Wednesday January 23, 2013
by Joon Choi, contributing editor Systems & Forecasts
It’s very hard to come by decent yields lately from traditional investment products. Average corporate bonds are yielding 2.74% and 10-year Treasuries are yielding 1.9%.
So, where can you obtain more yields? Look to mortgage real estate investment trusts (REIT) such as American Capital Agency Corporation (AGNC).
The advantage of a REIT is that its profits are not subject to federal taxes as long as the company distributes over 90% of its earnings. For this reason, the dividends earned from REITs are taxed as ordinary income and not at the lower dividend tax rate.
American Capital Agency was incorporated in 2008 to invest in residential mortgages. The company borrows at a short-term rate and invests in higher yielding mortgages to capture the spread between the two rates. Moreover, it leverages the portfolio by 7 fold to magnify the earnings.
This current dividend yield is 16%. and you may ask “Is it sustainable?”. The answer is probably not. But the company should be able to yield about 13%.
The recent slump in its stock price was, in large part, due to the Fed’s action to buy mortgages and Treasuries. Anticipation of lower rates was a negative outlook for AGNC because the spread between the borrowing rate and the yields from the mortgages they own is expected to tighten and lead to lower yield.
In addition, increased home refinancing in 2012 meant that AGNC had to replace the mortgages that were prepaid with ones having a lower rate. This further lowered the expected spread which also contributed to the stock price decline.
If the factors above were so negative for AGNC, then why is the stock a good investment?
Recent minutes from the Fed meeting revealed that voting members were split on when to stop the quantitative easing. Many of them thought that the Fed should stop during the middle of the year; contrary to investors’ expectations.
This is good news for AGNC because the spread between the short and the long term rates may not narrow as much as expected earlier.
Further, mortgage prepayment may slow down since the mortgage rates have stopped falling and may start to rise this year if the Fed stops buying mortgages.
Meanwhile, the stock price is currently below its book value (portfolio value of its holdings); book value is $32.49 as of September 30, 2012, and likely rose further during the 4th quarter.
Technically speaking, AGNC held key support area. The stock recently bounced well from the trading channel established since 2009. It was able to peek above the 50-day moving average which may be a sign of further price appreciation.
What could go wrong? The dividend should decrease in the near future but only by couple of percent. As with any other investment, there are some concerns about investing in AGNC, such as dividend decrease and funding shortage for leverage.
Funding availability for the leverage maybe another concern. Nevertheless, AGNC seems to be well positioned, barring a catastrophic event that may lead to liquidity crisis.
Overall, with the interest rates expected to stop falling and the mortgage prepayment to slow this year, the company’s attractive yield should provide a good opportunity.
Learn more about this financial newsletter at Systems & Forecasts.