I am long Annaly Capital Management, Inc. (NYSE:NLY) but do not have a position in American Capital Agency Corp. (NASDAQ:AGNC) or any other mortgage Real Estate Investment Trust (mREIT). The question I ask is whether I should allocate a portion of my mREIT exposure to AGNC.
QE2, the second round of the Federal Reserve's "Quantitative Easing" monetary policy aimed at stimulating the U.S. economy following the recession that followed the bankruptcy of Lehman Brothers, was announced in the fourth quarter of 2010 and included massive ($600-$900 billion) of long-term Treasury securities. Such purchases drive up prices, and drive down yields, not only of Treasury securities but also of the mortgage-backed securities issued by U.S. government agencies or U.S. government sponsored entities (Fannie Mae, Freddie Mac or Ginnie Mae, together "Agency MBS"), which form the bulk of the asset portfolios of NLY and AGNC. As their asset yields have come down, their interest rate spreads have shrunk:
Figure 1: Declining interest rate spreads Mar 2011 - Sep 2012
Figure 1 indicates NLY's interest rate spreads have experienced a sharper decline.
Under QE3 (announced September 13, 2012), the Federal Reserve launched a new $40 billion a month, open-ended, bond purchasing program of agency mortgage-backed securities - thus directly competing with NLY and AGNC, and driving up the prices (and driving down the yields) of precisely the types of securities these mREITs seek to purchase.
Figure 1 also indicates the gap between the interest rate spreads achieved by AGNC vs. NLY widened considerably between 6/30/12 and 9/30/12.
Both NLY and AGNC rely primarily on short-term borrowings to acquire agency mortgage-backed securities with long-term maturities. Interest rate spreads, together with the shape of yield curve, amount of leverage and Prepayment speeds as reflected by the Constant Prepayment Rate ("CPR") are the key drivers of profitability. In 2009-2010, these factors combined in a manner that permitted these mREITs to provide double-digit dividend yields and produce share price appreciation. Performance in 2011-2012 did not match that of the prior two years, but AGNC shareholders did significantly better than NLY shareholders, as seen in Table 1 below:
Table 1: One-year returns 2008-2012 year-to-date (through 12/26/12)
Cumulative, compound, returns delivered for 4, 3, 2 and 1-year holding periods also show that AGNC shareholders did significantly better than NLY shareholders, as seen in Table 2 below:
Table 2: Cumulative, compound, returns based on 4, 3, 2 and 1-year holding periods
AGNC exhibited lower CPR rates, as shown in Table 3 below:
Table 3: CPR experienced on Agency mortgage-backed securities, annualized basis
The higher the CPR the more of the premium has to be written off and the greater the adverse impact of losing interest-bearing assets generating higher yields. Lower CPR rates played a role in producing the consistently superior net interest margins achieved by AGNC shown in Figure 1. Management explained that it positioned its investment portfolio toward Agency MBS that it believes have favorable prepayment attributes, but this does not do much to clarify how this superior performance was achieved. For purpose of this analysis I accept as a given that AGNC can do a better job at keeping CPR low.
The extent to which net interest income has covered dividends paid, as shown in Table 4 below:
Table 4: Coverage of dividends based on net interest income
Based on Table 4, NLY had higher coverage ratios, and therefore was more conservative in its distributions, for 5 of the last 7 quarterly periods. NLY's management seems to have aligned its most recent dividend to what I consider sustainable cash flow (see article published December 21, 2012). On the other hand, AGNC did not reduce its dividend and I believe it will need to align its dividend distribution to a level that more closely approximates sustainability (see article published December 24, 2012).
Despite its superior CPR rates and net interest margins, AGNC trades at a 17.2% yield compared with 12.2% for NLY. This may indicate a cut in dividend is widely expected. The yields would be roughly equal if AGNC reduced its quarterly dividend to ~$0.90 and if the share price would stay the same. But I don't believe such a sharp cut is expected and think the higher yield reflects a perception that AGNC embodies greater risk than NLY. Total leverage and premiums paid to acquire Agency MBS are a quantifiable measure of this higher risk.
All else being equal, when interest rate margins are positive a more highly levered mREIT should produce better coverage of dividends based on net interest income ratios. AGNC is more highly levered, as seen in Table 5 below:
Table 5: Quarter-end total assets divided by total equity (including preferred shares)
Despite its higher leverage, we saw in Table 4 that AGNC provides lower dividend coverage. I conclude that AGNC is more exposed to sharper dividend cuts should the current adverse business environment facing Agency MBS-centered mREITS deteriorate further, or even stay static.
Another indication of this exposure is the amount of premiums paid to purchase the Agency MBS portfolio. The greater the premium paid, the larger the potential economic loss resulting from prepayment. Both NLY and AGNC purchase mortgage-backed securities at a premium (net of purchases at a discount). But AGNC appears to have been paying higher premiums, as seen in Table 6 below:
Higher premiums paid indicate greater exposure to increases in CPR. AGNC may be able to maintain its CPR advantage over NLY, but if the gap narrows to half its present level, the adverse effect for AGNC will, relative to NLY, be far greater. And, given the lower coverage ratios, the adverse impact on AGNC's ability to maintain distributions will also be far greater.
An additional factor to consider is that NLY also generates investment advisory fee income (~$20 million per quarter). While I do not consider it a core activity and do not include it in my dividend coverage calculations, it nevertheless provides further cushion to NLY's ability to distribute dividends. AGNC is totally reliant on net interest margin. Finally, NLY has taken steps to diversify away from Agency MBS securities.
I do not have a quantifiable measure that would help adjust AGNC's superior CPR rates and net interest margins for the higher risk it embodies. The conclusion I draw from my assessment is that AGNC will cut its dividend, that the resultant stock price decline will be relatively modest, and that it will maintain its yield advantage over, and offer a valuation more compelling than, NLY. This may present an opportunity for me to allocate a portion of the portfolio dedicated to mREITS away from NLY and into AGNC.