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American Capital Agency (NASDAQ:AGNC), a U.S. mortgage REITs that is largely followed, disclosed its third quarter performance on October 29, 2012.

The company's net interest income will be negatively affected if the Fed decides to accelerate its bond buying. AGNC has one of the lowest conditional prepayment rates but at the same time most of the company's asset portfolio is invested in fixed rate securities. High exposure to fixed rates securities does pose a threat of a future dividend cut but this risk is with almost every mREIT. AGNC remains one of our most favored agency mortgage REITs, as it has the lowest conditional prepayment rate among its peers. Therefore, we recommend the stock to income-oriented investors for a 15.6% dividend yield.

The company reported a surge in interest income for the third quarter of the current year as compared to the second quarter.

The reported interest income of $520 million surged 3% sequentially, while it jumped a significant 59% YoY. Much of the sequential surge in interest income, despite an 18 basis point decline in asset yield, was a result of a 15% increase in the company's interest earnings assets. The average asset yield at the end of the third quarter was 2.55%, against 2.73%. The decline was a direct result of a decline in the yields of mortgage-backed securities that the company owns due to the implementation of QE3. As a result of QE3, the prices for fixed rate long term mortgage-backed securities jumped, decreasing the yields. If the Fed accelerates this practice, we believe the company will experience a further decline in its asset yield in the coming future.

Interest expense of $139 million surged 16% QoQ, while it jumped over 40% when compared to the interest expense of the same quarter of the previous year. The cost of funds during the third quarter surged 5 basis points sequentially to 1.13%, while the repo rate increased from 0.42% at the end of the second quarter to 0.46% at the end of the third quarter, partially offset by a lower ratio of interest rate swaps to repurchase agreements. A higher interest expense reflects the fact that American Capital Agency was not able to benefit from the ultra low interest rate environment, which the Fed intends to keep until 2015.

The net interest margin of 1.42% at the end of the third quarter that the company earned remained 23 basis points behind what the company earned during the second quarter. As a result, the net interest income of $381 million at the end of the third quarter remained 1% below the net interest income figure of the second quarter. Against a 23 basis point sequential decline in net interest margin for AGNC, the decline in net interest spreads for Capstead Mortgage (NYSE:CMO) and Hatteras Financial (NYSE:HTS) were 20 basis points and 27 basis points, respectively.

AGNC was also not able to curtail its expense during the third quarter, which is why it surged 11% sequentially to $40 million. The company reported a profit of $83 million against a loss of $261 million at the end of the second quarter.

Asset Portfolio Composition

During the third quarter, the company increased its interest yielding assets by 15% to $89.6 billion, with over 98% invested in fixed rate mortgage-backed securities, while only 1% was invested in adjustable rate securities. All of the fixed rate securities are invested in 15-year or more maturity mortgage-backed securities. The following chart gives a clear picture of the weights of each type of security within the asset portfolio at the end of the third quarter.

The Conditional Prepayment Rate of 9% at the end of the third quarter remained below the 10% rate at the end of the second quarter. Projected average CPR for all the company's assets portfolio increased from 12% to 14%, sequentially. This was a direct impact of the third round of quantitative easing conducted by the Fed.

Dividends

The stock offers an attractive dividend yield of 15.6%, well backed by an operating cash flow yield of 16%. The annual cash dividend coverage ratio comes out to be 1.5 times, reflecting the fact that the company has enough financial muscle to continue this elevated dividend distribution, given the interest rate spread that the company earns is not compressed. American Capital Agency remains one of the very few mREITs that did not slash its dividend distributions this year.

Source: Is American Capital Agency's 15.6% Dividend Yield Best Amongst mREITs?