Good ole American Capital Agency (NASDAQ:AGNC). What a nightmare this name has been over the last three years. Of course, in the last few months the stock has been extremely volatile, touching lows under $16 this year. Yikes! It is a name I have held a small position through a 40% plus drop and continue to reinvest the dividends. It has been tough to watch the unrealized losses mount, but of course they are just on paper. As many of you know I have covered this name from just about every angle you can think of. While many continue to question their very existence citing a poor business model I do believe that with the rate cycle ramping up, interest rate spreads may take a hit at first, but then subsequently widen. That bodes well for the earnings potential, but for now there is pain. I have also predicted the constant prepayment rate would subside here in the first half of 2016, but then level off and reverse higher in the second half of 2016. But for now there is pain. Speaking of pain, the company's Q1 earnings are out, which were once again a bit painful.
It was once again a tough quarter for the company with a few key positives and a number of negatives. Let's start off of course with the headline numbers. The company reported earnings of $0.52 which missed by $0.04. Ouch. This follows a Q4 in which the company reported earnings of $0.54. So another downtick. If you go back 18 to 24 months ago you wouldn't believe this was the same company. Yes, this is pain. The pain is real. This of course was not enough to cover the dividends paid in the quarter which was $0.60. However, this is the net spread and dollar roll income, which the company uses as its best gauge for covering its dividend. This income is down almost 40% in a year. It is important to note that this $0.52 does exclude a $0.16 "catch-up" premium amortization cost but includes a $0.15 per share dollar roll income. It had a $0.06 comprehensive gain last quarter, but this quarter it saw just $0.01 in comprehensive income.
Recall that the company put in another cut to its payout, dropping it to $0.60 quarterly late last year. It has managed to maintain this payout so far, but this is now the third quarter in a row where the quarterly earnings (from the spread and dollar roll income) were less than the dividend. With earnings like this, the dividend may certainly be cut again because the company is barely covering it (or not at all) with net spread and dollar roll income.
To add some color to these results it is prudent to review some of the key metrics to better understand what the deal is here. Let me start by highlighting the constant prepayment rate which I predicted would come down. Recall, this measures the average risk for the percent of loans to be prepaid over a period of time. The higher this number the worse, because the company misses out on interest from the loans. It's a true risk to the company's business model. We simply don't want prepayments. Well, my prediction that the constant prepayment rate would decline came to pass. In fact, the constant prepayment rate dropped 70 basis points to 8.8%, down from 9.5% in Q4 and down from 12.4% in Q3. While 8.8% remains high given this company's history, this is a substantial reversal in line with my expectations.
How about the net interest rate spread, which is often directly impacted the constant prepayment rate? Well first its average cost of funds rose to 1.64%, increasing 4 basis points from Q4's 1.6%. This is much higher than the 1.28% a year ago. When we exclude swap costs related to TBA dollar roll funded assets, the adjusted cost of funds for its repo funded assets was approximately 1.51% compared to 1.45% for the prior quarter. Factoring in the average yield on assets, the net interest rate spread on its repo and dollar roll funded assets for the quarter was 1.31%, compared to 1.38% for Q4. Ouch. Despite the decline in prepayments, the rise in cost of funds more than offset the positive impact to yields. That is a recipe for pain.
Book-value has been an ongoing issue. Quarter after quarter it seems to decline. Looking back to Q2 2015 it fell heavily, to $24.00, down from $25.53 from Q1 2015. Then in Q3 it once again it fell to $23.00, or dropping another 4%. In Q4 there was more punishment with the book value coming in at $22.59, falling almost 2%. Now here we are reporting on Q1 2016, and well, book value is down once again. It fell $0.50 or 2.2% quarter-over-quarter. These declines are why the market has been pricing the stock at such a large discount-to-book. What I mean is that the Street expects book value to continue to fall. I am surprised shares rebounded as much as they did in the last two months. In fact, at the current share price at the time of this writing, which is $18.66, the stock has narrowed its discount. When I last highlighted the name it was at a $5.69, or 25.2% discount-to-book. Now it trades at a $3.93, or a 17.8% discount-to-book.
My take home here is that the dividend is at risk once again in my estimation. I am pleased to collect the payout which I am reinvesting, but with a recent spike in refinances, prompted by the first rate hike out of the Fed in a decade last month, more pain could be on the horizon if my prediction of prepayments spiking comes to pass. At this point I am not adding to holdings in the sector. The company will do what it can to weather the storm. The dividend reinvestments will grow my position. Those who have been in since the high $20 range are feeling the pinch. Time is on your side, but with the company constantly on defense there is not much to expect. All-in-all this quarter was more of the same, if not weaker than I expected, and as such I continue to recommend a hold on AGNC.
Note from the author: Christopher F. Davis has been a leading contributor with Seeking Alpha since early 2012. If you like his material and want to see more, scroll to the top of the article and hit "follow." He also writes a lot of "breaking" articles that are time sensitive. If you would like to be among the first to be updated, be sure to check the box for "Real-time alerts on this author" under "Follow."
Disclosure: I am/we are long AGNC.
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.