Can Anything Stop American Capital Agency?

Shares of American Capital Agency (Nasdaq: AGNC  ) hit another 52-week high on Thursday. Let's take a look at how it got there and see whether clear skies are still in the forecast.

How it got here
In a world where investors are continuing to be risk-averse, the prospect of investing in a company that has a dividend yield just shy of 14% and is investing in government-backed agency securities is simply too great to ignore. That's the perfect one-line summation of why American Capital is motoring higher.

As a mortgage real estate investment trust, American Capital returns at least 90% of its profits in the form of a dividend to its shareholders. Its profits are made on the difference at which it borrows (i.e., record-low lending rates) and the rate at which it lends. Although this difference, known as net interest margin, is frequently small (often in the low-to-mid single-digits for mREITs), these companies will often sell shares of their own stock to raise capital and lever their positions to take advantage of favorable investing conditions.

The real differentiation among mREITs has to do with what type of securities they choose to invest in and how much they lever their portfolios. American Capital, Annaly Capital Management (NYSE: NLY  ) , and Capstead Mortgage (NYSE: CMO  ) are three mREITs that purchase agency-backed securities, which are implicitly protected from default by the full faith and credit of the U.S. government. Invesco Mortgage Capital (NYSE: IVR  ) and Chimera Investment (NYSE: CIM  ) , on the other hand, own both agency and non-agency securities. Non-agency securities can offer more lucrative interest-rate spreads but also come with greater risk of default, since they aren't federally backed. In Invesco's defense, though, only a fairly small portion of its portfolio is devoted to non-agency assets.

How it stacks up
Let's see how American Capital Agency stacks up next to its peers.

<a href="http://ycharts.com/companies/AGNC/chart"><img src="http://media.ycharts.com/charts/217d4e661035c78f5d82865e7a18e44f.png" alt="AGNC Chart" /></a><p style="credit"><a href="http://ycharts.com/companies/AGNC">AGNC</a> data by <a href="http://ycharts.com">YCharts</a></p>

Unsurprisingly, as the mREITs that have the greatest exposure to risk, Invesco and Chimera have performed the worst over the past three years.

Normally here, I would compare each company's metrics side-by-side, but that's sort of fruitless given that each mREIT has its own double-digit dividend. Instead, I'm going to break this down by what government actions stand to move the entire sector.

First off, Operation Twist, the Federal Reserve's program whereby it sells short-term debt securities and buys an equal amount of longer-term debt securities, has been extended through the remainder of 2012. This program has the potential to shrink mREITs' net interest margins, although its effect has thus far been minimal.

However, the announcement of a third wave of quantitative easing that will take the form of $40 billion in monthly purchases of mortgage-backed securities, as well as the Federal Reserve's stance that it will not be raising its federal funds target rate until at least mid-2015, now further threatens interest-rate spreads. As these actions lower the interest rates on long-term securities, the likelihood that margins will tighten appears almost a given. That's bad news for companies like Annaly, which have seen these spreads tighten by nearly 200 basis points in just the past year.

Leverage and security type also play an important role. If the housing market or credit conditions deteriorate rapidly, mREITs with lower leverage should be able to exit their positions easier than companies that are highly levered. For much of the sector, leverage has been decreasing from its peak, partly in response to already lowering margin spreads.

It's also worth noting that a company like Chimera has garnered no breaks from shareholders, having not reported a timely quarterly report in a year and only recently releasing its audit findings.

What's next
Now for the $64,000 question: What's next for American Capital Agency? That question depends on the magnitude by which its spread shrinks, exactly how long the Federal Reserve plans to buy MBSes, and how attractive American Capital's dividend remains to investors.

Our very own CAPS community gives the company a four-star rating (out of five), with 95.4% of members expecting it to outperform. I've yet to make a CAPScall on American Capital Agency in either direction, and once again you'll not be getting a definitive selection from me today.

On the plus side, the Fed's actions create a sense of clarity on future monetary policy that the markets rarely have. This will allow mREITs like American Capital to adjust their investing approach accordingly. On the downside, it's obvious that spreads will remain under pressure and probably move lower. Unless American Capital chooses to unwisely boost its leverage again to inflate its profits, it's probable that its dividend yield will head lower over the next few years. In short, I'm about as neutral as you could possibly get on American Capital Agency right here.

Is QE3 a death knell to the dividend of America's favorite mREIT, Annaly Capital? Find out the answer to this question and much more by getting your copy of our latest premium research report on Annaly Capital Management. This report walks you through the long-term opportunities and pitfalls that could affect the stock and comes with a full year of regular updates. Claim your investing edge now!

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (2)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 16, 2012, at 7:15 PM, neamakri wrote:

    A nice article. I own some REIT stock, so I am interested.

    Something you said is confusing:"mREITs with lower leverage should be able to exit their positions easier than companies that are highly levered."

    I do not understand how your leverage affects your abilty to sell holdings?

    If a holding has value it will sell, regardless of how it was purchased. Am I correct?

  • Report this Comment On September 16, 2012, at 8:22 PM, TrackUltraLong wrote:

    nemakri,

    If mREITs own a lot of assets and the market turns south, it could be difficult to unload those assets if everyone is heading for the exit at the same time. That's the meat and potatoes of that point.

    TMFUltraLong

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