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American Capital Agency (AGNC) is an mREIT with a high dividend yield, but very few investors really understand how these businesses operate. In this article, I will examine how American Capital conducts its business, generates income and pays out its big 14.7% dividend. This mREIT builds up its investment portfolio by primarily investing in mortgage backed securities issued by federally sponsored mortgage agencies, such as Fannie Mae and Freddie Mac and the government-owned Ginnie Mae. This means that the securities are insured against default, and therefore, provide a relatively low rate of return. Other than this, there is some exposure to instruments, such as interest swap derivatives, and US Treasuries. The question is how this company is able to build up $88 billion in assets on an equity base of $9.8 billion and deliver a high return on equity. Lets find out.

American Capital achieves this by using a high level of debt or leverage by using repurchase agreements or repo's. The initial equity of $9 billion is used to buy mortgage backed securities. The company then enters into a repo transaction with the securities as collateral and receives $8.5 billion (this difference is called the haircut- it is to protect the lender against the drop in the value of the collateral). The cash is used to buy new mortgage backed securities, which are then offered as collateral in a new repo transaction and so on, until the desired leverage has been achieved. The difference between the interest received on these mortgage backed securities and the amount paid out on the haircut is the company's profit.

High leverage magnifies the effect of gains and losses on the portfolio, and we can see where the business risks are. Interest rate risk means that interest rates could go up suddenly. For instance, if interest rates rise 1%, the company says that net interest income would drop by over 16%, while the value of the portfolio would depreciate by more than 10%. Prepayment risk means that if mortgages are repaid ahead of schedule, the repayments will have to be invested in mortgage backed securities with lower yields. Finally, spread risk is the difference between interest received and borrowing costs that constitutes the net income of the company. To understand spread risk, lets assume that potential lenders decide that mortgage backed securities have gotten riskier. They would then raise the haircut to protect themselves. This double whammy will result in increased costs of borrowing (and therefore reduced spreads) as well as a reduction in the total level of permissible leverage.

Recently, there has been some good news for the REIT industry. The Fed has announced that it will keep the rate on Fed funds low up to at least late 2014. This should ensure that there is no diminution in the portfolio value of American Capital in the near future. This means that the company can continue to earn an annual interest spread in excess of 2% and maintain its handsome dividend of 14.7%. This also means that there is minimal interest rate risk at least till late in 2014, so you should be fairly safe investing in American Capital and other high quality REITs. The continuation of Operation Twist should have the effect of keeping interest rates low and encouraging a steady supply of new mortgages. It will also have the effect of stabilizing house prices. However, if the Fed decides on another round of quantitative easing, they may purchase agency backed mortgage securities in a large way, and this would have the effect of increasing the price of these securities while simultaneously increasing the rates of prepayment.

American Capital has reported impressive results for the first quarter of 2012. EPS was $1.29 a share, which was comfortably ahead of the consensus estimate of $1.15 per share. The projected prepayment rate has dropped considerably to 9% from 14% in the preceding quarter, primarily due to increased interest rates and changes in the pattern of the investment portfolio. Interest income at $514 million rose 200% over the preceding quarter and the company added more than $25 billion in new assets to reach a total asset level in excess of $80 billion. The company had $1.7 billion in cash and cash equivalents up nearly 30% over the preceding quarter.

I would like to draw your attention to some of the competitors of American Capital in the mortgage industry as investment alternatives. Chimera (CIM), unlike American Capital, also invests heavily in non-agency backed mortgage securities which make for a riskier portfolio. Chimera currently pays a dividend yield of 15%. The company has had problems with auditors and has been unable to produce up-to-date audited financials, so investors should research this company further before investing. Equity Residential (EQR) is one of the largest mortgage operators, but only has a dividend yield of 2.1%. Hatteras Financial (HTS) is much smaller, but has a dividend yield of over 12% that appears to be sustainable. Two other investments worth considering are Annaly (NLY), which yields 13%, and ARMOUR Residential REIT (ARR), which currently yields 16.5%.

I do not consider REITs to be a particularly good long-term yield investment, but if you are selective in your choice, well-managed ones, such as American Capital, offer an irresistible investment opportunity. Given the present conditions, I see little downside in buying American Capital now, because nothing adverse is likely to happen until the third quarter of 2014, and you are rewarded with a mouthwatering dividend yield of 14.7%. You should, of course, keep a close eye on developments such as interest rate trends and moves by the Fed, and exit your position if you see any trends that could negatively impact the stock. In the meantime, buy the stock and enjoy your returns.

Source: American Capital REIT: Don't Skip This Dividend King