The open secret that is AGNC Investment’s Achilles heel

AGNC investment (NASDAQ: AGNC) is not a dividend stock, despite its whopping 14% or so dividend yield. It’s a total return stock, which essentially means you’ll need to reinvest dividends to reap the full benefits. But there’s another open secret about AGNC’s business model that you should understand before you buy the mortgage real estate investment trust (REIT).

What does AGNC Investment do?

It’s important to understand that AGNC Investment is not a typical real estate REIT. Real estate 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 property. Mortgage REITs like AGNC buy mortgages that are rolled up into bond-like securities.

In this way, AGNC is more like a bond fund than a traditional REIT. However, it is still a business, so it has more leeway in how it finances its business. The big open secret here is that AGNC, like other mortgage REITs, uses leverage liberally in an effort to improve shareholder returns. The goal is to generate more interest from its mortgage bonds than it pays in interest costs.

At the end of the second quarter of 2024, AGNC Investment’s balance sheet showed that it had committed nearly $55 billion of its roughly $59.6 billion agency securities (its mortgage bond portfolio). Some simple math shows that the firm has actually committed about 92% of its bond portfolio. But what does “committed” mean?

AGNC’s leverage increases risk

The company’s 10Q report (its quarterly report to the SEC) states:

There’s a lot to unpack here. For starters, “pledge” essentially means the company is using its mortgage bond portfolio as collateral for loans. But go back to the percentage of the portfolio that’s pledged — pretty much the entire thing, about 92%! Mortgage bonds aren’t like buildings that trade infrequently. They trade all day, so their value can be affected quickly, with AGNC offering just a few of the potential catalysts (from interest rates to housing market dynamics) that could cause price volatility.

In and of itself, using leverage is not bad, but it does increase 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 if things don’t go as planned, meaning the value of the collateral declines. Well, that’s when a margin call could occur, which would require AGNC to either provide additional collateral (there’s not much left to pledge) or call in its loans. A margin call would likely mean selling mortgage bonds at what I assume would be an inopportune time.

While AGNC Investment hasn’t had any problems with the loans it made, it also didn’t survive the severe blow of the housing-induced Great Recession, having gone public in May 2008. (That may have been a good time to get started, given that the mortgage market was in a deep recession at the time.) For example, American Home Mortgage, once one of the top 10 mortgage lenders, went bankrupt in 2007. New Century Financial filed for bankruptcy protection that same year. But there were also numerous mortgage REITs that were hit hard by margin calls during the coronavirus pandemic, including MFA Financial, Invesco Mortgage CapitalAnd AG Mortgage Investment FundThe fear of a margin call could cause the entire mortgage REIT sector to decline in value.

In other words, if things go bad, they could go dramatically bad because AGNC could get caught in a mortgage REIT sell-off or even become a forced seller itself. Downturns can quickly turn into downward spirals.

AGNC is not intended for the average investor

The problem with AGNC Investment is that dividends are a significant part of its return profile, as the stock has a dividend yield of around 14%. However, as the chart above highlights, the dividend has been cut regularly for years. The yield has remained high because the share price has followed the dividend cut. That’s a terrible outcome if you’re spending the dividend income your portfolio is generating. This is not an income stock.

But if you reinvest the dividends, AGNC Investment has actually been a positive investment. That’s because the huge dividend buys a lot of additional shares, allowing investors to benefit from compounding. Asset allocators looking for mortgage exposure will likely be interested. You just have to understand the dynamics of the business, which brings with it the added risk of leverage. The company doesn’t hide that fact, but it’s often overlooked because the downsides it can cause aren’t often seen. The problem is that when the risk does reveal itself, it can be a swift and painful reminder that leverage can magnify both gains and losses.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The Open Secret That’s AGNC Investment’s Achilles Heel was originally published by The Motley Fool