What Just Happened To American Capital Agency Corporation?

| About: AGNC Investment (AGNC)

Summary

American Capital Agency suffered a fierce sell-off as investors worried over the sustainability of its dividend.

Weak net spread income shouldn't be emphasized too much, because changes to hedging and leverage suggest stronger net spread income in Q2.

The dividend would be in jeopardy even at current levels of leverage if the yield curve was flattened further, but so would that of most other mREITs.

American Capital Agency remains more attractively priced than peers that trade at materially smaller discounts.

American Capital Agency Corporation (NASDAQ:AGNC) reported its first-quarter results yesterday. The performance wasn't bad, but the net interest income figures may have spooked some investors into thinking that a dividend cut was imminent. Gary Kain spoke directly about this situation on the earnings call, while pointing out that the company doesn't give dividend guidance:

"Now, let me go on to your second question, which relates to the dividend and net spread income and what I would start with there is, what I've said in the past, which is we don't give dividend guidance, but in addition, we also don't and have not viewed net spread income as an all-encompassing figure that really perfectly expresses the true earnings power of the portfolio and in prior calls over the years, I've discussed some of the shortcomings of that measure. So in the end, what is going to determine kind of our go forward earnings and our expectation of earnings over the intermediate period are the other things we talked about earlier with the second question which related to what's going to happen with our leverage and what's going to happen in essence with our duration gap.

And to the extent that we are comfortable, we will be taking more, increasing those risk positions. Our earnings are going to improve and then this kind of - and then that will obviously kind of provide a tailwind - earnings improving to kind of the overall dividend equation. So I think that's really the key thing to keep in mind. So, again, we do not focus, we've never focused on net spread income as sort of the guiding light so to speak to the dividend, but I think the driver is our expectation of our earnings power overtime and again, that's a function of the market environments and it's a function of our expectation on how much risk we're willing to take."

Essentially, Gary Kain is indicating that he can't talk about the future dividend, but investors shouldn't be so quick with the knee-jerk reactions. I believe there is some risk on the dividend, but I don't foresee a cut occurring unless we see further spread tightening. If the yield term is not further compressed, then I wouldn't expect a cut to be necessary.

Despite Positive Remarks, Investors Still Sell Off

The following chart demonstrates the exceptionally weak price performance for AGNC relative to several peers:

Click to enlarge

The substantially weaker performance for AGNC looks like investors are in a panic over the dividend. Relative to some of these peers, such as Orchid Island Capital (NYSE:ORC), the discount on AGNC looks materially larger and thus more attractive. I remain concerned that the overall level of prices in the mREIT sector is reflecting a lack of fear. Investors should aim to be bold when others are timid and meek when others are foolhardy.

Further Remarks And Hedges

In some of his other remarks on the earnings call, Gary Kain stated:

"In short, the Fed adopted a decidedly more dovish tone in the first quarter than many expected. When you combine a more dovish stance from the Fed with aggressive easing on the part of other large Central Banks, it is logical that interest rates across the globe are at or near their all-time lows. Collectively, the Central Bank actions support the low for longer theme we stressed on our prior call. This benign interest rate landscape is very supportive of our business and so we're not surprised by the recent improvement we've seen in mortgage REIT equity valuations. As we said on our last call, mortgage REIT price to book ratios were unsustainably low in our opinion and completely inconsistent with the improving fundamentals of the business."

AGNC is walking the walk. The following chart shows its hedge positions at the end of the first quarter relative to the end of Q4 2015:

At first glance, investors might think this indicates very little change in the portfolio. That would be a thoroughly inaccurate assessment. The duration of the total hedge portfolio is falling from 3.4 to 3.2. That might seem like a marginal decrease in the hedging, but AGNC is stepping into this stance on the asset side as well. At the end of the first quarter, the economic leverage was 7.3x, compared to 6.8x at the end of December and 6.5x a year ago.

The combination of higher leverage with lower hedges means AGNC is in a position to see significantly stronger net spread plus drop income in the second quarter if there are no major changes in the interest rate environment.

So far, the interest rates have increased slightly during the year at the longer end of the yield curve, and MBS rates have moved up slightly. The combination suggests slightly lower expectations for prepayments, which would be great for AGNC.

Conclusion

AGNC sold off and fiercely underperformed the sector even as management provided indications that they were taking a longer-term view at the situation and not focusing solely on the net spread income. If the yield curve flattens further, I would expect a cut to follow, but the increase in leverage, combined with a slight reduction in hedges suggests an increase in the expected level of net spread income for the next quarter.

I put together an article with some charts showing the rough discounts to book value for mortgage REITs. Be advised that the numbers use trailing book value, and I would prefer to use estimates of current book value.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PREFERRED SHARES OF ANY OF THE MREITS 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.

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