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ARMOUR Residential REIT, Inc. (NYSE:ARR) has a trailing dividend yield of 16.93% and this is expected to be 15.87%, going forward. Even better for investors, the dividend is paid monthly. That is somewhat unique in the Residential REIT industry where most of them pay dividends quarterly. But how can Armour pay such a high dividend and what are some of the risks of investing in it?

Well, how Armour does it is fairly easy to explain. Armour borrows money that requires it to pay a certain interest rate, and buy mortgage-backed securities that pays it interest at rates higher than its cost of borrowing. Simple enough, but it does not end there. Once the mortgage-backed securities are on the balance sheet, Armour can actually use it as collateral to get additional funding, and make additional security purchases, and so on, and so on.

In the case of Armour Residential, it is currently leveraged about 10 times. That means the total liabilities exceeds the total equity on the balance sheet by 10 times.

A back of the envelope calculation looks as follows, based on June 30, 2012 data obtained from the 10-Q:

According to ARR's 10-Q, the weighted average yield of the mortgage backed securities it holds on its balance sheet is 2.97%. The cost of its borrowing, through debt, equity, and repurchase agreements is 0.82%. That leaves a net interest margin of 2.15%. Subtract the additional funding costs for the repurchase agreements of 0.39% and you get a net margin after REPO costs of 1.76%. Leverage that 10 times and you have a 17.6% return. Subtract operating expenses and make any slight adjustments here and there...but you get the idea.

So what are the risks?

The main risks associated with the performance of Armour Residential REIT and subsequently, it's stock price and dividend yield, are as follows:

Prepayment Risk

Since all of the securities purchased by Armour have been at a premium, there is the risk that if prepayments increase or are higher than expected, Armour will only receive the par value of the security, which is 100. The fair value of the securities held on the portfolio as of June 30, was 106.11 on average. This premium is amortized over the expected life of the security. If it gets paid early at 100, Armour not only loses the interest expected from the security, but only receives 100 on a security currently valued at 106+. It would have to write-down the value of those securities to 100 obviously, and the question is then whether that will trigger a margin call. This is where there high amount of leverage can really hurt. That being said, Armour does hold 40% of unlevered equity in cash or cash-like securities in order to deal with margin calls. In addition, Armour runs the risk of not being able to reinvest the proceeds at the same or better rate.

While this may very well be the biggest risk faced by Armour, (as mentioned by management as well), it looks like the prepayment rate trend has been falling...which is positive.

Interest Rate Risk

As interest rates rise, the value of the securities held by Armour will tend to fall. This risk can be mitigated by investing in shorter duration securities and/or hedging exposure to interest rate changes through a combination of swaps, swaptions, and other derivatives, of which Armour uses a combination of. The following table summarizes the risk of a parallel shift in the yield curve to both net interest income and portfolio value.

As you can see in the right-hand column, the portfolio is fairly insulated from interest rate changes due to the hedging employed by the firm. However, the there is a potentially huge risk if interest rates fall by 1%. We don't see that happening at all, so we give this a very low probability of occurring. But interestingly enough, a small rise in rates will actually help net interest income considerably. Only if rates rise by 1% or more does net interest income become negatively affected.

Liquidity Risk

Liquidity risk arises from financing long-maturity Agency securities with shorter-term debt. Since the interest rates on borrowings generally adjust more frequently than interest rates on the adjustable rate securities, there is a risk that borrowing costs will increase faster than interest earnings.

Credit Risk

While mortgage-backed securities typically do have credit risk, Armour only invests in securities guaranteed by the U.S. government or U.S. Government sponsored agencies. Therefore, there is no credit risk in the securities they purchase.

Conclusion

Armour pays a very attractive dividend that yield-starved investors have been seeking. It does come with risks, but as any finance professor will tell you: The higher the potential return, the higher the risk you must take. We think the risks are low enough, at least for the time being, to justify an investment where there is a 16% yield and possible price appreciation. And even if the stock price actually falls, it would have to fall substantially to mitigate the dividend. The monthly distribution isn't bad either.

Source: Armour Residential: How It Manages To Pay A 16% Yield And The Risks Of Investing In It