This market really sets up well for Portfolio Guru, LLC holding ARMOUR Residential REIT (ARR) and its mortgage REIT brethren. Yet, the market is not fully recognizing that fact.
ARR reported 2013 earnings Wednesday night, featuring a book value of $4.75 per share, so at its closing price of $4.34 yesterday, ARR shares still traded at a 9% discount to book.
The overarching theme for 2014's bond market has been boredom. The 10-year U.S. Treasury note has done very little this year. It has actually been range bound -- primarily between 2.6% and 3.0% -- for the last six months.
Thus, the Fear of the Fed panic that we saw last May and through the summer is a distant memory. They are tapering, we all get that. In addition, the economic reports have shown their schizophrenic nature by fluctuating between "surprisingly good" and "really bad". This suggests to this bond market analyst that the Treasury market really has the economy pegged for 2014. In a word: "blah."
The lack of a material increase in the 10-year's yield is a clear indication that the bond market is far less ebullient than its equity cousin -- and I believe that is the correct outlook.
The pricing environment is favorable for the benchmark, and mortgage backed securities themselves have responded. The reference 30-Year FNMA 4.0% coupon security is now trading at just below 105 cents on the dollar. That is up from about 103 cents on the dollar at year-end and it is recovering most of the losses sustained from the disastrous Bernanke May 22, 2013 speech which ignited the "Taper Tantrum" in the bond market.
The other notable positive has been the huge decline in mortgage refinance applications. The party was over in the refi market as soon as Bernanke opened his mouth last May. But when valuing companies, the absolute numbers are important. According to the Mortgage Bankers Association data released Wednesday, refi applications declined 11 percent week-on-week. The MBA's refi index itself sits near a five-year low, and the refi window seems to have closed for this economic cycle.
This benefits ARR and its brethren as early mortgage payments are amortized against revenues, and have previously represented ARR's largest expense item. A look at ARR's February 11 company update shows an average CPR (Constant Prepayment Rate) for the month of 3.9%. This is the lowest figure the company has reported and continues the recent, sharp downtrend from typical CPRs for ARR in the low-double-digit percentages.
The pressure on the cost side is gone. With interest risk seemingly abating, I just don't see the risk in the mREIT sector, especially given the double-digit yields prevailing among mREIT companies.
That's a theme for 2014. I believe the mREITs will trade back to book value and shed the 10-25% discounts that they were first shackled with when fear of the Fed was the rage.
In addition to the $4.75 book value, ARR's earnings report indicated the company will continue to reduce the duration of its MBS portfolio. Net of portfolio repositioning, ARR's first quarter book value development should be a positive one, given the rebound in MBS pricing.
Also helping ARR's implied book value per share is a lower share count, as the company aggressively bought back shares in the fourth quarter.
That's the final feather in ARR's cap and a key theme for Portfolio Guru, LLC's Mad Money portfolio (of which ARR is a member): activist shareholders. In ARR's case the activism (by Phil Goldstein's aptly-named Bulldog Investors fund) was directed not at it, but at sister company JAVELIN Mortgage (JMI).
Javelin and ARR share their senior management team (co-CEOs Scott Ulm and Jeffery Zimmer) and corporate headquarters. Javelin's decision to begin an aggressive repurchase program (9% of shares to date,) including a large block from Bulldog itself, was clearly a shot across the bow for ARR. Bulldog dropped its proxy battle against Javelin in mid-December, but I believe the specter of similar action against Armour precipitated ARR's own share repurchase.
A little pressure is a positive thing, and in ARR's case I believe it will help narrow the gap between the share price and book value while keeping management's feet to the fire to increase book value. The 14% yield is just the icing on the cake!
