American Capital Mortgage Investment (MTGE) displays several attractive characteristics. It pays a dividend more than adequately supported by earnings. It grows net assets per share ("NAV") even as it pays dividends. The dividend it pays has grown since it was first declared for the partial quarter in which the company launched last year, and based on the rate at which it last paid a dividend ($0.90/q), its dividend yield as priced near $24 exceeds 15%.
As Real Estate Investment Trusts ("REITs"), American Capital Mortgage Investment and its sister company American Capital Agency Corp. (AGNC) must pay at least 90% of their taxable income to investors in order to avoid paying corporate-level taxes. (Taxable income is not the same as SEC-reportable "earnings," which include things like unrealized gains and changes in NAV that result from non-taxable events.) The tax-efficiency of avoiding double-taxation is addressed in some detail in an earlier article on the real tax rate paid by Warren Buffett on his primarily-dividend income. The dividend-paying obligation is not a per-share obligation, but an obligation of the entity only. Thus, if the company issues equity at NAV (which includes no material tax obligations among its liabilities because the company generally avoids corporate-level taxation) following the earning of income, the undistributed taxable income ("UTI") per share (and hence the tax liability of the shareholders) will decline as the share count expands. NAV, of course, does not decline in an issuance at or above NAV. In fact, at the REITs managed by American Capital Ltd. (ACAS), NAV frequently grows upon issuance. But the reduction in UTI per share following a post-earnings issuance isn't a loss to shareholders. It's an opportunity for indefinite tax deferral.
So, what's the news?
The news is that American Capital Mortgage stands poised to offer another 11,500,000 shares or more; over-allotments drove last quarter's issuance higher. Despite more than doubling the share count through issuance last quarter, American Capital Mortgage's management earned so much taxable income for shareholders that UTI actually grew from 29¢/sh to 53¢/sh despite the issuance. The fact that management is making money too fast to defer more of it may seem sad at first, but imagine doubling the number of piggy banks in which you allocated your annual earnings . . . and finding the cash in each had grown despite it. Worse things could happen to an investment fund.
Because American Capital Mortgage Investment is so much smaller than American Capital Agency Corp., an equity issuance in the range of $300 million has a much greater impact in reducing UTI per share to effect deferral. (Again, since issuance is not below NAV, there is no dilution of equity in the issuance. There is only a reduction in the amount of NAV per share that's destined to be taxed this year. The difference - the UTI that's reduced without reducing NAV - is non taxable to shareholders or the entity as a result of raising new equity.)
The new issuance will amount to approximately 50% of the company's value at the time of the issuance. After the issuance, shareholders (whether buyers at issuance, or those holding through it) will have shares whose UTI is about a third less than immediately before the issuance. The replacement of per-share taxable income with per-share equity is a tax advantage investors can enjoy even in a non-tax-advantaged account. While American Capital Mortgage's tax-pass-through status makes it attractive in an IRA (where reinvestment can occur without annual losses to taxes), the fact that American Capital Ltd. achieves in-effect tax deferral at American Capital Mortgage even outside a tax-advantaged account makes the investment attractive for funds on which taxes cannot be deferred. Since American Capital Mortgage is so much smaller than American Capital Agency, investors seeking this tax deferral effect (which is more valuable to taxpayers in higher income brackets) may want to consider American Capital Mortgage rather than its sister company American Capital Agency Corp.
Replacing undistributed income per share with untaxed equity per share is a coup for the asset managers at American Capital Ltd. and all invested in their externally managed mREITs.