American Capital Agency: Implications of the Dividend Cut

American Capital Agency: Implications of the Dividend Cut

Source: Images Money.

American Capital Agency Corp. recently announced its third-quarter dividend of just $0.80 per common share, representing a massive 24% cut compared to the previous quarter's dividend of $1.05.

There is no denying the dividend cut was enormous, and it certainly looks even worse when you consider the firm had slashed another 16% off its first-quarter dividend in the second quarter.

In short, this mREIT has shed a massive $0.45 dividend per common share in a short span of just two quarters. Should investors expect this ugly downtrend to continue? What are the chances this scenario will be repeated in the coming quarter(s)?

Finding the reasonable balance
Although the cut looked ugly, American Capital Agency's investors can now breathe sigh of relief. American Capital Agency's current dividend of $0.80 is around the firm's steady-state dividend -- a level the company can sustain with a modest 25 basis point increase per quarter in interest rates.

The current dividend yield stands at 13.5% compared to the second quarter's 18.9% yield. This lower dividend yield is more commensurate with the firm's current earning power.

Covering costs
American Capital Agency reported that it had repurchased 11.9 million shares of the firm in the open market during the third quarter, at an average $22.16 per share (including $263 million expenses). After the dividend payout and the share buyback, the firm will be left with about $317 million of Undistributed Taxable Income, equivalent to $0.82 per common share for the rest of 2013.

In reality, American Capital Agency had enough to pay out third-quarter dividends at the previous quarter's level of $1.05. But doing this is, of course, not a very prudent risk management practice since it would only leave about $200 million to cover the fourth quarter.

The firm's management, therefore, did the right thing by protecting long-term investors from further shocks in the coming quarters, at least as far as dividend payouts are concerned.

Other mREITs cut dividends, too
American Capital Agency was not alone in the cuts. Annaly Capital Management slashed its dividends by 12.5% to $0.35 per common share, while American Capital Agency's non-agency cousin American Capital Mortgage also cut its payout by 12.5%.

Armour Residential REIT ,isa mortgage agency REIT that pays monthly dividends and announces its dividends prospectively. The firm announced a $0.05 monthly dividend for the fourth quarter, translating to a 14.7% dividend yield. Armour Residential's third-quarter dividend stood at $0.07 per month, meaning the fourth-quarter dividend will be a huge 28.6% drop from third-quarter dividends.

Armour Residential was among the first agency-focused mREITs to expand their purview by going beyond their traditional business of dealing in agency-backed securities. The company set the stage for a shift in the second quarter to allow for non-agency purchases. Annaly also responded by adding commercial real estate investments.

American Capital Agency's CIO Gary Kain, however, did not make any drastic investment restructurings, preferring instead to stay true to the company's name and stick to agency-backed bonds. In any case, the firm's sister company, American Capital Mortgage, operates with a broader scope, so there was little need for that company to change its strategy.

In the past, I've expressed my concerns that if American Capital Agnecy's dividend cuts continued at the mid-teen percentage levels or worse, it would not be long before the trend started impugning on the company's solid reputation as a leading all-weather dividend play.

Looking ahead
Although American Capital Agency's dividend cut was huge, we should not forget that this is only the second time that the company has cut down its payouts in recent times, whereas mREITs such as Annaly and Armour have made multiple cuts since last year. American Capital's current yield looks more sustainable, and investors can take some comfort in the fact that they are not likely to see any more drastic cuts in the near future.

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