2023-08-24 00:41:53 ET
Summary
- ARMOUR Residential primarily invests in government-backed agency MBS, minimizing credit risk.
- However, the company faces risks from interest rate fluctuations, spread risk, and prepayment risk.
- ARMOUR Residential is facing challenges in the MBS market, but should benefit greatly when the Fed stops raising rates and spreads normalize.
ARMOUR Residential ( ARR ) is battling a tough MBS market, but it should benefit when the Fed stops raising rates and spreads start to normalize.
Company Profile
ARR is a mortgage REIT that earns money from the spread between the interest income on the mortgage-backed securities (MBS) it owns and its borrowing costs. The firm then uses leverage to increase its returns.
The firm mostly invests in MBS that is backed by government-sponsored agencies, such as Fannie Mae and Freddie Mac, or guaranteed by Ginnie Mae. These loans carry little to no credit risk. From time to time, the firm may also invest in U.S. Treasuries, Interest-only Securities, or money market instruments.
Since it is structured as a real estate investment trust ((REIT)), it doesn’t pay taxes at the corporate level and is required to distribute 90% of its earnings to shareholders in the form of dividends.
At the end of Q2 2023, ARR's investment portfolio was valued at $12.1 billion. Nearly 99% was in agency fixed rate MBS.
Company Presentation
Opportunities and Risks
Similar to other mortgage REITs, ARR runs a spread business, where it gets short-term funding through repurchase agreements and then buys mortgage-backed securities. It then leverages up to boost its earnings power, which in its case was 7.6x at the end of Q2 and 7.8x at the time of its late July earnings report . This is notably higher than most of its peers. AGNC ( AGNC ) is a bit lower at 7.2x, Two Harbors ( TWO ) was at 6.4x, and Annaly ( NLY ) was at 5.8x. Less leverage will allow mortgage REITs the opportunity to later increase leverage and purchase better yielding and/or more attractively priced MBS down the road when the cycle begins to shift. With higher leverage, ARR is at a bit of a disadvantage in this regard and will have a little less flexibility.
ARR gets about half of its repo agreements through Buckler Securities, as broker-deal in which it owns nearly an 11% stake. Relying on one related party for much of its funding does add some counterparty risk.
ARR faces very little credit risk, given that its portfolio consists of nearly 99% agency-backed securities. That said, it does face other risks, such as interest rate risk, spread risk, and prepayment risks.
As with other agency-focused mortgage REITS, ARR has felt a lot of pressure from rising interest rates. The reason is that as interest rates increase, the current value of its portfolio of older MBS with smaller coupons becomes less valuable. This causes its book value to shrink. In 2022, ARR saw its book value decline from $10.33 at the end of 2021 to $5.78 at the end of 2022, a -44% decline. It was $5.38 at the end of Q2 2023.
The company firm has been moving its portfolio to higher coupon MBS, and in Q2 allocated $1.3 billion into 5% and 5.5% Ginnie Mae pools.
Discussing its portfolio on its Q2 earnings call, Co-CEO Scott Ulm said:
“Our current portfolio is concentrated in the most liquid low-premium production coupon pools featuring more favorable geographics, LTVs, FICO scores and loan balance characteristics versus generic production cohorts. We continue to favor specified pools over TBAs as we expect no improvement in the deliverable collateral and the implied funding of dollar rolls lag current repo rates. These lower pay-up premium specified stories should perform strongly as demand for Agency MBS remains. Despite seasonal driving up CPRs marginally, these investments reflect historically low prepayment risks and still a significant amount of borrowers are out of the money. ARMOUR's average prepayment rate for all MBS assets in the second quarter of 2023 was 6.3 CPR and still a very low 6 CPR for July. Although mortgage rates have already declined, from the highs of 7.2% in early November of 2022 to 6.8% in mid-July 2023, a substantial refinancing wave will require mortgage rates to fall below 5% in our view.”
Prepayment is another risk that a mortgage REIT like ARR faces, although this tends to be more in a falling rate environment when people look to refinance into lower rates. Prepayments will always be part of MBS investing, as mortgages get paid off when people not only refinance but sell their homes as well. The risk is more not being able to replace an existing security with a similar yielding one. With the average 30-year fixed mortgage hitting 7.5%, this risk remains on the back burner at the moment.
The firm also faces spread risk. If spreads widen between Treasury and MBS, it can hurt book value, while if spreads between borrowing costs and MBS tighten, it hurts earnings power. The spread between the 10-Year Treasury and mortgage rates have been historically high, while the yield curve between 2-Year and 10-Year Treasuries has become negative, with the 2-Year having a higher yield currently.
Valuation
When looking at mortgage REITs, I generally look at price to book value as a good way to value them. Given that these firms own a portfolio of assets, this tells you what the stock is trading at in relation to the value of those assets.
On that front, ARR trades at 0.87x. By comparison, AGNC trades at 1.01x, Annaly trades at 0.92x, and Two Harbors trades at 0.78x.
AGNC and NLY have been a bit better managed than ARR over this difficult period, which is part of the reason why they trade at slightly higher valuations.
Conclusion
From rising interest and mortgage rates, to high mortgage to Treasury spreads, to an inverted yield curve, mortgage REITs have faced a very difficult environment over the past couple of years. The good thing is that as the Fed rate cycle begins to come to an end, and when spreads return to more normal levels, mortgage REITs, including ARR, should see a very nice boost.
In the near term, with mortgage rates up once again from end of Q2 levels, there could be some more pain before things get better. Book value undoubtedly will drop once again in Q3 unless mortgage rates reverse course. However, as the Fed tightening cycle come closer to an end, the more attractive mortgage REIT stocks become. Make no mistake though, these are not buy and hold investments.
ARR currently yields over 20%, and that is after it reduced its monthly dividend from 10 cents to 8 cents. I prefer AGNC and NLY, as I think they’ve done a better job navigating this environment. AGNC has been great at hedging, while NLY has low leverage, giving it more flexibility. That said, ARR should ride the same waves when the tide turns and is a bit cheaper, although it does have a little less flexibility given its higher leverage. As such, I also view ARR as a “Buy,” just one that carries a little more risk and bit more upside if the cycle turns more quickly than expected.
For further details see:
ARMOUR Residential: Buy Before The Tide Shifts