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American Capital Agency Corp (AGNC) represents my largest holding, both in my taxable account and my tax-deferred account. In case you didn't know, AGNC is a real estate investment trust that owns only mortgage securities (hence, mREIT) that are guaranteed by the US Government. By opting to be taxed as a REIT, AGNC must pay out 90% of its income to investors, who benefit because its earnings taxed just once (when they receive distributions), compared to corporations who pay tax on their earnings and then pay a dividend, for which tax is then paid by the recipient.

Recently mREIT's have been getting a lot of press, with much commentary dedicated to the sustainability of their payouts. Having many of my eggs in the AGNC basket, I've spent some time running sifting through their numbers, which are laid out in a very readable fashion on their own Investors Fact Sheet.

The book value per share as of 3/31/2011 stood at $29.06 on which they earn 3.32%. Additionally, they borrow another 8.2 times their asset value and invest in securities that also yield 3.32%. The cost of funds (interest expense, plus swaps, etc) is 1.01%, so the net investment income is:

Book Value: $29.06
Interest Income: 3.32%
Subtotal $0.964

Levered holdings
(8.2x book) $238.29
Interest (after swaps) 2.31%
Subtotal $5.505

Less Mgmt Fee (1.28%) ($0.372)

Total per share $6.097

At the current distribution rate of $1.25 per quarter, they will payout $5.00 leaving the company with $1.09 in undistributed earnings at the end of the year.

Clearly, the model is dependent on the availability of cheap borrowed money. However, the likelihood that the environment changes from being highly accommodating in the near-term future is very low, I think. For starters, Ben Bernake continues to indicate that the Fed will keep short-term interest rates at the record low level at least through the end of 2014, indicating that each share should be able to earn over $15.00 ($3.00 in the second half of 2012, $6.00 in 2013 and $6.00 in 2014) before an interest rate rise is expected to occur.

We can't expect the interest rate environment to go from highly accommodating to highly unaccommodating overnight, so that signals for a slow rise in interest rates.

How would that affect AGNC?

Supposing that their long-term investments continued to yield 3.32%, the current model works until AGNC's cost of funds reaches 1.47%, where it would still post combined earnings of $5.00 per share. To note, that is a 46 basis point jump, not the type of thing that would happen overnight unless the economy had suddenly roared to life. And any movement above 1.47% could be accommodated by making slight adjustments to the distribution rate.

Even if AGNC's cost of funds were to double to 2.02% and their portfolio remained otherwise unchanged, they would generate income each year of $3.69 per share. With a required payout ratio of 90%, that works out to $3.32 to shareholders annually, which, though it represents a decline from the current $5.00 rate, would still provide a yield on NAV of 11.4% or a yield on price of 10.6% (at AGNC's current price of $31.10 per share). I don't think that there is much likelihood of AGNC's cost of funds doubling without there being any change to long-term rates, but if that scenario happened, yes, distributions would decline, but they would still be among the highest that we could find in the publicly traded markets.

The other risk to the model would be for a rise in long-term rates, which might cause the AGNC to have to post additional collateral. According to AGNC's 1st Quarter 2012 Shareholder Presentation, the effect of a sudden 100bp increase in mortgage rates, would be that their NAV would decline by 10.7%. As jarring as that may be, I think that any risk of declines in the value of AGNC's assets due to rising yields is more than offset by their ability to purchase new, higher yielding assets. That might mean that rather than facing the end of the world, a sudden jump in rates could stand to

AGNC has just shy of 300 million shares outstanding, and on March 31, 2012 they filed to increase their total shares outstanding from 300 million to 600 million. A sudden jump in rates, as jarring as that may be, would likely benefit current holders in the long-term, so long as they have the conviction to hold onto their positions while AGNC deployed its dry powder by selling additional shares to recapitalize itself via secondary public offerings (SPO's). Any equity sales made beyond what was required post as collateral would be able to be used to purchase higher-yielding assets.

With mortgages at (probably) rock-bottom rates, we can't expect there to be many refinancings from the current portfolio, but with more than half of each payment being allotted to principal, when rates begin to rise, those payments will be able to be redeployed to purchase higher-yielding securities. And, if/when the housing market becomes more healthy, the current owners might be enticed to sell their current residences (returning principal) and purchasing new residences (and, hopefully, pay higher rates on their mortgages).

Conclusion:

I am very comfortable owning my concentrated position in American Capital Agency Corp. Their management has navigated the market quite successfully so far, delivering stellar returns to their investors. Even when today's low-interest rate environment eventually fades, AGNC should continue to be a sustainable enterprise, though as interest rates make substantial changes, there will come a time to re-evaluate if AGNC continues to merit occupying such a dominating position in my portfolio.

There are plenty of other mREIT's available for investment, with different risk characteristics ranging from differences in leverage, or investment in securities that may not have Federal Government backing. Additionally, AGNC (among others) offers a preferred stock for investors who are looking for more certainty of a payment stream.

Disclosure: I am long AGNC and MTGE (AGNC's cousin, which is allowed to purchase non-agency backed securities). I am considering purchases of AGNCP (the 8% Preferred Stock) and ACAS (American Capital, Ltd, the manager of AGNC) but will not be making purchases in the next 72 hours.

Also, this is not investment advice. Do your own due diligence. I don't know your personal financial situation, the level of risk you're comfortable with, or anything else about you.


Source: AGNC, By The Numbers