American Capital Agency: A good interest rate play

This mortgage REIT's preferred stock offers an attractive yield and little downside risk.

By TheStockAdvisors Mar 21, 2013 2:47PM
Miniature home on sheet of percent signs copyright Comstock, Getty ImagesBy Joon Choi, Systems & Forecasts

Long-term interest rates may rise but the Fed is unlikely to raise the short-term rates (i.e. overnight lending rate) in the near future.

This presents an opportunity for American Capital Agency Corp. (AGNC) because it borrows at short-term yields and buys longer-term mortgages; potentially leading to long-term interest rates rising more than the borrowing cost. This will result in higher spread capture, which should lead to better earnings.

I like the preferred stocks issued by mortgage REITs -- and am especially recommending American Capital Agency Corp. cumulative preferred series A, (AGNCP) -- because they pay cumulative dividends and these securities may not be as sensitive to higher interest rates.

In addition, AGNC currently pays common stock dividend of 16% (which is little high in my view and may come down few percent) and this payment needs to be suspended before AGNCP dividends are not paid.

Even if the company misses the dividends, AGNC has to catch up on all the missed dividends because they are cumulative. In short, the company needs to go out of business for you to not receive the dividends owed to you.

Even if the company files for bankruptcy, book value per share ($32.49 as of Sept. 30, 2012) of AGNC's portfolio is slightly higher than currently common share price ($31.05 as of Feb. 7, 2013) which means common stock holders should be able to recoup most of the money invested.

Furthermore, preferred stock holders' senior status to common stock holders gives them the ability to recoup 100% of the capital invested.

AGNCP is trading at around $26 and it is callable date on April 5, 2017 at $25. This means that AGNCP holders will lose about a $1 if the stock is called in four years, which translates to 4% or 1% a year.

As a result, the yield to maturity will be 6.6% (current yield of 7.6% minus 1%). Not bad for a vehicle with almost no downside risk. As an added bonus, you may see an appreciation in the AGNCP price if AGNC does well.

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