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American Capital: High Income REIT

05/27/2015 8:00 am EST

Focus: REITS

Marvin Appel

President, Signalert Asset Management LLC

Marvin Appel, president of Signalert Asset Management, LLC, looks at a mortgage REIT for aggressive income investors; his stronger recommendation, however, goes to the REIT's preferred shares.

American Capital Agency Corp. (AGNC) is a mortgage REIT that we have followed and recommended for years because of its high dividend yield. Its current dividend yield is 11.5% on the common stock.

It leverages shareholder equity by as much as 7:1 and uses the leverage and equity to buy federally guaranteed conventional mortgages. AGNC makes money from the difference between the yield on its holdings and the lower cost of borrowing.

These profits are paid out as dividends. Since AGNC is a REIT, its common and preferred dividends are taxed as ordinary income.

Investors did not approve of the first quarter's performance. One problem was a dividend cut from $2.64/year to $2.40/year.

Here's one reason why AGNC cut its dividend: The spread between what it earns from mortgages and what it pays to borrow for leverage narrowed sharply from 2010 to 2014, falling from 2.33% to 1.29%.

The good news for buyers of AGNC is that the shares now trade at a significant discount, recently 16% below book value of $21.33.

In general, when interest rates rise, the shares of AGNC will fall. We saw that in 2013, which was a year of sharply rising interest rates. Since shares are still at a healthy discount, that part of price risk is potentially absent, or at least, extremely attenuated.

However, my strongest recommendation goes to the American Capital Agency 7.75% preferred (AGNCB), which yields 7.7%.

History suggests that the interest rate risk of AGNCB should be approximately one-third that of AGNC, making the risk-adjusted potential return better for the preferred stock.

During the first quarter, AGNC earned $297 million in net interest income and paid out $232 million in common stock dividends plus $7 million in preferred stock dividends. That provides a large cushion to protect the preferred dividend.

The preferred stock AGNCB remains a strong recommendation at any price below $26 for long-term holding.

This is especially attractive for IRA accounts because the dividend is taxed as ordinary income rather than as a qualified dividend. AGNC itself is also recommended below $21 for aggressive income investors.

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