American Capital Agency And Hatteras Financial: Growth, Dividends And Lessons For Mortgage REIT Investors

by: James Shell

I got a suggestion from one of my followers the other day in response to this article about AG Mortgage Investment Trust (MITT) and American Capital Mortgage, (MTGE).

The question was posed whether an investor would be better off in either of these two mREITs versus Hatteras Financial Corp (NYSE:HTS), which has a lower yield, and has recently announced a share issuance.

Here is a summary of the recent pricing and yields:

Price Div Yield
American Agency Capital AGNC 29.88 16.90%
AG Mortgage Investment Trust MITT 20.09 13.94%
American Mortgage Capital MTGE 23.45 15.30%
Hatteras Financial Corporation HTS 28.80 12.50%
Click to enlarge

The history of HTS is actually quite interesting because it illustrates the importance of growth in this business, and the relationship between growth and the nice high dividends that are the prime motivation for most investors considering the mREITs as a potential investment.

Here are some updated tables:

Portfolio ($B) 55 1.4 1.78 17.7
2011 Int Income ($M) 1108 10.2 16.4 424
2.03% 0.73% 0.92% 2.40%
Click to enlarge

Hatteras has been around for much longer than either MITT or MTGE, and it is quite clear that it is much more like AGNC than like the other two newer funds. We developed these two tables the other day. HTS, like AGNC, is invested 100% in agency backed mortgages, and has a similar degree of leverage. Hatteras also has very nearly a half percent lower interest rate spread than AGNC, in approximately the same marketplace.

Agency 100% 88% 92% 100%
Non Agency 0 8% 3% 0
Comm/Other 0 4% 5% 0
Click to enlarge

Interest Spread 2.30% 2.25% 2.36% 1.78%
Leverage 7.9 5.9 8 7.7
Click to enlarge

I am ready to say that the most telling indicator is the following:

Realized Derivative Income/Loss ($M) 26.4 -2.6 -2.162 20.0
Realized Derivative/Interest Ratio 2.4% -25.5% -13.2% 4.7%
Click to enlarge

I've been trying to characterize these funds on the basis of what part of their life cycle they are in. MITT and MTGE are clearly in their infancy. The high percentage of their bottom line, either positive or negative that is derived from hedging is an indicator of that. HTS is behaving more like the mature company that it is, making income in the business of lending mortgage money rather than in speculation.

We've been doing some work examining the management discussion of risk of these funds for the sensitivity of the funds' interest income to changes in interest rates:

(Click charts to enlarge)

Click to enlarge

There is a slight difference in management attitude as to the future direction of interest rates. AGNC's managers have their hedging system set up in anticipation of a slight increase in interest rates, MTS more toward a slight decrease. Both are accepting larger risks that rates will change more than 50 basis points.

I had made a point in one of my earlier articles that over the last few months, the growth rate of these funds has been critical in their ability to maintain a constant dividend. I have a couple of graphs to illustrate this key idea:

Click to enlarge

The source of the above are the companies' 10Ks, and years 1 through 4 above are year-end 2008, 2009, 2010 and 2011 respectively. You can see that all of AGNC's rapid portfolio growth took place in 2011.

However, here is some more detail on what happened in 2011:

Click to enlarge

There were two factors involved in the flattening of the growth rates. First of all, the economy slowed down, due in no small part to the oil price spike that happened last spring, and very nearly went into recession. Secondly when a company gets big, it is difficult to accommodate the additional growth. As those of us with familiarity with math are aware, there is a limit to growth.

Here is a graph of the dividend history:

Click to enlarge

HTS has been cutting its dividend since early in 2010, which is the point at which its growth rate started to slow down. In the case of AGNC the dividend was just recently reduced after roughly one quarter of no growth.

Here is a table of the average portfolio coupon value, that is, the average interest rate of the funds' portfolio at the beginning and end of 2011:

Average Coupon of Securities FY 2010 FY2011
AGNC 5.03% 4.42%
HTS 3.74% 2.84%
Click to enlarge

You can see that for both companies, the average coupon on their portfolio decreased last year. You can also see that HTS' average coupon was less than AGNC's, and the reason for that is that 90% of AGNC's mortgages are fixed rate, and about half of their portfolio is 30-year mortgages, whereas 75% of HTS' portfolio will reset between three and eight years, with an average coupon rate of about 3.0%.

So, with all of this data, it is pretty clear what happened:

Both AGNC and HTS were on a rapid growth trajectory, AGNC being the more aggressively growing of the two. HTS' dividend became vulnerable in 2010 when its growth rate leveled to less than 10% year on year, and AGNC continued to grow. AGNC's dividend became vulnerable when the growth rate flattened to about zero at the end of 2011. So growth is good, and a good economy in which to grow is good as well. That might be the bigger lesson.

So, what about the future:

Both AGNC and HTS have announced some share issuances.
The AGNC announcement is for roughly 70 million additional shares,
which at the current price of around $30 per share, and at a leverage rate of about 8:1 and at about 2.5% interest rate spread, should be able to increase their net income by about $340M, which is about a 30% increase in the profitability of the company. There are currently approximately 224.1 million shares outstanding, so it would be increasing the amount of shares outstanding by about 30% as well.

The HTS announcement is for 10 million shares, and given an optimistic issuance price of about 30, a leverage rate of 8:1 and an average interest spread of 1.78% will bring an additional $42M to the bottom line of that company. There are currently 70 million HTS shares outstanding so the increase in shares would be by 14%, so the AGNC share offering is the more attractive.

There is one lingering question: Why are there two companies? Why would the shareholders in these two companies not be better off with both being turned into one somehow. I will leave this question for another article.

For now, here is what we have:

When the growth slowed down in both AGNC and HTS, in the chaotic environment of 2011, the dividend got into jeopardy, and I am ready to say that the managements of both companies recognized this, and have taken steps to fire up the growth engine.

Based on a situation of stable interest rates, we would expect the AGNC share issuance to be the more productive of the two. The 30% increase in shares outstanding should result in a roughly equal 30% income increase. The 14% increase in HTS' shares outstanding should bring only a 10% income increase.

Further questions: Why should HTS be trading at 7.25 earnings, while AGNC is trading at 5.62? Why should HTS not be trading somewhere in the low $20s, in light of its lower dividend, lower interest rate spread, and higher percentage of ARM's and short-term rates?

Is it not also clear that in an environment like we now have, growth is good? If an investor is making a mREIT selection, would not a smaller, more aggressive fund with a higher level of growth be better? If that is your attitude as an investor, maybe sticking with MTGE and MITT would be better.

As we are so fond of saying, the world is chaotic, and there are no guarantees on anything. Sometimes after a little research, we end up with more questions than answers.

Disclosure: I am long AGNC, CIM, CYS, TWO, ARR, IVR.