On 7/27/2016, American Capital Agency Corp. (NASDAQ:AGNC) reported results for the second quarter of 2016. AGNC reported a net loss of ($135) million, other comprehensive income ("OCI") of $382 million, comprehensive (total) income of $240 million, and a book value ("BV") of $22.22 per common share as of 6/30/2016.
In my prior AGNC Q2 2016 income statement and EPS projection article, I anticipated the company would report the following amounts in relation to the second quarter of 2016: 1) a net loss of ($278) million; 2) OCI of $465 million; and 3) comprehensive income of $180 million. In my prior AGNC Q2 2016 book value projection article, I anticipated the company would report a BV of $22.10 per common share as of 6/30/2016. As such, I believe AGNC reported results that were a slight outperformance when compared to my projections (but within all my projected ranges).
Within the first section of this article, I will summarize my prior articles' account projections and compare each amount to AGNC's actual results. If a specific account had at least a modest variance between my projection versus AGNC's actual results, I will also provide an explanation on the variance. I will list AGNC's accounts in the same order as projected in my income statement and earnings projection series (see link provided above).
Side Note: Through 8/1/2016, four other mortgage real estate investment trust ("mREIT") peers and one company that had "mREIT-like" characteristics (a "C-Corporation" for tax purposes) that I currently cover recently disclosed to the public 6/30/2016 BV per share amounts. I believe providing readers each company's quarterly BV fluctuations is beneficial for comparative purposes. As such, the following were the recent BV fluctuations for AGNC and five other companies during the second quarter of 2016 (in order of largest percentage increase to largest percentage decrease):
1) American Capital Mortgage Investment Corp. (NASDAQ:MTGE): Actual Q2 2016 BV increase of 2.31%
2) CYS Investments Inc. (NYSE:CYS): Actual Q2 2016 BV increase of 0.95%
3) AGNC: Actual Q2 2016 BV increase of 0.59%
4) Capstead Mortgage Corp. (NYSE:CMO): Actual Q2 2016 BV decrease of (0.36%)
5) Arlington Asset Investment Corp. (NYSE:AI): Actual Q2 2016 BV decrease of (0.48%)
6) Orchid Island Capital Inc. (NYSE:ORC): Actual Q2 2016 BV decrease of (1.36%)
Actual Versus Projected Results:
To highlight my projected account figures versus AGNC's actual reported amounts for the second quarter of 2016, Table 1 is presented below. Table 1 shows AGNC's consolidated statement of comprehensive income from a three-months ended timeframe.
Table 1 - AGNC Three-Months Ended Consolidated Statement of Comprehensive Income (Actual Versus Projected)
(Source: Table created entirely by myself, partially using data obtained from AGNC's quarterly investor presentation slides)
First, let us compare AGNC's interest income account. My projection for this account was $330 million. AGNC reported interest income of $318 million. This minor variance was well within my stated range. This was a minor underperformance in my opinion as AGNC's actual interest income was slightly below my stated mean. When broken out, one "sub-account" within this account was a minor disappointment while the other sub-account was slightly better than anticipated. AGNC's "cash interest income" sub-account underperformed by ($23) million ($452 million versus a projected $475 million) while the company's "premium amortization, net" expense sub-account outperformed by $11 million when compared to my projections ($134 million versus a projected $145 million). These minor variances were due to the fact management did not increase leverage as much as I anticipated during the second quarter of 2016. As such, AGNC's weighted average MBS portfolio balance during the second quarter of 2016 was not as high as I projected by a minor amount. My projection for AGNC's lifetime "conditional prepayment rate" ("CPR") percentage was an exact match to what the company projected as of 6/30/2016. Even though both sub-account variances were not "material" in my opinion, I still believe both variances should be broken out.
Second, my projection for AGNC's interest expense account was $108 million. AGNC reported interest expense of $101 million. This minor variance was well within my stated range. As anticipated, the weighted average interest rate on AGNC's repurchase loans slightly increased during the second quarter of 2016. AGNC's weighted average interest rate on the company's repurchase loans was 0.76% as of 3/31/2016 which slightly increased to 0.78% as of 6/30/2016. I correctly anticipated the weighted average interest rate on AGNC's repurchase loans would increase by exactly 2 basis points ("bps") during the second quarter of 2016. Since markets anticipated a 25 bp movement in the Federal ("Fed") Funds Rate during December 2015, the London Interbank Offered Rate (LIBOR) increased by roughly the same amount by the end of the fourth quarter of 2015. In direct correlation, repurchase loan rates "followed suit" and increased during the quarter. The relationship between repurchase loan rates and LIBOR was originally discussed within my income statement projection article (see link provided above). Similar to the reasoning behind AGNC's interest income account variance discussed above, the minor variance within the company's interest expense account was due to the fact management did not increase leverage as much as I anticipated during the second quarter of 2016. As such, AGNC's weighted average repurchase loan agreements balance was not as high as I projected during the quarter by a minor amount.
Third, my projection for AGNC's MBS sales account was a minor net gain of $25 million. In comparison, AGNC reported a minor net gain of $55 million. This minor variance was well within my stated range. The main reason for the slight variance was due to the fact AGNC sold some existing fixed-rate agency MBS holdings in order to purchases new investments with certain pre-payment protected features. Such MBS holdings are classified as "specified pools" and consist of mortgages classified under the "Home Affordable Refinance Program" ("HARP") and "low loan balance" (LLB) securities. This strategy is to directly combat an increase in CPR percentages when mortgage interest rates/long-term U.S. Treasury yields net decrease (or hold near historical lows) over a prolonged period of time. Since this account only had a minor variance (a $30 million variance on the potential net realized fluctuation within AGNC's MBS portfolio of $55 billion as of 6/30/2016), further analysis of this account is unwarranted.
Fourth, my projection for AGNC's derivative instruments and other securities account was a net loss of ($493) million. In comparison, AGNC reported a net loss of ($367) million for this account. While not as close to some of the very minor variances witnessed over the past several quarters, I still believe having a $126 million variance within this account is a hard "feat" to accomplish due to the complexities surrounding how one values a company's derivatives portfolio. I would also note projecting AGNC's hedging portfolio is highly complex and involves projecting four material derivative sub-accounts ("to-be-announced" ["TBA"] MBS, interest rate swaps, interest rate swaptions, and U.S. Treasury securities) and several other minor derivative sub-accounts. While no one has a "crystal ball" per se regarding future events, being able to project all these derivative sub-accounts, before any sector peer provides quarterly results, takes a great deal of expertise in my opinion. This includes fully understanding how to value all theses derivative instruments and correctly deciding on specific assumptions that one believes coincided with management's overall risk management strategy during any particular quarter.
Within AGNC's four material derivative sub-accounts, I projected a net gain (loss) of $105, ($490), ($10), and ($100) million in regards to the company's TBA MBS, interest rate swaps, interest rate swaptions, and U.S. Treasury securities, respectively. In comparison, AGNC reported a net gain (loss) of $108, ($356), ($4), and ($116) million on the company's TBA MBS, interest rate swaps, interest rate swaptions, and U.S. Treasury securities, respectively. As such, three out of the four derivative sub-account projections were very close to my projected valuations (especially when considering each account had notional/face amounts that were valued in billions). As previously stated, within these four derivative sub-account projections I typically utilize offsetting "cautious" and "aggressive" assumptions. As such, if one derivative sub-account has a projected fairly aggressive valuation, another derivative sub-account would likely have a more projected cautious valuation.
Regarding this quarter, AGNC modestly outperformed my expectations when it came the company's interest rate swaps portfolio. Since this was a modest variance, I will explain why my projection had a $134 million variance when compared to actual results. During the second quarter of 2016, AGNC terminated/had expired $5.6 billion of interest rate payer swaps with generally longer tenor/maturities while adding just ($2.6) billion of interest rate payer swaps which generally had shorter tenor/maturities. This positively impacted the net valuation loss of this derivative sub-account and I applaud this decision/strategy for two main reasons. First, since interest rate payer swaps with longer tenors/maturities had more severe valuation losses during the second quarter of 2016 when compared to interest rate payer swaps with shorter tenors/maturities, AGNC was able to mitigate some valuation losses during the quarter with active portfolio management (similar to CYS; unlike ORC).
Second, AGNC was able to notably decrease the company's net pay rate within this derivative sub-account which has cumulative net benefits. Within AGNC's interest rate swaps net (short) position as of 3/31/2016, the company had a weighted average fixed pay rate of 1.73% (exclusive of forward-starting swaps) and a weighted average floating receive rate of 0.62%. This calculates to a net pay rate of 1.11%. As of 6/30/2016, AGNC had a weighted average fixed pay rate of 1.51% (exclusive of forward-starting swaps) and a weighted average floating receive rate of 0.64%. This calculates to a net pay rate of just 0.87%. When calculated, this was a quarterly net pay rate decrease of (24) bps. This may not seem material to some readers, however, I stress it is notable. This decrease directly led to AGNC reporting a "net periodic interest costs of interest rate swaps" expense decrease of ($20) million during the second quarter of 2016. It should be noted this decrease will also have benefits in future reporting periods. Simply put, I believe this should be seen as a positive catalyst/trend as this directly mitigates both a rise in future borrowing costs and the future general decrease in MBS coupons. For further discussion of this relationship, please go to the link that was provided near the beginning of this article (AGNC Q2 2016 income statement and EPS projection article; specifically PART 2).
Fifth, my projection for AGNC's management fees and operating expense accounts were $26 and $6 million, respectively. AGNC reported management fees and operating expenses of $25 and $15 million, respectively. AGNC's operating expenses had an "uptick" during the second quarter of 2016 due to the fact the company had some "one-time" costs associated with the internalization of the company's management structure through its acquisition of American Capital Mortgage Management, LLC ("ACMM") which was purchased from American Capital Ltd. (NASDAQ:ACAS) (who is in the process of being acquired by Ares Capital Corp. (NASDAQ:ARCC)).
When all the accounts described above are combined, I projected AGNC would report a net loss of ($278) million. In comparison, AGNC reported a net loss of ($135) million which calculates to a variance of ($143) million. While this variance was still within my stated range (halfway within my upper range), I would note AGNC modestly exceeded my expectations when it came to the severity of the company's net loss amount.
Sixth, my projection for AGNC's unrealized gain (loss) on AFS securities, net account was $450 million. In comparison, AGNC reported a net unrealized gain of $370 million. Out of this $80 million variance for this account, $30 million was the result of AGNC reporting a $55 million net realized gain versus my projected $25 million net realized gain with the company's MBS sales account (discussed earlier). So, the actual variance within these two combined accounts was $50 million. I believe only having a $50 million variance within this account is an extremely hard "feat" to accomplish due to the sheer size of AGNC's MBS portfolio. For example, as of 3/31/2016, AGNC had MBS holdings of $56.1 billion which decreased to $54.5 billion as of 6/30/2016. AGNC's minor ($50) million underperformance within the company's MBS portfolio was due to the fact management did not increase leverage as much as I anticipated during the second quarter of 2016. As such, AGNC's weighted average MBS portfolio balance was not as high as I projected during the quarter by a minor amount which directly led to less valuation gains being reported.
Seventh, I projected a net unrealized gain on interest rate swaps reclassified to interest expense of $15 million for the second quarter of 2016. In comparison, AGNC reported an interest rate swaps reclassified to interest expense of $12 million for the second quarter of 2016 which was within my stated range. As such, further analysis of this account is unwarranted.
When all my account projections are combined, I projected AGNC would report comprehensive income of $187 million or $0.55 per common share during the second quarter of 2016. AGNC reported comprehensive income of $247 million or $0.73 per common share. When combined, this was a total variance of only $60 million.
When including projections within AGNC's equity section of the balance sheet, this ultimately led AGNC to report a BV of $22.22 per common share versus my projection of $22.10 per common share. As such, I believe a $0.12 per common share variance regarding AGNC's BV as of 6/30/2016 ($40 million BV variance) should be deemed well with my stated range and a minor outperformance by the company.
Readers have continued to request that I provide these types of "update/follow-up" articles showing how my quarterly projections "stacked-up" to AGNC's actual results. I believe the analysis above accomplishes this request. With that being said, let me briefly highlight some quarterly compositional changes that occurred within AGNC's MBS portfolio and briefly discuss the recent change to the company's hedging coverage ratio.
MBS Portfolio Considerations:
During the second quarter of 2016, AGNC slightly decreased the company's "at-risk" (total) leverage by slightly altering the composition of the company's on-balance sheet MBS portfolio and the company's off-balance sheet net long TBA MBS position. AGNC had an at-risk (total) leverage ratio, when including the company's off-balance sheet net long TBA MBS position, of 7.3x as of 3/31/2016. AGNC's had an at-risk (total) leverage ratio of 7.2x as of 6/30/2016. To show the compositional changes to AGNC's on- and off-balance sheet MBS portfolio during the second quarter of 2016, Table 2 is presented below.
Table 2 - AGNC MBS Portfolio Quarterly Compositional Changes (6/30/2016 Versus 3/31/2016)
(Source: Table created entirely by myself, including all calculated figures and percentages)
Using Table 2 above as a reference, when comparing AGNC's portfolio as of 6/30/2016 versus 3/31/2016, the company had a net par value increase (decrease) in its 15-year fixed-rate agency MBS holdings with a 2.5%, 3.0%, 3.5%, 4.0%, and 4.5% coupon of $0.3, ($0.2), ($0.2), ($0.2), and less than ($0.1) billion, respectively. When all 15-year fixed-rate agency MBS holdings are combined, this was a quarterly net par value decrease of ($0.3) billion. AGNC had a net par value increase (decrease) in the company's 30-year fixed-rate agency MBS holdings with a 3.0%, 3.5%, 4.0%, 4.5%, 5.0%, and 5.5% coupon of $1.1, ($1.3), ($0.3), ($0.1), less than ($0.1), and less than ($0.1) billion, respectively. When all 30-year fixed-rate agency MBS holdings are combined, this was a quarterly net par value decrease of ($0.5) billion (rounded).
Since AGNC decreased the par value of its fixed-rate agency MBS portfolio by ($0.9) billion (rounded), the company's leverage slightly decreased as of 6/30/2016 when compared to 3/31/2016. This is an important notion for readers to understand. It should also be noted AGNC unchanged the company's proportional share of 15- and 30-year fixed-rate agency MBS holdings during the second quarter of 2016.
Since mortgage interest rates/U.S. Treasury yields first slightly - modestly net increased but then recently have reverted back lower (through 7/29/2016), there was first a negative impact per a valuation standpoint to most fixed-rate agency MBS. However, more recently (in particular last week), MBS prices have regained most of the decreases sustained in the first few weeks of the quarter. In addition, AGNC maintained a fairly high proportion of fixed-rate agency MBS holdings in pre-payment protected specified pools during the second quarter of 2016. As such, this factor causes a slight increase to the company's MBS valuations during July 2016 (through 7/29/2016). However, partially offsetting this positive factor is the eventual minor increase in most CPR percentages if mortgage interest rates/U.S. Treasury yields continue to remain near historical lows. Now let us move on to AGNC's derivatives portfolio.
Derivatives Portfolio Considerations:
Due to the events that have unfolded in July 2016 (through 7/29/2016) regarding first a minor - modest net increase in mortgage interest rates/U.S. Treasury yields then a subsequent decrease, mREIT companies who had a lower hedging coverage ratio at the end of the second quarter of 2016 likely had lower valuation gains within its derivatives portfolio versus peers who had higher hedging coverage ratios. This is basically the exact opposite trend that occurred during the second quarter of 2016. However, since mortgage interest rates/U.S. Treasury yields have reverted back lower this past week, this general negative valuation has abated somewhat. These "swings" in market interest rates, across the entire yield curve in this instance, can impact an mREIT's performance "quarter-to-quarter" when compared to sector peers. As such, when AGNC reported the company slightly decreased the company's hedging coverage ratio from 83% as of 3/31/2016 to 79% as of 6/30/2016, I believe this is a positive catalyst/trend for the third quarter of 2016 (through 7/29/2016). In my opinion, this was a more modest hedging coverage ratio and more appropriately indicates the interest rate risk of the current environment ("lower-for-longer").
I believe AGNC's results for the second quarter of 2016 were a slight outperformance when compared to my projections. Most of the accounts that I projected were very close to actual reported results. The lone exception where a more modest variance occurred was within AGNC's interest rate swaps portfolio. The reasoning behind this modest outperformance was due to active portfolio management (which I commend). As I correctly projected, AGNC reported a minor (less than 5%) increase in both BV and economic return during the second quarter of 2016. I believe this should be seen as a positive trend, in light of what some mREIT peers have reported/will be reporting over the next week or so.
It should also be noted spread/basis risk has modestly decreased during July 2016 (through 7/29/2016). Even though the positive correlation between MBS prices and derivative instrument valuations slightly decreased during the last week of July, most (if not all) mREIT companies should report a net positive correlation in this relationship for July 2016. I believe this should be seen as a recent positive catalyst/trend regarding mREIT book values and valuations.
Through a detailed analysis that will be omitted from this particular article, I am projecting AGNC's BV as of 7/31/2016 has increased $0.10-$0.40 per common share when compared to the company's BV as of 6/30/2016. This projection includes the July 2016 monthly dividend of $0.20 per common share (ex-dividend was 7/27/2016).
In addition, through the internalization of ACMM, the company expects to save approximately $50-$60 million in annual operating expenses. This is one of several reasons why I was disappointed with AGNC's recent announcement of a ($0.02) per common share decrease to the company's monthly dividend per share rate beginning in August 2016. AGNC has recently lowered the company's cost of funds rate through notably lower hedging costs and has lowered its operating cost structure. Both these factors are positive regarding a company's dividend sustainability. However, as management noted in AGNC's earnings conference call for the second quarter of 2016, the company basically took a "preemptive" approach when it came to declaring August 2016's reduced dividend. The following commentary from AGNC's Chief Executive Officer ("CEO") Gary Kain summarizes the company's perspective in regards to the recently declared dividend reduction:
… As we have discussed on prior earnings calls, our dividend policy is not based upon our net spread income. In this case, our decision to lower the dividend was a function of a number of different factors. The single largest driver was the rallying interest rates which coupled with a flatter yield curve and the performance of agency MBS impacted our near-term outlook. While this environment is positive in that lower for longer should enable AGNC to produce consistently solid returns over the intermediate term, today's very low rates reduce carry and serve as a disincentive to run a materially positive duration gap. As such, it makes sense for us to pay a slightly lower dividend…"
In other words, I believe Mr. Kain is implying management believes that an overall lower interest rate environment is here to stay, at least over the next year or so. The main reason behind this reasoning is the extreme suppression of global sovereign debt yields. This will likely continue to put a "damper" on long-term U.S. interest rates/yields. Ultimately, this eventually impacts the coupons offered on agency MBS in the secondary market (also cannot chase too high of a yield based on fear of heightened prepayments). So, while I believe AGNC certainly could have continued to declare a stable $0.20 per common share dividend heading into 2017, the company wanted to take a preemptive approach and cautiously reduce the dividend now.
While I am not stating I completely agree with AGNC's decision to reduce the company's monthly common stock dividend per share rate at this point in time, I can understand management's reasoning behind the dividend reduction. In addition, reducing the dividend in August 2016 notably lowers the probability of another dividend reduction heading into 2017. This gets more into a technical discussion of AGNC's dividend metrics/sustainability which is beyond the scope of this particular article.
My BUY, SELL, or HOLD Recommendation:
From the analysis provided above, including additional catalysts/factors not discussed within this article, I currently rate AGNC as a SELL when I believe the company's stock price is trading at less than a (7.5%) discount to my projected CURRENT BV (BV as of 7/31/2016; projection provided above), a HOLD when trading at or greater than a (7.5%) but less than a (15.0%) discount to my projected CURRENT BV, and a BUY when trading at or greater than a (15.0%) discount to my projected CURRENT BV.
Therefore, I currently rate AGNC as a HOLD since the stock is trading at or greater than a (7.5%) but less than a (15.0%) discount to my projected CURRENT BV. My current price target for AGNC is approximately $20.75 per share. This is currently the price where my HOLD recommendation would change to a SELL. This price target is a $0.25 per share increase when compared to my last AGNC article. The current price where I would increase my AGNC position is approximately $19.10 per share. This is currently the price where my HOLD recommendation would change to a BUY. This price is a $0.30 per share increase when compared to my last AGNC article.
Along with the data presented within this article, these recommendations consider the following mREIT catalysts/factors: 1) projected future MBS price movements; 2) projected future derivative valuations; and 3) projected near-term dividend per share rates. This recommendation also considers the notably lower probability of several Fed Funds Rate increases by the Federal Open Market Committee ("FOMC") during 2016 (most bullish case is now only one rate increase during 2016; more market participants now anticipate no increases) due to recent macroeconomic trends/events.
Final Note: Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader's current investing strategy. The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions. Within the past 120 days, I have not directly increased or decreased my AGNC or MTGE position (only through reinvested dividends).
On 11/27/2015, I initiated a position in AGNCB. On 12/7/2015, 12/9/2015, 12/14/2015, 1/14/2016, and 1/20/2016, I selectively increased my position in AGNCB. When combined, my current AGNCB position has a weighted average price of $23.215 per share. This weighted average per share price excludes all dividends received/reinvested. I currently hold 0.71% of the outstanding shares of AGNCB. Each AGNCB trade was disclosed to readers in "real time" (that day) via the "StockTalks" feature of Seeking Alpha. Through this resource, readers can look up all my prior disclosures (buys/sells) regarding companies I cover here at Seeking Alpha.
Disclosure: I am/we are long AGNC, MTGE.
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.
Additional disclosure: I currently have no position in ACAS, AI, ARCC, CMO, CYS, or ORC.