The Fed has finally signaled that it will start tapering its massive bond buying program later this year, while a complete halt is in sight by mid-next year. The latest update by the Fed will further increase volatility in the interest rates, which started in mid-May this year. Since May, the mortgage REITs sector has skydived on concerns of book value erosion. Some mREITs were hit harder than others. American Capital Agency (AGNC) is one such mREIT. Looking at the company's future, analysts at Barclays have downgraded it to equal weight. Let's see what were the reasons behind this downgrade and why the corrective actions taken by its management proved sufficient.
Increased volatility in the markets
Since the start of the speculations about the Fed's exit, the mortgage markets have seen tremendous volatility, causing American Capital Agency and Annaly Capital Management (NLY), the two largest agency mortgage REITs, to report 8.6% and 4% respective declines in their first quarter book values.
You might notice that the decline in American Capital's book value is over twice that of Annaly Capital's. That's because American Capital Agency was not prepared for the volatility and the rising interest rates environment.
Looking at the situation during the first quarter, the management at American Capital took some corrective actions with the objective of protecting the book value from a further decline. At the same time, the management also recognized that the company's book value had further plunged 9% since the beginning of the second quarter.
So, the management decided to reduce its exposure in the 30-year fixed rate residential MBS. This security is considered to be highly sensitive to changes in interest rates due to its longer duration. Besides, the management decided to manage its assets and hedges more actively in order to create attractive investment opportunities as the situation unfolds.
At the same time, the management displayed its intensions of increasing its leverage as the company was not under any pressure from its lenders to decrease leverage. However, I believe this would not be advisable given the increased volatility.
What led to the downgrade?
Now, while the above actions will make the company's book value less sensitive to changes in the interest rates, it will also cause the company to earn less return in the coming quarters. Let's see how.
First, the 30-year fixed rate agency residential MBS is the highest yielding asset for an agency mREIT. For American Capital, it was a major part of the entire investment portfolio. Reducing its exposure would mean less average asset yields in the coming quarters. Also, the active management of assets and hedges needs additional costs. So, a combination of the two would mean compressed bottom line for American Capital Agency in the coming quarters.
Besides, analysts at Barclays believe that the corrective actions taken by American Capital Agency's management are not sufficient to protect its book value from eroding further.
American Capital Agency announced a 16.6% dividend cut when it declared its second quarter's dividend rate of $1.05 per share.
I am still bullish on American Capital Agency. The two major concerns for the company's rating downgrade were fears of a further decline in the book value and the reduced earnings potential. While I believe the book value will erode further, I don't think the corrective actions taken by American Capital hinder its earnings potential so much. That's because, we have ignored the fact that the rates are climbing and the agency spread is widening. So, American Capital Agency will benefit from this widened spread and produce higher earnings in the coming quarter to sustain its current dividends.
Disclaimer: The article has been written by Equity Whisper's financials analyst. Equity Whisper is not receiving compensation for it (other than from Seeking Alpha). Equity Whisper has no business relationship with any company whose stock is mentioned in this article.