Armour Residential REIT Inc. (NYSE:ARR) is a mortgage REIT. It is managed externally by Armour Residential Management LLC. ARR pays a monthly dividend/distribution. For the three months of Q4 2012, that dividend was $0.09 per share per month. For the three months of Q1 2013, that dividend was $0.08 per share per month. For the three months of Q2 2013, that dividend has been $0.07 per share per month (about 17% at the closing stock price on June 13, 2013). Many were afraid that this dividend would be cut again soon. The dividend has been falling in a continuing trend since the beginning of 2011 along with the falling net interest margin. The net interest margin has fallen from 2.23% as of March 31, 2011, to 1.55% as of December 31, 2012, to 1.35% as of March 31, 2013. These two trends had convinced nearly all of the "trend followers" that ARR was sure to cut its dividend again in Q3 2013. Yet on June 13, 2013, ARR declared a $0.07 per share per month dividend/distribution for the three months of Q3 2013. ARR also announced that undistributed REIT taxable income at June 30, 2013 will exceed $15 million. In other words, a dividend cut is definitely not going to occur in the near term. ARR rallied on the news that day; but as you can see from the two-year chart of ARR below, ARR's stock price has continued its downtrend since.
The chart above indicates that ARR does seem to have found a bottom in early July; and it may be headed up from there. This is not really surprising given the turnaround in the US Treasury Bond market and the turnaround in mortgage rates in July 2013. This last dividend/distribution means that the fast erosion of book value as mortgage rates rose in June 2013 has most likely reversed and/or flattened for the near term. The same can be said for US Treasury Bond Yields. The chart below shows the 30-year US Treasury Bond Yield.
From July 5, 2013 to July 22, 2013, the yield of the 30-year US Treasury Bond fell from 3.71% to 3.56% (15 bps). During this time the Fed has been backpedaling on its promise to start cutting down on its bond buying soon. Many are no longer convinced that the Fed will start to cut back in September 2013. Bernanke has recently made more of a point of saying that the Fed will act according to what the data indicate. In other words, he may not start easing away from quantitative easing quite as soon or quite as quickly. This doesn't mean mortgage rates will return to their historical lows; but it may mean that their trip upward will be slower and more delayed. The table below of Freddie Mac mortgage rates for the most recent week shows clearly that they have fallen a bit from their recent highs.
As you can see the Freddie Mac 30-year fixed rate was down to 4.37% in the week of July 19, 2013 from 4.51% in the week of July 12, 2013. Admittedly 14 bps is not much in comparison to the roughly 100 bps run up prior to that, but it is significant. Plus it does seem to end the current mortgage rate rally. This likely means that ARR and other mortgage REITs with significant Agency RMBS holdings will regain some of their recently lost book value.
Exactly how much book value did ARR lose in Q2 2013? It is hard to say without the complete financial break down that comes with a quarterly report. However, ARR gave out some of the information in a July 16, 2013 release. The table below gives the data about ARR's portfolio as of July 15, 2013 based on a third party valuation.
The table below gives the data about ARR's portfolio as of May 8, 2013.
As you can see both the total market values of the fixed rate securities and the total market values of the Hybrid and ARM securities have fallen dramatically in a short period of time. On May 8, 2013 the total Current Value of the fixed rate securities was $20.0348B. The Current Value of the ARM & Hybrid securities was $1.7831B. By July 15, 2013 these values had declined to $17.2171B and $0.9895B respectively. Some of this will be due to sale of securities; but the total difference in value is -$3.6112B. This is a huge amount for such a short period of time. In both cases ARR says it is targeting 8x-9x in leverage, but it does not specify this exactly. The -$3.6112B less in investments means ARR has suffered a huge book value loss. The -$3.6112B loss represents approximately -16.6% of previous investments. Since ARR claims that the leverage target is about the same in each case, this roughly represents a -16.6% loss of book value. Presumably ARR's hedging prevented its losses from being much worse. I note it did increase its hedges from March 31, 2013 to July 15, 2013 by more than 10%. However, the exact timing is unspecified. Also I have not included the lower liquidity amount as of July 15, 2013 as part of the loss calculation. Therefore the losses could be worse.
ARR's book value as of March 31, 2013 was $6.69. This had fallen from $7.29 per common share as of December 31, 2013. In other words, ARR lost -$0.60 in book value as the average mortgage rate climbed from a 3.34% average rate in December 2013 to a 3.55% average rate in March 2013 (or up only 21 bps). If ARR only lost -16.6% of its book value as mortgage rates rose from May 8, 2013 to July 15, 2013 by roughly 100 bps, it has actually performed relatively better in preserving its book value during this time than in Q1 2013. An approximate (and I emphasize approximate) book value loss of -16.6% of approximately $6.69 as of March 31, 2013 is $1.11 per share. This would leave a book value of $5.58 per common share. However, I do note that the book value on May 8, 2013 was very likely higher than the book value on March 31, 2013. Therefore the book value at the end of Q2 2013 could well be slightly higher. Either way this is significantly higher than the current $4.52 per share stock price.
Obviously the dividend is the second item of great importance to investors. The weighted average coupon net/gross rate for ARM and Hybrid securities is higher as of July 15, 2013 at 3.84%/4.29% versus the 3.68%/4.13% as of May 8, 2013 (slightly higher now). The weighted average coupon net/gross rate for fixed rate securities is slightly lower as of July 15, 2013 at 3.35%/3.80% versus the 3.38%/3.83% as of May 8, 2013 (slightly lower now). Let's call this a wash as there are more fixed rate securities. The CPRs (constant prepayment rates) are slightly higher as of July 15, 2013 at 11.0 versus the 10.2 of May 2013. I will ignore this too.
In contrast, the market value of the fixed rate securities is much less as of July 15, 2013 versus May 8, 2013. For instance, the value of 301 month to 360 month to maturity fixed rate securities with an average net/gross coupon rate of 3.21%/3.69% is 98.5% of par as of July 15, 2013. The value of 301 month to 360 month to maturity fixed rate securities with an average net/gross coupon rate of 3.23%/3.71% was 105.0% of par as of May 8, 2013. For the first case, using the average gross coupon rate (3.69%), the yield to maturity would be 3.77% (compounded annually). This is slightly higher than the face rate due to the bonds selling at below face value. When the bonds were selling at above face value on May 8, 2013, the yield to maturity was 3.56%. Admittedly these are approximate figures, and they are only one instance. However, they indicate that the effective gross coupon rate of these bonds has gone up by about 21 bps during this period.
Presuming most other costs are constant, the net interest spread should be approximately 21 bps higher. My own guesstimate is for a figure of more like 30-40 bps higher. Given that the net interest margin was 1.35% as of March 31, 2013, the increase in the net interest spread should make earnings from net interest spread, even given the lower total amount of investments, provide the same or a higher amount of income. In short, the dividend should be relatively safe. This means that ARR is likely to keep paying its 18.5% dividend in the short term. However, if repo rates rise substantially in the near future, as some are fearing, then the dividend rate may again be in danger. At a stock price of $4.52 per share and a likely book value of $5.58 per share, this makes ARR a buy. The market reaction has for now been an overreaction. Plus ARR's management team has almost certainly learned how to better guard itself against large book value losses in the future. This too is worth something.
The-two year chart of ARR is near the beginning of this article. Both the slow stochastic and the relative strength sub charts show that it is neither overbought not oversold. The main chart shows that it is in a strong downtrend. However, it is likely that downtrend has bottomed, at least for the near term. This makes ARR a good investment for the near term at its current price.
Plus don't forget that it changed its charter in 2012 to allow it to diversify into non-Agency securities. Investors can expect to see more of this. Since the real estate market has been going up recently, these currently heavily discounted securities have turned in great returns. Many expect this trend to continue for the near term. Admittedly a downturn in the real estate markets due to higher mortgage rates is a risk for these securities. However, many are still selling at 30% to 50% discounts to face value. Hence there is a lot of money that can be made by investing in these securities. They may even present less risk than investing in Agency securities at the current time.
Note: Some of the fundamental fiscal data above is from Yahoo Finance.
Good Luck Trading.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ARR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.