American Capital Agency (NASDAQ:AGNC) reported its second-quarter earnings figures. The company's comprehensive income was approximately $862 million, or $2.43 per share. This was made up of $0.08 net income per common share and $2.35 of other comprehensive income, which ultimately led to $0.28 estimated taxable income per share, which is far below the $0.65 per common share paid in dividends for the quarter, resulting in a $0.37 per share deficit. However, when it is all tallied, the company still had an additional $0.04 per share in undistributed taxable income. This is a positive but clearly the company needs to step up its earnings game to cover its dividend. The annualized yield on average interest-earning assets was 2.71%, and the annualized cost of funds on average interest-bearing liabilities was 1.45%. If we exclude swap hedge costs related to dollar roll funded assets, the average cost of funds was 1.16%, which resulted in an average interest rate spread of 1.55%. When we factor in both the repo and dollar roll funded assets for the quarter, the net interest rate spread ballooned to 1.84% in the quarter. This is incredibly strong relative to past quarters and represented a 41-basis point increase from the 1.43% average interest rate spread for the first quarter.
In my January article, I argued that American Capital Agency stock had bottomed and that the risk was nearly entirely to the upside. The present quarterly results support my thesis from the article. Unlike its smaller competitor, Javelin Mortgage Investment (NYSE:JMI), which entered 2014 on a strong note, American Capital was bumping along five-year lows to start the year. I predicted that the rebalancing of American Capital's portfolio would be a huge benefit to the company in 2014, and that the dividend cuts were likely over. That has since proved to be correct. In addition, unlike Javelin, which has seen slight book value erosion, American Capital's book value rose yet again to $26.26, a 13% premium to the current share price of $23.20.
Thus far, the call I made in the January article has been correct. American Capital Agency did hit its bottom, barring an absolute market meltdown in the coming months. Since that time, shares are up 15%. I predicted the dividend would likely be maintained at $0.65, and it has been, and I believe this has served as a catalyst for the stock. The present earnings report has many strengths but some notable weaknesses. Strength was seen in comprehensive income, the net interest spread as well as book value appreciation. However, taxable income, the basis for dividend payments, was light. That needs to improve. I think it can because right now interest rate concerns have dissipated, and now they are back to the levels from early 2013. I believe that American Capital's portfolio rebalancing efforts have been successful. But we need to see earnings improve in Q3 and Q4, or else the dividend can be cut. At this time, I believe the discount to book value is a result of doubt that American Capital Agency can hit its earnings target. I maintain a "buy" rating on the stock, but do not have the same conviction I had in January. Instead, you must pick your spots wisely on pullbacks, and keep an eye on interest rates and mortgage activity.
Disclosure: The author is long AGNC, JMI. 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.