Armour Residential REIT (ARR) released its 2011 10K yesterday. It was a little late to be included in my recent article on interest rate risk hedging strategies, but this REIT is particularly interesting and deserves additional scrutiny.
First of all, here is the rate sensitivity section of the "Discussion of Qualitative and Quantitative Risk" from the ARR 10K: (Click to enlarge)
This amounts to the management's interest rate hedging strategy. Like all of the mortgage REITs, they set up a system of hedging instruments to protect themselves and/or benefit from a change in mainly long-term interest rates. We have discussed this at great length in this article.
We can graph these values to make them a little easier to visualize: (Click to enlarge)
Sometime in the fall, Armour's management shifted the company's interest rate hedging program dramatically. As of September, the company was set up to benefit from a 50 basis point rise in interest rates. As of the end of the year, the interest rate sensitivity curve shifted to the right: This is something Armour might do if it was anticipating a further decrease in interest rates. In this case, the potential benefit to Armour's NOI will be on the order of 9%. Note that the company's strategy at the end of 2010, when the fund was much smaller, was basically the same shape as it is now, except Armour's sensitivity to an interest rate increase is much lower right now than it was at the time.
We are working with a population of mortgage REITs and are tracking how all of these strategies changed between the third and fourth quarter, and here is the updated chart: (Click to enlarge)
This is a graph of the effects of a 50 basis point increase or decrease on the NOI of this group of REITs. The closer to the center, the lower the risk. American Capital Agency Corp's (AGNC) management, for example, changed its hedging portfolio to make it generally less risky. Two Harbors Investment Corp. (TWO) also had a minor change, moving upward and to the right, which would position them favorably if interest rates changed in either direction.
Armour's strategy would put it in an excellent position if interest rates go down, and also, even if interest rates go up slightly, the REIT will be protected.
We had another article recently on Armour's growth strategy. It had a new share issuance at $7 earlier this month, increasing the float from 95 million to 135 million, with the potential to add an additional $188M to its portfolio, given its 8:1 leverage.
Here is why you should care about all of this: This company is set up to continue to grow. The company is hedged against both increases and decreases in interest rates, and has just issued enough shares to increase the top line substantially. This company grew almost 10 times in income between 2010 and 2011, and is still on the steep part of the growth curve. American Agency Mortgage is one of the leaders in this industry, and Armour is still relatively small.
So what are the headwinds? For one thing, Armour just reported a big net annual loss of $122M, of which $97M were unrealized losses on derivative instruments. You can see that the management had its third quarter hedging strategy set up in anticipation of an interest rate increase, and the opposite happened. The market has shrugged this off though and the stock has been climbing steadily. This is because the nice, high dividend appears to be largely safe, and these losses are on paper for now.
But, this points out exactly why these curves matter a lot in this industry. If you are an investor, you have a theory about the future. If you anticipate that the current period of historically low interest rates is drawing to an end, you should select one of the funds that will benefit from an interest rate increase, or at least be immunized from it. If you think we are in for more low rates, your selection will be completely different.
As we are so fond of saying, the world is full of chaos, and there are no guarantees on anything, particularly in the world of REITs. At least at this point we can form a theory and act on it.
Additional disclosure: I still have a limit order to go long on ARR on a pullback, but it looks as though the pullback is becoming less likely.