Can American Capital Agency Maintain Its Big Dividend As Rates Increase?

| About: AGNC Investment (AGNC)

American Capital Agency (NASDAQ:AGNC), with its hefty 14.9% dividend yield, is the second largest mortgage REIT in the U.S., the largest being Annaly Capital Management (NYSE:NLY). Both are in the business of investing in mortgage backed securities that are Agency guaranteed. American Capital is a relative newcomer after going public in 2008 and has quickly developed a following among the yield conscious.

The combination of low rates and well positioned debt leverage will continue to provide steady dividend returns for American Capital and other REITs in the same space, such as Annaly, MFA Financial (NYSE:MFA), and Invesco Mortgage capital (NYSE:IVR). Another factor at play is the angst caused by the eurozone crisis, particularly Spain needing a bailout, making investments in high yielding stocks more attractive to investors at home and abroad.

A report by Credit Suisse has the outlook for REITs in 2012 as optimistic, but preferring non-Agency paper to Agency REITS. The report prefers hybrid/non-Agency paper for more attractive value and the potential for more capital appreciation. Two Harbors (NYSE:TWO) is the top pick as it has been adding non-Agency assets to achieve better risk-adjusted yields. Two Harbors trades around $10.50 and yields 15.4%.

Non-agency paper will be dependent on a more risk-oriented market than the current state of affairs. The report sees 2012 as a year that will be able to provide double-digit returns to REIT investors. The non-Agency returns are more attractive now than they were in 2011, as the market's risk appetite is growing somewhat, but is continually tempered by macro-economic risks in foreign markets, and slow growth domestically always comes into play. Current data out of China has the markets breathing a little easier as the economy there is faring slightly better than the previous month, with industrial production up from 9.3% to 9.6%. Inflation was 3% down from the government's target of 4%. For now, it appears that the economic condition of China has stopped deteriorating.

In March, homeowners who have Agency guaranteed paper on their homes were allowed to apply through the Home Affordable Refinance Program (HARP) launched in 2009 and modified this year. Under previous versions of HARP, to qualify for refinancing, the amount of the loan could not exceed 125% of the current value of the home. This cap is a major difficulty for many home owners, as property values took a nosedive in the collapse of the real estate market.

New guidelines have removed the cap and there no longer a reasonable ability to pay clause to the extent that the payment does not increase by more than 20%, otherwise a 45% debt to income ratio applies. These modifications will either help fix the problem of underwater loans or it will create an environment in which lenders can make more risky loans without having any duty to repay. Rates above 4% could have a negative affect on the appeal and effect of the program; 30-year loans are quoted by Zillow at 3.56% this week, with 15year fixed mortgages coming is at 2.95% with adjusted rate mortgages.

The current effect of the new HARP is that there are more homeowners who do qualify for the new loans and are able to refinance. With Agencies issuing more loans and mortgage backed securities, Agency Capital and other like REITs have made a push to invest in newly available guaranteed paper with longer payment periods, stable lower borrowing costs and a better outlook for guaranteed returns in the near term. It has reflected in the share price of REITs such as Agency Capital. In this environment, there is still room for caution as the recovery in the U.S. has still not gathered any meaningful steam and there is still room for housing prices to collapse in certain regions - which may mean more loans go upside-down, creating another wave of foreclosures and the need for more loan modifications.

Armour Residential REIT (NYSE:ARR) is also in the business of investing in Agency guaranteed mortgage backed securities and its stock trades around $7, providing a 17% dividend. It had a good first quarter of 2012 reporting net income of $47.6 million or $0.35 per share. The company's book value per share was $6.79 at the end of the first quarter 2012. Additional paid in capital moves that to $6.95. The company offered 26 million shares of common stock during the quarter for proceeds in excess of $1 billion. In May, the company offered a Series A Preferred share yielding 8%.

MFA Financial also invests in mortgage backed securities that are Agency guaranteed. MFA invests a small amount of its portfolio in non-Agency guaranteed paper. Its first quarter of 2012 results have the company's book value per share increasing to $7.48 per share due largely to price increases in its non-Agency portfolio assets. The company's agency portfolio yielded 3.15% in the first quarter 2012. The non-Agency yields were 6.92%. The company's shares trade around $7.70.

Invesco invests in both Agency and non-agency guaranteed mortgage backed securities. Invesco's first quarter 2012 showed net income of $84.1 million or $0.72 per share. This compares to $76.5 million or $0.66 per share for December 2011 quarter. The average return on equity was 16.16% in the quarter. The shares trade around $18 and yield 14.5%.

American Capital and its peers have raised additional capital at a time when double digits are being returned to investors. During the first quarter of 2012, the company completed an offering of 71 million common shares at $29 per share. Net proceeds from the public offering were $2.1 billion. The company also privately sold 5 million shares at $30.70 for net proceeds of $142 million. There are currently 21 million shares remaining under the private sale agreement. In April, 2012 the company offered 7 million Series A Preferred Shares at $24.21 for $167 million. These shares pay an 8% cash dividends.

It is the right time for all of these companies to be raising money, as there will come a time when those distributions will not be able to be achieved, which in turn will mean any new investment will be very hard to attract. Agency Capital has performed well and has been rewarded well with the ability to sell out public offerings. It is conceivable that there will be some capital appreciation in the share price, but that is more likely in companies that have a diversified portfolio of Agency and non-Agency paper. Some of the companies mentioned here are trading at or near year-highs, in which event investors should measure the best bang for the buck when considering a REIT investment. For investors who are positive on recovery and have a higher risk profile, investing in REITs with non-Agency paper may be the way to go.

American Capital Agency has performed well in getting a better interest spread and shoring up its equity. Despite thinner margins and a dividend cut, the stock price has not been impacted negatively by either the cut in yield and diminished performance. The market right now is the perfect storm of low borrowing costs and measurable yield. REITs that properly manage leverage and yield are poised to continue delivering great returns in this year. American Capital's stock price is a little rich compared to peers that offer the same or better returns at a lower price. I don't believe that the quality of American Capital's portfolio is any better or worse than other REITs in the same space.

What the company is able to do is to retire debt in a timely and efficient manner, raise capital to shore up book value and make distributions to investors provided the current rate environment continues. The test will relate to what the company intends to do when the Fed starts to raise rates. Until the election is over, we can assume that American Capital has that much time to figure out how it will perform in a different environment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.