American Capital Agency Corp.'s (AGNC) new series of Class A Preferred (AGNCP) is a new twist on the company's ongoing fundraising. This article describes what the new issue means for buyers of the issue, and for the common shareholders holding through the issuance period. To appreciate the effect of the preferred issue, it's important to understand how the company makes its money.
The Business Model
American Capital Agency is a real estate investment trust ("REIT") that invests not in real estate, but in security interests in real estate. American Capital Ltd. does not make its money like a landlord, by collecting rents. Instead, like like any mortgage REIT ("mREIT"), it makes its money like a bank by collecting a higher rate of interest than it spends to acquire investment funds. Thus, the firm can be likened to a leveraged bond fund.
Leverage is critical to profiting from home mortgage interest rates as low as currently prevail in the United States. American Capital Agency historically uses approximately 8x leverage in its investment portfolio, and at the end of the last quarter had a net spread of nearly 2% (the difference in the percentage rate paid for investable funds and the percentage rate earned on investments). With about 8 parts of borrowings for each part of equity and about 2% rate spread in each invested part, American Capital Agency should have about nine times its equity invested in instruments that earn it the prevailing interest rate on its investments plus eight times its (~2%) interest spread, which after its 1.25% annualized management fee should net it very roughly 18%. Exact numbers are not helpful from quarter to quarter (except for trend-tracking) because the applicable rates and rate spread change monthly.
American Capital Agency has grown the scale of its investments as it has issued additional equity over time, which has generally worked to the advantage of earlier shareholders due to the availability of prompt investment at similar terms and the high price per share obtained at each issuance. Narrowing rate spreads have led to the current dividend being set at $1.25 per quarter, which at $5 per year is a bit north of 16% annually based on current prices just north of $30. Management explained it believed this new dividend rate would be sustainable in the current interest rate environment, which on the above back-of-the-napkin math looks to be accurate.
The New Preferred Issue
The new 8% preferred cost $25 at issue and has a $25 repayment preference. This means that if the company is liquidated and its value paid to shareholders, the preferred holders are paid their $25 before common shareholders are paid whatever is left. Considering the billions American Capital Agency has invested and the current limit on the $25 preferred issue (about $150 million), the $25 preference looks to have a wide margin of safety.
Considering the roughly 18% American Capital Agency is able to earn on investors' equity, the dividend looks safe, too. Paid on the face value of $25 rather than on the price of the shares, the 8% dividend is significantly less than American Capital Agency has demonstrated it can earn for shareholders. Preferred shareholders have another reason to feel secure: their dividend is preferred. The income declared payable to common shareholders will be paid from what's left of distributable earnings after obligations to the preferred shareholders are satisfied. If in theory American Capital Agency were to suffer an adverse interest rate environment that impaired its ability to maintain the $5/year dividend for common shareholders, the billions of dollars' worth of shareholders' equity behind the common shares will still generate enough revenue to take care of the dividend due the preferred shares' dividend.
Buyers of the new 8% preferred issue will get what they bargained for.
When the new preferred was priced at the end of 1Q2012, Common shareholders' stubs were backed with what was likely $28 per share or higher (at the close of 4Q2011, NAV per share reached $27.71 per share, up $0.81 from the end of 3Q2011, which was itself up $0.14 in a quarter full of financial turmoil) and they were expecting a dividend just north of 16% based on then-current share prices. Equity per share had been steadily increasing since the firm's first issuance in 2008 at $20. So, what changed?
The issuance caused the company to grow by about $150 million in invested assets, while obligating the company to repay a new class of shareholders of 6 million shares their equity of $25 apiece in preference to other shareholders. The equity backing the common thus had no immediate change: the $150 million in, and the $150 million preference, are a wash. But each quarter as management reinvests earnings that aren't paid as dividends, the $25 preference remains fixed. Management invests the $150 million alongside common shareholders' funds - presumably to the benefit of about 16% - and after paying the preferred shareholders 8% on their $25 equity have everything left over to add to the income attributable to the common.
At $150 million in preferred equity, American Capital Agency is on track to accumulate additional earnings (beyond those promised to preferred shareholders) at a rate north of $3 million per quarter. After the March offering of common, American Capital Agency's count of common shares should be 62 million shares ahead of the 2011 year-end share count of 224.15 million, for a total of 286.15 million shares. The extra $3m per quarter thus amounts to a bit over 1¢ per common share the company can reinvest to grow the NAV and earning power of AGNC's common.
If demand for the preferred is good, we should see more issuance of the Class A preferred.
Since Google Finance shows consistent market valuation above issuance price, it seems fair to conclude that the shares are well-received by the market. Growth of preferred share count should be expected. Since management will surely continue growing the common share count through accretive issuance, the relative safety of the preferred in its equity preference should be maintained even as the common shareholders benefit from a cheap source of equity with which to bolster returns.
Outstanding management by American Capital Ltd. (ACAS) continues to improve the strategic position of investors by offering preferred shareholders the protection of excessive asset and income backing (the 8% and $25 promises are easily dwarfed by American Capital Agency's enterprise-wide income and assets), and magnifying the safety of common shareholders' expected returns by accessing relatively cheap capital on terms that won't eat into their NAV accretion. American Capital Ltd. provides its managed fund excellent service while growing its assets under management, to provide a win-win-win for its own shareholders and both the common and preferred shareholders of its managed fund. I hope to see similar creativity at work to magnify the returns of American Capital Ltd.'s other publicly-traded managed fund American Capital Mortgage Investment Corp. (MTGE). How often do you see a company improve everyone's odds of getting what they bargained for?