AGNC Upgraded to Outperform

We have recently upgraded the long-term recommendation for American Capital Agency Corp. ( AGNC - Analyst Report ) , a real estate investment trust (REIT), from Neutral to Outperform primarily driven by its healthy first quarter 2012 results and strong growth perspectives.

American Capital Agency focuses on investments in mortgage pass-through securities and collateralized mortgage obligations (CMOs). The company purchases single-family residential pass-through securities which are interests in pooled loans of principal and interest including pre-paid principal that are made to the holders of the notes.

Collateralized mortgage obligations consist of multiple classes with payments of principal and interest being made to note holders based on the maturity date of the class of security.

The mortgages underlying these agency securities are fixed rate, adjustable rate or hybrid (fixed and adjustable) securities. Agency securities differ from traditional fixed-income investments as principal and interest are paid on a regular schedule and there is a possibility that principal will be pre-paid by mortgage holders if interest rates fall.

American Capital Agency invests only in fixed-rate agency securities where payments are guaranteed by the U.S. government or government-owned entities, such as Fannie Mae (FNMA), Freddie Mac (FHLMC) and Ginnie Mae (GNMA). Specifically, American Capital Agency invests in FHLMC Gold certificates, FNMA certificates, and GNMA certificates.

We like the company’s focused investment approach, which is not distracted by originations, servicing, or credit risk from investments in mortgages that do not have the backing of the U.S. government.

With the government takeover of FNMA and FHLMC, American Capital Agency’s securities now have an explicit government guarantee, which makes it a much more attractive prospect for investors. Additionally, the company’s portfolio of government-backed assets is relatively liquid and credit risk is limited.

American Capital Agency borrows against its investment portfolio pursuant to a master repurchase agreement which provides short-term financing, typically 30-90 days. The company makes a profit and pays dividends from net interest income, which is the difference between interest earned on investments and its cost of borrowing.

American Capital Agency also purchases payer "swaptions" to protect against lower interest rates that might lead to early prepayment of mortgages. This measure ultimately facilitates the company to continue making money by collecting premiums and ensures a steady revenue stream.

However, the residential mortgage market in the U.S. has experienced defaults, credit losses and liquidity concerns in the recent past, which have reduced financial industry capital, leading to reduced liquidity for some institutions. These factors have impacted investor perception of the risk associated with real estate related assets, including agency securities and other high-quality RMBS (residential mortgage backed securities) assets. As a result, values for RMBS assets, including some agency securities and other AAA-rated RMBS assets, have experienced a certain amount of volatility. Increased volatility and deterioration in the broader residential mortgage and RMBS markets may adversely affect the performance of American Capital Agency in the future.

We presently have a Zacks #1 Rank for American Capital Agency, which translates into a short-term Strong Buy rating. However, we have a Neutral recommendation and a Zacks #3 Rank (short-term Hold rating) for Anworth Mortgage Asset Corporation ( ANH - Snapshot Report ) , one of the competitors of American Capital Agency.