Why AGNC’s 15% Yield Might Be Unsustainable But Still Worth Considering

Summary:

• AGNC Investment Corp. has a 15% forward yield, but it may not be sustainable due to negative net interest income.
• The company relies on derivatives to mitigate the risks of borrowing short and lending long, but this reduces profitability.
• The current environment of high short-term rates and lower long-term rates may normalize, potentially benefiting AGNC’s business model.

AGNC Investment Corp. (NASDAQ:AGNC) is a mortgage REIT, and it is currently sporting a 15% forward yield. It buys Agency MBS assets with short-term leverage through RePo agreements.

The first thing I’m going to say is that the 15% forward yield doesn’t look sustainable to me, and then I’ll spend the rest of the article arguing it could still be a good bet anyway.

At the risk of oversimplifying things, when I pull up the latest 10-Q and I scroll down to the income statement, it looks like this:

Interest income equals $642 million and interest expenses equal $672 million. The net interest income is a negative $30 million.

Lots of people have already argued that the dividend is actually sustainable because corporate earnings really aren’t that bad.

I agree the interest income on the last quarter, or really any quarter, is merely a snapshot in time of how profitable the business is right now. In reality, only a small portion of AGNC’s portfolio is made up of securities that have just been issued.

Inherently, borrowing short and lending long (the banking business model) is vulnerable. The company relies on derivatives like interest rate swaps, interest rate swaptions and tba securities to make its business model less vulnerable.

This protection isn’t free, though. Over time, it takes away from the profitability of the business. My point is that if you lose money at the core business, you can’t hedge yourself to profitability.

The current environment combines: high short term rates but importantly lower long-term rates. These yield curve inversions are rare and they rarely last as long as it has.

It’s not exactly as bad as the example above illustrates though. The company finances at RePo, but it buys mortgages that trade at a positive spread to treasuries. To my knowledge, the latter has never inverted, and I can’t think of a scenario where it should.

At some point, this relationship should normalize. In my humble opinion, it makes little sense for short-term rates to remain higher than long-term rates. The only scenario where it makes sense is because investors expect both rates to come down, and they’re eager to lock in rates for longer. Pushing longer rates below short rates in the process. Usually, investors would do so with a recession coming up, and that’s why the yield curve is viewed as a recession predictor.

My real view as to whether the 15% yield is sustainable is that it definitely isn’t under all circumstances. Yet, there are certainly scenarios, quite feasible ones, where it will turn out to be. Both increases and decreases at the long-end of the agency mortgage curve could turn out positive. Decreases of rates at the short-end would help as well. The curve steepening will likely help unless it happens to fast and unexpected. Rate volatility decreasing will help because it reduces the cost of hedging the book as well as future business.

On the earnings call, which illustrates how reliant the business is on future interest rate policy, management said something I thought funny:

Absent further adverse inflation developments, which cause the Fed to change the direction of monetary policy, we believe this period of fixed income market turbulence will be relatively short-lived.

Fixed income volatility has come down quite a bit. It is the primary reason I changed my view on the iShares 20+ Year Treasury Bond Buywrite Strategy ETF (BATS:TLTW) to a “hold at best.” I thought it was a funny comment because volatility tends to be fleeting if the stress goes away. It’s like saying, unless the sun doesn’t go down, the night will be dark. Yet, I also have to give management credit because they do have a view, and they are biasing their capital allocation decisions that way. For example:

…We highlighted our belief that short-term rates had peaked for this tightening cycle that interest rate volatility would decline and that Agency MBS would remain in this new, more attractive trading range…

This isn’t a unique view, and they exhibited other consensus views as well. Here are two more examples where management exhibited their views fairly clearly:

…Moreover, if monetary policy evolves largely as expected, interest rate volatility will decline, the yield curve will steepen and quantitative tightening will come to an end. The specific timing of Fed rate cuts is not critical to the long run performance of Agency MBS…

I also get the impression the company is preparing to tilt its positioning further toward cuts if the economy would show signs of deterioration:

And as we get more confidence in the magnitude of the Fed cuts, then we’ll ultimately probably operate with even a lower hedge ratio such that at some point in the monetary policy easing process we would want to operate with, in a sense, some percent of our short-term debt unhedged

Management even stated they believe the market will price in the Fed ultimately taking the Fed funds rate all the way down to 3%. I’m a bit worried about the confidence management seems to have around this view. It’s not like they’re betting the farm on that scenario, but I would have liked more open-mindedness to other scenarios. Something, I think, can go perfectly fine alongside a strong specific view.

I currently don’t have a strong view about the long-end, unlike in May 2022, and maybe that’s why I’m wary. I don’t expect inflation to come surging back, possibly driving short rates higher, but it wouldn’t baffle me either. Having said all this, as long as the rate path going forward is just somewhat disadvantageous, I’d expect AGNC to show a decent total return. There are a lot of scenarios where the investment will work out reasonably well. I think it requires some luck for shareholders to hit a 15% total return annually over the next year. But it could happen for sure.

The dividend is a lot more likely to be sustained than a similar total return to be achieved. Yet, what good is a dividend that’s offset by a decrease in the share price? At the same time, 15% is a tremendous return. If AGNC Investment Corp. achieves a 8%-10% total return over the next year, that still seems quite solid to me.

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Analyst’s 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.

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