Luis Alvarez
Arlington Asset Investment Corp. 8.250 CUM PFD C (NYSE:AAIC.PC) has been in operation for almost 40 months and has generated an average yield of 7.9 percent. Being a preferred shares series, it gets a priority over common equities w.r.t. dividend payment. The total annual preferred dividend pay-out is less than $3 million. However, the company has failed to generate that much income over the last 3 years. As a result, Arlington Asset Investment Corp (AAIC) did not pay any dividend to its equity shareholders. This mortgage based Real Estate Investment Trust (mREIT) is adopting various strategies to generate strong earnings. However, this will take time, and how the strategies will unfold during a period of economic uncertainties, creates further doubt in the mind of potential investors.
Arlington Asset Investment Corp. and its Shareholders
Arlington Asset Investment Corp. holds leveraged mortgage backed securities (MBS) focusing on Agency MBS. Agency MBS consists of residential mortgage pass-through certificates that are guaranteed by the U.S. government agency and government-sponsored enterprises. Thus the principal and interest payments are almost certain. In addition it also deals on private-label MBS, mortgage servicing right related assets, credit investments, single-family residential (SFR) properties and net long to-be-announced (TBA) positions. The seller and buyer in a TBA position decides to select the exact securities that will be transferred just before the delivery takes place, rather than during the time of the original trade.
AAIC currently has two series of preferred stocks. While AAIC.PC is fixed-to-floating cumulative redeemable preferred stock, the Arlington Asset Investment Corp. PFD SER B (AAIC.PB) is cumulative perpetual redeemable preferred stock. AAIC.PB has a dividend rate of 7 percent as against 8.25 percent of AAIC.PC. However, AAIC.PB has generated a higher yield. AAIC.PB’s four year average yield stands at 8.75 percent as against 7.89 percent of AAIC.PC. This is due to AAIC.PB’s lower average market price over the past four years. This way, the market price of AAIC.PC is less volatile.
With regards to the common equity shares, the management has gone for a share buyback program in 2020 in order to reduce the number of outstanding shares. The company failed to offer dividends to equity shareholders since then, and probably will fail to do so this year too. Since reinstituting its current common stock repurchase program in 2020, the company has repurchased 25% of its outstanding shares and the company has a substantial remaining authorization from its board to buy back 10.7 million shares. It seems that the company has sensed quite well that its poor financial performance will continue further, and a buy-back may limit the pressure of generating sufficient earnings on AAIC’s management.
Financial Performance During Q2, 2022
AAIC’s management is expecting strong performance from its portfolio of MSRs, single family rentals, and opportunistic credit investments, as these assets perform well in the volatile markets. Considerable appreciation in AAIC’s MSR investments has contributed positively and has now become the company’s largest allocation at 41 percent. With only 3.1 percent weighted average coupon in the underlying MSRs, the company’s mortgage servicing right investments are well-equipped to mitigate the impact of changes in interest rates.
This mREIT has made significant progress in acquisition and lease generation of its SFR properties. AAIC has successfully achieved its goal of acquiring 200 million homes with an investment budget of $55 million. The company has entered into an agreement to generate a capital of $131.9 million through selling of 376 single family rental properties. In the words of Rock Tonkel, the President and Chief Executive Officer of AAIC,
This opportunistic sale would capture a strong bulk premium for a portfolio of leased homes we constructed from individual purchases with strong rental yields in attractive markets.
According to him, the company’s credit investment strategy is delivering results as widening of credit spreads made scope for some new investment opportunities in high quality assets. In Q2, 2022, AAIC made various investments in floating rate senior securities with unlevered spreads between 2.5 percent to 3 percent over Secured Overnight Financing Rate (SOFR). These investments were made on AAA rated securities with maturities less than five years, that are secured by the commercial real estate properties. Going forward, the management expects these investments to deliver double-digit levered returns.
However, Agency MBS, historically AAIC’s major source of revenue, doesn’t offer much optimism, and the company is not interested in substantially increasing its capital allocation to agency MBS. Rather, it will allocate more funds to the SFR portfolio. As per the company’s assessment, based on current conditions, the potential risk to capital remained excessively high. Overall, during Q2, 2022, the company reported a generally accepted accounting principles (GAAP) net loss of $0.01 per share and operating income of $0.05 per share. The earning figures remained unchanged from that of Q1, 2022.
Investment Thesis
AAIC is slowly shifting its focus towards MSR investments and SFR portfolio from its highest revenue generating segment of Agency MBS. However, this will take time, and how the SFR process will unfold during this period of high inflation and looming recession, is also very doubtful. Moreover, the company intends to utilize the earnings from SFR portfolio to buy-back more equity shares. The company has pushed its agency MBS portfolio on the backburner, and that doesn’t bode well for this mREIT in the medium term. The only silver lining remains a low weighted average coupon in its MSR investments.
Arlington Asset Investment Corp. 8.250 CUM PFD C has so far been successful in generating a high yield. But the yield has been paid out of capital. For the past 3 years, AAIC failed to generate sufficient income to cover any kind of dividend, and it did not pay any dividend to its equity shareholders. No doubt that the market conditions were challenging, but AAIC’s inability to meet the expectations of its investors raises a doubt over the sustainability of preferred dividends, too. Thus, taking a cautious approach, I’d prefer not to buy the C series of preferred shares of Arlington Asset Investment Corp.
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