American Capital Agency (NASDAQ:AGNC) stands to be one of the most followed large cap U.S. mortgage REITs with an unmatched dividend yield of 14.5%, which is well backed by its operating cash flows. The average cash dividend coverage ratio over the past 4 quarters has been 1.7 times, while the most recent quarter's cash dividend coverage ratio improved to 2.15 times. While there are risks associated to the future income growth at American Capital Agency, we still believe the company has enough financial muscle to continue its dividend distributions in the coming quarters. The company also has one of the lowest projected conditional prepayment rate (CPR) of 12%, with 70% of its securities consisting of low coupon and low balance, which means they will less likely be impacted by acceleration in prepayments due to the third round of quantitative easing. The fact the American Capital Agency is one of the few mortgage REITs that has not announced a dividend cut also supports our belief that the company has the ability to sustain dividend distributions. Despite the analyst downgrades, we reiterate our buy rating on the stock for income-oriented investors.
Impact of QE3:
The company has been affected, one way or the other, due to the recent actions of the Fed. The launch of the third round of easing by the Fed to stimulate the sluggish U.S. economy has resulted in a more downward pressure on the longer-term rates than on the short-term rates. Bond buying by the Fed has resulted in an increase in demand for the securities that American Capital Agency invests in, resulting in lower spreads. Some of the decline in spreads can be covered by realizing capital gains on the bonds. However, the mortgage-backed securities replaced will have lower coupons.
Due to the aforementioned concerns, Morgan Stanley downgraded the stock of American Capital Agency from overweight to equal weight. Morgan Stanley has a current price target of $37, which is above the previous price target of $35. The consensus mean price target for the stock is $34.28. The stock is currently trading at $32.5 per share.
Similarly, the Jefferies Group also downgraded the stock from its previously buy rating to hold. The company has a price target of $34 for American Capital. On the other hand, analysts at Wunderlich raised their price target for American Capital to $34 per share.
The stock, with a 20% price appreciation since the beginning of the year, is trading at a premium of 14% to its book value. Comparatively, Annaly Capital Management's (NYSE:NLY) stock is currently trading in line with its book value.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by Qineqt's Financial Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.