I previously rated American Capital Agency (AGNC) as among the worst performing mREITs around the unwinding of the third round of easing. My opinions were formed after looking at the structure of the company's investment portfolio at that time. However, the management at American Capital Agency took some actions that were disclosed as they presented at the Morgan Stanley Financial Conference yesterday. Lets how these actions would help American Capital Agency.
The corrective actions
Previously American Capital's investment portfolio was constructed to benefit from lower interest rates. However, the rates did not decrease further as expected by the company's management. As a result, during the first quarter, we saw a 9% decline in the book value, an 11 bps contraction in the spread and profits that were 72% behind prior quarter's profits.
Looking at the situation, the company has attempted to rebalance its investment portfolio to better suit the prevailing rising interest rate environment. It has gotten rid of the lower coupon 30-year fixed rate MBS and the higher pay-up 4% coupon specified pools. Additionally, the company has decided to increase the duration of its hedges and actively manage its assets and hedges from now onwards.
These corrective actions will enable the company to secure its book value and report higher earnings during rising interest rates. However, keep in mind that the book value has already plunged 9% in this quarter so far.
American Capital hints at taking up leverage
While the rebalancing and active management of assets and hedges was a necessity, taking up more leverage during such volatile times is not advisable. Just because its lenders are not putting any pressure on the company to reduce leverage, should not become a pretext of increasing leverage.
American Capital currently employs 5.9 times leverage in its capital structure, compared to 6.7 times employed by Annaly Capital Management (NLY) and over 9 times employed by ARMOUR Residential (ARR). Annaly's less leverage compared to ARMOUR's is considered a cushion against volatility in Annaly's financial results, while ARMOUR's high leverage is considered a negative. Therefore, I believe American Capital should not increase leverage until the risk/ return tradeoff becomes more attractive.
ARMOUR Residential is another pure-play mREIT with a similar situation. Besides, employing higher leverage that will magnify the decline in its book value, it purchased new production MBS recently, which perform worse during a rising interest rate environment. So, ARMUOR's investor should prepare themselves for a significant decline in its book value coupled with some contraction in its spread.
Not all of the pure-play mREITs are facing the same pressure. It seems like Annaly Capital was already prepared for the widening Agency MBS spreads. That's because its portfolio was designed to benefit from rising interest rates. It has other positive stock price drivers, which I discussed in detail, in my prior article. They include lower compensation expense, higher returns coming from CreXus Investment and the book value cushion provided by CRE loans.
American Capital Agency has successfully taken some corrective actions to save itself from being the worst performing mREIT around the unwinding of the QE. However, Annaly Capital is better positioned with an abundance of positive stock price drivers to outmaneuver the prevailing challenging environment.