From June 2021 until the start of this year, AGNC Investment (NASDAQ: AGNC) had seen its stock decline steadily. This year, AGNC’s stock price is up a modest 5%.
So why would anyone predict that this perpetual underperformer will outperform the market over the next year? Let’s delve into why I think AGNC’s total return will outperform the market over the next year. But first, let’s also look at why it has been underperforming the market.
Years of underperformance
To understand why AGNC has been underperforming over the past few years, you first have to understand what it actually does. AGNC is a real estate investment trust (REIT) that invests in mortgage-backed securities (MBS) that are backed by government-sponsored agencies. In essence, it’s a fund that owns mortgages.
Importantly, its investments carry virtually no credit risk, because they are essentially back-stopped by the U.S. government through Fannie Mae and Freddie Mac. However, that does not mean these mortgage investments are risk-free. When mortgage rates go up, the present value of these mortgage investments goes down. This is typically referred to as interest rate risk.
Why it works this way is simple. If I owned an MBS security that paid a rate of 3%, you wouldn’t give me full value of the security if you could get a newly issued MBS security paying 6%. Instead, if I needed to sell that security, I would have to sell it at a discount to its face value.
This is one of the reasons why AGNC’s stock has greatly underperformed in the past few years. As the Fed began raising interest rates after years of very low rates, mortgage rates also increased. This left the value of AGNC’s portfolio of low coupon MBS securities worth less.
Perhaps an even bigger issue, though, was that the spread between risk-free Treasury yields and mortgage yields also widened, which just exacerbated the declines that AGNC saw in its MBS portfolio.
The value of AGNC’s portfolio is represented by its tangible net book (TBV) value. On that front, the REIT’s TBV per share sank 45% from the end of 2021 until the end of 2023, going from $15.75 per share down to $8.70 per share.
Lower rates ahead
After a couple of years of Fed rate hikes and higher mortgage rates, Federal Reserve Chairman Jerome Powell indicated at the Fed’s annual retreat in Jackson Hole, Wyoming that interest rate cuts are coming. Powell said that while data and its outlook will influence the timing and pace of rate cuts, the direction is clear.
Meanwhile, according to the latest Fed Dot Plot chart (this is a chart showing where each member of the Fed policymaking committee thinks rates are headed), Fed members are expecting the Fed Funds rate to fall to around 4% to 4.25% by the end of 2025 and to around 3.00% to 3.25% by the end of 2026. Rates currently sit at between 5.25% to 5.50%.
With lower interest rates, mortgage rates should presumably head lower as well. And similar to how AGNC’s portfolio declined in value as mortgage rates rose, its portfolio value should rise in value as mortgage rates fall.
Ultimately, AGNC’s stock price generally tracks its TBV per share, which is based on the value of its MBS portfolio.
Goldilocks environment
One risk mortgage REITs face when rates begin to decline is prepayment risk, whereby people increasingly refinance their mortgages or sell their homes at higher rates than expected. When they do this, REITs need to replace their investments with MBS that typically would have a lower yield.
Mortgage rates have already begun to fall in anticipation of a Fed cut and now sit at around 6.5%. However, about 80% of AGNC’s portfolio is in MBS with coupons of 6% or under, lessening this prepayment risk.
This sets the company up nicely to see an increasing benefit in tangible book value without much prepayment risk.
Meanwhile, mortgage REITs tend to perform very well during normal rate cutting cycles (not related to a housing crisis). While AGNC has not been around for many of them, fellow mortgage REIT Annaly Capital Management (NYSE: NLY) has. Its stock saw a big rally during the Fed rate cut cycle starting in 2001 after the dotcom bubble burst.
The combination of a Fed rate cutting cycle, AGNC’s portfolio composition, and the stock’s $0.12 monthly dividend set AGNC up to outperform the market over the next year. With a yield of 14%, the stock also doesn’t need a lot of price appreciation to outperform and could easily see a 20% to 25% total return over the next year.
However, if MBS spreads tighten as rates go down, AGNC’s TBV could jump significantly, as would its shares. This could happen if banks start to reenter the MBS market as rates ease, thinking they are now worthwhile investments. This would then increase demand in the space and potentially tighten spreads that have widened out to historically high levels. This would lead to much larger returns for the stock.
That is the best-case scenario, but even without that happening, the stock is still set to outperform over the next year as the Fed methodically lowers rates.
Should you invest $1,000 in AGNC Investment Corp. right now?
Before you buy stock in AGNC Investment Corp., consider this:
The Motley Fool Stock Advisor analyst team just identified what they believe are the 10 best stocks for investors to buy now… and AGNC Investment Corp. wasn’t one of them. The 10 stocks that made the cut could produce monster returns in the coming years.
Consider when Nvidia made this list on April 15, 2005… if you invested $1,000 at the time of our recommendation, you’d have $720,542!*
Stock Advisor provides investors with an easy-to-follow blueprint for success, including guidance on building a portfolio, regular updates from analysts, and two new stock picks each month. The Stock Advisor service has more than quadrupled the return of S&P 500 since 2002*.
See the 10 stocks »
*Stock Advisor returns as of August 26, 2024
Geoffrey Seiler has positions in Annaly Capital Management. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
Prediction: AGNC Investment Will Outperform the Market Over the Next Year was originally published by The Motley Fool
Read the full article here