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American Capital Agency Corp (NASDAQ:AGNC) is a high dividend yielding mREIT. Over the last couple of years REITs in general have become somewhat of a fad among segments knowledgeable investors.

This article is aimed at both novices and seasoned investors alike who are interested in taking a small step back from all the abbreviations and general technical nonsense in order to consider some of the following basic questions. What does AGNC actually do? How does this lead to their double digit dividend? What risk factors do they face going forward (in particular in light of the recent earnings miss and price drop)? Finally after considering these basic questions, we will be in position to give a recommendation regarding investing in AGNC, again in particular in light of the recent earnings miss.

What does AGNC do? And how does this lead to their double digit dividend?

AGNC invests primarily in mortgages (formally mortgage securities or MBSs) guaranteed by the US government, where both the principal and interest payments of the mortgages are guaranteed. It is for this reason that you may sometimes see people referring to AGNC as a "safe haven." The thing is, safe investments, cannot generate the 15% dividend that AGNC offers its investors. So what AGNC does next is to take these investments in guaranteed mortgages and sells them to a "repo," or a company that fronts them the cash from the investment at a cost of roughly .5% currently (this .5% figure is highly dependent upon interest rates as well as speculation regarding interest rates). Moreover, the repo purchaser lends out only 95% (according to the most recent 10K) of the value of the investment it purchases (again this 5% figure is dependent upon interest rates). The rest is kept as a collateral for the repo purchaser. Then AGNC takes the roughly 95% of its original investment amount and iterates this process by making another investment in mortgages guaranteed by the US government.

In theory, this process give what mathematicians call a geometric series. Specifically, starting with roughly 10B investment in mortgages, in the next iteration, they can make an additional 9.5B investment in mortgages, then a 9.025B (9.5*9.5) investment….The sum of this 10+9.5+9.025+…= 10/(1-.95)= 200B. In other words given current market conditions, AGNC can invest up to 200B worth of mortgages. This would give a leverage ratio of 20:1. In practice, according to their most recent 10K, AGNC has a stated goal of keeping their leverage ratio between 6-11. Currently the leverage is between 7-8.

Now, it is clear how the double digit dividend kind of profit is earned. Specifically with a leverage ratio of roughly 8, and a cost of borrowing of a half a percent, AGNC can earn a 15% return (on its original 10B investment) by merely earning roughly a 2% return on its mortgage investments.

Note: All the numbers here while not entirely precise, are roughly correct and are used for the ease of the exposition.

What are the risk factors AGNC faces?

Now that we know how AGNC operates, we can clearly see the risk factors they face. Given the scale and diversity of the investments, the primary risk factor is not due to the investments themselves, after all they are "safe havens," but instead to interest rate risk. Specifically, as interest rates change, their whole well oiled money printing machine of an operation described above, becomes unhinged. Significantly, if interest rates increase suddenly, then while AGNC's return of 2.5% from mortgages is only mildly changed (because of the prevalence of fixed rate long term mortgages. In fact, over 60% of AGNCs portfolio is in 30 year fixed rate mortgages.) the charge of repo purchaser is increased in theory by precisely the amount of the interest rate hike. In fact, if the change in interest rates is say 2 percent, because of the aforementioned leverage, this could turn AGNC into a money losing hole. Moreover, an increase in interest rate may also have the effect of increasing the 5% collateral rate thus potentially limiting the maximal leverage ratio that AGNC can achieve. For instance if the 5% collateral rate were to become 10%, then using the geometric series calculations from above, AGNC would only have a potential maximal leverage ratio of 10.

In more technical terms, an increase in interest rate risk, and in fact even a scare that such an interest rate hike may be looming as seems to have been the case in poor recent earnings announcement, adversely affects the Book value of AGNC.

It should be stressed that by the above, a slow and steady change in rates in either direction does not represent a significant risk to AGNC.

Recommendation

AGNC had a rough quarter, shaving off $1.57 in book value. But if you look carefully, they actually gained $.64 in income, but lost $2.21 in primarily what was due to unrealized loss in investments marked to market. Being as the Fed seems intent on keeping rates low and STABLE for the near future, and because the market this morning already has given AGNC an over $2 haircut (keeping the Price/Book ratio just above 1.), now with the price below $31 may be a good time to add a small portion of AGNC to a diverse portfolio. Wells Fargo seems to believe this as well.

AGNCs dividend of 15% must be attractive to any investor. Although an honest investor must realize that the 1.25$/qtr dividend is by no means guaranteed after this year. [The dividend is based on earnings and the fact that a REIT has to distribute at least 90% of earnings to shareholders.] In fact, my assumption is that it may decrease next year slightly, but as long as the unemployment rate remains above 6.5% hence keeping the Fed involved, AGNC should be able to maintain a double digit yield as well as a pretty stable stock price (the beta is .26!). In sum, AGNC still looks like a nice investment, and perhaps particularly so using the earnings miss as a discounted entry price. Nonetheless, an investor in AGNC must be an active investor. Sitting and holding forever with AGNC can be pretty dangerous.

Source: The ABCs Of An mREIT And Its 15% Dividend Yield