Armour: This 17% Yielder Is A Buy Now

Jul. 3.12 | About: ARMOUR Residential (ARR)

If you look at the low interest rate environment and the still depressed state of the real estate market, you may not consider mortgage related investments to be particularly attractive. And yet, some REIT investments may be worth investigating further for their short-term yields. One such investment is ARMOUR Residential REIT, Inc. (NYSE:ARR). Armour offers an attractive dividend yield through its prudent and conservative trading strategies.

Armour is in the business of buying mortgage-backed securities from federal agencies Fannie Mae, Ginnie Mae, and Freddie Mac, but differs from its competitors in dealing with different types of mortgage such as fixed-rate, adjustable-rate, and hybrid rate securities. Many analysts expect that Armour's earnings per share is going to increase 400% by the end of the year 2013. The company and its competitors are expected to gain from the new rules proposed by the Consumer Financial Protection Bureau to reduce the rate of foreclosure in the short term. There is also a proposal that would make mortgage companies provide extra staff to help borrowers avoid foreclosure.

This type of setup presents a high risk factor, and the company offers a dividend yield of better than 17% in order to compensate for this. Later on in this article, we will explore whether this dividend is sustainable. Armour tends to trade in mortgage-backed securities that may be considered riskier than some of its competition but, in my opinion, this risk is balanced out by the more moderate approach that the company brings to the trading of derivatives, unlike the more aggressive approach of some other REITs.

One of Armour's competitors, Annaly Capital Management (NYSE:NLY), is something of a mixed bag when it comes to producing results for investors. The company has recently reported earnings per share of $.49, along with a dividend yield in the region of 13.1%. Annaly is making a new offering of convertible senior notes, worth approximately $750 million. The problem is that the conversion price is higher than the current stock price, which could see a further drop in the event of a margin call. For this reason, Annaly is probably best avoided as an investment at this point in time. Another possible investment is CYS Investments (NYSE:CYS), which offers a dividend yield of 14.5%, but is regarded as a higher risk investment compared to many other REITs.

Other companies in the industry that are better avoided are Chimera (NYSE:CIM) and American Capital Agency (NASDAQ:AGNC). Chimera has had problems with its auditors and, as of this writing, had not produced audited financial statements for the year 2011. In addition, it is classified as a hybrid mREIT, which means that its investment portfolio contains both agency and non-agency backed mortgage securities.

Armour's portfolio is made up of different kinds of mortgages. Adjustable-rate and hybrid rate mortgages make up about 20% of the portfolio. The rest is spread out over pass-through securities with maturities of 10 to 20 years. I do not consider mortgage REITs to be good long-term fixed income investments because of their vulnerability to interest rate movements and changes in regulation.

In the short term, however, mortgage REITs can be considered when interest rates are stable and there is enough of an interest rate spread to provide the revenues to support dividend payments. REITs like Armour could face potential threats if regulation continues to support troubled mortgage borrowers with easier refinancing, as prepayments could have a negative impact on revenue.

Armour has to constantly keep buying new pools of mortgage-backed securities, and the news of the decline in mortgage applications could affect the supply of securities. Fewer mortgage applications will result in pools of higher quality, but the company will have to pay a premium for these securities. Some of the company's portfolio will consist of highly rated securities but, necessarily, there has to be a mix of ratings to offset the higher premiums on these securities, and thus protect earnings and dividends.

Moreover, well-qualified borrowers will tend to have a higher prepayment rate. Another worrying trend is the general increase in prepayment rates on 30-year securities. Fannie Mae reported a 10% rise in prepayment rates in March, while Freddie Mac reported a substantial 13.7% increase back in February. REITs like Armour are affected by prepayments, because the replacement assets that they purchase may not be of equivalent risk and yield. For protection against prepayment risk, Armour only participates in mortgage pools where it can choose securities with the characteristics that it prefers, and prepayment rates have therefore stayed constant at just under 10%.

Armour also prudently follows a policy of hedging with non-mortgage derivatives. The company currently holds a total of $5.5 billion in non-mortgage derivatives, which is an acceptable 45% hedge against total assets of $12 billion. Most of these derivatives are interest-rate swaps that are relatively low risk, and Armour has not been as aggressive as some of its peers in trading derivatives. Given the continuation of a stable interest rate regime, there is no reason why the company cannot sustain its dividend payout as long as it protects its interest spread.

Though an investment in Armour is relatively high risk, there is plenty of compensation for the risk in terms of the mouthwatering dividend yield of over 17%. I would have no hesitation in recommending Armour as an income investment for the short term. However, you should continue to watch developments on the interest rate front, along with possibly disadvantageous regulatory activity. If you see any of these warning signs, you should sell your holding.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.