Thesis

I last wrote about AGNC Investment (NASDAQ:AGNC) early in the year (January the 15^th, 2022 to be exact) under the title “Understand The Credit Cycle Before Taking On Its 9%+ Dividend”. The thesis at that time was that the Fed’s hawkish tapering and anticipated interest rate raises will narrow the spread between the long-term and short-term rates, and such narrowing would exacerbate the deterioration of AGNC’s profitability.

The thesis is confirmed by what has transpired in the last 5 months or so. AGNC stock price has fallen by more than 22% and has suffered a total loss of almost 20% after dividends are accounted for since that time. Some readers asked if the thesis needs to be updated after such a large price correction. And the answer unfortunately is no. I am still maintaining my original thesis. I actually think the thesis is even more valid now. I see the possibility higher than 5 months ago for the yield curve spread narrowing to continue or even to invert. And many parts of its Q1 2022 earnings release supports this view, as we will detail next.

Recap of Q1 earnings

It reported its 2022 Q1 earnings on May 5, 2022. Overall, it is a quite bleak picture. It suffered a $2.23 comprehensive loss per Share, translating to a negative 14.4% economic return on tangible common equity for the quarter. As you can see from the following chart below, this marks the second consecutive quarter that it has suffered a negative economic return. Expanding the horizon a bit wider, out of the past four quarters, it only earned a small positive economic return of 2.3% during the third quarter of 2021.

To make the bad news worse, it suffered an even larger loss of its book value. Its tangible book value decreased by $2.63 per share from a quarter ago, a decline of 16.7%. The tangible book value now stands at $13.12 per share as of Mar 31, 2022, compared to $15.75 per share a quarter ago.

Next, we will see the underlying drivers for such bleak performances – the cost of funds.

Cost of funds and yield curve inversion

Mortgage REIT stocks like AGNC make their money from the spread between short-term borrowing rates and long-term lending rates. The next chart shows what has happened to the short-term borrowing rates in the past two years since the break out of the COVID pandemic and the Fed flooded the market with an epic amount of QE. ANGC’s cost of funds decreased from 1.67% in Q1 2020 all the way to essentially 0%. In Q3 2021 and Q4 2021, the cost of funds even dipped below zero. AGNG gets paid for its funds! And of course, it gets paid again for lending out the borrowed money.

This is the core reason for my earlier thesis. I simply do not see such dynamics being sustainable. Now, as you can see, the trend begins to reverse. The cost of funds increased to 0.09% this past quarter, and even such a small increase has caused large losses already in terms of both profit and book value.

Looking forward, I see more pressure coming. As CEO Perter Federico commented in the earnings report (the emphases were added by me):

Interest rates ended the quarter materially higher with the yield on the 2-year treasury increasing over 160 basis points. A rate move of that magnitude hasn’t occurred in more than 30 years. This challenging environment led to a risk-off sentiment, pressured equity markets and caused fixed income prices to decline. The Bloomberg Aggregate Bond Index posted its worst quarterly performance in more than 40 years with a price decline of almost 6 points.

The next chart shows the effects of the 2-year treasury increases Federico mentioned. The 160 basis points increase in 2-year rates was large enough to cause the yield curve to briefly invert in early April. The spread has widened a little to 0.21 percent now, a level I consider to be dangerously narrow and close to inversion. And even a brief inversion can signal trouble already. To learn from recent history, the last time the yield curve inverted, also very temporarily, was towards the end of 2019. And a recession materialized in early 2020 shortly afterward.

Playing defense via deleveraging

Sensing trouble ahead, AGNC is now in full defensive mode. The business hunkered down with a lower leveraging ratio AND high hedging ratio at the same time. As CEO Perter Federico commented (the emphases were added by me)

We started the quarter with a defensive position characterized by lower leverage and a high hedge ratio. We also took meaningful steps during the quarter to further reduce our aggregate risk profile. These steps included reducing our asset position, adjusting our coupon profile and increasing our hedge portfolio. As the Fed aggressively raises short-term rates and ramps up its balance sheet runoff, we will likely remain defensive in our portfolio positioning.

AGNC is now operating with a hedge ratio of 121%. The total hedging portfolio is evaluated at $77.5 B and provides 21% of excess coverage of its funding liabilities, including Agency Repo, other debt, and net TBA position. In terms of deleveraging, as you can see from the chart below, it has been consistently reducing its leveraging from 9.4x all the way to 7.5x times in recent quarters. Its leverage ratio is now at the lowest point since the pandemic breakout. A 7.5x leverage ratio enables some flexibility going forward, both to reduce risk exposure should things become worse and also to take advantage of new opportunities should mortgage spreads normalize. However, note that the 7.5x leverage ratio is still higher than the mREIT sector average (about 6x based on my analysis).

Valuation

Finally, in terms of valuation, it is trading close to its historical average (or at a slight discount). As you can see from the following chart, during the past ten years, it has been trading at an average price to tangible book ratio of about 0.96x. Its current priced book value ratio is at 0.9, about a 6% discount from the historical average. Given the uncertainties ahead, I do not feel such a small discount justifies an investment here. The uncertainties in estimating its tangible book value could easily be a few percent. The margin of safety is too thin here.

Conclusion and other risks

My original thesis on AGNC was that the yield spread narrowing would continue to exacerbate the deterioration of AGNC’s profitability. I not only maintain my original thesis now but also see a higher possibility for the yield curve spread narrowing to continue or even to invert in the near future because of the Fed’s plans to aggressively raise short-term interest rates and combat the ongoing rampant inflation. As argued in my earlier article here,

Fed’s dot-plot suggests that short-term interest rates will gradually rise to 2.5% to 3% level in a few years. I expect the long-term rate to rise no more than that because long-term rates eventually cannot rise above inflation or GDP growth. This means the current narrowing is expected to continue and further pressure NRZ’s profitability.

Yet, in terms of valuation, it is essentially trading at the historical average. There might be a small discount, but not large enough to overcome the margin of uncertainty. Given the risks ahead, I do not feel the current valuation justifies an investment here.

Besides the risks of tightening monetary policy, AGNC also faces other macro risks such as the mounting geopolitical risk and growing inflation concerns.