The first quarter results from American Capital Agency (NASDAQ:AGNC) provide a short-term picture of what could go wrong in the mortgage REIT sector if mortgage-backed security rates and prices change rapidly. While management at American Capital Agency believes the quarterly results were due to a temporary disruption in the MBS markets, the results do point out that the profits of the leveraged mortgage REITs are driven by factors that the companies cannot completely control.
Book Value Drop
American Capital Agency reported that the company's book value per share had declined to $28.93 at the end of the first quarter, off 8.6% from the year end value and down 11% from the book value peak of $32.49 at the end of Q3 2012.
During the earnings conference call, the cause of the book value drop in the quarter was attributed to falling MBS prices when the financial world feared an early end to the Fed's QE3 bond buying program. Currently those fears have abated since the Fed recently indicated no plans to slow its purchase of agency MBS.
Management at American Capital Agency states that its metric of total economic return, consisting of book value change plus dividends paid as the best way to judge the return from the company. For the 2013 first quarter, that number was a negative 4.6% compared to a positive 1.25% for the last quarter of 2012.
Spread Income Good News
On the good news side, American Capital Agency reported $1.19 per share of net spread income for the quarter, nearly covering the $1.25 dividend. This is much better than the 89 cents reported for the Q4 2012. The higher spread income was due to 40 cents worth of "dollar roll income", a strategy which was covered in my article: American Capital Agency Shifts Gears To Profit From Fed MBS Purchases. The dollar roll or net carry income has set American Capital Agency apart from its peers over the last half-year.
However, the company reported just 50 cents of taxable income for the quarter after booking some realized losses. As a result, undistributed taxable income dropped to $1.08 per share from the $2.21 of UTI at the end of 2012.
During the earnings conference call, management from American Capital Agency discussed that their strategy is to hedge against large interest rate changes and that those hedges do not work as well against the smaller rate swings experienced during the first quarter of 2013. My analysis is more along the thought that MBS rates can experience changes that are much different than rates on other bonds, primarily Treasury rate, which are the actual rates being hedged. Presentation slides from the conference call showed that 2, 5 and 10-year Treasury rates hardly budged during the first quarter while MBS prices dropped by up to 1.75%. If your bond portfolio is leveraged 7 to 8 times, a 1.5% value change puts a serious double digit dent in the book value.
For the past 3 years or so, the mortgage REITs have been fighting the battle of rapid principal prepayments in a falling rate environment. The first quarter results from American Capital Agency shows what can happen when rates increase and extension risk becomes the issue. With higher rates, prepayments slow, average maturities extend and MBS prices fall. It will be interesting to see how well the interest rate hedges the mREIT companies are using actually perform when mortgage rate start to rise.
As the second quarter moves into its second month it seems the rising rates/falling prices scare in the MBS market was short-lived - at least for now. After two sub-par quarters in a row, investors in American Capital Agency will be looking for some stability in the book value per share.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.