Buy American Capital: Compression In Interest Income Will Leave Dividend Unthreatened

Aug. 6.12 | About: American Capital (AGNC)

American Capital Agency (AGNC), with a dividend yield of 15.2%, reported its second quarter performance on August 3, 2012. The company missed consensus analyst estimates by a considerable margin and reported a net loss. Excluding the second quarter's results, and taking into account the seven previous quarters, American Capital maintained a history of beating analyst expectations for revenues and EPS by 9% and 25%, respectively. The table below demonstrates how the company missed expectations for the second quarter for both revenues and earnings.

The company reported a top line of $348 million, which was 7% below estimates of $414 million. The loss per share of $0.88 is against the consensus expectations of EPS of $0.86. Compared to the second quarter loss, in Q1 the company reported EPS of $2.66, exceeding analyst estimates by over 100%.

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Sequential Financial Comparison

Interest income decline 2% to $504 million, due to a 66bps decline in the net interest spread when compared to the first quarter of the current year. Interest expense of $120 million increased 13% when compared sequentially. The resultant net interest income of $384 million decreased by 6% compared to the previous quarter. However, it was significantly above last year's $201 million. The company was not able to manage its operating expenses efficiently. Expenses increased 29% QoQ, to $36 million. The company was able to increase its net book value to $29.41 per share, up by $0.35 compared to the previous quarter.

Portfolio Composition

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The entire portfolio remains tilted to fixed rate and longer maturity mortgage securities. The portfolio for the company's assets ballooned to $77.9 billion with 97% of the holdings in fixed-rate mortgages, while only 1% were adjustable rate. Of this majority fixed rate securities, 60% are composed up of 30-year fixed rate securities, resulting in increased interest rate sensitivity. The entire fixed rate portfolio is composed up of 15 years of greater maturity. As opposed to this, 28% of the fixed rate portfolio was composed up of securities with 3-to-5 year maturities during the quarter ended March 30, 2012. This means the company has now more exposure to changes in interest rates. The company is expecting current accelerated prepayments of 10% to reach the projected rate of 12%. To mitigate this accelerated prepayment risk, the company has positioned its asset portfolio into securities with HARP securities and low loan balances. The new low MBS will also help reduce the prepayment risk.

Since most of the asset portfolio is long term fixed rate in nature, we believe the portfolio is not well positioned to deal with the Quantitative Easing 3 (QE3).

Asset Yield, Cost of Funds and Interest Rate Spread

The declining interest rate environment had an adverse impact on asset yields and interest rate spread. The average yield that the company earned on its assets during the second quarter decreased 59bps to 2.73%, compared to the previous quarter. This is also below the 3.35% asset yield that the company earned during the same quarter from last year. Mostly changes in the asset portfolio composition and accelerated forecasted prepayments were the cause of a decline in the company's asset yield.

The company's cost of funds (repurchase agreements) for the second quarter increased to 1.08%, up by 7bps compared to the previous quarter, reflecting the company's inability to enjoy the near zero interest rate environment. The ratio of interest rate swaps to repurchase agreements and other debt increased during the quarter, which resulted in increased cost of funds. The company also increased the average maturity of its repurchase agreement to 121 days from 104 days in the first quarter of the current year. Fair value of longer maturity repurchase agreements will decline sharply as a result of a further decline in interest rates, benefiting the company.

The increasing and decreasing trend in the company's cost of funds and asset yield respectively caused a 66bps QoQ decline in the interest rate spread that the company earned during the quarter. It was able to earn 1.65% during the second quarter, as opposed to 2.46% during the same quarter of the prior year. Earlier, we were of the view that the company's spread during the second quarter will decline due to the general declining interest rate environment, and a decline in the asset yield, as most of the portfolio was classified as available for sale securities. Therefore, the sale and the resultant purchase of securities with low asset yield will ultimately lower average asset yield for the company during the quarter.

To reduce the company's exposure to interest rates, the company increased its interest rate swap positions. For the quarter ended June 30, 2012, the company had $48.6 billion of notional principal in swaps with a maturity of 4.3 years. This was $12 billion above the positions that the company had as of March 30, 2012. The swaps that the company entered into during the second quarter had an approximate maturity of 6.7 year. The reason to enter into longer maturity swaps was to protect the book value of the portfolio in a rising interest rate scenario, and at the same time maintain the long term earnings potential.

Outlook

For the time being, the Fed has put on hold more bond buying initiatives, but it believes that the U.S. economy is in need of another round of easing. Many are anticipating that QE3 will have multiple effects on the performance of American Capital Agency. Where it will drive prepayments to significant new highs, it also has the potential to drive down short term interest rates to record lows, meaning the company would be able to borrow funds at cheaper rates. However, we believe the company's portfolio is not well positioned to gain from this decrease in interest rates. The significant proportion of hedges employed, along with longer maturity fixed rate mortgage security, will keep the book value under pressure.

In conclusion, we believe the company is well positioned to deal with a rising interest rate environment. However, going forward, the much anticipated decline in interest rates will put its book value and interest rate spread under pressure. Having said that, we believe the compression in interest income will still not threaten the dividend, and shareholder distribution will stay intact. We reiterate our buy rating on the stock. However, investors looking to invest should be watchful of any decline in interest rates and the resultant decline in interest income and the book value of the company.

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