Huge dividends can tempt investors but sometimes they turn out to be yield traps -- especially if the company cuts its payout due to financial strain. With a humungous 15% yield at its current share price, AGNC Investment Corp.(NASDAQ: AGNC) certainly catches your attention.
Skepticism over the dividend's dependability is expected, but investors might be surprised by how much the company is poised to pay investors in the future. AGNC could be an income investor's dream stock, but there are some risks to understand.
Understanding AGNC Investment Corp's business
A real estate investment trust (REIT) is a business that leases real estate (usually commercial) or invests in real estate loans for income. REITs let investors benefit from owning real estate without needing millions of dollars to own entire properties and are generally great income investments. This is because REITs are required by law to pay out at least 90% of their taxable income to investors.
REITs generally specialize in a type of property, like retail or industrial. In contrast, AGNC is what's called an agency mortgage REIT. It purchases mortgage-backed securities (MBS), which are mortgages that are grouped together and sold to investors. As an agency mortgage REIT, AGNC buys MBSs created from mortgages guaranteed by government-sponsored enterprises like Fannie Mae and Freddie Mac.
Because the government backs the mortgages in these securities, there's technically a low risk of default. AGNC Investment, like many REITs, uses debt to finance its business and makes money by managing the return on its investments, versus its borrowing costs. I'll break that down further below.
Interest-rate dynamics and the dividend
The risk in this business model is in how interest rates behave. Generally, REITs want to create a spread between their investment returns and borrowing costs. If rates surge higher on Treasury bonds, as they did these past couple of years, it can threaten that spread. Fortunately, AGNC management has done an excellent job navigating these tricky waters.
Image source: AGNC Investment Corp.
You can see that the return on MBS adapted to higher Treasury rates throughout the past year.
AGNC generates profits from two avenues. First, is income generated by the net spread, or the difference between its investment-portfolio income and its debt expense. Second, it makes money from trading MBS securities with other institutions. Combined, these two sources of income added up to $2.61 a share in 2023 against a dividend payout of $1.44.That's a payout ratio of just 55%.
Management noted in its Q4 earnings call that AGNC's profits would decline over the next six months as benefits from derivative contracts on interest rates expired. Importantly, management believes the dividend will remain sustainable.
Should investors buy AGNC today?
AGNC stock has historically traded at a slight discount to its book value over the years, and its premium today means that the stock could decline if it reverts toward its historical levels.
AGNC Price to Tangible Book Value data by YCharts.
The healthy payout ratio and management's confidence in the dividend's sustainability, despite decreasing income should give investors some confidence in the stock's tremendous yield.
Total returns could be a different story. Tangible book value declined $1.14 per share in 2023, and the potential valuation reversion could eat into the gains for the company's dividend.
For those looking for income as a primary investment motive, however, AGNC deserves some consideration.
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Justin Pope 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.
