Investors have been starving for yield over the past couple of years. In a low interest rate environment, nothing looks attractive. Even if a dividend focused company could afford to hike dividends, they often chose to take advantage of the low cost of debt and expanded instead, sometimes leading to disastrous results (see Linn Energy (LINEQ)). What's worse is that even when the management seems to be committed to dividend investors (e.g. I've warned investors many times about ConocoPhillips (NYSE:COP)), they can go back on their words in an instant, leaving investors to deal with the consequences themselves.
It is a treacherous market indeed.
Can one safely invest in high yield securities? To answer that question, we first have to define what is "safe." If you subscribe to the idea that safety is the lack volatility (which is completely fine), then I say you should not be looking for high yield investments in the first place. Securities that offer high yields are often cast aside by the market, people can't wait to get rid of them. When you are going against the crowd, there is no practical way to guard against volatility (unless derivatives are used, but that's a whole another topic). However, if you are willing to accept that the market is sometimes wrong and high volatility does not entail risk, then we are talking.
The second question we have to answer is whether the dividend is a return of capital or a return on capital. If a dividend is merely a return of capital, then a decline in the security is completely justified. If you had $100 in your bank account (the stock) and you withdrew $10 (the dividend), then only $90 would be left in the bank. However, if we determine that a dividend is a return on capital, then the security is worthy of further analysis.
However, things are rarely this clear in reality. For example, if a cyclical company posts a money losing quarter, yet still chooses to pay a dividend, is this a return of capital or a return on capital? To answer this question we must recognize that capital and earnings are intertwined. For example, the dividend can be treated as a return of capital as the company did not generate earnings in the most recent reporting period. However, it could also be viewed as a return on capital as the company has generated profits in previous years. How do we deal with this situation?
Rarely is a company immune from cyclicality (if you do find one please let me know), especially if they are high yielders. In this situation, we would need to make a decision whether a loss was the result of secular change or a temporary hiccup that it can recover from. If the loss is the result of secular change, then we have to determine if the current yield provides a satisfactory margin of safety (e.g. you would still be willing to invest even if the yield is cut in half). My belief is that dividend investors would do well to stay away from companies with deteriorating prospects (i.e. secular change), especially when dealing with the common stock, as subsequent declines in profit often accelerate much faster than anticipated.
When we deem a loss to be transitory in nature, then we must analyze the company's near term financial obligations. "But wait, I thought investing is about focusing on the long-term?" That is true, but only if you are investing for growth or total return. For a dividend/income investor however, a company's ability to honor its payments is of utmost importance. Furthermore, high yielders often plunge after a payment is skipped, hurting investors twice in the process.
Introducing The Seven Percenter List
To guide investors with this process. I'll be regularly analyzing various high yield securities and share my opinions with you. There is only one criterion needed for securities to be featured on the Seven Percenter List: an annual yield of 7% or higher. The Seven Percenter List will include securities that are deemed to be unfit as well as securities that are deemed to be acceptable. Over time, we can evaluate the performance of both groups. Why did I choose 7%? Currently the Vanguard High Dividend Yield Index Fund (NYSEARCA:VYM) is yielding just 3.03%, SPDR Barclays Capital High Yield Bond ETF is yielding 6.3% (NYSEARCA:JNK)), and the Vanguard REIT ETF (NYSEARCA:VNQ) is yielding 4.2%; so the 7% threshold exceeds some of the most popular yield focused ETFs.
To begin, we'll be looking at both Series A and Series B preferred stock of American Capital Agency (NASDAQ:AGNC). Series A (AGNCP) is yielding 7.67% and Series B (NASDAQ:AGNCB) is yielding 7.60%. The similarity in yield is the result of the same level of seniority.
If you are not familiar with the mortgage REIT business you can get a bit of background through my discussion about the effects of the rate hike on mREITs.
In Q1 2016, the company lost $2.33/share, but dividends were still paid for both common shares and preferred shares. Industry returns are volatile, as an mREIT generates returns from the shape of the yield curve, which changes from time to time. Furthermore, net income is often distorted by irregular charges (e.g. derivative gains/losses), making it an unreliable indicator of future returns. For the above reasons, it's understandable that earnings have fluctuated significantly in the past.
There is one thing that makes our life a lot easier however. Because preferred shares have seniority, the common stock provides an equity cushion. As of Q1, the company had a book value of $7.66 billion, including $348 million of aggregate liquidation preference for both classes of preferred shares. This means that preferred shareholders have a comfortable $7.3 billion equity cushion. This equity cushion seems to be more than enough as the annual preferred dividend payout is only $28 million. Preferred shareholders may be inclined to think that the $7.3 billion cushion would cover their dividends for 261 years. Unfortunately, the management is also busy paying common shareholders. Last year alone, common shareholders received $874 million of dividends. The management has also been returning capital to common shareholders through buybacks, which amounted to $285 million in 2015. Management increased the capital return to common shareholders in 2016, spending $317 million on dividends and buybacks in the first quarter alone. Each payment to common shareholders depletes the equity cushion, so the equity cushion will shrink as times goes on. If the company does not generate a return in subsequent years, this cushion will quickly evaporate, leaving preferred shareholders exposed. So we are back to square one, how much can American Capital Agency earn?
The easiest way is to examine the average net interest rate spread, which declined from 1.29% in Q1 2015 to 0.68% in Q1 2016. The majority of the shrinkage can be attributed to the rising cost of funds, which increased from 1.28% to 1.64%. The balance of the compression can be attributed to the falling asset yield, which declined from 2.57% to 2.32%. These figures don't include G&A expenses, which would reduce the spread by another 10 bps to 0.58%, assuming that the management will realize the projected savings from the recent acquisition of its external manager.
The annual income that can be generated at a spread of 0.58% is $295 million based on the current investment portfolio of $51 billion. The portfolio is virtually 100% financed with debt (cost basis of $51 billion vs. mortgage borrowings of $49 billion), but the small difference does bump the effective spread to 0.65%. At a spread of 0.65%, the company can generate $331 million of income annually, much higher than the $28 million preferred dividend and almost as high as the liquidation preference. If the company can sustain just a fraction of this performance, then the preferred dividend should be safe.
I see two major headwinds that could significantly impair this spread: the impending rate hike and the management's reluctance to shift asset allocation. While the chance of a rate hike in the near-term has been reduced, we must accept that we are in a period of tight monetary policy. It is not a matter of if, but when. As mentioned earlier, we must determine both the short-term and the long-term prospects of a company. Hence there is little comfort in knowing that the Fed won't increase rate in 2016 ( which is still a speculation). Any rate increase will negatively impact American Capital Agency's ability to generate a return as cost of funds will rise. In 2015, agency borrowing interest expense increased from 0.41% in Q1 to over 0.49% in Q4, it then jumped to 0.70% in Q1 2016. Every 1 bps increase will decrease income by $4.89 million. So if the rate increases by just 25 bps (as was the case back in December), the company would see its income drop by $122 million, more than a third of the sustainable income of $331 million. Two rounds of rate hikes later, the profit would disappear. Unlike Annaly Capital (NYSE:NLY) (read Big Changes Are Coming To Annaly Capital), the management has not made any changes to the portfolio, 97% is still allocated to fixed rate MBS, hence the impact of future rate increases will not be softened.
To summarize our current findings, we know that there is a large equity cushion. Currently that cushion is deteriorating as the management is rapidly returning capital to common shareholders (e.g. $317 million in Q1, well in excess of annual income of $331 million. Furthermore, impending rate increases will likely erase any profit unless the management shifts portfolio allocation.
However, despite the negative factors above, it does not mean that the preferred shares are poor investments. Because the company is earning well beyond the annual preferred dividend payout of $28 million, we can be sure that the dividends represent a return on capital. We also know that the dividends will be safe in the short-term due to the equity cushion provided by common shareholders. There is a question of whether the dividend can be sustained over the long-term however, as the equity cushion is shrinking and the company's future earnings are in jeopardy. But these changes will not occur overnight. It will still take a couple of years for the equity cushion to be completely depleted (depending on quickly capital is returned to common shareholders). Furthermore, there is still time for the management to make changes to the portfolio. Given the above, I believe that the preferred shares are investable, but investors should keep an eye on two things: 1) how much cash is returned to common shareholders every quarter and 2) any changes to the investment portfolio.
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