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American Capital Agency Corp. (AGNC) is a mortgage REIT company, which primarily invests in residential mortgage-backed securities and collateralized mortgage obligations. Both its principal and interest payments are guaranteed by government-sponsored entities. Although the company has experienced a poor third quarter, I remain bullish on the company as it trades at a significant discount to its book value and offers an exciting double digit dividend yield. Furthermore, I believe that the Fed's tapering does not pose a serious threat to the company, and in the past, the market has overreacted to the news of tapering. Also, the company is now well equipped to deal with a gradual rise in interest rates with its defensive approach.

Finally, the Fed started to cut down on its asset purchases, as it sees more encouraging economic indicators, especially in the job market and retail sales. However, the inflation figure was below the Fed's expectations, which might have restricted them to only cut $10 billion.

I believe that there are two positive takeaways for investors. Firstly, the Fed is expected to slowly cut down on its asset purchases by the end of 2014, which means that there will be no panic in the market and interest rates will slowly increase. It will help mortgage REIT companies manage their book values in an effective manner, unlike the large decline in book values for mortgage REITs in the last 6 months, which hurts the bottom lines of the companies and eventually forces dividend cuts. Furthermore, the Fed currently has no intentions to change short-term interest rates.

Secondly, it is important for investors to realize that in the past, mortgage REITs performed well with a rising interest rate when it was backed by strong economic growth. Bernanke, the Fed chairman, has made it clear that the strong economic data is the key determinant of its cut down in asset purchases. In a recent report, it was highlighted that new claims for unemployment benefits have hit a new low in nearly a month, which means we can again expect improvements in the job market for the month of December. Also, retail sales have improved because of various discounts and promotions. So, I think the economy has been showing steady signs of improvement and this momentum could be carried to this year as well.

Valuation

(click to enlarge)

Source: ycharts.com

The company has historically been trading at a premium to its book value, as shown in the figure above, just like its peer companies. But I believe the next year paints an encouraging outlook because the market now expects a gradual increase in interest rates, and AGNC is planning accordingly, as it has shifted its focus to 15-year MBS (increasing their exposure to 52% from 42%) from 30-year MBS (decreasing the exposure to 43% from 56%) in 3Q to reduce the duration and minimize the impact of the rise in interest rates. Similarly, the company's hedging portfolio covers around 91% of total repo and other debt figures. As a result, AGNC has experienced a loss of 0.9% in the last quarter, and I am expecting a relatively stable book value for the last quarter of 2013. So, I remain positive on the stock and expect the company to trade at 0.90x bvps, which makes my price target $22.73 with price appreciation of 18.9%.

Dividends
The company recently cut down on its dividend to $0.65 from $0.80, which I believe is more sustainable given the third quarter earnings were $0.61 per share, but still the company continues to maintain an attractive yield of 13.50% among its peer companies.

Companies

4Q'13 Dividends

Change in percent (QoQ)

Dividend Yield

AGNC

$0.65

-23.07%

13.50%

Hatteras Financial (HTS)

$0.50

-9.09%

12.30%

CYS Investments (CYS)

$0.32

-5.8%

17.20%

Annaly Capital (NLY)

$0.30

-14.28%

12.20%

Source: Company Data

AGNC is also undergoing a massive share buyback program and the management said that it would continue to buy back shares as long as the shares continued to trade at such large discounts to book value per share. It has extended its stock authorization to $1 billion till the end of this year. In the third quarter, it purchased 11.9 million shares at an average price of $22.16.

Risks
Interest rate risk is one of the primary risks, as a rapid rise in interest rates will shrink the company's book value and eventually force a dividend cut. As mortgage REITs depend upon short-term repo agreements to fund their investments in mortgage-backed securities, any volatility in short-term interest rates could increase their cost of funds.

Conclusion
In the last year, the company's stock price was down by 36.70% and traded at the bottom-end of its 52-week range, so I believe that $19.29 is a strong entry point for investors. AGNC continues to maintain its attractiveness as it offers a compelling total return opportunity with significant potential for price appreciation, evident by the massive share buyback program and large gap between price and book value. Also, it offers a high double digit dividend yield.

Source: American Capital Agency: Current Price Is An Ideal Entry Point