans go into default, they are repurchased at par, not 105+/- cost. Is that where hedges help? Does that imply a risk to NAV for the portfolio? Thanks

[The Value Portfolio]

Not only do hedges help, but if you look at how much the company's share price has collapsed, that potential 5% drop is already more than priced in.

[drconsul]

Rida, on your advice I bought AGNCO and AGNCP last year along with NLYG. They are all below the price I paid for them currently but because they are Preferreds I sleep well at night knowing the dividend is very unlikely to get suspended. I will gladly trade the difference between the Preferreds 7.5% dividend and the Common shares higher pay and possible price appreciation for the assurance I will continue to get paid. The reduced price votality of the Preferreds help me sleep better at night too but they sure did take a big hit for a short period of time. I also have LMRKN on your advice from last year.

[PendragonY]

@drconsul

That is exactly why I hold the preferred in those companies as well. Right now the price of the commons makes them attractive, but long term the variability of the common dividend makes the preferreds more attractive.

[Pops007]

The CEO just bought 2.3 million worth at 12.6

[PendragonY]

Kain bout 189K shares on May 6th, and Fiske bought 15.6K shares on 4/30.

openinsider.com/...

[kbaba]

Interesting that Kain also bought 1.6 million $ worth in May 2019 at $17. So much for sell in May and go away

[jmor1]

Kain has several accounts for his children and family...the most recent purchase was for his Family Trust so he may be doing some estate planning.

[Joachim Ophalfens]

Why would you buy the preffereds from a company in which you already own the common?

In times of trouble share price for both types of stock in one company will generally correlate, adding no real short term stability, or risk reduction to the portfolio. Investing in preffereds and bonds is a good way to reduce risk, but buying preffereds from the same company you already own the common makes no sense to me.

If you think agnc will do good in the short term, buy the common. If you think more pain is coming, buy the preffered.

Buying the preffered from a company you are comfortable with owning the common of only reduces yield with very limited risk reduction.
In my view it would make more sense to diversify and reduce risk by investing in preffereds or bonds that don't correlate with the common stocks you already own.

I am an owner of and long AGNC common, and the preffereds of several other companies.

[PendragonY]

@Joachim Ophalfens

You are making the incorrect assumption that the only risk is price action. But we are INCOME investors, and the preferred have a much safer dividend.

[Joachim Ophalfens]

Than why keep the common stock in your portfolio instead of completely switching to the preferred if a safer income is what you want?

I am not assuming that risk is limited to price swings. You must have misread the second sentence from my previous comment: “short term stability, OR risk reduction”.

In this case, owning both common and preferred shares of one company the economic risk, inflationary risk, commodity price risk, legislative risk, obsolescence risk, geographical risk, rating risk, headline risk, model risk and interest rate risk are all pretty much the same as it is the same company.
The liquidation and volatility risks are somewhat higher for the common stock than it is for the preferred stock, although they are by far not as secure as bonds. The only difference between the two will be the size of the price changes and the somewhat securer dividend flow from the preferred shares.

In an income portfolio there will almost always be riskier high yield plays and more secure preferred or bond investments. But in every good portfolio risk management is key and keeping both the common and preferred shares of a single company seems to me as ignoring many of the abovementioned risks. The more prudent way to get a secure income stream is diversification that goes beyond the asset classes of one company.

I know you also hold many other stocks and therefor are already diversified, but I still don’t get why you would buy both common and preferred from the same company as the loss in yield is only offset by a minimal risk reduction.

For somebody not owning any AGNC stock yet, both can be good investment opportunities depending on many personal and portfolio factors. Just pick one, picking both is in my view not very prudent portfolio management.

[PendragonY]

@Joachim Ophalfens

Try reading the article. The idea is that a mix of holdings can be better than just one or the other.

[6019791]

Thanks for the article. It has been on my radar for a while, so I did a quick skim through and I like what I see. (I'll read it carefully later in the day.) I did a little bit of other DD. It's quite an impressive company. Most people find it scary since it invests in securites that scare the bejesus out of some people. Fortunately, I've gotten over the sub-prime mortgage mess hangover. I own NLY, so not so scary for me. It's moved from my radar screen to watchlist now and perhaps by the end of the day, my 'Buy' list. (dividend cut noted)

[The Value Portfolio]

Whenever people get irrationally afraid of a single market is when there tends to be the most opportunity.

[Cyclenut]

Hi Rida, nice article , long AGNC common and EPR, any thoughts on EPR suspending common div ? I intend to stay long EPR. Also MAIN reported Q1 this afternoon ..not bad.

[PendragonY]

EPR is a REIT, and that means it will have to pay dividends. Right now, because its tenants are closed it is not collecting rent, but that rent is still due and it still will require dividends from EPR. As soon as things start opening, the tenants will start paying rent, and that will soon result in a resumption of the dividend.

[novice229]

Rida - thank you for this article - I own both AGNC & NLY. Do you have any insight on the commercial mREITs such as BXMT and GPMT?

[Rida Morwa]

@novice229 LADR had a reasonably strong report, but it will be an uphill battle for commercial mREITs. The large unknown right now is how many loans will default and that credit risk is going to make or break those mREITs. The longer the country is shut-down, the worse it will get.

[The Value Portfolio]

the commercial REITs are solid but they have much less history - especially through the 2008 crash and I'd consider them worse thaan AGNC / NLY in terms of risk.

[JMichaelPalmer]

I have held AGNC for several years, my position is significantly down in NAV and they just cut the dividend by 25%. Not good for a retiree. After having been burned I am not inclined to be as sanguine as you are.

[Rida Morwa]

@JMichaelPalmer As a pass-through entity, when you invest in AGNC you are essentially investing in the underlying bet that AGNC is making- a levered investment on agency MBS. For several years, with rising interest rates that has been a very poor bet, as spreads restricted significantly. With borrowing rates much lower, spreads are much higher and that will improve cash-flow. As they recover from the volatility, we will see much larger spreads, more cash-flow and the dividends will rise back up.

[lk200]

Added NLY and AGNC. during this difficult time. Especially AGNC adding under 12 to make up what the dividend cut. And I am happy.
Thanks for your article.

[The Value Portfolio]

Glad you enjoyed it - let us know if you have any other questions.

[lewhite]

Rida
Per your advice I purchased NLY earlier. Average cost $9. I'm curious if you think AGNC is a better investment than NLY. Should I switch to AGNC, keep NLY, keep NLY but add any new money to AGNC, or keep adding to NLY ? I subscribe to your thesis that these cos. should do well in a low interest rate environment.

[Rida Morwa]

@lewhite AGNC and NLY over the long-term will perform similarly. Currently, the two are positioned quite differently. AGNC has maintained more of their hedges, so if interest rates go up, then AGNC will outperform. NLY has eliminated most of their hedges, so they are better positioned if interest rates stay low or decline. It is typical that one outperforms the other in any given quarter, but overall, we expect them to have similar results.

[lewhite]

Thanks, Rida, most helpful. I believe interest rates will remain low for quite an extended period of time. Incidentally, Chairman Powell has said as much, and the Fed will act accordingly. Sticking with NLY for now, maybe even adding to the position. Will consider AGNC later, but the monthly dividend of AGNC is certainly appealing.

[posane3]

For many years I have watched the pundits fight over which is best - NLY or AGNC. My solution? Buy them both. I have been happy,despite recent dividend reductions. Wouldn't be surprised to see NLY reduce again.

[Bill Zettler]

With lower rates (LIBOR 3 month at.47 now versus 2.56 1 year ago) aren't the preferreds subject to a much lower rate when they go fixed to floating assuming rates stay low for a few years?

[Rida Morwa]

@Bill Zettler If rates stay low, then the floating rate could be lower that the current dividend. On the other hand, if rates stay low, the value of fixed income holdings goes up. The floating rates are LIBOR + 433 bps to +511 bps, so that is a very good spread over LIBOR. So while the dividend would change, we would expect that the value of the preferred would stay near par.

[BarkingShark]

thanks Rida, I’ll add a position of AGNCM if it’s down today. I never buy on a Green Day.

[Rida Morwa]

@BarkingShark Thank you for reading and commenting, buy low!

[rbow]

AGNCM has a low floating rate. I don't think it should be priced higher than AGNCO which pays a little less now but has a much better floater.

[farmed out]

Long both AGNC and AGNCM, so this article will gets a hearty YES from me!

[Rida Morwa]

@farmed out my savings Anytime you can get an AGNC below par it is a great thing!