Armour Residential: Retired Before Prepayment Risk Emerges (Downgrade) (NYSE:ARR)

Last time we covered ARMOR Residential REIT, Inc. (NYSE:ARR) A year ago, it claimed it would benefit from favorable spreads and lower prepayment rates. While the mortgage REIT (mREIT) delivered solid dividends last year, its price performance was subpar.

Given Armour's year-over-year performance and our previous rating, I decided to update our thesis. Additionally, a changing mortgage rate environment and changes in Armour Residential's fundamental attributes have emerged, providing further discussion points.

Without further ado, here is my final take on Armour Residential REIT.

Recent performance

In the introduction I reported on the fund's year-over-year performance. However, the following chart provides a time series observation that illustrates Armour Residential's year-to-date performance.

The REIT's strong performance so far this year was likely due to record-high mortgage rates and improved economic profitability. However, I note that Armour Residential surpassed its normalization July earnings per share estimates (up eleven cents), but has not gained market value since then. So the question is: do investors think Armour Residential is overvalued?

Let us move on to a fundamental analysis to address the central question.

Key talking points

Systematic analysis

The mortgage rate environment is a growing concern for Armour Residential's asset base.

According to the St. Louis Federal Reserve, 30-year fixed-rate mortgage rates have declined by about 85 basis points year over year amid They talk about a pivot in the interest rate in the United States. In addition, the The US yield curve suggests Lower implied interest rates are on the horizon, raising the possibility of further declines in mortgage rates.

Let's expand on what was mentioned above to explain why lower mortgage rates could be bad for Armour Residential.

Lower mortgage rates can lead to refinances, lower variable rates, and more compressed entry-level deals. So we have what's called “negative duration,” which is a fancy word for a positive relationship between mortgage valuations and mortgage rates. Also, the interest components of mortgages may be less lucrative than in a high-rate environment.

Approximately 84.9% of Armour Residential’s portfolio is agency fixed rate assets. So, in isolation, the interest component of the portfolio is largely collateralized at high rates and insured by federal agencies. Sounds perfect, right? Not quite; an explanation for this is provided below the diagram below.

While much of the mREIT portfolio is fixed rate and insured, prepayment risk remains. Armour Residential’s current conditional prepayment rate (“CPR”) is below 10%, likely due to elevated mortgage rates. However, like interest rates, CPR can be a cyclical metric.

Below is an illustration of the CPR, showing prepayments below 10%.

He The following chart looks back to 2021. when the target federal funds rate was approximately 5.25% Lower than todayNote how Armour Residential's prepayments were above 10% during that stage. I think prevailing sentiment and bond yields suggest that lower interest rates are imminent, which could inflate Armour Residential's annual interest rate to around 10%.

Higher prepayment risk can deflate Armour Residential’s portfolio. However, other components need to be considered. Therefore, I conducted a deeper analysis of Armour Residential. Let’s move on to the next section!

Portfolio Hedging/Liability Level

Armour Residential uses a reverse repurchase methodology. The strategy involves shorting one set of securities to finance the acquisition of others. As far as I know, Armour typically shorts 10-year Treasury bonds and interest rate swaps for a few months and then rolls over the short position to maintain its exposure to longer-dated mortgages.

I think short swap positions are a smart strategy, as they could allow Armour to lock in profits when interest rates fall (if Armour goes short with floating payouts, it will receive fixed swaps). However, I foresee problems with using Treasury bonds, as lower bond yields could boost Treasury bond prices, while simultaneously increasing repo rates.

Aside: Repurchase rates are calculated as (buyback price/sale price) – 1

At its core, potential losses on repurchase agreements are a risk. However, I see potential in the vehicle's swap strategy, which may lead to a lower financing cost base. Nonetheless, I still expect lower net interest income and asset valuations to follow; let's examine Armour Residential's latest earnings report and valuation multiples to see why.

Latest results

Armour Residential released its second quarter earnings report in July, which revealed earnings per share of $1.08, beating estimates by eleven cents. In addition, the vehicle achieved an economic net interest spread of 2.05% and a book value per common share of $20.30, suggesting a positive quarter overall.

I believe Armour's results reflect a cyclical peak. As I mentioned earlier, I expect lower asset-level revenues and book values. While I foresee financing opportunities through swap sales, I think it will be difficult to cope with a rapid decline in mortgage rates.

In addition, Armour suffered losses on mortgage-backed securities during the second quarter, which depressed the fund's accounting income. I expect this trend to resume amid the negative duration effect on mortgages (discussed in the previous section).

Armour's earnings were stronger than in the first quarter. However, as mentioned, its sustainability is questionable as lower mortgage rates and a challenging repo rate environment could take over.

Valuation Metrics and Dividends

Price returns

I used an intraday price from September 3 and Armour Residential's second quarter book value to calculate its common stock price-to-book ratio. The variables gave me a ratio of 1x, implying that the asset is priced in.

Furthermore, I reiterate that I expect lower net interest income and compressed book value, so I do not see a value opportunity here.

The chart below illustrates Armour Residential’s market performance compared to some of its peers, including Dynex Capital (DX), Orchard Island Capital (ORC), and Ellington Financial (EFC). While the disparity in market performance compared to its peers is evident, I don’t see enough to justify a pair trade.

Dividends

A stand-alone, peer-based look at Armour Residential's dividend conveys that it is a solid income-producing investment. However, as seen over the past year and throughout its trading history, Armour Residential's lackluster price performance has canceled out the benefits of its dividend distributions. Furthermore, the mREIT has a negative dividend growth rate over the cycle, which concerns me, especially given the mREIT's fundamental headwinds.

Final thoughts

I am wary of Armour Residential because lower mortgage rates are likely to introduce prepayment risk and weigh on the value of the REIT's assets. While Armour can reduce its funding base by selling fixed-rate swaps, I think its asset base is a primary concern.

Furthermore, I see little in Armour Residential's valuation. Sure, it has an attractive dividend yield. However, remember that the mREIT has lost over 90% of its market value since its inception.

I fear that Armour Residential may incur losses in the next twelve months, so I have decided to lower my forecast.