The key to diversification in Arlington Asset Investment Corps (AAIC) is preferred and baby bonds

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Arlington Asset Investment Corp. (New York Stock Exchange: AAIC) is a diversified real estate investment trust (REIT). Historically, the company has primarily invested in mortgage-backed securities. The company has two different preferred issues of stock and baby bonds (publicly traded debt with ticker symbol). The The company’s preferred stock currently yields close to 10%, while the baby bond holds a yield-to-maturity of just under 9% at favorable coupon rates. I currently “hold” blue chips and “buy” junior bonds.

A comparison of AAIC's high-yield securities

public database

source: Public Google Docs spreadsheet

Arlington’s balance sheet highlights the company’s increasingly diversified investment structure. Over the past year, the company has significantly increased its investment in securities. In addition, the company has invested and increased its investments in single-family residential real estate. Interest on credit securities and income from real estate rentals are two very different streams of income apart from the company’s primary objective of investing in mortgage securities.

AAIC's balance sheet

Third Quarter 2022 SEC 10-Q

In terms of profitability, Arlington doesn’t let rising interest rates hold it back. The company saw an increase of approximately 50% in interest income year-over-year in the nine months ended September 30. The tenth. And while interest expense doubled in proportion to the increase in income, the company managed to increase its net operating income by 12% to $14.8 million year-to-date. While compensation and benefits has absorbed positive variance, it’s impressive that Arlington has managed to hold out in a higher interest rate environment.

AAIC's income statement

Third Quarter 2022 SEC 10-Q

While operating cash flow is important to Arlington, and to many other organizations, the bulk of the company’s activity occurs in its investing activities. Arlington thrives on its ability to trade mortgage-backed securities, but the company also participated in the purchase of credit securities in 2022. By effectively managing investment cash flows in 2022, Arlington was able to reduce debt by paying off repurchase agreements, and paying off debt secured. The only net increase in debt came in the form of $17 million in single-family property purchases.

Al-Ahlia Operational Insurance and Cash Flow Investment Company

Third Quarter 2022 SEC 10-Q

AAIC financing cash flow

Third Quarter 2022 SEC 10-Q

While securities carry their own risks, Arlington does not invest in high-yield debt. According to the 10-Q, Arlington’s focus on credit securities includes a rating of AA or better corporate bonds. This asset class is currently yielding more than 5% and offers some measure of protection to the mortgage market, which is no doubt slowing as rates continue to rise.

AAIC Memorandum on Credit Securities

Third Quarter 2022 SEC 10-Q

One risk that investors should watch is the interest rate on the company’s repurchase agreement loans. While it rose from 0.25% to 3.27% in one year, Arlington managed to increase its net worth of secured investments less existing repurchase agreements. The full effects of the Fed’s rate hikes have not yet been realized, as rate increases occurred after the end of the quarter. If repurchase borrowing rates exceed interest rates on AA corporate bonds, Arlington’s credit securities investment strategy could be disrupted.

Summary of AAIC Repurchase Agreements

Third Quarter 2022 SEC 10-Q

While interest rates, specifically the spreads between loan origination and repurchase agreements are a definite risk to the company’s future earnings, there are a few other risks worth noting. One risk is the default on loans held by Arlington. If loan defaults rise, it will lead to a downward revision of the company’s asset value, while preserving the value of counterparty liabilities and reducing its overall capital position.

Another risk worth mentioning is the freezing of available financing either through a decrease in loan origination or the willingness of counterparties to lend in repurchase agreements. Under either case, a forbearance agreement may be required to maintain the company’s solvent, and preferred dividend payments will be suspended (this has been done by several peers in the industry during COVID). Overall, I think Arlington Asset Investment will weather the storm by diversifying its investments, into both hard and soft assets.

Editor’s note: This article covers one or more smaller cap stocks. Please be aware of the risks associated with these stocks.