AGNC: A Favorable Environment For The 8.3%-Yielding AGNCL Preferred (NASDAQ:AGNC)

This article was first released to Systematic Income subscribers and free trials on Feb. 3.

The income market has gone through a huge reversal over the past 3 months as prices have rallied nearly across the board. This rally has caused some investors to trim certain positions or rotate into more attractive pockets of the market. In this article we take a look at the Agency MBS-focused mortgage REIT AGNC Investment Corp Series G Preferred (AGNCL), which trades at a 8.3% yield and offers an attractive opportunity in the current environment.

We recently rotated into the stock from an Armour Resi REIT preferred (ARR.PC), which has rallied sharply since the start of the year – outperforming the Agency preferred sub-sector by around 7% due to its longer-duration profile (ARR.PC is a Fixed-rate stock while most are Fix/Float).

Apart from an increase in yield (AGNCL yields 0.3% more than ARR.PC) and a shortening up of duration exposure given the rally in Treasury yields, the rotation also moves up in management-quality as we discuss below and diversifies investor preferred portfolios by allocating to one of the few Fix/Float preferreds linked to the Treasury yield rather than shorter-dated interest rates like Libor or SOFR.

AGNCL is a particularly nice complement to Libor-based floating-rate preferreds such as NLY.PF or AGNCN in a diversified income portfolio. Its longer-duration means it can outperform if rates continue to move lower (as it has year-to-date already) and its Treasury-yield link means it’s less dependent on the Fed’s interest rate stance than most other Fix/Float preferreds.

Preferred vs. Common Redux

Over the last several years, we have made two points about the mREIT sector. First is that for strategic investors, preferreds are a surer bet than common shares. This is because Agency mortgage REITs (real estate investment trusts) carry highly leveraged portfolios that they are forced to deleverage during periodic bouts of volatility. The chart below shows how the common share price responds to these deleveraging episodes while the preferreds remain much more resilient.

The second point is that common mREIT shares are not uninvestable as many analysts would have you think whenever volatility and stock prices fall. Just like with any investment, the key is valuation. In the case of mREITs common shares, the key valuation consideration is Agency spreads (i.e., Agency MBS yield differential over Treasuries).

Interestingly, Agencies recently bounced off nearly the same exact level that they reached during the COVID drawdown in 2020 of around 1% spread for longer-maturity MBS. This was also in the neighborhood of the level reached during the GFC crisis. Since this peak late last year, Agency mREIT common shares have rallied by 50% or more. In other words, it’s not that Agency mREIT common shares are uninvestable, it’s that starting valuations matter a whole lot, so investors in common shares need to be extra-vigilant and, arguably, more tactical, than investors in preferred shares.

Lower In Duration, Up-in-Management Quality

As many investors know, despite allocating to the very same assets, not all Agency mREITs are created equal. Specifically, there is wide variation in risk management quality. The reason risk management is important is that preferreds investors bear downside risk without benefiting as much from potential upside which is primarily soaked up by common shareholders.

One of the key metrics we focus on in gauging risk management quality is how the portfolios of various mREITs fared over the COVID quarter or Q1-2020. The chart below captures these moves in book value terms. What we see is that there was enormous variation in book value performance. This disparity is owed to such factors as internal vs. external management, the composition of hedges, relationship with leverage providers, speed of risk reduction and others. Within the sector, AGNC fared reasonably well in this regard and better than ARR. And although some time has passed since 2020, risk management is an institutional feature that is typically hard to change quickly which should give investors’ confidence in the company.

As many investors are aware, one reason for the broad-based rally in the income space is the fall in Treasury yields. 5Y Treasury yields stand around 0.7% lower from their peak last year. We adopt a countercyclical approach to investing. This means that when Treasury yields fall, we tend to shorten up on duration for the simple reason that the compensation on offer for bearing duration risk is now lower. AGNCL has a 2027 first call date at which point its coupon resets to a 5Y Treasury yield + 4.39%. This means that its duration is between zero and 5 at any given time versus ARR.PC whose duration is closer to 12 (which is similar to the duration of other Fixed-rate preferreds). With yields well below their peaks, it makes sense to dial this risk exposure down.

The third reason to give AGNCL a look is that it is the only one in the AGNC suite, and one of the few in the mREIT sector that has a coupon linked to the 5Y Treasury yield. Historically, Treasury yields have tended to trade significantly above Libor. The yield curve (3-Month / 5-Year) is currently very inverted (see chart below). If / when the yield curve normalizes, AGNCL will enjoy a significant income uplift relative to Libor-based preferreds.

A Look At The Suite

AGNC has 5 preferreds in its suite as shown in the following table from our service Preferreds Tool. Four are Libor-based Fix/Float preferreds while AGNCL is a 5Y CMT preferred i.e. one linked to the 5Y Treasury Yield (CMT stands for Constant Maturity Treasury). On its first call date in 2027, the stock’s coupon will switch to the yield of the then 5Y Treasury Yield + 4.39% and will reset every 5 years after, if not redeemed.

At the moment, AGNCL (dark blue line) has the second-highest yield in the suite. The chart below shows forward or projected yields based on forward Libor and Treasury rates. One attractive feature of the stock is that if the Fed decides to take its policy rate significantly lower, its yield is “locked in” till 2027 and after that is linked to Treasury yields which the Fed has less control over unlike the other stocks in the suite.

Takeaways

The sharp moves in the income space over the last 3 months has scrambled a lot of income portfolios. Specifically, the drop in Treasury yields means duration is not rewarded as handsomely as it was last year. For this reason, we take some of the gains in our longer-duration holdings such as ARR.PC and rotate them into a medium-duration AGNCL. Apart from an attractive yield, the stock also benefits from a link to Treasury yield-based coupons rather than the more common Libor/SOFR anchor, which sets the stock up for outperformance when the yield curve eventually dis-inverts.