American Capital Agency Corp. Grows Toward The Future

| About: AGNC Investment (AGNC)

Summary

AGNC paid $0.65 for the 5th quarter in a row for an 11.23% yield.

Book Value rose $1.77 to $26.26 for a 9.9% increase for the quarter.

Portfolio is $71.9 billion and well managed.

AGNC is rated a buy and hold.

On July 28, 2014 American Capital Agency Corp. (NASDAQ: AGNC) reported a dividend of $0.65 for the fifth quarter in a row. More importantly, the company stated a comprehensive income for the second quarter 2014 of $862 million, or $2.43 per common share. The return for the quarter, to include the dividend plus the change in net book value per common share, was a gain of 9.9% for the quarter, or 39.6% on an annualized basis.

This is a phenomenal quarterly report, and is not likely to occur repeatedly, however, this does display the company is managing their portfolio based on the current market conditions. A more detailed review of their hedge position shows they are preparing for a change in interest rates, which is expected to begin sometime in 2015. The portfolio has $71.9 billion agency MBS investment portfolio and $202 million investment in mortgage REIT equity securities as of June 30, 2014. We expect the company to provide strong financial reports for the rest of 2014 with two key results. We anticipate the dividend to remain near $0.65 each quarter and the book value to continue to increase. A double-digit dividend return and increasing stock price will make investors happy with this investment.

Digging deeper, $2.35 was attributed to other comprehensive income per common share, which includes net unrealized gains on investments market-to-market. Although this is credited through the accounting process, until they are realized, the numbers will fluctuate up and down. Only $0.08 was attributed to net income per common share. This is a more accurate focus for investors to comprehend. First quarter 2014, the comprehensive income was $1.59 per common share, and $0.41 loss per common share for investments, for a total of $1.18. Both of these numbers improved for second quarter. We anticipate the other comprehensive income to remain strong for third quarter, but to expect another $2.35 may be a high mark to match. Based on current market activity and the competitiveness, we could expect the comprehensive gain to near the $2.00 mark for the next two quarters.

American Capital rode the perfect storm, per se, as the Fed continued to reduce the amount of bonds it purchases each month. The reduction in purchases is having little to no affect on the market, and not pushing interest rates up. There is sufficient capital in the market. The Federal Reserve Board's Chairwoman, Janet Yellen, has maintained a steady performance as the most powerful person in the world of finance, and yet has quietly prevented the heating up of inflation that would force interest rates to rise. The financial industry as a whole as benefited from the controlled market. We do expect the purchasing of bonds to end in October 2014, and it is conceivable that interest rates will remain low into 2015. The artificially low rates will have to increase sometime, but until the market pressures begin pushing the Federal Reserve Board is content to hold rates down.

Interesting question: when the Federal government has to pay interest on all the bonds it has purchased, who gets the money? The real effect of buying of all the bonds was to pump billions of dollars into the economy. At some point, the Federal Reserve is expected to write off all the bonds and leave the billions of dollars in the economy. Investment companies have sufficient funds in the market to offer loans and the money is not tight, which would drive up the costs of borrowing (raise interest rates).

Some of the important stats from AGNC's second quarter financial statement included:

The net interest rate spread for second quarter was 1.84% annualized net interest rate spread and $0.87 per common share of dollar roll income. The net spread supports the profit margin and the first quarter spread was 1.43%, and $0.39 per common share of dollar roll income. The higher spread, although only increased by 25%, allowed the profit margin to double. In the future, after interest rates rise, the spread will increase more, allowing American Capital and others to have more profitable positions.

The estimated undistributed taxable income per common share as of June 30, 2014 is $0.04. Last quarter it was stated at $0.42 per common share. With a very low number for this report, the company is not expected to have a catch-up dividend to maintain it REIT status of distributing 90% or more of earned income (taxable income).

Maybe the second most important figure after the dividend is the book value. The net book value per common share increased $1.77 per common share, or 7.2%, from $24.49 to $26.26 per common share as of June 30, 2014. The economic return on common equity for the quarter was 9.9%, or 39.6% annualized. A strong book value demonstrates that the company can pay a healthy 11% dividend and grow its book value. The company is not giving away book value to pay its dividends. We believe the company will continue to grow its book value throughout 2014, and this can support a stock price appreciation for investors.

The leverage a company maintains is important, as the percentage of money borrowed cost interests and cuts into the profit line. Any numbers over 8% are considered higher than average for REITs. This quarter, the leverage was stated as 6.9x, as of June 30, 2014. First quarter 2014 was 7.6% and this represents a healthy drop and a strong financial quarter.

Final Analysis: Investors profited from the strong economic return this quarter, making it one of the best quarters in recent history. AGNC will continue to perform well throughout 2014, and will adjust into 2015 when the interest rates are anticipated to increase.

Some investors are concerned that stock prices will drop when interest rates begin to climb. Yes, they will on a temporary jolt in the market. AGNC has adjusted their portfolio to soften the effect, but it will still occur. The positive is when interest rates settle to the new level (whatever that rate is), the company (as well as every other company in the financial markets) will adjust and continue doing business. The higher rates will allow a higher profit margin, and the company will make higher profits. At that point we would anticipate stock prices to rise and dividend payout to remain above 10%.

We continue to recommend American Capital Agency Corporation as a profitable investment. We believe the company will continue to pay strong dividends over 10% and continue to grow their book value, which will lead to stock price appreciation for investors. AGNC is rated a buy and hold with the understanding that there will be an adjustment when interest rates rise. After the interest rates rise, we would anticipate the stock price will appreciate and profits from the spread will increase, rewarding investors.

Disclosure: The author is long AGNC. 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.