AGNC Investment: Dividend Yield And Safety In Focus

Summary

• With a 9.3% dividend yield, AGNC Investment Corp appears attractive to many income-oriented investors, especially under a low-rate environment.
• Its dividend coverage is at a very safe and comforting level by payout ratio.
• However, you should be aware that its dividend yield is far below the historical average and its dividend cushion ratio is also below the historical average.
• And also be aware of the implications of the Fed tapering and anticipated interest rate raises.

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Thesis and Background

You may find the 9.3% dividend yield from AGNC Investment Corp (NASDAQ:AGNC) attractive – for very good reasons. Just to name a few: first, we are in a secular interest rate environment, and the 10-year Treasury bond yields about 1.4%. Second, at the same time, inflation is surging. Depending on whose reports you are reading, it is in a range between 5.3% (Fed’s most recent report) to 7.8% (BofA Global Investment report). And finally, AGNC’s dividend coverage is at a very safe and comforting level by payout ratio. Its current dividend payout ratio is about 50% only, significantly below the historical average. It is indeed very safe in both absolute and relative terms.

However, you should be aware that its dividend yield is far below the historical average. It is actually near a record low in a decade. At the same time, you should be aware of the limitations of using the simple payout ratio to gauge dividend safety. When measured in dividend cushion ratio, a more comprehensive metric, its dividend safety is below the historical average. And lastly, you should also be aware of the implications of the Fed’s tapering and anticipated interest rate raises.

It is the purpose of this article to discuss the above questions in detail. So that you could make a more informed decision regarding this investment.

Dividend yield near-record low in a decade

The following chart shows the dividend yield of AGNC in the past decade. As you can see, the dividend yield started above 20% at the beginning of the decade, and then gradually decreased all the way to the current level of 9.3%. As you can see, 9.3% is indeed attractive in absolute terms. However, in relative terms, it is near a historical low in a decade.

You may argue that the risk-free interest rates also decreased over the decade. The risk-free rates act as the gravity on all asset valuations. And when interest rates fall, the valuations for other assets such as AGNC just have to go up. So there is nothing abnormal about AGNC’s yield decrease - even if there is no profitability improvement at all.

True. But the issue here is that AGNC’s yield decreased faster than the risk-free rate. As a result, its yield spread relative to the risk-free rate (say the 10-year treasury rates) is also near a historical low. The yield spread started near 17% at the beginning of the decade (20% yield minus about 4% of 10-year treasury rate). And now the yield spread is only about 8% (9.3% yield minus about 1.4% of 10-year treasury rate), near the lowest level in a decade.

Source: Seeking Alpha

Dividend coverage

For dividend investors, dividend safety is the name of the game. And I am sure all of us know all the typical metrics to gauge dividend safety such as payout ratio in terms of earnings, payout ratio in terms of cash flow, et al. The following chart shows AGNC’s payout ratio in terms of earnings. As seen, AGNC has been doing a consistent job of managing its dividend payout. The earning payout ratio has been on average 70% - a relatively safe and comfortable range for mREIT businesses. And the current payout ratios have been significantly lower than the historical average in recent years – only about 50%.

In my view, part of the reason for this conservative move is to prepare for the anticipated Fed’s tapering and interest rate raises. We will discuss that later. Here we will first dissect the dividend safety and discuss the caveats of interpreting the payout ratio.

Source: Author based on Seeking Alpha data

Dividend cushion ratio

The pay-out ratio we commonly quote enjoys simplicity and directness. However, it has several limitations and can be “too simple” in some cases. The major limitations are twofold. First, the simple payout ratio ignores the current asset that a firm has on its balance sheet. Obviously, for two firms with the same earning power, the one with more cash sitting on its balance sheet should have a higher level of dividend safety. Second, the simple payout ratio also ignores the upcoming financial obligations. Again, obviously, for two firms with the same earning power, the one with a lower level of obligations (pension, interest expenses, CAPEX expenses, et al) should have a higher level of dividend safety.

However, the simple payout ratio we commonly use ignores all these important pieces. For a more advanced analysis of dividends stocks, I recommend the so-called dividend cushion ratio. I found it an effective tool to gain a more comprehensive picture of dividend safety. A detailed description of the concept can be found in Brian M Nelson’s book entitled Value Trap. And a brief summary is quoted below:

The Dividend Cushion measure is a ratio that sums the existing net cash (total cash less total long-term debt) a company has on hand (on its balance sheet) plus its expected future free cash flows (cash from operations less all capital expenditures) over the next five years and divides that sum by future expected cash dividends (including expected growth in them, where applicable) over the same time period. If the ratio is significantly above 1, the company generally has sufficient financial capacity to pay out its expected future dividends, by our estimates. The higher the ratio, the better, all else equal.

With this background, the dividend cushion ratio for AGNC is calculated and shown in the following chart. Note that to suit the particular case of AGNC, my calculations A) used the cash from operations as the free cash flow, and B) obtained the net cash position by considering cash and equivalent, receivables, and payables. The analysis are shown in the table and also the chart below for more visual-oriented readers.

As can be seen, the current dividend cushion ratio is about 1.62. So it is good news that it is significantly above 1, providing another reassuring piece of information about dividend safety. However, on the other hand, you can also see that the dividend cushion ratio is below the historical average of 1.72. In particular, the current cushion ratio is substantially below its peak ratio of 2.0, by about 20%.

Source: Author based on Seeking Alpha data

Source: Author based on Seeking Alpha data

Risks

The major risk as I see is the interest rate risk.

Businesses like AGNC heavily depend on leveraging and are therefore sensitive to interest rate change. AGNC has been deleveraging in anticipation of the Federal Reserve’s tapering and interest rate raises. AGNC's leverage has been on average 8.5x in the past decade in terms of book value. And the leverage peaked around 11x during 2018 – a dangerously high level in my view. The business has significantly deleveraged from the peak to the current level of 7x – a reduction of more than 1/3. The current leverage is also significantly below the historical peak and at the lowest point in a decade. More details of its deleveraging can be found in my earlier article here.

However, despite the significant deleverage, higher interest rates are detrimental to AGNC (or mREIT in general). AGNC has been enjoying nearly 0% cost of fund (i.e., free access to funds) since mid of 2020 when the Fed started injecting a massive amount of liquidity to combat the pandemic and lower the Fed fund to near 0% level. As interest rates rise, the cost of funds will increase and the tailwinds that benefited AGNC will begin to reverse. Furthermore, the interest rates might increase faster and more than what the current dot-plot suggests.

Conclusion and final thoughts

If you are looking for income, you may be attracted to a 9.3% dividend yield from AGNC – for very good reasons. The yield is very appealing given the current low-interest-rate environment and beats even the higher end of inflation projection.

However, a closer examination reveals some reasons for reservation too. Given the mixed signals, I myself will stay on the sideline for now.

Specifically, the reasons for reservation analyzed in this article include:

• Its dividend yield is far below the historical average. It is actually near a record low in a decade. Its peak dividend yield has been above 20% (which occurred 4 or 5 times over the past decade) and its average yield has been about 15%. The current level of 9.3% is indeed attractive in absolute terms. However, in relative terms, it is near a historical low in a decade.
• Furthermore, AGNC’s yield decreased faster than risk-free rates. As a result, its yield spread relative to the risk-free rate (say the 10-year treasury rates) is also near a historical low. The yield spread started near 17% at the beginning of the decade (20% yield minus about 4% of 10-year treasury rate). And now the yield spread is only about 8% (9.3% yield minus about 1.4% of 10-year treasury rate), also near the lowest level in a decade as detailed in my earlier analysis.
• The dividend payout ratio is about 50% only, safe in both absolute and relative terms. However, a more comprehensive analysis shows that the current dividend cushion ratio is about 1.62. It is reassuringly above 1. However, on the other hand, it is below the historical average of 1.72 and substantially below its peak ratio of 2.0, by about 20%.
• Lastly, despite the significant deleveraging since 2018, higher interest rates still pose substantial risks to AGNC. As interest rates rise, the cost of funds will increase for AGNC.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.