On August 9, 2011, American Capital Mortgage Investment Corp. (MTGE) raised approximately $199 million in a public offering and concurrent private placement. Since the firm's IPO at $20, investors have suffered a variety of disappointments in the form of employment numbers, consumer sentiment, and other potential harbingers of a threatened double-dip recession. One year on, how have early investors done?
To gauge the incentives of the parties, it's helpful to know who the parties are, and whom is being paid for what. American Capital Mortgage Investment Corp. has no employees. It has no compensation expense, but is externally managed by a fully-owned subsidiary of American Capital Ltd. (ACAS). All its officers are compensated by American Capital, which is obliged to provide management in exchange for the monthly payment of one-twelfth of 1.5% of stockholders' equity. MTGE therefore has no management compensation schedule to threaten dilution to shareholders: management's compensation is the problem of its external manager. Moreover, the external manager has no special incentive to prefer realized income to unrealized income, or to game quarter-by-quarter results to meet incentive thresholds.
Happily for shareholders, MTGE's external manager is also a major shareholder. At the time of MTGE's IPO, ACAS bought 2 million shares at the same $20 paid by IPO subscribers (though MTGE presumably didn't have to pay fees to underwriters on the equity raised through the private placement; this aspect of the IPO was a good deal for IPO participants, whose $20 tickets were tapped by middle-men to the tune of 80¢ per stub). Although ACAS is paid as a manager based on MTGE's funds under management, it hasn't been driven to print shares below NAV simply to game its compensation schedule like some other external managers. Instead, ACAS avoided issuing further shares until MTGE traded at or above its net asset value ("NAV") per share, and then issued shares above the IPO price of $20, both in the first quarter of 2012 and then again at $23 in the second quarter. In doing so, American Capital Ltd. not only avoided diluting its own investment but gained a tax advantage it will repeat every time investors buy new shares of American Capital Mortgage. Since the shareholder's equity at MTGE drives ACAS' fee income, one would expect ACAS to pay careful attention to the protection of MTGE's shareholders' equity. And it does:
Company-wide shareholder's equity metrics mean little without adjustment for the share-count increases following each issuance. What an owner of shares wants to know is what has happened to the investment backing each share. Following its initial stub quarter, MTGE went from $19.96 per share at the start of 4Q2011, MTGE posted quarter-end NAVs of $20.87 on 12/31/11 (+91¢, or +4.6%, atop an 80¢ dividend) and $21.78 on 3/31/12 (+91¢, or 4.4%, atop a 90¢ dividend), and $22.08 on 6/30/12 (+30¢, or 1.4%, atop a 90¢ dividend). These per-quarter NAV increases aren't annualized numbers, mind you. They are the overall NAV increases for the quarter.
As illustrated in the prior paragraph, MTGE offers investors per-share NAV increases in almost the same scale as its impressive dividend. Since the NAV increase isn't taxed to investors until disposition (and MTGE's REIT status prevents it from paying taxes on what's paid in dividends), MTGE's NAV increases offer a serious advantage in the form of compounding returns. The $2.08 in NAV increase means that buyers at the IPO price of $20 have more than 10% additional capital deployed to earn future dividends than they paid in when the shares went public - even despite the "loss" on Day One of the underwriting fees involved in the IPO.
After its 3Q2011 stub-quarter dividend of 20¢, American Capital Mortgage Investment has consistently paid a double-digit dividend that grew from 80¢ in 4Q2011 to 90¢ in each of the first two quarters of 2012. In all, the dividends from the company's stub quarter and three full quarters total $2.80 - fully 14% of the IPO price in less than a year of investment. Management hasn't made any signals that it hopes to change the dividend, but rather, explained when it set the 90¢ dividend that it expected that dividend to be maintainable by the company going forward. Looking at the company's increase in NAV, one might imagine the total return to be 24.4%. But the shares don't trade at the last-reported NAV of $22.08. They've traded above NAV since the first quarter of the year, a few times north even of $24:
At the time of this writing, MTGE trades at $23.75 per share. An IPO buyer selling at the shares' one-year anniversary - willing to forego the dividend to be announced for the first full third quarter - would enjoy a total return north of 29%.
American Capital Ltd. runs externally-managed funds for two reasons. First, fee business from managed funds has driven its asset manager's value upward to the point that the asset manager is its valuable investment. Second, American Capital Ltd. wants to invest its own money in the investments targeted by the funds, but to enjoy much better economies of scale with billions under management than a few tens of millions. Both of these interests favor growth in NAV per share.
Expect American Capital Mortgage Investment Corp. to be operated so as to protect the fund's assets, and those of its manager, while at the same time protecting the fee stream flowing to the manager from all the investors' funds under management. Expect American Capital Mortgage to continue paying a steady dividend while growing NAV. Volatility may be expected from quarter to quarter in the earnings management can keep atop those it pays in dividends, but management is not just playing with other people's money: it's protecting its own.
Protecting its own includes a variety of defensive measures. Since American Capital Mortgage Investment Corp. is permitted to invest in mortgages that are not guaranteed by a U.S. government agency, the company depends for credit risk on the same underwriting techniques with which it historically has achieved enviably low prepayment rates. Since the default of a government-guaranteed mortgage results in a prepayment to its holder in just the same way as a refinance would result in a prepayment, the discipline for underwriting these risks is similar. Macro-environmental factors impact the results management achieves, however. Although the company's average constant prepayment rate ("CPR") remained below 5% for the quarter, its prepayment rates rose and in the July period reached 5.5% for the first time; lifetime CPR projections now stand at 9.5%. Reinvestment in lower-yielding mortgages, elevated costs of hedges, and faster repayment led to a decline in the company's net interest spread from 2.38% (where it stood at the end of 2011) to 1.94%. The company's new $322 million in equity raised during the quarter may have helped reduce its average leverage, which dropped below 7x; the company averaged 6.5x and closed the quarter at 6.8x.
The lower leverage gives an interesting opportunity to make a comparison to the company's initial stub quarter, in which average leverage was very low. In the initial stub quarter, average leverage was 4.7x, though the company closed at 7.8x leverage. In that quarter, the net interest rate spread averaged 2.13% on a portfolio containing only 4% of non-agency investments. In the just-announced quarter, non-agency securities have grown to 17% of the company's holdings. The measured addition of non-agency investments has allowed American Capital Mortgage to outperform its sister fund American Capital Agency Corp. (AGNC) in net interest spread (AGNC closed the quarter with a 1.62% net interest spread) and in prepayment speed (AGNC experienced 10% CPR for the quarter and projected a 12% lifetime CPR). Due to the differences in characteristics available in the universe of agency-backed and non-agency mortgages, MTGE was able to increase its average non-agency yield five basis points over the last quarter, from 7.34% to 7.39%. The freedom to follow underwriting to the best investments appears a real advantage at American Capital Mortgage Investment. And as the interest rate curve flattens, and yield spreads narrow, that underwriting expertise and the fund's freedom of investment will ultimately represent shareholders' real advantage.
Even at the quarter's average net yield spread of 2.12%, the quarter-average leverage supports a Return on Equity of about 16%. The possibility that the investment pool may become more heavily weighted toward non-agency securities bodes well for the safety of the dividend, as it is in those securities where underwriting efforts best provide for the twin objectives of maintaining yield and avoiding prepayment. Since growth in the non-agency portfolio appears to take more time than does growth in the agency-backed portfolio, it's possible that large equity raises could become associated with transient yield hiccoughs as the portfolio rebalances toward a heavier mix of non-agency securities.
As predicted earlier this year, American Capital Mortgage Investment has done better for its shareholders than would have been suggested even by its lofty dividend. Although the shares traded below their IPO price - and below NAV - prior to the announcement of the 90¢ dividend, shares have generally traded at or above NAV since then. Closely viewing the company's SEC-reportable earnings or its reported taxable income in isolation may create quarter-by-quarter confusion for those seeking to read future dividend trends as if from tea leaves. Taxable income and SEC-reported income will vary from one another from quarter to quarter due to the impact of tax-unrealized hedging activities and tax-unrealized changes in value of investments over their holding periods. Management's record over time has been to grow NAV both over the first year of American Capital Mortgage Investment, and over the lifespan of its older sibling American Capital Agency Corp.
The yield curve has flattened further since the beginning of the year. Movement in the yield curve does not prevent carefully-underwritten investments in loans that - due to a loan's size or its security - will not be refinanced to take advantage of fallen rates. To the extent that MTGE comes to depend on non-agency investment performance for its survival, it may be unable to raise large blocks of equity without impacting quarterly performance. However, the first year of American Capital Mortgage Investment Corp. has shown that it performs under current conditions even better than its sister fund American Capital Agency Corp., and has shown that its management can do outstanding things with non-agency mortgage investments.
While the metrics with which management must work will continue to change - yields, yield curves, costs of funds, costs of hedges - the outstanding performance of management over the last year suggests more good things both in the form of dividends and increased NAV.