Armour Residential REIT Inc. (ARR), like other mortgage REITs in the U.S., has been favored by the Fed's efforts to keep interest rates low. This is reflected by ARR's YTD performance of 4.4%. We are bullish on the stock due to its cheap relative valuations, effective risk mitigation strategies and its massive sustainable dividend yield of 16.4%. Additionally, the company has the choice to enhance its net interest margin by including high-yielding non-agency mortgage backed securities. The company pays monthly dividends. Investors should be wary of a further decrease in interest rates, as it will result in a decrease in the book value of the company.
Armour Residential operates in the U.S. financial sector as a mortgage REIT, and seeks to invest primarily in all three types of residential mortgage backed securities (fixed rate, adjustable rate and hybrid), for which the principal and interest payments are guaranteed by a government-sponsored entity (agency). Last year in December, the board amended the company's charter, allowing the management to invest in non-agency mortgage backed securities as well. However, the company has no investments in non-agency mortgage backed securities at present. The company earns a spread between the yields it earns on its assets and the cost it pays on its borrowings. To fund its asset portfolio, the company uses short term investment (repurchase agreements).
Asset and Liability Composition/Maturities
The company has a portfolio of agency securities worth $13.3 billion, 78% of which are fixed rate, exposing the company to interest rate and prepayment risk. All fixed rate securities have a maturity of 20-years or shorter. The remaining 22% of the portfolio consists of adjustable rate mortgages (ARM) and hybrid ARMs. As per the policy of Armour Residential, mortgages with longer than 18 months-to-reset-dates are classified as hybrid ARMs, while mortgages with shorter than 19 months are classified as adjustable rate mortgages.
As at June 30, 2012, the weighted average maturity of Armour Residential's $12.1 billion repurchase agreements was approximately 32 days. The maturity for repurchase agreements increased 14 days when compared to the linked quarter. The company now has repurchase agreements with 26 counterparties as opposed to 23 in the first quarter of the current year. This reflects that the company is focusing on diversifying its sources of financing.
Like other mortgage REITs, Armour Residential's interest income and portfolio value are interest rate sensitive. However, Armour Residential has done well to mitigate this risk. Besides investing in adjustable rate and hybrid securities, which are less sensitive to interest rates as far as their market values are concerned, the company seeks to hedge 40% of its fixed rate mortgage securities. It also uses derivatives to shorten the duration of the interest sensitive fixed rate securities. The broad focus of the hedging strategy is to ensure that the company holds those derivative instruments that move in an opposite direction, with regards to their market value and cash flows, to the movements of the company's asset and liabilities. The company, in its SEC filings, demonstrates how a 0.5% decrease in the general interest rates will result in a 2.9% and 1.39% decline in the projected net interest income and value of the company's portfolio, respectively. A 2.9% decline in the projected net interest income translates into a $2.18 million reduction.
Another risk faced by Armour Residential is the prepayments risk on the mortgages it holds. Before picking up a security for investment, Armour Residential assesses a variety of factors, including balance levels, principal, borrower credit profile and others, to reduce prepayment risk.
Recent Quarter's Performance Review
For the second quarter of the current year, the company reported interest income, net of amortization of premium, of $86.2 million, against $29.1 million in the previous year. This is a significant increase of 196%. The effect of the increase in interest income was partially offset by a surge in interest expense. Over the same period, the interest expense surged by 372% to $11.1 million. The surge in both interest income and interest expense was primarily associated to significant increases in the holdings of mortgage backed securities and repurchase agreements over the previous year. The net interest income for the second quarter reached $75 million, up from $26.7 million in the second quarter of the prior year. The company's expenses of $5.7 million increased over the previous year's $2.1 million, largely due to an increase in compensation and the management fees that Armour Residential paid. The company realized $12.4 million losses on its derivatives, while the unrealized loss on derivatives surged to $70.4 million.
Asset Yields, Cost of Funds and Net Interest Margin
Assets yields, cost of funds and the net interest margin that the company earns during a quarter are directly affected by the prevailing interest rates. Where the non-existent interest rates have benefited Armour Residential by decreasing its cost of funds from 0.99% in the previous year to 0.82% in the second quarter of the current year, the flattening of the yield curve, as a result of several efforts made by the Federal Reserve Bank, offset the benefit by decreasing the yields that ARR earns on its interest yielding assets. Asset yields declined from 3.35% in the second quarter of the previous year to 2.97% in the recent quarter. Second quarter asset yields declined 7bps when compared to the linked quarter. This led to an 8bps depression in the net interest margin that the company earned during the second quarter of the current year. In comparison, the declines in net interest margin for Capstead Mortgage Corporation (CMO) and MFA Financial (MFA) were 15bps and 9bps when compared to the linked quarter. To enhance its net interest margin, Armour Residential needs to invest in high yielding non-agency mortgage securities like Two Harbors Investment (TWO). Two Harbors earned a net interest margin of 3.6%.
With a target leverage ratio of 6 to 10 times, and total borrowings (repurchase agreements) of $12.1 billion, Armour Residential is highly leveraged. It has an approximate leverage ratio of 8.9 times, against 3.4 times and 8.6 times for MFA Financial and Capstead Mortgage Corporation.
Dividends and Equity Issuance
The stock offers an unmatched dividend yield of 16.4%, given the near zero interest rate environment and the Fed's continuous resolve to keep interest rates at this level until 2014. The most recent monthly dividend of $0.1 per share dropped from $0.4 per share (quarterly) in 2010. Over the past four quarters, the company demonstrated significant ability to pay dividends through its operating cash flows. Armour Residential paid on average $39.6 million in quarterly dividends over the past four quarters, and on average generated $43.3 million in cash from operations over the same period. This makes the average cash dividend coverage ratio to be 1.09 times. As we analyzed above in the risk section, a possible reduction in interest rates of 0.5%, as a result of further easing by the Federal Reserve Bank, would cause a reduction in net interest income of $2.18 million. This reduction in income is not large enough to threaten the current shareholder distribution.
The figure below shows how Armour Residential has been issuing equity on a quarterly basis. Most of this equity issuance is used to fund mortgage backed securities. It would have been a matter of concern if the company used this regular issuance of shares to pay dividends.
Source: Bloomberg, Qineqt's calculations.
Armour Residential's stock trades at a slight 2% premium to its book value. This is opposed to 6%, 7% and 17% premiums in case of MFA Financial, Capstead Mortgage Corporation and American Capital Agency (AGNC), respectively. The market caps of MFA Financial, Capstead and Armour Residential fall in the range of $1.4 billion-$2.9 billion, while American Capital Agency, like Armour Residential, exclusively invests in agency securities, which is why it has been chosen for the comparison.