American Capital Agency's (AGNC) third-quarter earnings report came in with a mixed bag of positive and negative results. Overall the company did an excellent job through the quarter with the management of its MBS portfolio. Despite the good management results the tightening yield spread had a significant effect on net interest income, and the company acknowledged that this is a very tough environment in which to make money.
MBS Portfolio Performs Well
The fact that American Capital experienced just a 9% constant prepayment rate (CPR) for the quarter is a big achievement for the portfolio management strategy of the company. The CPR was down from the 10% level experienced in the second quarter. Other mREITs have reported higher CPRs for the quarter, such as a 26% CPR for Anworth Mortgage Asset Corporation (ANH), up from 24%. Capstead Mortgage (CMO) reported a CPR of 18.7% during the third quarter, compared to a CPR of 15.9% during the second quarter of 2012.
American Capital Agency also reported a large gain in book value, up $3.08 or 10% to $32.49 per share. The book value gain came primarily from the $1.2 billion or $3.73 per share of net unrealized gains on the company's MBS portfolio. The higher book value and the newly announced share buyback, which will be triggered if the stock price drops below book -- where it now sits at $32 -- should quickly push AGNC back above $34 when the markets reopen.
Interest Margins Continue to Shrink
Even with the low CPR, American Capital Agency was not immune to a shrinking interest rate spread over the third quarter. The company's net interest spread was 1.50% at the end of the quarter, compared to 1.62% at the end of the second quarter and 1.94% a year ago. American Capital has also reduced its leverage down to seven times equity from the near eight area earlier in the year. As a result, the reported net interest return on equity was 11.16% in the third quarter, compared to 13.51%, 20.74% (when leverage was at eight times), and 15.77%, stepping backward in time through the previous three quarters.
When American Capital Agency elected to reduce the dividend from $1.40 per quarter to $1.25, the company was earning 20% on its equity on a net spread over 2%. Those margins have shrunk by over one-third as the dividend has been maintained at the $1.25 level.
Future Dividend Expectations
Of the $1.25 dividend paid for the third quarter, 79 cents was covered by net interest income earnings. In the first quarter of 2012 the net interest earnings were $1.42 per share, and for the second quarter interest earnings chipped in 94 cents per share. Sustainable earnings from interest on the company's MBS securities are currently only covering about 65% of the quarterly dividend.
There were a couple of interesting nuggets in the third-quarter earnings presentation, which has not at the time of this writing yet been given live. The following notes concern the ongoing purchase of MBS by the Fed:
This will likely have significant ramifications for mortgage investors:
- The yields and risk-adjusted returns on new purchases will likely be materially lower
- Mortgage rates to borrowers will be lower
- Refinancing volumes will likely increase, driving prepayments on many types of mortgages to new highs mortgages to new highs
A correctly positioned and actively managed portfolio should be able to generate attractive albeit lower risk-adjusted returns. (emphasis added)
I believe that American Capital Agency will continue to focus on total return, which in this case mean maintaining or increasing the book value. The current dividend rate is not in line with that goal, so a dividend reduction seems inevitable. The question is whether the payout will be reduced for the fourth quarter or the 2013 first quarter. I am leaning toward getting a new dividend rate in the first quarter. I expect the 2013 payout to be around 85 to 90 cents quarterly, producing a 10% yield on a $35 share price.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.