- 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.
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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 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.
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.
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.
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
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.
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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This article was written by
Rida Morwa is a former investment and commercial Banker, with over 35 years of experience. He has been advising individual and institutional clients on high-yield investment strategies since 1991.Rida Morwa leads the investing group High Dividend Opportunities where he teams up with some of Seeking Alpha's top income investing analysts. The service focuses on sustainable income through a variety of high yield investments with a targeted safe +9% yield. Features include: model portfolio with buy/sell alerts, preferred and baby bond portfolios for more conservative investors, vibrant and active chat with access to the service’s leaders, dividend and portfolio trackers, and regular market updates. The service philosophy focuses on community, education, and the belief that nobody should invest alone. Lean More.
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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.