On 2/1/2016, American Capital Agency Corp. (NASDAQ:AGNC) reported results for the fourth quarter of 2015. AGNC reported net income of $588 million, an other comprehensive loss ("OCL") of ($561) million, comprehensive (total) income of $27 million, and a book value ("BV") of $22.59 per common share as of 12/31/2015.
In my prior AGNC Q4 2015 income statement projection article, I anticipated the company would report the following amounts in relation to the fourth quarter of 2015: 1) net income of $566 million; 2) an OCL of ($514) million; and 3) comprehensive income of $52 million. In my prior AGNC Q4 2015 book value projection article, I anticipated the company would report a BV of $22.60 per common share as of 12/31/2015. As such, I believe AGNC reported results were "as expected" when compared to my projections.
Within the first section of this article, I will summarize my prior articles' account projections and compare each amount to AGNC's actual results. If a specific account had at least a modest variance between my projection versus AGNC's actual results, I will also provide an explanation on the variance. I will list AGNC's accounts in the same order as projected in my income statement projection series (see link provided above).
Side Note: Through 2/1/2016, four other mortgage real estate investment trust ("mREIT") peers and one company that had "mREIT-like" characteristics (a "limited liability company" for tax purposes) that I currently cover have recently disclosed to the public actual (or in some cases internally estimated) BV as of 12/31/2015 or as of 12/21/2015 in the case with two affiliated mREITs. The following were the BV fluctuations for AGNC and the five other companies during the fourth quarter of 2015 (in order of least to most severe percentage decrease):
1) Orchid Island Capital Inc. (NYSE:ORC): Estimated BV decrease of (0.43%)
2) AGNC: Actual BV decrease of (1.78%)
2) Ellington Financial LLC (NYSE:EFC): Estimated BV decrease of (1.78%)
4) Capstead Mortgage Corp. (NYSE:CMO): Actual BV decrease of (4.52%)
5) ARMOUR Residential REIT Inc. (NYSE:ARR): Estimated BV decrease of (4.68%)*
6) Javelin Mortgage Investment Corp. (NYSE:JMI): Estimated BV decrease of (6.25%)*
* = Estimated BV mean as of 12/21/2015
It should also be noted a fellow contributor, Colorado Wealth Management Fund, recently provided an AGNC analysis where he/she projected the company would report BV as of 12/31/2015 of $22.58 per share. This contributor's analysis was also highly accurate. As such, I believe this contributor should be commended by readers. This contributor covers the mREIT sector in a timely, concise matter and I believe provides a valuable service to readers through this forum.
Actual Versus Projected Results:
To highlight my projected account figures versus AGNC's actual reported amounts for the fourth quarter of 2015, Table 1 is presented below. Table 1 shows AGNC's consolidated statement of comprehensive income from a three-months ended timeframe.
Table 1 - AGNC Three-Months Ended Consolidated Statement of Comprehensive Income (Actual Versus Projected)
(Source: Table created entirely by myself, partially using data obtained from AGNC's quarterly investor presentation slides)
First, let us compare AGNC's interest income account. My projection for this account was $365 million. AGNC reported interest income of $374 million. This was a slight outperformance in my opinion and this minor variance was well within my stated range. In addition, all "sub-accounts" within this account performed pretty much as expected during the fourth quarter of 2015. As such, further discussion of this account is unwarranted.
Second, my projection for AGNC's interest expense account was $90 million. AGNC reported interest expense of $86 million. Again, this minor variance was well within my stated range. As anticipated, the weighted average interest rate on AGNC's repurchase loans increased during the fourth quarter of 2015 (especially during December 2015). AGNC's weighted average interest rate on the company's repurchase loans was 0.52% as of 9/30/2015 which increased to 0.61% as of 12/31/2015. Since markets anticipated a 25 basis point ("bps") movement in the Federal ("Fed") Funds Rate during December 2015, the London Interbank Offered Rate (LIBOR) increased by roughly the same amount during the fourth quarter of 2015. In direct correlation, repurchase loan rates "followed suit" and increased during the quarter. The relationship between repurchase loan rates and LIBOR was originally discussed within my income statement projection article (see link provided above). Simply put, I correctly anticipated the weighted average interest rate on AGNC's repurchase loans would slightly increase during the fourth quarter of 2015.
Third, my projection for AGNC's MBS sales account was a minor net loss of ($60) million. In comparison, AGNC reported a minor net gain of $2 million. For this account, AGNC actually outperformed my expectations but this variance was still well within my stated range. As originally discussed within my income statement projection article (see link provided above), AGNC's "gain (loss) on sale of agency securities, net" account is DIRECTLY tied to the company's "unrealized gain (loss) on available-for-sale ("AFS") securities, net" account. Therefore, if AGNC's gain (loss) on sale of agency securities, net actual amount is above or below my projected figure/range, the variance is automatically offset in the company's unrealized gain (loss) on AFS securities, net account. As anticipated, this inverse relationship held true during the fourth quarter of 2015. When calculated, AGNC's quarterly MBS sales amount outperformed my projection by $62 million during the fourth quarter of 2015. However, since AGNC had an outperformance within its gain (loss) on sale of agency securities, net account, the company also had an underperformance within its unrealized gain (loss) on AFS securities, net account. My projection for AGNC's unrealized gain (loss) on AFS securities, net account was ($535) million. In comparison, AGNC reported a net unrealized loss of ($583) million. As such, when compared to my projection, AGNC underperformed within the company's unrealized MBS account by ($48) million. Therefore, when combining AGNC's net realized MBS sales outperformance of $62 million and the company's net unrealized MBS underperformance of ($48) million, both accounts had a combined net outperformance of just $14 million which was basically a valuation "match" when compared to my projections (based on an MBS portfolio of approximately $50 billion throughout the quarter).
Fourth, my projection for AGNC's derivative instruments and other securities account was a net gain of $385 million. In comparison, AGNC reported a net gain of $331 million for this account. I believe only having a $51 million variance within this account is an extremely hard "feat" to accomplish due to the complexities surrounding how one values a company's derivatives portfolio. I would also note projecting AGNC's derivative instruments and other securities, net account is highly complex and involves projecting four material derivative sub-accounts ("to-be-announced" ["TBA"] MBS, interest rate swaps, interest rate swaptions, and U.S. Treasury securities) including several other minor derivative sub-accounts. While no one has a "crystal ball" per se regarding future events, being able to project all these derivative sub-accounts, before any sector peer provides quarterly results, takes a great deal of expertise in my opinion. This includes fully understanding how to value all theses derivative instruments as well as correctly deciding on specific assumptions that one believes coincided with management's overall risk management strategy during any particular quarter.
Within AGNC's four material derivative sub-accounts, I projected a net gain (loss) of ($15), 360, $25, and $14 million in regards to the company's TBA MBS, interest rate swaps, interest rate swaptions, and U.S. Treasury securities, respectively. In comparison, AGNC reported a net gain (loss) of ($33), $347, ($8), and $35 million on the company's TBA MBS, interest rate swaps, interest rate swaptions, and U.S. Treasury securities, respectively. As such, all four derivative sub-account projections were very close to my projected valuations (especially when considering each account had notional/face amounts that were valued in billions). As previously stated, within these four derivative sub-account projections I typically utilize offsetting "cautious" and "aggressive" assumptions. As such, if one derivative sub-account has a projected fairly aggressive valuation, another derivative sub-account would likely have a more projected cautious valuation. This is exactly what occurred within this derivative account during the fourth quarter of 2015. If anything, the net valuation change within AGNC's interest rate swaptions was a minor disappointment due to the fact I projected the company would add a minor net (short) position during the quarter due to, at the time, the potential heightened risk of continued interest rate increases in the near future. This notion was in relation to the Federal Open Market Committee's ("FOMC") Fed Funds Rate increase in December 2015. However, AGNC decided not to add to this position which has proven to be the correct move in regards to events that have occurred thus far during the first quarter of 2016 (will be discussed towards the end of the article).
Fifth, my projection for AGNC's management fees and operating expense accounts were $27 and $7 million, respectively. AGNC reported management fees and operating expenses of $28 and $5 million, respectively. These two accounts had a combined variance of $1 million which was well within my stated ranges. When all the accounts described above are combined, I projected AGNC would report net income of $566 million. When calculated, AGNC's reported net income of $588 million was only a variance of ($22) million when compared to my projections and was well within my stated range.
Sixth, as discussed earlier, my projection for AGNC's gain (loss) on sale of agency securities, net account was ($535) million. In comparison, AGNC reported a net unrealized loss of ($583) million. For a discussion of this specific account's minor variance/relationship to AGNC's MBS sales account, please see the reconciliation that was provided earlier.
Seventh, I projected a net unrealized gain on interest rate swaps reclassified to interest expense of $21 million for the fourth quarter of 2015. In comparison, AGNC reported an interest rate swaps reclassified to interest expense of $22 million for the fourth quarter of 2015 which was well within my stated range.
When all my account projections are combined, I projected AGNC would report comprehensive income of $52 million or $0.13 per common share during the fourth quarter of 2015. AGNC reported comprehensive income of $27 million or $0.06 per common share. When combined, this would be a total variance of $24 million or $0.07 per common share. In my opinion, this should be deemed as highly accurate due to the complexities involved when trying to project accounts/valuations within the mREIT sector. My projections were based on AGNC's "total assets" which were $60.6 billion at the end of the third quarter of 2015. Therefore, when compared to my projections, AGNC's actual results were as expected.
Readers have continued to request that I provide these types of "update"/"follow-up" articles showing how my quarterly projections "stacked-up" to AGNC's actual results. I believe the analysis above accomplishes this request. With that being said, let me highlight a few key points I believe should be considered when reviewing AGNC's quarterly results.
MBS Portfolio Considerations:
During the fourth quarter of 2015, AGNC maintained the company's "at-risk" (total) leverage by not materially changing the composition of the company's on-balance sheet MBS portfolio and the company's off-balance sheet net long TBA MBS position. AGNC had an at-risk (total) leverage ratio, when including the company's off-balance sheet net long TBA MBS position, of 6.8x as of 9/30/2015. AGNC maintained the company's at-risk (total) leverage ratio at 6.8x as of 12/31/2015. To show the compositional changes to AGNC's on- and off-balance sheet MBS portfolio during the fourth quarter of 2015, Table 2 is presented below.
Table 2 - AGNC MBS Portfolio Quarterly Compositional Changes (12/31/2015 Versus 9/30/2015)
(Source: Table created entirely by myself, including all calculated figures and percentages)
Using Table 2 above as a reference, when comparing AGNC's portfolio as of 12/31/2015 versus 9/30/2015, the company had a net par value decrease in its 15-year fixed-rate agency MBS holdings with a 2.5%, 3.0%, 3.5%, 4.0%, and 4.5% coupon of ($0.2), ($0.2), ($0.2), ($0.2), and less than ($0.1) billion, respectively. When all 15-year fixed-rate agency MBS holdings are combined, this was a quarterly net par value decrease of ($0.8) billion. AGNC had a net par value decrease in the company's 30-year fixed-rate agency MBS holdings with a 3.0%, 3.5%, 4.0%, 4.5%, 5.0%, and 5.5% coupon of ($0.1), ($0.5), ($0.1), ($0.1), less than ($0.1), and less than ($0.1) billion, respectively. When all 30-year fixed-rate agency MBS holdings are combined, this was a quarterly net par value decrease of ($0.7) billion (rounded).
Since AGNC decreased the par value of its fixed-rate agency MBS portfolio by ($1.6) billion during the fourth quarter of 2015 but also repurchased 9.0 million outstanding share of common stock during the quarter, the company's leverage remained basically unchanged as of 12/31/2015 when compared to 9/30/2015. This is an important notion for readers to understand. It should also be noted AGNC maintained the company's proportional share of 15- and 30- year fixed-rate agency MBS holdings.
Since mortgage interest rates/U.S. Treasury yields have sharply net decreased during January 2016, existing MBS have had more attractive coupon rates when compared to current market MBS. In other words, existing MBS are more "attractive" to market participants due to a higher stated coupon rate (generally speaking). Per a valuation standpoint, I believe AGNC maintaining the company's proportion of 30-year fixed-rate agency MBS holdings (as opposed to decreasing this proportion) is a positive factor as these investments have experienced additional price increases versus 15-year fixed-rate agency holdings. In addition, AGNC maintained a high proportion of fixed-rate agency MBS holdings in pre-payment protected "specified pools" during the first quarter of 2016 which should help "subdue" the modest uptick in conditional prepayment rates ("CPR") experienced so far during the first quarter of 2016. Now let us move on to AGNC's derivatives portfolio.
Derivatives Portfolio Considerations:
Due to the events that have unfolded in January 2016 regarding a sharp net decrease in mortgage interest rates/U.S. Treasury yields, mREIT companies who had a higher hedging coverage ratio at the end of the fourth quarter of 2015 were at heightened risk for severe valuation losses within its derivatives portfolio. This is basically the exact opposite trend that occurred during the fourth quarter of 2015. These "swings" in market interest rates, across the entire yield curve in this instance, can negatively impact a company's risk management efficiency.
As such, when AGNC reported the company modestly decreased the company's hedging coverage ratio from 96% as of 9/30/2015 to 87% as of 12/31/2015, I believe this was a step in the "right direction" regarding a reduction in derivative instruments prior to January's sharp decrease in market rates. However, knowing what has occurring in January 2016, this was still a fairly elevated hedging coverage ratio to have at the start of the first quarter of 2016. While AGNC's modest decrease in the company's proportion of hedges was far from the "worst case" scenario, it also was not the "best case" scenario either. As such, I believe AGNC's hedging coverage ratio as of 12/31/2015 should currently be seen as a short-term "cautious" trend.
I believe there were two main derivative strategies AGNC could have implemented during January 2016 which would have mitigated some valuation losses. First, management should have reduced/terminated a portion of the company's existing interest rate payer swaps. This would have helped mitigate derivative valuation losses seen across most net (short) derivative instruments. Even if a company wanted to maintain a fairly similar hedging coverage ratio, management could reduce/terminative existing interest rate payer swap contracts and enter into new contracts with lower fixed-rates (by 30-40 bps across most tenors/maturities through the week ending 1/29/2016) to lower the net expense currently charged on such derivative instruments.
Second, companies should have entered into interest rate receiver swaptions/swaps to counter a flattening yield curve currently being experienced by market participants. This way, a company's "net periodic interest costs of interest rate swaps" expense would noticeable decrease which would directly lead to a mitigation of net interest spread erosion. Even if LIBOR increased say 50 bps over the next two years, most interest rate receiver swaptions/swaps would have an immediate, positive impact on spreads spanning out over the next several years which would assist with dividend sustainability.
I believe AGNC's results for the fourth quarter of 2015 were as expected when compared to my projections. All of the accounts that I projected were either fairly or very close to actual reported results. Even though AGNC reported a minor (less than 5%) decrease in BV during the fourth quarter of 2015, the company was also able to generate a minor economic return. I believe this should be seen as a positive trend.
It should also be noted AGNC repurchased 9.0 million outstanding shares of common stock at a weighted average purchase price of $17.88 per share during the fourth quarter of 2015. This had a minor accretive effect to BV. More importantly in my opinion, this should signal to market participants AGNC continues to utilize the strategy of repurchasing outstanding shares of common stock when the company trades at a excessively material discount to CURRENT BV.
With that being said, I would also highlight to readers the events that have unfolded during January 2016 regarding the volatile nature of market rates in general and the continued unattractive correlation between most MBS prices and derivative instrument valuations. This unfavorable correlation between MBS prices and derivative instrument valuations is always a possibility in the mREIT sector and is termed "spread/basis risk". While companies can take steps to minimize spread/basis risk, a company can never completely "mitigate" this risk.
Mortgage interest rates/U.S. Treasury yields have reversed course and quickly net decreased through 1/29/2016 when compared to what occurred during the fourth quarter of 2015. This was mainly due to the impacts of a very bearish commodities market, a slowing Chinese economy, and the continued "monetary easing" strategies implemented by the European Central Bank ("ECB") and Bank of Japan. In fact, the fixed-pay rate on interest rate swaps across all tenors/maturities and MBS prices across most coupons have had material (offsetting) net valuation fluctuations through 1/29/2016.
Due to continued spread/basis risk that has persisted during January 2016 (abated somewhat during the week ending 1/29/2016), I project AGNC's BV as of 1/29/2016 has decreased ($0.05)-($0.35) per share when compared to the company's BV as of 12/31/2015 (including the impact from January's dividend of $0.20 per share). In my opinion, the company's current stock price would appear to have already priced in this projected minor decrease in BV for January 2016.
My BUY, SELL, or HOLD Recommendation:
From the analysis provided above, including additional factors not discussed within this article, I currently rate AGNC as a SELL when I believe the company's stock price is trading at less than a (15%) discount to CURRENT BV (BV as of 1/29/2016), a HOLD when trading at or greater than a (15%) but less than a (25%) discount to CURRENT BV, and a BUY when trading at or greater than a (25%) discount to CURRENT BV.
As such, I currently rate AGNC as a HOLD since the stock is trading at or greater than a (15%) but less than a (25%) discount to my projected CURRENT BV.
This recommendation considers the following mREIT factors: 1) projected future MBS price movements; 2) projected future derivative valuations; and 3) projected near-term dividend per share rates. This recommendation also considers the recent lowered probability of several Fed Funds Rate increases by the FOMC during 2016 due to recent macroeconomic trends/events. I will discuss AGNC's near-term dividend sustainability in a future article since this topic involves its own detailed analysis/discussion.
Final Note: Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader's current investing strategy. Within the past 90 days, I have not directly increased or decreased my AGNC position (only through reinvested dividends). On 11/27/2015, I initiated a position in AGNC's "Series B Preferred Stock" which trades under the symbol "AGNCB." Subsequent to 11/27/2015, I have selectively increased my position in AGNCB. When combined, my current AGNCB position has a weighted average price of $23.215 per share. Each trade was disclosed to readers in real time (that day) via the "StockTalks" feature of Seeking Alpha. This weighted average per share price excludes all dividends received/reinvested.
Disclosure: I am/we are long AGNC, ORC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I currently have no position in ARR, CMO, EFC, or JMI.