American Capital Agency Corp. (NASDAQ:AGNC) delivered an exceptionally strong second quarter. Its performance is unlikely to exceed some of the mREITs that were positioned to benefit from credit risk, but for an agency mortgage REIT, the performance was solid. The mortgage REIT had comprehensive income of $.73 on the quarter. It paid a dividend of $.60. That leaves $.13 to add to book value. Therefore, book value moved from $22.09 to $22.22.
It Was Better Than I Predicted
I run book value estimates for quite a few mortgage REITs and AGNC's results came in materially higher than I expected. At the time of writing, AGNC was up .5% on the day. To be up half a percentage point is a strong result given the 10% cut in the dividend. AGNC chopped its dividend from $.20 down to $.18 per month.
The cut in the dividend also came as a bit of a surprise. AGNC's dividend yield on book value was already lower than normal for the industry. At $.18 per month, the new dividend would be $2.16 annually. That is less than a 10% yield on the Q2 book value. Shares are currently $19.60, so it is over 10% yield on price.
Be Concerned, But Do Not Panic
The cut in the dividend indicates that AGNC does not believe strong dividends are sustainable from investing in agency MBS. Since most mortgage REITs use agency MBS as a significant portion of their portfolio, this is a negative indicator for the sector.
Cutting the dividend was a reaction to a weaker spread. However, the size of the spread will still determine on how the investor measures it. One of the metrics AGNC uses is to compare the value on the 15-year and 30-year mortgage price index with the 10-year Treasury. Sounds complicated, right? I will break it down with a slide from the earnings presentation:
The lines evolve over time. The changes in the chart influence AGNC's expectations. To get an exceptionally low rate on the 10-year Treasury, we would want to look back to the summer of 2012. The 10-year Treasury rates have recently falling below those levels, though they bounced back in July.
In summer of 2012, the price index on the MBS was hitting around $108. It ended the quarter around $106. There are three logical explanations for the change:
Investors fear the value of the call option in the MBS. This option suggests that investors do not like the risk of prepayment. Therefore, they assign a higher value to the certainty of Treasuries. This means a higher risk premium.
The second option is that the market is correctly predicting a surge in refinancing behavior. The unique thing about option 2 is the lack of a higher risk premium. In this case, the market is correctly pricing the call option. Remember that the owner of the MBS is effectively shorting the call option. The homeowner on a residential mortgage has a right to prepay their loan. The right to prepay is essentially the same as the right to call a bond.
The third option is that the market is not effectively assessing the desired risk premiums. In the third option, the change in price is due to manipulation. Who could manipulate a security with the enormous volume of agency MBS? The only institution with such raw power is the Federal Reserve. The Federal Reserve had a huge program to buy agency RMBS. Now, its program is simply reinvesting the proceeds from principal payments. It is possible that prices were simply exceptionally high in 2012. Why? Because of stronger demand from the Federal Reserve. That demand could distort the normal supply and demand curves.
AGNC had a great second quarter. It delivered more than enough comprehensive income to cover the dividend. However, it was not enough to reverse the damage from the first quarter. If AGNC believes that prepayments are going to jump higher, it would be an incentive to trim the dividend preemptively. From what we have seen so far, prepayments did pick up quite a bit from March through June. Consequently, the trimming of the dividend should be seen as a negative omen for other mortgage REITs. While many other REITs are incorporating credit risk to generate higher yields, most still rely on significant positions in agency RMBS as part of their investing strategy.
This is a time for some concern, but panic would be overreacting. No change in my outlook on AGNC. I still view its valuation as being "middle of the road". As I revise my estimates on book value to incorporate the portfolio changes during the quarter, I may need to upgrade AGNC relative to several peers. The company's decision to trim its dividend tells me more about the expectations for other mortgage REITs than it does about AGNC's futures.
For instance, this bodes poorly for Annaly Capital Management (NYSE:NLY), CYS Investments (NYSE:CYS), Capstead Mortgage Corporation (NYSE:CMO), ARMOUR Residential REIT (NYSE:ARR), and American Capital Mortgage Investment (NASDAQ:MTGE). However, my rankings will remain on each until I can dig a little further. I am long MTGE and ARR. I might buy any of the others upon revising my estimates. I might sell my long positions if I find the discount to book has narrowed sufficiently to remove the margin of safety.
Disclosure: I am/we are long ARR, MTGE.
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