News Analysis date published New: 
Wednesday, February 23, 2011 - 11:00
New Date created: 
Wednesday, February 23, 2011 - 14:55
New Date last updated: 
Wednesday, February 23, 2011 - 11:00

This Small Cap Yields an INCREDIBLE 19%

Wednesday, February 23, 2011 11:00 AM

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 dividend yield of the S&P 500 is just 2.1%.

So, in the current environment, is a 19% yield too good to be true?

Not for a company with earnings that grow as the 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.

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 a benchmark for 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 economy 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 and inflation fears grow. The 10-year treasury has absolutely soared to a 3.5% yield from 2.5% less than six months ago. The Fed's continuing desire to stimulate the economy 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 more shares on the capital markets, the REIT has been able to earn a high enough return on investments to more than compensate for the additional shares and grow per share earnings.

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, and earnings per share rose to $7.89 in 2010 from $6.78 in 2009 and $2.36 in 2008. The quarterly dividend has been $1.40 a share since the middle of 2009, translating to a monster 19% yield at current prices.

But can the dividend be 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, the dividend will 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.

P.S. -- If you’re looking to squeeze as much cash out of your portfolio as possible, you need to see this. In short, a Texas man has figured out how to get the equivalent of a $112 dividend check every single day of the year. Here’s how he does it…

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