“The second quarter of the current year was characterized by extreme volatility in both interest rates and mortgage rates,” said the CIO of American Capital Agency Corp. (NASDAQ:AGNC). American Capital is one of the largest Agency-only players and the best managed mREITs. In order to provide some cushion to its deteriorating book value, American Capital’s management decided to re-balance its portfolio. Yesterday, the company disclosed its performance for the second quarter. Let’s review its recent performance and compare it with its peers to determine which mREIT structure best suits the prevailing environment.
mREIT structures
Agency mREITs invest largely in MBS that are issued and guaranteed by any of the government agencies. These could be fixed-rate or adjustable-rate securities. Fixed rate securities payout a fixed amount every time, while the adjustable-rate securities adjust their coupon payments to more current rates on the next reset date. So, the Agency-only mREITs can be classified into ones that invest exclusively in fixed rate securities, or adjustable-rate securities. American Capital Agency Corp. (NASDAQ:AGNC) invests exclusively in the fixed rate Agency securities, while Capstead Mortgage Corporation (NYSE:CMO) also invests in adjustable rate Agency securities.
Now, let’s move to reviewing American Capital Agency’s latest earnings disclosure.
Rebalancing limits book value erosion
American Capital Agency Corp. (NASDAQ:AGNC) reported a comprehensive loss of $2.37 per share and a book value of $25.51 per share, compared to a comprehensive loss of $1.57 per share and a book value of $28.93 per share at the end of the first quarter. The company reported core EPS inclusive of dollar roll income of $1.01 for the second quarter.
The company reported a book value decline of 11.8%, which is less compared to some of American Capital Agency Corp. (NASDAQ:AGNC)’s peers due to better management of its portfolio in a rising interest rate environment. The company also managed to increase its duration gap from 0.4 years at the end of April to 0.6 year. With a wider duration gap, the interest rate risk profile is more benign today than earlier in the quarter. The asset portfolio totaled $92 billion at the end of the quarter. During the quarter, the company tilted its portfolio towards the 15-year fixed-rate MBS. The proportion of the 15-year fixed rate security increased from 31% to 42% from the linked quarter.
Higher rates caused the company to decrease its prospective prepayment speed from 9% to 7%. However, the net interest rate spread of the company declined 12 basis points over the linked quarter to 159 basis points. Much of the decline in the spread was a result of higher cost of funds due to higher average swap costs as the company increased its longer-dated swap portfolio. During the quarter, the company increased its percentage of repos swapped (hedged) from 78% to 80%.
Now, let’s look at the performance of other Agency-only players.
Peers
CYS Investments Inc (NYSE:CYS) and Capstead Mortgage Corporation (NYSE:CMO) have disclosed their performances so far. Both experienced pressure on their book values due to the prevailing rising rates.
CYS Investments has a large portion of fixed rate Agency paper in its portfolio with some adjustable-rates securities. During the quarter, CYS Investments accumulated the 30-year fixed rate security after getting rid of some of the 15-year security. I believe this move resulted is much of the decline in the book value as the prices of 30-year MBS are more vulnerable to changes in interest rates. This led the company to report a 26% decline in its book value over the linked quarter, which is much higher than the decline experienced by American Capital Agency. On the revenue side, CYS Investments Inc (NYSE:CYS) experienced some gains as its net interest rate spread increased 20 basis points over the prior quarter.
Capstead Mortgage Corporation (NYSE:CMO) is an exclusively adjustable-rate MBS investor. Despite having adjustable-rate securities in its portfolio, the company did not benefit from the rising rates as I had imagined. It reported a decline in its net interest spread and book value during the quarter. The company reported a book value that was 5.9% below the prior quarter’s figure. However, this was much below American Capital’s and CYS Investments’ book value erosion. On the revenue front, the company’s net interest spread plunged 15 basis points. However, the stock is still trading at an attractive 35% discount to its book value.
Conclusion
While American Capital Agency Corp. (NASDAQ:AGNC)’s re-balancing efforts capped its book value erosion at 12%, I believe the current scenario demands Agency-only mREITs to include adjustable-rate securities in their portfolios. Since American Capital’s charter doesn’t allow it, Capstead Mortgage Corporation (NYSE:CMO) and other mREITs with a similar portfolio design and structure are more preferred. These mREITs will report lower book value erosion with some expansion in their spreads.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article American Capital Reports: Capstead Still Better? originally appeared on Fool.com and is written by Adnan Khan.
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