I've written about the mortgage real estate investment trusts -- or mREITs -- in this space, and about the positive impact of lower prepayment speeds caused by the massive drop in mortgage refinancing, coincident with the rise in long-term interest rates.
A recent monthly portfolio update from Armour Residential REIT (ARR), a name I have mentioned, shows this decline quite dramatically. As the chart shows, Armour's "mortality rate," essentially the prepayment speed of its portfolio, has declined dramatically in the past few months. At 6.9%, the constant prepayment rate is at a cycle low for Armour, and the components of the CPR are telling: the 25- and 30-year prepayment speeds are much lower than the corporate average, and Armour's strategy of "going long" with its exposure has indeed worked.
The upside is that Armour's largest cost item, cost of prepayments (prepayments are amortized as they occur), is declining materially. So, by my modeling, Armour can maintain its dividend at $0.07 for the fourth quarter. I expect Armour to announce its fourth-quarter dividend in the next few days -- it pays dividends prospectively, on the basis of estimates of the next quarter's profitability -- and we'll see if management's forecasting matches up with mine.
But much like the Federal Reserve's dual mandate to maintain employment and price stability, Armour's management has a dual mandate to maximize the dividend while preserving book value. On several occasions the company has emphasized to me that its main job is to focus on preserving book value. Its record on this has been less than stellar, and there is a third factor in play: the day-to-day liquidity that Armour is required to maintain to satisfy its creditors.
The company has sold $5.65 billion of mortgage securities since June 30 and raised the percentage of its portfolio that is hedged to 82%, from 45% at this time last year. This is really about liquidity preservation more than book-value preservation, but clearly its leverage -- 6.7x June 30, 2013, book value -- while much lower than historical levels, is still an area of focus. Yet that concern has not resulted in a material increase in the amount of collateral "haircut" that Armour has been required to maintain, nor has it affected its cost of repo funds, which still sits at 0.40%
So Armour has battened down the hatches, and its focus on liquidity means that it now has $1.15 billion in cash to back up its $16.1 billion in mortgage-backed securities holdings. Put another way, Armour now has $3.10 per share in cash on its balance sheet, and its current stock price is $4.08. I have never believed in the dollar-for-dollar cash valuation technique (sorry, Apple (AAPL) shareholders), even when it's a net cash position, which Armour's will never be. Also, as we move into 2014, it will be more difficult for Armour to maintain that $0.07 dividend rate, given the lower gross asset size.
I continue to believe the best way to play Armour is through its Preferred Series A shares, which are yielding 9.2% at current levels. The common stock is going to move on the basis of real-time market perception of Armour's book value (which I believe is near $5, but clearly a "fear of the Fed" discount is being applied to all the stocks in the mREIT sector), but the preferred really should trade on creditworthiness, and the strengthening of Armour's balance sheet in terms of cash ratios is a plus there.
As for the common stock, the market needs clarity on if and when Armour's portfolio pruning will end, and until management starts buying its own shares (either through a stock buyback or through personal purchases), it's hard to recommend that my clients buy it themselves. So we're still writing call options against existing positions and getting paid to wait via the options premiums and the monthly dividend payments.