Once, over the course of one week in college, my fiancée ate every single one of a batch of little flans I had carefully made. They had gone promptly into the bottom drawer of the refrigerator, because I didn't want to gobble them up - I had wanted to savor them. I knew that once I started in on the little flans, they were doomed. And when I really needed one a week later, I knew exactly where to go -- where I had stashed them against my time of need.
And the drawer was bare.
Apparently you can't have your flan and let your fiancée eat it, too.
So imagine my pleasure in the Q1 quarterly report of American Capital Mortgage Investment Corp. (MTGE) when I saw that although the company had paid a dividend of $0.90 (something my wife can eat now), the company had also grown net asset value ("NAV") 91¢ - not in replacement of the funds spent paying the dividend, but in addition - something I can enjoy every quarter. That's because the extra 91¢ helps American Capital Mortgage Investment's managers at American Capital Ltd. (ACAS) in their quest to provide more of the income for which I originally invested: every quarter, that extra 91¢ will be working to make more money. By growing my holdings' value against my time of need, American Capital Ltd. lets investors in its fund American Capital Mortgage Investment eat delicious dividend cake while regenerating the cake itself. Just as suggested here before either of the last two quarters' results were released, American Capital Mortgage Investment gives investors more than a pretty dividend: it gives significant NAV growth, too.
Business In 1Q2012
Over the quarter (results summary), American Capital Mortgage more than doubled its investible assets in an oversubscribed issuance that included $34 million in over-allotment exercises (quarter presentation slides). Although the company closed the quarter with 7.6x leverage (down from 8x at the end of the prior quarter), it had an average leverage over the quarter of only 6.8x - likely due in part to the time required to deploy the company's doubled equity base. American Capital Mortgage was able to end the quarter with net interest spread of 2.38%, exactly the same as it ended the previous quarter on December 31, 2011. Interestingly, despite identical beginning and ending net interest spread, average net interest spread over the quarter increased from 2.40% in 4Q2011 to 2.75%.
Risks and Rewards
Because the majority ($3.845 billion vs $181 million) of American Capital Mortgage's holdings are guaranteed directly or indirectly (e.g., via "Fannie Mae", the Federal National Mortgage Association (FNMA)) by an agency of the United States government, the primary risk to the company is considered not to be default risk. The leading risks, rather, are interest rate risk and prepayment risk.
Interest rate risk exists in a leveraged mREIT because its profit turns on the difference between the rates at which the mREIT can borrow and the rates at which it is paid a return on its investments. If the interest rate environment works against the mREIT, it can affect net interest spreads and thus leveraged returns. Moreover, interest rate changes impact the value of an mREIT's holdings and thus pose a risk to the value of invested capital. Interest rate risk is managed by American Capital Ltd. for its managed funds through the use of hedges.
Prepayment is a risk because the bulk of attractively-yielding mortgage investments are being sold above face value due to their high yield. Above-estimated prepayments pose the risk not only of not making back expected returns, but of capital losses between purchase price and repaid face value. American Capital Ltd.'s underwriting techniques seek to protect its managed mREITs from prepayment risk. That is, American Capital Ltd. selects mortgages whose characteristics (is the loan underwater? is the principal too small to make the transaction costs of refinancing sensible?) make them unlikely to be refinanced. Still, people buy and sell homes - causing prepayment regardless of loan characteristics. Thus, there is some non-zero prepayment rate expected in a mortgage portfolio. At the end of the quarter, American Capital Mortgage's portfolio had a projected lifetime constant prepayment rate ("CPR") of 7.3%. Over the quarter, actual CPR was 5.7% - and in the month of March 2012 it was 4.7%.
American Capital Ltd.'s risk-management techniques' success is reflected by the quarter's results at American Capital Mortgage: of the $1.82 of SEC-reportable income for the quarter, $1.07 was net spread income and $0.75 was investment-related net gains. Considering that the company entered the quarter with a NAV of $20.87, this result amounts to a return over the quarter that exceeds 8.7%.
That wasn't 8.7% on an annualized basis. That was 8.7% over the quarter. Given that the share price at the beginning of 1Q2012 was below NAV, this result would be rather higher from the perspective of a shareholder. However, as the NAV discount no longer exists, investors should look to management's performance as compared to NAV to ascertain the price at which they believe the shares to be fairly valued. Given that the last quarter's annualized return approaches 40% based on NAV, it is reasonable that investors would attribute a certain premium to the shares if they view this performance as having the stability demonstrated by the same management team at American Capital Agency since 2008. Since American Capital Agency turned in an even better quarterly result despite a smaller net interest spread, it's not unreasonable to suppose that as American Capital Mortgage continues to grow its returns will improve as a result of improving efficiencies of scale.
Fees and expenses at American Capital Mortgage and its sister company American Capital Agency (AGNC) are compared to those at Apollo Investment (AINV) in Part II of an earlier article. Since both of American Capital Ltd.'s publicly-traded funds are managed for a fixed percentage of assets under management, the sizeable difference between the two is likely attributable to non-fee costs, which in turn are likely subject to improvement with scale. Lowering costs as a percentage of assets under management would necessarily improve after-expense returns. Because American Capital Ltd. is compensated based on assets under management, it has a strong incentive to grow assets under management by issuing equity at or above NAV.
American Capital Mortgage entered 1Q2012 with an undistributed taxable income of 24¢ per share, and despite more than doubling its equity (and share count) managed to close the quarter with undistributed taxable income of 53¢ per share. Since at least 90% of undistributed taxable income must be paid to shareholders as dividends in order to maintain REIT status, American Capital Mortgage will have to raise the dividend over the tax period or issue more shares to obtain indefinite deferral - preferably while raising NAV. However, even the growth from 24¢ to 53¢ per share in undistributed income doesn't explain the NAV growth of 91¢ over the quarter: equity per share is growing beyond the company's requirement to pay a dividend. American Capital Mortgage Investment Corp. is delivering NAV growth and a solid dividend, and as it grows its growing transaction scale should allow it to perform even better than its sister company American Capital Agency Corp.