- Volatility seen in past year in book values of mREITs likely to reduce.
- AGNC’s investments in securities backed by the U.S. government give it a lower credit risk.
- Current valuations remain attractive.
American Capital Agency (NASDAQ:AGNC) is an externally managed REIT that invests in securities whose interest and principal payments are guaranteed by government entities. The company had a tough and volatile last year, 2013, as the rising Treasury Yields adversely affected the company's net spread earned and book value. However, I believe the volatility in the book values for mREITs is likely to reduce due to relatively stable current Treasury Yields and repositioning of investment portfolios in the industry. I am bullish on AGNC, as the ROE is expected to stay high due to a relatively high spread between asset yield and borrowing costs. Also, as the company entirely invests in securities backed by the U.S. government, the company has a lower credit risk. Moreover, the company has repositioned its portfolio to protect its book value, and valuations for the company remain attractive.
The company's portfolio rebalancing decisions are mainly determined by the forecasted slope of the yield curve. As economic conditions in recent quarters improve and the Fed continues to taper, the yield curve is expected to steepen and 15-year MBS are likely to remain favorable as compared to 30-year MBS. On the contrary, if economic conditions deteriorate and the ongoing asset purchase tapering is deferred, 30-year MBS securities will become more valuable.
As the yield curve is expected to steepen in the coming quarters, the company is likely to reposition its portfolio, favoring 15-year MBS. In 4Q2013, the company's portfolio allocation remained unchanged. However, the company's management indicated favoring 15-year MBS, as 15-year MBS has a higher reinvestment flexibility and shorter duration. At the end of 4Q2013, AGNC's investment portfolio consisted of 95.5% fixed rate securities, 2.6% of CMOs and 1.9% of adjustable rate securities. The following chart shows the investment portfolio composition for AGNC at the end of 4Q2013.
Source: Company Report
At the end of 4Q2013, the company's net assets value dropped by 12% quarter-on-quarter; the decline was mainly due to the sale of MBS to fund share buybacks and make investments in mREITs equity securities. Also, the company's leverage dropped from 7.9x in 3Q2013 to 7.3x in 4Q2013.
Share Repurchases and Dividends
In the rising Treasury Yields environment, share repurchases are an attractive option in the hands of the company to grow EPS and protect its book value. AGNC repurchased 7% of its common stock outstanding in 4Q2013; since 4Q2012, the company has repurchased 46.3 million shares for $1 billion, or 11% of its total outstanding shares. The company is likely to continue its share buybacks in the coming quarters, as the company increased its existing share repurchase program to $2 billion from $1 billion. The existing share repurchase program is set to expire by 31st December, 2014. Other than repurchasing its own shares, the company has been purchasing equity securities of other mREITs; by the end of 31st January, 2014, AGNC purchased $400 million worth of other mREITs equity securities. I believe these initiatives are shareholder-friendly, and are likely to portend well for the stock price and provide incremental capital flexibility. Also, as the current valuations of the mREITs remain at a discount, AGNC's share repurchases and equity security investments provide value to investors.
In the last one year, the mREIT industry has lowered its dividends, as the net interest spread narrowed and book values observed losses, mainly due to rumors of asset purchase tapering. Consistent with the industry's dividend cuts, AGNC lowered its dividends by 48%, from $1.25 per share in 1Q2013 to $0.65 per share in 4Q2013. AGNC currently offers a high dividend yield of 11.60%. Last week, the company announced a quarterly dividend yield of $0.65 per share, flat quarter-on-quarter. The dividend is payable on 28th April, 2014. I believe the dividend offered by the company is safe and will be supported by its EPS, as the volatility in the mREITs space is likely to reduce in the future. Also, I believe the rising Treasury Yields are likely to result in lower CPR, which will lead to asset yield improvement, hence the improving net spread and the support to the dividends.
Valuations and Conclusion
2013 was a tough year for the industry, as the net spread contracted and dividend cuts were announced by companies, which took a toll on valuations and stock prices. However, I believe the sell-off is overdone. As the volatility is likely to lower and the environment is likely to stabilize in the near future, mREITs are likely to undergo multiples expansion. At the start of 2014, AGNC's stock was trading at a price-to-book value of 0.80x, since then, the stock has been observing multiples expansion, and currently, it is trading at a price-to-book value of 0.91x; historically, the stock has traded at a price-to-book value of greater than 1.0x. I believe the stock will continue to see a lift in its valuations and the stock will trade at a price-to-book value of 1.0x (targeted price-to-book value). The following chart shows the historical price-to-book value for AGNC.
(click to enlarge)
I calculated the stock price target of $24 for AGNC using the current book value of $24 and targeted price-to-book value of 1.0x. Based on my price target of $24, the stock offers a potential price appreciation of approximately 10% and total return of almost 22%, including a dividend yield of 11.6%. The following table shows the price target calculation.
Current Book Value
Targeted Price-to-Book Value
The company has been taking the right measures, including undertaking share buybacks and repositioning its portfolio to protect its book value. Also, the stock offers a high dividend yield of 11.6%, which makes it an attractive investment option for dividend-seeking investors. Due to the above mentioned factors, I am bullish on the stock.