Investors in mortgage REITs learned a valuable lesson in 2013: Do not only focus on the dividend yield when you need to decide about your income investments.
And investors in ARMOUR Residential REIT (NYSE:ARR) certainly learned that lessen the hard way as its book value per share and its share price fell off a cliff in 2013 in light of a more restrictive monetary policy of the Federal Reserve.
Mortgage REITs have been extremely attractive investments over the last five years when low interest rates and a collapse in the housing market fueled speculation in residential mortgage-backed securities.
Mortgage REITs take on pretty large amounts of debt and invest their short-term funds in long-term mortgage securities. This is a risky business model, which has worked well from 2008-2012, but it relies on favorable market conditions for leveraged investment strategies, namely low debt costs and the availability of leverage.
Mortgage REITs disappointed investors in 2013
Investors made a crucial mistake as 2013 come around: They solely bought mortgage REITs such as Armour Residential or Annaly Capital Management (NYSE:NLY) because they chased their double-digit dividend yields, but didn't factor in underlying book value declines as a result of increasing long-term interest rates.
Mortgage-backed securities are immensely complicated investment structures, but rising interest rates (implying higher interest rate volatility) will reduce the value of investment portfolios that are largely invested in mortgage-backed securities.
Though ARMOUR Residential's dividend yield, which has stayed at the upper end of the yield spectrum at 14% for a long time, was appealing to investors, the total return really does not look that great.
Even though investors may have benefited from a 14% dividend yield, this seems like a rather poor return considering that ARMOUR Residential's shares actually lost 38% in 2013.
Shares of Annaly Capital Management lost 29% of value, but the market seems generally more optimistic about the industry leader than ARMOUR Residential.
Book value discounts
As can be seen in the chart below, Annaly Capital Management consistently traded at lower discounts to book value compared to ARMOUR Residential over the last year.
Presently, ARMOUR Residential trades at a 17% discount to its first quarter 2014 book value per share of $5.23 whereas Annaly Capital Management trades at a 9% discount to its Q1 2014 book value per share of $12.30.
And the reasons for the apparently more negative attitude of investors with respect to ARMOUR Residential are quickly identified: High leverage ratios, ongoing book value declines and a less reliable dividend record all contribute to ARMOUR Residential's comparatively large discount to book value.
ARMOUR Residential has generally had high leverage ratios in the past. At the end of the first quarter of 2013, ARMOUR Residential reported a leverage ratio of approximately 9:1. Fast forward one year and ARMOUR Residential has brought down its leverage ratio a bit to around 8:1.
Though investors have seen a slight decrease in indebtedness, leverage ratios are still relatively high particularly considering that many mortgage REITs have largely de-risked their balance sheets in 2013.
Annaly Capital Management, for instance, reported a leverage ratio of 5.2:1 in the most recent quarter and a ratio of 6.6:1 in the first quarter of last year. In other words: Compared to ARMOUR Residential, Annaly Capital Management is significantly lower leveraged and also de-risked faster than ARMOUR Residential.
2. Doubts about the stability of ARMOUR Residential's book value
The second reason for the valuation discrepancy between these two mortgage REITs relates to their different book value developments. While Annaly Capital Management reported a slight sequential increase in its book value in the first quarter of 2014 to $12.30 per share, ARMOUR Residential reported another sequential decline in its book value per share from $5.32 to $5.23 in the most recent quarter.
Investors are highly skeptical of mortgage REITs, that have not yet stopped the bleeding of book value. Declining book values may foreshadow dividend cuts and investors don't hate anymore than cuts in their distributions.
The market still has doubts about ARMOUR Residential's book value stability. A return to sequential book value growth, however, could be a catalyst for ARMOUR Residential's stock.
3. Dividend record
Last but not least, dividend records play a large role in the different perception of the two mortgage REITs. Annaly Capital Management pays investors regularly since 1997 and is a industry-leader that carries some weight in the marketplace. Put differently: Its dividend record has much higher credibility than the one of ARMOUR Residential which pays investors only since 2010.
A reliable dividend record over a variety of business cycles carries a lot of value when investors question underlying book values and the future profitability of the companies involved in the sector.
Higher leverage ratios, ongoing book value declines and a shorter, less reliable dividend record are the reasons why investors correctly perceive ARMOUR Residential as riskier than its larger mortgage REIT rival Annaly Capital Management.
Both mortgage REITs still suffer from a loss of investor confidence due to a series of dividend cuts and book value declines in 2013. Annaly Capital Management, however, gets the benefit of the doubt whereas ARMOUR Residential will have no other choice but to prove itself in 2014.