The fall of the interest rates to historical lows offered a great opportunity to dividend paying stocks as well as mortgage real estate investment trusts (mREITs) to attract investors. The decline in interest rates caused the deposit rates to fall, which sent investors to dividend paying stocks and mREITs as these investors needed to park their cash. As a result, the price performance of these stocks and mREITs has been impressive over the last few years. However, as the interest rates are starting to go up, the prospect of investing in mREITs and dividend stocks may become less attractive as the deposits will provide a safer investment outlet.
American Capital Agency (NASDAQ:AGNC) is one of these companies that may be affected by rising interest rates. The agency earns income primarily from investing on a leveraged basis in agency mortgage-backed securities issued by government sponsored entities. The company earns through the interest spread between mortgage securities and the cost of funding. With the amount of leverage used, AGNC must be highly effective in risk management ensuring that its assets and liabilities are balanced to capture the required spread without becoming insolvent due to interest rate risk.
Interest Rate Volatility
The interest rate volatility in the last year made the earnings suffer, the portfolios were pressured, the interest rate spreads narrowed and the book values were hurt. The whole sector was hurt due to the volatility. However, the economic conditions at the end of the year proved to be favorable for AGNC. In addition to reduced volatility, the combination of higher yields on Mortgaged Backed Securities (MBS), a steeper yield curve and prepayments made the landscape more appealing for AGNC as well as its investors. Nonetheless, AGNC has taken measures and the effects are starting to show now.
These steps were changes in the duration and an increase in the leverage. Furthermore, the management at AGNC believes that the effect of tapering in quantitative easing has completely baked in. The shares are trading at a discount to book value, which offers an opportunity to investors to add to their current positions. An interesting point to notice here is that the value of the mREITs have dropped more than the decline in the value of the securities held (value of bonds and debt securities fall with the rising interest rates). As a result, the book value (Net Asset Value) is higher than the market value of these stocks.
Yield Growth Rate
According to the Mortgage Bankers Association, the average 30-year mortgage rate has risen to 4.33% from 4.28% with the start of this year. The latest data is showing that the average rate for a 30-year fixed rate mortgage increased 4 basis points. However, some analysts and investors are concerned about the decreased house bookings number followed by hiked mortgage rates. The reason behind this shortfall is the severe weather that hit the nation. The National Association of Home Builders sentiment Index showed a steep uptrend continued from the last year - reflecting a strengthening housing market. Sales of new homes went up by 16.4% over the last year, the highest level in five years.
Many mREITs are now trading at significant discounts to book value. This has prompted some of them to buy back some of their shares outstanding. AGNC has stated that its latest book value is $23.93 and the stock last traded at $22.02. The decline in net book value per common share is due to the combination of wider mortgage spreads and higher interest rates. The move to repurchase shares at below book value is extremely attractive. AGNC bought 43 million shares during the last year. The source of the funds that mREITs use to buy back share is generally the principal payments made by the mortgage securities in their portfolio.
When shares are bought back at prices below book value, the result is an increase in book value - which is favorable for the mREITs. AGNC also took some creative steps to enhance the shareholders' value by purchasing stocks of other mREITs. This risky move made by AGNC makes a lot of sense considering the downtrend observed in the mREIT sector. With the stable economic conditions in the coming year and the increased asset base of AGNC, the net interest spreads will show improvement in the margin.
According to the Wells Fargo Economics Outlook for 2014, the long-term rates are expected to rise higher in the coming years. The 10-year Treasury will rise to around 3.2% by the end of 2014 from its current 2.85%. The conventional mortgage rate will also slowly edge higher from around 4.7% in the first quarter of this year to 4.9% by the end of the year. The growth in the housing market is also expected to be strong during the current year. According to the U.S Economics Forecast, the future mortgage rates are expected to increase to 4.80% in 2014 and 5.05% by the next year.
The fears about the interest rates have been overplayed in my opinion. There is no doubt that unfavorable interest rate movement can harm the returns of the company, but the current market price of the share is the result of putting too much focus on the interest rates. Despite a gain of about 14% year-to-date, the stock is trading at 31% below the year ago value. As I mentioned above, the mix of assets and the changes in the duration and leverage has positioned AGNC well for the next few quarters. This will be a good time to buy AGNC as I believe the income will be strong and we will see the discount to book value disappear over the next few months and the stock will be trading at least in line with its book value.