American Capital Agency Corp. (NASDAQ:AGNC) has not only repurchased its own shares, it has also gotten hold of other REIT stocks, which is a good strategy as it will be earning from another agency while paying no hedging costs. Net interest rate spread increased during the fourth quarter to 1.57%, which means that the company might give out better dividends during the first quarter of 2014 compared to 2013's fourth quarter. AGNC has the capacity to increase its dividends, not only due to a high OCF yield but also due to an increase in profit margins (net interest rate spread), making it a very good investment for the medium term until interest rates start to rise.
AGNC is a real estate investment trust (REIT) involved in the financing and management of mortgage pass-through securities and collateralized mortgage. Mortgage pass-through securities are a pool of fixed income securities that are backed by assets and involve payments to the investor through an intermediary. The company has opted to be taxed as a REIT, which means that it is exempted from any tax as long as it continues to pay out 90% of its taxable income. American Capital Agency is externally managed by AGNC Management LLC, a wholly-owned subsidiary of American Capital (NASDAQ:ACAS). The company had been performing well last year until first quarter results reporting comprehensive losses of $560 million were released, directly impacting the share price at the start of May 2013. The decline in share price continued till the end of 2013. Since then, it has managed to show some recovery.
American Capital Agency purchased 0.3 million, 11.9 million and 28.2 million shares during the second, third and fourth quarters of 2013 respectively. The aim behind the repurchase was to avoid a decrease in book value per share due to the decline in share price with the anticipation of tapering. However, the company was unable to control the net book value per share, and it continued to decline during 2013 from $28.93 per share to $23.93 per share (almost a 17% decline) from the start of the second quarter to the end of the year.
One of the reasons behind this decrease might have been the reduction in value of MBS due to an increase in MBS rates before the tapering announcement, as can be seen from the graph below. So far, the mREIT has paid more than $851 million for the repurchase program and further increased the repurchase authorization from $1 billion to $2 billion for the total program till the end of 2014. However, these repurchases have yet to show an effect on the book value per share.
Not only did AGNC repurchase its own share, it also got hold of its peer's stock amounting to approx. $400 million during December and January. This move should be considered as a good initiative, as the company managed to buy REIT stocks when they were at a low. It was a great move by the management, as the company had the option to buy MBS assets at current market value while it went for MBS stocks at a 20% discount to book value. However, the name(s) of the agency REIT was not revealed by the company.
Interest Rate Spread
Interest rate spread is similar to profit margin for REITs, a higher rate results in a better profit. It is essentially the difference between the borrowing and lending rate of the company (as mREITs mostly finance their activities through debt). American Capital Agency has shown an improvement in this regard, as it managed to increase its interest rate spread during 2013. Compared to the fourth quarter of 2012 it has declined by 4%, but it has been a great recovery quarter-over-quarter (in the fourth quarter 2013) of almost 31%.
Net spread increased because of an increase in asset yield (which is the revenue rate of mREITs) and a decrease in cost of funds (which is the rate paid on debt). This shows that the company is efficiently improving its results, while the cost of funds decreases. The LT debt also went up quarter-over-quarter by almost 10%, from $3.6 billion to $3.9 billion.
Dividends in the entire REIT industry declined with the anticipation of tapering, along with a decline in share price. AGNC's dividend also fell during 2013 (by 48% year-over-year and 19% quarter-over-quarter), as it reported the fourth quarter's dividend of $0.65 per share.
Source: AGNC Disclosures
Source: AGNC Disclosures
AGNC has always had one of the highest yields amongst its peers, and despite a declining dividend trend, the company's current dividend yield is still higher than many of its competitors (sitting at 17%, according to our estimates), which is impressive even after a decrease of 26% during 2013. During the third quarter of 2013, the Operating Cash Flow (OCF) yield of AGNC was 25.5% (much higher than the forward annual dividend yield), which shows that it has the capacity to pay such a high level of dividend yield.
Dividend Yield (%)
American Capital Agency
Newcastle Investment (NYSE:NCT)
Hatteras Financial (NYSE:HTS)
Source: Yahoo Finance
Stockholders' equity decreased to $8.7 billion in the fourth quarter of 2013 after a decline of 12% quarter-over-quarter as the company reported a comprehensive loss of $369 million (for the third time during 2013), this is a $0.99 loss per share. However, AGNC managed to decrease its cost of funds to 1.25%, which is a 10% decrease quarter-over-quarter, because of which it increased its interest rate spread. As a REIT has to pay around 90% of its earnings to avoid taxes, we expect that due to an increase in the interest spread the dividends might go up for the first quarter of 2013 due to an increase in expected earnings.
Source: Yahoo Finance
American Capital reduced its overall portfolio to $68.2 billion, largely reducing mortgage-backed securities (MBS) of both 30-year and 15-year maturity. The reason behind this might have been past reductions in the book value of these securities because of an increase in their yield. The company has maintained a higher percentage of 15-year MBS due to the fact that when the yield increases or decreases, the value of 30-year MBS changes by twice the amount of 15-year MBS, making them less riskier during times of highly volatile mortgage yields. (click to enlarge)
Source: Mortgage News Daily
From the graph above, we can see that the value of 30-year MBS has increased by around 1% year-to-date due to the decrease in the interest rate of 10-year US Treasury Bonds. While the tapering is being continued the supply of treasuries will increase in the market, and if demand fails to match the increased supply, the treasury yield will go up. As treasury yield is directly related to the mortgage interest rate, the rates will go up as well, and this will decrease the value of MBS. If we look at the current market conditions, the treasury yield is expected to increase in the future, which means that we should expect a decrease in the value of MBS in the long run.
We can see that the company has positioned itself to give good returns in the medium term. We are expecting dividends in excess of $0.65 per share due to an increase in the net interest rate spread. Furthermore, we expect that the US treasury yield will stay low in the medium term due to foreign investment. China, Japan and other emerging countries need the dollar to maintain their growth rate, which means that demand for US Treasury Bonds will go up; keeping yield low and resulting in a higher value of MBS. This situation will help AGNC to change its To-Be-Announced (TBA) position from net short to net long. That being said, the US Treasury yield is expected to increase in the long term, because as China's and Japan's economy strengthens, further purchase of the dollar won't be needed, resulting in less demand for US Treasury. This will lead to an increase in yield, damaging the value of MBS, and in turn, decreasing the book value of American Capital.
We are expecting this stock to generate good returns for the investor in the medium term and would not recommend it for long-term investment due to the expected increase in US Treasury yield.
Additional disclosure: Equity Flux is a team of analysts. This article was written by our Basic Material and Financial analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.