AGNC Investment Corp.(NASDAQ: AGNC) appears to be an attractive investment option for those seeking a robust income stream, thanks to its impressive dividend yield of 15.6%. Its high yield stands out especially for investors seeking to generate passive income from their holdings.
In recent years, AGNC has faced challenges, primarily due to the rising interest rates. While the stock has underperformed, there is potential for recovery and improved performance as market conditions evolve. However, before you invest in AGNC for its high yield, consider these points first.
AGNC Investment is an attractive option for investors seeking exposure to the residential real estate market without directly purchasing properties. As a mortgage real estate investment trust (mREIT), AGNC focuses on purchasing mortgage-backed securities (MBS), which are bundles of home loans sold to investors.
AGNC takes a conservative approach by investing primarily in mortgages backed by government-sponsored enterprises, such as the Federal National Mortgage Association (commonly known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (often referred to as Freddie Mac).
One of the most appealing features of AGNC is its ultra-high dividend yield. You may wonder how a company can offer such a high dividend when current mortgage rates are lower than this.
The answer lies in AGNC’s use of leverage. AGNC utilizes instruments such as repurchase agreements and short-term debt to finance its investments in ABSs, which usually have longer maturities. These arrangements enable AGNC to borrow money at relatively low interest rates because they have a repayment timeline of one year or less.
Image source: Getty Images.
AGNC’s use of leverage can indeed amplify profits, but it also exposes the company to risks, particularly fluctuations in interest rates. To visualize this, consider the yield curve, a graphic representation that shows the interest rates of bonds of similar quality across different time frames.
AGNC performs best when short-term interest rates are lower than the long-term rates it earns on its MBS investments. That’s because it can borrow at lower interest rates on a short-term basis and invest those funds in higher-yielding MBS.
However, the economic landscape has undergone significant shifts in recent years. Short-term interest rates rose, while AGNC held on to longer-term MBS that were purchased years earlier during a period of lower rates. Consequently, this has created a challenging situation for AGNC because short-term borrowing costs increased much more than the returns on its existing MBS.
In 2022, AGNC earned $1.6 billion in interest income, while interest expense was $625 million. Last year, it earned $2.9 billion in interest income, but higher borrowing costs resulted in interest expense surging to $2.9 billion, leaving it with a net interest income of just $18 million.
While rising rates increased borrowing costs for AGNC, they also impact the value of its investment portfolio. That’s because there is an inverse relationship in play here: When interest rates rise, the value of existing fixed-income holdings typically declines. Since the start of 2022, AGNC’s tangible net book value per share has plummeted by 48% and now sits at $8.31.
This dynamic hurt AGNC’s stock performance during the past few years. Since the start of 2022, AGNC’s total return (which includes reinvested dividends) has been -0.4%. For comparison, the S&P 500(SNPINDEX: ^GSPC) returned 31.9% over this period, while the Vanguard Real Estate Index Fund ETF returned -12.2%, illustrating how rising interest rates have weighed on the real estate sector as a whole.
There is a silver lining. AGNC has faced some market headwinds recently, but the worst could be behind it. The company has been investing in a wave of higher-yield mortgages, thereby boosting the yield on its MBS portfolio.
At the end of the first quarter, AGNC’s average asset yield was 4.87%, up from 3.9% two years earlier. Not only that, but its net interest spread, or the difference between the yield earnings on its MBS minus its funding cost, increased from 1.91% at the end of Q4 to 2.12% at the end of Q1.
Short-term interest rates could decrease if the Federal Reserve continues to cut its benchmark interest rate, the federal funds rate. Last year, the Fed reduced this rate from an upper limit of 5.5% to 4.5%. Many expected further cuts, but uncertainty around tariffs and their potential impact on inflation has left the Fed on pause for now.
If inflationary pressures don’t reemerge, the Fed could continue to cut rates, which could help reduce short-term borrowing costs. With its MBS portfolio yield rising, this could be a favorable tailwind for AGNC, as it would boost its net interest spread and the book value of its portfolio. If you have a positive outlook on the prospect of declining interest rates and are seeking a high-yielding investment, AGNC could be for you.
However, I don’t think AGNC is right for all investors. AGNC may expose investors to more interest rate risks than they would prefer, and its performance in recent years highlights this risk. Although it could do well if shorter-term interest rates fall, it remains vulnerable if inflationary pressures reemerge, which could lead to higher borrowing costs once again. Dividend investors seeking steady, reliable returns are better off looking elsewhere for yield.
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Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Real Estate ETF. The Motley Fool has a disclosure policy.
