The US economy is struggling to cope with unusually high inflation, which has not been a problem for decades. If anything, the Federal Reserve has been unhappy because inflation has been too low for too long in the past.
The latest bout of inflation has been blamed on supply chain issues, product shortages, labor shortages and wage hikes, and the Fed is forced to take action to solve the problem. To deal with the coronavirus pandemic, the Fed has stepped up the purchase of treasury bills and mortgage-backed securities. To cope with rising inflation, the Fed recently announced its intention to start gradually reducing its purchases of these assets.
The move could potentially mean bad things for mortgage investors from agencies like AGNC investment (NASDAQ: AGNC).
Mortgage REITs are different from typical REITs
AGNC is a Mortgage Real Estate Investment Trust (REIT), which is different from most REITs. The typical REIT develops real estate assets and then leases them. It can develop apartment complexes, office buildings or shopping centers.
Mortgage REITs do not invest in real estate, but rather buy out real estate debt. If you’ve recently refinanced your mortgage, chances are it ended up being secured by Fannie mae Where Freddie mac, then securitized. A common investor for these mortgage backed securities is a mortgage REIT like AGNC Investment. These securities are guaranteed by the US government, so there is virtually no risk of default.
Fed actions could negatively affect the sector
The other big investor for these mortgage-backed securities is the Federal Reserve, which has been buying them since the early days of the pandemic. The Fed entered this market as the broader financial markets became illiquid at the start of the pandemic. This stabilized the financial markets, and now the Fed is starting to reduce its footprint. Starting in November, it will reduce its purchases of mortgage-backed securities and T-bills with the aim of completely ending the excess purchases by next summer. The term for this program is “tapering”.
So far, the mortgage-backed securities markets are following the plans announced by the Fed on the heels, which is good news for mortgage REIT investors. In 2013, the Fed began to reduce its purchases of mortgage-backed securities in the aftermath of the Great Recession. Interest rates have risen so rapidly that mortgage REITs like AGNC have experienced a sharp decline in book value per share and have been forced to cut dividends. The Fed appears keen to avoid a repeat offense, so it has been much more transparent in its plans.
AGNC is positioned conservatively
Although we do not see a sharp increase in interest rates, AGNC Investment still maintains a conservative approach to risk, operating at a low level of leverage (average debt divided by average equity) of approximately 7.5 time. Leverage is another term for borrowed money, and this is how AGNC Investment turns a portfolio of mortgage-backed securities paying 3% into a dividend yield of 9%. It is the same concept as using the margin on your stock transactions. If your stock goes up, it amplifies your earnings. If your stock falls, you may be subject to margin calls or require you to put up additional cash.
AGNC said the tangible book value per share in the third quarter (which is one of the most important numbers for mortgage REIT investors) was $ 16.41, an increase of $ 0.02 per share. Mortgage REITs typically trade around book value per share, and at current levels AGNC is trading at a small discount. The tangible book value will depend on the earnings and prices of the mortgage backed securities.
The other crucial number for mortgage REITs is the dividend yield, which is currently 9%. AGNC pays a monthly dividend of $ 0.12 per share. So far, mortgage-backed securities markets have been bullish on the Fed’s policy changes, but mortgage REIT investors need to be cautious and price sensitive. Investors should only intervene when the stock is trading at a high single-digit discount to the tangible book value per share.
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