What You Must Watch When American Capital Agency Reports Earnings


Will American Capital Agency back up its massive dividend with a massive fourth quarter?

Over the next few days, investors can expect to see the results from quite a few companies in the mortgage-REIT industry. American Capital Agency is slated to release its results after the market close on Thursday. It'll be joined by Two Harbors , CYS Investments , and Invesco Mortgage Capital , all of which are expected to report before the week closes. And while Annaly Capital -- which we could probably call the standard bearer for the space -- hasn't set a firm date for its release, I wouldn't be surprised if we saw that later this week as well.

But as investors gear up for this rush, and American Capital Agency's report in particular, what should they be looking out for in the earnings reports and conference calls that follow?

What we know: Spreads ain't pretty
While the rapidly falling interest rate environment of 2007, 2008, and the years that followed was great for mortgage REITs, the more recent experience hasn't been as favorable.

The short-term rates at which mREITs borrow fell quickly, but over time, the rate compression has caught up on the asset side and the rates that the mREITs can earn have fallen, reducing the spread they collect in the middle. That the Federal Reserve has stepped in to buy billions in mortgage-backed securities -- thereby pushing up prices and reducing yield -- hasn't helped, either.

The fact that this is happening shouldn't be news to American Capital Agency investors. When fourth-quarter numbers come out, there's little reason to believe that there will be any major improvement on this front, though it's possible that further pressure has been muted.

So... how's your book?
Here's the upside to the above: When rates are going down, that's happening as prices are rising. That means that as it's become harder for American Capital Agency and its fellow mREITs to lock down paper with a sizable yield, the securities already in their respective portfolios are faring well.

In past quarters, the company's management has pointed to increases in book value as part of its total return -- that is, book value growth plus the dividends it's paid. While this does make sense to an extent, unless American Capital Agency decides to start selling off its portfolio to pay dividends, investors can't "eat" book value -- the proceeds from selling now-higher-priced securities would have to be reinvested in today's low rate environment. I expect we'll see a strong showing from the pricing on the MBSes that the company owns, but I'm less enthusiastic about that than its management.

Prepayment rising
While interest rate risk is obviously front and center for anyone investing in fixed-income instruments, when buying up agency-backed MBS paper -- as American Capital Agency does -- the risk that borrowers pay back their loans sooner than expected is another key risk. In particular, when rates fall, borrowers tend to do things like refinance in order to take advantage of cheaper borrowing.

American Capital Agency's management team has been fixated on minimizing the portfolio's exposure to rising prepayment rates. Investors will want to look for signs in the fourth-quarter results that this positioning is paying off.

One quarter, meet the long term
Who's set to come out on top of the mortgage REIT sector? The 15.8% dividend yield from American Capital Agency is noticeably larger than Annaly Capital's 12.1% yield. But could the longevity and experience of Annaly's management help it outperform over the longer term? To dig in deeper on the outlook for Annaly, I invite you to download our premium research report on the company.

Our analyst runs through absolute must-know topics, as well as the future opportunities and pitfalls of Annaly's strategy. Click here now to claim your copy.

The article What You Must Watch When American Capital Agency Reports Earnings originally appeared on Fool.com.

Matt Koppenheffer 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.

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