Last year was one to forget for most financial stocks, but especially for real estate investment trusts (REITs). The early days of the COVID-19 pandemic were characterized by widespread business closures and extreme bond market volatility. Mall-focused REITs suffered as tenants closed their stores and were unable to pay rent. Ands some mortgage REITs had near-death experiences.
Amidst all of that, AGNC Investment Corp. (NASDAQ:AGNC), an agency mortgage REIT, actually performed relatively well. While it did slice its dividend, the cut was smaller than most other mortgage REITs made to their payouts. But for income investors considering the stock now, the question is, how safe is its dividend today?
Mortgage REITs have an unusual business model
Most REITs follow a landlord/tenant business model: They build or buy office towers, apartment buildings, retail space, etc., and then lease out the various units. But mortgage REITs are entirely different. They don’t own property. They own property debt — i.e., mortgages. These companies invest in mortgage-backed securities, often of the variety backed by a U.S. government guarantee (aka agency mortgages). That’s the investment class that AGNC primarily focuses on.
While AGNC Investment’s portfolio is guaranteed by the federal government, that doesn’t mean it is riskless. When interest rates plummeted in response to the Fed’s actions, volatility increased in the mortgage-backed security market. Agency REITs use borrowed money to boost their potential returns, and these loans are subject to margin calls. Margin calls forced AGNC and every other mortgage REIT to sell assets and cut their dividends. AGNC cut its monthly payout from $0.15 per share to $0.12 per share. It also cut its leverage ratio (assets divided by equity) from 9.4 at the end of 2019 to 8.4 at the end of 2020. CEO Gary Kain did mention on the second-quarter conference call that the dividend cut was “unnecessary.”
Prepayment speeds are the big issue now
Given that AGNC’s investments are government-guaranteed, it will get paid its interest and principal. The biggest risks it faces right now relate to interest rates and the potential for prepayments. Prepayment risk represents the chance that a mortgage-backed security will get paid off early. This is happening at elevated rates now since so many borrowers are refinancing their mortgages. Since mortgage-backed securities are usually issued at a premium to par, an investor needs to collect a few interest payments to make back that premium. If an investor pays 104 cents on the dollar for a bond and it quickly prepays, the investor gets back 100, which works out to be a 4% loss. However, AGNC focuses on mortgage-backed securities with inherent characteristics that make it unlikely it will see an elevated level of prepayments.
A dividend hike could be a possibility
AGNC Investment is currently paying a monthly dividend of $0.12, which works out to an annual yield of 8.8%. Kain was asked on the fourth-quarter earnings conference call about the company’s thinking regarding the dividend. He said:
We’re going to continue to evaluate the dividend on a go-forward basis. And it is an important component of how AGNC takes care of our shareholders. But it, again, isn’t the only piece. And it’s the combination of the dividend, book value, which then translates to stock price. We’ll continue to be active in buying back stock when it makes sense. And so we think in the long run, that’s the best overall equation for shareholders.
During the past several quarters, AGNC has traded at around a 9% discount to book value. When a company is trading below book, it can increase book value per share simply by repurchasing its stock. So, Kain is saying that it will look at all avenues to increase shareholder value. With the stock yielding just below 9%, and his viewpoint that the early 2020 dividend cut was probably not necessary, a payout hike is probably on the table. AGNC is much less leveraged than it was at the beginning of the year, so it should be more insulated from unexpected bond market volatility. While no dividend is completely safe, AGNC’s payout is probably the safest of all the mortgage REITs.
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