- The dividend for Q2 2014 has already been declared as $0.05 per month ($0.15 for Q2 2014). This is stable now for the third quarter in a row.
- The decrease in the yield for the 10 year US Treasury Note should mean a book value increase in Q2 2014 for ARR.
- The portfolio realignment in Q1 and Q2 2014 should make ARR's portfolio safer from interest rate increases going forward.
- The interest rates decreased in Q1 2014. Yet ARR lost book value. What will change that for ARR in Q2 2014 and future quarters?
ARMOUR Residential REIT (NYSE:ARR) is a mortgage REIT. It is managed externally by ARMOUR Residential Management LLC. ARR pays a monthly dividend. This fell dramatically in 2013 from $0.09 per common share per month in Q4 2012 to $0.05 per common share per month in Q4 2013. It remained at $0.05 per common share per month in Q1 2014; and it has been declared again at $0.05 per common share per month for Q2 2014. This hugely important metric for most income investors seems to have finally stabilized.
In Q1 2014 investors saw 10 year US Treasury yields fall from 3.03% as of December 31, 2013 to 2.72% as of March 31, 2014. Most fixed rate Agency RMBS gained value during that time as one would expect. However, ARR still managed to lose book value in Q1 2014 -- albeit a small amount (-$0.08 per common share to $4.67). This baffled and disappointed many investors.
I shall try to explain the above. To do this, it is necessary to look at the portfolio changes that took place during Q1 2014. The portfolio as of January 9, 2014 is below.
The portfolio as of March 14, 2014 is below.
As investors can see, the big change is that the Agency fixed rate MBS maturing between 301 and 360 months went from $6,501.2 million on January 9, 2014 to $1,293.9 million on March 14, 2014. Most of the monies from those sales went into fixed rate MBS maturing between 121 and 180 months. This large shift in the distribution of the portfolio's holdings was almost certainly expensive, especially since many other companies had been making similar shifts at approximately the same time. In other words, the 30 year fixed rate MBS were probably oversold and the 15 year fixed rate MBS were probably overbought. ARR lost on both ends. However, it ended up with a portfolio that was more resistant to interest rate increases. Both the repos and the hedges for the portfolio were also cheaper. This put ARR in a much safer position going forward.
In early April, ARR completed this transition by selling the remaining $1.2B of its 30 year Agency fixed rate MBS. It again put these monies into fixed rate Agency MBS maturing between 121 and 180 months. Undoubtedly this was again expensive. However, this should have been much less expensive than the comparable move during Q1 2014. That move exchanged roughly $5.3B of the described securities. This was more than 4 times as much. Yet ARR still had only a small book value loss in Q1 2014. This bodes extremely well for the portfolio performance in Q2 2014.
As of June 26, 2014 the 10 year US Treasury Note yield was 2.53%. This is down -19 bps from the 2.72% close on March 31, 2014. This is less than the -31 bps fall from December 31, 2014 to March 31, 2014. However, it should still mean that ARR's Agency fixed rate MBS should have gained value during Q2 2014. The chart below of the 15 year FNMA 3.5% coupon MBS shows that it has gained about 1% during Q2 2014. Since leverage has been approximately 8.1x to 8.2x for Q2 2014, the portfolio should experience a nice book value gain from the downward move in interest rates.
The only worry after the above is the hedging, which tends to subtract from the book value gains. It is an expense that guards against rising interest rates; and the hedges tend to experience losses as the Agency fixed rate MBS experience gains. As of March 31, ARR had a notional amount of about $10.0B of various maturities of interest rate swap contracts with a weighted average swap rate of 1.50%. It had a notional amount of $5.3B of various maturities of swaptions with a weighted average swap rate of 2.94%. It had a notional amount of about $55.0 million of various maturities of Eurodollar contracts sold at a weighted average swap equivalent rate of 1.97%. The total notional amount of hedges was about $15.355B. The portfolio value as of March 31, 2014 was about $16.5B. Hence ARR was approximately 93% hedged. During Q2 the amount of hedging has risen to 97.1% of assets hedged as of June 9, 2014. Still this should allow for some book value gains.
It is a bit unclear how large the expense of the portfolio realignment operations in Q2 2014 were. However, they should be significantly less than those incurred in Q1 2014 (less than 25% of the costs incurred in Q1 2014). As the interest rate situation stands right now with only days to go until the end of Q2 2014, I would bet on ARR seeing a book value increase in Q2 2014. In fact with the latest reading of the US Q1 GDP Growth rate of -2.9%, interest rates may be more likely to decrease between now (June 26, 2014) and the end of Q2 2014 (June 30, 2014). This should lead to book value gains. Such gains seem even more likely with the $1B notional amount in 10 year US Treasuries that ARR now has. These were acquired sometime between April 15, 2014 and May 19, 2014.
The Core Income and estimated taxable Real Estate Investment Trust ("REIT") income of approximately $58.3 million ($0.15 per common share in Q1 was enough to sustain the $0.15 quarterly dividend. The small decrease in interest rates should hurt the net interest margin of 1.82% a bit; but the damage should be small. Plus ARR has already elected to retain its $0.15 per common share quarterly dividend ($0.05 per month) for Q2 2014. This should help investors believe in ARR's dividend story. ARR is a buy with its current portfolio and its current Q2 2014 outlook, especially after the latest US Q1 GDP Growth rate reading of -2.9%.
The one year chart of ARR provides some technical direction for this trade.
The slow stochastic sub chart shows that ARR is oversold. The main chart shows that ARR has bottomed; and ARR has been moving sideways (or upwards and sideways). It had a book value of $4.67 as of March 31, 2014. ARR's stock price of $4.29 at the close on June 26, 2014 represents a substantial discount to the March 31, 2014 book value. The book value is likely to go up or stay nearly the same based on Q2 2014 results. Further ARR's portfolio is much more conservative now (safer). This should make it more attractive to investors. ARR's dividend of about 14% should add further to ARR's attractiveness. ARR is a buy. CAPS agrees with me with a rating of four stars (a buy).
NOTE: Some of the fundamental fiscal data above is from Yahoo Finance.
Good Luck Trading.