Patrick Harden's  Instablog

High-flying agency-backed mortgage REIT American Capital Agency Corp. (AGNC) recently turned in third quarter numbers - the first in its sector to report for Q3.  The headline numbers were impressive, with $1.82/share in GAAP earnings and $1.89/share in taxable income - well above the $1.40/share Q3 dividend.  However, a quick review of the earnings release and the shareholder presentation reveals that AGNC's stunning results were once again the result of selling off its appreciated MBS holdings. 

Last quarter, the Company traded out its high-yield fixed MBS for higher-yielding ARMs, using the capital gains to boost EPS by $0.72/share.  This quarter, the Company traded out the high-yielding ARMs for lower-yielding ARMs, again achieving capital gains that boosted EPS by about $0.73/share.

To AGNC's credit, the Company included a new slide in its Q3 shareholder presentation noting that its YTD taxable income of $3.90/share includes $1.26/share in (potentially non-recurring) capital gain income.  Ordinary taxable income was just $2.64/share, well below AGNC's YTD distributions of $3.75/share.  For the quarter, the Company earned $1.16/share in ordinary taxable income - below the $1.40/share dividend.  It's clear from the slide presentation that the 2009 dividend is being supported by $0.22/share in 2008 TI spillover plus 2009 capital gain income.

Given AGNC's portfolio actions - swapping into lower-yielding coupon securities - it's likely that the net interest spread for the Company has peaked, pressuring the ordinary taxable income run rate going forward.  Although AGNC has $0.90/share in undistributed taxable income remaining to support the dividend in Q4 09 and 2010, it won't be enough to sustain the dividend at current levels.  AGNC will likely have to cut its dividend to $1.00/share or lower in future quarters, bringing the yield down to a more reasonable 14% or so.  Although the yield will remain attractive, at a price/book value of 1.27x, AGNC is already fairly valued compared to peers.  A dividend cut will likely send retail investors fleeing to other names in the sector that have pursued a more stable dividend policy.

Disclosure:  Author has no position in AGNC.