It is frequently noted that the stock market is a discounting mechanism, and a look at Armour Residential REIT's (ARR) share price shows that the market began discounting quickly after a signature event: Federal Reserve Chairman Bernanke's disastrous May 21 press conference in which he let the "T-word" (tapering) enter into the market's vocabulary.
So, Armour and its mortgage REIT brethren were slaughtered as the market began pricing in:
- A tapering of the Fed's QE3 ($40 billion per month in agency mortgage-backed securities, the securities Armour holds) and QE4 ($45 billion per month in Treasuries) asset purchase programs.
- Which would produce much higher interest rates.
- Which would force mREITs to shrink asset bases and cut dividends.
- The market was largely ignoring the fact that higher interest rates would lead to much reduced mortgage refinance activity.
OK, so what happened.
- There has been no taper. Government shutdown? From Oct. 1 through the Oct. 10 the New York Fed bought $22.7 billion in agency MBS. You may not have been able to visit the Grand Canyon, but the Maiden Lane boys were hard at work.
- The 10-year Treasury rates rose from about 2% when Bernanke spoke to 3%, but have now fallen back to 2.61% as of this writing. The economy is simply not strong enough to support 10-year Treasury rates above 3%. Also, we are entering a period of probably 45 days where every economic data point is somehow going to reference "the shutdown." So, not only will the data remain weak, but the credibility will be low, as well.
- Mortgage REITS have cut dividends: Armour cut its fourth quarter (the company pays dividends prospectively) monthly dividend to five cents from seven cents, American Capital Agency's (AGNC) third quarter dividend (paid Oct. 28) is 80 cents vs. the $1.25 dividend paid in April and Annaly Capital Management (NLY) cut its third quarter dividend (payable Oct. 31) to 35 cents a share from April's rate of 45 cents a share.
- Mortgage refinancing ground to a halt in the summer and refi activity remains at levels not seen since the advent of quantitative easing.
So, as I have mentioned countless times, the most important factor in investing is the second derivative. And that point has been reached, certainly for Armour. To wit:
- Armour's balance sheet has grown in the past month. The company's October monthly update shows a total asset base of $16.5 billion versus September's $16.1 billion. Still quite far from the peak of $23.7 billion in May, but clearly Armour's panic selling has stopped.
- Armour's average prices of owned securities have risen and the average coupon has started to rise after a steady decline for two years. Armour's weighted average market price was 101.4% in October vs. 99.7% in September. Reassuring to see things back above par, even if still well below the 105.1% average cost basis.
- Armour has hedged virtually all its interest rate risk. In the last month Armour purchased interest rate swaptions with a notional value of $5 billion. So, Armour has the right, but not the obligation to enter into a 60-month interest rate swap with counterparties. Adding the notional value of Armour's swaptions to their existing swaps ($11.15 billion), and Armour has almost $16.2 billion of notional value of hedges versus an asset value of $16.5 billion.
- Prepayments are below anyone's estimations, certainly mine, anyway. Amortization of prepayments is Armour's largest cost, and with a cycle-low mortality rate of 4.9% in October, Armour's margins -- and the dividend -- are supported.
So, what does it all mean:
- I believe we have reached the bottom for Armour's dividend. This management team has continually disappointed The Street with its lack of value creation and it takes some intestinal fortitude for me to put that in print. The numbers don't lie, however, and my model shows five cents is easily attainable going forward, and actually low assuming a stable asset base and sluggish prepayments. So, I believe the next move will be higher, although I believe management will postpone that as long as possible.
- Armour's interest rate risk has been greatly diminished, therefore Armour's creditworthiness has increased -- which is not being reflected in the price of their preferred shares. ARR-A is currently trading at nearly a 10% discount to face value and yielding 9.1%.
So, Armour's Preferred Series A is still the best way to play a company that solely owns assets guaranteed by the U.S. government (via Fannie, Freddie and Ginnie.) But, as I mentioned in my column on July 8, Armour common could offer a deep-value, high-yielding (even at current dividend levels) long-term play. Since that date Armour's share price has actually risen four cents, recovering from its late August swoon. Not a princely sum, but add in the 26 cents in dividends an investor would have earned in those four months, and the total return is at least in the high single-digits.
We own Armour Residential preferreds in Portfolio Guru client accounts, and the common is truly tempting here. But we are seeing so much value (and capital appreciation) in our oil patch names that we just can't sell them to buy Armour Residential. But, after one crazy summer, Armour is back on the radar screen, and that is a second derivative event in and of itself.