American Capital Agency: Off To The Races?

Oct.18.13 | About: American Capital (AGNC)

"And they're off". That's what I heard a lot of today. One of my favorite lines from the Sport of Kings, thoroughbred racing. In fact, a lot of stock picking can be compared to picking horses. There's winners and losers. Solid bets and long shots.

Well as we know, the mortgage real estate investment trusts (mREITs) have been at the back of the pack this year. But, could this be the quarter things finally settle in and turn around for American Capital Agency (NASDAQ:AGNC)? Is this once dividend king finally finding its legs once again? Well there have been some signs this may be the case. The last few weeks of Q3 and the first three weeks into Q4 have been very strong for AGNC. Things are looking much improved in recent weeks after the absolute massacre that has occurred in share price and dividends paid in 2013. Figure 1 shows what has happened to the share price this year.

Figure 1. Year To Date Share Price Of American Capital Agency

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AGNC is down a whopping 25.7% year to date in 2013, primarily as a result of being pressured by a sharp rise in interest rates, a decline in value of mortgage backed securities and subsequent dividend slashes (table 1). I recently laid out several of the key ways that AGNC makes money. While there are a lot of nuances in this process, overall it is not too difficult to understand, in my opinion. Without repeating a lot of information that I have given you in the past, for the purposes of this article we need to keep in mind that at the most basic level, AGNC borrows money at lower rates and lends at higher rates. Primarily, AGNC deals in mortgage backed securities which are just debt obligations that represent claims to the cash flows from pools of mortgage loans. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools agencies that turn them into securities. These are then bought and sold by banks, investors, mREITs etc.

Table 1. Dividend History of American Capital Agency, 2013.

Ex-Dividend Date

Dividend Paid Date

Dividend Amount

12/24/2012

1/28/2013

$1.25

3/18/2013

4/26/2013

$1.25

6/26/2013

7/26/2013

$1.05

9/26/2013

10/28/2013

$0.80

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So Why Is It A Good Start?

While the end of Q3 was good to AGNC, the start of Q4 was even better. At my trading desk today the saying of the day for the mREITs was "off to the races." This wasn't unique to AGNC, which did have a nice 3% pop today after we finally got clarity on the budget/debt mess in Washington DC. Why did the mREITs and AGNC in particular react well? Well, remember what feeds into their profits? The interest rate that AGNC borrows at and the interest rate they lend at determines the all important interest rate spread. As I have stated many times before, this metric is absolutely key because AGNC profits from a wider spread. One of the key rates to watch is the ten-year treasury. The rates on the ten year had risen sharply in the spring and summer. However, figure 2 shows where rates have gone in the last month. Today (10/17/13) the rates on the ten year were down 3.2% to 2.58%, the lowest in a month. So AGNC is "off to the races" this quarter because the ten year has finally settled in. The decrease directly feeds into their spread as AGNC is borrowing at a lower cost and then lending at a higher rate, pocketing the difference. Mortgage backed securities have gone up in tandem with the decline in rates, as expected (figure 3). What this means is that any mortgage products that have been acquired in the last 30 days are now worth more than where they were purchased at. This often benefits financial companies, like AGNC, that hold these products in their portfolio.

Figure 2. Interest Rates on The Ten Year Treasury, Last 30 Days.

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Figure 3. Value Of The 30 Year FMNA 3.0 Mortgage Backed Securities , Last 30 Days.

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Rumors Of Continued Asset Purchases?

As we know the rate at which AGNC borrows is so important. As this rate rises, it is detrimental particularly if the rise is sharp, preventing the company from having proper time to adjust. With Janet Yellen scheduled to take the reins at the Fed from Ben Bernanke, things are looking good for the zero interest rate policy to remain in place. This keeps shorter term interest rates between 0 and 0.3%, so AGNC can borrow money for almost nothing. In the last few years, this has been key to maintaining a favorable spread, borrowing at next to nothing, lending at some predetermined rate. A Yellen Fed is likely to keep this in place. Pressuring the spread somewhat has been Fed purchase programs which can keep the longer term interest rates low as they purchase longer term treasuries. The consistent buying has helped bolster the prices of mortgage backed securities (which in turn keeps rates lower). The fear is that ceasing these asset purchases could lead to a rapid rise in rates and pressure prices, hammering the portfolio of AGNC and other mREITs. No one knows for sure what the slowing of asset purchases will actually do.

The Fed's actions are not the only thing controlling interest rates. If their action had direct control, then why would interest rates have shot up so quickly? That said, with Yellen set to take command, the possibility exists that taper may not occur in a timely manner. Some have opined purchases could increase in early 2014. Bottom line, in this horse race, we have to watch what the Fed does, and pay less attention to what people say. For now, Q4 has started very well. After the upcoming Q3 earnings report and conference call, we should have even stronger clarity as to whether AGNC has found its legs once more.

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.