With earnings season already underway, it will be time for the mortgage REIT sector soon. The sector should have a very strong performance on average. There will certainly be a few outliers, but for the most part this was a very positive quarter for the sector. AGNC Investment Corp. (NASDAQ:AGNC) is one of the companies that should be performing quite well.
When the earnings release comes out, investors should expect the comprehensive income to exceed the net spread plus drop income. The difference between the two is the net impact of fluctuations in the fair value of hedge positions and mortgage-backed securities. Overall the net change in valuation should be a significant positive impact. The result should be a couple percentage point gain for book value.
Internalization and the Run Rate of Expenses
Expect management to spend a little time talking about their internalization. They spent a significant amount of money on buying the external manager. Based on projections of run-rate expenses, AGNC should have the lowest ratio of operating expenses to equity. Since some charges associated with the transaction may show up in the third quarter, investors shouldn't use the third-quarter figures as the expected expenses for future. Therefore it makes sense the AGNC Investment Corp. decided to change their name in the third quarter. I would expect them to shove the entire cost into the third quarter income statement. Doing it that way will allow the fourth quarter income statement to provide investors with a much better picture of the expected expense ratio in future periods.
Some people are going to argue that changing their name is a pointless activity. They can very reasonably argue that the name of the company shouldn't matter. In this case, I will politely disagree. They simplified the names of the individual parties to make it easier for investors and analysts to recognize and understand all linked transactions. With external management agreements, the reporting can become extremely complex. If a company wants to show investors they are serious about transparency, making it easier to trace cash flows between companies is a great choice. This is something investors may think "doesn't matter", but that is only true until things change.
Why Transparency Matters
Remember that there was another REIT that encountered a raid of their offices. I'm speaking about United Development Funding IV (NASDAQ:UDF). A follower wrote to me when the first accusations came out and asked if they were true. I looked into the company for 30 to 60 minutes and responded that I couldn't tell because it would take hours for me to work through the related transactions and figure out where the money was going. Even then, there would be an enormous amount of work following those steps. There simply wasn't a large enough payoff to warrant the work.
Having a simple naming process makes it easier for an analyst to look through the statements. AGNC was already a strong mortgage REIT, but intentional transparency shouldn't be underrated as a virtue. Intentional transparency is wonderful.
LIBOR and Repurchase Agreements
During the quarter we saw a significant increase in the yield on Treasury Securities. We saw an even larger increase in the LIBOR rates. Perhaps the most notable increase is the boost in the three month LIBOR rate. The increase in the three-month LIBOR rate will decrease the effective periodic cost of running a large hedge portfolio. In previous periods 3 month LIBOR would run slightly below the cost of financing through repurchase agreements. In this quarter and in future quarters it appears that 3 month LIBOR will run higher than the right on repurchase agreements. This is a natural consequence of the money market reform. This may be one of the most underappreciated aspects of the reform. Demand for repurchase agreements backed by agency debt should assist in keeping rates lower. That allows AGNC Investment Corp. to earn a spread between 3 month LIBOR and the repurchase agreement. Overall this should be a tailwind for net interest income in future periods.
Projected Book Value For End of Q3
I'm estimating book value to come in around $22.90 to $22.95. If I'm within 2%, I consider the projections to be fairly accurate.
I'm estimating around a 15% discount to current book value based off a recent closing price of $22.48. When management is able to speak to analysts and investors about the expected impact of money market reform on their cost of funds, it should be a positive dialogue. Further the company will have an opportunity to discuss the expected run rate of expenses in future periods. I wouldn't be surprised if they aim to nail that down for analysts.
They know how much they should be saving, and it is enough AGNC Investment Corp. should trade at a better than average discount to book value. The biggest threat to their ratio is the possibility of investors using "tangible book value". Tangible book value is often a useful metric. However, in the case of AGNC Investment Corp. it undervalues the company because it fails to recognize the future cash flow savings from buying their external manager.
Outlook: At $19.48, I'm going to fall into the "neutral" camp. However, it is neutral with a significant lean towards the bullish side. I'm on the edge of an upgrade. If shares were last trading in the $19 to $19.20 range, the difference of a bit over 1% would've been enough to push me just over the edge. I believe there are better opportunities available in a couple other mortgage REITs. My latest buys were Annaly Capital Management (NYSE:NLY) and Capstead Mortgage Corporation (NYSE:CMO).
I am long AGNCB, but I may look to exit the position very shortly if I can get the right price for my position. Demand was extremely strong shortly before the close on Friday.
Disclosure: I am/we are long CMO, NLY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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