American Capital Agency (NASDAQ:AGNC) is a name I have covered in detail over the past two years. As it has been some time since my last deep analysis of the company, the purpose of this article is to examine the performance of key metrics of this mREIT that I have highlighted in the past. This includes the key drivers of the company's income, the company's all-important book value as well as the building blocks of the company's interest rate spread. In other words, let's face the facts, things are improving.
Impact of the recent quarterly report
The very first thing most will notice when reviewing the most recent quarterly report was that AGNC reported a Q2 comprehensive income of $862.0 million, or $2.43 per common share. But what went into this number? Well, AGNC reported $0.08 of net income per common share (this is GAAP income) and $2.35 of other comprehensive income. With the recent losses that mREITs had posted in mid-to-late 2013, this represents a good turnaround. The $2.35 in other comprehensive income was driven by unrealized gains in AGNC's holdings of agency securities. Looking directly at other income, AGNC saw a net loss of $222 million or a loss of $0.63 per share. How did this come about? Well, due to ongoing portfolio rebalancing efforts, AGNC has $22 million in realized gains from sales of agency securities, but sizable losses associated with swaps. The big loss was $500 million in net unrealized losses on interest rate swaps and early termination fees. Another $87 million was lost to interest rate swap short-term interest rate costs and $41 million of net losses in said swaptions. At the end of Q2, the company had payer swaptions totaling $7.7 billion. Recall that these interest rate swaptions are used to offset the damaging impact of general rises in interest rates.
Surprisingly, AGNC also had $182 million in losses on US treasury positions. This caught me somewhat by surprise given that interest rates had been declining for 2014, and declined nicely throughout Q2 (figure 1). Recall the rates decline as treasury values increase, so it is somewhat surprising to see the losses, although it is unclear exactly when they were purchased. These other losses were offset by a $138 million TBA dollar income figure, and a large $406 million in net mark-to-market gains on TBA positions. Rounding the positive side out was another $24 million in REIT security income. Finally, estimated taxable income for the second quarter was $0.28 per common share, or $0.20 higher than the GAAP net income per common share of $0.08.
Figure 1. Interest Rate on the Ten-Year Treasury, March 31, 2014 to June 30, 2014
Source: Yahoo Finance
A key metric: The interest rate spread
Now that we better understand a good portion of the earnings figures, let us turn to other measures that can heavily impact AGNC's earnings potential and subsequently share prices. First up, what about the critical interest rate spread? Well, to get to this critical figure, we must understand the building blocks of the spread. The formula is simple. The interest rate spread is equal to the average yield on assets minus the cost to purchase those assets. Well, AGNC's average asset yield on its agency security portfolio was 2.71%, compared to 2.54% for the first quarter. That's pretty high. It was a nice improvement over the first quarter. That's the first piece. Further, the average cost of funds for the second quarter also increased just a bit, by 10 basis points to 1.45% from 1.35% for the first quarter. If we exclude some of the swap hedge costs attributed to dollar roll funded assets, the company's total costs of funds for repo assets was 1.16% for the second quarter, for an annualized net interest rate spread of 1.55% on repo assets. But we also need to consider the company's dollar roll funded assets. The dollar roll funded assets generated an annualized net interest rate spread of 2.92%. When we combine the net interest rate spread on AGNC's repo and dollar roll funded assets, the net interest rate spread for Q2 was 1.84%, which is up sharply compared to Q1's 1.43%
Constant prepayment rate
One measure to keep an eye on is the constant pre-payment rate, which is the rate at which the principal of a loan is expected to be prepaid in a given time period. For example, if a certain mortgage loan pool has a constant prepayment rate of 7%, then 7% of the existing pool principal outstanding is expected to prepay, or was prepaid over the time period of measurement. The higher this goes, the larger the impact on potential interest income. Now, in total, American Capital's portfolio saw its constant pre-payment rate jump from 7% in Q1 to 9% in Q2. Further, projected constant pre-payment rate for the life of the current agency securities in the portfolio (as of the end of Q2) is approximately 8%. Again, the lower the better, but sub-10% is indeed favorable.
American Capital's risk exposure
Another key measure to be aware of is the company's risk exposure, which is best measured by leverage. What do we mean by so-called leverage? Leverage is using borrowed money to magnify returns. I will again point you to read more about leverage in this article. Leverage includes repurchase agreements, convertible senior notes, securitized debt, loan participation and mortgages payable. Leverage at the end of Q2 2014 was 6.9:1, compared to 7.6:1 as of the end of Q1 2014. This de-leveraging was a result of gains in the company's portfolio holdings as well as an increase in equity that resulted from the second quarter preferred stock offering.
The plain fact is that book value is a key driver of any given mREIT's share price. The book value of many mREITs decreased sharply since 2012 given that these companies' earnings have drastically fallen since that time. Since the great sell-off of 2013 in mREITs following the sharp rise in interest rates we saw during that time, book value has started rebounding in many of these names. Again, book value is the best predictor of an mREIT's price. In the last quarterly report, book value was $24.49. For the second quarter, AGNC reported another increase in book value. In fact, quarter-over-quarter book value jumped 7.2% to $26.26 per share. Given the current trend into Q3 for interest rates, and the trajectory book value has seen in 2014, I predict that Q3 2014 will see book value rise to at least $27.00. Overall, the company posted a 9.9% return on shareholder equity in the quarter considering the dividend and book value improvement.
Let's talk dividends.
The primary reason to own mREITs is for the dividend. The long-term investor, one with a ten-year plus horizon, can reinvest dividends to potentially compound returns. Those in retirement can collect a sizable dividend as a source income. Over a decade, the dividend will fluctuate substantially in response to the cyclical nature of interest rates, changes in the company's portfolio holdings as well as the interest rate spread and other key metrics. Currently, the company has an annualized yield of 11.2% based on its current share price of $23.65. This assumes the $0.65 dividend paid to shareholders in Q2 will remain for the rest of the year. Now, this dividend amount is down substantially from historical levels, and has sent the yield down by nearly 50% from historical levels. It was not uncommon for AGNC to yield 20%-22% at times. However, the current 11.2% yield is nothing to sneeze at. This yield is more on par with other mREITs in the space, and is likely to be maintained. And this brings me to my next point.
The question is "will American Capital's dividend be maintained?" Well, I believe that it will be. Recall that the company's taxable income of $0.28 was far below the $0.65 paid in dividends. However, given that the company has carry-forward losses, it can pay out dividends far in excess of taxable income without repercussion, for now. Eventually, the company, like any other, will need realized income. What is interesting is that on the first quarter conference call, management highlighted this issue. Management stated:
"To this point, taxable earnings will become less relevant in understanding our financial performance and our capacity to pay dividends. For this reason, we will likely deemphasize taxable earnings as a supplement non-GAAP measure in the quarters ahead.
Now it's important to understand that the tax versus GAAP differences created by dollar roll income will not impact our decision with regard to where we set our dividends. As we have said many times in the past, we determine our dividend based on our view of the all in economics earnings power of our portfolio and not based on earnings geography.
If we can utilize our capital loss carry forward by generating capital gains via dollar rolls, we can in essence pass along that tax benefit to our shareholders by continuing the base of the dividend amount on the economic earnings power of the portfolio and changing the tax characterization of our dividend from ordinary to return of principal.
Based on this logic, and the performance of the dollar roll income stats (as well as taxable income), it seems the dividend is safe. Further, there are some advantages to shareholders. Dividends characterized as return of principal reduce an investor's basis in their stock. Thus, the capital gain or loss they have upon sale of the stock will change. This is generally beneficial to shareholders in that return of principal dividends represented deferred tax liability for shareholders and are typically taxed at the lower capital gains tax rate rather than being taxed in the current year at the ordinary income tax rate.
In fact, I think given the current interest rate climate, the improvements to the portfolio holdings, the efficient hedging in place and the trajectory of income, the dividend risk is to the upside, that is, a dividend raise is more likely than a cut. I think what is most likely is that the dividend will be maintained. In a detailed analysis, Seeking Author Scott Kennedy outlines why he believes the dividend will remain stable, and the issues of the capital loss carry-forward and TBA dollar roll income were key components of this analysis. but there is no denying things are on the mend. Overall, I think the dividend is safe so long as the market as a whole does not enter a major sell-off. Further, and perhaps more relevant, is that interest rates continue to stay low. They have moved with little volatility here in Q3, which indicates that agency security holdings should not be negatively impacted. Further, the interest rate spread has been widening, which is a huge positive catalyst for generating income. Given the spread trajectory, a separate analysis suggests a dividend raise is possible in coming quarters. This is possible if rates hold steady. It is rate volatility, or sharp short-term increases, that crush mREIT portfolio holdings and can hurt earnings.
Let's face the facts. It is hard to argue with the fact that, for the most part, the key metrics of American Capital are improving. The widening of the net interest spread is a huge positive and book value is on the rise. At present levels, shares trade at a $23.65 and so book value is 11% higher than share prices. This represents opportunity in my opinion, but also represents some hesitancy on the part of the Street to pump share prices up to fair value, or a premium to book. But the bottom line is that shares are up substantially since they bottomed in the winter. The company is recovering nicely since the mREIT sell-off of 2013. While I do not rate American Capital a conviction buy as I did in the winter, I certainly think shares are worth a buy based on my analysis of the company's current health.
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.