Why AGNC’s 15% Yield May Be Unsustainable But Still Worth Considering (NASDAQ:AGNC)

ANC Investment Company (Nasdaq: AGNC) is a real estate REIT, currently yielding a forward yield of 15%. It purchases agency MBS assets with short-term leverage through RePo agreements.

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

At the risk of oversimplifying things, when I pull up my most recent 10-Q and go to the income statement, it looks like this:

Interest income is $642 million and interest expense is $672 million. Net interest income is negative $30 million.

Many people have actually argued that dividends are actually sustainable because corporate profits are actually not that bad.

I agree to Interest income last quarter, or any quarter, is just a snapshot of how profitable the business is right now. In fact, only a small portion of AGNC’s portfolio consists of just-issued securities.

Of course, short-term borrowing and long-term lending (the banking business model) are at risk. The company relies on derivatives such as interest rate swaps, interest rate swaps and TBA securities to make its business model less vulnerable.

But this protection is not free. Over time, it takes away from the profitability of the business. My point is that if you lose money in the core business, you cannot protect yourself from profitability.

The current environment combines: high short-term interest rates but, more importantly, low long-term interest rates. Yield curve inversions are rare and rarely last this long.

It’s not quite as bad as the example above shows. The company funds in RePo, but buys mortgages that trade at a positive spread over Treasuries. To my knowledge, the latter has never been reversed, and I can’t think of a scenario where it should.

At some point, this relationship must return to normal. In my humble opinion, it makes no sense for short-term interest rates to remain higher than long-term interest rates. The only scenario where it makes sense is that investors expect both prices to fall, and are keen to hold prices in for a longer period. Pushing longer interest rates below short rates in the process. Investors typically do this as a recession approaches, which is why the yield curve is seen as a recession forecasting indicator.

My real view on whether a 15% yield is sustainable is that it certainly is not in all circumstances. However, there are certainly scenarios, quite possible, where this will end. Both increases and decreases at the end of the agency mortgage curve can be positive. Lowering short-term interest rates would also help. Steepening the curve is more likely to help unless it happens quickly and unexpectedly. Lower price volatility will help because it reduces the cost of hedging the book as well as future business.

On the earnings call, highlighting how dependent the company is on future interest rate policy, management said something I thought funny:

In the absence of further negative inflation-related developments that prompt the Fed to change the direction of monetary policy, we believe this period of turmoil in the fixed income market will be relatively short-lived.

Fixed income volatility has declined slightly. This is the main reason I changed my view on the iShares 20+ Year ETF (BATS:TLTW) Treasuries buying strategy to “hold at best.” I thought it was a funny comment because fluctuations tend to be fleeting if the stress goes away. It is as if he is saying that unless the sun sets, the night becomes dark. However, I also have to give management credit because they have a point of view, and they are biased in their decisions to allocate capital in this way. For example:

…We highlighted our belief that short-term interest rates have peaked in this tightening cycle, that interest rate volatility will decline, and that agency MBS will remain in the new, more attractive trading range…

This is not a unique viewpoint, and they have demonstrated other agreed-upon viewpoints as well. Here are two other examples where management has laid out its views fairly clearly:

Moreover, if monetary policy develops 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-term performance of agency MBS…

I also get the impression that the company is preparing to tilt its position further toward cuts if the economy shows signs of deteriorating:

As we gain more confidence in the scale of the Fed’s cuts, it is likely that we will eventually operate with a lower hedging ratio such that at some point in the process of easing monetary policy we may want to operate with some cuts. percent of our unhedged short-term debt

The administration even stated that it believes the market will eventually price in the Fed causing the federal funds rate to drop to 3%. I’m a little concerned about the confidence that management seems to have about this view. It’s not like they’re betting the farm on this scenario, but I would have liked more openness to the other scenarios. I think something can go well combined with a strong specific point of view.

I currently don’t have a strong long-term view, unlike May 2022, and perhaps that’s why I’m worried. I don’t expect inflation to pick back up, which would cause short-term interest rates to rise, but that wouldn’t puzzle me either. Having said all this, as long as the future price path is somewhat unfavorable, I expect AGNC to show a decent total return. There are a lot of scenarios in which the investment will work out well. I think it will take some luck for shareholders to achieve a total return of 15% per annum over the next year. But it can definitely happen.

Dividends are more likely to be sustained than to achieve a similar total return. However, what is the benefit of a dividend that is offset by a decrease in the share price? Meanwhile, 15% is a massive return. If AGNC Investment Corp. For a total return of 8% to 10% over the next year, this still looks very strong to me.