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Summary

  • American Capital posted some of its best quarterly results in over a year, yet the stock still fell on the news.
  • While book value did see an increase, some were expecting more.
  • In addition, concerns were raised regarding the drop in net interest income and the possible impact on the dividend going forward.

What a perplexing week for American Capital Agency Corp (NASDAQ:AGNC). While the stock posted its best quarter since 2012, shares of the company have actually declined in recent days. This begs the question: What has American Capital done wrong in the market's eyes? The focus of this article is to try to answer this question and provide further insight into the quarterly results.

Q1 2014 Overview

For a more in-depth overview please check out my previous article.

Below are a few of the key stats for American Capital's Q1:

  • Comprehensive income : $1.18 per share (consisting of a $0.41 per share net loss and $1.59 in OCI, or other comprehensive income)
  • Net spread and dollar roll income: $0.71 per share
  • Taxable income: $0.47 per share (excludes $0.29 per share in net capital gains and dollar roll income applied against last year's net capital loss carryforward)
  • Net interest rate spread: 1.19%
  • Net spread including dollar roll income: 1.43%
  • Book value: $24.49, up 2.3% from $23.93 last quarter
  • 5.1% quarterly economic return (comprised of the $0.65 dividend and $0.56 increase in book value)

Overall, American Capital posted a decent quarter. However, the 2.3% increase in book value was lower than expected. Furthermore, American Capital's 1.19% net interest rate spread was well below even the Q3 2013 low of 1.20%.

Why was American Capital's book value increase so paltry?

Below are some of the book value increases posted by other mREITs compared to American Capital:

StockQ4 2013 BVQ1 2014 BVPercent Change
CYS Investments (NYSE:CYS)$9.24$9.684.70%
Hatteras Financial (NYSE:HTS)$21.50$21.811.40%
American Capital$23.93$24.492.30%

While some may argue American Capital should have posted an increase similar to CYS, Hatteras is a clear example that not all mREITs will post large BV gains. Do note that many mREITs have still not reported their quarterly results, greatly limiting my sample size.

Furthermore, from the conference call, American Capital hinted at a possible reason for the soft BV gains. In a question regarding hedges, Peter Federico, SVP and Chief Risk Officer, noted that:

...depending on where you've had your hedges, obviously, it was a huge drive of the performance of the mortgage portfolio. We still need and want a lot of our hedges in intermediate to longer-term part of the curve. It's close to about 60% today. And obviously, if we had them while shorter, this last quarter, our book value would have been up much more but that wouldn't have been the right position to have in the long run.

To put this more simply, American Capital hedges may have negatively impacted the BV for the quarter.

Heading into the year, American Capital greatly increased its hedges, largely to protect itself from interest rate volatility. This was done largely through swaptions. However, as implied volatility ("risk") declined, so did the value of these swaptions.

Fortunately, the company exited a large portion of the swaptions mid quarter, from around $14 billion to $8 billion. However, as noted by Gary Kain, CIO of American Capital, "...the losses on our swaption portfolio, while still material, were considerably smaller than they otherwise would have been."

Is the dividend safe? A look into the net spread going forward

Finally, let us talk about American Capital's dividend. Currently at $0.65 per quarter, you would think that the $0.71 generated in net spread and dollar roll income would suffice to cover it.

However, investors are worried about the tightening spread. In the quarter, the company generated a mere $291 million, or $0.82 per share, in net interest income ("NII"), down from $422 million, or $1.13 per share, last quarter. As noted earlier, the main culprit here were lower spreads, down to 1.19%.

That being said, I would not worry that much about the dividend for several reasons.

First, taxable income came in at $0.76 per share when adding back in the non-taxed items.

Second, American Capital generated a large amount of income from the TBA dollar roll position. During the quarter, this income constituted $0.14 per share. This results in $0.71 per share when combined with the net spread income.

Lastly, American Capital itself believes that the current market stability is suitable for maintaining the $0.65 per share dividend. Specifically, the company noted that the decline in taxable income in UTI will not impact its decision regarding future dividends.

Conclusion

It appears as if some form of stability has returned to the MBS and mREIT market. American Capital posted an impressive 20% annualized return last quarter. For owners of the stock pre-2013, this was pretty much in line with its previous performance.

American Capital's Gary Kain noted that "...implied volatility should remain low while the prepayment landscape continues to be benign." Furthermore, he noted that the "supply and demand equation and the overall positioning in the mortgage market remain very favorable." In addition, that this was "despite our view that the Fed will continue to taper their purchases along the current trajectory."

That being said, American Capital is remaining vigilant. The company has noted that it could rebalance its portfolio if volatility returns or in the event of future Fed tightening.

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.

Disclosure: I am long AGNC, CYS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: American Capital Agency: A Return To Stability