Author's Note: PART 2 of this article is a continuation from PART 1 which was discussed in a previous publication. Please see PART 1 of this article for an initial discussion on the dividend sustainability of American Capital Agency Corp. (NASDAQ:AGNC). PART 1 helps lead to a better understanding of the topics and analysis that will be discussed in PART 2. The link to PART 1's analysis is provided below:
PART 1 mainly dealt with AGNC's past and current performance regarding its estimated REIT taxable income ('ERTI') and cumulative undistributed taxable income ('UTI') figures (including two tests being performed). PART 2 discusses additional topics/trends to consider in a rising interest rate environment and the impact these topics would have on the dividend sustainability of AGNC. PART 2 also includes a brief discussion of AGNC's sister company American Capital Mortgage Investment Corp. (NASDAQ:MTGE) regarding the same topics. PART 2 provides additional support and evidence to the conclusions already discussed in PART 1 of this article.
This two-part article is a very detailed look at AGNC's dividend sustainability. I perform this detailed analysis for readers who anticipate/want such an analysis performed each quarter. For readers who just want the summarized conclusions/results, I would suggest to just scroll down to the "Conclusions Drawn" section at the bottom of the each part of the article.
Additional Topics/Trends to Consider in a Rising Interest Rate Environment Regarding the Dividend Sustainability of AGNC:
In addition to TEST 1 and TEST 2 having been performed in PART 1 of this article, some recent topics/trends that will affect the future dividend sustainability of AGNC should also be addressed. These topics/trends will mainly consider an eventual rise in mortgage rates/U.S. Treasury yields over the next several quarters. In certain instances, I may also talk about the effects of a decrease in mortgage rates/U.S. Treasury yields and the effects that scenario would cause to the specific topic/trend being discussed. I feel the following four topics/trends should be addressed regarding an eventual rise in market interest rates and its impact on the dividend sustainability of AGNC: 1) continued realignment of its MBS portfolio; 2) hedging costs (in particular periodic interest costs on interest rate swaps); 3) taxation impact of realized losses on MBS sales; and 4) taxation impact of a net deferred gain on interest rate swaptions.
1) Continued Realignment of AGNC's MBS Portfolio:
The first topic/trend to discuss is the recent proportional change in AGNC's MBS portfolio regarding its 15-year and 30-year fixed-rate agency holdings. AGNC's management team has continued to take a "defensive posture" regarding its current MBS portfolio. This was a direct result of the volatile nature of the MBS markets during the latter half of the second quarter of 2013 and first half of third quarter of 2013 regarding valuations. AGNC made the conscience decision of continuing to lower its exposure to 30-year fixed-rate agency MBS holdings which are more price sensitive to interest rate movements when compared to its 15-year fixed-rate agency MBS counterparts. (when comparing similar coupon rates). To minimize book value ('BV') erosion was the main reason AGNC decided to continue to shift a portion of its 30-year fixed-rate agency MBS holdings into 15-year fixed-rate agency MBS holdings.
Purely looking at this strategy from a BV perspective, I feel this proportional shift definitely makes sense and was a wise decision on the part of management. However, along with a less price sensitive 15-year fixed-rate agency MBS comes an overall average lower coupon yield. For dividend sustainability purposes, this was a cause for concern back in my last dividend sustainability article for the third quarter of 2013. Looking at the data from AGNC's second quarter of 2013, its overall MBS portfolio yield had 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 dropped 17 basis points to 3.56%. This was a direct result of "shifting" its MBS portfolio to the lower-yielding 15-year fixed-rate agency MBS with a similar coupon.
However, I also noted in a rising interest rate scenario, if AGNC were to "re-roll" its portfolio into higher-yielding coupons with the same proportion of 15- and 30-year fixed-rate agency MBS, average yields should begin to rise. This was exactly what management did in the third quarter of 2013. AGNC re-rolled its MBS portfolio in two major instances.
First, AGNC converted $14.5 billion of its net long TBA MBS position into regular MBS within the first few weeks of the third quarter of 2013. AGNC usually never converts a balance this size that quickly. This was in additional to the fairly large conversion that took place near the end of the second quarter of 2013 regarding its net long TBA MBS position. As such, AGNC converted approximately $26 billion of net long TBA MBS positions into regular MBS within a matter of weeks. Again, in a quickly rising interest rate environment, these specific future securities suffer the largest valuation losses due to the generally low coupon rates originally offered. The weighted average coupon on AGNC's TBA MBS position as of 6/30/2013 was only 3.22% (when including both 15- and 30-year TBA MBS). As such, if AGNC continued to maintain its net long TBA MBS position in a rising interest rate environment, the company would continue to realize material valuation losses every settlement date. Furthermore, AGNC would continue to obtain a relatively low dollar-roll income yield. Either way, this spelt bad news for AGNC if they continued to be net long its TBA MBS position as rates continued to rise.
Second, to take this strategy a step further, AGNC sold a material proportion of their lowest-coupon MBS (especially their 30-year fixed-rate agency MBS holdings) in the third quarter of 2013. Some of the sold MBS were actually the newly converted lowest-coupon MBS from the prior net long TBA MBS position discussed above. As such, AGNC reported a fairly large realized loss in the third quarter of 2013.
Table 5 - AGNC MBS Portfolio Quarterly Change (9/30/2013 versus 6/30/2013)
Using Table 5 above a reference, when comparing its investment portfolio at 9/30/2013 versus 6/30/2013, AGNC had a net par value decrease in its 15-year fixed-rate agency MBS holdings with a 2.5% and 3.0% coupon of ($3.8) billion and ($2.8) billion, respectively. Also, AGNC had a net par value decrease in its 30-year fixed-rate agency MBS holdings with a 3.0% and 3.5% coupon of ($10.3) billion and ($5.5) billion, respectively. In contrast, AGNC had a net par value increase in its 15-year fixed-rate agency MBS holdings with a 3.5% coupon of $8.2 billion. I feel this evidence shows AGNC materially shifted its MBS portfolio in the third quarter of 2013 into less price sensitive 15-year fixed-rate agency MBS while actually increasing its weighted average coupon yield by a modest amount.
Side Note: Table 5 above includes the quarterly change in AGNC's TBA MBS position and hides coupons that had immaterial valuation changes. As such, the "subtotal" balances will not directly "add-up" to the coupons shown above because I had to "hide" some coupons so the 15-year and 30-year MBS holdings would fit all on one table.
From a BV perspective, the shift into less price sensitive 15-year fixed-rate agency MBS should combat an erosion in asset valuations if interest rates once again sharply increase over a short period of time. BV would still decrease, but at a lower percentage when compared to its past MBS portfolio. If market interest rates rapidly decrease over a relatively short period of time, BV would still increase, but at a lower percentage when compared to its past MBS portfolio.
From a dividend sustainability perspective, the higher coupon realignment is positive news for the future dividend. However, it may take a few quarters for this positive effect to fully take effect. I say this because AGNC may continue to shift its MBS portfolio into less price sensitive 15-year fixed-rate agency holdings if the company feels interest rates will be rising in the near future.
2) Hedging costs (Periodic Interest Costs on Interest Rate Swaps):
The second topic/trend to discuss is AGNC's increased hedging costs associated with an overall larger hedging portfolio to minimize BV erosion in a rising interest rate environment. I feel there is one specific hedging cost that should be addressed which has a direct impact on AGNC's quarterly ERTI. This hedging cost is AGNC's periodic costs on interest rate swaps.
Generally, in a rising interest rate environment, AGNC will have a higher net short notional balance regarding its interest rate swaps if leverage and portfolio composition is maintained at the same level. AGNC's interest rate swaps position had a net short notional balance of ($55.7) billion at 6/30/2013. This was a ($4.4) billion net short notional increase when compared to its 3/31/2013 balance. AGNC increased its interest rate swaps portfolio (especially in the latter half of the quarter) to combat rising interest rates (preservation of BV). Furthermore AGNC's net pay rate on its interest rate swaps increased 12 basis points during the second quarter of 2013. As such, AGNC had an increase in its periodic interest costs of interest rate swaps, net account of $19.3 million (quarterly expense of $105.2 million) for the second quarter of 2013.
For most of the third quarter of 2013, AGNC continued to keep a relatively large net short notional balance regarding the company's interest rate swaps. In addition, AGNC's net pay rate on its interest rate swaps increased another 6 basis points during the third quarter of 2013. As such, AGNC had an increased expense of approximately $26 million (quarterly expense of approximately $131 million) in regards to the company's periodic interest costs on interest rate swaps, net account for the third quarter of 2013.
From a BV perspective, the large interest rate swaps net short position would combat an erosion in MBS valuations if interest rates once again sharply increase over a short period of time.
However, from a dividend sustainability perspective, the large interest rate swaps net short position is discouraging news for the future dividend. Since a larger interest rate swaps net short position means a higher hedging cost (under the current environment of extremely low LIBOR), quarterly ERTI and cumulative UTI would be negatively impacted.
However, it should be noted AGNC's interest rate swaps net short position at 9/30/2013 had a notional value of ($50.2) billion. This was a $5.5 billion decrease when compared to its 6/30/2013 balance of ($55.7) billion. This is due to the fact AGNC has slightly less hedging protection under the current interest rate environment regarding the Federal Reserve's ('FED') "non-tapering" announcement in September 2013 and subsequent drop in overall market interest rates (slight increase in the company's duration gap). Another factor to the lowered interest rate swaps balance is the proportional shift into less price sensitive 15-year fixed-rate agency MBS versus 30-year fixed-rate agency MBS (as discussed in the first topic/trend above). As such, AGNC should see a reduced expense in regards to the company's periodic interest costs of interest rate swaps, net account for the fourth quarter of 2013.
This is a small positive sign regarding AGNC's future dividend sustainability. However, if interest rates once again increase at a modest to sharp pace in the future, AGNC would most likely revert back to its prior strategy and increase the company's interest rate swaps net short position. When this scenario unfolds, AGNC will most likely see a decrease in the company's quarterly ERTI due to the increase in hedging costs. This would have negative ramifications regarding the future dividend sustainability of AGNC.
3) Taxation Impact of Realized Losses on MBS Sales:
This third topic/trend is indirectly related to the first topic discussed above (continued realignment of AGNC's MBS portfolio). As discussed within the first topic/trend above, AGNC sold a material proportion of its newly converted TBA MBS holdings and regular MBS holdings with relatively low coupons. Due to somewhat poorly timed asset dispositions, AGNC realized a net valuation loss of ($849) million in the third quarter of 2013 regarding its sold MBS. After a reclassification of its quarterly interest on sold MBS, AGNC recorded a net realized loss of ($733) million in the third quarter of 2013.
I will briefly explain why this material realized loss occurred (using a general example). Typically, as mortgage rates/U.S. Treasury yields rise, the existing MBS that AGNC purchased as investments in past quarters tend to lose value. As the coupon rate of a particular existing MBS holding drifts lower and farther away from the current coupon rate offered on a similar type of security in the market, the existing lower coupon MBS has escalated 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 price. If the seller of a lower coupon MBS does not offer such a discount, all potential buyers would not buy this lower coupon MBS because this purchaser would acquire another MBS in the open market with a higher coupon for the same face amount.
Regarding AGNC's sold MBS, looking back in hindsight a better opportunity would have presented itself if AGNC was more patient and waited until the end of the quarter to unload its lowest coupon MBS holdings. However, management must put the shareholders first and thus erred on the side of caution in the third quarter of 2013. Management did not want to be left with the "short-side of the straw" if the FED did in fact begin to taper their QE3 program in September 2013 thus causing rates to continue to rise at a fairly modest clip. In a sense, AGNC "sacrificed" results in the third quarter of 2013 for a more attractive MBS portfolio going forward. These management actions are generally good news for AGNC's future BV (minimization of future valuation losses). However, this scenario does not bode particularly well for AGNC's ERTI in a given quarter. Due to the initial conversion and subsequent sale of the company's newly acquired regular MBS holdings, including its continued proportion shift into 15-year MBS with a slightly higher coupon, AGNC reported material realized losses for the third quarter of 2013.
Now let us move on to the taxation impact of the realized loss on MBS sales. Due to the fact AGNC did not report any material realized gains for the first and second quarters of 2013, when the company reported its realized loss on MBS sales of ($849) million in the third quarter of 2013, a new scenario regarding taxable income has occurred. Currently, AGNC has capital losses (realized losses on MBS sales) in excess of its capital gains (realized gains on MBS sales) regarding its 2013 tax year. As such, a new scenario has currently presented itself that has a material impact on AGNC's future ERTI figures. This new situation (realized loss on MBS sales) has both positive and negative implications regarding the future dividend sustainability of AGNC. The general movement of future interest rates will dictate whether positive or negative dividend sustainability implications come to fruition.
As mentioned earlier, when there is a modest to sharp rise in interest rates, MBS prices typically decline. As such, the probability of a cumulative unrealized valuation loss on AGNC's MBS portfolio increases. If interest rates continue to rise over a prolonged period of time, the probability of realized valuation losses occurring greatly increases (because of the mounting cumulative unrealized loss). This especially holds true for shortly-held MBS (since premium amortization has not been materially written-off yet). This was the exact scenario that AGNC dealt with in the latter half of the second quarter of 2013 and first half of the third quarter of 2013.
Due to this new scenario (at least new for AGNC), all future net realized losses on MBS sales will be reversed out of AGNC's ERTI account. As such, if interest rates were to rise over a prolonged period of time, all future net realized losses will be deferred and offset against future net realized gains. This is an important concept to understand regarding AGNC's future ERTI and UTI implications. Capital losses (realized losses on MBS sales) in excess of capital gains (realized gains on MBS sales) are NOT deductible from AGNC's ERTI and are allowed to be carried forward for up to five years. This new scenario actually helps AGNC's future dividend sustainability because all future net realized losses on MBS sales will NOT lower AGNC's quarterly ERTI. Do not get me wrong, having net realized losses is never a great scenario for any company. However, purely from a dividend sustainability perspective, this scenario is positive in nature. As mentioned in PART 1 of this article, under the Internal Revenue Code ('IRC'), an entity qualified to be taxed as a real estate investment trust ('REIT') under "Subchapter M" of the IRC must distribute a minimum of 90% of its annual ERTI to shareholders to maintain its REIT status.
Let us now discuss this topic/trend under a different interest rate scenario. Let us say interest rates continue to reverse course and decline once again for several quarters. If this specific scenario occurs, MBS prices typically increase. As such, the probability of a cumulative unrealized valuation gain on AGNC's MBS portfolio increases. If interest rates continue to decline over a prolonged period of time, the probability of realized valuation gains occurring greatly increases (because of the mounting cumulative unrealized gain). This especially holds true for longer-held MBS (since premium amortization has been materially written-off in past quarters). However, now that AGNC has a net capital loss carryforward of ($849) million, all future net capital gains up to $849 million would be netted against this capital loss carryforward and will not be recognized as taxable income. As such, if interest rates were to decrease sharply once again over the next five years and AGNC realizes a material amount of net realized capital gains, these gains would have to be first offset against the capital loss carryforward of $849 million thus NOT increasing AGNC's quarterly ERTI. Purely from a dividend sustainability perspective, this scenario is negative in nature.
AGNC's net realized gains on MBS sales have been an important component of its ERTI in prior years. If rates continue to modestly climb higher, even though the company does not have to recognize its net capital losses on MBS sales, AGNC would also not realize all future net capital gains from MBS sales. As such, AGNC's ERTI would suffer as a result. Therefore, this topic/trend could either have positive impacts or negative impacts regarding the future dividend sustainability of AGNC.
4) Taxation Impact of Net Deferred Gain on Interest Rate Swaptions:
This final topic/trend is indirectly related to the second topic discussed above (an overall larger hedging portfolio to minimize book value losses in a rising interest rate environment). Interest rate swaptions are basically options to enter into underlying interest rate swap contracts. Whereas interest rate swap contracts have no initial upfront costs (gains and losses are incurred as interest rates fluctuate over the life of the swaps), interest rate swaptions have implicit upfront costs (like any typical option contract; generally speaking). AGNC enters into interest rate swaption contracts to help mitigate the potential impact of large interest rates movements thus impacting MBS valuations. Interest rate swaption contracts allow AGNC to "plan ahead" regarding the possibility of entering into future interest rate swap agreements where the swap's notional amount, stated term, and fixed pay rate are contractually stated. If an mREIT is anticipating a prolonged rising interest rate environment, adding payer swaptions to a company's hedging portfolio can be a useful tool.
AGNC has continued to maintain a relatively large net short interest rate swaptions balance due to its defensive posture regarding the possible/eventual interest rate increases (thus causing MBS price declines). If interest rates were to increase at a modest to sharp pace, the added interest rate swaptions will help further reduce the associated valuation losses sustained on AGNC's MBS portfolio because these swaptions have a fair market valuation ('FMV') (aka "mark-to-market") gain (loss) associated to the underlying interest rate swap.
Another important point to understand is if an interest rate swaption expires without being exercised, a realized valuation loss would occur totaling the amount of the premium initially paid upon creation of the swaption. As such, during the third quarter of 2013, AGNC felt they already had enough existing interest rate swaps within its hedging portfolio and therefore took advantage of some of the unrealized valuation gains on its interest rate swaptions. During the third quarter of 2013, AGNC recognized an estimated interest rate swaption valuation gain of $222 million.
However, a new scenario has transpired regarding the realized valuation gains on AGNC's interest rate swaptions. Since AGNC already paid an upfront cost on these swaptions, for tax purposes these interest rate swaption valuation gains need to be deferred and recognized into ERTI over the remaining life of the particular underlying interest rate swap (as if AGNC had converted the swaption contract and kept the underlying swap until termination). As such, this initial lowering of ERTI in the third quarter of 2013 will slightly increase future ERTI over several years.
If market interest rates eventually rise, AGNC may once again feel it has enough interest rate swaps within its hedging portfolio and terminate additional interest rate swaption contracts thus recognizing additional valuation gains that will be need to be deferred over the remaining life of the underlying swaps. As of 9/30/2013, out of the ($20.2) billion net short notional balance regarding AGNC's interest rate swaptions (notional balance of the underlying swaps), ($13.2) billion of these interest rate swaptions have expirations of one year or less. As such, AGNC may deem they do not need the additional interest rate swaps as the swaptions are expiring. As such, a realized valuation gain will most likely occur and must be deferred over the remaining life of the underlying interest rate swap. Currently, the $222 net deferred gain on interest rate swaptions will not have a material impact on quarterly ERTI. However, over time, this topic/trend may add some additional meaningful taxable income to AGNC's ERTI.
Brief Discussion of Additional Topics/Trends to Consider in a Rising Interest Rate Environment Regarding the Dividend Sustainability of MTGE:
Regarding the first two additional topics/trends discussed above, MTGE and AGNC have an extremely similar MBS and derivative portfolio as of 9/30/2013. One minor exception between the two companies is that MTGE has approximately 12% of its MBS portfolio in non-agency securities (when including its net short TBA MBS position) whereas AGNC is currently a pure agency mREIT. As such, MTGE has also continued to shift its MBS portfolio to the less price sensitive 15-year fixed-rate MBS and continues to maintain a rather large hedging portfolio in a rising interest rate environment. However, just like AGNC, MTGE recently has reduced its net short notional balance during the third quarter of 2013. However, the net short notional balance is still relatively high when compared to past quarters. As such, MTGE's periodic interest costs on interest rate swaps could negatively impact quarterly ERTI in future quarters with rates were to rise once again and MTGE adds to its net short notional balance to mitigate BV erosion.
Regarding the third topic/trend, MTGE also had a very similar taxation impact on its realized MBS losses. As was the case with AGNC, MTGE currently has capital losses (realized losses on MBS sales) in excess of its capital gains (realized gains on MBS sales) regarding its 2013 tax year. For the third quarter of 2013, MTGE recognized a net realized loss on MBS sales of ($63.1) million. Similar to what was discussed above regarding AGNC, capital losses (realized losses on MBS sales) in excess of capital gains (realized gains on MBS sales) are NOT deductible from MTGE's ERTI and are carried forward for up to five years. This scenario actually helps MTGE's future dividend sustainability (to an extent) if rates continue to modestly rise and realized MBS losses continue to occur (reverses out of quarterly ERTI).
Regarding the fourth topic/trend, MTGE also had very similar taxation impact on its realized gains regarding its hedging portfolio. In particular, MTGE had realized interest rate swap and swaption valuation gains. During the third quarter of 2013, MTGE recognized an estimated interest rate swap valuation gain of $54 million and interest rate swaption valuation gain of $14 million. As was the case with AGNC, for tax purposes these interest rate swap/swaption valuation gains need to be deferred and recognized into ERTI over the remaining life of the particular swap/underlying swap (as if MTGE had kept the swap until termination/converted the swaption contract and kept the underlying swap until termination). As such, this initial lowering of ERTI in the third quarter of 2013 will slightly increase future ERTI over several years.
Also, MTGE recently announced the company is in talks to acquire a "mortgage servicing rights" ('MSR') company. This could be an attractive addition for MTGE. A key component when entering into this market is the percentage of delinquencies and defaults on mortgage loans of the underlying MBS. If or when MTGE acquires this company, MTGE will either record the MSR as an asset or liability. This determination is based on the amount paid upfront to the originator of the loan (or the "middleman" per se; such as a government sponsored entity ('GSE')) and the estimated total value of the MSR. Typically, the upfront fee to acquire the rights to service a particular MBS is originally reported at its FMV. Subsequent valuation measurements can either be recorded at FMV or by an amortized cost basis. Each quarter, an impairment test would be performed to determine whether the original valuation of the MSR is correctly valued. As such, there is a high level of management judgments that come into play. Additional accounts that would be established are servicing advances (including setting up a proper reserve balance on the receivables), compensatory fees (if applicable), and repurchase reserves (a liability based on the premium added in direct relation to the MSR attached to the underlying sold MBS). Since MTGE stated this deal has yet to be finalized (or established), additional considerations regarding the impact of the MSR acquisition on MTGE's dividend is deemed unwarranted at this time.
Conclusions Drawn From PART 1 and PART 2:
In PART 1 of this analysis, I concluded even though AGNC had "stopped the bleeding" regarding its quarterly ERTI and cumulative UTI amounts in the second quarter of 2013, an aggressive portfolio rebalancing and poorly timed MBS sales in the third quarter of 2013 caused a rather bleak ERTI figure to be generated in the third quarter of 2013. As such, both TEST 1 and TEST 2 showed continued signs of stress regarding the future dividend sustainability of AGNC in the near future (especially TEST 1). However, I also noted that AGNC's ERTI "break-even" has decreased from nearly $500 million in the first quarter of 2013 to only $311 million in the third quarter of 2013. This break-even will continue to decrease as AGNC continues to buy back shares at a material discount to CURRENT BV. However, I felt the positive factors were overshadowed by the growing negative factors pertaining to AGNC's dividend sustainability (especially in the next quarter or two). I further felt if AGNC has another weak quarter or several modestly weaker quarters regarding ERTI, the future sustainability of AGNC's dividend at the $0.80 per share rate will definitely be in jeopardy. I noted this could occur as early as AGNC's next dividend declaration in the fourth quarter of 2013.
Regarding PART 2, AGNC's ERTI could be adversely affected by the following topics/trends in conjunction with rising interest rates: 1) the overall decrease in portfolio yield from its increased proportion of 15-year fixed-rate agency MBS when compared to 30-year fixed-rate agency MBS (to protect BV); 2) the continued fairly high periodic interest costs on interest rate swaps (again to protect BV); and 3) the lack of net realized gains on MBS sales from continued valuation losses due in part from the cumulative unrealized loss position.
However, there are a few positive signs as well. AGNC's ERTI could be positively affected by the following trends in conjunction with rising interest rates: 1) the overall increase in portfolio yield as AGNC stabilizes its proportion of 15-year and 30-year fixed-rate agency MBS and re-rolls its portfolio into higher coupons; 2) the deferment/carryforward of all net capital losses (net realized losses on MBS sales) for up to five years being offset only against future net capital gains (net realized gains on MBS sales); and 3) the continued and increasing deferred interest rate swaption valuation gains accreted back into ERTI.
Specifically regarding the second positive point above, this should help quarterly ERTI keep modest balances going forward (since net realized MBS valuation losses are excluded from ERTI). However, one should understand all possible future net realized capital gains (net realized gains on MBS sales) will be first netted against the capital loss carryforward from prior quarters/years and thus hinder quarterly ERTI as well (neutralizing effect). As such, I feel future material dividend per share price changes should not occur in 2014. However, I feel the possibility still remains for the fourth quarter of 2013.
From all the data presented above, I personally feel the negative evidence overshadows the positive. As such, AGNC's dividend is currently under a rather large deal of stress (at least in the next quarter or two). I feel an additional dividend cut could occur as early as the fourth quarter of 2013. If interest rates continue to climb throughout 2014, AGNC will eventually benefit from continuing to re-roll its MBS portfolio into higher coupon MBS. Again, all future MBS realized losses will be reversed out of ERTI and added to the capital loss carryforward balance. Due to the fact LIBOR will not increase until the FED Funds Rate increases (current estimates are late 2015/early 2016), a potential increase in net spread should eventually occur under a rising interest rate scenario. With that being said, I personally feel a meaningful net spread increase is at least a few quarters "down-the-road". People may argue the net pay rate of AGNC's interest rate swaps will also increase as rates increase. However, AGNC's current interest rate swaps have already "locked-in" its fixed pay rate. Furthermore, all existing interest rate swaptions have its fixed pay rate locked-in as well. I feel the increase in AGNC's weighted average coupon/yield would trump any offsetting slight increases in the fixed pay rate of the interest rate swaps/exercised swaptions.
Finally, it should be noted as of 11/13/2013, AGNC has repurchased approximately 7.2 million of its outstanding common shares during the fourth quarter of 2013. Over the next several quarters, I believe any future dividend cut will be in direct correlation to the number of outstanding common shares that are repurchased in the open market.
Author's Note: This article excludes a detailed analysis of AGNC's dividend range scenarios for the fourth quarter of 2013. The article I have written above focuses on AGNC's dividend sustainability in general, regardless of what quarter any dividend change might occur. As such, it is more a broad discussion of AGNC's dividend sustainability and tends to look over the next several quarters. A future article will focus on AGNC's dividend range scenarios for the fourth quarter of 2013. This future article will be released in December 2013. Also, a recent comparison article by Christopher F. Davis should be read for investors who have an interest in AGNC and/or Annaly Capital Management (NYSE:NLY). The article analyzes several key determinants including BV, interest rate spread, dividend sustainability, leverage, and insider buying. I thought it was a very good, summarized article for both stocks.
Full Disclosure on "Long" Position of AGNC: I have owned AGNC since early 2011. I have gradually increased my position in AGNC when certain pullbacks have occurred. I have also sold minor positions in AGNC when I felt the stock was highly overpriced (late 2012). I have taken both cash and reinvested dividends depending on the stock price of AGNC when the quarterly dividends were distributed. I have also held put options on AGNC prior to the material sell-off a few quarters back. As such, my recent unrealized losses have been mitigated to an extent.
I am "long" AGNC for the longer-term prospects of this specific company. This means I may just "hold" my position during this volatile interest rate environment. It also means I may purchase additional shares when I feel the company is materially undervalued from a "price to book" ratio. Even though I would not necessarily advise starting any initial positions within AGNC during this volatile interest rate environment, I would not explicitly sell any positions as well. Most of the negative catalysts for the mREIT sector have partially been priced into the stock prices already. This is just my personal view of the current situation.
I believe there is a moderate chance AGNC will continue to report a few future quarters that are "disappointing" if interest rates sharply rise thus causing existing MBS prices to quickly decline. However, I believe this situation will not occur. I feel the market has recently "over-panicked" thus causing mortgage interest rates/U.S. Treasury yields to rise faster than they should have. This environment has caused MBS prices to be negatively impacted. Even if mortgage interest rates/U.S. Treasury yields gradually rise, this is not the worst possible outcome for the mREIT sector. The main issue is the "SPEED" and "MAGNITUDE" of the rate/yield moves. Whenever there are "spikes" in interest rates, this usually has negative implications for the fixed-rate agency mREIT sector (variable/hybrid mREITs can have differing results).
As such, I am long AGNC in regards to its longer-term fundamentals and future prospects. This would entail a 1-3 year time horizon. I understand this may not be the most profitable strategy to pursue. However, regarding this specific investment, it's a strategy I feel comfortable with. Again, this may not be the best strategy for some "short-term" investors because of the recent volatile environment regarding the mREIT sector. AGNC is one of many stocks I own and I classify AGNC as a "risky" investment.