Author: Ron Hiram
Published: August 28, 2014
- AGNC’s sustainable coverage of dividends turned positive in 4Q13 and has remained so for the last 3 consecutive quarters.
- The improved performance was primarily driven by dividend reductions.
- The improved performance was achieved while decreasing leverage.
- The 5-year trend of declining or flat dividends may finally break if net interest rate spreads hold.
The bulk of the assets owned by American Capital Agency Corp. (AGNC) consist of mortgage-backed securities (“MBS”) and debentures issued by Fannie Mae, Freddie Mac, Ginnie Mae and the Federal Home Loan Bank (together, “Agency Securities”). These securities account for 80% of AGNC’s asset portfolio as of 6/30/14 (86% as of 12/31/13). AGNC relies primarily on short-term borrowings to acquire Agency Securities with long-term maturities. The shape of yield curve, the spread between returns on assets owned and the interest paid on amounts borrowed to purchase these assets, and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of profitability.
AGNC’s Agency Securities are typically classified for accounting purposes as “available-for-sale”. They appear on the balance sheet at fair value, but unrealized gains and losses on these securities do not appear on the income statement. Instead, such gains and losses and are reported on the balance sheet as a separate component of stockholders’ equity. In addition, net interest income as measured by GAAP does not include all the expenses of interest rate swaps.
AGNC also engages in a form of off-balance sheet financing of agency MBS on a generic pool, or to-be-announced (“TBA”), basis. In TBA dollar roll transactions AGNC purchases agency MBS paper for a forward settlement date. The difference between the price paid and the price of the same paper for settlement in the current month is referred to as the “price drop”. The price drop is the economic equivalent of the net interest carry (interest income less implied financing cost). AGNC accounts for these positions as derivative instruments and recognizes dollar roll income in “other income (loss)” on its financial statements (i.e., not as interest expense).
Management therefore uses a non-GAAP measures to evaluate its performance, of which “economic return for the period” appears to be the most important. Economic return (loss) on common equity represents the sum of the change in net asset value per common share (“book value”) and dividends declared on common stock during the period, over beginning book value per common share. Management recently reported economic return of 39.6% and 30.6% (on an annualized basis) for the 3 and 6 months ended 6/30/14, respectively.
Economic return does not, in my opinion, provide a good enough indication as to whether the dividends paid are sustainable in light of AGNC’s leverage and interest rate spreads. To perform that evaluation I use a simple analysis (also non-GAAP based) that models AGNC’s bread and butter business of using short-term borrowings to acquire Agency Securities. The model can be used to assess whether AGNC’s dividends are sustainable and whether there is reason to be optimistic about a prospective dividend increase. Applying this model to AGNC’s recent quarterly and trailing twelve months (“TTM”) results generates the following output:
|1||Debt per $1 of book value (BV)||7.03||7.31||7.47||7.97||8.22||7.45||7.9|
|2||BV of Equity||1||1||1||1||1||1||1|
|3||Interest bearing assets per $1 BV||8.03||8.31||8.47||8.97||9.22||8.45||8.9|
|4||Net Interest Income (spread)||1.26%||1.19%||1.57%||1.20%||1.49%||1.31%||1.52%|
|5||Yield on avg. int. earning assets||2.71%||2.54%||2.82%||2.59%||2.92%||2.66%||2.75%|
|6||Earnings- debt financed assets (1x4)||8.85%||8.70%||11.73%||9.57%||12.24%||9.77%||11.98%|
|7||Earnings- equity financed assets (2x5)||2.71%||2.54%||2.82%||2.59%||2.92%||2.66%||2.75%|
|8||Management fee on int. bearing assets||-0.20%||-0.17%||-0.14%||-0.15%||-0.17%||-1.25%||-1.25%|
|9||Earnings- int. bearing assets (6+7+8)||11.36%||11.07%||14.41%||12.01%||14.99%||11.18%||13.48%|
|10||BV per share (end of period)||26.26||24.49||23.93||25.27||25.51||26.26||25.51|
|11||BV x sustainable div. yield (9x10)||2.98||2.71||3.45||3.04||3.82||2.94||3.44|
|12||Sustainable dividend in period||0.75||0.68||0.86||0.76||0.96||2.94||3.44|
|13||Actual dividend in period||0.65||0.65||0.65||0.8||1.05||2.75||4.8|
|14||Sustainable coverage of div. (12/13)||1.15||1.04||1.33||0.95||0.91||1.07||0.72|
Table 1: Dividend sustainability model
AGNC’s sustainable coverage of dividends turned positive (i.e., above the 1x threshold) in 4Q13 after 5 consecutive quarters of below 1x coverage. It has remained so for the last 3 consecutive quarters as well as the latest TTM period.
The improved performance seems to have primarily driven by dividend reductions (line 13) in these quarters and was achieved without increasing leverage. In fact, leverage decreased somewhat.The current dividend now seems to be aligned with what AGNC’s basic business model can produce under 2Q14 levels of interest rate spreads and leverage. I believe it is prudent for management to see if this continues for another 1 or 2 quarters. If it does, the long trend of declining or flat dividends (the last increase was over 5 years ago, in 2Q09) may finally be broken. The model also provides investors an order of magnitude with respect to the amount of a possible dividend increase.