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American Capital Agency May Benefit From A Flight To Safety In H2 2015

  • Agency mortgage REIT, AGNC, pays a 12.3% annual dividend.
  • AGNC lost -$0.97 per common share in book value in Q2 2015. It appears to have gained back approximately +$0.25 per share as of August 21, 2015.
  • The Net Spread and Dollar Roll income is likely to exceed (in Q3 2015) the $0.60 per common share earned in Q2 2015. The dividend appears safe.
  • AGNC's assets are US government guaranteed securities. They should be a safe haven in uncertain times. That should allow the book value and the stock price to appreciate.

American Capital Agency Corp. (NASDAQ:AGNC) is a blue chip mortgage REIT. Its President and CIO, Gary Kain, is considered one of the gurus of the MBS world, especially the Agency RMBS world. AGNC invests primarily in Agency RMBS. AGNC's goal is to preserve its net asset value, while providing risk-adjusted returns for distribution to shareholders. It currently pays a healthy 12.3% annual dividend ($0.20 per common share per month). Since its IPO in May 2008 at $20.00 per share, it has paid $31.70 per common share in dividends through August 21, 2015; and its net asset value has risen to $24.13 per common share as of July 31, 2015 (a +179.2% total economic return over a period that included the Great Recession).

In Q2 2015 it lost -$0.97 per common share in book value as the yield on the 10 year US Treasury Note rose from 1.92% to 2.35% (+43 bps). In Q3 2015 so far, this situation has reversed dramatically. The yield on the 10 year US Treasury Note has already fallen (as of August 21, 2015) to 2.05% (-30 bps) with Q3 only about half over. AGNC has already reported a gain in book value through July 31, 2015 of +$0.13 per common share (about +0.54%). The drop in the yield of the 10 year US Treasury was only to 2.18% (-17 bps) by July 31, 2015. The extra -13 bps drop since then is certain to have added to AGNC's book value. This likely means a gain in book value of roughly +$0.25 per common share (+1.0%) through August 21, 2015. This is a positive for the book value. It is also a positive for the spread between the book value and the stock price. AGNC has been trading at a huge discount to its book value. The chart of the 10 year US Treasury Note yield is below. It shows the recent downtrend in the yield clearly.

(click to enlarge)

There have been overall weaker world economic conditions recently, especially the weaker Chinese economic conditions. For instance, the recent Flash Caixin PMI fell to 47.1 in August 2015 (contraction). This was a 6.5 year low. The expectations for rapidly rising interest rates have been scaled back; and they may be scaled back further. Rates have been going down; and they may go down further. AGNC's average CPR (Constant Prepayment Rate), which rose in Q2 2015 from 8.4% in Q1 2015 to 11.6% in Q2 2015, may also fall back a bit in Q3 and Q4 2015. ARMOUR Residential REIT has already reported that its average portfolio CPR has been falling recently. The spring and summer selling season is almost over. Further the percentage of people spurred by climbing interest rates in Q2 2015 to refinance seems likely to go down with falling interest rates.

Of course, if interest rates go low enough, we may see a further spurt of refinancing. Also longer term, if the US goes into a new recession within the next year, we could see an increased number of foreclosures. These would likely translate into a higher average portfolio prepayment rate. However, in the immediate term a lower average CPR in Q3 2015 for AGNC should have a positive effect on the net spread income (via lower amortization costs due to a lower amount of prepayments). For reference, AGNC's average CPR for Q2 2015 was 11.6%. Its annualized net interest rate spread for Q2 2015 was 1.74%; and its leverage was 6.1x including TBA positions.

Investors should also understand that it is easier to make good profits from the TBA market as interest rates are falling. You get the interest rate for the Agency MBS sold temporarily; plus you get the appreciation in the value of the Agency MBS when you buy it back at the pre-fixed price, which is then lower than the fair value of the Agency MBS.

At this point it is appropriate to look at AGNC's portfolio (see below).

(click to enlarge)

61% of AGNC's portfolio is in 30 year fixed rate Agency RMBS. The highest percentage holding in 30 year fixed rate Agency RMBS is the 4.0% coupon Agency RMBS. The chart below of the 30 year fixed rate FNMA 4.0% coupon RMBS is a good approximation of AGNC's portfolio performance.

(click to enlarge)

As investors can see the 30 year fixed rate FNMA 4.0% coupon MBS has gained about 1% so far in Q3 2015. Investors can also see that it had gained only about one half as much by July 31, 2015 (the data on which AGNC's most recent book value estimate was calculated). In other words, my rough estimate of approximately a gain of +$0.25 per common share in book value through August 21, 2015 is largely confirmed by the FNMA MBS chart above. AGNC has officially estimated a +$0.13 per common share gain through July 31, 2015. My rough estimate puts the book value at $24.25 as of August 21, 2015. This gain in book value should allow a bit more upside movement in the stock price.

The naysayers will say the fall in interest rates puts the dividend at risk. However, TBA investments normally make significantly more money as interest rates fall. These monies are put into the pool from which the dividend is paid. AGNC earned $0.60 for this pool in Q2 2015. The total dividends paid out were $0.62 for Q2 2015. In Q3 2015, the total dividends paid out will likely be $0.60 per common share. If Gary Kain is his usual self, AGNC should have significantly higher income for this pool in Q3 2015. With more income and a lower total dividend payment, the dividend should be very safe. AGNC should even be able to store up a little for paying the Q4 2015 dividends, if the earnings from net spread income and drop income (TBA income) fall a little short in Q4 2015.

In sum the $0.20 per common share per month dividend should be safe at least through the end of 2015. Since economic conditions are apt to change by the end of 2015, I will refrain from making any predictions beyond that. Still AGNC would have to rise about 24% just to get to the book value I estimated above for AGNC as of August 21, 2015. This makes AGNC a buy.

Yes, the overall market is correcting; but AGNC's holdings are mostly government guaranteed securities. With an interest rate environment that is much less likely to rise quickly now, AGNC is a buy. Further the increased stability of the interest rate environment should allow AGNC's book value and its stock price to converge perhaps 10%. It should allow AGNC's Agency RMBS to appreciate in value a bit just from the greater stability. Further AGNC's book value is currently rising slowly based on falling interest rates. AGNC is a buy. Mortgage REITs normally perform well in this sort of environment.

The two year chart of AGNC provides some technical direction for a trade/investment.

(click to enlarge)

AGNC's stock has been in a downtrend. It would appear to have broken out of that downtrend recently. It is possible that the breakout could fail, especially if the overall market continues to fall at the rate it has been. However, while the market may still fall more, a complete rout at this time seems unlikely given the huge amount of QE most of the largest economies are doing. Follow this link to get a review of the QE actions of the biggest economies. Instead the current pullback seems more likely to be a normal pullback of the 8% to 15%-20% variety. Yes, the market may eventually go into a bear market. One is overdue. However, this doesn't feel like a bear yet to me; and the huge amounts of QE still in play would seem likely to prevent such a thing.

The US Fed might add their own QE program to those of the Japanese, Chinese, and the ECB, before such a bear market could get fully started. With all of that QE, there would inevitably be "buyers". Even without any actions by the US Fed, there will likely be "buyers" soon. Technology, Consumer Discretionary (especially brick and mortar), and Healthcare/Biotechnology stocks are overdue for a pullback. This may just be the market's way of providing that pullback.

Any fears about a cancellation of ObamaCare are likely a year away. Any fears about a cancellation or paring down of FinReg are likely a year away. Besides paring down FinReg should be a positive for banks and other financials. There really should be limited fear there. The only fear for banks, etc. should be that many international loans from many different countries may go bad at the same time. However, AGNC's holdings are largely US government guaranteed securities. When AGNC is already trading far below its book value, there can be only limited downside. That should make AGNC one of the safest buys in the market at this time.

NOTE: Some of the fundamental fiscal data above is from Yahoo Finance.

Good Luck Trading/Investing.