1 Reason To Buy Javelin Mortgage Instead of ARMOUR Residential REIT


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ARMOUR Residential REIT  and JAVELIN Mortgage both sport a massive 13% plus dividend yield -- which is high even for mortgage REITs. However, that's not the only thing the two companies have in common.

Both are externally managed by ARMOUR Residential Management (ARRM), meaning they share executives, six of their seven board members, and use very similar investing strategies. 


There is one big difference between the two companies, however. ARMOUR buys exclusively "agency" residential mortgage-backed securities, while JAVELIN has roughly an 80/20 mix of agency and non-agency securities. While the difference may not seem substantial, it makes an enormous difference, and it's the reasons investors should favor JAVELIN over ARMOUR. 

Agency vs. Non-agency
There are three big differences between agency and non-agency securities.

First, agency securities are packaged by GSEs (government sponsored entities) like Fannie Mae, Freddie Mac, and Ginnie Mae. Because of this, the bonds come with a guarantee against default. This means, baring a government meltdown, they are about as safe an investment as there is. Non-agency securities, on the other hand, are packaged by private entities which do not stamp a guarantee on the bonds.

The second difference is the type of loans underlying the securities. GSEs have very strict guidelines for the type of loans they'll buy, this includes: stronger credit quality, full documentation, are within a certain total value, among other criteria. Non-agency securities run the gambit of everything else.

Finally, since non-agency securities come with a little (or a lot depending on what's purchased) more risk, investors are compensated with greater yields. This is the big one, because JAVELIN is willing to utilize better opportunities it can improve the companies "spread" and, ultimately, profitability.

The spread
The "spread," or net interest rate margin, is difference between what it costs to borrow and the yield on interest earning assets. Because this has a direct impact on earnings, it is the quintessential mREIT metric.

Net Interest Rate Margin -- First Quarter 2014
CompanyAverage asset yieldAverage Cost of FundsNet Interest Margin
ARMOUR Residential 3.2% 1.4% 1.8%
JAVELIN Mortgage 3.7% 1.7% 2%

As shown in the chart above, since JAVELIN extends its investments into non-agencies it can capture more yield than the more plain-vanilla ARMOUR.

ARMOUR, however, has the lower cost of funds. This has to do with the type of borrowing the companies use. It's called a repurchase agreement and it works similar to collateral loans. Since ARMOUR's securities (which it uses as collateral) are all agency securities, they are deemed safer and stronger collateral. Thus, it costs the company less to borrow.

Ultimately, it comes down to spread. Despite JAVELIN's higher funding costs, its greater yields make up the difference. And while 0.2% may not seem like much of an advantage, it gets magnified when using leverage. 

Risk, but not too much
mREITs use leverage (total debt divided by shareholder's equity) to amplify returns. The more a company borrows against its equity the more it will magnify returns and losses - therefore, the greater both the risk and reward.

In general, companies that buy exclusively agency securities, like ARMOUR, are more likely to have higher leverage ratios because they take less risk with their investments.

However, that isn't the case here. ARMOUR and JAVELIN have debt-to-equity ratios of 8.5 and 9.9, respectively. 

JAVELIN is able to do this because it's actually isn't taking that much risk. Yes, 20% of its portfolio isn't covered against defaults, however, not all non-agency securities have a high risk of default. In fact, "prime" and "Alt-A" securities (JAVELIN's major non-agency assets) are pools of strong to fairly strong credit quality borrowers -- but, since the loans are very large, or borrows don't meet the GSEs guidelines perfectly, they fall to non-agencies. 

This gives JAVELIN the best of both worlds. They can still implement large amount of leverage, while capturing better yields.

Looking forward
Since 2009, unemployment has improved substantially, and according to a Bloomberg article mortgage delinquencies are the lowest they've been since 2007. Both are great signs of an improving economy.

Ultimately, JAVELIN's investments are only more risky if we see a spike in default rates. While that's certainly possible, I don't find it particularly probable. Therefore, I think the opportunity to create stronger returns is significantly better among the mREITs with some exposure to non-agencies. Which is one reason I'm favoring JAVELIN over ARMOUR.

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The article 1 Reason To Buy Javelin Mortgage Instead of ARMOUR Residential REIT originally appeared on Fool.com.

Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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