The mortgage real estate investment trust sector went through the wringer in 2020 as the initial pandemic lockdowns completely disrupted the mortgage-backed securities market. Just about every mortgage REIT was forced to cut its dividend, and most reported big declines in book value.
A year on, the sector appears to have recovered, although many stocks are still well below pre-COVID levels. Looking forward, is AGNC Investment (NASDAQ:AGNC) a suitable income stock for a dividend investor?
Mortgage REITs have a somewhat unusual business model, which is why it makes sense to take a minute to understand what makes them tick. While most REITs invest in real properties (think apartment buildings, office complexes, and shopping malls), mortgage REITs invest in debt (i.e., mortgages). An agency REIT like AGNC Investment concentrates its investment portfolio into mortgage-backed securities, which are guaranteed by U.S. government agencies.
Mortgage-backed securities issued by Fannie Mae and Freddie Mac are the bread-and-butter investments for agency mortgage REITs like AGNC Investment. Since these securities are guaranteed by the U.S. government, AGNC doesn’t really have credit risk. It does have interest rate risk, and also something called prepayment risk. And here is where things get interesting.
Prepayment risk and what it means to a mortgage REIT
Prepayment risk reflects the fact that a homeowner can pay off their mortgage early. Homeowners do this for one of two reasons: either they move, or they refinance. When AGNC buys a mortgage-backed security, it typically pays a premium to face value. If the loan prepays early, AGNC loses the premium it paid. The REIT is betting that it will receive enough interest payments to recoup the premium it paid for the security.
The Federal Housing Finance Agency has made quite a few changes in the past few months, stemming from policies issued at the end of the Trump administration. These rules essentially restrict the types of mortgages that Fannie Mae and Freddie Mac can guarantee. Fannie Mae and Freddie Mac now have caps on investment properties, second homes, and mortgages with other risk characteristics like credit scores and down payments. Big picture, the universe of loans that will be guaranteed by Fannie and Freddie is shrinking.
Other lenders will undoubtedly step in and do these loans if Fannie and Freddie won’t, but they almost certainly won’t be able to offer the same low rates. This means that refinancing activity is going to slow down, and that is good news for AGNC. Falling prepayment speeds means the value of AGNC’s mortgage-backed securities will increase, since they will last longer. Therefore, book value per share should increase as well.
The stock is looking ripe for a dividend hike
AGNC was forced to cut its dividend after the mortgage market seized up a year ago. In retrospect it admitted it probably didn’t need to. The stock has rebounded smartly from its initial decline in March 2020, up 41% over the past year with a sizable dividend yield of 8.3%. Historically, the stock has traded with a dividend yield of 10% plus, so a dividend increase could be in the cards.
Agency mortgage REITs generally trade around book value, and AGNC is trading at a 3% discount to its end-of-year book value per share. In other words, the dividend yield indicates that there might be room to increase the dividend, not necessarily that AGNC is overvalued. It is trading right around book value, which is where it should be.
Agency mortgage REITs are generally not going to be fast growers like tech stocks. They are suitable for income investors who want a steady return and a good night’s sleep. Their portfolio is guaranteed by the government, so even if the economy crashes they will still get paid.
I wouldn’t be surprised to see a dividend hike when AGNC reports first-quarter earnings. Given that yield like this is so difficult to find in this market, AGNC might be the dividend stock for you.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.