Arlington Investment - Is 8.7% Enough?

About: Arlington Asset Investment Corp. (AI), Includes: AGNCN, CHMI, CHMI.PA, CHMI.PB, CIM, CIM.PD, NLY, NLY.PD, NYMT, NYMTO
by: Rubicon Associates

Arlington has shed its C-corp status and gone REIT.

It is currently primarily invested in GSE-backed mortgages, changing the risk profile of the firm.

With shares being volatile (and down 18% in the last year on a reinvested basis), preferred is (potentially) a better way to play.

My thoughts on this new preferred.

For the sixth time this year, a REIT has tapped the preferred market for capital. This will be the fourth mortgage REIT that has used the preferred market to get permanent capital and the third that has issued at 8%+.

The details of the offering are:

Source: Author spreadsheet

Arlington Asset Investment (AI) is a company (now a REIT) that focuses on acquiring and holding a levered portfolio of MBS, consisting of agency MBS and private-label MBS. Agency MBS includes GSE (Fannie Mae and Freddie Mac) and government agency (Ginnie Mae). Non-agency MBS includes residential MBS that are not guaranteed by a GSE or the U.S. government. As of December 31, 2018, nearly all of the firm's investment capital was allocated to agency MBS.

For tax years ended December 31, 2018, and earlier, AI was taxed as a C corporation. Commencing with taxable year ending December 31, 2019, AI intends to elect to be taxed as a REIT.

Arlington's investors have not had a good year:

Chart Data by YCharts

As a result, looking at the common is inherently dangerous.

But is the preferred?

Before even looking at the preferred (by which I mean me writing more and you reading more), an assessment has to be made on its ability to service the preferred stock (as we tend to be sticklers on getting the income that is owed to us, don't we?). The following table shows the preferred dividend coverage on a variety of income levels:

Source: Author spreadsheet

As the table shows, the preferred is well covered and, therefore, merits additional investigation.

The following table shows the outstanding Arlington preferred and baby bonds and their details:

Source: Author spreadsheet

Note that two of the outstandings are baby bonds and senior to the preferred.

The market picture of the outstandings is as follows:

Source: Author spreadsheet

As the table above shows, there is a significant difference between the preferred and the baby bonds and an increasing difference between the new Series C and the existing Series B preferreds. The two issues are parity ranked, which makes the discrepancy odd.

The stripped yield of the outstanding graphically:

Source: Author spreadsheet

Recently, the preferred stock and baby bonds have been hit as well:

Source: Author spreadsheet

It is worth noting that the baby bonds have recovered better than the preferred.

From a yield perspective, we see the same.

Source: Author spreadsheet

The yields were stable before the November/December smackdown (which we saw with most rate-sensitive securities/firms), and they have begun to stabilize near current levels, but this has caused the preferreds to reprice to higher yields. The only thing that has really changed (aside from the investment loss in Q4) is the conversion to a REIT. This may be because it forces the REIT to pay out the majority of its taxable income (reducing the cushion), but I cannot say for certain.

The spread between the preferred and the baby bond is now at its wides:

Source: Author spreadsheet

The new preferred would be even wider, making it attractive relative to the baby bonds.

It must be noted that volume (liquidity) in the complex is thin, and the issues do not always trade:

Source: Author spreadsheet

If one chooses to invest in these securities, I would recommend limit orders and try to bring the market down to you.

The following table shows how the Arlington new issue (and complex) trades relative to peers:

Source: Author spreadsheet

The new AI issue trades wide to the recently issued Chimera (CIM) Series D (CIM.PD) and the Cherry Hill (CHMI) Series B (CHMI.PB) and trades more in line with the ever-yieldy New York Mortgage Trust (NYMT).

I will note that I am long AGNC Investment (AGNCN), Annaly common (NLY) and preferred (NLY.PD), Chimera preferred (CIM.PD), Cherry Hill preferred (CHMI.PA) and New York Mortgage Trust (NYMTO).

The peer group stripped yield graphically:

Source: Author spreadsheet

The peer group yield-to-call (truncated at 10%) graphically:

Source: Author spreadsheet

One reason for the relative trading level is the amount of leverage used by Arlington:

Source: Author spreadsheet

Despite the agency nature of its portfolio, it is very leveraged. This ensures that any misstep or hiccup will be magnified in the effect on the shares and book value.

The impact on book value can be seen in the following chart:

Source: Author spreadsheet

Leverage is not always your friend.

It has also not helped sustain its dividend:

Chart Data by YCharts

Given the variability and volatility in the book value and the dividend, one might expect that the more stable preferred would have a larger "cost" (or lower yield) relative to the common shares.

Source: Author spreadsheet

If one assumed that, one was absolutely right!

Source: Author spreadsheet

Bottom Line: I am torn on this preferred, I have to be honest. On the one hand, the REIT employs significant leverage - approximately 2x its agency peers - has been sloughing off book value faster than peers, cutting its dividend, and focused predominantly on one slice of the MBS market - 30yr fixed and TBAs (this is making a big leveraged bet). This is, however, an equity problem. The preferred is well covered as it is a small slice of its capital structure. The preferred also trades wide to the baby bonds, making it attractive relative to its other $25 par instruments. Ultimately, I fall on the side of buying the preferred with a MARKET PERFORM rating, as I believe the new issue trades wide to the existing preferred and the baby bonds and has adequate coverage to pay the dividend. It should also do well if rates hold where they are or recede, as the hunt for yield inevitably fuels a higher beta rally.

As Arlington Asset Investment Corp. is levered and will focus its bet on a mortgage sector, it would be wise to consider this when sizing a position in the preferred stock.

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Disclosure: I am/we are long NLY, NLY.PD, CHMI.PA, CIM.PD, NYMTO, AGNCN. 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.