American Capital Agency Corp (AGNC) has dropped 23% in the past three months making me question my original investment in the company – initially purchased for its high yield, the potential end of QE3 and assault on book value make me wonder what to do with the stock.
At a Glance:
Symbol: AGNC:US Price: $23.11 Market Cap: $9.32B Yield: 18.17%
As I mentioned, a few years ago, I was on the hunt for some dividend / high yield stocks. In my search I came across REITs and invested in both Commercial REITs (i.e. KRE.UN) and mortgage REITs. American Capital Agency Corp (AGNC) is mortgage REIT.
AGNC borrows short-term money to buy mortgages and makes money on the interest rate spread. It then uses leverage to super charge that spread. Example: the REIT can borrow money at 1%, and buy a mortgage-backed security that pay 3.5%. Leverage that by 7x and you’re now at 17.5%. This is similar to how a bank operates – they loan money from me and you (i.e. the $1000 in our bank accounts), pay us money for borrowing (right now like 0.5%), and use that money to loan to other customers/companies at 2%. Since we’re not likely to ask for all our money back at one time, our $1000 can be used to provide maybe $10,000 worth of loans. Remember how REITs pay 80-90% of their income (depending on US or Canadian law)? That’s why AGNC’s yield has hit a ridiculous 17+%.
Wait a second – this sounds eerily similar to 2008 when all those mortgage-backed securities tanked the economy. It’s slightly different – 1) there is no bundling, packaging, re-packing, and hiding of mortgages – we’re looking at straight mortgages and 2) these mortgages are backed by the U.S. government (agency-backed). In 2008, an issue came about when the people who owned the houses didn’t pay their mortgage. Agency-backed mortgages are a guarantee that if the payment is not made, the U.S. government will make the payment – this came about in 2009 with the government’s plan to help ease the mortgage crisis. There are mortgage REITs that invest in non-agency mortgages which offer less security – they likely have better interest rate spreads, but also can’t leverage as much due to less security of the underlying mortgage.
Interest rates pose the biggest threat to this business model. If short-term rates rise, or long-term rates fall, the spread between the two becomes smaller, and the yield shrinks. If this were to happen, investors would likely be willing to pay less for a lower dividend. This becomes especially bad when the short-term rates increase above the long-term rates as the spread goes negative – and when leveraged 7x, that +17% gain becomes a -17% loss. Of course, interest rates don’t suddenly increase and decrease by multiple percentage points overnight, so this is something to watch out for. Since the Chairman of the Federal Reserve, Ben Bernanke indicated that short-term rates aren’t going to go up for any foreseeable future, that at least kept the bottom part of the spread low.
On September 13, 2012, the Federal Reserve announced the starting of Quantitative Easing 3 (known as QE3). QE3 involved purchasing $40B a month in mortgage-backed securities as well as continuing to buy treasury securities.
Upon hearing this, I thought this would actually hurt mortgage REITs. From my understanding of basic economics, more demand for treasury securities, increases the value of those securities, but lowers the yield – meaning long-term rates were being kept steady or lower. This would have a negative impact on the spread faced by mortgage REITs. By buying mortgage-backed securities, the same impact would happen – companies would have to pay more for mortgages that had the same yield. And perhaps the announcement of QE3 did have an effect, as the stock price (see chart above) dropped from a high of $36 to around $30 when QE3 was announced. Actually what I found surprising was during QE1 and 2 (meant to lower long-term rates), AGNC actually hit record highs.
The bigger surprise has been AGNC’s losses the last two quarters – with most of the losses attributed to decrease in the book value of the securities they hold. It appears that demand for fixed income securities has gone down, causing yields to go up. Again, with my basic understanding of economics, if I paid $1000 for a security that paid 3%, and now that same $1000 can buy a security that pays 4%, the value of the security I bought goes down (it should go down in line to be equivalent to giving me 4%). This is what I picture is happening to AGNC and other mortage REITs – which is causing their book values (basically consisting of existing mortgages) to go down.
The good news is AGNC’s management team has handled their portfolio mix better than other mortgage REITs where book values dropped over 20% compared to AGNC’s 12%. However, I figure this should be beneficial for the company going forward. If rates rise, so should the yield on any new mortgages they purchase. With short-term borrowing rates continuing to be low, this should all still work in favour of the business model – AND most importantly continue to provide the dividend the company produces.
So, in the end, maybe my knowledge of how this whole industry works needs a little more understanding but while losses look to be mostly from declining book values of existing portfolios. That’s not to say all this interest rates haven’t had an effect on the company’s profit – management has been adjusting the portfolio with holdings that are less interest rate sensitive at the cost of lower earnings. Since I’ve held the stock, I’ve seen dividends cut from $1.40 to $1.25 to $1.05 – but still returning around 15% from my purchase cost. Unfortunately, the drop in price has also cost me about a year in dividends.
Since I obviously have more to learn about this type of investment, I’m neither selling or buying more – I’ll closely monitor the company’s book value and earnings as quarters progress but for the moment, I feel as if the sell-off in REITs is overdone and confident that management knows their way around getting the best return and a pretty good yield should continue as long as short-term rates stay low.