Strong Investment Performance Guarantees AGNC’s Dividends

1

Conservative investors may take a pass

Stock: AGNC Investment Corp (NASDAQ:AGNC) 

AGNC Investment Corporation, a $7.8 billion Maryland-based REIT, demonstrates an attractive 10% dividend yield and a 47% payout ratio in the past four quarters.

Other than this attractive payout, the nine-year-old REIT also had $1.12 billion in cash and cash equivalents as of June, and has a book value of $7.75 billion (0.6% higher vs. last year), and has reduced its debt by $3.16 billion compared to its year-ago period.

In review, AGNC responsible reduced its debt remarkably brought by its $3 billion payment to its Federal Home Loan Bank Advances that matured on February leaving the company in much better balance sheet situation at a debt-equity ratio of 0.05 times vs. 0.46 a year earlier.

Meanwhile, AGNC recorded 8.2% net interest income year over year as its recent six months period ended in June, while profits rose to $86 million compared to $921 million in losses a year earlier.

In review, AGNC experienced a remarkable $1.36 billion losses a year earlier brought by its derivative and hedging investments concerning interest rate swaps.

Here is why AGNC use such derivatives (page 30; Q2 2016 filing):

“We use interest rate swaps and other hedges to attempt to protect our net book value against moves in interest rates, we may not hedge certain interest rate, prepayment or extension risks if we believe that bearing such risks enhances our return relative to our risk/return profile, or the hedging transaction would negatively impact our REIT status.

The risk management actions we take may lower our earnings and dividends in the short term to further our objective of maintaining attractive levels of earnings and dividends over the long term. In addition, some of our hedges are intended to provide protection against larger rate moves and as a result may be relatively ineffective for smaller changes in interest rates. There can also be no certainty that our projections of our exposures to interest rates, prepayments, extension or other risks will be accurate or that our hedging activities will be effective and, therefore, actual results could differ materially.”

Company metrics (2)

1 Tangible net book value

As of June, AGNC had a tangible net book value of $19.25 per common shares—$0.06 lower than in March.

2 Economic return on tangible common equity

Economic return (loss) on common equity represents the change in tangible net book value per common share and dividends declared on common stock during the period over the beginning tangible net book value per common share.

The return as of June was 2.5% compared to 3.3% a year earlier.

AGNC Investment Corporation 

According to filings, AGNC earns income primarily from investing in Agency residential mortgage-backed securities on a leveraged basis.

These investments consists of residential mortgage pass-through securities and collateralized mortgage obligations for which the principal and interest payments are guaranteed by a U.S. Government-sponsored enterprise, such as the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or by a U.S. Government agency, such as the Government National Mortgage Association (“Ginnie Mae”) (collectively referred to as “GSEs”).

Further, AGNC may also invest in other types of mortgage and mortgage-related residential and commercial mortgage-backed securities where repayment of principal and interest is not guaranteed by a GSE or U.S. Government agency.

Cash flow

In the first half, AGNC’s cash flow from operations declined by 1.3% year over year to $679 million. The company also generated $958 million in Agency mortgage-backed securities (net investment purchases).

The company also allocated $1.35 billion in debt repayments (net issuances and other financing activities), and $679 million representing 55.5% of its cash flow in dividends.

The cash flow summary

In the past three years, the company generated proceeds of $21.4 billion in investment activities (net purchases), reduced debt by $23.1 billion, generated $4.4 billion in free cash flow, and provided $3.27 billion in dividends.

Conclusion

AGNC’s dividend payouts have not been strongly supported by its net income alone in recent years, but REIT’s ability to generate billions of cash flow from its investments have amply did so.

Meanwhile, the REIT’s more than a billion dollar losses in its derivatives a year ago is not the first time it recorded such losses. Back in fiscal year 2012 and 2014, AGNC recorded $1.35 billion and $1.24 billion losses related to derivative instruments.

The company admits that it cannot foresee these hedges to do well in certainty as completely described earlier, but this should be kept in mind by those attracted to the company’s amazingly bountiful dividends.

Analysts have a hold recommendation and a target price of $20.09 a share vs. $21.59 at the time of writing. Applying three-year price-book average and a 15% margin to AGNC’s current book value indicated a per share figure of $14.51.

In summary, AGNC is a pass.

Quotes

Gary Kain, the Company’s Chief Executive Officer, President and Chief Investment Officer

“We are pleased to report another quarter of solid financial performance for AGNC.”

“Our earnings profile continues to be supportive of our dividend despite an elevated hedge ratio and a reduction in our aggregate interest rate risk position. As we enter the third quarter, returns on levered Agency MBS remain attractive as current valuations reflect the anticipated near-term reduction in MBS purchases by the Federal Reserve. The overhang of possible Federal Reserve tapering has driven wider spreads on Agency MBS over the last year. In stark contrast, the spreads on most credit-centric fixed income investments have tightened to multiyear lows. At the same time, the funding picture for Agency MBS, including rate level and capacity, continues to be very attractive. As such, Agency MBS provide levered investors like AGNC with favorable return potential on an absolute basis and relative to alternatives in the fixed-income and equity markets.”

Peter Federico, the Company’s Executive Vice President and Chief Financial Officer

“For the quarter, AGNC generated an economic return of 2.5% on tangible common equity.”

“In addition to our strong financial results, we continued to expand our use of our captive broker-dealer, Bethesda Securities (‘BES’), as the size of our repo position funded through BES grew to almost $10 billion and we began clearing trades for our TBA securities position. Finally, we increased our hedge portfolio during the second quarter, thus providing us with greater protection against net asset value fluctuations due to interest rate changes. All in all, we believe these actions position AGNC for success across a broad spectrum of market conditions.”

Disclosure: I do not have shares in any of the companies mentioned.