American Capital Agency (AGNC)

AGNC is the last of the publicly traded  mREITs (actually, an amREIT) I’ve chosen to describe in this series, with about $800 million in market capitalization.

It hasn’t been around long, and has already had one complete change of management (other than the Chairman, CEO of parent company ACAS).  I worked with the former head of investment, Russell Jeffrey, a lifetime ago, but do not know the new team personally.

Given that the management change came only eight months after the AGNC IPO, and that IPO was only two yearss ago, there really isn’t much history to judge.

Fortunately, AGNC has been quite good in disclosing their portfolio mix, financing and hedging strategies, so I can guess at their portfolio management philosophy by observing the shift over the first five quarters under Gary Kain.

They also gave all amREIT investors some good basic analyses of how the MBS market spreads, leverage, and trends (curve flattening, steepening, bonds bullish or bearish) affect the return of a generic amREIT.  I think this is worth bookmarking as an easy “cheat sheet” for investors in any amREIT.  I’m talking about slides 9 and 10 in this presentation.

A nifty chart from that presentation at the KBW conference on June 3rd (Slide 10):

This is basically the reason for the question asked by xofruticake on the amREIT Basics post.  Why wouldn’t an amREIT simply crank up the leverage to pay its shareholders a better return?  Interestingly, some of the answer is in Slide 9 from that same presentation.  In both the Bull Flattener and Bear Flattener MBS spreads widen, making them cheaper.  As many homeowners are painfully aware, owning something purchased primarily with borrowed money can be very painful if it gets cheaper.

I see two things I find very interesting in the Investor Presentation for Q1, 2010.

First is the addition of swaptions to the hedge book.  Those options are both a put and a call triggered by the steepness of the yield curve.  It cost them $2.6 million to buy less than a year of protection against flattening ($200 million face amount of a “payer” swaption) and against steepening ($100 million of a “receiver”).  Obviously any hedging against yield curve shape changes will help, but against a $5 billion + portfolio, that’s nowhere near 100% hedged.

The other is the positioning of the portfolio for a dramatic slowdown in prepayments.  They added $38 million in IOs over the quarter.  That effectively raised the average price of the portfolio from 104.2% (already pretty high) to around 104.9%.  By adding IO’s, though, they could choose to pay their premium for MBS they thought most likely to slow down.  They are the most exposed in the group to principal losses from a surge in home sales or refinancing.

Kain is definitely showing his years of training at Freddie Mac, where he had all the analytic firepower of Blackrock at his disposal.  I see that in the main hedging book, a book of swaps that are designed to hedge against adverse financing environments (i.e. protect income) rather than hedging to protect book value.  They are hedging around half their repo cost exposure, and that is further divided into two thirds shorter duration (1 to 3 years) and one third longer than 3 years but less than 5 years.

FWIW, I think those ratios and durations are pretty much on the mark, though only hedging half the exposure is a little aggressive.  At 7.9x leverage, AGNC is also at the aggressive end of the leverage spectrum relative to its peers, though near the low end of historical averages for the group.

By spending less on hedging, leveraging at a higher ratio and actively seeking yield (their high premium average cost basis), AGNC is playing for a higher dividend yield, and they are delivering.  Throw in a little profit-taking by selling appreciated assets, and the company has managed to deliver return on equity north of 30%, highest in the group.  As of the end of Q1 this year, they were capturing net spread of 258 basis points, also at the high end for the group.

They delivered again in the current quarter, with a $1.40 dividend declared for Q2, 2010, which translates into an investor yield above 20%.

That won’t continue forever, but at least they show awareness of the risk to the strategy in adding those swaptions, which at least have very high natural leverage.  What I mean by that is that the $200 million swaption shown at a cost of $2.1 million could easily be worth $10 million or more if the yield curve were to flatten drastically in the next six months.  On the other hand, with a $5 billion book, widening by even 10 basis points will be expensive.

This will be an interesting one to watch, especially because they show strong opinions regarding prepayments and funding costs in the future.

I don’t own any at the moment, having unloaded even my “core” shares recently when they were trading a few points higher, at what I thought was an unsustainable premium to book.  (If nothing else, I expected them to go to market with a secondary, which would have been good from an investor income point of view, but always seems to result in a stock price decline.)

As always, what I do with my money and what you do with yours are our own personal decisions.  I don’t know your circumstances, so I can’t say what’s right for you.

hh

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3 Responses to American Capital Agency (AGNC)

  1. GeorgeR says:

    The occasional volatility makes this one of the best buy/write play in the space. I bought the stock under $27 this morning and wrote the July 27.5 calls for a lucky $0.40. Thanks for all these write ups, Howard.

  2. dreverts says:

    Do you think the lower and lower treasury yields will pose a problem for AGNC in term of increased pre-payments?

    • hhill51 says:

      I think there is such a logjam for refinancing right now that the risk of that kind of prepayments is minor for another 18 to 24 months. At some point the market will revive, but for now, appraisals, etc. are so difficult that most prepayments will still be from defaults rather than voluntary refinancing or sale of the homes.

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