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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 - American Capital Agency's Dividend Sustainability Analysis (Post Q4 2013 Earnings)

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 scroll down to the "Conclusions Drawn" section at the bottom of the each part of the article.

Focus of PART 2 of Article:

PART 1 of this article mainly analyzed AGNC's past and current performance regarding the company's quarterly ERTI/AREITTI and cumulative UTI figures (including two tests being performed). PART 2 discusses additional topics/trends to consider in a general net rising interest rate environment and the impact this scenario would have on the future dividend sustainability of AGNC. PART 2 also includes a brief discussion of AGNC's sister company American Capital Mortgage Corp. (NASDAQ:MTGE) and the company's closest sector peer Annaly Capital Management, Inc. (NYSE:NLY) regarding the same topics/trends.

Additional Topics/Trends to Consider in a General Net Rising Interest Rate Environment Regarding the Future Dividend Sustainability of AGNC:

In addition to TEST 1 and TEST 2 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 a general net rise in mortgage interest rates/U.S. Treasury yields over the next several quarters. In certain instances, I may also talk about the effects of a net drop in mortgage interest 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 a general net rise in mortgage interest rates/U.S. Treasury yields and the impact on the future 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.

1) Continued Realignment of AGNC's MBS Portfolio:

The first topic/trend to discuss is the continued realignment of AGNC's MBS portfolio regarding the company's 15 and 30-year fixed-rate agency holdings and the coupons held within each maturity. AGNC's management team has continued to take a somewhat "defensive posture" regarding the company's current MBS portfolio through deleveraging. This was a direct result of the volatile nature of the markets during the latter half of the second and fourth quarters of 2013 regarding MBS valuations.

During the second and third quarters of 2013, AGNC made the conscience decision of continuing to lower the company's exposure to 30-year fixed-rate agency MBS holdings which are more price sensitive to interest rate movements when compared to the company's 15-year fixed-rate agency MBS counterparts (when comparing similar coupon rates). However, as AGNC felt mortgage interest rates/U.S. Treasury yields were overextended during the fourth quarter of 2013, the company "eased-off" on the continued proportional shift from 30-year fixed-rate agency MBS to 15-year fixed-rate agency MBS.

Looking back at the second and third quarters of 2013, the proportional shift out of 30-year fixed-rate agency MBS to 15-year fixed-rate agency MBS made sense from a book value ('BV') perspective. However, a less price sensitive 15-year fixed-rate agency MBS comes with an overall average lower coupon yield. This was a cause for concern in several of my prior dividend sustainability articles. Looking at the data from AGNC's second quarter of 2013, the company's overall MBS portfolio yield had 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 trend continued into the third quarter of 2013. At the end of the third quarter of 2013, AGNC's average coupon yield dropped an additional 2 basis points to 3.54%. The 2 basis point drop was from the following two AGNC scenarios: 1) a continued decrease in yield from the continued shift from 30-year fixed-rate agency MBS to 15-year fixed-rate agency MBS; and 2) an increase in yield from selling a modest portion of the company's lower-coupon MBS within both maturities.

Since management basically maintained AGNC's proportion of 15 and 30-year fixed-rate agency MBS during the fourth quarter of 2013, the decrease in the average coupon yield reversed course. At the end of the fourth quarter of 2013, AGNC's average coupon yield increased 4 basis points to 3.58%. This was largely due to AGNC continuing to "re-roll" the company's MBS portfolio into higher coupons within the same maturities. During the fourth quarter of 2013, AGNC continued to sell a modest proportion of the company's lower-coupon MBS. As was the case in the third quarter of 2013, this caused a large realized MBS valuation loss in the fourth quarter of 2013.

Furthermore, as of 12/31/2013 AGNC had a net long (short) TBA MBS position of ($4.1) billion regarding the company's 15-year fixed-rate agency MBS holdings with a weighted average coupon ('WAC') of 2.92%. In comparison, as of 12/31/2013 AGNC had a net long (short) TBA MBS position of $6.4 billion regarding the company's 30-year fixed-rate agency MBS holdings with a weighted average coupon ('WAC') of 4.06%. As such, through the TBA MBS position, AGNC had planned to further increase the company's WAC for the upcoming first quarter of 2014. Let us briefly take a look at the quarterly compositional changes that occurred within AGNC's MBS portfolio between 12/31/2013 versus 9/30/2013.

Table 4 - AGNC MBS Portfolio Quarterly Compositional Change (12/31/2013 versus 9/30/2013)

(click to enlarge)

(Source: Table created entirely by myself, including all calculated figures and percentages)

Using Table 4 above a reference, when comparing investment portfolios at 12/31/2013 versus 9/30/2013, AGNC had a net par value increase (decrease) in the company's 15-year fixed-rate agency MBS holdings with a 2.5% and 3.5% coupon of ($2.7) billion and ($1.7) billion, respectively. Also, AGNC had a net par value increase (decrease) in the company's 30-year fixed-rate agency MBS holdings with a 3.0% and 4.0% coupon of ($2.4) billion and ($1.2) billion, respectively. In contrast, AGNC had a net par value increase (decrease) in the company's 30-year fixed-rate agency MBS holdings with a 4.5% coupon of $0.6 billion. I feel Table 4 shows AGNC continued to re-roll the company's MBS portfolio into higher coupons during the fourth quarter of 2013 while also deleveraging the balance sheet.

Side Note: Table 4 above includes the quarterly changes in AGNC's net long (short) TBA MBS position and "hides" all coupons that had immaterial valuation changes. As such, the coupon balances shown above will not directly equal the "subtotal" balances because I had to hide some coupons so both the 15 and 30-year maturities would fit within one table.

From a future dividend sustainability perspective, the MBS portfolio realignment into higher coupons should be seen as a positive sign. In a prior dividend sustainability article (post Q3 2013 earnings) - part 2, I stated it may take a few quarters for this positive aspect to materially take effect. As projected, it now appears AGNC has begun to see the positive effects of this particular strategy/trend.

2) Hedging Costs (Periodic Interest Costs on Interest Rate Swaps):

The second topic/trend to discuss is AGNC's hedging costs associated with the company's derivative portfolio in a general net 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/AREITTI. This hedging cost is AGNC's periodic costs on interest rate swaps.

Typically, in a general net rising interest rate environment, AGNC will have an elevated net (short) notional balance regarding the company's interest rate swaps if leverage and the MBS portfolio's composition remain relatively unchanged from one quarter to the next. From a BV perspective, the elevated interest rate swaps net (short) position would combat the erosion in MBS valuations if mortgage interest rates/U.S. Treasury yields sharply increase over a relatively short period of time. However, from a future dividend sustainability perspective, the elevated interest rate swaps net (short) position should be seen as a negative sign. Since an elevated interest rate swaps net (short) position means higher hedging costs under the current environment of extremely low LIBOR, quarterly ERTI/AREITTI and cumulative UTI would be negatively impacted (generally speaking).

AGNC had a net (short) interest rate swaps position of ($50.2) billion as of 9/30/2013. This was a net (short) reduction of $5.5 billion or approximately 10% of AGNC's interest rate swaps net (short) position of ($55.7) billion as of 6/30/2013. AGNC slightly decreased the company's overall interest rate swaps net (short) position during the third quarter of 2013 for two main reasons. First, AGNC reduced the company's net long TBA MBS and forward settling MBS position by ($21.7) billion during the third quarter of 2013. As such, AGNC reduced the company's at risk leverage from a ratio of 8.5 as of 6/30/2013 to 7.2 as of 9/30/2013. Since, when combined, AGNC's off-balance sheet TBA MBS portfolio and on-balance sheet MBS portfolio decreased ($16.1) billion during the third quarter of 2013, management felt a smaller net (short) interest rate swaps position was appropriate. Second, during the last few weeks of the third quarter of 2013, mortgage interest rates/U.S. Treasury yields sharply decreased. As such, MBS prices quickly increased. As such, the probability of MBS valuation losses slightly decreased. Therefore, management felt the continued extremely high ratio of interest rate swaps versus MBS/repo loans was unwarranted.

However, when compared to several prior quarters, AGNC's net (short) interest rate swaps position of ($50.2) billion was still a rather large balance. AGNC continued to maintain a relatively high interest rate swaps net (short) position due to the company's "defensive posture" regarding the current environment surrounding rising mortgage interest rates/U.S. Treasury yields and decreasing MBS prices. If mortgage interest rates/U.S. Treasury yields continued to rise at a modest to sharp pace, the elevated interest rate swaps net (short) position would help reduce the associated valuation losses sustained on AGNC's MBS portfolio.

Since AGNC's weighted average fixed pay rate slightly increased while the company's weighted average floating receive rate slightly decreased during the third quarter of 2013, the company had an increased net periodic interest costs of interest rate swaps expense. During the third quarter of 2013, AGNC had a net periodic interest costs of interest rate swaps expense of $131 million. This calculated to an additional expense of $26 million when compared to the prior quarter. Generally speaking, this didn't bode well for AGNC's quarterly ERTI/AREITTI.

However, AGNC had a net (short) interest rate swaps position of only ($43.3) billion as of 12/31/2013. This was a net (short) reduction of $6.9 billion or approximately 14% of AGNC's interest rate swaps net (short) position of ($50.2) billion as of 9/30/2013. AGNC slightly decreased the company's overall interest rate swaps net (short) position during the fourth quarter of 2013 for two main reasons. First, AGNC decreased the company's MBS portfolio by ($8.8) billion during the fourth quarter of 2013 (based on par value; including all TBA MBS balances as of 9/30/2013 and 12/31/2013). As such, a smaller net (short) interest rate swaps position was warranted if AGNC wanted to keep the same hedging coverage ratio. Second, AGNC increased the company's net duration gap from 0.9 years as of 9/30/2013 to 1.5 years as of 12/31/2013. Since AGNC increased the company's net duration gap, generally a smaller net (short) hedging position is warranted.

This strategy actually lowered AGNC's net periodic interest costs of interest rate swaps expense in the fourth quarter of 2013. AGNC had a net periodic interest costs of interest rate swaps expense of only $104 million during the fourth quarter of 2013. This calculated to a reduced expense of ($27) million when compared to the prior quarter. This reduced expense, through a smaller net (short) interest rate swaps position/higher net duration gap, is a small positive sign regarding AGNC's future dividend sustainability. However, if mortgage interest rates/U.S. Treasury yields once again increase at a modest to sharp pace in the future, AGNC would most likely revert back to the company's prior strategy of modestly increasing the company's interest rate swaps net (short) position. If this scenario unfolds, AGNC will most likely see a minor to modest decrease in the company's quarterly ERTI/AREITTI due to the increase in hedging costs (mainly the periodic interest costs on interest rate swaps expense). This would have negative ramifications regarding the future dividend sustainability of AGNC and readers should be aware of such a scenario.

3) Taxation Impact of Realized Losses on MBS Sales:

The third topic/trend is indirectly related to the first topic/trend discussed above (continued realignment of AGNC's MBS portfolio). As was discussed within the first topic/trend above, AGNC continued to sell a modest proportion of the company's fixed-rate agency MBS holdings with relatively low coupons. Due to material MBS price declines across most 15 and 30-year fixed-rate agency coupons throughout the latter-half of 2013, AGNC recorded a combined IRC net capital gain (loss) of ($1.79) billion in the third and fourth quarters of 2013. After a reclassification of the company's quarterly interest on sold MBS, AGNC recorded a combined GAAP net realized valuation gain (loss) of ($1.4) billion in the third and fourth quarters of 2013.

Regarding AGNC's sold MBS, looking back in hindsight a better opportunity would have presented itself if AGNC was more patient and waited until January 2014 to unload the company's lower-coupon MBS holdings. However, management must put the shareholders first and thus erred on the side of caution in the third and fourth quarters of 2013. Management did not want to be left with the "short-side of the straw" if mortgage interest rates/U.S. Treasury yields continued to rise at a fairly modest clip in future quarters. In a sense, AGNC "sacrificed" results in the third and fourth quarters of 2013 for a more attractive/higher-yielding MBS portfolio going forward. This strategy is generally good news for AGNC's future BV in a generally net rising interest rate environment (minimization of future MBS valuation losses). However, this scenario does not bode particularly well for AGNC's quarterly ERTI/AREITTI when these strategies are first implemented. Due to the sale of a modest portion of the company's fixed-rate agency MBS holdings, AGNC reported material realized valuation losses for the third and fourth quarters of 2013.

Now let us move on to the taxation impact of the net capital loss. Due to the fact AGNC did not report a material net capital gain for the first and second quarters of 2013, when management reported the company's combined net capital gain (loss) of ($1.79) billion in the third and fourth quarters of 2013, a new scenario regarding taxable income occurred. For the 2013 calendar tax year, AGNC had capital losses (realized losses on MBS sales) in excess of the company's capital gains (realized gains on MBS sales). In other words, AGNC recognized a material net capital loss for the 2013 calendar tax year. This scenario currently has a direct impact on AGNC's future ERTI/AREITTI figures over the next five years. AGNC's net capital loss in 2013 has both positive and negative implications regarding the future dividend sustainability of the company. The future movements of mortgage interest rates/U.S. Treasury yields will dictate whether positive or negative implications come to fruition regarding the future dividend sustainability of AGNC.

As mentioned earlier, when there is a modest to rapid rise in mortgage interest rates/U.S. Treasury yields, MBS prices decline. As such, the probability of a net capital loss on AGNC's MBS portfolio increases (generally speaking). If mortgage interest rates/U.S. Treasury yields continue to net rise over a prolonged period of time, the probability of a net capital loss eventually being recorded greatly increases. This was the exact scenario that AGNC dealt with in the third and fourth quarters of 2013.

Due to this new scenario unfolding (AGNC recognizing a material net capital loss in 2013), two situations can occur in future tax calendar years. First, let us assume mortgage interest rates/U.S. Treasury yields net rise for a calendar tax year. In this example, all future net capital losses will continue to be "reversed-out" of quarterly ERTI/AREITTI. As such, AGNC's quarterly ERTI/AREITTI figure will continue to be positively affected in this scenario. Furthermore, all capital losses in excess of capital gains will be accumulated annually and added to the capital loss carryforward balance first established in 2013. However, each annual capital loss carryforward will keep its notional amounts for capital loss carryforward timetables and expirations. This is an important concept to understand regarding AGNC's future quarterly ERTI/AREITTI and UTI implications. Capital losses in excess of capital gains are NOT deductible from AGNC's ERTI/AREITTI 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 capital losses (for the next five years) will NOT lower AGNC's quarterly ERTI/AREITTI. Do not get me wrong, having net capital losses is never a great scenario for any company. However, purely from a future dividend sustainability perspective, this scenario is positive in nature. Just know this is negative for BV purposes. As mentioned in prior dividend sustainability articles, under Subchapter M of the IRC, an qualified entity must distribute a minimum of 90% of the company's AREITTI to shareholders to remain in REIT compliance.

Second, let us now assume mortgage interest rates/U.S. Treasury yields reverse course and net decline for a calendar tax year. If this specific scenario occurs, MBS prices will typically increase. As such, the probability of a net capital gain on AGNC's MBS portfolio generally increases. So, in this example, let us assume AGNC records a net capital gain. However, now that AGNC has a capital loss carryforward of ($1.79) billion (from the net capital loss in 2013), all future net capital gains up to $1.79 billion would be "netted" against this capital loss carryforward and will not be recognized in quarterly ERTI/AREITTI. So if mortgage interest rates/U.S. Treasury yields were to decrease (on a net annual basis) over the next five years, AGNC would most likely recognize an initial net capital gain. However, since AGNC has a net capital loss carryforward from 2013, the company's net capital gain (up to $1.79 billion) would be offset/reversed out and NOT increase AGNC's quarterly ERTI/AREITTI. Purely from a future dividend sustainability perspective, this scenario is negative in nature. In prior years, AGNC's net capital gain has been an important component of the company's quarterly ERTI/AREITTI. Therefore, I feel this topic/trend has both positive and negative impacts regarding the future dividend sustainability of AGNC. Basically, this scenario will cause a "buffer" regarding AGNC's future dividend sustainability. Additional material increases/decreases to AGNC's dividend should not occur over the foreseeable future as a result of this topic/trend.

4) Taxation Impact of Net Deferred Gain on Interest Rate Swaptions:

The final topic/trend is indirectly related to the second topic/trend discussed above (an overall larger derivative portfolio in a general net rising interest rate environment (to minimize BV losses)). Interest rate swaptions are basically options to enter into underlying interest rate swap contracts. Whereas interest rate swap contracts have no initial "up-front" costs (gains (losses) are incurred as interest rates fluctuate over the life of the swaps), interest rate swaptions have implicit up-front costs (similar to an option contract; generally speaking). AGNC enters into interest rate swaption contracts to help mitigate the potential impact of large increases in mortgage interest rates/U.S. Treasury yields thus negatively impacting MBS valuations. Interest rate swaptions allow AGNC to "plan ahead" regarding the possibility of entering into future interest rate swap contracts where the swap's notional amount, term, and fixed pay rate are contractually stated. If AGNC is anticipating a prolonged net rising interest rate environment, adding payer swaptions to a company's derivative portfolio can be a useful tool.

AGNC has continued to maintain a relatively large net (short) interest rate swaptions balance due to the company's defensive posture regarding the possible interest rate increases over the next several years (thus causing MBS price declines). If mortgage interest rates/U.S. Treasury yields were to increase at a modest to sharp pace, an elevated interest rate swaptions net (short) position will help reduce the associated valuation losses sustained on AGNC's MBS portfolio because 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, management felt AGNC already had enough existing interest rate swaps within the company's derivative portfolio and therefore took advantage of some of the unrealized valuation gains accumulated on the interest rate swaptions. During the third quarter of 2013, AGNC recognized an interest rate swaption valuation gain (loss) of $222 million.

AGNC had a net (short) interest rate swaptions position of only ($14.3) billion as of 12/31/2013. This was a net (short) reduction of $6.0 billion or approximately 29% of AGNC's interest rate swaptions net (short) position of ($20.2) billion as of 9/30/2013. Similar to the company's interest rate swaps, management continued to decrease the company's net (short) interest rate swaptions position during the fourth quarter of 2013 for two main reasons. As discussed earlier, one reason was due to the reduced MBS portfolio AGNC held at the end of the fourth quarter of 2013. Second, AGNC increased the company's net duration gap from 0.9 years as of 9/30/2013 to 1.5 years as of 12/31/2013. Since AGNC increased the company's net duration gap, generally a smaller net (short) hedging position is warranted.

Now let us move on to the taxation impact of the net realized valuation gain on interest rate swaptions. Since AGNC already paid an upfront cost on the interest rate swaptions, for taxation purposes these net valuation gains need to be deferred and recognized into quarterly ERTI/AREITTI 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 taxation treatment initially lowers quarterly ERTI/AREITTI in the quarter/year the net realized valuation gain occurs but will slightly increase future quarterly ERTI/AREITTI over the life of the underlying interest rate swap.

If mortgage interest rates/U.S. Treasury yields continue to net rise over a prolonged period of time, the probability of a realized valuation gain eventually being recorded greatly increases. As such, AGNC will most likely recognize an additional net valuation gain on the company's interest rate swaptions that will be needed to be deferred over the remaining life of the underlying swaps. As of 12/31/2013, out of the ($14.3) billion net (short) notional balance regarding AGNC's interest rate swaptions (notional balance of the underlying swaps), ($9.4) billion have expirations of one year or less. Therefore, AGNC may deem the company does not need the additional interest rate swaps prior to the expiration of the swaptions. In this scenario, a net realized valuation gain will most likely occur and would be deferred over the remaining life of the underlying interest rate swap. Currently, the net deferred gain on interest rate swaptions of $222 million will not have a material impact on AGNC's quarterly ERTI/AREITTI. However, if gains continue to be recognized over time, this scenario may add some modest quarterly ERTI/AREITTI for the company and help the future dividend sustainability of AGNC.

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

Regarding the first two additional topics/trends discussed above, MTGE and AGNC had similar MBS and derivative portfolios as of 12/31/2013 (proportionally speaking). One minor exception between the two companies was that MTGE had approximately 24% of the company's MBS portfolio in non-agency holdings (when including the net (short) TBA MBS position) whereas AGNC is basically a pure agency mREIT. As such, over the past several quarters, MTGE had also shifted the company's MBS portfolio to the less price sensitive 15-year fixed-rate agency holdings. Also, MTGE continued to maintain an elevated derivative portfolio. However, similar to AGNC, MTGE recently reduced the company's net (short) interest rate swaps notional balance during the fourth quarter of 2013. As such, MTGE's periodic interest costs on interest rate swaps expense could negatively impact the company's quarterly ERTI/AREITTI in future quarters if mortgage interest rates/U.S. Treasury yields were to rise once again and MTGE adds to the company's net (short) notional balance to mitigate BV erosion. However, MTGE may keep the company's hedging coverage ratio at a lower level now that the acquisition of RCS, a fully-licensed mortgage servicer also known as a "mortgage servicing rights" ('MSR') company, acts as a indirect hedge per say.

Regarding the third topic/trend, MTGE also has a very similar taxation impact (when compared to AGNC) on the company's net capital loss. As was the case with AGNC for the 2013 calendar tax year, MTGE had capital losses (realized losses on MBS sales) in excess of the company's capital gains (realized gains on MBS sales). In other words, MTGE also recognized a material net capital loss for the 2013 calendar tax year. MTGE recognized a net capital loss of ($195.2) million for the 2013 calendar tax year. Similar to the taxation methodology for AGNC, capital losses in excess of capital gains are NOT deductible from MTGE's ERTI/AREITTI and are allowed to be carried forward for up to five years. This new scenario actually helps MTGE's future dividend sustainability because all future net capital losses (for the next five years) will NOT lower MTGE's quarterly ERTI/AREITTI. However, now that MTGE has a capital loss carryforward of ($195.2) million (from the net capital loss in 2013), all future net capital gains up to $195.2 million would be "netted" against the company's capital loss carryforward and will not be recognized in quarterly ERTI/AREITTI.

Regarding the fourth topic/trend, MTGE also had a very similar taxation impact on the company's derivative portfolio. In particular, MTGE recently recorded a net realized valuation gain on the company's interest rate swaps and swaptions. During the third quarter of 2013, MTGE recognized an interest rate swaps net valuation gain (loss) of $54 million and an interest rate swaptions net valuation gain (loss) of $14 million. During the fourth quarter of 2013, MTGE recognized an interest rate swaps net valuation gain (loss) of $47 million and an interest rate swaptions net valuation gain (loss) of ($3) million. Similar to the taxation methodology for AGNC, MTGE's net realized valuation gain need to be deferred and recognized into quarterly ERTI/AREITTI 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 taxation treatment initially lowers quarterly ERTI/AREITTI in the quarter/year of occurrence but will slightly increase future quarterly ERTI/AREITTI over the life of the swap/underlying swap.

When compared to AGNC, NLY did not have the same level of material realized MBS valuation losses during 2013. During the third quarter of 2013, NLY realized a net valuation gain (loss) of ($43.6) million on disposals of investments. NLY is subject to the same taxation methodologies as AGNC. Therefore, the same implications discussed in the third topic/trend above in regards to net capital losses also applies to NLY. Regarding the fourth topic/trend above, NLY also had an interest rate swap net realized valuation gain during the calendar tax year of 2013. During the third quarter of 2013, NLY realized a net valuation gain (loss) of $36.7 million in regards to the company's interest rate swaps. Therefore, the same implications discussed in the fourth topic/trend above (in regards to AGNC) also apply to NLY and readers should be aware as such. Both these topics/trends have a direct impact on the future dividend sustainability of both AGNC and NLY.

Conclusions Drawn From PART 1 and PART 2:

In PART 1 of this analysis, I concluded 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 future sustainability of AGNC's dividend at the $0.65 per share rate will definitely 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. 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 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.

Regarding PART 2 of this analysis, AGNC's quarterly ERTI/AREITTI could be adversely affected by the following topics/trends in conjunction with a general net rising interest rate environment: 1) an overall decrease in portfolio yield if the company once again increases the proportion of 15-year fixed-rate agency MBS holdings when compared to 30-year fixed-rate agency MBS holdings (to protect BV); 2) an elevated net (short) interest rate swaps position which leads to the continued fairly high periodic interest costs on interest rate swaps expense; and 3) the reversal of all net capital gains up to $1.79 billion over the next five calendar tax years due to the 2013 capital loss carryforward.

However, there are a few positive signs as well. AGNC's quarterly ERTI/AREITTI could be positively affected by the following trends in conjunction with a general net rising interest rate environment: 1) an overall increase in portfolio yield if the company continues to maintain the proportion of 15 and 30-year fixed-rate agency MBS holdings and continues to re-roll the portfolio into higher coupons within the same maturities; 2) the reversal of all net capital losses which will have a carryforward effect of five calendar tax years offset only against future net capital gains; and 3) the continued and increasing deferred interest rate swaption net realized valuation gain recorded back into quarterly ERTI/AREITTI over the life of the underlying interest rate swap.

Specifically regarding the second positive point above, this should help AGNC maintain the company's quarterly ERTI/AREITTI going forward (since net capital losses are excluded from quarterly ERTI/AREITTI). However, one should also understand all future net capital gains in a calendar tax year, up to $1.79 billion, will first have to be netted against the capital loss carryforward from prior years. This is a material capital loss carryforward. This hinders AGNC's quarterly ERTI/AREITTI (neutralizing effect).

When combining all the positive and negative topics/trends discussed above, I currently feel AGNC should be able to maintain the company's quarterly dividend rate of $0.65 per share throughout 2014. I still feel the possibility remains for a slight dividend increase beginning in the fourth quarter of 2014.

If interest rates net rise during 2014, AGNC will eventually benefit from continuing to re-roll the company's MBS portfolio into higher coupons. Due to the fact LIBOR will not increase until the FED Funds Rate increases (current estimates are late 2015), a potential increase in net spread income should eventually occur under a general net rising interest rate scenario. With that being said, I personally feel the beginning to the net spread increase occurred during the fourth quarter of 2013. People may argue the net pay rate on AGNC's interest rate swaps will also increase as rates increase. However, AGNC's current interest rate swaps have already "locked-in" the company's fixed pay rate. Furthermore, all existing interest rate swaptions have the fixed pay rate locked-in as well. I feel the increase in AGNC's WAC would trump any offsetting slight increases in the fixed pay rate of the company's interest rate swaps/swaptions that are exercised.

Final Note: This article excludes a detailed analysis of AGNC's dividend range scenarios for the first quarter of 2014. 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 future dividend sustainability and tends to look over the next several quarters. A future article will specifically focus on AGNC's dividend range scenarios for the first quarter of 2014. This future article will be released in March 2014.

Source: American Capital Agency's Dividend Sustainability Analysis (Post Q4 2013 Earnings) - Part 2

Additional disclosure: I have no position in NLY.