ARMOUR Residential REIT [ARR] Conference call transcript for 2023 q2
2023-07-27 10:35:02
Fiscal: 2023 q2
Operator: Good morning, and welcome to ARMOUR Residential REIT's Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.
James Mountain: Thank you, Drew, and thank you to all of you for joining us on our call this morning to discuss ARMOUR's second quarter 2023 results. With me today are ARMOUR's Co-CEOs, Scott Ulm and Jeff Zimmer; and our CIO, Mark Gruber. By now everyone has access to ARMOUR's earnings release, which can be found on ARMOUR's website, www.armourreit.com. This conference call includes forward-looking statements, which are intended to be subject to the Safe Harbor protection provided by the Private Securities Litigation Reform Act of 1995. The Risk Factors section of ARMOUR's periodic reports filed with the Securities and Exchange Commission described certain factors beyond ARMOUR's control that could cause actual results to differ materially from those expressed in or implied by these forward-looking statements. Those periodic filings can be found on the SEC's website at www.sec.gov. All of today's forward-looking statements are subject to change without notice. We disclaim any obligation to update them unless required by law. Also, today's discussion refers to certain non-GAAP measures. These measures are reconciled with comparable GAAP measures in our earnings release. An online replay of this conference call will be available on ARMOUR's website shortly and it will continue for one year. ARMOUR's Q2 earnings available to common shareholders was $40 million, which includes $43 million of GAAP net income. We sold the last of our legacy available for sale mortgage-backed securities in Q1. Going forward, there will be no mark-to-market items excluded from GAAP net income. We will continue to report total comprehensive income for comparable prior periods as long as they remain relevant. Net interest income was $5.8 million. Distributable earnings available to common stockholders was $45.4 million or $0.23 per common share. This non-GAAP measure is defined as net interest income plus TBA Drop Income adjusted for the net coupon effective interest rate swaps, less net operating expenses. Our asset yield of 4.24% less net cost of funds of 2.49%, gave us net interest margin of 1.75% for the quarter. ARMOUR Capital Management continues to waive a portion of their management fees. They waived $1.65 million for Q2, which offset operating expenses. This waiver will continue until further notice. ARMOUR paid monthly common stock dividends of $0.08 per common share. That's total of $0.24 per common share for the quarter. We have maintained the $0.08 per share common dividend rate for July and August. As we've discussed on our previous call, our aim is to pay an attractive dividend that is appropriate in context and stable over the medium-term. Taken together with the contractual dividends on preferred stock, ARMOUR has made cumulative distribution to stockholders of $2.1 billion over its history. During the second quarter, we issued 15,160,000 shares under our common stock ATM program, raising $77.5 million of capital after fees and expenses. During the second quarter, we also repurchased 425,000 shares of common stock at an average cost of $4.88 per share, that was under our existing standing repurchase authorization. For the first half of the year, our capital activities have been accretive to book value per common share and reducing per share running costs. So far in Q3, we've issued another 21,499,175 common shares, raising net capital of $109.3 million. That completes our current ATM program. This brings our common share count to 228,309,234 common shares. Recently, we've approved a new ATM program, offering up to 75 million shares through our affiliate, BUCKLER, and four other agents. Quarter-end book value was $5.38 per common share. Our most recent available book value estimate as of Monday night, July 24 was estimated to be $5.25 per common share. Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm. Scott, if you'd like to discuss in more detail our portfolio position and current strategy, please go ahead.
Scott Ulm: Thanks, Jim. Market conditions in the second quarter continue to support our thesis that we are entering into a compelling period for investment in Agency MBS. Spreads remain near historic highs, funding and hedging are widely available. With the Fed nearing the end of its hiking cycle, we believe MBS will offer significant returns through carry, spread tightening, or both. Throughout this hiking cycle, U.S. treasuries have had a persistent trend of extreme fluctuations, the two-year treasury yield surged by 112 basis points from its low 3.78% for the quarter. Simultaneously, the 10-year treasury yield experienced a gain of over 50 basis points, reaching a quarter high of 3.84%. Notably, the spread between these two tenors also made history, closing the week below a negative 100 basis points for the first time since 1981. In response, the portfolio team rebalanced the hedge book to favor a steeper yield curve environment, which we expect will begin later this year. In early May, ARMOUR sold $1.8 billion of the lowest premium specified pools as the looming fight over the debt ceiling greatly increased the likelihood of more volatility in the market. ARMOUR decreased its net portfolio leverage and duration from 8.9x and 1.15x, respectively, down to 6.8x and 0.87x to address this increase of risk. Production coupon MBS underperformed significantly into this event, which presented a good opportunity to buyback exposure to 5.5% and 6% pools shortly after the debt ceiling resolution occurred. The other widely anticipated event was the liquidation of the FDIC portfolio. Net sales of agency mortgage passes have now surpassed 75% in what has been a remarkably orderly fair. The fear of a major market disruption has faded with demand stronger than initially thought and we do not expect the remaining liquidation of the FDIC's MBS portfolio to have a material impact on valuations. Despite this, we view the relevant valuation of FDIC coupons as too rich versus the opportunities of the coupon stack, where we own over 60% of our mortgage assets. We are maintaining our short position of negative $500 million Fannie 33% TBAs and have reallocated capital towards Agency CMBS DUS 10/9.5 pools. These DUS pools are trading at over 100 basis points wide [indiscernible] swaps, which is almost double the [indiscernible] of lower coupon pools. Coupled this with favorable financing like pools, ARMOUR likes this trade from a total return perspective. Although spreads may remain at these valuations for a while, we see long-term value to positive convexity DUS bonds. Additionally, we've recently allocated over $1.3 billion of recently issued capital in 5% and 5.5% Ginnie Mae pools. There is 0% risk weighting and wider spreads favor domestic and foreign bank demand in the second half of the year. We feel that the newly proposed banking regulation should provide a greater boost to the Ginnie Mae MBS sector longer-term. Our leverage closed the quarter at 7.6x and currently sits at 7.8x as of 20th of July. A number that reflects attractive valuations is prudent enough to withstand still elevated and highly unpredictable levels of daily market volatility. Additionally, ARMOUR maintains healthy levels of available liquidity at $714 million, which includes cash, unlevered securities and principal and interest receivables as of the 20th of July. Our current portfolio is concentrated in the most liquid, low premium production coupon pools featuring more favorable demographics, LTVs, FICO scores and loan balance characteristics versus generic production cohorts. We continue to favor specified pools over TBAs as we expect no improvement in the deliverable collateral and the implied funding of dollar rolls lag current repo rates. These lower pay up premiums specified stories should perform strongly as demand for Agency MBS remains. Despite seasonals driving up CPRs margin, these investments reflect historically low prepayment risks and still a significant amount of borrowers are out of the money. ARMOUR's average prepayment rate for all MBS assets in the second quarter of 2023 was 6.3 CPR and still a very low 6 CPR for July. Although mortgage rates have already declined from the highs of 7.2% in early November of 2022 to 6.8% in mid-July 2023, a substantial refinancing wave would require mortgage rates to fall below 5% in our view. ARMOUR continues to fund just over 50% of its borrowings to our broker dealer affiliate, BUCKLER Securities. Since the debt ceiling resolution, the rebuilding of the Treasury General Account has been orderly and Agency MBS repo funding has been stable. The weighted average haircut on our repo book remained exceptionally low at 2.7% as of the 18th of July. As we've already noted, we set our dividend to be appropriate for the medium-term. We will, as always, continue to evaluate the level of the dividend. We are also mindful that this environment can deliver upside prices, surprises that they can move our metrics substantially. Thank you very much. And with that, we will open for questions.
Operator: We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Trevor Cranston with JMP Securities. Please go ahead.
Trevor Cranston: Hey, thanks. It looks like you guys – you mentioned that you added to the portfolio post debt ceiling in June and it looks like you've continued to add to it to some extent in July. Can you talk about how you guys are approaching leverage overall right now and kind of how high you're willing to go and leverage given the seemingly favorable backdrop for MBS? Thanks.
Mark Gruber: Hi, Trevor, it's Mark. So we view leverage here as appropriate in that there's still some volatility out there with both rates and spreads. So we feel comfortable where we’re at. We think it's appropriate. We do like mortgages a lot, but we do have some dry powder if we think that volatility is going to subside here and rates are basically topped out.
Trevor Cranston: Okay. And can you talk about how you guys are thinking about sort of the supply demand picture over the rest of the year? And if you think there's any potential catalysts for spread tightening out there, particularly after the FDIC portfolios have cleared the market?
Jeffrey Zimmer: So this is Jeffrey, good morning. In Scott's comments, he mentioned specifically our increased exposure to the Ginnie Mae sector. So everyone knows mortgages on a historic basis are achieved the treasuries. There are investors in all sorts of asset classes that are going to be looking at this – are looking at this and they're going to say, wow, mortgages are really good alternative to corporates or some other assets that they may have, particularly in an environment where you may experience some credit deterioration down the road. Now the reason we increased our exposure to Ginnie's is because the banking rules may positively affect banks’ ability to purchase there, but they won't be the only ones. Ginnie's are particularly cheap right now to historically to their Fannie Mae and Freddie Mac counterparty. So catalysts come from buyers from other asset classes, catalyst for Ginnie specifically come from banks and other buyers [indiscernible]. We have our coupon stack is such that we are not one on one affected negatively by the liquidations from the FDIC. And Mark said earlier, I think Scott comment, too, we still maintain a short position in one of the coupons that they'll be selling. So we're very comfortable where we are and we have a optimistic outlook on spreads for the rest of the year.
Trevor Cranston: Got it. Okay. Appreciate the comments. Thank you.
Jeffrey Zimmer: Thank you.
Operator: The next question comes from Matthew Erdner with JonesTrading. Please go ahead.
Matthew Erdner: Hey, good morning, guys. Thanks for taking the question. You mentioned getting into CMBS, the DUS pools. What kind of other opportunistic opportunities are you seeing there? And how large are you willing to increase that CMBS position as a percentage of the portfolio?
James Mountain: So as of this morning, I believe we have $551 million of DUS, which represents 4.5% of the portfolio. We are targeting a number that's larger than that. I think that generally spreads got as wide as 111, 112 to the peak curve. They're 105 today. We've made purchases as low as the 100 kind of area. So we are still selectively looking to buy. Could we take it to 10%? We feasibly could. If they come in quickly, we will stop buying. So we are opportunistically looking to add to the sector. We're going to be very happy down the road that we have that added convexity at really good spreads. Mark, do you want to expand on that?
Mark Gruber: Yes. And just if you look at our history, our DUS position has been, I think, a little north of 20% of the portfolio pre-COVID. We just have to balance the fact that there is no liquid TBA market for DUS. So there is some spread risk there that's a little more magnified than agency pools. So we're just balancing that versus where the spreads are today.
Matthew Erdner: That's helpful. Thank you.
Operator: The next question comes from Christopher Nolan with Ladenburg Thalmann. Please go ahead.
Christopher Nolan: Hey, guys. A follow-up to that question on the CMBS. Are you guys sort of warming up to go back into CRT types securities as the commercial real estate market develops?
James Mountain: We are warming up to continue our exposure to DUS and we are not warming up to increase our exposure to CRTs.
Christopher Nolan: And on the commercial real estate front, if that turns into a large issue for the commercial banking sector, how do you anticipate that could impact on residential mortgage-backed securities?
James Mountain: When the tide goes up and the tide goes down, all ships move up and down in the harbor, okay? And that's why Mark commented to the fact that there could be – there is spread risk in the DUS sector that maybe different than there are on Fannie 5.5 pass-throughs. We're cognizant of that and that's why although we intend to potentially increase our exposure to 10% or more of the portfolio highly unlikely that we'd be up at 20% again like we were in the spring of 2020, in the winter of 2019. Mark?
Mark Gruber: I think the other mechanism is going to be through regulation. As Scott commented about why we purchased some Ginnie’s. The banks get in trouble because of personal real estate, they're going to focus on the assets that have 100% backing that are very liquid and that's going to be the Ginnie Mae's.
Christopher Nolan: Great. And then I guess the last question, there was a comment, steeper yield curve later in the year. Would that be for a more inverted yield curve?
James Mountain: No. The other way around. As the Fed gets to the end of their hiking cycle, we would expect as a steeper curve as the short end should start to come down.
Christopher Nolan: Okay. Thank you.
Operator: The next question comes from Matthew Howlett with B. Riley. Please go ahead.
Matthew Howlett: Good morning and thanks for taking my question. Just on the margin outlook, I mean, you have the portfolio still very well hedged, the swap roll offs, they're really throwing out much of it left into 2023. Do you think the margin as you add duration could – the higher coupons improve here? And what's the outlooks for the rest of the year?
James Mountain: So, is your question more about where do we think spreads and higher coupons are going to go?
Matthew Howlett: What's sort of the 175 net interest margin we're looking at sort of adjusted income? Really the core earnings power of the company. Obviously, repos going up and it's going to continue repricing, but you have the hedges in place and then the coupons are rising. Sort of we modeled that margin, that adjusted margin, any sort of guidance on where that could go towards the end of the year?
Scott Ulm: Right. So as I just stated, a steeper curve is going to help us on earnings power because we can always take off hedges and beforehand or reposition the portfolio and the hedges. But a steeper curve is where we want to be. We want to borrow short and lend long.
Jeffrey Zimmer: And our modeling shows that if the Fed does increase 25 basis points in September. By the way, the work pays on Bloomberg only says there's a 19% chance of that right now.
Matthew Howlett: Right.
Jeffrey Zimmer: It doesn’t seem to affect our income very much. We have 76% of our repo balance hedged right now and 67% of our assets hedged right now. We don't want to hedge more than that because we believe we're at or very near the end of the cycle. We think that'd be inappropriate. So where the NIM is going to end up at the end of Q3, it should be within a short kick of where we are right now. But there can be technical things that could change the – while the exact number comes down. But I think Scott and I have been very clear that we're very positive on mortgages over the course of year. So you may experience total return, not just from NIM, but you may experience it from the asset class improving versus treasuries and versus hedge counterparties in terms of spread for the rest of the year. So there are various ways that you could see improvement in the company's outcome. Is that helpful?
Matthew Howlett: Absolutely. And Jeff, you and the team have been through all the cycles. What do you – I mean, it sounds like you're setting up a terrific environment, particularly if you think there's going to be a bull steepener and the Fed is going to stop. And when do you really put the pedal to the metal, so to speak? And really, this is it, we're going to start taking leverage up and we're going to see repo start come – costs come down. When do you – what are you waiting for to see to really start being more aggressive?
Jeffrey Zimmer: I think we'd like to see a little more deterioration in credit. And the deterioration in credit will be the leading indicator that the world needs to stop raising rates and probably you're going to see some cutting at some point. And you don't know exactly when – at what point in time you're going to say. Let's take $0.5 billion of swaps off or let's do.
Matthew Howlett: Right.
Jeffrey Zimmer: But kind of when you walk in, we're going to smell it and we're going to figure it out. And so there's a number of things that could happen as you well know. And we're in the business of assessing those and making those decisions.
Matthew Howlett: Look forward to that. Thanks for taking my question.
Jeffrey Zimmer: Thank you.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Jim Mountain for any closing remarks.
James Mountain: Well, we'd like to thank you all for joining us this morning. We look forward to speaking with you again in about 90 days. Until then…
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
