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Dividend Cut or Not, American Capital May Be a Buy

AGNC Chart

AGNC data by YCharts. American Capital Agency vs. S&P 500 over the trailing-five-year period.

The stock market might be in full rally mode, but you’d have a hard time convincing shareholders of mortgage real estate investment trusts, or mREITs, including American Capital Agency .

Why investors dislike mREITs
The wheels really began to fall off the bus for the mREIT sector in mid-2013, when U.S. economic growth began to really pick up and the Federal Reserve had to seriously consider what it was going to do with its quantitative easing program, known as QE3. This economic stimulus was injecting $85 billion on a monthly basis into the economy via mortgage-backed security purchases and long-term Treasury purchases.

The goal of QE3 was to keep lending rates low so as to encourage a recovery in the housing sector and spur employers to borrow, expand, and hire. The program appears to have worked, as U.S. GDP growth in the third quarter came in at a revised and robust 5%, while the holiday-helped fourth quarter was revised lower, but to a still-solid 2.2% growth rate. Retrospectively, it was a smart move for the Fed to pull the plug on QE3 in October 2014 after months of cutting back on its monthly stimulus.

The problem for mREITs and American Capital Agency is that a growing U.S. economy, and a lack of economic stimulus, likely means the next step for the Federal Reserve is to raise the federal fund’s target rate.

Rising rates can be bad news for the industry since mREITs make money by borrowing at near-record-low short-term lending rates, then purchasing mortgage-backed securities with varying maturity dates that have notably higher yields than what they’re borrowing at. This net interest margin difference is where the profitability for mREITs lies. But in order to supercharge its gains, American Capital Agency and its peers use high leverage to multiply their earnings potential. The worry is that as rates rise, the cost of borrowing rises (since many of its assets are fixed-rate securities), squeezing mREITs’ net interest margins and their profitability.

American Capital Agency takes it on the chin
American Capital Agency has already witnessed a tightening in its net interest margin in anticipation of an eventual rate hike.

For instance, in the fourth quarter American Capital announced its net interest rate spread had fallen to 1.18%, down from 1.27% in the sequential third quarter, and well off the 1.57% it reported in Q4 2013. This tightening means the company needs to leverage its position even more (which can be dangerous) in order to generate similar income to the year-ago quarter, or simply bite the bullet and lower its distributable income. The recent path for American Capital Agency has been the latter.

Q4 2014 slide presentation Source: American Capital Agency.

Although it recently began doling out dividends on a monthly basis (currently at $0.22 per share per month), during the peak of the mREIT craze when American Capital Agency was delivering robust net interest margins and was able to use incredible leverage to boost its income, it would have paid out the equivalent of $0.50 per month. Since the end of 2011 its dividend has equivalently fallen by more than half. And plainly put, income investors aren’t happy about it. In fact, they’re quite concerned another dividend cut could be around the corner — especially if the Fed does suggest a rate hike later this year, as expected.

But what if I told you American Capital Agency could be a strong buy even if another dividend cut is on the way?

American Capital Agency just might be a buy
Admittedly, investors buy an mREIT like American Capital Agency for its dividend. One great aspect of any REIT-structured company is that in order to gain the tax benefits of being a REIT and avoid corporate tax rates, a company needs to pay a minimum of 90% of its profits to shareholders in the form of a dividend. In other words, shareholders are likely to receive a superior payout relative to the average dividend yield of the broader market, which is around 2%.

But what if that dividend gets cut? Even if American Capital Agency were to see its dividend halved to $0.11 per month, or a 6.4% yield — a figure that I suspect would entail the federal funds target rapidly rising to 3%-4% from its current level of 0.25% — dividend reinvestment back into shares of American Capital Agency could allow an investor to double his or her money in just a hair over 11 years, assuming no change to the dividend or stock price. Better yet, one of American Capital’s mREIT peers has averaged a dividend yield of closer to 10% over the past 15 years (and that’s with lending rates near record lows and above 5%), meaning my scenario here is potentially conservative at best.

Another key point is the sheer nature of American Capital’s business; it’s an agency-only mREIT. Without getting too technical, agency-only mREITs have the full backing of the U.S. government for the mortgage-backed securities they buy. On the flip side, some mREITs buy agency and non-agency products. As you might have correctly surmised, non-agency products have no U.S. government safeguards. “What’s the trade-off?” you ask? Non-agency assets usually have higher yield potential, but they can also come with bigger risks of loss. So consider American Capital among those mREITs that are willing to accept lower yields but also have a portfolio of well-protected assets.

Third, keep in mind that American Capital Agency has been incredibly nimble and fluid with its asset portfolio. In the latest quarter it reduced its exposure to “higher coupon 30 year generic securities, which are the mortgage instruments most exposed to faster prepayment rates,” and increased its holdings in shorter-term securities, which its press release notes “offer more favorable prepayment attributes in lower interest rate environments.” Not to mention it’s done an excellent job using derivatives to hedge against future rate hikes or a rapidly rising rate environment.

Also, American Capital has worked to reduce its leverage, which currently sits at 6.9-to-1 from 7.5-to-1 in the year-ago quarter. Lower leverage means a more nimble portfolio and likely less risk to investors.

Finally, we have a sheer case of valuation. As of the end of February, American Capital had a book value of $25.79 after deducting for its upcoming $0.22 monthly dividend. This means shares are valued at close to 80% of book value. While I wouldn’t suggest that mREITs should carry much of a premium considering the up-and-down nature of interest rates, I’d also opine that they probably should trade nearer to their book value than, say, 80%.

I want to be clear that mREIT stocks aren’t without risks, and as time has shown, from a share price perspective they aren’t great creators of wealth. However, the dividend income generated by mREITs like American Capital Agency, along with some of these points I’ve highlighted above, could make it an attractive contrarian play to consider.

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Sean Williams has no material interest in any companies mentioned in this article.

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Dividend Cut or Not, American Capital May Be a Buy Reviewed by on . AGNC data by YCharts. American Capital Agency vs. S&P 500 over the trailing-five-year period. The stock market might be in full rally mode, but you'd have a AGNC data by YCharts. American Capital Agency vs. S&P 500 over the trailing-five-year period. The stock market might be in full rally mode, but you'd have a Rating:
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