Mortgage real estate investment trusts (REITs) have been a very weak sector over the past year as markets priced in rate hikes from the Federal Reserve. Rising interest rates are usually bad news for financial assets in general, and the mortgage REIT sector has taken the chin.

The Fed has been raising the fed funds rate at an aggressive pace, but if you look at fed funds futures, we’re probably at the end of this rate hike cycle. The economy is weakening and the 10-year treasury has a lower yield than the two-year bond. This is a signal that long-term interest rates have probably risen as much as they should this year. If rates stabilize, it’s time to take a fresh look at the mortgage REIT industry.

Mortgage REITs will benefit from the end of the Fed’s hike cycle

AGNC Investment (AGNC 0.48%) is a mortgage REIT that invests almost exclusively in mortgage-backed securities, which are guaranteed by the US government. If you refinanced your home last year with a Fannie Mae or Freddie Mac loan, chances are it ended up with a mortgage-backed title similar to those held by AGNC. Because these mortgage-backed securities are guaranteed by the US government, AGNC will get its principal and interest even if the economy goes into a recession and borrowers default. An environment of economic weakness and stable interest rates is the ideal situation for AGNC, as government-backed mortgage-backed securities are considered a fairly safe investment.

The business model of a mortgage REIT resembles that of a bank. Instead of taking deposits, it borrows money through repurchase agreements, which are secured loans. He then uses this borrowed money to purchase a large portfolio of mortgage-backed securities. This use of borrowed money (or leverage) is how AGNC can turn a bond portfolio that has yielded 3.09% on average into a dividend yield of over 11%. Like a bank, its profits are the difference between what it earns on its wallet and what it costs to borrow money. The company’s cost of borrowing in the buyout market last quarter was 0.74%.

Mortgage REITs have big dividend yields

An 11% yield would normally be a red flag for most common stocks — a too-good-to-be-true dividend yield usually is — but for mortgage REITs, it’s typical. Mortgage REITs are very vulnerable to interest rate volatility, which will undermine book value over time. When rates stabilize, book value rebuilds and the company continues to earn its interest margin and pay dividends. AGNC pays a monthly dividend of $0.12 per share and has maintained that level since cutting it by $0.16 at the start of the COVID-19 pandemic.

Mortgage REITs are still licking their wounds following the rapid rise in rates over the last quarter. Tangible book value per share fell 12.9% to $11.43 per share during the quarter. The stock, as shown in the chart below, has fallen significantly over the past year. That said, with rising rates, the supply of mortgage-backed securities from mortgage originators is shrinking (simply because lenders are making fewer loans) and the Fed is shrinking its portfolio more slowly because fewer borrowers repay their loans early. The supply and demand situation is improving and management believes that agency mortgage-backed securities are very attractive on a historical basis.

AGNC data by YCharts

Not an investment for those with a weak stomach

AGNC Investment is not for the faint of heart. Interest rate volatility remains high, but markets expect the Fed to be done with rate hikes by the end of the year – in fact, markets are handicapping rate cuts in 2023. A market stable bond could be just what the doctor ordered for this badly undervalued stock. Income investors looking for passive income should put this name on their shopping list, especially if they can buy the stock for less than book value.