Wednesday, December 21, 2011

MTGE: On the First Full Quarter's Dividend

Previously, the Jaded Consumer wrote about American Capital Mortgage Investment Corp.'s $0.20 stub-quarter dividend. Now, MTGE has announced its first full-quarter dividend of $0.80. What could have happened to quadruple MTGE's dividend?

Looking at MTGE's quarterly announcement following its stub quarter, we can see that MTGE moved from an average leverage of 4.7x during the stub period to 7.8x leverage, to turn its $200 million in IPO proceeds (counting ACAS' direct investment as IPO proceeds here) into a $1.7 billion investment portfolio. Annualized net interest rate spread moved from 2.13% during the stub period to 2.41% as of September 30, 2011. At 7.8x leverage, the 2.41% spread suggests a return at quarter-end of 18.8% (less management fees of 1.5%, paid monthly). On an estimated post-IPO-costs NAV of $19.90, this suggests annual returns on the order of $3.44 (considering the 1.5% management fee paid to American Capital Ltd.), or a quarterly earnings number of about 86¢.

But the recent dividend announcement was just 80¢, right? Right.

Looking back to MTGE's sister AGNC, which began its dividend payments with a 27-day stub-period dividend of 31¢, we can draw some parallels. The stub-period dividend at AGNC didn't represent all AGNC's economic benefit; the company actually earned 37¢ in its stub period, or nearly 20% more than paid. The resulting increases in NAV lead to increases in per-share earnings and thus per-share dividends. The dividend history of AGNC from 31¢/share/quarter to $1.40/share/quarter – not the exact progression one expects repeated; AGNC had some windfall derivatives gains during the economic panic that might not be readily replicated – is something management surely hopes to repeat.

And it's on the road to do so. MTGE's 20¢ stub-quarter dividend was backed with 25¢ in earnings, 25% more than paid. The $0.80 declared as the next quarterly payment is $0.06 below the Jaded Consumer's calculated expected earnings (assuming the stability of the financial situation obtaining at MTGE at the end of the stub quarter). This means that MTGE should add over 20¢ to NAV while making payouts exceeding 17%. Mind you, this neglects the benefit ACAS (as MTGE's manager) can bring MTGE from the reinvested nickels, and assumes pricing that remains stable at about $18.50. The fact is, MTGE's been volatile and to date I've never paid more than $17.50 for a share. Most of the shares held here were picked up at $16.75. From where I stand, dividend yield looks to stand north of 19%. Since I've enrolled all my shares in dividend-reinvestment, the basis will definitely creep up – but assuming pricing returns to the $20 level last seen on the day of the IPO, dividends will reinvest at about 16% while NAV continues to be be pushed up over a nickel a quarter. Adding the expected but unpaid $0.06 in earnings – a benefit that accrues to the DRIP investor in the form of share price rather than share count – a $20 share price would leave a yield north of 17%. At present prices (last traded at $18.63), that's a yield of 18.5%. On the other hand, that's also based on current dividends.

Like AGNC, which was priced below NAV for some time before the market recognized what it was doing, MTGE is likely to continue retaining gains on which to build the assets under management that drive ACAS' management fees (and shareholders' earnings). While MTGE's partial-year results and stub-quarter performance continue to be reported as full-year results (as happened for a while in AGNC), we should expect to find below-NAV share pricing (DRIP opportunity!) and to enjoy NAV increases based on dividends that leave room for reinvestment. The long-term benefit of MTGE is that while management can pursue the winning strategy used at AGNC, it has the freedom to pick up non-Agency mortgage products when the price is right. When is the price right? Some mortgage bundle – perhaps with an insurer's guarantee instead of the government's – may have characteristics that lead ACAS (MTGE's manager and AGNC's) to expect a payout of 83¢ on the dollar, will be hated by the market for its lack of government guarantee and its ugly (but discoverable) default rate, and could sell for 50¢ on the dollar. An ugly duckling like that can contain mortgages reflecting ugly levels of prepayment and default and – because it was underpriced – return much more than was invested. This kind of underpricing is not going to overwhelm MTGE's portfolio – indeed, the use of its portfolio as collateral likely depends on this kind of product being a minority among MTGE's holdings – but it offers a yield boost simply not available to AGNC.

My initial thesis in investing in MTGE was that it was trading below NAV and should be expected to perform along the lines of AGNC. While MTGE continues to trade below NAV, it's an extremely attractive alternative to AGNC as a subject of dividend reinvestment. Like AGNC, MTGE makes its money by investing largely borrowed funds in a portfolio of largely government-backed securities. MTGE (like AGNC) must manage prepayment risk (if principal is returned early, money paid for government guarantees of interest aren't worth much and premiums to face value are lost) and risks related to interest-rate spread. With yields as low as they are now, it's not easy to believe that MTGE's investment targets would drop in yield much, but factors affecting MTGE's borrowing rates would impair the spread – the profit potential between MTGE's borrowing rate and its rate of return on its own holdings – are of material concern to MTGE. Given the leverage with which MTGE operates, small changes in yield spread are magnified – for good or ill – into big changes in performance.

AGNC has shown that ACAS can manage this risk toward a stable dividend, while growing NAV. While the jury is out on how significant a factor the ability to buy non-agency MBS will be for MTGE, my favorable experience with AGNC leaves me completely willing to pay ACAS a management fee to find out.

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