A recent article described American Capital Agency Corp. (AGNC) as a short based on (1) two yield curves plotted three months apart, and (2) a description of the REIT requirement that the company pay over 90% of its "income" as dividends. While there may be reasons to worry about mREITs, the lack of depth offered for this short thesis should caution readers to think harder about their money.
The Dividend Requirement
Real Estate Investment Trusts such as American Capital Agency have a special tax status that protects investors from double-level taxation so long as the firm pays to shareholders over 90% of taxable income. Taxable income isn't GAAP earnings because of the differences in each accounting system with respect to the timing of income recognition. In GAAP, unrealized gains are "earnings" requiring a provision to be made for tax liability, even if - like Berkshire Hathaway (BRK.B), about which I wrote in Part III of this article on why to sell Apollo Investment (AINV) - the company's anticipated holding period is "forever" and there is no genuine expectation of ever paying a tax. By contrast, investors are familiar from their own returns that taxable income is based on the post-exit assessment of the gain/loss of an exited position. Unrealized capital gains and accumulated but unpaid interest may be "earnings" under GAAP, but they are not taxable income and never enter the dividend-paying requirement.
With this in mind, one should look closely at the analysis - the entire, unredacted analysis - provided to "explain" why American Capital Agency Corp. is forced to dilute shareholders with frequent equity issuance:
By law, mREITs are required to pay more than 90% of their income. So to continue operating these companies need to raise money frequently. AGNC has been issuing equity instead of borrowing.
Keeping in mind that the dividend-paying requirement is based on taxable income - income that has been realized and is thus in-hand and available to pay to shareholders - exposes this explanation as meritless. American Capital Agency Corp. can happily pay 90% of its taxable income to shareholders without raising a cent to do so. Why? The taxable income is on-hand unless it's reinvested.
American Capital Agency Corp. doesn't tie up its income from quarter to quarter to make one large payment at the end of a calendar year, though it can. American Capital Agency Corp. is managed by American Capital Ltd. (ACAS), the same external manager that manages American Capital Mortgage Investment (MTGE). In January of 2012, American Capital Mortgage Investment paid a dividend of 80¢ per share that was applied toward its 2011 tax year's dividend-payment requirement. In theory, the entire annual dividend requirement could be handled this way. However, American Capital Agency Corp. Doesn't pay one dividend in January for the whole of the prior year, requiring a sudden year-end liquidity panic; it pays each quarter from realized earnings it has on hand because they were just realized.
What makes the article even more puzzling is that it pitches issuance as a reason to fear American Capital Agency. The history of American Capital Agency is that its manager issues the company's shares when issuance is accretive, not dilutive. As explained in the article "Understanding Dilution vs. Accretion At American Capital's Managed Funds", issuance at American Capital Agency Corp. is no friend to shorts.
The Yield Curve
The above-linked article publishes a pair of superimposed yield curves, which depict the interest rate difference between short-term and longer-term borrowings. The curves indicate pressure on the yield curve, reducing the profit to be made on the yield spread. It's this yield-spread pressure that caused American Capital Agency Corp. to reduce its dividend to $1.25 per quarter. The reader begins to suspect that Mr. Kushwaha is going to predict that curve-flattening will kill American Capital's business model - but the reader is mistaken! Instead, the reader is offered this:
Recently AGNC cut its dividend from $1.4 / share to $1.25 / share dropping its yield from ~20% to ~16%. I am expecting the yield to go up to 20% and thus price to drop to around 26/27. Based on this belief I recently bought puts on AGNC. I bought June 2012 put at a strike price of 29 for ~$1. Thus my break-even point is at 28. I have up to June 12, 2012 for the price to fall to that level.
The reader is asked to believe that American Capital Agency's business will continue to justify a 20% yield despite the yield curve pressing the company's yield spread below 2%. Based on the company's <8x leverage and its historical leverage in the neighborhood of 8.5x (which its manager has explained can't be safely raised due to intra-month liquidity concerns), expecting a yield of 20% would seemingly require some explanation.
Alas, no. We're asked to take this pricing on faith.
Although the return of a 20% yield following the dividend reduction is the apparent foundation of the short play, there's no reason to believe a 20% yield will be seen unless and until yield curves steepen. And we've heard Mr. Bernanke hint that raising rates is unlikely anytime soon. Certainly not by the summer expiration date of the puts described in the article pitching American Capital Agency as a short.
The yield curve changes explain why American Capital Agency Corp. should have a lower yield now than when the yield curve supported a higher yield spread, which in turn supported higher earnings from the company's leveraged portfolio. The company has a history of managing net asset value successfully, including with hedges against interest rate changes. The company's manager has done an outstanding job, which is why it's been able to continue growing the portfolio through accretive issuance. If the manager's plan were truly to pay dividends with funds raised in offerings, there would be no reason to adjust dividends to match rate-spread income. The short trade described above is simply lacking in sound support.
To find a short bond fund, one might want to look at a company that pays a vastly higher expense ratio, seeks to sell new shares below net asset value, and has a history of declining net asset value per share. As I wrote in March, Apollo Investment Corp. might be a place to start. Shorting a well-managed company like American Capital Agency would require a lot more explanation and analysis than has been published.