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  • Unrealized gains and losses on the bulk of AGNC's assets do not appear on the income statement.
  • Net interest income does not include all the expenses of interest rate swaps.
  • A non-GAAP based model is therefore required to assess dividend sustainability.
  • The model presented indicates the current dividend rate is sustainable under Q114 levels of interest rate spreads and leverage.

This article applies a methodology described in my prior articles to assess whether the dividends paid by American Capital Agency Corp. (NASDAQ:AGNC) are sustainable in light of the latest available information (Q1 2014 data) on leverage and interest rate spreads.

The bulk of AGNC's assets consist of mortgage-backed securities (MBS) and debentures issued by Fannie Mae, Freddie Mac, Ginnie Mae and the Federal Home Loan Bank (together, "Agency Securities"). These securities account for 82% of AGNC's asset portfolio as of 3/31/14 (86% as of 12/31/13). AGNC relies primarily on short-term borrowings to acquire Agency Securities with long-term maturities. The shape of yield curve, the spread between returns on assets owned and the interest paid on amounts borrowed to purchase these assets, and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of profitability.

AGNC's Agency Securities are typically classified for accounting purposes as "available-for-sale". They appear on the balance sheet at fair value, but unrealized gains and losses on these securities do not appear on the income statement. Instead, such gains and losses and are reported on the balance sheet as a separate component of stockholders' equity. In addition, net interest income as measured by GAAP does not include all the expenses of interest rate swaps.

AGNC also engages in a form of off-balance sheet financing of agency MBS on a generic pool, or to-be-announced (TBA), basis. In TBA dollar roll transactions, AGNC purchases agency MBS paper for a forward settlement date. The difference between the price paid and the price of the same paper for settlement in the current month is referred to as the "price drop". The price drop is the economic equivalent of the net interest carry (interest income less implied financing cost). AGNC accounts for these positions as derivative instruments, and recognizes dollar roll income in "other income (loss)" on its financial statements (i.e., not as interest expense).

Management therefore uses non-GAAP measures to evaluate its performance, of which "economic return for the period" appears to be the most important. Economic return (loss) on common equity represents the sum of the change in net asset value per common share ("book value") and dividends declared on common stock during the period, over beginning book value per common share. Economic return for recent quarters and the trailing twelve months (TTM) ended 3/31/14 and 3/31/13 is presented in Table 1 below:

(click to enlarge)Table 1: $ per common share; economic return for quarterly periods not annualized. Source: Company 10-Q, 10-K, 8-K filings and author estimates.

Economic return, however, does not provide a good enough indication as to whether the dividends paid are sustainable in light of AGNC's leverage and interest rate spreads. To perform that evaluation, I use a model (also non-GAAP based) that can provide insights as to what is happening to AGNC's bread-and-butter business of using short-term borrowings to acquire Agency Securities. This model and the relationship it shows between sustainable dividends and actual dividends paid is presented in Table 2 below:

(click to enlarge)

Table 2: Dividend sustainability model. Source: Company 10-Q, 10-K, 8-K filings and author estimates.

AGNC's sustainable coverage of dividends turned positive in Q4 2013 after 5 consecutive quarters of below 1x coverage. This was made possible by the more-than-50% reduction in quarterly dividends (from $1.25 to $0.65). The current dividend now seems to be aligned with what AGNC's basic business model can produce under Q1 2014 levels of net interest spreads and leverage. Contrasting this with what, as shown in a prior article, the model indicates for Annaly Capital Management, Inc. (NYSE:NLY), I would prefer AGNC.

Source: Model For Assessing Sustainability Of AGNC's 11% Dividend Yield - Q1 2014 Update