Can American Capital Agency Keep Fighting the Fed?

On Thursday, American Capital Agency (AGNC 0.22%) will release its latest quarterly results. The key to making smart investment decisions on stocks reporting earnings is to anticipate how they'll do before they announce results, leaving you fully prepared to respond quickly to whatever inevitable surprises arise. That way, you'll be less likely to make an uninformed, kneejerk reaction to news that turns out to be exactly the wrong move.

Mortgage REITs like American Capital Agency have prospered for years, paying double-digit dividends as they took advantage of low short-term interest rates to make the most of their leveraged portfolios. But the Federal Reserve's move to use mortgage-backed securities to implement its quantitative easing program has threatened to crowd out mortgage REITs hungry for the same securities. Let's take an early look at what's been happening with American Capital Agency over the past quarter and what we're likely to see in its quarterly report.

Stats on American Capital Agency

Source: S&P Capital IQ.

Can American Capital Agency keep the growth flowing this quarter?
Analysts have become increasingly cautious about American Capital Agency's earnings prospects, as their long-range projections have earnings remains flat to slightly lower in 2014 and 2015 compared to this year's projections. The stock, though, has managed a total return of about 9% since late January.

What's especially noteworthy about American Capital Agency's share-price performance is that the company made a huge secondary offering back in March, with 50 million shares issued to ordinary investors and 7.5 million more offered to underwriters. Yet as with past offerings, the March issue didn't hurt the stock price, and with shares trading near book value, the issuance didn't dilute the value of existing shareholders' stock.

At some point, though, American Capital Agency will get so large that it will create concerns about systemic risk in the mortgage-security space. Between it and rival Annaly Capital (NLY 0.61%), the two largest mortgage REITs own $235 billion in assets, showcasing the amount of leverage available to the major industry players. If Congress takes away favorable tax-status for mortgage REITs, it could send effective dividend yields plunging, and other measures could even limit the ability of American Capital Agency and its peers to use as much leverage as they currently have.

Still, one advantage investors have with American Capital Agency is the expertise of CEO Gary Kain. As a former employee at Freddie Mac, Kain earned more than 20 years of experience with mortgages and mortgage-backed securities. With an understanding of likely Fed policy, Kain has positioned American Capital Agency to take advantage of current conditions, sporting a much lower prepayment rate and using esoteric strategies like the dollar-roll market to reap extra profits.

In American Capital Agency's quarterly report, look closely to see what measures the mortgage REIT has in place to hedge its exposure to interest rate risk. With an improving economy having pushed up the probability of interest rate hikes within the next couple of years, now's the time for American Capital Agency to take steps to protect itself from the damage that higher rates could cause to its leveraged portfolio. 

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