Last week, American Capital Agency Corp. (AGNC) announced and priced a secondary stock offering of 50 million shares. The offering should raise about $1.58 billion, before expenses. Additionally, the Company granted the underwriters an option for 30 days to acquire up to an additional 7.5 millions shares, which they will likely do. The offering is expected to close on March 5, 2013.
American Capital Agency is a mortgage REIT that exclusively buys residential mortgage-backed securities that are backed by federal agencies. Mortgage REITs like AGNC generally pay out substantial dividends that are taxed as income and not at the lower corporate dividend rate. REITs must distribute at least 90 percent of their income in order to avoid being taxed at the corporate level. Because of this, many REITs and especially mortgage REITs tend to issue equity through secondary offerings like this one.
Last year, AGNC had two secondary stock offerings, and the company had four in 2011. These secondaries have helped AGNC balloon in size. It is now the second largest publicly traded mREIT, and after this secondary is completed it will have a market valuation of around $12.3 billion, making it around ten percent smaller than Annaly Capital Management (NLY), the largest mREIT. If AGNC continues to issue secondaries and/or outperforms Annaly from here, it may become the largest mREIT some time this year.
In late October, AGNC announced a stock buyback program of up to $500 million. At that point, the company noted that "it would be its intent only to repurchase shares when the repurchase price is less than its estimate of the current net book value of a share of common stock." The company generally provides book valuations with its quarterly reports, which will note the value at the end of the prior quarter, but the book value of an mREIT will fluctuate on a day-to-day basis.
At the time when AGNC announced its buyback program it appeared likely that AGNC shares were trading below their book valuation, or at least below the value at the end of Q3 2012, which was reported on October 29, the same day that the share repurchase plan was announced. The buyback also came about two weeks after Annaly announced its own repurchase plan for up to $1.5 billion, which also sought to acquire shares below book value.
More recently, AGNC has been trading at or above its last stated net book value of $31.64 per share. Share repurchasing appears far less probable while above book value, but the companies may maintain the plans so that they are able to acquire shares if they do again trade at a discount. While at a premium to their net book value, secondary offerings can be accretive to existing shareholders.
Though AGNC does try to make profit through the buying and selling of its portfolio, many of its sales are compelled through prepayment rights that are built into the securities. Prepayments occur for various reasons, including borrower default, borrower refinancing and even agency refinancing. Agency-backed mortgages are guaranteed by government-sponsored entities such as Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB) and pay a yield that is generally slightly higher than a similar length Treasury. Most agency-backed paper is callable by the issuing agency, and when the agencies issue new paper at low rates they often use the proceeds to prepay existing paper that has a higher interest rate.
Mortgage bond investors risk losses when buying debt for more than par, or above the bonds call rate when it is above par. Declining interest rates have pushed up the prices of previously issued long term debt, including agency paper. Historically low rates have made the portfolios held by most agency mREITs susceptible to a significant book valuation haircut through prepayment losses.
Agency prepayments spiked in the second half of 2012, but in the first half of the year, AGNC noted that it "repositioned the portfolio during the quarter into lower coupon MBS and lower loan balance and HARP securities, which are less susceptible to prepayment risk, reducing the impact of the decline in long-term interest rates on the company's prepayment forecast."
The move worked out well for the company, which had about half the rate of prepayment of its peers like Annaly and Hatteras (HTS). Nonetheless, AGNC last reported having an unamortized net premium balance of $4.4 billion at the end of 2012, which means there is the potential for substantial prepayment losses if the mREIT's prepayment rate increases in the future. So far, AGNC has done an excellent job of managing that risk.
Agency mREITs have often issued secondaries at about the same time as their peers, but it is possible that Annaly will not mimic this move by AGNC, given that it has recently made a move to acquire a commercial mREIT, Crexus Investment Corp. (CXS), for about $872 million. Annaly already owns 12.4 percent of Crexus and offered to pay $13 per share in cash for the remaining stock, valuing the company at about $996 million. This move into alternative mortgage paper may indicate that Annaly is wary of acquiring more agency debt at the point in time, and that it is instead looking for higher yielding options to complement the portfolio.
Historically, investing in AGNC at or around a secondary offering price has been a profitable endeavor. While it is unclear whether this time will be any different, the risk of losses should increase along with the company's unamortized premium balance and leverage rates. Nonetheless, Gary Kain, the president of AGNC since January of 2009 and the REIT's Chief Investment Officer since April of 2011, has done an excellent job of managing these risks so far.
Mr. Kain is well versed in agency debt and previously worked at Freddie Mac as Head Trader (1995-2001), Vice President of Mortgage Portfolio Strategy (2001 to 2005), Senior Vice President of Mortgage Investments and Structuring (2005 to 2008) and Senior Vice President of Investments and Capital Markets (2008 to 2009). Given his experience and track record of performing at AGNC, investors are likely to continue extending him the freedom to manage as he desires, with the expectation he knows the business about as well as anybody else in the market.
Disclosure: I am long NLY.