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Armour Residential REIT, Inc. (NYSE:ARR) is an agency mortgage REIT that invests in hybrid, adjustable and fixed rate mortgage securities, which are guaranteed by the U.S. government. I am bullish on the company as it is trading at a 29% discount to its book value and is yielding 14.55%. The company has successfully managed to reshape its investment portfolio to cope with rising interest rates, as the book value for the third quarter was better than analyst expectations.

Mortgage REITs have been under pressure since the last four months, ever since the Fed announced possible tapering. Since the announcement of an $85 billion monthly cut down by the Fed, interest rates have been on the rise. The rising interest rates have negatively impacted the company's book value. The reduction in book value has also forced companies to cut down their healthy dividends, which are one of the primary attractions among investors.


(Click to enlarge)

Source: Google Finance

Historically, mortgage REITs have traded at a premium to their book values, but as of now, mortgage REITs are trading at a significant discount to their book values. However, the rise in interest rates has not been accompanied by any actual reductions in asset purchases by the Fed. I believe the market has adjusted to the Fed's announcement so that companies like ARR have now reduced their agency exposure and sold $6 billion worth of agency MBS, as they are more sensitive to the rise in interest rates. Also, it has sold a major chunk of its hybrid portfolio, as the said portfolio suffered the largest loss in value with the rise in interest rates.

Tapering

I believe that tapering might be further delayed since economic data has not shown any meaningful improvement. Consumer and business confidence has been hit by the U.S. government shutdown and the debt ceiling crisis, as the conference board announced a drop in the consumer confidence index from 80.2 to 71.2 in October. Similarly, the state street investor confidence index was also down by 5.6 basis points last month. All important job data results have failed to meet expectations of 180,000 new jobs, as only 148,000 jobs were added in September. Furthermore, inflation for the last 12 months has been around 1.2%, whereas the central bank was targeting 2%.

So the Fed will continue to extend its $85 billion asset purchases, at least for the next few months, which would give mREIT companies ample time to shape up their asset bases and hedges in such a way so as to minimize the losses when tapering actually happens.

Valuations

Although the company has been historically trading at a premium to its book value in the past, currently ARR is trading at a discount of 29% to its book value due to the rising interest rate scenario. But its peer companies who are facing similar macro-economic pressures are not trading at such large discounts, as shown in the table below. Another worrying sign for investors is that the company has cut down its dividends to $0.05 per share, but still its dividend yield is competitive among its peer companies.

Companies

P/BV

Dividend Yield

ARR

0.71x

14.55%

American Capital Agency (NASDAQ:AGNC)

0.89x

14.67%

CYS Investments (NYSE:CYS)

0.83x

16.03%

Annaly Capital Management (NYSE:NLY)

0.89x

12.03%

Hatteras Financial (NYSE:HTS)

0.83x

12.38%

Source:Ycharts.com

My price target is $4.74 based on a 0.90xBVPS, which means we can expect price appreciation of 15%. Also, the company offers a striking dividend yield of 14.55%. I believe it's the right time to buy ARR, as the company is trading at the bottom end of its 52-week range of $3.74-$7.19.

Key highlights of Financial Performance of 3Q'13

The company reported an EPS of $0.11, below analyst expectations of $0.17, which was the result of the lower spread margins. The company's book value was $5.26, which experienced a decline of 3% from the previous quarter. The net interest rate spread was 1.32%, down by 9bps QoQ. Although the asset yield increased by 7bps, it was offset by a 22bps increase in the cost of funds.

The total investment portfolio was down by 26%, reaching $16.7 billion, due to the management's decision to sell off $6 billion of agency MBS. Also, the company has managed to lower its leverage (debt-to-equity) to 7.0x. With the rise in interest rates, the constant prepayment rate (CPR) has been down to 8.8%.

Risks

Interest rates pose a major risk, as a rapid rise in interest rates shrinks company's book value. The company has been leveraging its long term assets with a short-term repurchase agreement, so unexpected volatility in the repo market might force the company to sell its assets in order to reduce its leverage. Any further deterioration of U.S. housing prices could adversely affect mortgage companies.

Conclusion

I think the stock price is bottomed out and it is expected to increase, as the difference between the market value and book value narrows. I believe that the market has overreacted to the news of tapering and the cut down of $85 billion will be further delayed for a few months, as the economic data was weaker than what was expected. Furthermore, a competitive dividend yield along with significant potential for price appreciation makes ARR a compelling opportunity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Source: Competitive Dividend Yield, Significant Price Appreciation Potential Set Armour Apart