High yields are hard to find these days. A three-year CD is paying about 1.5% on average. A 10-year treasury bond is paying 3.5%. The of the S&P 500 is just 2.1%.
So, in the current environment, is a 19%too good to be true?
Not for a company with yield curve steepens. A yield curve is the difference between short-term and long-term interest rates, and a steep yield curve occurs when there is a large disparity between these rates. Today's yield curve is historically steep and getting steeper because there are pressures keeping short term rates low and long term rates higher.that grow as the
Short-term interest rates are near historic lows. The Federal Discount Rate (the interest rate that the government charges banks to borrow money, used as afor short-term rates) is currently just 0.75%. To add perspective, this rate was 6.25% as recently as 2007. The Federal Reserve has kept rates low to stimulate the since the financial crisis and has indicated that it intends to keep rates low for the near future.
Meanwhile, longer-term rates are on the rise as the dollar weakens andfears grow. The 10-year treasury has absolutely soared to a 3.5% from 2.5% less than six months ago. 's continuing desire to stimulate the should keep short rates low, and upward pressure on longer-term rates should continue for the foreseeable future.
With all this in mind, I think there is a way investors can get a 19% yield from the current dynamic. Here's how...
American Capital Agency Corp. (Nasdaq: AGNC) is a mortgage Real Estate Investment Trust (REIT) that generates quarterly distributions through interest income earned on the spreads between short-term borrowings and long-term investments. Credit risk is virtually nonexistent because American Capital invests exclusively in mortgage securities with principal and interest guaranteed by a U.S. government-sponsored agency, such as Fannie Mae or Freddie Mac.
The REIT has a balanced portfolio of mortgages, including 15-year fixed (40%), 30-year fixed (22%) and adjustable rate mortgages (29%). While American Capital has continued to issue moreon the , the REIT has been able to earn a high enough return on investments to more than compensate for the additional and grow per share .
As a REIT, American Capital is required to pay out at least 90% of taxable income to shareholders. The fact that dividends vary with income has been a good thing of late. Revenue doubled in 2010 from 2009 levels, andper share rose to $7.89 in 2010 from $6.78 in 2009 and $2.36 in 2008. The quarterly has been $1.40 a share since the middle of 2009, translating to a monster 19% yield at current prices.
But can thebe maintained?
It appears that it can for the time being. But, make no mistake about it: at some point, short-term rates will rise and spreads will narrow. When that happens, thewill likely be reduced and the share price will fall. But, while things can certainly get dicey for the REIT in the long-run, the foreseeable future looks good.
Interest rate spreads (the difference between American Capital's cost of borrowing and the yield on its investments) have been on the rise. The net spread in the fourth quarter was 2.58% compared with an average of 2.33% for 2010. But long rates have recently been on the rise. The average rate on a 30-year mortgage has soared to near 5%, from 4.2% as recently as November 2010, while short-term rates have remained the same. The increasing yield curve should continue to juice earnings in the short term, which will likely lead to an even higher dividend.
Despite the fact that the stock returned 48% in 2009 and 30% in 2010, American Capital still sells for less than five times trailing earnings. Its 19% yield blows away the 4% average yield of its competitors.
Action to Take --> American Capital is a speculative investment over the longer term, but it should be a reliable income-generating machine with reasonable price performance for at least the next several quarters. The stock is a good buy at current prices.