Agency MBS (Mortgage-Backed Securities) are mortgages in which the principal is guaranteed by Government-Sponsored Enterprises or agencies like Fannie Mae, Freddie Mac, and Ginnie Mac, making them to be of the highest credit, given government backing. If a borrower defaults on a mortgage, the agency will buy it back at par value, protecting the investment altogether.
Treasury prices fell in response to the Federal Reserve’s quantitative tightening. MBS prices experienced a double-whammy as they were impacted by rate changes and the Federal Reserve significantly cutting back on its MBS purchases. Since the Great Financial Crisis, the Federal Reserve has been the largest buyer of agency MBS. It cut back its buying while prices were falling, and many other regular investors in agency MBS, like mREITs, also stopped buying.
MBS prices are likely close to a multi-decade low. As interest rates decline, MBS prices will go up; that is a fairly direct cause and effect. If prices are going up, a larger portfolio will help book value recover more quickly. In a leveraged investment, you want to have lower leverage as prices fall, and higher leverage as they rise. Let us now look at two seasoned companies that are experienced in operating a leveraged MBS portfolio.
Pick 1: AGNC – Yield 14.1%
AGNC Investment (AGNC) is a mortgage REIT that invests in agency MBS.
The risk that AGNC takes on is primarily interest rate risk. AGNC allowed its MBS portfolio to bottom out at $40.9 billion. Source
AGNC Q2 2024 Presentation
This compares to over $100 billion in Q4 2019: Source
Through 2023, we saw AGNC start getting more aggressive with purchases, but it has not yet fully stepped on the gas as the Federal Reserve delayed rate cuts much longer than the market was anticipating last year.
AGNC is operating at 7.4x leverage, which in the agency MBS business is quite low and the reason they've been cautious. AGNC has managed to maintain cash flow well in excess of the dividend thanks to its significant portfolio of swaps with very low fixed-rate payments. This inflates the current earnings, but as those swaps mature, AGNC's interest expense rises. While they still have a couple years of runway, it will be essential to grow the portfolio to support the current or higher dividend.
AGNC pays monthly dividends, annualizing to 14.1%. A larger portfolio produces higher returns, and the upcoming rate cuts bode well for the mREIT to raise leverage and boost returns.
Pick 2: NLY – Yield 12.9%
Annaly Capital Management (NLY) is a time-tested mREIT with a history of outperforming the market the market since its inception in 1997.
But make no mistake, NLY, like any mREIT is not a buy and hold forever investment. In the chart above, we specifically note the strong bursts of outperformance during the DOTCOM bubble and the GFC.
NLY’s earnings available for distribution went up in Q2 to $0.68, up from $0.64, and importantly, getting back to covering the dividend. The mREIT has been rotating into higher coupons, with over 45% of its portfolio now in coupons that are 5.5% or higher. NLY has also focused on "High Quality".
NLY Q2 2024 Presentation
Note that in the agency MBS world, "High Quality" is not a measure of credit risk. It is based upon expected prepayment risk. With higher coupons, NLY wants those loans paying for as long as possible.
NLY has reached a point where its EAD is stable in the current rate environment and we can expect the dividend to remain stable while we wait for upside from rate cuts.
Conclusion
I often get asked, 'Are we at a market top, and with forecasts pointing to a tough recession, how should I invest in this climate?' My answer is simple: time in the market is more effective than trying to time the market. That's why I stay invested with a highly diversified portfolio of income-payers that thrive in various economic conditions, ensuring my income remains strong through thick and thin.
Agency MBS are particularly attractive during weak economies and recessions, as investors—especially institutions—seek safe assets. mREITs, which use leverage to invest in these guaranteed instruments, are well-positioned to benefit in this environment. These holdings play a crucial role in my portfolio, ready to capitalize on a weak economic outlook. At High Dividend Opportunities, we diversify to protect and grow our income, and that’s the true power of income investing.
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