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Summary

  • Core EPS pressurized by high hedging costs and lower asset yield.
  • Company should give up defensive approach and take advantage of lower interest rates.
  • Company offers exciting double-digit dividend yield with potential for modest price appreciation.

ARMOUR Residential REIT (NYSE:ARR) is an externally-managed mortgage REIT company that primarily invests in fixed rate and adjustable rate residential mortgage-backed securities. Both its principal and interest payments are being guaranteed by the government or its sponsored entities. I have change my bullish stance to neutral, as the company continued its defensive approach in the second quarter. It continues to shift its portfolio to low yielding 15-year and 20-year MBS and it also remains over-hedged. Overall, interest rates are expected to remain stable and less volatile.

Defensive Approach
The defensive approach is difficult to understand given that the rates are expected to remain stable. The company continues to maintain considerable hedge positions. It has $16.3 billion in hedges in 2Q'14, which nearly represents 97% of the company's assets and 106% of repurchase agreements. Its competitors like Annaly Capital (NYSE:NLY) and American Capital (NASDAQ:AGNC) are reducing their hedges to benefit from the low interest rates. So, I believe the company should reduce its hedges to reduce its cost of funds and hence improve core EPS.

The figure below shows the 10-year treasury yield for the last one year. It shows that interest rates have significantly declined even though the Fed has been continuously cutting its stimulus package by $10 billion after each meeting. The cut down in asset purchase is expected to end by the year end and I believe the transition will be smooth due to favorable demand-supply dynamics. Although the Fed has reduced its demand, it still has the major chunk of the market due to the reduced supply.

(click to enlarge)

Source: Yahoo Finance

Secondly, the Fed has identified two slacks in the labor market and decided to maintain the expansionary monetary policy. The two slacks are low labor force participation rate and low earnings growth. So what the management needs to do is closely follow the labor market and then adjust its portfolio accordingly.

However, there has been a benefit of reduced interest rate risk by raising hedge positions. At the end of the second quarter, a 100bps increase in interest rates will cause a decrease of 0.06% in the projected value of the portfolio, as opposed to a decrease of 0.71% on December 31, 2013.

In the second quarter, ARR reported net interest margin of 1.46%, which was 36bps lower than the previous quarter. The primary reason behind such a massive decline was the sharp 33bps decrease in asset yield. I believe diverting capital from relatively high yielding 30-year MBS to low yielding 15- and 20-year MBS is the primary reason behind the sharp decline in asset yield. Furthermore, the company has also given up the opportunity of a large increase in book value due to the tightening of the spread, as the company moves to short-term MBS.

Both the above mentioned approaches of the management have caused the company to miss analyst expectations regarding core EPS. I believe the rates are expected to remain low and stable as long as there is under-utilization in the labor market. So, ARR should reduce its hedges and direct its resources to high yielding assets.

Dividends and Valuation
The company pays monthly dividends of $0.05 per share, which means quarterly dividends of $0.15 per share. It offers an attractive yield of 14.10%, but the core EPS of $0.13 does not completely cover its dividend payout. ARR has opted for a defensive approach, which will continue to pressurize its core EPS. So, I believe the company should opt for a more aggressive approach so that it can improve its dividend coverage.

In the second quarter, ARR's book value was up by 4.9% and reached $4.90. Furthermore, the company is also trading at a larger discount to its book value as opposed to its peer companies. So, I am raising my price target to $4.36. It is based on a P/BV multiple of 0.89x, which is the average of its competitors mentioned in the table below. My target price dictates a modest price appreciation of 3%

Companies

P/BV

Dividend Yield

ARR

0.85x

14.10%

NLY

0.89x

10.3%

AGNC

0.89x

11.0%

CYS Investments (NYSE:CYS)

0.90x

14.5%

Hatteras Financial (NYSE:HTS)

0.88x

10.10%

Source: Yahoo Finance

Conclusion
The core EPS is pressurized by high hedging costs and lower asset yield. I believe interest rates are expected to remain stable at least till the second half of the year. So the company should give up its defensive approach and start taking advantage of lower interest rates. However, ARR offers an exciting double-digit dividend yield with potential for price appreciation.

Source: Continuation Of Defensive Approach In 2Q Forces Change Of Thesis On ARMOUR From Bullish To Neutral