Prediction: AGNC Investment will outperform the market in the coming year

From June 2021 until the beginning of this year, AGNC Investments (AGNC 0.49%) he saw his stock drop steadily. This year, AGNC’s share price is up 5%.

So why would anyone predict that this perennial underperformer will outperform the market over the next year? Let’s look at 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 underperformed in the market.

Years of underperformance

To understand why AGNC has underperformed over the past few years, you first need 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. It is essentially a fund that holds mortgages.

Importantly, its investments carry virtually no credit risk because they are essentially backed by the US government through Fannie Mae and Freddie Mac. However, that doesn’t mean these mortgage investments are risk-free. When mortgage rates rise, the present value of these mortgage investments falls. This is usually referred to as interest rate risk.

Why it works this way is simple. If I owned an MBS paying 3%, you wouldn’t give me the full value of the collateral if you could get a newly issued MBS paying 6%. Instead, if I needed to sell that security, I would have to sell it at a discount to face value.

That’s one of the reasons why AGNC stock has performed so well over the past few years. As the Fed began raising interest rates after years of very low rates, mortgage rates rose as well. This left the value of AGNC’s portfolio of low-coupon MBS securities less.

Perhaps an even bigger problem, however, was that the spread between risk-free Treasury yields and mortgage yields widened, which only exacerbated the declines experienced by AGNC in its MBS portfolio.

The value of the AGNC portfolio is represented by the tangible net book value (TBV). On this front, the REIT’s TBV per share fell 45% from the end of 2021 to the end of 2023, going from $15.75 per share to $8.70 per share.

Image source: Getty Images.

Lower prices before

After several years of Fed rate hikes and higher mortgage rates, Federal Reserve Chairman Jerome Powell signaled at the Fed’s annual retreat in Jackson Hole, Wyoming, that rate cuts are ahead. Powell said that while the 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 (this is a chart that shows where each member of the Fed’s policy-making committee thinks rates are headed), Fed members expect the Fed Funds rate to fall to around 4 % to 4.25% until the end. from 2025 and to around 3.00% to 3.25% by the end of 2026. Rates are currently between 5.25% and 5.50%.

With lower interest rates, mortgage rates should probably go down as well. And similar to how AGNC’s portfolio declined in value as mortgage rates rose, the value of its portfolio should increase in value as mortgage rates fall.

Finally, AGNC’s stock price generally tracks its TBV per share, which is based on the value of its MBS portfolio.

AGNC data by YCharts.

The Goldilocks environment

One risk mortgage REITs face when rates start to fall is prepayment risk, whereby people increasingly refinance their mortgages or sell their homes at higher rates than expected. When they do this, REITs must replace their investments with MBS that would typically have a lower yield.

Mortgage rates have already started to fall in anticipation of a Fed tapering and now stand at around 6.5%. However, about 80% of AGNC’s portfolio is in MBS with coupons of 6% or less, mitigating this prepayment risk.

This causes the company to see an increasing benefit in tangible book value without high prepayment risks.

Meanwhile, mortgage REITs tend to perform very well during normal rate cut cycles (not related to a housing crisis). While AGNC did not exist for many of them, fellow mortgage REIT Annaly Capital Management (NLY 0.55%) has. Its shares saw a major rally during the Fed’s rate-cutting cycle starting in 2001, after the dotcom bubble burst.

The combination of a Fed rate cut cycle, the composition of AGNC’s portfolio, and the stock’s $0.12 monthly dividend has caused AGNC to outperform the market over the next year. With a yield of 14%, the stock doesn’t need much price appreciation to outperform and could easily see a total return of 20% to 25% over the next year.

However, if MBS spreads narrow as rates fall, AGNC’s TBV could rise significantly, as could its stock. This could happen if banks start re-entering the MBS market as rates ease, believing they are now valuable investments. This would then increase demand in the space and potentially tighten spreads that have widened to historically high levels. This would lead to much higher returns for the stock.

That’s the best-case scenario, but even without that happening, stocks will outperform over the next year as the Fed methodically lowers interest rates.