A 17% Yield People Hate

Friday, October 9, 2009 - 1:37pm

by Tom Hutchinson

How many companies have seen profits explode +86% in the past three months? I've found a company that's making a killing in today's economy. It's also selling dirt cheap, at just seven times earnings.

Best of all, it's yielding a spectacular 17.7%

How can this be?

This company is invisible to most investors because it operates in a sector few investors would even consider. This company's business is at the epicenter of the financial crisis: Mortgage-backed securities. These, as you will recall, are the very financial instruments that brought the U.S. economy to its knees.

In light of their nefarious role in the subprime debacle, investors have a similar connotation "mortgage-backed securities" as they have to "Hindenburg" or "black plague." This negative association has kept most investors away -- and kept this security at a rock-bottom price.

But there's a critical, and potentially lucrative, distinction to be made.

It's simply this: Not all mortgages are subprime. And though foreclosure rates are still high and the economy has been in better shape, the fact remains that most mortgages are doing just fine. Most borrowers are current.

The second point is who’s backing these securities. It used to be Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). Today, it's Uncle Sam. That's right, a lot of mortgage securities have been guaranteed by the U.S. government. Some people hear "mortgage security" and they think "risk." But these government-backed securities are actually no more risky than Treasuries!

American Capital Agency (Nasdaq: AGNC) is a real-estate investment trust that invests in mortgages. It invests in securities issued by Fannie Mae, Freddie Mac and Ginnie Mae. All of the mortgage-backed securities it buys are guaranteed by the federal government. They carry an implied AAA rating, meaning these securities have essentially zero default risk.

American Capital borrows at low, short-term rates and uses the money to buy higher-yielding longer-term securities. The difference between the rate it borrows at and the rate it invests at -- the "spread" -- is its profit.

Today's spreads are wide. The Federal Reserve, in an attempt to stimulate the economy, has lowered the discount rate from 2.25% a year ago to just 0.50% today, making short-term borrowing costs dirt cheap. At the same time, a 30-year mortgage is paying more than 5.0%.

Spreads just keep on rising. Rates on long term mortgages increased once again from the previous quarter while short-term borrowing rates fell even lower. American Capital achieved a spread of 3.55% in the second quarter versus 3.02% in the first quarter and just 1.19% in the fourth quarter from the previous year. The asset yield for the second quarter was 5.35% while the average cost of financing was just 1.80%.

These ideal business conditions led to a remarkable +86% surge in net income last quarter. The company earned $30.4 million compared with $16.3 million in the first quarter, or $2.02 a share versus $1.09 a share.

Even though the price has surged +31% so far this year, American Capital still sells at a microscopic seven times projected 2009 earnings. But here's the best part. As a REIT, the company is required to pay out a least 90% of taxable income to shareholders. Its rising profits go right from the company's balance sheet to your pocket.

AGNC pays quarterly dividends in January, April, July and October. Dividends vary with income. This past year's dividends have ranged between $0.85 a share to $1.50. October's announced $1.40 per share dividend gives the stock a trailing twelve-month yield of 17.7%.

Inflation could spoil the party. In order to fight rising prices, the Fed might restrict the country's money supply by raising short-term rates. Higher short-term rates would increase AGNC's capital cost and hurt earnings.

But inflation doesn’t appear to be anywhere on the horizon at this point. American Capital's prospects for the near-term look bright as spreads remain wide. As a matter of fact, management at one of AGNC's peers recently said that they "expect the current favorable conditions to persist for some time."

A 17.7% yield won't last forever -- rising prices push down yields. But right now AGNC is a great place to park some cash to generate a rich income stream and position your portfolio for price appreciation as well.

Tom Hutchinson does not personally hold positions in any securities mentioned in this article.