AGNC Turns Back the Clock

Edited by Vani Rao

Posts impressive results to wipe out gloom from Fed-hit MREITs

American Capital Agency Corporation (NASDAQ: AGNC), a mortgage real estate investment trust or commonly known as MREIT, reported encouraging Q1 2014 results with a comprehensive income of $1.18 per share, reversing the loss of $0.99 per share in Q4 2013 and the loss of $1.57 in Q1 2013.During Q1 2014, the company benefited from lower volatility in the mortgage markets, which allowed it to recognize gains on its portfolio of mortgage-backed securities.

In total, AGNC’s comprehensive income stood at $420 million in the first quarter compared to loss of $369 million in the prior-year quarter. This was mainly attributed to the appreciation in value of its securities, as it recognized a gain of $521 million on its available for sale securities, versus a loss of $311 million in Q4 2013. Its book value rose by almost 2.5% to $24.49. This is the first time since the third quarter of 2012 that AGNC witnessed an increase in its net book value. The economic return of 5% includes both the increase in book value and the dividends of $0.65 per share.

Turning the tide

MREITs have not been the best investments over the last two years. Benefiting from unprecedented monetary easing policies and low interest rates, MREITs shot up in popularity during the financial crisis. With a massive increase in assets and market valuations, MREITs did become cornerstone investments for many income investors who accentuate regular income over capital gains. AGNCis among the largest and most dominant MREIT that offers investors dividend yields of over 10% each.

Source: Q1 2014 Stockholder Presentation
Source: Q1 2014 Stockholder Presentation

Things changed in April 2013 when the 10-year treasury bond interest rate rose from 1.61% yield to over 2% at the mention of tapering bond purchases by the Chairman of the Federal Reserve. By the end of the year, this yield had risen to 3%. In reaction to this move, REIT investments, including MREITs, fell precipitously in price. As their book values dropped in sympathy with the value of their portfolio of mortgage-backed securities (MBSs), MREITs such as American Capital Agency fell in price and cut their dividends.

Source: Yahoo Finance
Source: Yahoo Finance

It can be seen from the above chart that there was a 46% drop in price in the aftermath of the taper talk. In the first four months of 2014, AGNC was up 18%. Note that the price moves opposite the 10-year treasury interest rate. To me, this indicates that AGNC is a leveraged long-term bond fund, which cycles opposite the 10-year treasury yield.

AGNC’s one-year share return is still pretty dismal; the MREIT lost 33% in value although the stock has recovered quite a bit from its 52-week low at $18.84 on May 1, 2014.

The chart below depicts the share prices of major MREITs and investors can clearly see a massive consolidation in the MREIT industry in 2013. It is pertinent to note that AGNC lost 28% over the last two years.

Source: Bloomberg
Source: Bloomberg

Healthy income statement

Last quarter, AGNC posted gains on its hedges, but a loss from other comprehensive income, largely from declines in its portfolio value. In Q1 2014, however, the opposite proved true. American Capital Agency lost $378 million on its hedges, but generated $521 million from unrealized gains in its mortgage-backed securities, alongside another $291 million in net interest income.

The extent to which lower forward volatility helped American Capital Agency cannot be overstated. Its first quarter presentation shows that MBSs traded higher in almost every duration and yield available. It seems that the mortgage markets would become less volatile as the Federal Reserve goes ahead with its tapering program. The Fed is purchasing MBSs at a rate of $25 billion per month, down from $40 billion per month last year.

That $15 billion change in monthly demand would be troublesome if it were not for fewer mortgages hitting the market. The Mortgage Bankers Association estimates have shown a consistent trend in declining originations over the past six quarters.

The trade group now estimates that 2014 will bring $1.12 trillion in new originations, down from $1.755 trillion in estimated volume in 2013.

The decline of $635 billion more than offsets the Fed’s declining demand for mortgages, suggesting that even if the Fed pulls out of the market entirely, existing buyers — MREITs, banks, and insurance companies can digest volumes at current interest rates.

Source: Mortgage Bankers Association
Source: Mortgage Bankers Association

MREIT buying spree pays off big

During Q4 2013, AGNC bought about $400 million worth of stock in its MREIT peers, including about 8.2 million shares, or 8.5%, of Hatteras Financial Corp. (NYSE:HTS). In its press release, AGNC noted that $0.14 per share, or about $49 million, came from dividends and gains from its MREIT equity holdings.By the end of the fourth quarter, AGNC had already recognized a gain of $237 million in its investments in other MREITs.

In Q1 2014, we find that AGNC’s buying spree did not stop at the end of the fourth quarter. The company purchased $352 million in MREIT equities, on which it recognized $49 million in capital gains and dividends. This is not trivial by any stretch; the gains provided $0.14 per share that can be returned to shareholders, assisting in AGNC’s dividend coverage.

Going up!

AGNC noted that ever since the Fed started with its quantitative easing, MBS as a whole were under-owned by the major players in the market. Indeed, banks, money managers, and other private investors seem to be well underweight in the sector. This may imply increase demand going forward, especially if the supply of fresh MBSs dwindles.

Source: Q1 2014 Stockholder Presentation
Source: Q1 2014 Stockholder Presentation

Conclusion

Dividend yields for selected MREITs are still relatively high and the question remains whether the yields will prove to be sustainable in an environment of rising interest rates. In any case, investors should not merely consider the dividend yield as a purchase criterion but also need to consider the impact of cyclical dividend increases on the value of the underlying mortgage portfolio.

A 20% annualized return for Q1 2014. This should be the key takeaway for investors. While I am sure there will be doubters, this quarter was extremely profitable for the company. Furthermore, given the amount of spread income, including To Be Announced (TBA) income generated, the current $0.65 per share dividend appears to be sustainable in the short term. AGNC really seems to have returned to form. Here’s hoping that this trend continues.

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