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American Capital Agency (NASDAQ:AGNC) invests in fixed rate agency Residential Mortgage Backed Security, or RBMS. With the increasing interest rates in the U.S, the company's revenue is declining, as this increases the cost of funding for REIT companies. The average rate for a 30 year fixed mortgage is around 4.52%. The company's objective is to preserve the book value and provide returns from net interest income. So, it is repurchasing shares and increasing investment in short term fixed RBMS. However, I think the rising mortgage rates will continue to have a negative impact on the company's income statement.

Book value per share of American Capital Agency

(click to enlarge)

In order to maintain its book value, the company is migrating long term fixed investment RBMS to short term fixed investment RBMS. The company has reduced its investment in 30 year fixed rate agency RBMS from 56% in June 2013 to 42% in September 2013.

American Capital Agency's asset portfolio as of September 2013

(Source: Investor Presentation)

The change in portfolio from long term fixed RBMS to short term fixed RBMS is expected to increase the extension risk for the company because extension risk goes up with the rising interest rate for long term fixed RBMS. With the rising interest rate, the company's borrowers don't opt for loan prepayment and instead make scheduled payments on mortgages. This adversely affects the company's revenue as the company has to finance its investment at a higher interest rate with less interest income, and the company loses the opportunity to invest in high yield investments.

The company's change in portfolio from long term fixed RBMS to short term fixed RBMS isn't expected to help it reduce the negative impact of higher interest rates. The interest rates are increasing continuously, and it is expected that in the beginning of 2014, the interest rate on a 30-year mortgage will be more than 4.55%.

Pursuing Share Buyback

American Capital is continuing its share repurchase program in order to increase its book value. The company has repurchased around 11.9 million shares in the third quarter of 2013 at the average rate of $22.16 per share, which is an approximately 13% discount to the book value as of June 2013.

American Capital increased its share repurchase authorization from $500 million in June 2013 to $1 billion and is planning to continue shares repurchase through December 2014.

Assuming that the company repurchases shares at the rate of $22.16 per share, as the current market price of the stock is around $20, I believe the company can repurchase around 45.12 million shares by December, 2014. This amounts to around 9 million shares every quarter for the next five quarters including the fourth quarter of 2013.

American Capital had a net loss of $701 million in the third quarter of 2013, and the number of outstanding shares is currently 384.3 million. With the rising interest rate, I believe the company will suffer losses in fourth quarter. Keeping net income constant, and reducing the number of outstanding shares to 373.3 million, I estimate the loss per share to increase from $1.80 to $1.87 in the next quarter.

This will continue to worsen, as the company's revenue is expected to decline in long run with the rising interest rate.

(click to enlarge)

(Source: ychart)

Competitors' action plan

The biggest competitor of American Capital Agency is MFA Financial (NYSE:MFA). Despite the fluctuating interest rate, the company is performing well. Its net interest rate spread increased from 2.22% in the third quarter of 2012 to 2.24% in the third quarter of 2013. The reason for increased net interest rate spread and increased revenue is the company's strategic portfolio diversification.

Investments in non-agency assets have paid well to the company because the interest rate on the company's borrowings are floating and return which the company receives as interest from non-agency securities are also floating. The net interest rate spread on agency assets declined from 1.13% in the third quarter of 2012 to 1.01% in the third quarter of 2013, and the net interest rate spread on non-agency assets increased from 4.24% in the second quarter of 2012 to 4.42% in the third quarter of 2013. I believe the net interest rate spread will increase in the long run thanks to improving economic conditions and the company's increased investment in non-agency assets.

Another competitor, Anworth Mortgage Asset Corporation (NYSE:ANH), invests primarily in agency mortgage based securities, or MBS. The company's net interest rate spread reduced from 1.08% in the second quarter of 2013 to 0.82% the third quarter of 2013. I believe the company's income and net interest rate spread will likely be affected by market conditions. Anworth invests in adjustable rate mortgages, or ARMs, which are subject to minimum interest rate payment. This means the interest rate payment on the company's borrowing rises with the rise in interest rates. On the other hand, the interest rate the company receives on mortgage assets is limited. This gap is expected to decrease the company's revenue with the rising interest rates in the U.S.

Conclusion

American Capital Agency is attracting income investors by paying significant dividends. The company has a trailing annual dividend yield as 21.80% as of November 28, 2013, and its forward annual dividend yield is 15.70%. In the long run, I expect the dividend yield to decline due to declining net income and revenue. Although the company is increasing its investment in short-term fixed RBMS, I believe stock price is likely to decline with the increasing interest rates. I recommend selling the stock.

Source: Rising Worries For American Capital Agency