In a recent article, I ranked American Capital Agency Corp. (NASDAQ:AGNC) as one of my least preferred pure-play mREITs. The reason was largely the composition of its investment portfolio that was constructed in a way in which the company would benefit if rates declined and vice versa. Further, I believe it provides little book value protection. Earlier this week American Capital Agency Corp. (NASDAQ:AGNC) presented at the Morgan Stanley Financial Conference and disclosed certain corrective measures it took. Let’s see how they will help the company.
Lessons from the recent past
The first quarter of the current year gave a glimpse of what to expect when the Fed finally decides to exit. During the first quarter, speculation about the Fed’s exit was at its peak and, as a result, the mortgage rates started climbing.
We saw American Capital Agency Corp. (NASDAQ:AGNC) reported a 9% sequential decline in the company’s book value. That’s not all: the company’s average net interest rate spread plunged 11 bps over the fourth quarter of the last year, leading the company to report profits that plunged 72% over the prior quarter.
American Capital Agency was alone. Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) shared this poor performance. Annaly Capital Management, Inc. (NYSE:NLY) reported a 4% decline in its book value, while its annualized spread plunged 4 bps. Similarly, ARMOUR reported an 8.2% sequential decline in first quarter book value, while its spread plunged 20 bps.
It’s evident that American Capital Agency Corp. (NASDAQ:AGNC) has structured its portfolio so that it will hurt the company if rates start increasing.
A look into the future
The speculation regarding the unwinding of QE has further increased volatility in interest rates and caused the Agency MBS spreads to widen. The widening of the spreads is negative for the current period’s book value. However, it should provide an opportunity to generate more attractive returns in the future. Therefore, I believe American Capital Agency’s investors should brace themselves for another challenging quarter.
Yesterday, American Capital Agency Corp. (NASDAQ:AGNC) reported at the Morgan Stanley Financial Conference and reported that Agency MBS spreads have continued to widen since the beginning of this quarter, which is why the company’s book value declined similarly to the first quarter’s decline.
Approach for the future
The management at American Capital Agency believes that the best approach for the company is to actively manage both its assets and hedges while keeping the leverage at the same levels until the risk/return trade-off becomes more compelling.
Some repositioning of the investment portfolio has also taken place, such as reducing the exposure to the 30-year fixed-rate MBS and higher pay-up 4% coupon specified pools. Besides, the management has increased the duration of its hedges to better suit higher interest rates. This active management will backfire if the Fed decides to prolong its stay in the Agency MBS markets and if the rates start falling.
While the portfolio rebalancing efforts and the active management of both assets and hedges are moving in the right direction, investors must understand that the volatile markets have already inflicted a lot of damage on American Capital Agency Corp. (NASDAQ:AGNC), which is why its book value is already down 9% since the start of this quarter.
Competition
In comparison, Annaly Capital Management, Inc. (NYSE:NLY) was already prepared for the volatility in the markets, which is why the damages it will face will be less severe compared to American Capital Agency. Annaly already has a portfolio that will produce higher net interest income if rates increased. Besides, its exposure into commercial MBS through the CreXus acquisition would provide the company with addition returns. Further, Annaly had some exposure in commercial real estate (CRE) loans, which act to provide a cushion to book value in times when the interest rates are on the rise. Last but not least, the company’s bottom line will be supported with less compensation expense as it shifts to its external manager.
In contrast to Annaly Capital, ARMOUR Residential REIT, Inc. (NYSE:ARR) was not prepared for a QE unwinding, and amid speculations of unwinding, its stock price has depreciated 29% since the beginning of the year, leading the decline in the pure-play mREITs. ARMOUR’s portfolio was constructed to generate higher income when rates decline. However, rates did not decrease as expected by the company’s management. Further, the company purchased new production MBS, which perform worse when rates increase. So, in short, I expect ARMOUR Residential to report a decline in its book value that will be magnified by its over 9 times leverage ratio.
Conclusion
As the volatility in the mortgage markets increase, American Capital Agency Corp. (NASDAQ:AGNC) attempts to rebalance its portfolio and attempts to actively manage it. However, still Annaly Capital Management, Inc. (NYSE:NLY) is better positioned for the prevailing macroeconomic environment, while ARMOUR Residential REIT, Inc. (NYSE:ARR) remains my least preferred Agency mREIT.
The article American Capital’s Approach for the Future originally appeared on Fool.com and is written by Adnan Khan.
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.
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