If you are familiar with and have been following American Capital Agency (AGNC) closely, I'm sure you've been scratching your head, and asking yourself, what exactly is going on here? The following is an analysis from my modest perspective, and it's rather simple to recognize once you connected several dots…
Intro & Annual Summary
For any given investment, recognizing the optimal time to close a position based on the underlying strategy remains of critical importance. The following analysis presents a reflection and breakdown regarding some of the recent events surrounding AGNC, and is intended for readers that are familiar with at least the fundamentals of the company, its industry, and its primary competitor, Annaly Capital Management (NLY). Very briefly, AGNC is an agency-backed mortgage REIT that manages a portfolio of primarily mortgage pass-through certificates, CMOs, and agency MBSs guaranteed by Fannie, Freddie and Ginnie, as well as some commercial paper and FHLB issued agency debentures. AGNC's net interest income is representative of its earnings, which are generated primarily through the difference between the interest income on securities and the funding costs of repurchase agreements and other short-term borrowings.
Structured as a REIT, AGNC has historically and currently remains not subject to federal corporate income taxation, but must distribute a minimum of 90% of taxable income to shareholders as dividends. Since its inception, the company has had an extraordinary dividend track record, distributing $1.40 per share for 8 consecutive quarters, until reducing its quarterly dividend to $1.25 per share in February of 2012. Since February, AGNC's dividend has remained stable and continues to distribute $5.00 per share on an annual basis. Throughout the past year, AGNC shares continuously appreciated, trading at $28.00 in mid-November 2011 to its historical high at roughly $36.75 in mid-September. Throughout this period, AGNC generated enormous returns to investors, particularly for those enrolled in the company's dividend reinvestment program.
Primary Risk-Related Hiccups
The most obvious reason for AGNC's outstanding performance is attributable to long-term interest rates being driven to historical lows. This environment was further encouragement for AGNC investors when the Fed announced that these rates would remain at historical low levels, at least throughout late-2014 to 2015. As the year pressed on, QE3 increasingly became imminent, and at the FOMC meeting in mid-September, the Fed announced that it would begin buying millions of agency MBSs per month for the foreseeable future. There are significant implications to this announcement, as the Fed's actions will increase the demand for agency MBSs, raising asset prices for companies like AGNC. However, this was not unprecedented, as "Operation Twist," a similar purchasing program, was introduced by the Fed in late 2011, and AGNC continued to prosper.
The reason that these actions by the Fed actually affect the agency REIT model is due to the fact that with low long-term interest rates, CPR continues to increase as many homeowners refinance at lower rates. When they re-fi, companies like AGNC must purchase more assets to offset. Since the net interest rate spread is being squeezed, coupled with the possibility of the flattening of the yield curve and the likely increase in short-term borrowing rates, which increases funding costs and reduces net interest income, AGNC faces many threats that could be detrimental to the company's performance.
The Onset & Fallout
After the FOMC meeting in mid-September, AGNC released its earnings at the end of October, followed by its official SEC 10-Q filing on November 7. Referring to Figure 1, one may easily misconstrue the Fed's announcement to be the first "trigger-pull" initiating AGNC's period of depreciation; however, I use the word misconstrue, because the initial drop to below $35 ensued on AGNC's ex-date of September 19. Anyone who doubts this suggestion may simply look at the historical prices on virtually every ex-date since AGNC's inception. There are great pricing shifts both before and after AGNC's ex-date, as the high yields attract many investors to buy after dividend is declared, and sell after their dividend is retained. In essence, shares have been selling at a discount immediately following the ex-date, at least throughout the past several quarters.
Figure 1 - AGNC 3-Month Price Chart
I acknowledge the ex-date as the initial "trigger-pull" simply to point out that nothing drastic had really changed. Referring back to Figure 1, it's evident that AGNC was following its normal trend of re-appreciation until roughly October 8, at which point the decline really set in. Right around this time, maybe October 10 give or take a few days, Annaly Capital was downgraded, resulting in a flash-crash across nearly the entire REIT industry. Throughout the rest of October, share price was up and down going into earnings.
When reporting on October 29, AGNC announced, "…comprehensive income for the third quarter of 2012 of $1.3 billion, or $3.98 per common share, and net book value of $32.49 per common share. Economic return, defined as dividends on common shares plus the change in net book value per common share, for the period was $4.33 per common share, or 59% on an annualized basis." There are many other components that are pertinent to analyzing AGNC's performance, but for the purpose of this article, I will not dive too deep into the 3rd quarter financials. I will note the following: net interest rate spread decreased to 1.42%, a much smaller decline relative to that of NLY; quarterly CPR decreased from 10% to 9%, while weighted average CPR increased from 12% to 14%; leverage deceased to 7.0x; $250 million or $0.75 per share was reported as other losses, a product of AGNC being engaged in expensive interest rate swaps for hedging purposes; and to reiterate, net book value per share increased from $29.41 to $32.49, a 10% percent increase throughout the third quarter. Altogether, and taking the economic and market environments into consideration, AGNC reported sound financial performance. Included in the earnings call, management announced plans of a $500 million stock buyback plan to be implemented in the event that shares start to trade below book value of $32.49.
Many financial institutions, including NLY, are increasingly employing similar strategies. Article after article has been written about AGNC's quarterly results. I have no intention of debating these results; rather, I have included them so that the core of this article, which will be addressed next, will be fully understood in the context in which I am interpreting the market's reaction to AGNC and its potential ability to perform and remain solvent in the future. Additionally, in using Annaly in this analysis, I am not criticizing NLY, its performance or strategy; rather I am using NLY for reference, as I believe it to be most comparable to AGNC on many levels.
The Underlying - Following earnings, we enter November. First and foremost, the election comes into play. With great uncertainty, much speculation and increased volatility, the market behaves "abnormally." Moreover, as was announced in September, the Fed is now buying large amounts of agency paper. After the election, nothing has really changed, other than overall market sentiment. Figure 2 charts AGNC's performance over the course of these events, also identifying the most pivotal points.
Figure 2 - AGNC 3-Week Price Chart
On November 12, NLY announced the acquisition of CreXus Investment Corp (CXS), a company specializing in commercial MBSs and other commercial real estate debt. NLY already had a 12% stake in CXS, before acquiring its entire portfolio in order to further diversify its balance sheet. In turn, this acquisition led many to believe that the underlying business model for agency MBSs will no longer be profitable, both an overreaction and a misconception. I believe that NLY's decision to diversify their balance sheet is smart, as the Fed purchasings are increasing demand and price of agency-backed securities, but this is nothing new.
As addressed earlier, Operation Twist was announced last year, and measures taken by the Fed have been long anticipated by both AGNC & NLY, arguably already priced into the market. The problem stems from the strong influence NLY has over the REIT industry. Annaly is the oldest, largest, the industry leader, and has good management, and when they make perceived changes to their overall business strategy, panic sets in, which clearly spreads across the entire REIT industry. What is important to recognize is that NLY's acquisition does not suggest that the agency REIT model has begun to fail. Ultimately, AGNC will likely start acquiring commercial paper too, as Fannie & Freddie are going to eventually dry up, but right now, AGNC continues to have one of the most important pieces of the puzzle, which is stout leadership and efficient and effective management. As market value has taken a hit over the past few weeks, the stock buyback has been implemented.
Closing just under $30 today, up more than 4%. The strategy is already in play, and appears to be working. With a BVPS of $32.49, and a dividend that I fully anticipate remains at $1.25 to be declared in less than a month, I conclude that $30 shares of AGNC are a bargain. As to the horizon, this will require further due diligence, particularly in light of the fiscal cliff. For those who have taken the time to read my opinions, I would recommend stops on shares purchased, dependent on both your level of confidence in AGNC and your particular aversion to risk.
Update - The above was written before market-open on Friday, November 16, and no content has been edited or changed in any capacity. As a follow-up, I would like to note Friday's trading session for AGNC. Opening at $30.26, AGNC traded between $30.15 - $31.22, closing at $30.99, a 3.85% increase. I believe this further supports my positions that the buyback is working to at least some extent, that the price is being corrected from the market's overreaction, and that this two-day upswing trend is by no means over, as AGNC is still trading below book. Moreover, with the current 17.4% yield, the December dividend declaration will undoubtedly give shares an additional adrenaline boost.