AGNC Funding Inventory: Name Threat Provides To Issues For Share Worth Restoration (AGNC)

Introduction

AGNC Funding Corp. (NASDAQ:AGNC) is an actual property funding belief that primarily invests in company backed mortgages (also called an mREIT). Company backed mortgages are securities backed by mortgaged property which are insured by the federal authorities. Again in April, I mentioned the challenges going through AGNC referring to increased rates of interest. I’ve been harsh prior to now about investing within the firm’s most popular shares. At present, I’m impartial on AGNC’s most popular inventory, however nonetheless brief on its frequent shares as I’ve found extra dangers than simply increased rates of interest to its monetary mannequin.

AGNC and the Destructive Web Curiosity Revenue

AGNC invests in mortgage-backed securities using leverage. The corporate borrows cash over a short-term period and makes use of the proceeds to purchase interest-bearing securities. In a traditional world, the unfold between the securities earnings and debt curiosity could be AGNC’s revenue for carrying these securities, however the world has been removed from regular over the previous few years.

Following the pandemic, rates of interest on borrowing dropped to close zero and mortgage demand skyrocketed. AGNC borrowed at close to zero charges and started shopping for mortgage-backed securities with coupons starting from 2.5 to three.5%, making stable internet curiosity earnings from the unfold. Then, the Federal Reserve raised charges aggressively to fight inflation, which precipitated AGNC’s debt prices to soar from 25 foundation factors to just about 550 foundation factors. Unable to dump its low coupon mortgages, AGNC confronted skyrocketing curiosity funds towards the low coupon mortgage securities.

As charges have remained excessive, AGNC has offset a few of its losses by investing in increased coupon mortgage securities. Within the first half of 2024, internet curiosity earnings (curiosity earnings much less curiosity expense) improved to a lack of $33 million, which was higher than the $167 million loss in the identical interval from a yr in the past. AGNC has turned to derivatives to additionally offset losses and noticed $1.4 billion in good points throughout the first half of the yr. Derivatives helped AGNC swing to a internet earnings of $395 million.

AGNC’s steadiness sheet exhibits the extent of its leverage. The corporate owns $59.6 billion price of company backed securities towards $57 billion of repurchase settlement debt. The $2.5 billion hole between the 2 is notably decrease than it was on the finish of final yr ($3.2 billion). Which means AGNC has determined to tackle extra leverage and spend money on extra mortgage-backed securities whereas charges are excessive. The hope is that the funding in increased yielding coupons will pace up the transformation to constructive internet curiosity earnings as rates of interest come down.

How Lengthy Will Curiosity Revenue Drag?

For AGNC to free itself from this example, the low-income securities should go. Promoting them now would create huge realized losses, as they’re price far lower than after they have been underwritten. The one different possibility is to carry them to maturity, however how lengthy is that? According to the corporate’s SEC submitting, greater than 80% of the corporate’s securities are invested with maturities starting from 5 to 10 years.

Shopping for Increased Yield Securities Results in New Issues

AGNC’s buy of upper curiosity securities is a logical step to stabilizing its internet curiosity earnings, however two main challenges current themselves with this technique. First, the rise in rates of interest vastly diminished the demand for brand spanking new mortgages, particularly since homebuyers didn’t wish to transfer and quit their beneath 4% mortgage charges. The dearth of availability in increased curiosity securities stays to at the present time with solely 20% of company debt yielding over 5% and practically two thirds yielding beneath 4%.

The issue of availability additional complicates itself with the second main problem – name danger. Many agency-backed securities that have been issued a yr in the past are presently getting known as in and being changed with decrease coupon securities as these securities have just one yr of name safety, and new securities are being supplied at decrease rates of interest. This turns into problematic as charges fall as a result of AGNC may discover itself shedding securities with coupons better than 5% by name danger solely to finish up settling with decrease coupon notes mixed with the big share of low-rate mortgages from the pandemic period.

To look at the market dimension of callable to non-callable company debt, I performed a search via my Constancy brokerage account. Of 1,064 company securities out there on the time of my search, solely 258 had name safety. Of these 258, solely 38 supplied coupons of better than 5%. Of these 38, solely 11 have been issued within the final couple of years with nearly none of them being issued between 2009 and 2022.

Does AGNC provide buyers the power to see whether or not the securities being held are callable or non-callable? It form of does. In its SEC submitting, the corporate particulars its holdings by coupon with the common period of its holdings. To spotlight the issue in holding high-yield notes, AGNC’s 6% and above coupon notes went from 7 to 11 months common period from December 2023 to June 2024. If the common period goes over 12 months in its Q3 submitting, then we are going to know that the corporate has some excessive coupon securities locked up for a very long time, however I imagine we’re going to see that period stall, hinting that most of the high-yield securities have been known as.

The Dilution Drawback

As if these points aren’t sufficient, I imagine that AGNC might want to concern extra shares to fund future investments. This idea is derived by the mix of elevated leverage throughout the first half of 2024 and the headwinds of high-yield securities being callable all through the following a number of months. AGNC does maintain the authorization to concern as much as $1 billion in shares and this might be a moist blanket on the frequent share worth.

The Most well-liked Shares

AGNC has a plethora of most popular share choices, and whereas I price all of them a maintain, I do wish to spotlight which safety I believe could be the perfect for an investor searching for to place new cash in right here. AGNCO is a most popular safety whose dividend is about to drift subsequent month. Whereas it should doubtless pay another dividend on the mounted price, a yield of 6.5%, subsequent dividends might be paid at a price of three-month SOFR plus 4.993%. This is able to indicate an estimated floating yield of 10.4%. Whereas AGNCN pays on the identical yield, it’s buying and selling at 3.5% over par, whereas AGNCO is buying and selling at par.

Put Choices, A Higher Brief Technique

Going brief on AGNC frequent shares may be costly, particularly for the reason that firm’s dividend of $1.44 per share per yr would must be funded by the brief vendor. Shopping for put choices presents a extra pragmatic strategy, because the $10 strike for January 2026 is buying and selling under the projected collected dividend obligation at $1.58 per share. It needs to be famous that quantity is skinny on these choices, so they could be tougher to shut at a later date.

Conclusion

The addition of name danger to high-yield company mortgage-backed securities is another layer of danger that makes AGNC unappealing to me. Mixed with the truth that the corporate is caught holding below-market price mortgage securities for a minimum of 5 years, I believe AGNC might want to proceed hedging with derivatives and issuing shares to remain related. Some most popular holders are getting nice yield to price, and people shares shouldn’t be bought, however at these costs with declining charges I’m not compelled to purchase most popular shares.