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Armour Residential REIT (ARR) finances its agency securities portfolio by repurchasing agreements and reverse agreements. Under repurchase agreements, the company sells agency securities and agrees to repurchase the same agency securities in the future for a price higher than the sales price. The difference between sales price and repurchase price is the interest paid to the lender.

Repurchase agreement of Armour

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As of the third quarter of 2013, the company's balance under repurchase agreements was around $14.9 billion compared to $19.8 billion in the second quarter of 2013. With the reduction in repurchase agreements, the company's debt to equity ratio, reduced from 7.77 to 6.93. At the time of increasing interest rates in the U.S, I think the company's decision to reduce repurchase agreements is justifiable, because the company's net interest rate spread can decline, as it can lead to increased finance costs for the company. Armour raises fund from repurchase agreements by keeping agency securities as collateral, which are subject to changes in interest rates. With the rising interest rates, I believe the gap will reduce, resulting in a decreasing net interest rate spread as the market value of Armour's agency security decreases.

Armour invests in agency residential mortgage-backed securities, or RBMS, including fixed-rate RBMS, adjustable-rate RBMS, and hybrid adjustable-rate RBMS. As of September 2013, agency securities accounted for 100 percent of the security portfolio, and it is expected to be same for the current quarter due to volatility in the U.S. interest rate market. In order to mitigate the negative impact of the volatile interest rates in the U.S, Armour sold around $6 billion worth of its agency securities. Its primary income is the interest income earned on its security portfolio. With the continuously increasing mortgage rates in the U.S., the net interest rate spread of Armour has decreased from 1.82% in the third quarter of 2012 to 1.24% in the third quarter of 2013.

Armour Residential REIT's free cash flow

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Source: Ychart

Quarter

Free cash flow ($)

Outstanding shares (million)

Free cash flow per share

First quarter 2013

94.97

374.05

0.25

Second quarter 2013

118.98

370.81

0.32

Third quarter 2013

86.27

370.9

0.23

Armour has around $86.27 million as cash from operations. The company generally uses its cash to purchase agency securities as well as to pay interest and principal on borrowings. In the last quarter, the company's cost of fund increased from around 0.89% to 1.36%, which had a negative impact on the company's asset yield, which decreased from 2.70% to 2.60%. With decreasing yield and increasing cost of fund, Armour's net interest rate spread and cash from operations decreased, reducing its free cash flow per share. With increasing interest rate, I think the company's cost of funding will rise, which will reduce its net interest rate spread.

Peer action plan

In the third quarter Annaly (NLY) had around $69.2 billion worth of outstanding repurchase agreements, which decreased from $81.4 billion in the second quarter of 2013. The company's average cost of fund on interest bearing liabilities was 1.81% in the third quarter, resulting in an increased net interest rate spread from 0.98% in the second quarter of 2013 to 1.01% in the third quarter of 2013.

Increasing interest rates in the U.S are expected to have a negative impact on the company's net interest rate spread. However, the company's investment in interest rate swap can help it increase the net interest rate spread. In September 2013, the company entered into an interest rate swap with a notional amount of $52.2 billion. Annaly's strong hedge portfolio is helping the company reduce its interest rate risk. Since the company pays a fixed rate on its borrowing and receives a floating rate on swaps, this can help it reduce the impact of interest change.

Another competitor Capstead Mortgage Corporation (CMO) borrowing under repurchase agreements totaled $12.62 billion in the third quarter of 2013. Its total financing spread decreased from 0.89% in the second quarter of 2013 to 0.79% in the third quarter of 2013 due to the rise in cost of fund. Since the company invests primarily in ARM agency securities, the impact of increasing interest rates is expected to be low. To mitigate the negative impact of rising interest rates, Capstead entered an interest rate swap, and it has a portfolio related swap agreement of around $7.10 billion. By adding more swap agreements to its portfolio, I expect the company to reduce the negative impact of rising interest rates.

Conclusion

In the situation of rising interest rates, I believe the cost of fund for Armour may increase, which will have a negative impact on the company's net interest rate spread. In the third quarter, the company implemented initiatives to reduce its leverage by reducing the balance of repurchase agreements. However, these aren't enough to reduce the negative impact of increasing interest rates. I recommend to hold investment in Armour until the company releases its fourth quarter results, as the company will reveal its portfolio and how this will impact its future performance.

Source: Armour Residential: Watch Out For Increasing Interest Rates