I am bullish on Armour Residential (ARR) for the following reasons:
- The company's charter allows the management to include non-Agency securities in the MBS portfolio.
- The company's MBS portfolio has low prepayment risk as measured by its CPR of 13%.
- The company owns shorter duration securities with low average coupon (3.54%), which the Fed is not interested in buying.
- Investors can expect capital appreciation of 16.6% and an elevated monthly dividend with a dividend yield of 14.3%.
The Company's Charter
Established in 2008 to find attractive returns in the form of dividends, Armour Residential invested largely in Agency mortgage backed securities before the company's charter was amended to include non-Agency MBS. This gives the company an opportunity to invest the high yielding non-Agency MBS, which under the prevailing macroeconomic environment would be very beneficial for the company's net interest margin. However, at the end of the third quarter, 100% of the MBS owned by Armour are Agency MBS. The company is externally managed by Armour Residential Management LLC.
MBS Portfolio Mix
The company targets a portfolio with shorter duration to minimize interest rate exposure. The company targets a portfolio that is tilted toward 20-year maturity or hybrid ARMs with longer than 18 months to reset. Deviating from the target, the company purchased a sizable amount of 30-year MBS with the August capital raise. The duration of the assets increased from 1.43 year to 1.66 years. At the end of the third quarter, the company had $22.1 billion of agency securities in its portfolio, 89% of which were Fixed rate, while 10.8% were adjustable rate securities. Around 35% of the MBS portfolio is composed up of the 30-year or greater fixed rate securities, followed by 20-year fixed rate securities at 44%. Hybrid/ARMs and 15-year securities are around 10% each. Currently, the company owns an MBS portfolio with an average coupon of 3.54%, which is much lower than the 4.10% average coupon for the securities of Annaly Capital (NLY).
Net Interest Spread
The net interest spread at the end of the third quarter compressed 33% basis points driven largely by lower asset yields. I believe further tightening in rates will occur due to QE4. The Fed's continued purchasing of MBS will put downward pressure on the asset yields compressing the net interest margins further.
Given the abundance of 15-year and 20-year MBS in the portfolio, Armour Residential has generally experienced lower prepayment risk than its peers. Its CPRs are consistent with other mortgage REITs who have prepayment protected portfolios. However, prepayments speeds will continue to remain elevated across the board as mortgage rates continue to fall below record low levels after the launch of QE4. The company reports an annualized average conditional prepayment rate (CPR) of 13% at the end of the third quarter of the current year. This is compared to over 19% CPR for MFA Financial (MFA). MFA invests in Agency and non-Agency MBS. The market capitalizations of both the stocks are similar, therefore MFA was selected for a comparison.
Compared to the 13% CPR for ARR, Invesco Mortgage Capital (IVR) reports a CPR of 14.3%, while American Capital Agency (AGNC) reports a CPR of 12% at the end of the third quarter of the current year. Both American Capital Agency and Invesco Mortgage Capital have an MBS portfolio with prepayment protection.
Armour Residential pays a monthly dividend based on its estimate of taxable income. The latest dividend has been declared a $0.08 per month distribution for the first quarter of the next year. This is down from the previous monthly distribution of $0.09 per common share. The stock offers a dividend yield of 14.3%. A detailed analysis on the sustainability of the company's dividend distribution was conducted in my previous report. Adding on to it, I believe additional capital gains through the sale of MBS would add to the core EPS leading to an upside.
Armour Residential trades at a 15% discount to its third quarter book value, while Capstead Mortgage trades at 13% discount to its book value. Competitively, Agency mREITs like American Capital Agency and Annaly Capital Agency trade at 3% and 12% discounts, respectively.
Analysts have a mean target of $7.79 for Armour Residential. It is currently trading at $6.68 per share, which makes the upside of 16.16%.