AGNC Investment Q4: 14% Yield, But No Major Re-Rating Potential (NASDAQ:AGNC)

AGNC Investment Corp. (NASDAQ:AGNC) is a well-managed mortgage real estate investment trust with a $60 billion portfolio consisting mainly of 30-year duration agency mortgage-backed securities.

The trust suffered painful declines in its book value last year as the central pushed rates up and mortgage-backed security spreads widened.

With that being said, with the shift in the central bank’s interest rate strategy for 2024, mortgage trusts have become more compelling passive income vehicles again for investors.

While the central bank policy shift benefits AGNC Investment, a major re-rating has already taken place in the fourth quarter. AGNC Investment’s stock is now selling at a premium to book value, which is a conservative fair value indicator, and I think that the potential for additional capital gains is not as attractive as it was before the central bank announced its shift.

My Rating History

Since my last piece in November (before the central bank rate guidance), AGNC Investment’s stock price has gone up by 17.56%. What has since changed is that the central bank, in response to falling inflation, anticipates lowering its short-term interest rates in 2024.

Declining inflation implies falling key interest rates which in turn is a catalyst for a re-rating of the company’s mortgage-backed securities. Mortgage-backed securities are fixed-income instruments and therefore falling interest rates are a tailwind for the valuation of such mortgage securities.

Since AGNC now sells at a premium to book value, these tailwinds are probably fully priced into the mortgage trust’s stock valuation and I am modifying my stock classification from Buy to Hold.

AGNC Investment Is A Premier Mortgage REIT With An Improving Outlook For Its Earnings

AGNC Investment is a giant mortgage trust with a $60 billion portfolio worth of mortgage-backed securities. It is, after Annaly Capital Management, Inc. (NLY), the second-biggest mortgage real estate investment trust in the industry.

The trust owns a boatload of securitized residential mortgage loans that are backed by a government agency such as Fannie Mae or Freddie Mac and are therefore considered low-risk investments. AGNC Investment owns other assets as well such as U.S. Treasury Securities, Credit Risk Transfer Securities, and cash. By far the most defining investment, however, is the Agency portfolio which included mainly 30-year securities.

Inflation Is Normalizing, Supporting Investments In Mortgage Trusts

Inflation is retreating, favoring an investment in mortgage real estate investment trusts that are poised to profit from a decline in short-term interest rates.

The inflation trend, in the long-term, points south, though the U.S. economy has seen a flare-up in inflation in December which is when consumer prices rose 3.4%. In long-term trend, however, strongly implies that short-term interest rates will fall.

This anticipated decline in short-term interest rates is set to lead to a reversal in borrowing costs that mortgage trusts so heavily rely on to make money. Mortgage trusts, more like any other industry, profit from zero interest rates because they use a lot of debt to make money on the spread between their borrowing costs and the yields on their mortgage investments.

AGNC Investment’s borrowing costs increased to 1.39% in Q4’23. My expectation is for the mortgage trust’s borrowing costs to decline gradually, in lock-step with the central bank lowering short-term interest rates.

AGNC Investment Is Probably Fairly Valued

A mortgage trust’s book value is a good, conservative indicator of its intrinsic value. AGNC Investment’s book value got pummeled last year as higher spreads and uncertainty about the short-term interest rate path negatively impacted the values of mortgage-backed securities.

Since the central bank announced its policy shift last month, I think that the trust’s main assets, mortgage-backed securities, could see increases in their fair value in a lower-rate environment.

AGNC Investment’s net book value was up 7.7% in 4Q-23, reflecting a strong reversal of an otherwise depressing book value trend in the last two years.

With the interest rate environment brightening up for mortgage trusts like AGNC Investment, however, I think that the outlook for book value gains has improved in 2024 as well.

AGNC Investment and Annaly Capital Management have re-rated higher since bottoming out in October and both mortgage trusts now sell for a premium to book value. The premium for Annaly Capital Management is 7% whereas the premium for AGNC Investment is 3%.

Since I think that AGNC’s GAAP book value is a solid yardstick for intrinsic value, the overvaluation is less extreme for AGNC Investment than it is for Annaly Capital Management right now. With that being said, I wouldn’t buy either of them at a premium-to-book value.

My Game Plan For AGNC Investment

I am disciplined when it comes to buying mortgage trusts and I don’t pay more than book value. Mortgage trusts like AGNC should be bought, in my view, at a reasonable discount to book value and this chance was in the October to November 2023 period.

I will reconsider my stance on AGNC should the stock drop at least 10% below book value which is a margin I prefer from a margin of safety perspective.

AGNC Investment’s Largest Risk

The largest risk for AGNC Investment is an unexpected shift in the interest curve which poses substantial valuation risk for the mortgage trust’s portfolio. AGNC Investment has already seen a rather large decline in its book value in 2023, but the book value grew again in 4Q-23.

A big, unexpected change in interest rates will hurt AGNC Investment’s portfolio as well as book value according to the following sensitivity table.

Also a risk: A strong economy could tempt the central bank to only very slowly adjust its short-term interest rates which might delay the positive benefits anticipated from lower borrowing costs.

My Conclusion

AGNC Investment is a mortgage-backed security-focused mortgage trust. The trust’s MBS portfolio is set to profit from tailwinds related to the central bank lowering short-term interest rates in 2024.

With inflation pressure subsiding, lower interest rates are poised to lower AGNC Investment’s borrowing costs. I think that AGNC Investment is probably selling at, or slightly above, the intrinsic value here, but if you already own AGNC, there is no reason right now to sell.

With headwinds to the trust’s book value also anticipated to fall by the wayside, I think that the prospects for portfolio and book value growth have improved.

Taking into account that I am generally uneasy about paying a premium to book value, I think AGNC Investment is deserving of a Hold stock classification after its 4Q-23 earnings.