Why Arlington Asset is misunderstood by investors

Arlington Asset Investments ((AI)) was the largest position in the Fifty Plus portfolio throughout 2013.The company is misunderstood, underfollowed and underpriced. People don’t understand the differences between it and your typical mortgage REIT.

First Arlington is a C corporation, so in taxable accounts its yield is taxed at the lower qualified tax rates, not higher mREIT marginal rates. Arlington chose to do this because it has a lot of tax loss carry-forwards from the financial crisis. Thus for someone in the 33% tax bracket, the 13.4% forward yield for AI is comparable to an mREIT paying 16%.

Second, Arlington is a C corporation so the yield doesn’t have to represent 90%+ of taxable income like other mREITs. The company’s payout ratio is lower and thus its dividend better protected. This also allows it greater flexibility to reinvest profits. Third, AI’s agency MBS is partially hedged so increases in interest rates didn’t hurt it too much.

Fourth, AI’s legacy non-agency assets are adjustable with short durations so increases in rates didn’t hurt them much either. Fifth those non-agency assets were held at a discount to par (currently held at 70% of par value).

As home prices improved, so too did the value of their discounted non-agency assets. Sixth, investors are starting to realize that the latest version of the Home Affordable Refinance Program (HARP) should be a net positive for Arlington. As people in their legacy MBS refinance, the 70¢ on the dollar should be counted as $1, in my opinion.

On the negative side, the Fifty Plus portfolio also had positions in American Capital Agency ((AGNC)) and Armour Residential REIT ((ARR)). Both stocks traded lower in 2013.

AGNC and ARR are better known real estate investment trusts which hold primarily agency mortgage backed securities guaranteed by Fannie Mae, Freddie Mac and other agencies. When the Chairman of the Federal Reserve, Ben Bernanke, first mentioned the Fed may start tapering its MBS and Treasury bond purchases in May, interest rates moved upward, causing the value of MBS to decline. Over the next few months these two companies dropped over 30% in value.

The Fifty Plus portfolio did not hold AGNC or ARR during this time. Where I went wrong is in buying them after their primary fall (AGNC in August and ARR in October) reasoning they were cheap and were in the process of stabilization As a matter of fact I wrote an article to that effect at the time.

Going forward, I continue to find the mREIT sector attractive and would probably have held the existing positions in AGNC and ARR despite losses. However, I decided to sell in December in order to harvest tax losses for the portfolio.

DISCLAIMER: The investments discussed are held in client accounts as of December 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.

The post Why Arlington Asset is misunderstood by investors appeared first on Smarter InvestingCovestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures.