Beaten Down Armour Residential REIT Looks Ready To Rebound

| About: ARMOUR Residential (ARR)

ARMOUR Residential REIT (NYSE:ARR) is a mortgage REIT. It is managed externally by ARMOUR Residential Management LLC. ARR pays a monthly dividend/distribution. This has fallen in the last year from $0.09 per share per month in Q4 2012 to $0.05 per share per month in Q4 2013. ARR has also seen its book value drop from $7.77 as of September 30, 2012 to $5.26 as of September 30, 2013. This was painful. However, that does not mean that it will continue.

The large interest rate spike on the 10-year US Treasury Note from May 2, 2013 (1.63%) through September 5, 2013 (2.99%) was 136 bps. It seemed to be induced by the threat of tapering by the Fed. Now that the Fed tapering has started (at $10B less buying per month), it is unlikely to induce another such spike. In fact we saw only a small one on the tapering start news on December 18, 2013. People sold US Treasuries on the rumor of tapering; and they may buy them on the news (or at least not sell them as much). There should be no huge late 2013 through FY2014 interest rate spike due to Fed tapering. I note here that ARR lost only $0.17 per share of book value in Q3 2013. This was only a small loss compared to the Q2 loss. In other words ARR is managing the rising rate situation better.

In Q4 2013 the 10-year US Treasury Note yield has been going up again. This seems to be due to several factors:

  1. The worry about Fed tapering.
  2. The worry that the many problems such as the budget and the national debt limit that the US government (Congress and President) has to deal with effectively in a short amount of time may not all get dealt with effectively.
  3. There have been a number of positive economic indicators reported recently, especially the official Chinese PMI data of 51.4 (expansion) for November 2013. A hotter than expected world economy usually translates into higher interest rates.

On September 30, 2013, the 10-year US Treasury Note yield was 2.61%. It had fallen back from its 2.99% closing high in early September 2013. As of this writing on December 18, 2013 the yield is 2.89% (28 bps higher) than on September 30, 2013; and that is after the Fed tapering announcement. Normally one might expect a company like ARR to experience book value losses in this environment. However, ARR has learned from its previous mistakes. It has positioned itself for an expected steady rise in interest rates over time.

Many had expected no or little loss in Q3 2013; yet ARR still had a $0.17 per share book value loss. The culprit was two-fold. A number of investments, especially Agency ARMs and Hybrids, saw CPRs (constant prepayment rates) spike higher. One would posit based on this data that there was a rush to convert ARMs & Hybrids to fixed rate mortgages as interest rates and mortgage rates continued to rise for the first two months of Q3 2013. These securities were on ARR's books at a premium to par value. When these type of loans were prepaid early, ARR took losses. Further selling in these securities caused still further losses in value.

A second culprit was the net Agency portfolio duration of 1.34 as of July 15, 2013. Due to this ARR still experienced losses in its Agency fixed rate securities. More specifically ARR had $18.2066B in Agency securities as of July 15, 2013. Yet it had only $13.144B in notional value of interest rate swaps and swaptions to hedge against any interest rate moves higher.

ARR has made corrections for both of these situations. First ARR had a total value of $989.5 million in ARM & Hybrid securities on July 15, 2013. As of November 8, 2013 it had only $256.5 million in these securities. ARR in Q4 2013 has a lot less of an investment in this area. Therefore it can lose little here. Plus it hadn't as of November 8, 2013 seen the huge CPR spike in these investments in Q4 2013 that it saw in Q3 2013.

Second ARR has added a lot more interest rate hedges since July 15, 2013. As of November 8, 2013, ARR had $16.0007B in Agency assets; but it also had $16.144B notional value in interest rate swaps and swaptions hedges. This is a huge difference from the previous situation. There is no guarantee, but it seems likely that ARR will lose no book value in Q4 2013. It may even gain some book value given the increase in interest rates and the slightly greater than 100% notional value of interest rate hedges.

In addition to all of the above, the chart below of ARR's CPRs in recent months shows a clear decline in CPRs.

Click to enlarge

The trend lower in CPRs (4.9 in both October and November 2013) would tend to decrease losses caused by early payback of above par valued securities; and it would tend to increase the net interest spread. The net effect should be that ARR will be more profitable in Q4 2013. The raises in interest rate should tend to increase the net interest spread further. This should raise core earnings profits.

I am sure many readers will point to the continued decrease in the stock price and in the dividend rate in the last year. They will decry any suggestion that someone should buy ARR; and they would have been correct for the last year. I believe the above description shows that the book value should be safe in Q4 2013; and ARR has already announced that the Q4 2013 dividend will be $0.05 per share per month. This amounts to a 16.21% annual dividend at the closing stock price on December 17, 2013. That's a fantastic dividend.

The only remaining issue is the likely ability of ARR to continue that dividend. ARR had Core Income of $43.8 million (or $0.11 per common share) in Q3 2013. This is still -$0.04 shy of the dividend to be paid out in Q4 2013. I don't have enough information to accurately predict exactly how this will come out. However, ARR decided on the Q4 2013 dividend based upon its expectation for Q4 2013 Taxable REIT income.

ARR has accurately predicted a rise in interest rates. It acquired the needed hedges (see above description) in order to hedge against these interest rate increases. CPRs have decreased in Q4 2013. The net interest spread has likely increased in Q4 2013. This convinces me that the company management made the right moves for Q4 2013; and there is every reason to believe that it will be approximately correct in its prediction of taxable REIT income. With no probable Q4 2013 book value losses, ARR with a book value of $5.26 as of September 30, 2013 is a huge buy at a stock price of $3.70 per share.

Even old dogs can learn given sufficient time; and it would appear that ARR's management has. They may not be perfect; but a near -30% discount to book value is compelling, especially when reasonable expectations indicate that there should be no further book value losses in Q4 2013. With an annual dividend of 16.21%, ARR is even more of a buy.

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

Click to enlarge

The slow stochastic sub chart shows that ARR is near oversold levels. The main chart shows that ARR has been in a downtrend since late 2012. However, the downtrend seems to have been bottoming for some months. The most recent small down leg was most likely an overall sector down move that was simply due to factors pushing interest rates up (see far above). Fundamentally and technically ARR is a buy. If you are a trader, ARR is a great risk/reward situation. If you are a longer-term investor, you can buy safely now.

The move of US equities strongly higher in response to the Fed tapering announcement shows that investors are not overly worried about a spike upward in interest rates. This will most likely be a sell on the rumor, buy on the news scenario. If you are a longer-term investor, you will still have to watch the situation long term; but you can only deal with the situations that exist (the cards you are dealt). You can calculate the probability of future events (future cards); but that is the best you can do. In this case the best you can do appears to be to buy ARR. CAPS gives ARR a three star rating (a hold); but I hope I have given convincing reasons for buying ARR at this time.

NOTE: Some of the above fundamental fiscal data 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.