American Capital Agency Corp. (NASDAQ:AGNC) is a blue chip mortgage REIT. Its President and CIO, Gary Kain, is considered one of the gurus of the MBS world, especially the Agency RMBS world. AGNC invests primarily in Agency RMBS. AGNC's goal is to preserve its net asset value, while providing risk-adjusted returns for distribution to shareholders. In an update to its investment policy in 2015, CIO Gary Kain said AGNC okayed the investment of up to 10% of its portfolio in non-Agency RMBS. Gary Kain says the addition of any non-Agency investments will likely be quite slow. AGNC currently pays a healthy 13.5% annual dividend ($0.20 per common share per month). Since its IPO in May 2008 at $20.00 per share, it has paid $32.70 per common share in dividends through January 2016, and its net asset value has risen to $22.59 per common share as of December 31, 2015 (a +176.5% total economic return over a period that included the Great Recession).
A lot of the above sounds very good; but the truth is that the company has struggled much of the time from 2013 onward. Still one can make a good case that American Capital Agency Corp. may be one of the best ports in the current "market drop" storm and possible recession. Its Agency RMBS investments are backed by the US federal government. Yes, AGNC can still lose money due to mortgage defaults and prepayments; but that is generally a much smaller percentage of "at risk" money than many companies are experiencing in the current environment. Remember if there are significant mortgage defaults, the government essentially guarantees the face values of the mortgages. AGNC's RMBS values would only be hurt by the amount of the premium to face value that Agency RMBS normally sell for. The government does not reimburse such losses. In this sense Agency RMBS are almost as safe a US Treasuries.
Consider that AGNC's stock price as of the close on February 8, 2016 was $17.77 per share. With a book value of $22.59 per common share as of December 31, 2015, AGNC seems like a great value with its full backing by the US government. AGNC is selling at a 21%+ discount to its December 31, 2015 book value. AGNC's stock price would have to rise 27%+ for its stock price just to get back to its book value. Remember that Agency RMBS are very liquid. AGNC could sell all of its Agency RMBS for very close to the book value at almost any time. That is why Agency mortgage REITs rarely trade for less than 80% of their book value. AGNC is already trading for slightly less than 80%. Hence its stock price should have upside on that basis alone. On top of that AGNC has almost assuredly gained book value in Q1 2016 thus far as the 10 year US Treasury Note yield has declined.
The 10 year US Treasury Note yield has dropped from 2.27% on December 31, 2015 to 1.75% on February 8, 2016 (-52 bps). Remember when yields go down, the prices of bonds go up. Agency RMBS generally follow US Treasuries. The chart below shows the recent dramatic drop in the 10 year US Treasury Note yield.
Further Bloomberg reports that credit rating "downgrades" account for their biggest percentage of rating actions since 2009. About one third of all companies worldwide are not making enough to cover their debt payments. In this sense China is a particular worry. Standard & Poor's had downgraded the credit of 15 Chinese companies in 2016 as of February 2, 2016. It had only upgraded the credit of one Chinese company. Roughly $22.6B in offshore Chinese bonds are now rated one step above junk. The potential for a rush out of risky debt is a worry.
Such factors make the "earnings recession" in the US that began with Q2 2015 even more ominous. With about 70% of the S&P 500 companies having reported as of February 5, 2016, the blended earnings decline is -3.8% for Q4 2015. This seems to ensure the third quarter in a row of an "earnings recession" in the US for the S&P 500. This leaves more room for downside in the US equities markets. If earnings are going down, so is the ability of companies to make payments on their debt. Also since stocks trade on multiples of earnings, stocks seem bound to go down further as earnings fall.
The US equities still look overpriced even after their recent fall. The chart below of the S&P 500 forward 12-month EPS versus the change in price over the last ten years shows that the market still has at least 10% downside to reach "normal value".
On top of this 57 companies have issued negative EPS guidance, while only 14 companies have issued positive guidance. That says there is likely even further downside than the above chart indicates. With this in mind, AGNC looks even more appealing.
Income investors have to love its current 13.5% annual dividend. That could get cut. When interest rates (Treasury yields) go down, Agency mortgage REITs usually have more trouble making large dividend payments. The "net spread income" is after all a good portion of the income used to make the dividend payments. This generally goes downward as interest rates go downward.
The good news for Q1 2016 at least is that Gary Kain is an expert at the Dollar Roll market. This market performs best when interest rates are falling; and I have every faith that Gary Kain will take full advantage of that in Q1 2015. I am sure he already has been. The drop in the Chinese stock markets on the first trading day of 2016 was a clear signal that the world economy will see trouble in 2016. By extension the drop was a signal that interest rates would likely drop. This has been confirmed by both the recent World Bank and the IMF cuts to their world GDP growth forecasts (to +3.4% for the IMF and to +2.9% for the World Bank). Slower GDP growth likely means lower interest rates.
AGNC's CIO Gary Kain is too experienced and too good not to have read this signal. He has no doubt been making great profits in the Dollar Roll market for AGNC in Q1 2016. The Dollar Roll profits are the second main contributor to the total monies used to pay the dividend. Hence I expect the dividend to be relatively safe for Q1 2016, although I am not sure how long the dividend rate will last beyond the end of Q1 2016. Remember AGNC's net spread and Dollar Roll income only amounted to $0.54 per common share in Q4 2015, while the dividend paid out was $0.60 per share. I expect the extra Dollar Roll income in Q1 2016 (versus Q4 2015). That should allow AGNC to cover the dividend nicely for Q1 2016. However, it is unclear how long the good to great Dollar Roll environment of Q1 2016 will last.
AGNC's portfolio as of December 31, 2015 is below.
As investors can see the portfolio is heavily weighted toward 30 year fixed rate Agency RMBS. Of the 30 year RMBS, 40% are 3.5% rate 30 year Agency RMBS. Another 30% are 4.0% rate 30 year Agency RMBS. In this case I will just look at the movement of the Bloomberg US Agency Bond Index (BAGY). The one year chart is below.
As readers can see US Agency Bonds have risen dramatically of late. For Q1 2015 so far the index has moved from 117.83 on December 31, 2015 to 120.00 as of this writing on February 9, 2016. That's roughly 2% upward. It is hard to imagine that the value of AGNC's Agency bonds has not also risen significantly. I will not make an estimate. The company will report a relatively exact number through the end of January 2016 by roughly mid-February 2016. The point is that AGNC should gain book value based on the above movement (at least so far in Q1 2016). Readers should note that all of AGNC's TBA positions were long ones as of December 31, 2015. These should return great profits as the Agency RMBS have increased dramatically in value.
Perhaps as importantly, AGNC has moved in the correct direction in decreasing its amount of hedging from September 30, 2015 (96% of funding liabilities) through December 31, 2015 (87% of funding liabilities). This bolsters the idea that Gary Kain has positioned the company correctly for Q1 2016. Since hedges are generally against rises in interest rates, AGNC would have lost more money on its hedges, if Gary Kain had maintained a higher hedging rate in Q1 2016. He may have decreased hedges further as the worldwide bad economic news has streamed in during Q1 2016.
As a result, AGNC may see its book value rise considerably in Q1 2016. If AGNC's book value goes up by +5% or more during Q1 2016, the stock price almost has to go up by a like amount. As I said earlier Agency Mortgage REITs seldom trade at more of a discount than 20% to book value. Remember Agency RMBS are highly liquid assets, so it makes no sense for a stock investing in them to trade a huge discount to its book value. AGNC is already trading at a 21%+ discount to the December 31, 2015 book value of $22.59 per common share. Hence the stock should have several percent upside due to book value gains alone. On top of that, AGNC is paying a 13.5% annual dividend; and it pays that dividend monthly. Even if you only want to invest in AGNC short term, it appears to be a great investment at this time. The FEAR TRADE should also help to move people into Agency RMBS in much the same way it moves people into US Treasuries, which are also backed by the US government.
Readers may want to consider that Q1 is usually a low CPR (constant prepayment rate) quarter. Hence AGNC should lose less due to amortization costs during Q1 2016 than say during Q2 and Q3 in 2015. The historical CPR chart is in the portfolio picture above. It appears to me at this time that the total economic return for Q1 2016 should exceed 5%; and it may exceed 10%. However, one can never be sure, so don't bet the farm on this one.
The Fed could decide to raise rates again. That could push interest rates up. However, a Fed Funds rate raise in the near future is looking increasingly unlikely with the increasingly negative economic news. Remember the jobs data for January 2016 was only 151K. This was a big miss of the consensus number of 190K. The markets have reacted accordingly, especially after the other negative US and world economic news before that.
As readers can see, it took a while for the FEAR trade to make AGNC and other mortgage REIT stocks look attractive. However, AGNC and Agency RMBS have clearly caught fire now; and if the powerful uptrend in the Bloomberg US Agency Bond Index is any indication, they have a goodly amount of upside to go. Admittedly the +2.13% gain in AGNC's stock price year to date in 2016 is meager; but it is about 12% better than the SPY performance year to date and about 17% better than the QQQ performance year to date. When you further consider that AGNC pays a 13.5% annual dividend in addition to any stock price gains, you really have a great investment at a time when other stocks are falling rapidly. That makes a BLUE CHIP Agency mREIT stocks such as AGNC a good investment. AGNC is a buy.
NOTE: Some of the fundamental fiscal data above is from Yahoo Finance.
Good Luck Trading/Investing.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AGNC over the next 72 hours.
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.