Focus of Article:
The focus of this article is to provide a detailed analysis with supporting documentation on the dividend sustainability of American Capital Agency Corp. (NASDAQ:AGNC). This analysis will be provided after a brief overview of AGNC's operations including a discussion of AGNC's real estate investment trust (REIT) classification per the Internal Revenue Code (IRS). AGNC's dividend sustainability analysis will mainly be composed of two calculations (2 TESTS). After these 2 TESTS are analyzed, a discussion of the recent market trends regarding AGNC's investment portfolio will be discussed. These recent trends could have a direct impact on the future sustainability of AGNC's dividend. Therefore, these recent market trends should also be added to this particular topic.
I am writing this particular article due to the high demand that such an analysis be performed. Understanding the REIT tax/dividend payout characteristics of AGNC will provide investors with an overall better understanding of the mortgage real estate investment trust (mREIT) sector as a whole. Due to the fact AGNC has produced an annual dividend yield of at least 15% in years past, many investors turn to this stock (including other stocks within the mREIT sector) as an equity investment which provides an attractive source of dividend income.
From reading this article, investors will better understand how AGNC comes up with its current dividend rate and specific signs when an impending dividend rise or cut would eventually be implemented. At the end of this article, there will be a conclusion on my personal opinion about the overall dividend sustainability of AGNC for several upcoming quarters. A specific analysis of AGNC's dividend range scenarios for the third quarter of 2013 will be discussed in a future article in the near future.
Side Note: I recently wrote a two-part article on AGNC where I projected its income statement for the second quarter of 2013. In a second article, I projected AGNC's book value (BV) for the second quarter of 2013. These two articles set the foundation for establishing figures used within three tables that will be shown as part my dividend sustainability analysis below. It may be wise for readers to first read my previous articles to gain a better understanding of AGNC's accounts and how certain figures are derived. The following are links to the two-part income statement article and separate BV article:
- American Capital Agency Corp.'s Upcoming Q2 2013 Income Statement Projection (Part 1)
- American Capital Agency Corp.'s Upcoming Q2 2013 Income Statement Projection (Part 2)
- American Capital Agency Corp.'s Upcoming Q2 2013 Book Value Projection (As of June 30, 2013)
General Overview of AGNC:
AGNC is classified as an mREIT which earns a majority of its income from investing (through leverage) in agency mortgage-backed securities (MBS). These investments consist of residential mortgage pass-through securities (RMBS) and collateralized mortgage obligations (CMO) for which the principal and interest payments are guaranteed by government-sponsored entities (GSE). AGNC currently has MBS holdings with the following GSE: 1) the Federal National Mortgage Association (Fannie Mae) (OTCQB:FNMA); 2) the Federal Home Loan Mortgage Corporation (Freddie Mac) (OTCQB:FMCC); and 3) the Government National Mortgage Association (Ginnie Mae). AGNC also occasionally invests in agency debenture securities issued by Fannie Mae, Freddie Mac, or the Federal Home Loan Bank (FHLB). For simplicity, agency debenture securities are also generally referred to as MBS.
One of the main goals for AGNC is to preserve its BV while yielding attractive risk-adjusted returns which ultimately are distributed to its stockholders. This occurs through quarterly dividends from the following accounts: 1) net interest income; 2) net realized gains on MBS investments; and 3) various gains from derivative/hedging strategies. AGNC funds its activities mainly through short-term borrowings structured as repurchase agreements (repo loans). AGNC enters into repo loans with a number of major investment banks. These repo loans are structured to pay variable interest tied to the London Interbank Offered Rate (LIBOR) of varying lengths ranging from one month to three years. On top of this variable component, AGNC pays a small fixed interest rate percentage on these repo loans. Within the past several quarters, AGNC has increased its off balance sheet portfolio of "to-be-announced" (TBA) MBS forward contracts. This is an additional source of revenue for AGNC via "dollar-roll" interest income. As such, AGNC's TBA MBS forward contract portfolio can be an alternate/attractive source of financing when the company deems such a strategy appropriate.
Discussion of AGNC's REIT Classification per the IRS:
AGNC currently qualifies to be taxed as a REIT under "Subchapter M" of the IRS. There are numerous REIT provisions that AGNC must adhere by to maintain its qualified REIT status for taxation purposes. However, for purposes of this specific article, we will focus on two specific provisions. First, AGNC is required to distribute at least 90% of its annual REIT taxable income in a given year in order to maintain its qualified REIT status. This provision allows for the exclusion of net capital gains within an entity's annual REIT taxable income amount. If AGNC were to fail this provision, it would be declassified as a REIT per the IRS for four years. This would be an extremely negative outcome for AGNC. As such, AGNC would have to pay taxes at the corporate level on its annual REIT taxable income figure. This would cause an entity level taxation amount of several hundred million dollars based on AGNC's current operations. This would occur because a "dividends paid deduction" would be denied at the entity level under Code Section 562. AGNC would still be able to distribute a dividend, but only after this tax is accounted for. Therefore, a much smaller dividend distribution would occur. As such, sound management would perceive this specific provision as paramount regarding REIT compliance.
Second, AGNC will not be subject to any federal or state corporate taxes if it distributes all (100%) of its annual REIT taxable income to stockholders. AGNC is allowed to treat dividends declared by September 15th and paid by December 31st of a given year as having been a distribution of its annual REIT taxable income for the prior tax year. This is basically AGNC's "paid-in-arrears" provision (AGNC uses the term "spill-back" provision). This is an important concept to understand and will be specifically discussed in AGNC's third quarter of 2013 dividend range scenarios article.
The provisions mentioned above are two of the most important determinants regarding AGNC's quarterly dividend rates for current and future periods. AGNC's management must adhere to the first provision and is highly encouraged to meet the second provision. Regarding the first provision, the tax consequences would be staggering from a shareholder's perspective. If AGNC were to fail this first provision, shareholders and the Board of Directors would basically assume management is incompetent and needs to be replaced.
Estimated REIT Taxable Income Overview:
- See Red References "A, B, C, D, E" in Table 1 Below Next to the June 30, 2013 Column
Before we begin AGNC's dividend sustainability analysis, let us first get accustomed to the information provided by AGNC in Table 1 below. Table 1 is the equivalent to AGNC's quarterly shareholder presentation slide named "Reconciliation of Generally Accepted Accounting Principles (GAAP) Net Income to Estimated Taxable Income". Table 1 shows AGNC's quarterly estimated REIT taxable income from the second quarter of 2013 and goes back to its second quarter in 2012. All figures within Table 1 are for the "three-month" (quarterly) time frame. All (ACTUAL) figures provided in Table 1 below are also derived from AGNC's quarterly SEC submissions via its 10-Q or 10-K where applicable.
Table 1 - AGNC Quarterly Estimated REIT Taxable Income Analysis
The data shown within Table 1 above is part of a larger spreadsheet that performs the 2 TESTS described at the beginning of this article. These 2 TESTS will be analyzed later in the article. I am just describing what the accounts in Table 1 mean regarding AGNC's estimated REIT taxable income calculation and where the information is derived from. This will make the 2 TESTS easier to discuss when the time comes. Let us now take a look at Table 1's accounts (in corresponding order) and briefly discuss AGNC's second quarter of 2013 results.
- See Red Reference "A" in Table 1 Above Next to the June 30, 2013 Column
The quarterly net income figures shown in Table 1 above are derived from AGNC's quarterly income statement. In an article I previously wrote in regards to AGNC's income statement (see links provided above), I explained in great detail how AGNC reported its recent quarterly net income figure of $1.83 billion. This was largely due to a gain on its derivative account of $1.5 billion. A further "in-depth" discussion of the quarterly net income account will not occur in this article. This article's focus is a dividend sustainability analysis. Therefore, please see my two-part AGNC income statement article for a deeper discussion of how the recent quarterly net income figure was obtained for the second quarter of 2013.
Total Book to Tax Differences (Reversals):
- See Red Reference "B" in Table 1 Above Next to the June 30, 2013 Column
In order for AGNC to come up with a proper estimated REIT taxable income figure, there are specific GAAP (book) to IRS (tax) adjustments (reversals) that need to be performed each quarter. Income and expense recognition of certain accounting transactions differ between GAAP and the IRS (book vs. tax accounting treatments).
Certain temporary differences can arise for AGNC near the end of a given quarter. One example could pertain to a sale of an MBS between AGNC and a counterparty near the end of the quarter. GAAP would recognize this sale when an agreement is signed by both parties and a receivable is set up prior to the close of a quarter. However, let us assume AGNC did not actually receive any cash proceeds prior to the close of the quarter. Per GAAP (accrual method of accounting), revenue will be recognized and recorded prior to the close of the quarter because a deal was struck and the likelihood of eventually receiving proceeds from this sale are high. As such, the pending revenue from the sale is recorded like the sale has already occurred (a receivable is set up). However, per the IRS (based on the cash method of accounting), the sale of this specific MBS would not be recognized until the cash was actually received by AGNC in the following quarter. Therefore, for tax purposes, any sales of this nature do not occur prior to the close of a quarter. As such, this transaction (and all other similar transactions) needs to be "reversed".
As shown in Table 1, one major reversal that occurred for the second quarter of 2013 was an unrealized gains reversal of ($1.3) billion. This was a huge reversal and drastically lowered AGNC's estimated REIT taxable income figure for the recent quarter. A major portion of this reversal was unrealized gains in association with AGNC's interest rate swaps and other derivatives. Since most of AGNC's derivatives account consisted of unsold hedging positions, these unrealized gains need to be reversed out for taxation purposes. All unrealized (gains) or losses will continue to be reversed within Table 1 until a realized activity occurs (termination, expiration, or a sale).
AGNC's premium amortization, net account is also another account where timing differences occur. This is a noncash GAAP account that is expensed over the estimated life of the MBS. However, for taxation purposes, this account does not exist because it is a noncash account and was initially accounted for when AGNC made its initial purchase of a specific MBS (cash premium paid "upfront"). Again, book to tax reversals need to be performed regarding this specific account.
There are other, more complex reversals than need to be performed. However, for purposes of this article, further discussion is unwarranted due to the immaterial dollar amounts of these reversals.
Estimated REIT Taxable Income (Including Common Shareholders):
- See Red References "C, D, E" in Table 1 Above Next to the June 30, 2013 Column
After adding back (or subtracting out) AGNC's book to tax differences from net income, one can now calculate AGNC's estimated REIT taxable income account (see red reference "C" in Table 1 above). Once this figure is known, one subtracts out AGNC's quarterly dividend on its preferred shares (see red reference "D" in Table 1 above). Once this is complete, the estimated REIT taxable income for common shareholders figure is known (see red reference "E" in Table 1 above). As discussed earlier, this figure is extremely important for AGNC. Due to the specific REIT provision stating an entity must distribute at least 90% of its annual REIT taxable income to retain its qualified REIT status, AGNC bases its current and future dividend upon this figure. This is not the only figure AGNC uses, but it's an extremely important figure nonetheless.
Now that there is a basic understanding of how AGNC calculates its estimated quarterly REIT taxable income, let us perform AGNC's dividend sustainability analysis. This analysis will be a good indicator of AGNC's current dividend sustainability for the foreseeable future (next several quarters) including whether an impending dividend rise or cut could eventually come to fruition.
Side Note: There are various other indicators and calculations that can help assist or add to one's viewpoint on the dividend sustainability of a company. Some researchers like to prepare some kind of discounted cash flow or "true earnings" analysis based solely on cash. With other sectors or even another mREIT company, I would agree with this notion. However, AGNC's management team provides to the public an estimated REIT taxable income spreadsheet each quarter. Many companies in general do not provide such disclosures to the public because it is not a GAAP requirement. This spreadsheet basically converts AGNC's quarterly net income per GAAP into its taxable net income figure per the IRS. Since AGNC provides this valuable information to the public, a discounted cash flow or true earnings analysis is "trumped" by the estimated REIT taxable income analysis. Since AGNC is classified as a REIT per the IRS, it must pay out 90% of its estimated REIT taxable income in a given year (discussed earlier in the article). Table 1 directly provides information regarding the amount of dividend distributions AGNC must make in a given year. Therefore, the 2 TESTS that will be performed below are a good starting point for an overall dividend sustainability analysis.
TEST 1 - Quarterly Estimated REIT Taxable Income - Common Shareholders vs. Quarterly Distributions Analysis:
- See Red References "E, F, G, H" in Table 2 Below Next to the June 30, 2013 Column
Before we begin TEST 1 for AGNC's dividend sustainability analysis, let us first get accustomed to the information provided in Table 2 below. Table 2 is an extension of the information provided in Table 1. Table 2 shows AGNC's quarterly estimated REIT taxable income figure from its most recently filed quarter (second quarter of 2013) and goes back to its second quarter in 2012 (discussed in Table 1 above). It also shows AGNC's quarterly dividend distributions for the same time period. Table 2 then compares these two figures and shows the quarterly underpayment or (overpayment) of AGNC's estimated REIT taxable income. All figures within Table 2 are for the "three-month" (quarterly) timeframe. All (ACTUAL) figures provided in Table 2 below are derived from AGNC's quarterly SEC submissions via its 10-Q or 10-K where applicable.
Table 2 - AGNC Quarterly Estimated REIT Taxable Income - Common Shareholders vs. Quarterly Distributions Analysis
AGNC does not provide a table that is comparable to the bottom portion of Table 2 (see red references "G, H" in Table 2 above). Therefore, Table 2 is partially created by my own researched data. Let us briefly describe the new accounts shown within Table 2 above.
Distributions to Stockholders from Estimated REIT Taxable Income:
- See Red Reference "G" in Table 2 Above Next to the June 30, 2013 Column
These figures represent the quarterly dividend distributions accrual AGNC makes in regards to its outstanding common shares. This accrual is made in the current quarter and paid the following quarter. AGNC does not directly provide this quarterly distributions figure. However, through research, one can calculate these quarterly amounts via disclosed data.
Underpayment (Overpayment) of Estimated REIT Taxable Income:
- See Red Reference "(E - G) = H" in Table 2 Above Next to the June 30, 2013 Column
These figures represent the quarterly underpayment or (overpayment) of AGNC's estimated REIT taxable income when compared to its dividend distributions on outstanding common shares (see red reference "(E - G) = H" in Table 2 above). Table 2 also includes what percentage of quarterly estimated REIT taxable income is paid out in the form of dividend distributions for additional clarity and insight. AGNC does not provide this specific information as well. However, one can easily perform this calculation.
TEST 1 - Analysis and Results:
For TEST 1, one takes AGNC's quarterly "estimated REIT taxable income - common shareholders" figure (see red reference "E" in Table 2 above) and subtracts this amount by the quarterly "distributions to stockholders from estimated REIT taxable income" figure (see red reference "G" in Table 2 above). If AGNC's red reference "E" is greater than its red reference "G", then AGNC technically has enough quarterly estimated REIT taxable income to pay out via its quarterly dividend distributions. As such, any excess quarterly estimated REIT taxable income will be added to its cumulative undistributed taxable income (UTI) balance. UTI will be discussed further within TEST 2 below. If AGNC's red reference "E" is less than its red reference "G", then AGNC has currently overpaid its quarterly dividend distribution and must use its remaining cumulative UTI balance to help pay for the overpayment in the current quarter.
After performing TEST 1, I conclude AGNC has consistently had ample quarterly estimated REIT taxable income to pay its quarterly common stock dividend until the first quarter of 2013. Prior to first quarter of 2013, only three quarters in AGNC's five-year history had a distribution that was over 90% of its quarterly estimated REIT taxable income. These quarters were the first quarter of 2011, the fourth quarter of 2011, and the second quarter of 2012. Even within these three quarters, the dividend distribution payout ratio never exceeded 95% of AGNC's quarterly estimated REIT taxable income. This was an extremely positive sign. In the second quarter of 2012, AGNC cut its dividend rate from $1.40 to $1.25 per share. After performing this dividend cut, AGNC only paid out a measly 58% of its quarterly estimated REIT taxable income for that quarter. This particular dividend cut was anticipatory due to the gradual decrease in overall market interest rates in the latter half of 2012 (hence an eventual lower yield on its MBS portfolio). People could argue whether the dividend cut was even needed at the time because AGNC's cumulative UTI surplus almost quadrupled in size during 2012. Continuing this past trend, AGNC only distributed a dividend of 65% on its estimated REIT taxable income during the fourth quarter of 2012. This extremely low payout ratio did not even include a dividend cut for that particular quarter.
However, beginning in the first quarter of 2013, AGNC's quarterly estimated REIT taxable income began to show signs of distress. The first quarter of 2013 was not particularly a "pretty" quarter regarding AGNC's quarterly estimated REIT taxable income figure. AGNC only generated a quarterly estimated REIT taxable income figure of $0.50 per share while paying out a quarterly dividend of $1.25 per share. This equated to an overpayment ratio of 282% and a quarterly overpayment of ($322) million. Such a huge overpayment caused AGNC's lofty cumulative UTI balance to lose approximately 43% of its overall balance in just one quarter.
The weak quarterly estimated REIT taxable income figure from AGNC's first quarter of 2013 resulted in a more cautionary outlook regarding its dividend sustainability. This quarter was AGNC's first quarter that has ever shown a truly disastrous figure regarding its estimated REIT taxable income. As such, AGNC declared a dividend cut of 16% or $0.20 per share for the second quarter of 2013. For some interested parties (including myself), this dividend cut was actually less than anticipated given the weak estimated REIT taxable income reported in the first quarter of 2013. The MBS secondary market began to show signs of a material price deterioration beginning in May and continuing through June of 2013. The material price declines were attributed to a rapid "spike" in mortgage and US Treasury rates brought on by the possible "tapering" of the Federal Reserve's (FED) Quantitative Easing Program (QE3). I wrote two separate articles discussing why AGNC will most likely reduce its dividend for the second quarter of 2013. The following are links to those two articles:
- American Capital Agency Corp.'s Dividend Range Scenarios for Q2 2013
- American Capital Agency Corp.'s Q2 2013 Dividend Compared to its Peers
For the second quarter of 2013, AGNC reported a quarterly estimated REIT taxable income figure of $1.04 per share. This was basically in line with AGNC's reduced dividend of $1.05 per share. As such, AGNC's cumulative UTI surplus only decreased $0.01 per share to $1.07 per share. When compared to the first quarter of 2013, this past quarter was a nice "bounce-back" in AGNC's quarterly estimated REIT taxable income. However, AGNC's $411 million of quarterly estimated REIT taxable income for the second quarter of 2013 this far from a figure to overly rejoice from. AGNC's payout ratio was still an elevated 102% for the second quarter of 2013. Compared to past quarters, this payout ratio is "mediocre" at best.
Through the first two quarters of 2013, AGNC has an estimated REIT taxable income available to common shareholders of $588 million. However, AGNC has already distributed $919 million of dividends. When combining both quarters, this equates to an overpayment of ($331) million or a 156% payout ratio. When compared to AGNC's past payout ratios through the first half of the year, 2013 is by far the worst year regarding overpayment of its dividend when compared to its estimated REIT taxable income. Between the years 2009-2012, the worst payout ratio for the first half of the year was 89% in 2011. The best payout ratio of 69% was in 2012. AGNC's 2013 payout ratio through the first half of the year is a pretty glaring deviation from its past results. This is a rather troubling sign for AGNC's future dividend sustainability.
When combining TEST 1 and my recent articles on AGNC together, a good foundation is formed on AGNC's past performance regarding its quarterly estimated REIT taxable income. However, TEST 1 does not come with certain drawbacks and limitations. This is why TEST 1 is only the first of 2 TESTS that will be performed in this article. Also, current market considerations will be addressed after the 2 TESTS are performed. TEST 1 does not specifically take into consider AGNC's cumulative UTI data (see TEST 2). Since TEST 1 does not specifically include this additional feature, it would only be prudent to perform TEST 2 regarding AGNC's cumulative UTI account and see if similar results can be ascertained. TEST 2 needs to be performed to gain further clarity on the sustainability of AGNC's dividend in the coming quarters.
Side Note: A separate "paid-in-arrears / spill-back" provision (TEST 3) that must be adhered to by AGNC will be discussed separately in a future article regarding AGNC's third quarter of 2013 dividend range scenarios.
TEST 2 - Cumulative UTI Balance vs. Quarterly Distributions Ratio Analysis:
- See Red References "I, J, K" in Table 3 Below Next to the June 30, 2013 Column
Before we begin TEST 2 for AGNC's dividend sustainability analysis, let us first get accustomed to the information provided in Table 3 below. Table 3 is an extension of the information provided in Table 2. Table 3 shows AGNC's quarterly dividend distributions and its quarterly underpayment or (overpayment) (discussed in Table 2 and TEST 1 above). Table 3 then compares AGNC's quarterly dividend distributions amount to its cumulative UTI balance for the same quarter. All figures within Table 3 above are for the "three-month" (quarterly) timeframe except for AGNC's cumulative UTI balance. AGNC's cumulative UTI balance is a figure that either increases or decreases quarterly and is presented as an overall figure at a stated point in time. All (ACTUAL) figures provided in Table 3 below are derived from AGNC's quarterly SEC submissions via its 10-Q or 10-K where applicable.
Table 3 - AGNC Cumulative UTI Balance vs. Quarterly Distributions Ratio Analysis:
AGNC does not provide a table that is comparable to Table 3 (red references "G, H, I, J, K" in Table 3 above). Therefore, Table 3 is created by my own researched data. Let us briefly describe the new accounts shown within Table 3 above.
Undistributed Taxable Income (UTI):
- See Red References "I, J" in Table 3 Below Next to the June 30, 2013 Column
UTI is the cumulative balance of past undistributed REIT taxable income after AGNC accrues for its quarterly dividend distributions. AGNC's cumulative UTI balance increases each quarter if the estimated REIT taxable income figure is more than the accrued quarterly dividend distributions figure. The cumulative UTI balance deceases if the estimated REIT taxable income figure is less than the accrued quarterly dividend distributions figure. The cumulative UTI balance is constantly a "running" balance and can be compared to any balance sheet account regarding valuations at a specific point in time.
TEST 2 - Analysis and Results:
For TEST 2, one takes AGNC's "cumulative UTI" (see red references "I, J" in Table 3 above) figure and divide this amount by the quarterly "distributions to stockholders from estimated REIT taxable income" figure (see red reference "G" in Table 3 above). From this calculation, AGNC's "UTI coverage of current dividend distributions ratio" is achieved (see red reference "J / G = K" in Table 3 above). This can also be referred to as AGNC's "UTI per share" amount. The higher this ratio (or per share amount) gets, the more positive the results regarding future dividend sustainability. This ratio shows the amount of cumulative UTI covering the current quarter's dividend distributions amount (after the accrual for the current quarter).
AGNC's cumulative UTI vs. quarterly dividend distributions ratio has gradually increased since the first quarter of 2011. There are a few quarters within the years 2011 and 2012 where the ratio slightly dropped for a quarter. However, the ratio eventually continued to rise higher in subsequent quarters. For the first quarter of 2011, AGNC's cumulative UTI vs. quarterly dividend distributions ratio was only a factor of 0.40. However, by the fourth quarter of 2012, this ratio grew to a factor of 1.76. This was AGNC's highest cumulative UTI ratio ever. This equated to a cumulative UTI balance of $749 million as of 12/31/2012. This was an extremely positive sign at the time.
However, when AGNC reported a very weak first quarter of 2013 estimated REIT taxable income of only $0.50 per share (see TEST 1 above), TEST 2 also began showing signs of stress in regards to AGNC's dividend sustainability. AGNC's cumulative UTI balance vs. quarterly distributions ratio fell from a factor of 1.76 as of 12/31/2012 to only a factor of 0.86 as of 3/31/2013. AGNC's first quarter of 2013 results were extremely negative regarding TEST 2. As mentioned in TEST 1 above, AGNC had a quarterly overpayment of ($322) million in the first quarter of 2013. Such a huge overpayment caused AGNC's cumulative UTI surplus to lose approximately 43% of its overall balance within three months. AGNC's cumulative UTI balance went to $746 million as of 12/31/2012 to $430 million as of 3/31/2013. For just one quarter's worth of activity, this was a huge hit to AGNC's cumulative UTI surplus.
As was the case with TEST 1, TEST 2 showed stabilization during AGNC's second quarter of 2013. As of 6/30/2013, AGNC reported a cumulative UTI balance of $422 million regarding its common shares. Since AGNC cut its dividend during the second quarter of 2013, instead of having to achieve an estimated quarterly REIT taxable income amount of nearly $500 million each quarter before "breaking-even" within its cumulative UTI balance, AGNC now only needs to achieve an estimated quarterly REIT taxable income amount of approximately $420 million to break-even. This is one positive piece of data from TEST 2's analysis. Furthermore, if AGNC were to repurchase more outstanding common shares in future quarters (strong possibility in the current environment), its quarterly break-even cumulative UTI amount each quarter will continue to decrease. Since AGNC's stock price currently resides materially lower than its stated BV of $25.51 as of 6/30/2013, additional equity raises will not occur (extremely low probability; dilution of BV). As such, AGNC's quarterly break-even on its cumulative UTI balance will not increase anytime soon because no equity raises will occur. This scenario will not occur until AGNC's stock price climbs above its current BV. Considering the bearish nature of the market in regards to the mREIT sector, it may be a while till AGNC's stock price climbs above its current BV. Strictly on a cumulative UTI quarterly break-even scenario, this spells good news for AGNC.
Another piece of positive news is that AGNC still has a surplus in its cumulative UTI account as of 6/30/2013. AGNC's cumulative UTI vs. quarterly dividend distributions ratio factor of 0.86 as of 3/31/2013 increased to a factor of 1.01 as of 6/30/2013. Even though this ratio's increase was due to AGNC's dividend cut, any rise to this ratio is good news. To put this ratio in perspective, AGNC had a cumulative UTI vs. quarterly dividend distribution ratio of 0.57 as of 12/31/2011 before a dividend cut in the first quarter of 2012. If future quarters show this ratio beginning to lower once again, the probability of a future quarterly dividend cut would increase in likelihood.
Conclusions Drawn from TEST 1 and TEST 2:
From the 2 TESTS performed above, there is evidence that AGNC's quarterly dividend of $1.05 per share could come under pressure in future quarters. As concluded from both TEST 1 and TEST 2, if AGNC has another extremely weak quarter or several modestly weaker quarters, the future sustainability of AGNC's dividend at the $1.05 per share rate will definitely be in jeopardy. This could occur as early as AGNC's next dividend declaration for the third quarter of 2013. Some negative signs are still being shown regarding AGNC's 2 TESTS. TEST 2 also showed any material quarterly overpayment of AGNC's estimated quarterly REIT taxable income figure would cause the cumulative UTI figure to be greatly reduced. Rather than have this occur, AGNC would seriously consider an additional dividend cut in all likelihood.
However, TEST 2 also specifically showed if only a minor shortfall in estimated REIT taxable income vs. quarterly dividend distributions were to occur next quarter or next few quarters, this minor deficit can be offset by AGNC's cumulative UTI balance of $422 million as of 6/30/2013. Furthermore, TEST 2 showed that due to AGNC's second quarter of 2013 dividend cut, its cumulative quarterly UTI break-even has decreased $80 million from the prior quarter and the cumulative UTI vs. quarterly dividend distributions ratio increased from a factor 0.86 as of 3/31/2013 to 1.01 as of 6/30/2013. This is a positive trend.
From the data presented above regarding the 2 TESTS, there seems to be both positive and negative signs for AGNC's dividend sustainability for the upcoming quarters. Based on the mixed results shown via the 2 TESTS, I felt it was only prudent to include additional research regarding AGNC's current environment regarding interest rates and MBS valuations.
Additional Trends to Consider in a Rising Interest Rate Environment Regarding AGNC's Dividend Sustainability:
In addition to the 2 TESTS performed above, some recent trends that could affect AGNC's future dividend sustainability should be discussed. All these trends will consider a continued modest rise in overall mortgage rates and US Treasury yields for the next several quarters. As the existing MBS market continues to remain volatile from the pressure of rising rates on mortgages and rising US Treasury yields, further stresses on existing MBS valuations could indirectly have negative impacts on AGNC's future dividend sustainability. I feel there are three topics to address regarding these negative MBS price movements and how AGNC currently has directly responded to this volatility.
The first topic to discuss is the recent change in AGNC's MBS portfolio composition. AGNC's management team has taken a "defensive posture" regarding its current MBS portfolio. This was a direct result of the volatile nature of the markets during the latter half of the second quarter of 2013 regarding MBS valuations. AGNC made the conscience decision of lowering its exposure to 30-year MBS which have more pronounced price movements when compared to its 15-year MBS counterparts with similar coupons. This was the main reason why AGNC decided to shift a portion of its MBS holdings into 15-year MBS. AGNC is trying to "defend" its BV through the acquisition of less "price sensitive" 15-year MBS. On a BV perspective, this definitely makes sense and is generally good news. However, along with a less price sensitive 15-year MBS comes an overall lower coupon yield. For dividend sustainability purposes, this could be a cause for concern over a prolonged period of time. Looking at AGNC's second quarter of 2013 data, its overall MBS portfolio yield has actually decreased when compared to the end of the first quarter of 2013. At the end of the first quarter of 2013, AGNC had an average coupon yield of 3.73%. At the end of the second quarter of 2013, AGNC's average coupon yield drops 17 basis points to 3.56%. This was a direct result of "shifting" its MBS portfolio to the lower-yielding 15-year MBS with a similar coupon. In a rising interest rate scenario, if a company were to "re-roll" its portfolio into a higher-yielding coupon with the same composition of 15 and 30-year MBS, average yields should rise. However, this is not currently the case for AGNC because of its increased exposure to 15-year MBS to protect BV. As such, AGNC's estimated REIT taxable income may suffer as a result. This could have adverse effects regarding AGNC's future dividend sustainability in future quarters.
The second topic to discuss is AGNC's portfolio regarding MBS sales. As mortgage rates and US Treasury yields rise in the current markets, the existing MBS that AGNC purchased as investments in past quarters will tend to lose value. As the coupon rate of a particular existing MBS drifts lower and farther away from the current coupon rate offered on a similar type of MBS in the market, the existing lower coupon MBS escalates its valuation losses. As overall rates rise, the holder of a lower coupon MBS must "entice" a potential buyer to acquire this MBS at a discounted principal price. If a seller of a lower coupon MBS does not offer such a discount, all potential buyers would not buy this lower coupon MBS because they would just purchase a newly bundled MBS with the higher current coupon for the same principal amount.
As an indirect comparison to the example described above, AGNC did not have much in the way of net capital gains regarding the sale of its MBS during the past two quarters. This is a direct result of the recent "spike" in interest rate which has caused MBS valuations to materially decrease. AGNC originally purchased a majority of its MBS at higher prices than today's current market prices. Therefore, realized gains from MBS sales will continue to be minimized and negatively impacted in a rising interest rate environment. AGNC may feel compelled to sell certain coupon MBS at losses in order to "re-roll" its portfolio into a higher coupon. This action is generally good news for AGNC's future BV (minimization of unrealized losses). However, this scenario would not bode particularly well for AGNC's estimated REIT taxable income in a given quarter. Instead of realized gains, AGNC may report realized losses on its sale of MBS. AGNC's realized gains on MBS sales have been an important component of its estimated REIT taxable income in past quarters. If rates continue to modestly climb higher, future gains on MBS sales could suffer as a result. Again, AGNC's estimated REIT taxable income would suffer as a result. As was the case with the first topic, this trend could have adverse effects regarding AGNC's future dividend sustainability in future quarters.
The third topic to discuss is AGNC's increased hedging costs associated with an overall larger hedging position to minimize book value losses in a rising interest rate scenario. Again, per a book value perspective, this is a wise decision. However, along with additional hedges come increased periodic hedging costs. Looking at AGNC's second quarter of 2013 data, its overall cost of funds has increased when compared to the end of the first quarter of 2013. At the end of the first quarter of 2013, AGNC had an average cost of funds of 1.32%. At the end of the second quarter of 2013, AGNC's average costs of funds increased 15 basis points to 1.47%. This was a direct result of AGNC increasing its overall hedging position and extending the average duration of its hedges. Again, this does not bode particularly well for AGNC's estimated REIT taxable income figure. As such, this trend could have adverse affects AGNC's future dividend sustainability in future quarters.
As a result of these three topics discussed above (in particular topic two), it was not too surprising to hear AGNC's cautious tone regarding its next quarterly dividend. Per AGNC's second quarter of 2013 earnings call with participants, Chief Investment Officer (CIO) Gary Kain stated the following:
"…However, it is important to point out that our taxable income in the third quarter is currently biased MATERIALLY LOWER given some of the actions we took in both the second quarter and third quarters, which will be realized for taxable earnings purposes in Q3..."
From this quote, it is pretty evident AGNC may have some short-term disruptions regarding the sustainability of its dividend. I'm making the assumption that realized capital losses have occurred when AGNC converted a majority of its TBA MBS forward contracts into regular MBS. When converted, AGNC realizes a net capital loss on the TBA MBS forward contract and carries the newly acquired regular MBS at its stated price/valuation at the time of settlement. The newly stated price/valuation becomes the new cost basis for this type of MBS (cash basis of accounting). These net capital losses can be "offset" against any current or future net capital gains when computing an entity's estimated REIT taxable income for a given tax year. These conversions immediately have a material negative impact on AGNC's estimated REIT taxable income.
Final Conclusion Drawn From All Discussed Material:
Even though AGNC has "stopped the bleeding" in the second quarter of 2013 regarding its estimated quarter REIT taxable income, a continued increase of future mortgage rates and US Treasury yields would have negative consequences regarding TEST 1, TEST 2, and the additional trends regarding AGNC's current portfolio composition. In particular, AGNC's estimated REIT taxable income could be adversely affected by the following trends in conjunction with rising interest rates: 1) an overall decrease in portfolio yield from its increased composition of 15-year MBS to protect BV; 2) a lack of realized gains on MBS sales from continued MBS valuation losses and the conversion of TBA MBS forward contracts to regular MBS holdings; and 3) and overall increase in hedging costs through a larger hedging position and hedging durations to protect BV.
In addition, management has already "hinted" that the estimated REIT taxable income is at a material disadvantage this quarter from transactions that have already occurred in the latter half of the second quarter and into the first half of the third quarter of 2013. This spells trouble regarding AGNC's future dividend sustainability (at least for the next couple of quarters).
As predicted in past AGNC dividend articles, I thought AGNC would cut its second quarter of 2013 dividend to $0.90 per share based on all my past research. When AGNC only cut its dividend to $1.05 per share for the second quarter of 2013, I determined this to be positive news. However, it seems my initial data/prediction may prove to be ultimately correct. I'm predicting a further reduction to AGNC's dividend within the next few quarters. This could begin as early as the third quarter of 2013. A specific third quarter of 2013 dividend per share projection will be provided in a future article (see below).
Final Note: This article excludes a detailed analysis of AGNC's upcoming third quarter of 2013 dividend range scenarios. The article I have written above focuses on AGNC's dividend sustainability in general, regardless of what quarter any dividend change could occur. As such, it is more a broad discussion of AGNC's dividend sustainability. The third quarter of 2013 dividend range scenarios article will focus around AGNC's "paid-in-arrears"/ "spill-back" provision due to the specific timing of the upcoming third quarter of 2013 dividend. This future article will be released within a few weeks (probably late August 2013).
Disclosure: I am long AGNC. 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.