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Author's Note: 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.

Focus of Article:

The focus of this article is to provide a detailed analysis with supporting documentation (via two tests) on the dividend sustainability of American Capital Agency Corp. (NASDAQ:AGNC). I am writing this particular article due to the continued high demand that such an analysis be performed. This analysis will be provided after a brief overview of AGNC's operations including a discussion of AGNC's real estate investment trust (REIT) classification per the Internal Revenue Code ('IRC'). Understanding the tax and dividend payout characteristics of AGNC will provide investors with an overall better understanding of the mortgage real estate investment trust (mREIT) sector as a whole. Due to the fact AGNC has produced an annual dividend yield of at least 11% since the company's inception in 2008, many investors have chosen this stock (including other stocks within the mREIT sector) for income-producing equity investments. From reading this article, investors will better understand how a qualified REIT entity per the IRC comes up with the company's current dividend rate and specific signs when an impending dividend raise or cut would be implemented.

I will be performing two dividend sustainability tests within this article. These two tests will be termed "TEST 1" and "TEST 2." After these two tests are analyzed, some recent trends to consider in a general net rising interest rate environment will also be discussed. These trends will have a direct impact on AGNC's future dividend sustainability and therefore should also be addressed. At the end of this article, there will be a conclusion on my personal opinion about the overall dividend sustainability of AGNC for several upcoming quarters. A specific analysis of AGNC's dividend range scenarios for the first quarter of 2014 will be discussed in a future article next month.

Due to the length of the material covered in this article, I feel it is necessary to break AGNC's dividend sustainability analysis into two parts. This article will be broken-down by the following categories:

PART 1:

- Brief Overview of AGNC

- AGNC's REIT Classification per the IRC

- Estimated REIT Taxable Income ('ERTI') Overview

- TEST 1: Analysis and Results

- TEST 2: Analysis and Results

- Brief Discussion of MTGE's and NLY's Dividend Sustainability (When Compared to AGNC):

PART 2:

- Additional Topics/Trends to Consider in a General Net Rising Interest Rate Environment Regarding AGNC's Dividend Sustainability

- Brief Discussion of Additional Topics/Trends to Consider in a General Net Rising Interest Rate Environment Regarding the Dividend Sustainability of MTGE and NLY

Side Note: I recently wrote a three-part article on AGNC where I projected the company's income statement for the fourth quarter of 2013. In a second article, I projected AGNC's book value ('BV') as of 12/31/2013. These two sets of articles set the foundation for understanding certain types of account descriptions and figures shown in several tables within this article's dividend sustainability analysis. As such, it would be wise for new readers to first read my previous articles to gain a better understanding of AGNC's accounts and how certain figures are derived. The following links are to my recent AGNC income statement and BV projection articles:

American Capital Agency's Upcoming Q4 2013 Income Statement Projection (Part 1)

American Capital Agency's Upcoming Q4 2013 Income Statement Projection (Part 2)

American Capital Agency's Upcoming Q4 2013 Income Statement Projection (Part 3)

American Capital Agency's Upcoming Q4 2013 Book Value Projection

General Overview of AGNC: Please see my prior dividend sustainability article (post Q3 2013 earnings) - part 1 for a discussion of this topic.

Discussion of AGNC's REIT Classification per the IRC: Please see the link above for a discussion of this topic.

Estimated REIT Taxable Income ('ERTI') Overview:

- See Red References "A, B, C, D, E" in Table 1 Below Next to the December 31, 2013 Column

Before we begin AGNC's dividend sustainability analysis, let us first get accustomed to the information provided by the company in Table 1 below. Table 1 is the equivalent to AGNC's quarterly shareholder presentation slide called "Reconciliation of Generally Accepted Accounting Principles ('GAAP') Net Income to Estimated Taxable Income." Table 1 below shows AGNC's ERTI from the fourth quarter of 2013 going back to the first quarter of 2013. All figures within Table 1 are for the "three-months ended" (quarterly) timeframe.

Table 1 - AGNC Quarterly ERTI Analysis

(click to enlarge)

(Table created by myself, partially using sourced data from AGNC's quarterly SEC disclosures)

The data shown within Table 1 above is part of a larger spreadsheet that performs both TEST 1 and TEST 2 later on in the article. For now, I am just describing what the accounts in Table 1 mean regarding AGNC's ERTI calculation and where the information is derived from. This will make TEST 1 and TEST 2 easier to follow when the time comes. Let us now take a look at the accounts within Table 1 above (in corresponding order) and briefly discuss AGNC's results for the fourth quarter of 2013.

A) Net Income (Loss):

- See Red Reference "A" in Table 1 Above Next to the December 31, 2013 Column

The quarterly net income (loss) figures shown in Table 1 above are derived from AGNC's income statement. In an article I previously wrote in regards to AGNC's income statement (see links provided near the beginning of the article), I explained in great detail how AGNC reports the company's quarterly net income (loss) figures.

Regarding the company's fourth quarter of 2013, AGNC reported a net income (loss) of ($101) million. This was largely due to AGNC's gain (loss) of ($667) million within the company's "gain (loss) on sale of agency securities, net" account. A further "in-depth" discussion of the quarterly net income (loss) figures will not occur in this article. This article's focus is a dividend sustainability analysis. Therefore, please see my three-part AGNC income statement projection article for a deeper discussion of the accounts that make up the company's quarterly net income (loss) figures.

B) Total Book to Tax Differences (Reversals):

- See Red Reference "B" in Table 1 Above Next to the December 31, 2013 Column

In order for AGNC to come up with a proper ERTI figure, there are specific GAAP to IRC adjustments (reversals) that need to be performed each quarter. Income and expense recognition of certain accounting transactions differ between GAAP and the IRC (book versus tax accounting treatments).

Certain book versus tax temporary differences can arise for AGNC near the end of a quarter. One example of a temporary difference could pertain to a sale of an MBS between AGNC and a counterparty near the end of any given quarter. Let us assume AGNC did not actually receive any cash proceeds from this sale prior to the close of the quarter. Per GAAP (accrual method of accounting), revenue will be recognized and recorded prior to the close of the quarter because a deal was struck and the likelihood of eventually receiving proceeds from this sale are high. In this instance, the pending revenue from the sale is recorded as if the sale has already occurred and a receivable is set up under GAAP. However, per the IRC (based on the cash method of accounting), the sale of this specific MBS would not be recognized until the cash was actually received by AGNC in the following quarter. As such, these types of transactions need to be "reversed-out" of the GAAP net income (loss) figure.

As shown in Table 1 above, AGNC's "premium amortization, net" account is another instance where timing differences occur. This is a noncash GAAP account where the premium paid (or discount received) relative to par is expensed (or accreted back to income) over the estimated life of a particular MBS. However, for taxation purposes, this account does not exist because it is a noncash figure and was initially recognized when AGNC made the initial purchase of the specific MBS (cash "upfront" premium paid (discount received)). For the fourth quarter of 2013, a reversal of ($21) million occurred.

A material book versus tax reversal for the fourth quarter of 2013 was AGNC's "capital losses in excess of capital gains" account. For just the fourth quarter of 2013 alone, this account increased AGNC's ERTI figure by $936 million. This reversal is in conjunction with AGNC's gain (loss) on sale of agency securities, net account briefly mentioned earlier. This particular reversal has some important future ERTI implications which will be further discussed in PART 2 of this article.

A material portion of AGNC's "realized ('gain') loss, net" and "unrealized ('gain') loss, net" reversals for the fourth quarter of 2013 was in conjunction with the following derivative accounts: 1) TBA MBS and forward settling MBS; 2) interest rate swaps; 3) interest rate swaptions; and 4) U.S. Treasury securities. Since most of AGNC's derivative portfolio consisted of unsold hedging positions, these net unrealized valuation ('gains') losses need to be reversed out for taxation purposes until a realized activity occurs (termination, expiration, conversion, or sale). A material portion of AGNC's net realized ('gain') loss reversal of ($92) million for the fourth quarter of 2013 has some important future ERTI implications which will be further discussed in PART 2 of this article.

In addition to the accounts described above, there could be some additional reversals that need to be performed in a given quarter. For purposes of this article, all remaining discussion of these additional reversals will be waived due to immateriality.

C) ERTI; D) Dividend on Preferred Stock; and E) ERTI - Common Shareholders:

- See Red References "C, D, E" in Table 1 Above Next to the December 31, 2013 Column

After accounting for AGNC's book versus tax reversals from net income (loss), one can now calculate the company's ERTI amount (see red reference "C" in Table 1 above). Once this figure is known, one subtracts out AGNC's quarterly dividend distributions on the company's preferred shares (see red reference "D" in Table 1 above). Once this is complete, the ERTI for common shareholders figure is known (see red reference "E" in Table 1 above). As discussed earlier, this figure is extremely important for AGNC. Due to the specific IRC provision stating an entity must distribute at least 90% of the AREITTI to retain the company's qualified REIT status, AGNC bases the current and future dividend per share amount upon this figure. This is not the only figure AGNC bases the company's quarterly dividend distributions on. However, it is an extremely important figure regarding MINIMUM required annual dividend distributions.

Now that there is a better understanding on how management calculates the company's quarterly ERTI figure, let us perform AGNC's dividend sustainability analysis. This analysis will be a good indicator of AGNC's current dividend sustainability for the foreseeable future (next several quarters) including whether an impending dividend raise or cut could eventually come to fruition.

Side Note: There are several other indicators and calculations that can help assist or add to one's viewpoint on the dividend sustainability of a company. Some analysts like to prepare some kind of discounted cash flow or "true earnings" analysis based solely on cash. With other sectors or even another mREIT company, I would tend to agree with this notion. However, AGNC's management team provides to the public quarterly ERTI figures. Most companies do not provide such disclosures to the public because ERTI is a non-GAAP measurement (not an SEC requirement). AGNC's ERTI calculation basically converts the company's quarterly net income (loss) per GAAP into the company's taxable net income (loss) per the IRC. Since AGNC provides this valuable information to the public, I feel a discounted cash flow or true earnings analysis is "trumped" by the quarterly ERTI figure. As discussed earlier in the article, since AGNC is classified as a REIT per the IRC, the company must distribute 90% of the AREITTI in a given calendar year (disregarding the spillback provision). Management has consistently stated the company bases AGNC's quarterly dividend distributions upon the quarterly ERTI/AREITTI and cumulative undistributed taxable income ('UTI') figures. Using this methodology, I have correctly projected (within range) AGNC's quarterly dividend distributions for the past five quarters. Therefore, I feel TEST 1 and TEST 2 below will be a good "starting point" for an overall dividend sustainability analysis.

TEST 1 - Quarterly ERTI - Common Shareholders Versus Quarterly Distributions Analysis:

- See Red References "E, G, H" in Table 2 Below Next to the December 31, 2013 Column

Before we begin TEST 1 of AGNC's dividend sustainability analysis, let us first briefly get accustomed to the information provided in Table 2 below. Table 2 is an extension of the information provided in Table 1 above. Table 2 below shows AGNC's ERTI from the fourth quarter of 2013 going back to the company's first quarter in 2013. All figures within Table 2 are for the "three-months ended" (quarterly) timeframe. Table 2 below compares AGNC's quarterly ERTI figure to the company's dividend distributions figure and then shows the quarterly underpayment (overpayment).

Table 2 - AGNC Quarterly ERTI - Common Shareholders Versus Quarterly Distributions Analysis (TEST 1)

(click to enlarge)

(Table created by myself, partially using sourced data from AGNC's quarterly SEC disclosures)

AGNC does not provide a table that is comparable to the bottom portion of Table 2 (see red references "G, H, G/E" in Table 2 above). Some past (ACTUAL) figures within Table 2 above are derived from either AGNC's quarterly investor presentation slides or SEC submissions via the company's 10-Q or 10-K where applicable (or a combination of both). As such, there will not be an identical sheet AGNC provides that matches the data I have prepared in Table 2. I have gathered specific information derived from multiple tables/charts for a more detailed analysis of AGNC's dividend sustainability. Let us briefly describe the new accounts shown within Table 2 above that were not included in Table 1 shown earlier in the article.

G) Distributions to Shareholders from ERTI:

- See Red Reference "G" in Table 2 Above Next to the December 31, 2013 Column

These figures represent the quarterly accrual AGNC makes in regards to the company's dividend distributions to common shareholders. This accrual is made in the current quarter and paid the following quarter. Through research, one can calculate these quarterly amounts via disclosed data.

H) Underpayment (Overpayment) of ERTI:

- See Red Reference "H" in Table 2 Above Next to the December 31, 2013 Column

These figures represent the quarterly underpayment (overpayment) of AGNC's ERTI when compared to the company's dividend distributions to common shareholders.

Table 2 also includes what percentage of quarterly ERTI is paid out in the form of dividend distributions for additional clarity and insight (see red reference "G/E" in Table 2 above). Again, AGNC does not provide this specific information. However, one can calculate the percentage of AGNC's quarterly underpayments (overpayments).

TEST 1 - Analysis and Results:

Using Table 2 above as a reference, I take AGNC's quarterly "ERTI - common shareholders" figure (see red reference "E" in Table 2 above) and subtract this amount by the quarterly "distributions to shareholders from ERTI" figure (see red reference "G" in Table 2 above). If AGNC's red reference "E" is greater than the company's red reference "G," then AGNC technically has enough quarterly ERTI to pay out the company's dividend distributions for a particular quarter. As such, any excess quarterly ERTI left over, after accounting for the dividend distributions, would be added to AGNC's cumulative UTI balance. UTI will be further discussed within TEST 2 later in the article. If AGNC's red reference "E" is less than the company's red reference "G," then AGNC has currently overpaid the company's quarterly dividend distributions and must use the remaining cumulative UTI balance to help pay for the overpayment.

Second Quarter of 2013 Dividend:

Beginning in the first quarter of 2013, AGNC's quarterly ERTI figure began to show signs of distress. The first quarter of 2013 was not particularly a "pretty" quarter regarding AGNC's quarterly ERTI figure. AGNC only generated a quarterly ERTI figure of $0.50 per share while distributing a quarterly dividend of $1.25 per share. This equated to a payout ratio of 282% due to a quarterly underpayment (overpayment) of ($322) million. Such a material overpayment caused AGNC's lofty cumulative UTI balance to decrease by 43% in just one quarter.

As I correctly projected in a prior dividend range scenarios article for the second quarter of 2013, the weak quarterly ERTI figure for the first quarter of 2013 resulted in a more cautionary outlook regarding AGNC's dividend sustainability. This prior article stated a dividend cut would occur in the second quarter of 2013. As such, when AGNC declared a dividend cut of 16% (or $0.20 per share) for the second quarter of 2013, I was not surprised. For some interested parties (including myself), this dividend cut was actually a little less than anticipated given the weak quarterly ERTI figure reported in the first quarter of 2013.

For the second quarter of 2013, AGNC reported a quarterly ERTI figure of $1.04 per share. This was basically in line with AGNC's reduced dividend of $1.05 per share. As such, AGNC's cumulative UTI balance only decreased ($0.01) per share to $1.07 per share. When compared to the prior quarter, the second quarter of 2013 saw a nice "bounce-back" in AGNC's quarterly ERTI figure. However, AGNC's $411 million of quarterly ERTI for the second quarter of 2013 was not a figure to overly rejoice from. AGNC's payout ratio was still an elevated 102% for the second quarter of 2013. Compared to past quarters, this payout ratio was "mediocre" at best.

Through the first two quarters of 2013, AGNC recognized ERTI of $588 million available to common shareholders. However, AGNC had already distributed ($919) million of dividends. When combining both quarters, this equated to an underpayment (overpayment) of ($331) million or a dividend distributions payout ratio of 156%. When compared to AGNC's past payout ratios through the first half of the year, 2013 was by far the worst year regarding an overpayment of the company's dividend. Between the years 2009 - 2012, the worst payout ratio for the first half of the year was 89% in 2011. The best payout ratio was 69% in 2012. AGNC's 2013 payout ratio, through the first half of the year, was a material deviation from the company's past results. This was a rather troubling sign for AGNC's future dividend sustainability (amongst other indicators).

Third Quarter of 2013 Dividend:

As I correctly projected in a prior dividend sustainability article (post Q2 2013 earnings), I concluded the relatively average quarterly ERTI figure from AGNC's second quarter of 2013 resulted in a continued negative outlook regarding the company's dividend sustainability. Within this analysis, I noted the MBS market continued to show signs of a material price deterioration that begin in May and continuing through the first half of the third quarter of 2013. The material MBS price declines were attributed to a rapid "spike" in mortgage interest rates/U.S. Treasury yields brought on by the possible "tapering" of the Federal Reserve's ('FED') Quantitative Easing Program (QE3). Due to the MBS market continuing to show signs of a material price deterioration throughout the latter half of the second quarter of 2013 and first half of the third quarter of 2013, AGNC's management made the decision of becoming extremely defensive regarding the company's MBS portfolio. As such, management aggressively implored three strategies.

First, AGNC converted the company's entire net long TBA MBS balance. AGNC converted the company's entire net long TBA MBS balance as of 6/30/2013 into regular MBS thus recognizing a material net realized valuation loss upon the conversion. Second, management continued to decrease AGNC's exposure to 30-year fixed-rate agency MBS and increased the company's proportion of the less price sensitive 15-year fixed-rate agency MBS. This caused an additional net realized valuation loss on the sold MBS. Upon these sales, AGNC "re-rolled" the company's MBS portfolio into higher coupons. Third, AGNC continued to hold a rather large derivative portfolio throughout most of the third quarter of 2013. When combining these three strategies, this caused an excessively low ERTI figure of only $116 million for the third quarter of 2013. As a result of the three defensive strategies mentioned above, it was not too surprising to hear AGNC's cautious tone regarding the company's dividend distributions for the third quarter of 2013.

Due to the aggressive defensive measures by management (along with MBS price declines), I correctly projected AGNC would further decrease the company's dividend in the third quarter of 2013. This was provided via my dividend range scenarios article for the third quarter of 2013. As such, when AGNC declared an additional dividend cut of 24% (or $0.25 per share) for the third quarter of 2013, I was not too surprised. However, the material dividend cut was countered by the repurchase of 11.9 million shares during the third quarter of 2013 at a material discount to BV.

For the third quarter of 2013, AGNC reported a quarterly ERTI figure of only $0.29 per share while distributing a quarterly dividend of $0.80 per share. This equated to a payout ratio of 275% due to a quarterly underpayment (overpayment) of ($198) million. As such, AGNC's cumulative UTI balance materially decreased ($0.50) per share to $0.57 per share. Such a material overpayment caused AGNC's cumulative UTI balance to decrease by an additional 48% in just one quarter.

Through the first three quarters of 2013, AGNC recognized ERTI of $701 million available to common shareholders. However, AGNC had already distributed ($1.2) billion of dividends. When combining the first three quarters, this equated to an underpayment (overpayment) of ($528) million or a dividend distributions payout ratio of 175%. This was a rather troubling sign for AGNC's future dividend sustainability.

Fourth Quarter of 2013 Dividend:

As I correctly projected in a prior dividend sustainability article (post Q3 2013 earnings) (linked earlier in article), I concluded the weak quarterly ERTI figure for the third quarter of 2013 resulted in a continued deterioration of AGNC's dividend sustainability. Due to the continued defensive measures by management (along with MBS price declines), I correctly projected AGNC would further decrease the company's dividend in the fourth quarter of 2013.

This was provided via my dividend range scenarios article for the fourth quarter of 2013. As such, when AGNC declared an additional dividend cut of 19% (or $0.15 per share) for the fourth quarter of 2013, I was not surprised. In fact, the dividend of $0.65 per share was exactly in the middle of my projected dividend range. As was the case with the prior quarter, the dividend cut was partially countered by the repurchase of 28.2 million shares during the fourth quarter of 2013 at a material discount to BV.

Still using Table 2 above a reference, for the fourth quarter of 2013, AGNC reported a quarterly ERTI figure of $0.65 per share. This was now in line with AGNC's reduced dividend of $0.65 per share. As such, AGNC's cumulative UTI balance actually increased $0.02 per share to $0.59 per share. When compared to the prior quarter, the fourth quarter of 2013 saw a nice "bounce-back" in AGNC's quarterly ERTI figure. However, AGNC's $241 million of quarterly ERTI for the fourth quarter of 2013 was still modestly lower when compared to results from the second quarter of 2011 through the fourth quarter of 2012. AGNC's payout ratio was 97% for the fourth quarter of 2013. When compared to the payout ratios for the first and third quarters of 2013, this quarterly payout ratio should be seen as a positive sign.

Through the calendar year of 2013, AGNC had ERTI available to common shareholders of $942 million. However, AGNC distributed ($1.5) billion of dividends. When combining all four quarters, this equated to an underpayment (overpayment) of ($522) million and a payout ratio of 155%. Dividends distributions were materially higher when compared to quarterly ERTI for the first and third quarters of 2013. Dividend distributions basically matched quarterly ERTI for the second and fourth quarters of 2013. When compared to AGNC's past payout ratios for the entire year, 2013 was by far the worst year regarding the overpayment of the company's dividend. However, one could argue the results shown for the fourth quarter of 2013 could be seen as an encouraging sign regarding the sustainability of the current dividend rate of $0.65 per share.

When combining results from TEST 1, along with conclusions drawn from my recent articles, a good foundation is formed on AGNC's recent performance regarding the company's quarterly ERTI. However, TEST 1 does not come with certain drawbacks and limitations. This is why additional analysis will be performed within this article. TEST 1 does not specifically account for AGNC's cumulative UTI data (which will be discussed in TEST 2 below) or any future trends and considerations (will be discussed in PART 2 of this article). Since TEST 1 does not specifically include these additional factors, it would only be prudent to now perform TEST 2 and see if similar results can be ascertained. TEST 2 needs to be performed to gain further clarity on the sustainability of AGNC's dividend in the upcoming quarters.

TEST 2 - Cumulative UTI Coverage of Quarterly Dividend Distributions Ratio Analysis:

- See Red References "I, J, K" in Table 3 Below Next to the December 31, 2013 Column

Before we begin TEST 2 of AGNC's dividend sustainability analysis, let us first get accustomed to the information provided in Table 3 below. Table 3 is an extension of the information provided in Table 2 above. Table 3 below shows AGNC's dividend distributions from the fourth quarter of 2013 going back to the company's first quarter in 2013. Table 3 also shows AGNC's quarterly underpayment (overpayment) of the company's ERTI (discussed in Table 2 and TEST 1 above). Table 3 below then compares AGNC's quarterly dividend distributions to the company's cumulative UTI balance for the same quarter. All figures within Table 3 are for the "three-months ended" (quarterly) timeframe except for AGNC's cumulative UTI balance. The cumulative UTI figure is a "running balance" that either increases or decreases each quarter as AGNC underpays (overpays) the company's quarterly dividend distributions.

Table 3 - AGNC Cumulative UTI Coverage of Quarterly Dividend Distributions Ratio Analysis (TEST 2)

(click to enlarge)

(Table created by myself, partially using sourced data from AGNC's quarterly SEC disclosures)

AGNC does not provide a table that is comparable to Table 3 (see red references "G, H, I, J, K" in Table 3 above). As such, there will not be an identical sheet AGNC provides that matches the data I have prepared in Table 3 above. I have gathered specific information derived from multiple tables/charts for a more detailed analysis of AGNC's dividend sustainability. Let us briefly describe the new accounts shown within Table 3 that were not included in Table 2 shown earlier in the article.

I) Cumulative UTI Recalculation; and J) Cumulative UTI Balance:

- See Red References "I, J" in Table 3 Above Next to the December 31, 2013 Column

UTI is the cumulative running balance of AGNC's past undistributed ERTI after management accrues for the company's quarterly dividend distributions. The cumulative UTI balance increases if AGNC's quarterly ERTI figure is more than the accrued quarterly dividend distributions figure. The cumulative UTI balance deceases if AGNC's quarterly ERTI figure is less than the accrued quarterly dividend distributions figure.

TEST 2 - Analysis and Results:

Using Table 3 above as a reference, I take AGNC's "cumulative UTI" figure (see red reference "J" in Table 3 above) and divide this amount by the quarterly "distributions to shareholders from ERTI" figure (see red reference "G" in Table 3 above). From this calculation, AGNC's "cumulative UTI coverage of quarterly dividend distributions ratio" is obtained (see red reference "K" in Table 3 above). This can also be referred to as AGNC's "UTI per share" amount. The higher this ratio (or per share amount) becomes, the more positive the results regarding AGNC's future dividend sustainability. Basically, this ratio/per share amount shows the amount of cumulative UTI covering the current quarter's dividend distributions (after taking the current quarter's dividend distributions accrual into account).

Prior to the first quarter of 2013, AGNC's cumulative UTI coverage of quarterly dividend distributions ratio gradually increased since the first quarter of 2011. There were a few quarters within 2011 and 2012 where this ratio slightly dropped for a quarter. However, the ratio eventually continued to rise higher in subsequent quarters. As of 3/30/2011, AGNC's cumulative UTI coverage of quarterly dividend distributions ratio was only a factor of 0.40. However, as of 12/31/2012, this ratio grew to a factor of 1.76. This was AGNC's highest cumulative UTI coverage of quarterly dividend distributions ratio ever recognized. This equated to a cumulative UTI balance of $749 million by the end of the fourth quarter of 2013. This was an extremely positive sign for AGNC at the time because the company had accumulated a massive UTI balance.

However, when AGNC reported a very weak quarterly ERTI figure of $0.50 per share for the first quarter of 2013 (as mentioned in TEST 1 above), TEST 2 also began to show signs of stress in regards to AGNC's dividend sustainability. AGNC's cumulative UTI coverage of quarterly dividend distributions ratio fell from a factor of 1.76 as of 12/31/2012 to only a factor of 0.86 as of 3/31/2013. AGNC's results for the first quarter of 2013 were extremely negative regarding TEST 2. As mentioned in TEST 1 above, AGNC had a quarterly underpayment (overpayment) of ($322) million in the first quarter of 2013. Such a material overpayment caused AGNC's cumulative UTI balance to decrease 43% within three months. AGNC's cumulative UTI balance went from $749 million as of 12/31/2012 to $430 million as of 3/31/2013. For just one quarter's worth of activity, this was a material hit to AGNC's cumulative UTI balance.

As was the case with TEST 1, TEST 2 showed stabilization during AGNC's second quarter of 2013. As of 6/30/2013, AGNC reported a cumulative UTI balance of $425 million. As such, AGNC's cumulative UTI balance only decreased ($5) million during the second quarter of 2013. Since there was a cut to the company's dividend during the second quarter of 2013, instead of having to achieve quarterly ERTI of nearly $500 million before "breaking-even" within the cumulative UTI balance, AGNC now only needed to achieve quarterly ERTI of $425 million to break-even. This was one positive piece of data from TEST 2's analysis at the time. Furthermore, if AGNC were to repurchase some outstanding shares of common stock in future quarters, the company's quarterly cumulative UTI break-even would decrease even further.

Another piece of positive data was that AGNC's cumulative UTI coverage of quarterly dividend distributions ratio rose from a factor of 0.86 as of 3/31/2013 to a factor of 1.01 as of 6/30/2013. This partially occurred from the material dividend cut that occurred in the second quarter of 2013. Even though this ratio's increase was due to AGNC's dividend cut, any rise in this ratio is positive news. To put this ratio in perspective, AGNC had a cumulative UTI coverage of quarterly dividend distributions ratio of 0.57 as of 12/31/2011 before a dividend cut in the first quarter of 2012. If future quarters showed this ratio beginning to lower once again, the probability of a future quarterly dividend cut would increase in likelihood. This was exactly what occurred during the third quarter of 2013.

Once again, AGNC reported a very weak quarterly ERTI figure of $0.29 per share for the third quarter of 2013 (as stated in TEST 1 above). Therefore, once again TEST 2 showed signs of stress in regards to AGNC's dividend sustainability. AGNC's cumulative UTI coverage of quarterly dividend distributions ratio fell from a factor of 1.01 as of 6/30/2013 to a factor of 0.70 as of 9/30/2013. This factor even takes into consideration the additional dividend cut of $0.25 per share that occurred during the third quarter of 2013. AGNC's results for the third quarter of 2013 were fairly negative regarding TEST 2. AGNC had a quarterly underpayment (overpayment) of ($198) million in the third quarter of 2013. Such a material overpayment caused AGNC's cumulative UTI balance to decrease by an additional 48% within just three months. AGNC's cumulative UTI balance went from $425 million as of 6/30/2013 to only $219 million as of 9/30/2013. For just one quarter's worth of activity, this was a material hit to AGNC's cumulative UTI balance.

As was the case with TEST 1, TEST 2 showed stabilization during AGNC's fourth quarter of 2013. As of 12/31/2013, AGNC reported a cumulative UTI balance of $210 million. As such, there was only a slight cumulative UTI change during the fourth quarter of 2013. Since there was another cut to the company's dividend during the fourth quarter of 2013, instead of having to achieve quarterly ERTI of $311 million before "breaking-even" within the cumulative UTI balance, AGNC now only needed to achieve quarterly ERTI of approximately $235 million to break-even. Furthermore, if AGNC were to repurchase more outstanding shares of common stock in future quarters (strong possibility in the current environment), the company's quarterly cumulative UTI break-even would continue to decrease even if quarterly dividend distributions of $0.65 per share remained consistent.

Since AGNC's current stock price continues to trade materially lower than the company's stated BV of $23.93 per share as of 12/31/2013 (and more important CURRENT BV), additional equity raises will not occur (extremely low probability; dilution of BV). As such, AGNC's quarterly cumulative UTI break-even should not materially increase over the foreseeable future. In fact, a moderate to strong argument could be made this break-even amount will continue to gradually decease as AGNC continues to repurchase outstanding shares of common stock. Strictly on a cumulative UTI break-even basis, this spells good news for AGNC's dividend sustainability.

As TEST 2 shows, AGNC's cumulative UTI balance continued to decrease throughout most of 2013 at a fairly rapid pace. As such, the material dividend cuts performed in the second, third, and fourth quarters of 2013 made sense. However, due to the fact AGNC cut the quarterly dividend distributions from $1.25 per share at the beginning of the year to $0.65 per share by the end of the year, the company has taken steps to materially lower the quarterly cumulative UTI break-even balance. Therefore, the odds of AGNC being able to maintain the company's current dividend of $0.65 per share have now increased. It would appear the results that were reported for the fourth quarter of 2013 support this viewpoint.

Brief Discussion of MTGE's and NLY's Dividend Sustainability (When Compared to AGNC):

This article usually provides a summarized comparison between AGNC and its sister company American Capital Mortgage Corp. (NASDAQ:MTGE) regarding TEST 1 and TEST 2. However, due to the sheer amount of data already provided to readers regarding AGNC above, I am omitting such a comparative analysis between the two companies this quarter. Depending on the demand for such a analysis, I may write a separate dividend sustainability article for MTGE this quarter. However, I will state MTGE experienced a positive increase in the company's cumulative UTI balance during the fourth quarter of 2013. This bodes well for the dividend sustainability of MTGE going into 2014.

When compared to AGNC, Annaly Capital Management Inc. (NYSE:NLY) has also seen material dividend cuts over the past few years. NLY cut the company's quarterly dividend from $0.45 per share during the first quarter of 2013 to $0.30 per share by the fourth quarter of 2013. Going back even further, NLY paid a quarterly dividend of $0.65 per share in the second quarter of 2011. When calculated, NLY's dividend cut between the second quarter of 2011 and the fourth quarter of 2013 was 54% ($0.65 per share versus $0.30 per share). In comparison, AGNC paid a quarterly dividend of $1.40 per share in the second quarter of 2011. When calculated, AGNC's dividend cut between the second quarter of 2011 and the fourth quarter of 2013 was also 54% ($1.40 per share versus $0.65 per share). Since NLY has continued to cut the quarterly dividend throughout most of 2011 - 2013 (smaller increments when compared to AGNC), the probability of the company being able to sustain the dividend at $0.30 per share has modestly increased. This is mainly due to the material decrease in NLY's quarterly dividend distributions break-even amount.

Conclusions Drawn (PART 1):

To sum up all the information in PART 1 of this article, this analysis showed strong evidence as to why AGNC cut the company's quarterly dividend from $1.25 per share for the first quarter of 2013 to $0.65 per share by the fourth quarter of 2013. TEST 1 showed AGNC had material quarterly ERTI overpayments in the first and third quarters of 2013 while basically paying a dividend consistent with quarterly ERTI for the second and fourth quarters of 2013.

TEST 2 showed any future material overpayments of AGNC's quarterly ERTI figure would cause the company's cumulative UTI balance to be further reduced to a relatively low level. As stated in TEST 2 earlier, AGNC used up a material portion of the company's cumulative UTI balance during 2013. However, TEST 2 also showed that due to AGNC's material dividend cuts in the second, third, and fourth quarters of 2013, the company's cumulative quarterly UTI break-even has decreased $264 million when comparing the first and fourth quarters of 2013. Furthermore, TEST 2 showed if AGNC only had a minor overpayment in the company's quarterly ERTI figure when compared to the quarterly dividend distributions break-even figure (currently $235 million), this minor deficit could be offset by AGNC's cumulative UTI balance of $210 million as of 12/31/2013. Another positive sign was that AGNC's cumulative UTI coverage of quarterly dividend distributions ratio climbed from a factor of 0.70 as of 9/30/2013 to 0.90 as of 12/31/2013.

From the data presented above regarding TEST 1 and TEST 2, there seems to be a few positive signs regarding AGNC's dividend sustainability for the upcoming quarters. With that being said, there are still some cautionary signs regarding the future sustainability of the dividend. As concluded from both TEST 1 and TEST 2, if AGNC has another weak quarter or several modestly weaker quarters regarding ERTI, the sustainability of AGNC's dividend at the current $0.65 per share rate will be in jeopardy. However, when compared to past quarters, the likelihood of this occurrence has dropped due to the defensive/rebalancing efforts by the AGNC management team.

Final Note: Based on the results shown in TEST 1 and TEST 2 above, I feel it is only prudent to include additional analysis regarding AGNC's dividend sustainability. As such, PART 1 of this article is only a PARTIAL analysis of AGNC's dividend sustainability over the foreseeable future. Therefore, a "full" conclusion regarding AGNC's dividend sustainability will not be provided yet. PART 2 of this article will just pick up where PART 1's analysis ends. PART 2 of this analysis will discuss some additional topics/trends to consider in a general net rising interest rate environment. I feel the following four topics/trends should be addressed regarding a general net rise in mortgage interest rates/U.S. Treasury yields and the impact on the dividend sustainability of AGNC: 1) continued realignment of the company's 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. PART 2 of this article will be available to readers next week.

Source: American Capital Agency's Dividend Sustainability Analysis (Post Q4 2013 Earnings) - Part 1