Blue Chip, 11% Dividend American Capital Agency May Be A Good Place For Your Money

Jul.18.14 | About: American Capital (AGNC)

Summary

The 10 year US Treasury Note yield has been going down. Hence MBS book values have been going up.

The net interest income is still good.

Gary Kain is making extra money through his investments in below book value mortgage REIT stocks in late 2013 and early 2014 that have appreciated in 2014.

Read for more details. If you like income stocks, you may wish to purchase AGNC.

American Capital Agency Corp. (NASDAQ:AGNC) is one of the blue chip Agency Mortgage REITs. The principal objective of AGNC is to preserve its asset value while generating attractive risk-adjusted returns to pay as dividends to shareholders. AGNC's manager is a subsidiary of a wholly owned subsidiary of American Capital Ltd. (NASDAQ:ACAS).

More recently AGNC not only invested directly in MBS of various types, it invested in the stocks of other companies that invest in MBS such as Hatteras Financial (NYSE:HTS). Many of the mortgage REIT companies were trading at a 20% discount to their book values late in 2013. Gary Kain, AGNC's CEO, saw this as a possible money making opportunity. One of his REIT investments was HTS. As of January 29, 2014 AGNC owned 7.3 million shares of HTS. As of June 27, 2014 AGNC only owned 4.37 million shares. SA analyst Albert Alfonso estimates that the shares sold amount to $11.50 million in realized gains; and the unsold shares amount to $17.50 million in unrealized gains. He says this should be a total return of 23% in less than six months. Gary Kain got the appreciation and the interest income in the MBS and the appreciation in the stock for AGNC. It is easy to see why he thought this was better than just the appreciation and interest income in the MBS.

In addition to "gifts" from Gary Kain from such good calls on investments as this, AGNC has also made good money its normal way. In Q1 2014 the 10 year US Treasury Note yield dropped 31 bps from 3.03% to 2.72% on March 31, 2014. The yield dropped a further 19 bps to 2.53% on June 30, 2014. As of this writing on July 17, 2014, the yield is 2.46% (-7 bps below the close of Q2 2014). Normally when this yield goes down, the value of MBS go up. Hence investors should expect to see book value gains by AGNC for Q2 2014. This will add to the gains already mentioned above. The chart of the 30 year FNMA 4.0% fixed rate MBS below shows the gain of a bond type that represented 25% of AGNC's portfolio as of March 31, 2014.

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Readers can see that this gained approximately 1.5% from March 31, 2014 through June 30, 2014. With leverage of 7.6x as of March 31, 2014, this would provide AGNC with a huge profit if one did not take into account hedges and other expenses. Hedges covered 94% of AGNC total repo, other debt, and net TBA positions as of March 31, 2014. This should be slightly more expensive than in Q1 2014, since this figure was 86% as of December 31, 2014. Further the drop in the 10 year US Treasury Note yield for Q1 2014 was 31 bps, while the drop was only 19 bps for Q2 2014. These two factors should translate into lower book value appreciation in Q2 2014 compared to Q1 2014, but there should still be book value appreciation, especially after the sale of some of the stocks in other mortgage REITs. The book value gain in Q1 2014 was $0.56 per common share. I am not sure how much stock investment sales may figure into the Q2 book value, but on an MBS appreciation basis alone one would expect the book value gain in Q2 2014 to be lower than the MBS appreciation gain in Q1 2014.

The lower interest rates should also lead to a slightly lower net interest rate spread for Q2 2014. The net interest rate spread was 1.43% annualized in Q1 2014. With Dollar Roll income the figure was 1.59%. A net interest rate spread of about 1.25% might be a reasonable expectation for Q2 2014. Since AGNC has already declared its Q2 dividend at $0.65 per common share, there is no chance for a decreased dividend in Q2 2014, but the continued downward trend in the 10 year US Treasury Note yield may bring a dividend decrease into play for Q3 or Q4 2014.

Of course, many people are expecting interest rates to rise later this year. If that happened it would likely remove the need for a dividend decrease. We will have to wait to see what happens. There are arguments for both scenarios. The chart and tables below describe AGNC's portfolio as of March 31, 2014.

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One thing investors should notice is the still high proportion of 30 year fixed rate Agency RMBS. These can devalue quickly in response to interest rate rises. This is likely the reason for the higher amount of hedging as of March 31, 2014 compared to December 31, 2014. However, the high amount of 30 year fixed rate Agency RMBS still represents a big duration risk; and AGNC's duration is still higher than many other mortgage REITs at 1.2 with hedging as of March 31, 2014. Durations of under 1.0 are a common standard.

One would expect the higher duration number to have decreased a little bit with the decreased interest rates in Q2 2014. However, this is still a long term problem for AGNC's portfolio; and it should not be ignored. The duration gap sensitivity table is below.

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As readers can see the 30 year MBS represent a duration of 6.1 (without hedges). This is worrisome; and hedging it is expensive. Of course, if rates continue to go down as they have been, this portfolio arrangement can be very profitable.

In sum AGNC is a buy. Many are expecting interest rates to go up; but geopolitical events have been heating up. An airliner was shot down over Ukraine recently. The current speculation is that this was done by Russians or by Russian backed separatists. Experts say it must have been a sophisticated surface to air missile guided by radar. It was not a shoulder fired missile. The US is threatening further sanctions. If these happen they could lead to further tensions and further economic problems for many countries.

Israel has finally moved forces into Gaza in response to repeated Palestinian attacks. Iraq is still a country of warring sects, which have hated each other for centuries. The situation there does not seem likely to be resolved soon. There are other problem areas. Even Ebola virus is rearing its head in Africa to threaten Africa, if not the world.

The US is again seeing a flight to quality (US Treasuries and other high quality bonds). The article, "16 Good Reasons To Be Wary Of A Market Downturn," contains some of the explanation of the many factors threatening the world economy. Many of these factors tend to make blue chip, Agency, fixed rate RMBS investing mortgage REITs look like good investments. With a dividend of about 11%, AGNC is a good buy in a rising book value environment. Many other investments may fall rapidly in such an environment.

The one year chart of AGNC provides some technical direction for this trade.

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The slow stochastic sub chart is near oversold levels. The main chart indicates AGNC has been in a slight uptrend since the beginning of 2014. It is unclear exactly what will happen in the future; but the prospects look good.

The book value as of March 31, 2014 was $24.49 per common share. One might posit that this number will go up by at least $0.25 per common share in Q2 2014. This would bring the current book value to about $24.74. Since the current stock price is $23.10 per share, the discount to book value is about -6.6%. This makes AGNC an even better buy, especially when you consider that the 10 year US Treasury Note yield is already -7 bps lower than at the end of Q2 2014. This means that more appreciation of MBS is already in your pocket for Q3 2014. AGNC is a buy in these unsettled circumstances. CAPS agrees with me with a four star rating (a buy). Consider also that AGNC has a Beta of only 0.13, so it will not be as susceptible to market downturns as many other stocks.

NOTE: Some of the above fundamental fiscal information is from Yahoo Finance.

Good Luck Trading.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in AGNC over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.