Wake Up And Smell The Cash Flow: AGNC
- Conditions are ideal for agency mREITs.
- The cost of debt is anchored at low rates, while mortgage rates are climbing.
- The result is that cash flow is higher than it has been for a decade in this sector.
- Buy before the market wakes up and smells the cash flow.
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Wake Up And Smell The Cash Flow: AGNC
Co-produced with Beyond Saving
There's nothing quite like a good cup of coffee. Personally, I prefer my coffee "old school." A fine single-origin bean, lightly roasted that I can grind fresh and put into a French Press. Forget the prepackaged packet with pre-ground coffee of unknown origins that has been roasted to oblivion and then mixed with some "flavoring" to hide the poor quality.
Sure, it's a bit more work, it takes a bit more time, but the reward is infinitely better. I can relax, sip my coffee while watching the sunrise, and know that life doesn't get any better.
I approach investing the same way. I'm not looking for a "quick and easy" investment that might just provide a shot of caffeine. No, I'm looking for value. Quality stocks that have high cash flow and big dividends. You see, I am an income investor, and I'm happy to take my time collecting recurrent dividends, knowing that in the long run, my portfolio will generate for me the monthly paychecks I need for my retirement.
Back to my love for investing. The smell of fresh coffee is wonderful, the smell of cash flow is even better. One sector where I'm smelling a lot of cash flows is the agency mREIT sector. With borrowing rates very low and mortgage rates going up, agency mREITs are positioned to continue raking in cash hand over fist.
Today, we take a closer look at AGNC Investment Corp. (NASDAQ:AGNC), an agency mREIT that is currently paying an 8.4% yield and has seen its cash flow improved significantly. Importantly, it has been buying back its own shares, and we expect to see dividend increases in the future.
Yet AGNC is still trading at a discount to book value. It's time for investors to top off their positions before the market wakes up and smells the cash flow.
Like a good cup of coffee, an mREIT is as good as the ingredients that go into it. "Agency" MBS is definitely the cream of the crop.
When you apply for a mortgage, you will go through an "originator," a company that will take your application, underwrite the loan, and verifies the information. Once the loan is funded, the originator has a problem – they have a finite amount of money. The U.S. mortgage market is over $11 trillion with $1-$2 trillion in new mortgages originated every year. Unlike coffee beans, money doesn't grow on trees and there's no mortgage originator sitting there with trillions of dollars ready to lend.
The solution? The originator sells the mortgage shortly after funding it. Freeing up capital so that they can generate a loan for the next customer. The vast majority of US mortgages are sold to the "agencies," government-sponsored enterprises that were created in an attempt to improve the liquidity of the mortgage market and therefore make housing more attainable.
You have probably heard of Fannie Mae and Freddie Mac, maybe even their cousin Ginnie Mae. These agencies will buy mortgages that fit their underwriting requirements, which is the vast majority of mortgages issued in the U.S. Yet even they don't have infinite capital, so instead of holding on to the mortgages forever, these agencies package together mortgages and sell "mortgage-backed securities" also known as MBS.
MBS provide the investor rights to a portion of the principal and interest payments from a bundle of mortgages. In order to ensure that there's sufficient demand to buy trillions in mortgages, the agencies provide a guarantee – if the borrower defaults, the agency will pay the principal of the mortgage.
The bottom line, agency MBS have virtually no credit risk. The risk of default is carried by Fannie and Freddie. This makes agency MBS popular investments for banks, insurance companies, foreign countries, and mortgage REITs such as AGNC.
Follow The Spread
With minimal credit risk, agency MBS have very low yields and importantly are very easy to use as collateral for borrowing. AGNC uses "repurchase agreements" as a form of financing to increase the amount of MBS they can buy. AGNC borrows cheap short-term debt, to invest in higher-yielding longer-term assets.
If we want to predict how much money AGNC is going to make, we need to know what their average asset yield is (the yield on MBS) and what their cost of funds is.
Source: AGNC Q4 Supplement
Subtract the cost of funds from the average yield and you have the "net interest spread," which we can see strongly impacts their income per share.
Source: AGNC Q4 Supplement
Mortgage rates have come down, driving AGNC's average yield from about 3% to about 2% over the course of 2020. However, their cost of funds plummeted from 1.76% to 0.05% over the same period. The result? AGNC saw its earnings increase dramatically in Q3 and Q4 2020.
Things Are Getting Even Better
Fortunately, we don't have to wait for AGNC to report to find out what's happening. Agency MBS is among one of the most liquid assets in the world and is frequently traded.
We can simply look at MBS prices to see if yields are going higher or lower. Over the past couple of months, prices have come down.
Source: Mortgage News Daily
Lower prices mean that AGNC is getting higher yields on new investments. The best part is that AGNC has allowed its leverage levels to decrease – building up cash when MBS prices were high.
AGNC was well positioned for the decline in prices on MBS. Now, with prices finally coming down, AGNC has an opportunity to redeploy capital at attractive prices and improve its cash flow even more.
What about the cost of funds side of the equation? Overnight repo rates have actually gone down significantly in March.
In other words, AGNC is seeing yields from their assets improving and their cost of funds staying very low. Their net interest spread and the resulting earnings are going to continue to be significantly elevated.
Despite rising earnings, agency mREITs have been slow to raise their dividends. The primary reason being that their shares have been trading at a large discount to book value. Over the past two quarters, AGNC has bought back over 14 million shares.
For example, last quarter AGNC spent $101 million on buybacks, which is the equivalent of paying an $0.18/share dividend. While buybacks might not satisfy the dividend itch, with the stock price trading 5%-10% below book value it was an effective way to generate value for shareholders and has accelerated the recovery of book value.
As a result, book value per share has substantially recovered to pre-COVID prices.
Source: AGNC Q4 Supplement
This growth continued into 2021, with AGNC's latest update, tangible net book value was $17.51 at the end of February. Amazingly, AGNC is still trading at a 3% discount to "book value."
Through 2021, we expect that the price of AGNC will go back to trading at a premium to book value. When that happens, then share buybacks become much less attractive as a way to return capital to shareholders. We believe that will be the trigger that encourages management to raise the common dividend.
The bottom line is that AGNC keeping the dividend at the current level is a decision driven by capital allocation decisions. Their cash flow is sufficient to support a sizable dividend raise, and when the share price is above book value we expect management to focus more on the dividend and stop spending cash on buybacks.
Wake up and smell the cash flow. AGNC is entering into the prime of their cycle with low short-term rates and climbing long-term rates. Earnings are going up, and it's only a matter of time before the dividend follows suit.
Federal Reserve Chairman Powell has reiterated numerous times that the target rate would be kept at zero for several years. Even if inflation runs over 2%, they do not anticipate raising it. For AGNC, this means a prolonged period of very low borrowing costs.
Mortgage rates, on the other hand, will inevitably rise along with long-term interest rates. AGNC's yield on assets is going to go up and their cost to borrow is going to remain low. The result? Tons of cash flow.
So buy yourself some AGNC, then make a pot of your favorite coffee, sit back and watch the dividends roll into your retirement account.
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