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American Capital Agency is Still a Safe High Yield Stock

High Yielding REITs have benefited from the steady recovery of the U.S. housing market in 2012.  A recent AP article stated that through June of this year real estate funds have gained $2.9 billion in new cash from investors, while a majority of other stock fund groups have seen investors pull out. The recent strength of REITs combined with their high yields have made them attractive targets for investors as interests rates and bond yields are near record lows.

Positive data supporting the U.S. housing market’s recovery continues to roll in. Data from FHFA showed that U.S. home prices rose for the fourth consecutive month with a 0.8 percent increase in May. Real-estate firm Zillow also recently put out a report showing home prices in the second quarter increased from the year-ago period for the first time in five years.  American Capital Agency (NASDAQ:AGNC) is one of the REITs performing near its highs for 2012.

American Capital, both directly and through its asset management business, originates, underwrites and manages investments in middle market private equity, leveraged finance, real estate and structured products. American Capital reported comprehensive income and net loss for the second quarter of 2012 of$480 million and $(261) million, respectively, or $1.58 and $(0.88) per common share, respectively, and net book value of $29.41 per common share.  Economic return, defined as dividends on common shares, plus the change in net book value per common share, for the period was $1.60 per common share, or 22% on an annualized basis.

Book Value: AGNC’s book value increased by 1% in the quarter to $29.41; this was at the upper end of the previous guidance. We expect book value to have benefited from quarter-to-date outperformance of specified pools in the third quarter.

Investment Portfolio: The investment portfolio totaled $77.9 billion at quarter-end; $5.1 billion (6%) lower than our estimate and average earning assets less than expected by a similar magnitude. Management indicated that they rotated the portfolio into prepayment protected securities (lower loan balances and HARP bonds) given the move lower in rates. We believe this rebalancing will position the portfolio to perform in the current rate environment. Leverage was 7.5x at quarter-end, down 0.8x from last quarter, below expected by a similar magnitude.

Prepayments: AGNC’s prepayments remained benign in the second quarter with the CPRs on the portfolio unchanged at 10%; the July speeds decreased to 8%. Due to the continued move lower in interest rates AGNC increased its lifetime prepayment assumptions to 12% from 9%. Management indicated that this resulted in a ‘catch-up’ premium amortization cost of $0.11/share that negatively impacted net income compared to a $0.12/share benefit last quarter.

Net Interest Spread: The net interest spread was 1.65% (1.83% excluding the CPR change) for the quarter, 37 bps lower than expected as a result of lower asset yields as the company moved down in coupon and higher cost of funds from a higher hedge ratio. At quarter end the net spread was 1.62%, 45 bps lower than March 31 from the decline in average coupon as the company shifted portfolio composition.

Hedging: During the second quarter AGNC increased the percentage of repos swapped to 71% from 52% last quarter. AGNC extended (up by 0.4 years) the duration of the swaps to 4.3 years. The company has an additional 13% of its repos hedged through swaptions to help protect book value in an up interest rate environment. The combination of swaps and swaptions covered 83% of repos, 13% higher than last quarter.

Undistributed Earnings: Undistributed taxable income totaled $492 million ($1.61/share) at quarter-end, a $0.33 per share increase from the last quarter given a $108 million increase in undistributed income.

Bottom line:  American Capital is still a great high yield stock with a current dividend yield of 14.27%.  It has an equity summary score of 8.9 out of 10 for a BULLISH outlook.  American Capital has a target price of $36 which is a 15% premium to book value.

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