An Earnings Review Of The American Capital Agency And Annaly Capital Management

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 |  Includes: AGNC, NLY
by: James Shell

The followers of American Capital Agency (NASDAQ:AGNC) and Annaly Capital Management (NYSE:NLY) may remember that a quarter ago, we looked extensively at these two companies in a series of articles. Ninety days have passed, so quickly, and we were treated recently to some more data points, as both of these companies have announced their quarterly earnings.

For those that wish to follow along, the AGNC earnings announcement is posted here, and the NLY announcement is posted here.

1. Price Performance

We had a long conversation about these two funds in this article, in which I predicted that because of a higher interest rate spread, higher leverage, and more aggressive growth, AGNC would be the better of the two funds. Here are the actual results:

90-Day Price Change 5/2/2012 8/2/2012 Change
AGNC 31.14 34.97 12%
NLY 16.29 17.31 6%
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and here is the stock chart:

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Here is the current pricing and yield information:

Price Dividend Div Yield
AGNC 34.97 5 14.20%
NLY 17.31 2.2 12.36%
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In a world of less than 1% money market account rates, both of these companies are in focus because of the high yield situation.

Portfolio Growth

Portfolio Growth Q2 2012 Q1 2012 Ratio
AGNC 77.9 80.6 0.966501
NLY 118.5 110.2 1.075318
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For the last quarter, NLY was actually the faster growing of the two funds. Note: AGNC announced the offering of an additional 35,000,000 shares on July 17th, and expects proceeds of $1.09B. At 7.5:1 leverage that will ultimately turn into an additional $8.175B in portfolio, approximately, so AGNC will grow approximately 10% in the upcoming quarter.

Value and ROE

Net Book Value per Common Share Q2 2012 Q1 2012 Ratio
AGNC 29.41 29.06 1.012044
NLY 16.72 16.43 1.017386
Return on Equity Q2 2012 Q1 2012 Ratio
AGNC 21.5 33.7 0.637982
NLY 13.56 13.34 1.016492
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Both companies added book value at similar rates during the last quarter, and although AGNC still had a much higher Return on Equity, it did not have as good a quarter as it did in Q1.

Interest Rate Spread and Leverage

Interest Rate Spread Q2 2012 Q1 2012 Ratio
AGNC 1.65 2.31 0.714286
NLY 1.54 1.71 0.900585
Leverage Q2 2012 Q1 2012 Ratio
AGNC 7.5 8.2 0.914634
NLY 6 5.8 1.034483
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These are pretty key operating factors. Interest rate spread is the net difference between borrowing costs and income, and factors in the success of the companies' hedging program. Of the two, AGNC has the higher interest rate spread, but it also suffered more than the more conservative NLY in an environment of declining mortgage rates.

This was entirely predictable, based on the "discussion of quantitative and qualitative risk" from the previous quarterly report, that we discussed at length in this article, we knew that AGNC would be the more vulnerable to a change in interest rates, and that is exactly what happened. Note that even at these diminished levels, the net borrowing cost for AGNC are still lower than for NLY.

Leverage is a descriptor for the management's risk tolerance at a given time, and historically, AGNC has run its portfolio between 7.5 and 8.0, but for the first quarter, AGNC had leverage of 8.2. Since then, the management has returned to more like their historical leverage rate. The more conservative NLY has maintained their leverage at about 6:1.

Cash Position

Q2 2012 Q1 2012 Ratio
AGNC ($B) 2,099 1,762 1.19126
NLY ($B) 924 932 0.991416
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AGNC had a 19% increase in cash position in the second quarter, NLY's cash position remained unchanged. I had to love the following statement from AGNC's management discussion:

strong book value performance and the substantial amount of undistributed taxable income give us significant flexibility with respect to our dividend despite a lower spread environment.

This suggests that at least for awhile, the dividend is safe. Nothing like having a couple of quarters of dividend payments in cash on the books.

Effects of Hedging

AGNC Q2 AGNC Q1 NLY Q2 NLY Q1
Net Interest Income 384 408 719 721
Gain on Sale of Securities 417 216 94 80
Loss on Derivatives (Net) -1029 47
Unrealized Gain on AFS Securities 689 -106
Unrealized Gain on Derivative Instruments 52 52
Net of Income and Hedging 513 617
Net Effect of Hedging Program 129 209
Unrealized Gains(loss) on Interest Only MBS -26.1 30.9
Realized Gain (Loss) on Interest Rate Swaps -222 -219
Unrealized Gain (Loss) on Interest Rate Swaps -611 341
Net of Income and Hedging -46 954
Net Effect of Hedging Program -765 233
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If you net out all of the realized and unrealized gains on securities sales and/or derivative activity, AGNC once again did much better than NLY during the last quarter. For both companies, there were issues, due no doubt to the decline in interest rates. Note the $1B-plus negative swing in derivatives for AGNC and the similarly sized net negative swing in interest rate swaps for NLY.

Additional Financing

Both AGNC and NLY have turned to alternate methods of financing to raise money at a lower cost than issuance of stock. In the case of AGNC, it was the issuance of preferred stock, and in the case of NLY, it was issuance of preferred stock as well as convertible senior notes. From the point of view of the investor, since both noteholders and preferred shareholders have precedence over the common shareholders, it represents a higher degree of security. The tradeoff is that the returns are lower. AGNC's preferred stock pays 8%, NLY's preferred stock pays 7.625% and the notes pay 5%.

So, what to make of all of this?

Both of these companies are making adjustments for the current low interest rate environment. AGNC reduced leverage and temporarily got more conservative on portfolio growth. NLY maintained its conservative approach. Of the two, because of the more successful hedging situation, AGNC did better, as reflected in the stock price, and I would anticipate that it will continue to do better for the next quarter because of their resumed expansion and higher interest rate spread.

The piece of information we are lacking at the moment, pending the release of the 10Q, is whether AGNC has modified its hedging program to anticipate an even further decrease in interest rates, or whether they will maintain their current strategy. We will have to look into that later.

Both of these companies are looking for cheaper ways to raise money. The question in the back of everyone's mind should be: do the investors in these lower-paying instruments know something that the rest of us don't, as it applies to the interest rate environment going forward? We can conjecture on that later.

The world is chaotic, and there are no guarantees on anything. There is much to think about.

Disclosure: I am long (AGNC), (NYSE:ARR), (NASDAQ:MTGE), (NYSE:IVR) (for now) (NYSE:TWO) and (NYSE:CYS).