American Capital Agency In Prime Position To Benefit From Lower Interest Rate Scenario

| About: AGNC Investment (AGNC)
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Company has taken right steps by increasing allocation to high yielding 30-year MBS and reducing overall hedged positions.

Rates will remain low since slacks identified by Fed continue to persist.

AGNC’s dividends are well covered by core EPS.

American Capital Agency (NASDAQ:AGNC) is an externally managed company, which primarily invests in agency residential mortgage-backed securities whose principal and interest payments are guaranteed by the U.S. government. I reiterate my bullish stance on the company because a major chunk of its allocation is towards high yielding assets. AGNC has also adjusted its hedged portfolio to take advantage of the lower interest rate scenario. It also offers a safe dividend yield with potential for price appreciation due to improvements in book value. Lastly, macro-economic conditions continue to remain favorable for the company.

Under-utilization of labor market
The two important slacks in the labor market identified by the Fed were no growth in wages and the low labor force participation rate. The recent job report for the last month showed that both these metrics have shown modest improvement. Average hourly earnings were up by $0.01 in July. The labor force participation rate increased to 62.9% in July from 62.8% from the previous months. I believe this modest improvements are no where close to the Fed's target. It means the Fed will continue with its expansionary monetary policy and keep interest rates low until there is a significant improvement in these numbers.

The July report was overall neutral and it was not at all the bad news for the economy. The solid job momentum built in the last few months cooled down, as the unemployment rate increased by 10bps to 6.2%. This increase was largely due to the increase in participation rate for labor. So it shows that the confidence of the public is restored, as they have returned to the labor market. The job growth was also below economists' expectations of 233,000. The economy only added 209,000 jobs in July, but overall it was the sixth consecutive month of job additions greater than 200,000.

The Fed also reaffirmed the labor market weaknesses in its guidance last week, as it said "there remains a significant under-utilization of the resources." Therefore, I am expecting low volatility in interest rates, which paints a compelling outlook for mortgage REIT companies. It means that the company could give up its defensive approach and divert its capital towards high yielding assets. AGNC was able to benefit from its aggressive approach in the first quarter and it continued its performance in the second quarter as well.

Aggressive approach
The company has shifted almost $7 billion of its 15-year MBS portfolio to 30-year MBS. This change in portfolio is driven by three factors. Firstly, as mentioned above, interest rates are expected to remain low as the Fed will continue its expansionary monetary policy as long as there is under-utilization of labor in the market. Secondly, the extension risk is low and there is much less protection needed. Lastly, the company can earn a higher yield with 30-year MBS, which will help increase its asset yield and hence the core EPS. Furthermore, the asset duration remains the same, 5.1 years, as it was in the first quarter. Overall, the Net Duration gap with swaptions decreases in the second quarter to 1.2 years, which means asset liability mismatch risk is low.

AGNC has also reduced its hedges, as interest rates are expected to remain stable in the short term. The company has reduced its swap positions by $1200 millions in the second quarter. This will help to decrease the cost of funds, which in turn will increase core EPS. It has also directed its hedges to longer-term rates, as AGNC has increased its exposure to 30-year MBS.

The company has reduced its investment in other mortgage REIT companies, but still continues to hold $202 million worth of shares, which shows that the management continues to see attractive opportunities in the sector. It is willing to take advantage as most companies are trading at a discount to their book values. In the first half of the year, AGNC realized $75 million in profits by selling its investments in its peer companies. This strategy works better because there is an upside potential, which is not present when the company buys its own shares and then retires them.

Dividends and Valuation
In the second quarter, the company reported core EPS of $0.87 per share, which means that the quarterly dividend of $0.65 per share is safe and sustainable. So, I believe the company will continue to yield an attractive double digit dividend yield of 11%.

The book value also increased by 7.2% QoQ to $26.26 per share in the second quarter. I am expecting the rise in book value to continue due to the lower rates and rise in agency prices due to tight spreads. So, I am raising the price target to $25, which is based on a discount of 5% to its book value. Currently the stock is trading at $23.18, which means price appreciation of nearly 8%. So, overall AGNC provides a compelling total return opportunity of 19%.

I believe AGNC has successfully positioned its portfolio to take advantage of the lower interest rate scenario. In the second quarter; the company has taken the right steps by increasing its allocation to high yielding 30-year MBS and reducing its overall hedged positions. The slacks identified by the Fed continue to persist, which will keep rates low. Furthermore, its dividends are well covered by its core EPS, and there is also potential for price appreciation.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.