American Capital Agency Corp. (NASDAQ:AGNC) reported earnings on April 25th, 2016 after the market closed. The results were fairly respectable considering the exceptionally difficult quarter. Management highlighted the normal values such as the net spread plus dollar roll income (similar to Core EPS of other mREITs) of $.52. This is fairly low compared to the dividend of $.60 per quarter, but I've been providing warnings along that front for a while. The dividend is just pushing at the edges of what can be sustained.
Why The Dividend is Difficult
The difficult aspect for sustaining dividends in the current macroeconomic environment is the flattening of the yield curve. As the yield curve becomes flatter it is materially more difficult for an mREIT to generate sufficient net interest income from borrowing short and lending long. On the other hand, the mREITs are seeing their ability to earn net interest income protected in future periods by an increase in the spread between the yields on new MBS and the rates on LIBOR swaps. The increase in this spread was cited by AGNC's CEO Gary Kain in the earnings release. Specifically he stated:
"In aggregate, spreads on agency MBS widened modestly relative to our hedges during the quarter and were the primary driver of the 2.2% decline in our net book value. "
An increase in the spreads can be demonstrated a few ways. One of the options AGNC regularly uses is demonstrating the OAS (option adjusted spread) on the MBS:
The spreads have been fairly terrible for years and finally began to reach respectable levels where an mREIT can expect to use some leverage and generate solid returns.
The important thing for shareholders to remember is that an increase in these spreads results in a materially more favorable scenario for increasing leverage and raising hedges. Those hedges do increase the cost of funds for future periods, but that should be more than offset by the increase in interest income from new leverage.
This is an area where American Capital Agency Corp. excelled. In previous quarters analysts encouraged the company to raise leverage but management refused on the basis that they didn't feel the spreads were sufficient for raising leverage. If management had raised leverage earlier they would've reported higher levels of net spread income or dollar roll income but they also would've lost more book value. As it stands the company was able to squeak out a positive total economic return of $.10 for the quarter. That comes from book value starting at $22.59 and decreasing to $22.09 while paying out a dividend of $.60.
While management was refusing to raise leverage while the spreads were too small to justify it, they did raise leverage during the first quarter. "At Risk" leverage, which includes TBA positions, was 7.3x. That is a material increase from 6.8x last quarter and reflects a logical response to a larger spread between MBS yields and LIBOR swaps.
Long Term Headwinds For the Industry
The biggest challenge facing the mREITs currently is the fairly weak yield curve. As the yield on treasuries fall and prices rise it is common for agency MBS to follow. During highly volatile periods the movement in the agency MBS may be slower than the treasuries, but the trend still follows. Due to a fairly weak yield curve with short term rates still near 0 there is little room for short rates to get lower and an increase in long term rates would devalue agency MBS. The only reasonable option for mREITs to protect their book value is to hedge against the long term rates. I would expect to see American Capital Agency Corp. protecting the higher level of leverage with a higher volume of hedges and wouldn't be surprised at all to see both interest income and the net interest expense on swaps higher for the second quarter than they are in the first quarter.
Dividends are threatened from both ends. Higher prepayments increase amortization costs and the potential for higher short term rates can raise the cost of borrowing through repo agreements and force mREITs to carry higher levels of hedges. Since those hedges aren't economically free, the combination puts a squeeze on the dividends. AGNC is running pretty close to the border for what can be sustained. If MBS yields fall further it could bring about a cut. If long rates trend back up, as they have been doing in April, then the dividend could be sustained.
American Capital Agency Corp. closed the day $18.66. This is a 15.5% discount to their trailing book value. Several mREITs have yet to report, but I believe AGNC is currently around middle of the pack for discount to book value. That makes them more attractive than the mREITs at higher valuations, but I'm still concerned about the headwinds facing the industry. Specifically the very low yield on new agency MBS concerns me and would make me want a discount to book in the range of 21% to 25% as protection against future dividend cuts. With a wide OAS on the MBS relative to recent values and a wide spread on the yields between par value MBS and LIBOR swaps, I would be happy investing at smaller discounts if it weren't for the exceptionally flat yield curve.
The spread between par value MBS and LIBOR swaps is demonstrated in the following chart, courtesy of CYS Investments (NYSE:CYS):
The values at the end of Q1 were materially better than previous values. The larger spreads are hard on book values as they are created, but excellent for future earnings. If we could see the yield curve steepen a bit, it would bode very well for the sector. Until then, the discounts just aren't big enough on common stock. I am still hunting for positions in preferred shares on several mREITs.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PREFERRED SHARES OF ANY MREIT over the next 72 hours.
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