Take Advantage of This 16.1% Dividend Yield While it Lasts

Jordo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I have been thinking a lot about the outlook in 2013 for American Capital Agency (NASDAQ: AGNC) as well as the Agency mREIT industry.

My Predictions

I anticipate that compression of net interest spreads will continue along with a further recovery of the U.S. housing market. Though I see yields continuing to remain low, significant additional pressure on net interest margins should ease while the book value will most probably remain flat, particularly for Agency mortgage REITs.

I anticipate that the Agency MBS sector will continue to be attractive from a long-term investment perspective. Mortgage spreads have already widened by 20 basis points over the past few weeks, reversing more than one third of the QE3 damage. The Fed's intention to keep short-term rates low until the U.S. labor market improves and its initiatives, including QE3, to buy long term assets have flattened the yield curve for 2012. This put pressure on spreads and forced many mortgage REITs to cut their dividends.  Reportedly Credit Suisse says that 1-year and 2-year forward yield curves are both currently pricing in 15 basis points of steeper yields, which adds to the attraction of incremental investment. 

Analyst's Predictions

In the fourth quarter, book values continued to be moderately soft. Analysts at Credit Suisse expect Agency MBS demand to outstrip supply by roughly $270 billion in 2013 because of Fed purchases and bank demand. Consequently, they expect book values to be stable. Prepayment is expected to remain elevated during the next year because of refinancing caused by low mortgage rates. Within lower coupon MBS, the return of the traditional advantage of convexity of 15-year MBS over 30-year is expected will result in 15-year securities being less prone to refinancing than 30-year securities for the first time since 2008. However, higher coupon MBS are expected to continue to experience higher prepayment levels because of intensified HARP activity.

Financials

American Capital Agency reported comprehensive income for the third quarter of 2012 of $1.3 billion. The annualized net interest rate spread for the third quarter was 1.42% while the annualized net interest rate spread for the quarter was 1.53%. The company also announced a share repurchase program of $500 million through Dec. 31, 2013.

As of Sept. 30, 2012, the company's fixed-rate investment portfolio was comprised of approximately $28.6 billion of 15-year fixed-rate securities, $2.7 billion of 20-year fixed-rate securities and $56.6 billion of 30-year fixed-rate securities.

71% of the company's fixed rate investment portfolio was comprised of agency securities backed by lower loan balance mortgages and loans originated under the U.S. Government sponsored Home Affordable Refinance Program ("HARP"). The remainder of the portfolio was primarily comprised of low coupon, new issuance fixed-rate agency securities.

The Competition

The outlook for prepayment remains a major factor on yield expectations and favored investments continue to be Agency mortgage REITs with low prepayment speeds or prepay protected mortgage backed securities portfolios. American Capital Agency trades at a moderate discount of 4% to its book value.

Annaly Capital (NYSE: NLY) is trading at 12% discount to its book value. Annaly has cut dividends twice from 55 cents to 45 cents quarterly, but the dividend yield is still attractive at around 12.2%.

Invesco Capital Mortgage (NYSE: IVR) and Two Harbors (NYSE: TWO) are good bets because these mortgage REITs have low prepayment risk and should generate more stable cash flows. Invesco has maintained a steady 65 cent quarterly dividend, while Two Harbors declared a 55 cent fourth quarter dividend to meet distribution requirements after cutting the dividend from 40 cents to 36 cents for the 2012 third quarter. 

CYS investments (NYSE: CYS) announced a $0.40 quarterly dividend, which was an 11.1% decline from the previous quarter's $0.45 dividend and a $250 million share buyback.  The dividend yield continues to be attractive at well over 13% at current prices.

Conclusion

American Capital Agency currently has a dividend yield of around 16.1% and is therefore an extremely attractive income investment.  Because of the 2013 outlook described above, dividend yields may decrease but are still most likely to be in the attractive double digit region.  In my view, because of the favorable interest rate regime which will continue at least through 2014, this is a good time to take advantage, though mortgage REITs are by no means ideal long-term fixed-income investments. I recommend buying American Capital Agency now and taking advantage of the dividend yield while it lasts.


jordobivona has no position in any stocks mentioned. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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