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Arlington Asset Investment Corporation (NYSE:AI) released a dreadful fourth-quarter report. Judging from the market's reaction, few analysts were pleased. The following chart breaks down the price movements over the last five days with comparisons for AGNC Investment Corp. (NASDAQ:AGNC), CYS Investments (NYSE:CYS), and Orchid Island Capital (NYSE:ORC). Those 3 are all primarily investing in agency RMBS, so they should provide a reasonable comparison for changes in market sentiment or interest rates.
AI got slaughtered as book value came in substantially below where many analysts might have forecast it. It certainly came in below my projections. AI is one of the newer entrants to my forecasting system, and it takes a couple quarters with significant swings to iron out potential mistakes in valuation. To me, the biggest question was how AI reached such dreadful results. If we can understand how AI got there, we can predict future quarters better and have a deeper understanding of the strengths (or at least the weaknesses) or their techniques.
Weak Asset Performance
Losses on assets (specifically agency RMBS) surpassed my expectations. What drove larger losses? The company is committing very heavily to using prepay-protected RMBS which effectively are producing more duration than similar RMBS without prepayment protections.
How Does That Work?
If interest rates increase significantly, all fixed-rate RMBS will fall in value. However, the higher coupon securities generally fall less in value because the higher rates mean fewer prepayments which increase the expected yield on the security. If the securities are already "prepay-protected," then they don't gain as much additional yield from rates moving higher. Consequently, they lose more price.
Why Would Anyone Want That?
When rates are falling lower instead of moving higher, the prepayment protection is very nice. Because expected prepayments won't increase as much, the yield on the securities won't fall as far and thus the price holds up better.
It looks like the impact may have been about an additional $1 per share relative to my estimates. I was forecasting for losses running $6.27 per share on fixed-rate assets plus TBA securities and they reported $7.27 per share. Granted, I don't expect these values to ever line up perfectly. Changes in the portfolio may play into this as well. The general rule is that the very heavy prepayment protection for AI came back to bite them. However, it isn't the biggest challenge they witnessed.
That Treasury Future Option Hedging Strategy
Forecasting a hedge portfolio that includes Treasury Future options is insanely difficult. I ran with the assumption that management was simply going to roll the portfolio forward at each expiration date. Nope, that was the wrong assumption. This comes back to the disclaimer that analysts cannot effectively forecast what changes management will make.
The Treasury Future options were expiring and being refreshed, but it looks like AI was refreshing their positions using options contracts that would specify prices around 20 or 30 basis points on either side of the current rate. That becomes a problem in a quarter where rates continue to increase because part way through the quarter those options are refreshed so that we need to see yields move another 20 to 30 basis points again before the options land in the money.
AI is both buying the put options and selling the call options, so they are effectively creating protection against a major swing in rates.
Didn't We Have a Major Swing?
Right, that is the problem. The fourth quarter was a major swing in yields, but it wasn't all within one hedging period. The hedges were only running around 1 to 2 months into the future from the quarter end dates. We don't have the full 10-K out for AI, so I'm limited to the information in the release and presentation, but it seems like the timing of the huge movement may have been a significant problem. Had the entire rate movement happened on October 1st, 2016, and then rates held entirely flat for the rest of the quarter, it would've been better for the way the option portfolio was designed.
A Silver Lining or a Brown Lining, Depending on Perspective
If you expect rates to gradually come back down, the option technique AI is using would be extremely favorable because Treasury rates would be slowly declining but both sides of the trade (buying the puts and selling the calls) would end out of the money. These options are generally paired (at least roughly) so that Treasury yields landing within the spread (of 40 to 60 basis points) means practically no change to book value because the premium they collect on selling calls is about equal to the premium they pay for the puts. Consequently, a slow trend down in rates would lead to virtually no loss on their net option position, while the mREITs hedging the rates more precisely would see small losses quarter after quarter.
How Can That Be a Brown Lining?
If rates were trending slowly higher instead of slowly lower, then both sides continue to expire worthless but AI would be missing the hedging gains some other mREITs would receive. Meanwhile, the value of agency RMBS would continue to decline slowly much like Treasury values (rates up, prices down).
Discount to Book
Compared to the end of the fourth quarter, Treasury rates are slightly lower (at least at 5 years and 10 years). The decline so far (February 9th, 2017, markets still open so changing constantly) is about 5 to 6 basis points. Lower yields means higher Treasury prices and at least for today the MBS to Treasury spread is holding reasonably enough. The standard pools of securities are up slightly in price. Not quite as much as I would expect for the movement in Treasury yields. I'm seeing the 30YR FNMA 4.0 up by about 13 basis points, which is just over half the price movement I would've expected on a 5-year Treasury. The mortgage REITs (and AI, technically a corporation) overwhelmingly positioned portfolios in favor of rates moving lower. AI followed the same trend. Consequently, I'd say we have an extremely slight spread widening but slightly lower rates. Remember that a slow decline is also the ideal way for declines to come through for AI's portfolio. I'll estimate that on the net they should be up ever so slightly since the end of Q4 plus they should have some net interest income accrual. Consequently, expect something around $16.40 to $16.50 for GAAP and $13.30 to $13.40 for tangible book value.
I'm seeing AI at $14.74, so here are my estimates on price-to-book value ratios using those values:
These estimates are ball parking the impact from the movement in rates.
Clearly, long-term buy-and-hold investors won't be interested in AI on the basis of tangible book value. They would need to be valuing the tax assets, so they would presumably be focused on whether paying 89% to 90% of GAAP BV makes sense.
In my view, the market is getting pretty hot (high valuations) for shares of the mREITs which puts them beyond the prices I would want to pay.
Since I track prices and BVs for each quarter, I also have a chart of where AI's price stood relative to their unreported GAAP book value for the end of each quarter.
I'm willing to accept that price-to-book-value ratios are generally higher across the industry. I'm not open to accepting an increase of 26.75% in the ratio. Investors can argue that spreads are more attractive for investing today. Why was that again? Most investors will cite the Treasury spreads. The 10-2 or the 7-1.
The 7-1, as of yesterday, was at 1.35% and the 10-2 was at 1.19%. At the end of Q4 2015, those values were 1.44% and 1.21%. How is that more attractive?
Perhaps someone will call out the OAS (option adjusted spread)? The values there don't look too bad. There are a few ways to measure spreads on agency RMBS and OAS is a fine one to use. AGNC uses that technique and included it in several presentations. They already reported for Q4 2016, so that chart is available. I added green boxes to help highlight the Q4 2015 values for comparison to the most recent values:
In both cases, they are showing the OAS being down by 1 basis point relative to Q4 2016.
That would bring us to what may be the final argument for higher prices. Correlation with the market is driving common stock price multiples higher. That may be entirely true, but it would also be a poor reason to agree to pay that premium.
If I seem like a constant pessimist, so be it. This is the strategy that helps me avoid losses. I stick to being frugal and refuse to pay the higher multiples. There are certainly fewer options here than I could find in some prior periods, but I still have found great opportunities within the last few weeks (most notably in the preferred shares).
The Challenge of High Prices
I would like AI much better at lower prices. Their strategy is fine, though it is dramatically more work to model. I think there is a strong case for rates slowly moving lower, but I don't like the risk of correlation with the markets sending AI back to trade at a much larger discount to book value. Even if they correctly predicted the direction of the rates and earn a nice level of spread income, there is a strong chance for better prices to be available in the future. Remember, the investor does not automatically receive the change in book value as part of their return. If they did, the returns on AI would've been terrible since Q4 2015 instead of excellent.
Prices Where I Would Like AI
For investors valuing based on total GAAP BV (valuing tax assets), I would give AI a buy at $12.30 (75% P to B) and a strong buy at $11.48 (70% P to B) based on current rates. This is based on generating income in an account where the deferred tax asset has value compared to holding a REIT.
For investors not interested in the tax assets (since they can't be invested to earn net interest income or the account is tax-exempt), I would see it as a buy at $10.91 (82% P to Tangible B) and a strong buy at $10.24 (77% P to Tangible B). This case is based on receiving a dividend or a few dividends while looking for a capital gain from taxable investors coming back into the stock.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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