Big Yield At Reduced Risk: AGNC Investment Corp. Preferreds (NASDAQ:AGNC)

AGNC Investment Corp. (AGNC) has become substantially stronger in recent periods. We note 3 specific areas of improvement:

1. NII (net interest income) has improved
2. Spreads between RMBS and treasuries have widened, resulting in significant book value gains
3. RMBS market has strong liquidity, which reduces risk

Many of these benefits have been reflected in the common stock, with AGNC up 25% in the last year.

However, the preferreds still trade at very high yields, all in the 8.5% to 9% range.

I find the yield quite attractive relative to what is now even lower risk.

We have consistently marked AGNC preferreds as among the lowest-risk mREIT preferreds. There are 2 factors that have made these preferreds particularly reliable:

1. Large common market cap
2. AGNC deals in agency-backed RMBS, which makes their assets have stable underlying value even if the market price of RMBS fluctuates a bit with spreads.

We shall begin by examining AGNC’s fundamentals and then discuss which preferreds look particularly opportunistic at current pricing.

NII improvement

Net interest income has improved substantially in recent years.

The formerly inverted yield curve was challenging for agency mREITs to deal with, as there was minimal spread in borrowing at short duration to buy fairly long duration RMBS.

In the last 12 months, the yield curve has steepened considerably with the long end essentially unchanged while the short end dropped.

With a steeper curve, AGNC can generate more positive carry.

Spread tightening

Agency-backed RMBS are low-risk instruments due to being supported by government agencies, making the principal somewhat guaranteed. That said, there are still 2 aspects which make them slightly riskier than treasuries:

1. Prepayment risk, making duration unknown yet estimable
2. Trading volatility. While treasuries move with interest rates, they do so in mathematical fashion. RMBS moves in a similar mathematical fashion with interest rates but also moves with spread tightening/widening.

Due to slightly higher risk, RMBS trade at higher yields than treasuries of similar duration.

This spread has 2 impacts on agency RMBS:

1. Wider spread makes acquiring new RMBS more profitable due to higher going in IRR
2. Widening of spread makes existing RMBS less valuable.

While AGNC in theory benefits from the higher IRRs of wide spreads, that impact is dwarfed by the value change of the billions of dollars of RMBS already on their balance sheet.

Thus, when spreads formerly widened, AGNC lost significant book value. In recent periods, however, spreads tightened, and AGNC regained significant book value.

RMBS market stability

There have been a few instances in which the RMBS market fell through due to insufficient liquidity, causing a weird level of volatility for assets that are essentially backed by the U.S. government.

Such liquidity events will always be a risk, but recent actions materially reduce that risk. The government is focused on reducing the cost of homeownership, and a big part of that is keeping mortgage rates affordable.

Tighter RMBS spreads help reduce the cost of homeownership, and multiple government and/or government agency initiatives are in place that serve as a sort of backstop to keep spreads from getting too wide. Key tools include:

• Fed buying more RMBS through cessation of quantitative tightening (QT)
• GSEs buying RMBS
• Lower fees on mortgages

In theory, this government-provided liquidity will support the pricing of RMBS even in the event of black swan events that disrupt free market purchases.

Generally speaking, I prefer free market forces to be the main driver of the market, but in the case of providing stability to what is fundamentally a highly stable instrument, I see minimal harm in the intervention.

As a result of these backstops, the forward stability of the RMBS market appears stronger than normal.

Preferred over common

The above factors have significantly improved AGNC’s fundamental outlook. As the improvement has already been reflected in the price of common shares, I view the common as fine but not particularly opportunistic.

AGNC preferreds also benefit from the aforementioned stability factors, but the preferreds have additional benefits from the issuance of common shares.

AGNC Investment Corp. is a serial issuer of common stock.

Common share issuance is a mixed bag for common share value. It can be accretive if executed at the right price and the capital is put to work at the right IRR, but it is also dilutive at times.

For preferreds, however, it is unequivocally beneficial.

Every share issued, whether dilutive or accretive, increases the size of the equity cushion that sits junior to the preferreds. The assets acquired with the fresh capital increase the revenues available to pay preferred dividends, which sit above common dividends in the waterfall.

With all this share issuance in addition to AGNC’s market price moving up due to legitimate fundamental improvement, the preferreds now have almost $12B of equity underneath them.

This cushion, in combination with ample cash flow supporting the preferred dividends, makes these preferreds among the lowest risk in the mREIT preferred universe.

In my opinion, the risk level is quite low relative to yields in the 8.5%-9% range. As such, I find the AGNC preferreds opportunistic.

Selecting the right AGNC preferred

Within the preferred stack, there are subtle yet important differences.

AGNCM, AGNCN, AGNCO, and AGNCP are each floating rate preferreds tied to 3-month SOFR.

AGNCL starts floating in October of 2027 and is tied to the 5-year Treasury yield.

AGNCZ is a fixed-rate preferred with an 8.75% coupon and is not callable until 10/15/2030.

This information is summarized below and continuously updated on an mREIT spreadsheet available to Portfolio Income Solutions.

While the current yields of each issue sit at similar levels, certain aspects stand out. One can select their instrument based on their own view of what will happen to interest rates.

If one thinks interest rates are going to rise, the variable rate preferreds are likely the better option.

SOFR moves in tandem with the Fed Funds rate, so as the Fed cuts or hikes the yield of AGNCM, AGNCN, AGNCO, and AGNCP will move in parallel.

Notably, the 5-year treasury has not necessarily moved with the Fed Funds rate. As we saw earlier with the yield curve, the longer-dated treasury yields did not really move even as the Fed cut repeatedly.

Thus, AGNCL will move in parallel with the 5-year treasury, which may or may not move with Fed cuts/hikes.

If one believes interest rates will be cut, AGNCZ looks the most attractive. The 8.75% coupon is a great yield in the current environment and would be even juicier in a lower yield environment.

Consensus currently anticipates a flat Fed Funds rate through the end of 2026 but is leaning more toward a cut than a hike.

At current pricing, I think the most opportunistic AGNC preferreds are AGNCZ and AGNCP.

Specifically, I would buy:

• AGNCZ if I think interest rates are flat or going down
• AGNCP if I think interest rates are going up.

I bought AGNCZ because inflation data has been quite tame aside from the temporary oil shock. Since the Fed is well aware that monetary policy works with a lag, I don’t think they will cater policy to what is broadly viewed as a temporary oil price spike. If they look through oil prices, or as oil prices come back down, I think the Fed is likely to hold flat or cut.

In either case, I think the yield of AGNCZ is phenomenal relative to the risk level.

Given that AGNCZ is not callable until late 2030, it can trade a fair bit above par, and it has.

The $26 level at which it was trading in early March seems about right to me. Buying at the just over $25 level, one can potentially capture 4% capital gains on top of a nearly 8.75% yield.