The open secret that is AGNC Investment’s Achilles heel

AGNC Investments (AGNC -0.39%) it is not a dividend stock despite its huge dividend yield of around 14%. It is a total return stock, which basically means to fully benefit here you have to reinvest the dividends. But there’s another open secret about AGNC’s business model that you need to understand before buying the mortgage real estate investment trust (REIT).

What does AGNC Investment do?

It is important to understand that AGNC Investment is not a property holding REIT. Property-owning REITs are pretty simple to understand: they buy a property (such as an apartment building, warehouse, or shopping center) and then rent the property to tenants. This is what you would do if you were buying a rental house. Mortgage REITs like AGNC buy mortgages that have been bundled into bond-like securities.

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In this way, AGNC is more like a bond fund than a traditional REIT. However, it is still a company, so it has more freedom in how its business is financed. The big open secret here is that AGNC, like other mortgage REITs, makes liberal use of leverage in an effort to increase shareholder returns. The goal is to generate more interest on the mortgage bond than it pays in interest costs.

At the end of the second quarter of 2024, AGNC Investment’s balance sheet noted that it had pledged nearly $55 billion of its roughly $59.6 billion in agency securities (that’s its mortgage bond portfolio). Some simple calculations show that the company has basically pledged about 92% of its bond portfolio. But what does “pledged” mean?

AGNC leverage increases risk

In the company’s 10Q (which is its quarterly report to the SEC), it states that:

We pledge our securities as collateral under our loans structured as repurchase agreements with financial institutions. The amounts available to be borrowed depend on the fair value of the securities pledged as collateral, which fluctuates with changes in interest rates, security type and liquidity conditions in the banking, mortgage and real estate industries. If the fair value of our pledged securities declines, lenders will typically require us to post additional collateral or repay loans to restore the agreed collateral requirements, referred to as “margin calls.”

There’s a lot to unpack there. For starters, pledging basically means that the company uses its portfolio of mortgage bonds as collateral for loans. But back to the percentage of the portfolio that is pledged — basically the whole of it, at 92% or so! Mortgage bonds are not like buildings that trade infrequently. They trade throughout the day, so their value can be affected quickly, with AGNC providing just a few of the possible catalysts (from interest rates to housing market dynamics) that could cause price volatility.

In itself, using leverage is not a bad thing, but it increases risk. This is especially true when you use a lot of leverage, such as pledging 92% of your mortgage bond portfolio as collateral. So investors have to wonder what happens when things don’t go as planned, i.e. the value of the collateral goes down. Well, then there might be a margin call, which would require AGNC to post additional collateral (there’s not much left to pledge) or pay off its loans. A margin call would likely mean selling mortgage bonds at what would likely be an inopportune time.

While AGNC Investment had no problem with the loans it made, it also didn’t go through the housing-led Great Recession bug that went public in May 2008. (This could have been a great time to start, (because the mortgage market at the time was in a deep downturn.) For example, American Home Mortgage, once a top 10 mortgage lender, went bankrupt in 2007. New Century Financial sought bankruptcy protection that same year. But there have been numerous mortgage REITs that have been hit hard by margin calls and during the coronavirus pandemic, including Financial MFA, Invesco Mortgage Capitaland AG Mortgage Investment Trust. In fact, the mere fear of a margin call can send the entire mortgage REIT sector down.

In other words, when things go south, they can go south in dramatic fashion, as AGNC could be caught up in a sale of a mortgage REIT, or perhaps end up being a forced seller itself. Declines can quickly turn into downward spirals.

AGNC data by YCharts

AGNC is not intended for the average investor

The problem with AGNC Investment is that dividends are a big part of its return profile, noting that the stock has a dividend yield of around 14%. Only, as the chart above highlights, the dividend has been cut regularly for years. The yield remained high as the share price tracked the dividend lower. This is a terrible result if you spend the dividend income generated by your portfolio. This is not an income stock.

But if you reinvested the dividends, AGNC Investment actually turned out to be a positive investment. This is because the huge dividend is buying a lot of additional shares, allowing investors to benefit from compounding. Asset allocators looking for mortgage exposure will likely be interested here. You just need to understand the dynamics of the business, which involves the added risk of leverage. The company does not hide this fact, but it is often overlooked because the disadvantage it can cause is not a frequent occurrence. The problem is that when risk becomes known, it can be a quick and painful reminder that leverage can increase both profits and losses.