Preferred Weekly Review: Agency Mortgage REITs Start Profiting

Darren 415

This article was first released to Systematic Income subscribers and free trials on October 31st.

Welcome to another installment of the Preferred Stock Market Weekly Review. Here, we take a look at the activity in the preferred stock and baby bond markets, both from the bottom up and highlight individual figures. It provides a top-down, broader market overview as well as news and events. We also try to add historical context as well as related themes that we believe are driving the market and that investors should keep in mind. This update covers the period through the last week of October.

Be sure to check out our other weekly magazines update It covers the Business Development Company (“BDC”) and Closed End Fund (“CEF”) markets, providing perspective across the broader income space.

market behavior

Preferred had a strong week with positive returns across all subsectors. However, heading into October, most sectors closed lower.

systematic income

systematic income

Unlike CEF and BDC, Preferred delivered a negative return in October.

systematic income

systematic income

For example, while credit spreads on BB-rated corporate bonds rose 0.7% from 3.76% in October, credit spreads on senior bonds actually widened in October, as the chart below shows. Overall, preferred stock offers excellent value to date, especially in the short duration institutional sector.

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For example, bank preferred securities, many of which are investment grade or near investment grade, offer yields approaching 7%.

systematic income

systematic income

Market commentary

Agency mREIT opened Q3 earnings in the sector.

AGNC (AGNC) book value fell about 20%. This is his fastest pace in the post-COVID period and about as big as the 23% drop in Q1 2020. AGNC issued $289 million worth of common stock and $150 million worth of new stock during the quarter. AGNCLNetnet, which, in addition to book value declines, has reduced equity coverage from 5.2x to 4.3x, a far cry from double-digit levels in 2019.

AGNC Series C (AGNCN) is now callable, and it makes sense for AGNC to redeem it for two reasons. First, the current coupon of the newly issued AGNC Series L is much lower than AGNCN, and the reduction in the company’s shareholders’ equity has increased the weight of preferred stock in the capital structure, increasing the company’s total cost of funding. (due to interest expense on preferred stock). outweighs the cost of the repo).

It’s entirely possible that the company is keeping AGNCN to maximize its exposure to agencies, which makes a lot of sense at its current valuation. Leverage also actually increased (8.7x), raising the sensitivity of the MBS basis to book value to a 3-year high of 19% (i.e. a 25bp increase in agency spreads reduces book value by 19%) This is consistent with the fact that ). AGCNN could indeed be redeemed if the agency base starts to bounce back, and the company will also reduce its leverage.

More broadly, what’s interesting is that agency valuations are far more extreme than those of other fixed income sectors.

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If valuations hit GFC’s peak levels, we would expect AGNC’s book value to decline by 40-50% (resulting in approximately doubling of equity coverage). Based on this, it makes sense to overweight the agency’s mREIT preferreds relative to other credit assets. For example, high-yield corporate credit spreads are more than 1% below his 2022 peak, about half of COVID’s peak levels and a quarter of his GFC’s peak levels.

Dynex Capital (DX) yielded fairly similar results. Its book value fell by around 16% due to its propensity to manage low-leverage portfolios. However, his leverage increased sharply from 6.6x to 8.5x. DX tends to be much more agile in leverage than other mREITs, so this jump means DX is finding great value in agencies. Like AGNC and Annaly Capital (NLY), DX also issued common stock. Equity/Preference coverage dropped to 5.9x.

Anna Lee also announced the results. The book value has fallen about 15% and the leverage has also decreased. A very attractive aspect of NLY is the convexity of its behavior. Specifically, this has to do with how we respond to significant book value declines. In the third quarter, the company issued 16% more common stock than his. The net result was that the book value fell 15%, but the stocks that actually mattered to the preferred stock fell only 1.2%. The company has increased its common stock by a whopping 29% this year as its book value has fallen.

AGNC and DX also issued new common stock, but to a lesser extent. In other words, when the book value falls significantly, NLY will issue common shares, mitigating the impact on preferred shares. And if the book value rises significantly, NLY is likely to do nothing (i.e. it won’t buy back 29% of the stock) and the preferred stock will be much more favorable due to the stock’s organic rally. .

As such, this convexity of equity coverage with little loss on the negative side and large potential gains in equity coverage on the upside is a great profile for a preferred company to have. In this sense, NLY priorities offer much higher convexity than their counterparts in the same sector. There is no guarantee that NLY will continue to be so bold by downsizing its common stock issuance, but the fact is that NLY has so far held itself in a better position than other companies in the sector. increase.

Another point worth emphasizing is that NLY tends to be somewhat conservative. For example, while DX and AGNC increased their leverage levels in Q3 (8.5x and 8.7x), NLY actually lowered them significantly from 6.6x to 5.8x.

Higher levels of leverage are more attractive to investors in bullish agency common stocks. However, priority holders are more interested in downside risks than upside gains, so they prefer lower leverage levels, all other things being equal.

Let’s take a look at the yields offered within the sector.

The chart below shows forward yields for the AGNC suite. There is no “best” inventory of Slam Dunk here. Stocks with high short-term yields, such as AGNCN and AGNCM, have low long-term yields and vice versa. Pricing is pretty efficient in this sense. Overall, we believe there is value in AGNCN in the short term and AGNCL in the long term.

Systematic Income Prioritization Tools

Systematic Income Prioritization Tools

In our favorite NLY suite NLY.PF When NLY.PG.

Systematic Income Prioritization Tools

Systematic Income Prioritization Tools

Combining shortest and longest call AGNC and NLY precedence with DX.PC gives the following picture. In the long term, we believe DX.PC will offer a lot of value, but April 2025 is a long time to wait for the coupon to rise, and by then Libor will be significantly more profitable than it is today. may be lower. LIBOR Forward priced.

Systematic Income Prioritization Tools

Systematic Income Prioritization Tools

Fundamentally, we continue to favor NLYs in this sector. Agency mREIT Preferred subsector with highest equity/preferred coverage and lowest leverage. As previously mentioned, the company is also the most aggressive in issuing common stock, expanding its preferred stock coverage.

Systematic Income Prioritization Tools

Systematic Income Prioritization Tools

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