Sell American Capital Agency And American Mortgage? Depends On Who You Believe

Includes: AGNC, MTGE
by: Jack Rice

Currently, there is a sell-off of American Capital Agency Corporation (NASDAQ:AGNC) and American Capital Mortgage Investment Corporation (NASDAQ:MTGE), driven by sentiment fueled largely by negative commentary. AGNC's portfolio consists exclusively of U.S. agency pass-through mortgage-backed securities (MBS). MTGE is a hybrid mREIT, which buys both agency and non-agency MBS, although the bulk of MTGE's portfolio is agency-backed. Thus, the difference in impact of quantitative easing (QE) on agency and non-agency mREITs will not act with the same force on AGNC and MTGE.

The chief investment officer of both AGNC and MTGE is Gary Kain.

Some facts about AGNC and MTGE in this QE3 environment:

1. The analyst downgrades have been to Hold, not to Underweight or Sell. Some target $34, others $37.

2. The strategy of AGNC/MTGE has been specifically aimed at the current QE3 environment.

3. The sell-off will drive down the price/book ratio, hardening the valuation.

4. The effect of a QE, while narrowing spreads, raises portfolio values and thus book values.

5. By keeping their CPR low, AGNC/MTGE will face minimal negative convexity.

6. By maintaining relatively high leverage, AGNC/MTGE will not have to recycle their portfolios and compete with the Fed for new MBS.

7. AGNC/MTGE management have emphasized book value over dividend. Even if they incrementally cut their dividend, it will be to maintain book value, which should support the share price.

Read one of the Sell commentaries, and you will see leverage spoken of as a negative factor. Indeed, leverage can be a negative factor in a rising rate environment, but not the current falling rate environment. Leverage is being used without understanding or used spuriously.

Time and again, AGNC/MTGE have emphasized their focus on providing for this current QE3 environment. They have pointed to their prepayment-resistant portfolios and explained why low leverage in a QE environment is a bad idea.

Either AGNC/MTGE's strategy will prove ineffective, and both will see declines in their net spreads and their book values; or the current sell-off is a panic without basis, incited by ill-advised commentary.

In case of the latter, a significant buying opportunity is developing. For example, even if AGNC's share price were to hit $28 and the dividend cut to $1, then the annual yield would be over 14%. If AGNC manages to maintain its current dividend, then the yield at $28 will be almost 18%.

AGNC/MTGE, in their portfolio selections and their leverage levels, have expressly provided for the very QE3 environment which commentators cite as reason to sell. These commentators refuse to address the merits of the AGNC/MTGE strategy specifically. On 29 October, 2012, AGNC will announce third quarter earnings. At that time, the effectiveness of AGNC's strategy vis-à-vis QE3 will become apparent.

Disclosure: I am long AGNC, MTGE. 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.

Additional disclosure: I may increase my position in one or both.

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