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Armour Residential REIT (ARR) invests primarily in agency securities of which the principal and interest are backed by the US government (e.g., Freddie Mac (FMCC.OB), Fannie Mae (FNMA.OB), etc.). Over the last month and a half, ARR's stock price has declined from $7.71 to $6.09 as of market close on November 14th. This article examines if we should be worried about the recent stock price decline in ARR. Two metrics important to assessing earnings and ultimately dividends on a forward basis are the net interest spread and constant prepayment rate. An examination of both of these items reveals no red flags. As such, the current downtick in ARR stock price represents a significant buying opportunity.

Net Interest Spread

A useful metric for evaluating the profitability of agency REITs is the net interest spread, which is defined as the difference between the yield on assets less both interest costs and interest rate hedging activities. Typically net interest spreads range from 1% to 2%. In order to provide shareholders significant returns, leverage is utilized. As a back of the envelope calculation, an agency REIT with 7.0x leverage and a net interest spread of 2% can provide 14% returns (7.0 times 2%). The larger the net interest spread, the greater the net interest income earned all other factors equal (e.g. leverage).

To illustrate the impact of net interest spread on dividend yield, I used data from Annaly Capital Management (NLY) going back to 2006. This was done because ARR is a newer company with a smaller data set to work with. In the figure below, three curves are plotted - the average quarterly difference between the 10-year and 1-year treasury yield curve rate (source: here), NLY's stated net interest margin (from 10Q's), and NLY's dividend yield (scaled by a factor of 3 for reference; source: Yahoo Finance). The correlation between the 10yr-1yr yield curve and NLY's dividend is apparent (r=0.95).

(click to enlarge)

Thus, the current 10yr-1yr treasury yield curve difference can be used to infer the net income of ARR (and therefore dividend) going forward. In Q3 2012, this metric averaged 1.46%. As of Nov 14, 2012, the current value sits at 1.41%. The current Q4 2012 average is actually a bit higher than Q3 2012 with a value of 1.55%. ARR has already declared its dividend for 4th quarter 2012 at $0.09 per share (paid monthly). While the 10yr-1yr treasury yield curve difference should be monitored closely, an analysis of the current treasury yield difference does not raise any red flags. If the treasury yield curve stays close to where it currently sits, the probability of ARR maintaining this dividend for subsequent quarters is high.

Constant Prepayment Rates

The agency-backed mortgages on ARR's balance sheet were purchased above par (i.e. above 100 cents on the dollar). As such, it is possible to realize losses when prepayment occurs (selling at 100 cents on the dollar). Thus, as prepayment increases, the likelihood of realized losses increases. In ARR's monthly company update, information is provided on the prepayment rate. The November 2012 value of 13.3 is a bit higher than previous months but well within the 8-15 range experienced between 2010 and 2012. A review of prepayment data does not raise any red flags either.

Conclusion

Analysis of both the treasury yield curve and prepayment rate does not show any red flags for ARR. As such, the out-sized dividend is likely to continue and the recent precipitous stock price drop represents a nice buying opportunity.

Source: Should We Worry About Armour Residential REIT's Recent Price Decline?