The Better Option: American Capital Agency or Annaly?

The Better Option: American Capital Agency or Annaly?

It's no secret that mREITs such as American Capital Agency , Annaly Capital Management , and CYS Investments have gone through a very turbulent trading period, with all major players losing a sizable share of market value.

Mortgage REITs seem to be moving in an elastic inverse correlation to 10-year Treasury yields, and that's perfectly understandable. These leveraged investments are also reacting strongly to shorter-term developments such as the announcement that CYS CEO Kevin Grant purchased 34,000 shares of stock. This led to spectacular gains for mREITs -- CYS led the rally, shooting up a hefty 7.1%, American Capital rose 4.1%, and Annaly gained 3.2% after this news last month.

Prior to the announcement, CYS stock had lost close to 47% since March, and the gains must have come as welcome news for shareholders. The firm is one of the highest dividend-paying mREITs in the market with a 17.5% dividend yield.

Investors are now wondering which mREIT offers better investment value between the two behemoths of the space: American Capital Agency or Annaly Capital Management. Many mREIT investors not only need high income paying stocks but also those that offer a certain level of protection against loss of capital. To compare them, investors can use the following criteria:

  • Earnings

  • Interest rates spread

  • Dividends

  • Book value

Annaly's second-quarter results looked fairly impressive, comparatively. The firm earned net income of $1.6 billion, equivalent to $1.71 per share. Annaly's second-quarter numbers look even more impressive when you compare them to last year's second-quarter results, when the firm booked a $91 million loss, or $0.10 loss per share.

In sharp contrast, American Capital Agency's second-quarter results looked pretty ugly. The firm booked a nasty overall loss of $936 million, or $2.37 per share.

Interest rates spread
Interest rates fluctuated wildly in the second quarter, thus improving the interest rate spread for many mREITs. The cost of borrowing rose at a slower pace compared to the pace at which yields from investments rose. Annaly reported a 0.98% net interest spread, an improvement over 0.91% in the first quarter. The interest rates spread was, however, considerably lower than last year's second-quarter spread, which came in at 1.54%. The firm's asset yield for its interest-earning portfolio stood at 2.51%. Its average cost of funds shot up seven basis points to 1.53%.

American Capital Agnecy's interest rate spread for the second quarter came in at 1.86%; a marginal drop compared to 1.87% in the first quarter. If we exclude the firm's TBA dollar roll income, the net spread falls to just 1.49%, a slight drop from the first quarter's 1.51%. American Capital Agency's asset yield stood at 2.71% while its average cost of funds shot up 15 basis points to 1.43%.

The average yield on assets rose by a higher absolute amount than the cost to borrow, leading to improved interest rates spread for both mREITs. Although the spread for both firms was OK, American Capital Agency beats Annaly hands-down for a much larger spread. Annaly Capital Management, however, beats American Capital Agency to the tape when we consider interest rate spread growth. Growth in interest rates spread is more important for capital appreciation than larger, but stagnant, absolute spreads. Annaly takes this category.

Annaly reported a $0.40 dividend per share for the quarter, a 2.25% sequential drop. The dividend is also considerably lower than 2012's second-quarter dividend of $0.55. Although Annaly's dividend for the quarter was quite low, it was well within the firm's estimated taxable income per share of $0.47. This means the firm had sufficient cash to pay out the dividend. At a share price of $11.50, the dividend is equivalent to an annualized yield of a respectable 14%.

American Capital Agency reported a second-quarter dividend of $1.05 per share, down 16% sequentially. Although the firm's dividend fell considerably, it still beat consensus estimates of about $1.00 per share. The $1.05 payment is less than the firm's dollar roll income and net spread of $1.15 per share. American Capital Agency, therefore, had sufficient cash to pay out the dividend. The dividend yield works out to be around 18.4%, based on today's price. This helps to buttress the firm's solid reputation as an all-weather mREIT dividend play.

Interest rates seem to have stabilized, and it is quite likely that dividends for both firms will remain around these levels for the rest of the year. Although American Capital Agency takes the cake for higher absolute dividend yield of 18.4% compared to Annaly's 14%, its dividend deterioration is outpacing Annaly's at 16% vs. 11%. If the deterioration in dividends continues at these rates, American Capital Agency's payout will eventually be lower than Annaly's.

Book value
Annaly's stock is currently trading 12% below the most recently reported book value. American Capital Agency is trading at 11% below book.

The volatility of mortgage-backed securities prices has led to both stocks declining considerably in the third quarter. In the previous quarter, Annaly's book valued declined roughly 18% while American Capital Agency experienced a nearly 20% decline. Annaly and its slightly more conservative strategy, therefore, lost slightly less book value and is the winner in this category.

The better value for investors
American Capital Agency reported far worse earnings in the second quarter than Annaly. Although the firm has a larger interest rate spread in absolute terms, its spread remains stagnant while Annaly's is expanding. Book values for both companies remain well above current stock prices. American Capital Agency pays a higher dividend than Annaly, but its dividend is falling at a faster pace.

At this point, Annaly may be the mREIT that offers the better value for investors.

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