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American Capital Agency Corp. (NASDAQ:AGNC) is a mortgage REIT that invests primarily in fixed rate Agency RMBS. As many know both U.S. Treasury bond yields and U.S. mortgage rates went up dramatically (roughly 100 bps) during Q2 2013. This caused pandemonium in the Agency RMBS markets. The Agency RMBS fell dramatically in book value as new mortgage rates climbed far above the previous quarter's values. In June the Agency RMBS markets almost seemed to panic as many Agency RMBS investors had to sell some of their assets in order to maintain safe capital levels (safe leverage levels). Most Agency fixed rate mortgage REITs are highly leveraged at 7x-10x. In AGNC's case it likes to maintain leverage of 8x-9x.

This leverage level led to a truly terrible "other comprehensive income" loss of -$6.89 per common share in Q2 2013. This was primarily comprised of net unrealized losses on agency securities due to the combination of higher interest rates and mortgage rates and wider spreads in the MBS market. When I mention spreads here, I am talking about the spread that is applied on top of the indexed interest rate for mortgages. When this expanded by say 6-10 bps for Agency fixed rate mortgages from the end of Q1 2013 to the end of Q2 2013, it was completely unhedged with interest rate hedges. This translated directly into book value losses. Of course, the interest rate / mortgage rate related raises of about 100 bps for Q2 2013 still accounted for the bulk of the losses. The following chart of the 30 year Fannie Mae 3.5% RMBS shows just how dramatic the Agency RMBS value changes were during the latter half of Q1 2013.


(Click to enlarge)

The hedging helped defray a lot of these losses. Still even with hedging, AGNC had a book value loss of -$3.42 per common share. This led to a June 30, 2013 book value of $25.51 per common share.

The semi-good news is that the net interest spread, which was at 1.87% with dollar roll income (and 1.52% without dollar roll income) at the end of Q1 2013, remained relatively steady at 1.86% with dollar roll income for Q2 2013. However, it did fall to 1.59% with dollar roll income at June 30, 2013. This could put AGNC's dividends in question going forward. In fact AGNC had already lowered its dividend for Q2 2013 to $1.05 per common share for Q2 2013. This still amounts to a 19.2% dividend at the July 29, 2013 closing price of $21.85, which is still an excellent dividend.

For Q2 2013 AGNC earned $1.15 in net spread and dollar roll income per common share. It had estimated taxable income of $1.04 per common share. It bought back 0.3 million common shares. It also had $1.07 of estimated undistributed taxable income per common share as of June 30, 2013. All this means that the dividend is not immediately in danger. However, the lower net interest spread of 1.59% as of June 30, 2013 (-0.28% lower than on March 31, 2013) indicates that the dividend could come under pressure again in Q3 2013.

Arguing counter to this, AGNC had an 11% actual portfolio CPR (constant prepayment rate) for Q2 2013. However, it forecast that the average projected portfolio life CPR as of June 30, 2013 would be 7%. This means more profits in the future. The higher mortgage rates will also eventually mean more profits (a higher net interest spread) down the road. Further the settling down of the Agency RMBS market should help AGNC recoup some of its lost book value and some of its net interest spread income. AGNC paid a high price for the high volatility in Q2 2013. Many expect the volatility to be lower going forward. Anyone who has looked at a chart of the VIX knows this is likely true. The end of June 2013 high volatility was likely the top of a spike in for the Agency RMBS markets.

AGNC looks like it may be a buy again, especially since its book value at $25.51 is significantly above June 30, 2013 book value. Further AGNC has likely regained a bit of the lost book value so far in July. Volatility has calmed a bit. The mortgage rate curve has flattened or ebbed a bit too. AGNC is a strong hold or even a buy. In fact if the newly higher mortgage rates slow the housing market significantly, the Fed would likely pull back on ending QE bond buying soon.

Many expect weakness in the U.S. and world economies in 2H 2013. For example the HSBC Flash PMI for July for China was 47.7 (contraction). If world economic slowing occurs, the Fed might well continue QE for much longer than currently expected. Life is uncertain. The markets are too. You can only bet on what you see; and currently the near 20% dividend paying AGNC looks like a decent bet in a very uncertain market. One can always sell AGNC if the situation changes appreciably.

The two year chart of AGNC provides some technical direction for this trade.


(Click to enlarge)

The slow stochastic sub chart shows that AGNC is neither overbought nor oversold. The main chart shows that AGNC seems to be trying to put in a solid base. It has fallen dramatically in the last few months. For those investors with a little daring AGNC may be a buy currently. For those who want more surety before they buy, it may be appropriate to wait to see the results of Q3 2013 before buying. I and many others think the net interest spread should widen significantly by the end of Q3 2013. Such action would almost certainly make AGNC a buy.

The average analysts' recommendation is 2.4 (a weak buy). The CAPS rating is four stars (a buy). There are no guarantees with stocks, but AGNC has been one of the better run mortgage REIT companies over the last few years. Its management team is likely to be able to cope with the current environment. However, investors should be willing to put up with a rocky ride. The recent sell off is unlikely to be the only one encountered in the next few years.

NOTE: Some of the fundamental financial data is from Yahoo Finance.

Good Luck Trading.

Source: American Capital Agency Corp. Had A Bad Q2, But It Wasn't As Bad As Many Expected