AGCN (NASDAQ:AGNC) last declared a monthly cash dividend of $0.12 per share, in line with its previous payment and for a yield of 14.8%. This payout is down from $0.16 per share just before the pandemic with a recovery hampered by the impact of rising federal funds rates on residential mortgage-backed securities that make up the bulk of AGNC’s portfolio.
The internally managed mREIT invests primarily in agency RMBS on a leveraged basis through the use of repurchase agreements. The portfolio has been valued at $59.5 billion at the end of its last published fourth quarter of fiscal 2022 and the MBS agency formed $39.5 billion. AGNC also held an $18.6 billion TBA mortgage position. This formed a tangible book value of $5.7 billion at the end of the fourth quarter, or about $9.84 per share.
The tangible book value must be fully stabilized
However, the impact of rising federal funds rates was marked and the corresponding rise in primary mortgage rates formed a structural headwind on AGNC’s book value.
The 30-year primary mortgage rate at 6.6% is at its highest level since 2008, a move that places AGNC’s positive duration as a barrier to book value growth. Therefore, the most relevant near-term catalyst remains the formation of a clear peak and then the decline in the fed funds rate. Book value is the most important metric because it determines the underlying price of the commons and underpins dividends. And although it was under pressure, AGNC said it went between $10.80 and $10.90 per share from February.
This would represent an increase of about 8.9% at the bottom of the scale compared to the fourth quarter. It would also mean that the commons are currently trading at a 10% discount to tangible book value. mREIT recorded GAAP EPS of $0.93 per share, a $0.27 beat on consensus estimates to form a payout ratio of 38.7% over the 3-month aggregate of the monthly dividend. While I don’t expect a near-term increase, as the low hedge ratio masks dividend payouts to five outstanding preferred shares, yield could rise further if the common stocks face near-term weakness.
Fixed-to-floating E-Series favorites
AGNC Series E Fixed to Floating Cumulative Preferred Shares (NASDAQ:AGNCO) offer distinct advantages over the commons and have been trading lower in recent weeks. What’s to love here? The annual fixed coupon of $1.63 equates to a 7.9% yield on cost, with the preferred shares currently trading at $20.75 per share. Although this is around 700 basis points lower than the dividend yield of common stocks, its returns over the past 12 months outperform common stocks by around 1,000 basis points with Series E down 15.3 % versus 25.3% for ordinary shares.
The coupon is paid in quarterly installments and therefore might be less attractive to investors looking to mimic paychecks compared to monthly paying commons. They are currently trading at a discount of $4.25 per share to face value to provide another avenue for shareholders to accrue positive returns. This 17% discount on their intrinsic value of $25 represents value to be seized on the upside. The uncertainty about this is the timeline for a return to normalcy. Preferred shares have been trading above this level for much of 2021, with the current downtrend also triggered by the rise in the fed funds rate and in place since the start of 2022.
The performance dichotomy between the two stocks on a total return basis is stark and likely reflects common stocks that have suffered from the specter of dividend cuts and quarterly book values in a seemingly perpetual downward trend. Series E investors would have realized a total return of 55.65% over the past three years compared to a total return of 14.49% for common stocks. Over the past 12 months, preferred stocks are down 8.91% on a total return basis versus a loss of 14.65% for common stocks.
This divergence in performance is expected to persist this year as rising interest rates and a weak economy continue to weigh on AGNC’s underlying book value and payout ratio. Series E will be redeemed on October 15, 2024 and will also transition to a floating rate of three-month LIBOR plus 4.993% per annum. It is important to note that LIBOR will be retired in June this year and will be replaced by the Secured Overnight Funding Rate (SOFR). In some context, SOFR currently stands at 4.57% and is up from near zero a year ago. Therefore, assuming the coupon floats today, preferred holders would realize a yield of 9.56%.
While SOFR is expected to follow higher on what appears to be two more 25 basis point hikes in the fed funds rate, SOFR at the time of redemption in the fourth quarter of 2024 could be lower than its current level if the United States fell into recession. This would be especially likely if inflation hits the Fed’s 2% target. Whether it’s for the E-series rather than the commons will depend on two factors. Risk tolerance and confidence in the safety of common stock dividends. The cumulative clause on preferred shares essentially eliminates any propensity for suspension in the event of future economic headwinds, as any unpaid coupon payment will accrue as a liability for redemption upon redemption. I’m neutral on both stocks, but common actions could be considered once the Fed stops raising rates.