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Interest rates remained volatile during the second quarter because of the uncertainty around the unwinding of QE. As a result, the mortgage REITs sector suffered the most. The third quarter is no different. Therefore, mortgage REITs, which invest exclusively in Agency residential mortgage backed securities, remain least preferred. American Capital Agency (AGNC) is one such mREIT. However, it was once considered one of the best managed mREITs. Let's see what are the immediate risks faced by the company.

Turbulence prevails

In the short-term, rising rates cause the book value of mREITs to decline. In the long-run, rising rates mean wider spreads. Wider spreads translate into higher dividends ultimately. Also, rising rates would push prepayments down, causing mortgage REITs to realize lower amortization costs.

The Fed is buying Agency MBS aggressively as part of QE3. So, mortgage REITs with exclusive investments in Agency MBS should be more concerned about the immediate-term risks. American Capital Agency and Annaly Capital Management (NLY) are two such mREITs that have large investments in residential Agency backed MBS. So, given the prevailing turbulence, these mREITs will face significant pressure on their book values.

Let's review American Capital Agency's latest performance to see what future potential it offers.

Weaker 2Q performance

American Capital Agency reported a comprehensive loss per share of $2.37 at the end of the second quarter. This is compared to a comprehensive loss of $1.57 per share at the end of the first quarter of the current year. Book value plunged 12% during the second quarter, compared to a 9% decline during the first quarter. So, the overall performance remained weaker during the second quarter.

Further erosion capped

During the quarter, the company used a more defensive approach to re-position its investment portfolio. The management made reductions in the troubled 30-year fixed-rate Agency MBS and added the outperforming 15-year Agency MBS instead. The 30-year fixed-rate securities are considered more vulnerable to changes in interest rates.

Further, management was able to reduce its gap duration extension by 0.1 years for a 100 bps hike in rates. Remember, a lower duration gap means a lower decline in book value if rates go up. In short, you can expect a 6% decline in American Capital's book value if rates go up 100 bps during 3Q. This is half of what the company's book value sensitivity was at the end of the first quarter.

So, it is obvious that American Capital Agency has capped its future book value declines.

Lower earnings potential

However, the 30-year MBS offers the highest yield as it has the highest duration. So, American Capital capped its book value erosion at the cost of lower earnings potential. Also, during the quarter, American Capital added more long-term hedges, which increased its hedge ratio to an all time high. I believe additional costs will be incurred during the third quarter because management is committed to managing its assets and hedges actively. A combination of higher costs and lower average asset yields will result in lower earnings potential for the company, ultimately threatening its future dividend. A research note by Barclays also supports this. Published on July 30th, the report says American Capital Agency is all set to report a 14% dividend cut. The new dividend shall be $0.90 per share for the coming quarter.

Peer analysis

Annaly Capital Management, the largest Agency-only mortgage REIT, is also facing a similar threat. Though Annaly's latest quarter's EPS exceeded consensus estimate, the company has been supporting its dividend by a one-time gain on sale of MBS for a long time. The future of this gain on sale is now limited, which is why its future dividends are under pressure. You can imagine the intensity of the threat when you adjust 2Q core EPS for one-time gains. The adjusted EPS comes out to be $0.31, which is far below the $0.40 per share dividend distribution.

Conclusion

Continued turbulence in interest rates, weak second quarter performance and lower earnings potential are the immediate-term risks faced by American Capital Agency. The only positive for the company right now is that it has been able to cap its future book value erosion. However, since its dividends are in danger now, I recommend investors stay away from American Capital Agency until the management is allowed to add adjustable-rate securities, or the rates stabilize.

Source: American Capital Agency: Dividend Cut In The Cards

Additional disclosure: Equity Whisper is a team of analysts. This article was written by our Financials analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.