What: Shares of American Capital Agency (AGNC 0.65%), a mortgage real estate investment trust that primarily invests in agency-backed mortgage-based securities, plunged 11% in June, based on data from S&P Capital IQ, following a downgrade and a rapid rise in lending rates.
So what: Arguably, American Capital Agency's biggest concern is the rapid rise in bond yields in June. For instance, the yield on the 10-year U.S. Treasury Bond vaulted to as high as 2.49% from a starting point of 2.1% at the beginning of June.
Rising bond yield rates are generally a problem for mortgage REITs, or mREITs, because the value of the fixed-income assets that they hold in their investment portfolio will fall. Making matters worse, mREITs with agency backing such as American Capital Agency have relied on leverage to boost their profits for years. Unfortunately, as rates rise, their leverage will also magnify the rate at which their portfolios' net asset value declines.
Adding to American Capital Agency's woes in June was Bank of America/Merrill Lynch's a downgrade to "underperform" from "neutral." The firm set a price target of just $16 on shares of American Capital Agency, implying a nearly 20% decline from where the stock closed the day the downgrade was announced.
Source: Flickr user Pictures of Money.
Now what: The question that investors need to be asking themselves here is whether or not American Capital Agency's swoon in June is a reason to pick up shares on the cheap or a warning to stay far, far away.
The answer, I believe, depends on your investing horizon.
It's pretty evident based on the mREIT sector's ongoing net interest margin contraction that profits and dividend payouts will continue to be pressured. What's remarkable is we really haven't even seen interest rates begin to move toward a normalized level, yet the mREIT sector as a whole has been taken to the woodshed.
On the bright side mREITs have generally scaled back their leverage and focused on shorter-term assets that allow them to be more flexible, which isn't a bad thing in this environment. Then again, as noted above, we sort of know that their margins are going to be pressured as the Federal Reserve begins to move its federal funds target up at some point in the somewhat near future.
So should you buy American Capital Agency? If your investing horizon is anything less than five years that may not be such a smart move. Even with a superior dividend yield, American Capital Agency's share price (and payout) are likely to fall as rates rise and its book value contracts. But, if you have an above-average risk profile and you're considering a five- or 10-year hold, then American Capital Agency could be intriguing. Historically, mREITs offer a dividend yield that crushes the broader market, even during a rising rate environment, which should help put a floor under your loss potential.
