Apollo Residential Mortgage Has Adapted Quickly To A Rising Interest Rate Environment

| About: Apollo Residential (AMTG)

Apollo Residential Mortgage Inc. (NYSE:AMTG) is a REIT that invests in, finances, and manages both Agency and non-Agency RMBS, residential mortgage loans, and other residential mortgage assets throughout the U.S. The company is externally managed and advised by ARM Manager LLC, which is an indirect subsidiary of Apollo Global Management LLC (NYSE:APO) -- a leading global alternative investment manager. AMTG is a new public company with an IPO date of July 21, 2011. This may be why it is not yet set in its ways, which may be a very good thing.

Like many of its peers, AMTG had a huge -$3.09 loss in book value from March 31, 2013 to June 30, 2013. This was -14.2% of book value, leaving a June 30, 2013 book value of $18.63 per common share. The company (and really all the other mortgage REIT companies) attributed this to the rapid rise of interest and mortgage rates in Q2 2013 and the consequent volatility.

On the plus side, AMTG reported operating earnings of $18.9 million (or $0.59 per common share) for Q2 2013. It declared a $0.70 quarterly dividend for shareholders of record on June 28, 2013. This is an annualized 19.24% dividend at the August 20, 2013 closing price of $14.55 per share. This dividend is very attractive. However, it seems likely that it will get cut in the near future. The only real question is by how much? It is probably premature to answer this, but AMTG will make an announcement on this later in Q3 2013.

With 10-year US Treasury rates rising rapidly again in the last week or so, AMTG may still be worth considering. It has been remaking itself in an image that should allow it to perform better in a rising and unstable interest rate environment. In Q2 2013 it sold $2.2B of its Agency RMBS; and it purchased $186.5 million of non-Agency RMBS. These actions brought its Agency RMBS portfolio to an estimated fair value of $2.6B and its non-Agency RMBS portfolio to an estimated fair value of $751 million as of June 30, 2013. This is a major change from the $4.3B in Agency RMBS and $595.8 million in non-Agency RMBS at the end of Q1 2013. AMTG added a short position in Fannie Mae TBAs in Q2 to further mitigate its interest rate exposure. AMTG increased its net interest rate swap and interest rate swaption positions by $375 million of notional value. When you consider the huge decrease in Agency RMBS, this hedging increase is indeed huge.

AMTG ended Q2 with a pro forma equity allocation of 50% Agency RMBS, 26% non-Agency RMBS, 5% securitized loans, and 19% cash. On June 30, 2013 the combined portfolio had a pro forma effective net interest spread of 2.1% and a pro forma leveraged asset yield of 11.8%. It expects the above actions to substantially stabilize its book value in future quarters. It lowered its total portfolio leverage from 5.1x as of March 31, 2013 to 3.9x as of June 30, 2013.

It mitigated its interest rate risk by selling a large portion of its Agency RMBS. Plus it bought more non-Agency RMBS, which should go up in value as the US economy recovers. The expectation is that this will happen at the same time as interest rates increase. Hence the extra non-Agency RMBS will gain book value as the Agency RMBS tend to lose value. AMTG intends to use some of its cash to buy further non-Agency RMBS, especially seasoned ARMs, which will yield more as interest rates increase.

The chart below shows the sources of the book value losses in Q2 2013.

As you can see from the chart above, most of the book values losses were due to realized and unrealized Agency RMBS losses. Most of the gains were due to realized and unrealized swap and swaption hedges. The non-Agency RMBS had little effect except to earn interest rate spread monies. This should tell investors the above described changes by AMTG should bode well for the future, if the future holds more interest rate increases.

AMTG cut the amount of Agency RMBS by about 40%. Plus it bought more swaps and swaptions. If the same quarter were now repeated, AMTG would have only about 60% of the Agency RMBS losses listed above. Plus it would have about 16% more swaps and swaptions. This would mean that the Agency RMBS losses would be only about -$3.30 per share; and the swaps and swaptions counter gains would be about +$3.25 per share. In other words there would be little if any losses.

Few if any quarters should be as bad as Q2 2013. Therefore AMTG should be able to grow its book value over time; and it should be able to pay a good dividend, although I expect that dividend to be substantially less than the approximately 19% annualized current dividend of $0.70 per quarter. Even so, investors should expect the dividend to be greater than 10%; and that will be a good dividend for what is now a much safer stock. AMTG is a buy with its new strategy. Plus don't forget AMTG declared a $0.35 dividend (2.4% at the August 20, 2013 closing stock price) in Q4 2012. I cannot say if AMTG will declare another such dividend in Q4 2013; but at least the past history is promising.

For those who want to see a more specific picture of AMTG's holdings, the table below describes both the ending Q1 and ending Q2 2013 Agency portfolios.

Another important point to take away from this is that the low mortgage rate 15-year Agency 3.0% and 3.5% coupon RMBS have all been sold. Plus more than half of the 30-year Agency 3.5% coupon RMBS have been sold. This should help decrease the extension risk. Again AMTG has been thinking of the future. It will not have as many losses to take in future quarters. It compares much better in this way to its more prominent peers, who do still have many of these low coupon (mortgage rate) Agency RMBS. Those peers will likely take further losses on those Agency RMBS.

The table below describes AMTG's non-Agency portfolio as of June 30, 2013.

There is nothing particularly unique about this non-Agency portfolio. However, it does show that there is a lot of possible book value to be gained as the residential real estate market improves. Along with the other changes, it shows that AMTG is a buy in its new and still changing form.

The two-year chart of AMTG provides some technical direction for this trade.

The slow stochastic sub chart shows that AMTG is near oversold territory. The main chart shows that AMTG is far oversold; and it is in a downtrend. However, it had a book value of $18.63 per common share as of June 30, 2013. Yet its price at the close on August 20, 2013 was $14.55 per share. It is trading at an approximately 22% discount to its June 30, 2013 book value.

Further I have shown far above that AMTG should lose very little money in Q3 with its new strategy, even if Q3 2013 turns out to be a repeat of Q2 2013 (very bad). In fact AMTG could actually gain book value if things go at all well. It is a buy in this troubled time. Compared to many of the other mortgage REITs it is probably a strong buy. The average analyst rating of AMTG is 2.0 (a buy). The CAPS rating is five stars (a strong buy). I don't think you can go too far wrong with AMTG. It should be able to weather the roughest of weather.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AMTG 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.