Description

Disclaimer: I own these and am biased. Do your own diligence. All investments involve the risk of loss, including this one.

Intro - mREIT Preferred Opportunity:

I’ve posted previously about the opportunity in mortgage REIT (mREIT) preferreds. I believe there is a systematic mispricing that allows a high-return “arbitrage-like” opportunity to make fairly safe 13-20% IRRs over a 12-36 month period. 

What follows is one of the shorter duration, more liquid, and therefore slightly lower expected returns of the group - a specific issuance by AGNC Investment Corp. - its Series F preferred.

AGNC is one of the largest mREITs in the world, and the basic description of the opportunity applies to many different mREITs. I tend to focus on mREITs that themselves focus on the Agency mortgage space, in order to avoid taking substantial underlying borrower credit risk, though there is plenty of opportunity in that part of the mREIT space as well.

I’ve owned a wide variety of mREIT preferreds over the past several years, during which time I’ve opportunistically rotated and added amongst the issuers. These securities are reasonably safe yet are amongst the highest-yielding non-stressed assets in markets - I believe they are mispriced relative to their place on the risk spectrum.

Many mREITs are small-cap companies and their preferreds are effectively microcap issuances, making them difficult for institutional buyers to acquire. That said, AGNC is a decent-sized example, with a market cap of $6.4 billion. The par value of the Series F preferreds is $575 million.

AGNC Series F Preferred:

I am not going to go in-depth on the nuances of AGNC’s business, as it’s only mildly relevant to the preferreds. With preferreds, there are really only two questions: 

1. Will it fail?

2. What will the future cost of capital be? 

Given AGNC is a healthy business and is unlikely to fail, this write-up focuses on #2.

As its name implies, AGNC is an Agency-focused mortgage REIT. Agency mortgage backed securities (MBS) are those guaranteed by Fannie, Freddie, and Ginnie and therefore have the imprimatur of a US government backstop. More than 98% of AGNC’s assets are Agency MBS. While the Agencies also offer certain credit-risk transfer securities (CRTs), those, along with other credit sensitive securities, represent <2% of AGNC’s portfolio. As a result, its portfolio is overwhelmingly focused on securities without credit risk - just duration, liquidity, and prepayment risk.

In a sense, a vanilla mREIT is akin to a wholesale funded Savings and Loan: it borrows via repo to make mortgage loans (via acquiring Agency securities). On the one hand, its funding source is less durable than a deposit-taking institution, but, on the other hand, it takes close to zero credit risk. AGNC operates at roughly 7x of leverage to the preferred stack. For the common equity, the preferreds serve as an additional form of expensive, but non-callable, leverage - financing tools targeted at retail investors to add juice to the ROE of the common equity. 

Preferreds are used primarily as a regulatory and/or tax arbitrage - yieldy products that pay dividends instead of interest and are treated like equity (but are senior to common). I’m simplifying for brevity, but preferreds typically have a par value of $25 (such that a pref trading at $20 is trading at 80% of par). The issuances are generally quite small and trade like microcaps.

Most mREIT preferreds are perpetual but can be redeemed (called) after a certain time. The general flavor of an mREIT preferred is that it offers a “fixed” coupon (dividend) for an initial number of years (e.g., 5 to 7 years). After the initial fixed period ends, most mREIT preferreds switch from a fixed coupon to a floating coupon (e.g., SOFR + 5.25%) and they become redeemable from that point forward. 

At the time most of today’s outstanding preferreds were issued, ZIRP prevailed and the floating coupon was expected to be similar to or less than the fixed coupon. The world has changed.

Like most mREITs, AGNC has a variety of preferred equity securities outstanding - currently five issuances (Series C, D, E, F, and a more recent G).

It is my assertion that once the preferreds flip-to-floating, they become somewhat non-economic for the issuer and most mREITs will eventually seek to call them at par ($25). Combined with the very high floating rate coupon, I expect most preferreds to experience a pull-to-par as they approach their floating period and become callable. We can observe this pull-to-par in any number of preferreds that have become floating (more on that later). 

Our AGNC Series F has 11 months until its coupon floats and 14 months until it becomes callable. Today, it trades at $23.20, or ~93% of par (slightly less actually, if you back out its accrued dividend). During the 14 months prior to the first floating payment, its stated yield is 6.125% ($1.53) for 11 months, which is a ~6.6% current yield on a $23.20 purchase price, then floating for the last three months.

Quick Aside: the standard convention is to talk about the “floating date” as the first floating coupon payment date (which also coincides with when the preferreds become callable). That said, the coupons are paid quarterly in arrears, so the floating interest actually begins accruing three months prior to the payment date. Throughout this write-up, I’m using the payment/call date, but you should know that technically, the floating coupon begins three months before that.

What makes this AGNC Series F preferred interesting is the pull-to-par should occur over the next 10-14 months, followed by a very-high floating rate coupon. 

For comparison, AGNC already has one preferred, its Series C, that has made the journey and flipped-to-floating and is callable. Compared to our Series F, the Series C has a slightly higher floating coupon: it trades at a premium to par. 

If we believe our Series F will trade at the same current yield as the Series C, it would trade to ~$24.60, implying a 6% price return during the next 14 months. We will also receive the 6.6% current yield for 11 months and 11.4% for three months, for a total return of ~15% to the floating conversion date in April 2025.

Further, because these are floating rate securities, you have very limited duration risk - if short-term rates rise, your floating coupon will rise alongside it.

One might worry that means you have risk if rates decline. Keep in mind that, once they become callable, the Series C, D, E, and F are - by far - the most expensive pieces of AGNC’s capital structure. If rates decline, it will create an incentive to redeem these preferreds at par by issuing new fixed-to-floating preferreds that lock-in the then-lower rates for AGNC.

A few observations, as you compare these various securities.

1. The Series D and E in red both become callable in the next eight months. You can see they trade at ~98% of par, ahead of the call date, which I believe highlights the arbitrage opportunity for preferreds that are >12 months from becoming callable.

2. Specifically, the Series D has technically already flipped, but isn’t callable for two more months. It has a lower floating yield than our Series F would have, yet it already trades at 98% of par. Given our Series F’s higher yield, it provides optimism that it will actually trade at par, rather than the discount I’ve assumed.

3. Keep in mind that, once these are callable, they are unlikely to trade for a substantial premium to par, given call risk.

4. The Series G is a different beast and isn’t directly comparable to C, D, E, and F. The Series G’s “floating” conversion is actually a series of new 5-year fixed periods, each priced at a spread to the then-prevailing 5-year US Treasury, whereas C, D, E, and F are a spread to SOFR, reset quarterly.

Summary of Opportunity:

With a 15%+ arbitrage-like expected total return over the next 14-months, I believe the Series F sits at a nice spot on the risk/return curve:

• Senior to common

• Liquid underlying asset portfolio that is duration hedged

• Expected teens IRR to initial floating payment date of 4/15/25

• Attractive interim high single digit cash yield

• Post-floating, earn 11.4% yield on today’s cost (holding rates flat)

• Protected from rate hikes

• If rates decline, increases the likelihood of a call at par, financed by new preferreds that lock-in lower rates for the fixed period

• The combination of a high coupon, protection from rate hikes, and call benefits from rate cuts creates a gravitational force toward par

Risks:

Rate shock: During the depths of the COVID market convulsions, Agency MBS disconnected from US Treasuries in surprising ways. If you are levered-long MBS, those disconnections are magnified and while the Fed and US Treasury are likely to step-in to stabilize (as they did in March 2020), if the damage is extreme enough, it could theoretically wipe out mREIT equities and impair the preferreds. No mREIT blew up in 2020, but most took substantial losses and the preferreds traded to steep discounts (which turned out to be incredible investment opportunities as they universally recovered to non-distressed levels).

GSEs Lose US Guarantee: This would almost certainly cause relevant Agency MBS spreads to widen which would be magnified by AGNC’s 7x leverage. AGNC’s asset portfolio has a ~5 year average duration to rising rates (excluding the benefits of rate hedges), so it would take a massive, single-day spread move to wipe out common (on the order of 300 bps, which has never come close to happening). Suffice it to say, that would be a bad day for all risk assets. Keep in mind the preferreds are senior to common, so even a wipeout of common doesn’t automatically impair our preferreds. But the price would of course get obliterated as we figure out the situation.

“SOFR” Risk: Virtually all mREIT preferreds are written with “LIBOR” as their floating benchmark rate, not SOFR. A different mREIT, Penny Mac, took the position that with no LIBOR, it was allowed to choose to keep the floating rate at the fixed coupon rate, because its documents allow it to choose the last dividend payment as the ongoing dividend payment if LIBOR isn’t calcuable. This caused PMT’s preferred prices to fall ~5% in a day. That said, Penny Mac’s preferred prospectuses were written differently than nearly every other mREITs’ because its preferreds were issued much longer ago, before LIBOR’s elimination was contemplated. AGNC, and every other prospectus I’ve read, include this concept (from the Series F prospectus):

(a)   If we determine on the relevant Dividend Determination Date that the LIBOR base rate has been discontinued, then we will appoint a Calculation Agent (as defined below) and the Calculation Agent will use a substitute or successor base rate that it has determined in its sole discretion is most comparable to the LIBOR base rate, provided that if the Calculation Agent determines there is an industry-accepted successor base rate, then the Calculation Agent shall use such successor base rate; and
(b)   If the Calculation Agent has determined a substitute or successor base rate in accordance with the foregoing, the Calculation Agent in its sole discretion may determine what business day convention to use, the definition of business day, the dividend determination date and any other relevant methodology for calculating such substitute or successor base rate in a manner that is consistent with industry-accepted practices for such substitute or successor base rate.

"Calculation Agent" shall mean a third-party independent financial institution of national standing with experience providing such services, which has been selected by us.

As we’ve discussed, AGNC already has adopted “SOFR + 0.26161” as a LIBOR replacement for its now-floating Series C and D and disclosed in public filings that Series D, E, and F will each use that standard. The below is probably a bit small to read, but it’s from Page 23 of the most recent AGNC 10-Q and it simply affirms what I wrote in the prior sentence.

Dividend Risk: In certain crisis situations, mREITs like AGNC have the right to turn off the dividend to the preferred, at which point they accumulate as a liquidation preference. Turning off our preferred dividends also requires AGNC cease paying dividends on the common (which can only be turned off in certain extreme situations, given REIT regulations). Dividends on the common cannot resume until the accumulated unpaid preferred dividends have been paid. No Agency-focused mREIT stopped its dividend during the COVID crisis, despite having substantial losses on book value.

Liquidity: The AGNC Series F preferred trades roughly $1mm per day.

In sum, I think we can earn a fairly low-risk teens IRR, over a 14+ month timeframe, driven by a highly attractive income stream. This is a great asset to hang out in.

Disclosure: I own AGNC preferreds, as well as securities in other mREIT issuers. I may buy, sell, or exit without disclosing those changes. All investments are risky. Do your own work. I’m just a guy on the internet who does not merit your trust.

Catalyst

• First floating coupon (and call date) in 14 months

• Pull-toward-par likely anticipates that by 6-10 months

• Collect coupons in the meantime