Mortgage REIT: Leverage and Yield

08/21/2014 9:00 am EST

Focus: STOCKS

Marvin Appel

President, Signalert Asset Management LLC

This highly leveraged mortgage REIT has a generous dividend yield that appears safe; in addition, the shares trade at nice discounts to book value, asserts Marvin Appel, editor Systems & Forecasts.

American Capital Agency Corp. (AGNC) reported a big profit of $2.42 per share for the second quarter. The majority of this was due to rising bond prices, which I do not view as sustainable.

AGNC is highly leveraged so that its purchases approximately $7-$8 of agency mortgage-backed securities for every $1 of shareholder equity. Book value per share was $26.26 on June 30, 2014, meaning that the shares traded at a discount of 10.8% at the end of the quarter.

There are three risks that AGNC faces. First, interest rates on mortgages could rise. This will reduce the value of the holdings in the portfolio. Such losses occurred in 2013, when AGNC suffered a total return loss of 22%.

Alternatively, interest rates could fall so much that mortgages are refinanced. In this case, interest income would decline and AGNC would have to cut its dividend.

Thirdly, the spread between its interest income and borrowing costs could narrow. Since AGNC borrows at short-term rates, any increases by the Fed are a potential threat.

Nobody expects the Fed to raise short-term interest rates until the middle of 2015, so, for now, AGNC is safe. However, when that occurs, AGNC might run into trouble.

AGNC remains attractive, given the high yield and the discount to book value. I recommend buying AGNC and holding until the first rate hike is announced, based on the expectation that the high level of earnings will outweigh the likely price volatility over the next twelve months at least.

In addition, AGNC has issued a new American Capital Agency preferred B (AGNCB) with a coupon of 7.75%. It yields less than the common, but shields you from much of the risk of lower long-term interest rates and from a reduction in the spread between borrowing costs and interest income.

AGNCB should be better able to withstand at least the first 1% of Fed rate hikes than the common stock, so my recommendation would be to buy AGNCB and hold until the Fed funds rate gets to 1.25%. Note that since AGNC is a REIT, both the preferred and the common dividends are taxed as ordinary income.

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