It is rare that one writes continuations so close to the preceding article but it is an unusual case. The last time we covered AGNC Investment Corp. (NASDAQ: AGNC) we explained why we stayed out.
Yes you’re expecting a truly epic rate explosion, then this isn’t the REIT for you. AGNC is more exposed on rates thanks to its weaker hedges and this is why we avoided this one.
Source: We keep staying out
One of the notable events since then has been that bond bulls have been burned at the stake. 30-year mortgage rates have climbed another 70 basis points in 3 weeks!
This coupled with the Federal Reserve basically telling everyone that it is actually way behind the curve. These facts, along with some of the talking points we saw in the last article, warranted some follow-up.
Does book value really matter?
GAAP reported book value has a different degree of importance for equity and mortgage REITs. On the REIT side, book value is about the most useless metric you can find. Depreciation does not equate to destruction of property value. If an analyst is quoting GAAP book value for equity REITs, you know they’ve ignored REIT 101. You need to get as far away as possible from anything presented alongside that analysis. In the case of mortgage REITs, book value is extremely critical. An extension of this, tangible book value is very close to liquidation value today. So yes, it is hugely important and we wouldn’t trust any point of view that says otherwise.
Why does book value matter if I’m still getting my dividends?
There are several reasons for this. The first is that mortgage REITs themselves measure their performance as the sum of dividends and the change in tangible book value.
If they consider it a real performance measure, why do you think you know anything else?
The second is that their tangible book value is what secures their credit facilities, secured loans, warehouses, or how they acquire debt. This is their true long-term guarantee, regardless of how things are structured in the short term. An extension of this is what happens to AGNC’s debt ratios when the tangible book value declines. Based on the last presentation we saw, AGNC was using tangible book value leverage of 7.7X.
So if we start at the end of 2021 with a tangible book value of $15.75, we get that AGNC had 7.7 times assets “at risk” or $121.28 assets per share. . Now, at the end of April, suppose we see a tangible book value of $11.75. AGNC could only maintain the same level of assets if it was willing to increase leverage to 10.32X. This is why the idea that declines in tangible book value can be ignored is laughable. AGNC will be liquidating assets and this will impact the ability to generate long-term dividends.
This brings us to the third reason. Declines in the book value of this gear create chaos. AGNC must liquidate its assets in the rapidly declining market and this is true for every mortgage REIT. Let’s all add to this that the Fed must liquidate in accordance with its announced quantitative tightening. Every big player liquids, so who’s buying? Note that mortgage REITs don’t have a choice unless they want to go into debt and risk having their capital explode to pieces. This process is marked by many slippages as the hurdles unfold and the spreads widen. The losses may be greater than you might think.
Finally, AGNC must continue to hedge its portfolio against risk. Buying option protection when things are quiet is one thing. Buying option protection after such a chaotic event will be different and extremely expensive. This will compress net margins.
The dividend is safe for now because AGNC still has a good buffer for now between what it generates and what it pays. After the next cycle of rebalancing and asset liquidation, we will reassess. The true economic return for the first quarter will be terrible as the decline in tangible book value overshadows the revenue generated. While a rebound could certainly occur, AGNC is unlikely to repurchase recently liquidated assets. Some losses will be actual permanent losses. We urge investors to assess whether this is the result you are happy with.
1-year total return, including dividends, relative to Vanguard Real Estate ETF (VNQ).
3-year total return including dividends vs. NVQ.
5-year total return including dividends vs NVQ.
10-year total return including dividends vs. NVQ.
We love the trades sector and yes, sometimes it settles in quite well. But it’s easily one of the worst sectors to buy and hold.
Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.