ARMOUR Residential REIT [ARR] Conference call transcript for 2024 q2
2024-07-25 10:19:07
Fiscal: 2024 q2
Operator: Good morning, and welcome to the ARMOUR Residential REITs Second Quarter 2024 Earnings Call. All participants will be in listen-only mode. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Scott Ulm. Please go ahead.
Scott Ulm: Thank you, and good morning, and welcome to the ARMOUR Residential REIT second quarter 2024 conference call. This morning, I'm joined by our CFO, Gordon Harper, as well as our co-CIOs, Sergey Losyev and Desmond Macauley. I'll now turn the call over to Gordon to run through the financial results. Gordon?
Gordon Harper: Thank you, Scott. 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 Exchange Commission describes 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 continue for one year. Turning to results, ARMOUR's Q2 GAAP net loss available to common stockholders was $51.3 million, or $1.05 per common share. Net interest income was $7 million. Distributable earnings available to common stockholders was $52.5 million, or $1.08 per common share. This non-GAAP measure is defined as net interest income plus TBA drop income, adjusted for interest income or expense, on our interest rate swaps and futures contracts minus net operating expenses. ARMOUR Capital Management continued to waive a portion of its management fees, waiving $1.65 million for Q2, which offsets operating expenses. This waiver continues until further notice. ARMOUR paid monthly common stock dividends per share of $0.24 per common share per month for a total of $0.72 for the quarter. Taken together with the contractual dividends on the preferred stock, ARMOUR has made cumulative distributions to stockholders of approximately $2.3 billion over its history. Quarter-end book value was $20.30 per common share. Our most recent available estimate of book value is as of Monday, July 22, which was $20.37 per common share. In July 2024, the voluntary notice of dismissal by the plaintiffs of their previously filed appeal in the JAVELIN Mortgage Investment Court charitable litigation was processed by the courts. I'll now turn the call back to Scott Ohm to discuss ARMOUR's portfolio position and current strategy.
Scott Ulm: Thanks, Gordon. The second quarter could become a turnaround point for the Fed in its fight on inflation initiated just over two years ago. Overcoming months of mixed economic data, May and June consumer prices finally affirmed the disinflationary trend toward the Fed's 2% annual inflation goal. Cooling prices, along with a rising unemployment rate, set the market expectations for the start of an easing cycle to commence at the September 18 FOMC meeting. The market is currently pricing in 2.5 cuts this year and another 4.5 cuts by the end of 2025. While we acknowledge that the trajectory of economic activity has shifted notably, we continue to evaluate each month's data and remain cautious against pricing in too deep of a cutting cycle. We can all recall a bit of overenthusiasm on the path of rate cuts last year. The yield on a 10-year to U.S. Treasury closed the second quarter at 4.4% after reaching 4.7% in early April, and as of July 26 is at just above 4.2%, the first quarter closing level. Mortgage-backed securities remain range-bound between roughly 135 and 155 basis points in nominal spread this quarter. Despite an overall range-bound environment in the second quarter, intra-quarter trading remained choppy. MBS nominal spreads finished the second quarter 10 basis points wider while the SOFR swap rate in the intermediate and longer part of the curve shifted 12 to 15 basis points above their respective marks at the end of the first quarter. These factors were the driving contributors to our negative 4.8% economic return in the second quarter. As of July 22, average book value was $0.2037 per share after accounting for July's dividend of $0.24. Looking ahead, we expect lower rates and eventual normalization of the yield curve to provide exceptionally strong tailwinds to the MBS market, the mortgage REIT sector, and ARMOUR REIT specifically. A full 25 basis point cut in the official overnight rate will flush out the cash sitting in short funds and overnight reverse repo facility into high-quality assets like U.S. MBS. It won't happen overnight, but with every subsequent interest rate cut, this momentum will build and multiply. We expect bank portfolios to follow a similar strategy. Owning mortgages right now is in many cases a negative carry versus short-term borrowing rates. Yet we've already seen bank demand flip positive for the first time since 2022. Once the 25 basis point cut is implemented, MBS carry will turn decisively positive and provide an even greater momentum to MBS demand from banks. We're noting similar strong inflows in the MBS mutual funds and ETFs this year and expect them to persist into the cutting cycle as flows in the fixed income accelerate. So taking all these factors together, we expect the Fed's actions to have a very profound impact on us in the markets. We believe we could see mortgage spreads move 10 to 15 basis points tighter into the yearend, but the path there will not be a straight line. So we continue to stay disciplined in the way we approach leverage and putting cash to work. Now I'd like to ask Desmond Macauley to give some more detail on our mortgage strategy and how it has evolved this quarter. Desmond?
Desmond Macauley: Thanks, Scott. Our mortgage strategy continues to target a well-diversified portfolio with approximately 10% market value exposures across each of the discount coupons from 3% and up while maintaining our overweight to 5.5% and 6% coupon MBS for their wide ZV option-adjusted spread and carry. While historically low existing home sales are keeping prepayment speeds in discount coupons very low, their spreads offer a compelling value for an eventual thaw in the housing market and consequently a pickup in turnover speeds thus improving their yield returns. ARMOUR's average prepayment rate on MBS assets in the second quarter of 2024 was 7.7 CPR, increasing from 4.6 CPR in Q1. A large portion of the increase was driven by speeds in discount coupons where the rate lock effect is expected to dissipate even more as home loan season and mortgage rates turn less expensive. This benign prepayment environment and near par prices continue to provide a tailwind for MBS. It is worth noting that we are starting to see an uptick in the mortgage refi index signaling that prepayment speeds should continue to rise gradually into the yearend. However, greater prepayment concerns would require a more significant drop in mortgage rates below 5% and are easily mitigated in higher coupon MBS by moving our exposure towards the middle of the coupon stack. Additionally, we continue to see value in lower premium specified pools tied to GEOs, lower FICO, and higher LTV loan characteristics which will mitigate prepayment risk in the scenario of lower mortgage rates versus the more generic MBS cohorts. We also maintain around 12% of the portfolio in forward TBA contracts for the attractive dollar role carry in premium coupon Ginnie MBS and for better market liquidity versus specified pools in lower coupon conventional MBS. ARMOUR continues to fund 50% to 60% of its MBS portfolio with Buffalo [ph] Securities and the remainder is diversified among 14 other counterparties with a weighted average haircut of just under 3%. The repo markets remain liquid and well bid. However, we began observing some funding pressures in SOFR rate and repo spreads towards the end of June. While it's a normal turn of events to see some upward pressure on funding costs into the quarter and yearends, rates remained 2 to 3 basis points above running averages into July, indicating that this year's record treasury issuance is beginning to weigh in on primary dealer balance sheets and their ability to intermediate bonds quickly and efficiently. We see the start of an easing cycle and rising expectations to an end of the quantitative tightening program as two major tailwinds to alleviate some of the pressures in funding spreads for the dealer community. Looking forward, we remain constructive on spreads over the medium to longer horizon as we await the start of an easing cycle to drive the steepness of the yield curve back to historical norms. A positively sloping curve is much needed to support the inflow of fresh bonds into the MBS market, a major tailwind for mortgage rates. Yet in the near term, we are mindful of the fact that mortgage spreads are trading near this year's highs and a rebound in macroeconomic data from its current trajectory would roll back an aggressive pricing of easy Fed expectations. With the disinflation story already priced in, we turn toward the labor market data in the coming months to indicate the health of economic growth. For now, we have increased our exposure to MBS at 7.7 turns of implied leverage and trimmed our duration risks to 0.1 years as of July 22. We have one to two turns of leverage to deploy at better risk-reward levels and as we see increased demand from the banking community. Our earnings available for distribution sufficiently covered our dividend for Q2. We believe our current dividend is appropriate and we expect earnings to cover the dividend rate into the year end. Our primary focus remains on generating total economic return on our portfolio to deliver to our shareholders. I'll now turn the call back to Scott.
Scott Ulm: Thanks, Desmond. I'd like to comment on capital raising. We've not been active raising capital this year because of an equity valuation that was just too low. Our thinking on raising equity remains as it has been. We will look to raise equity if there are good investments opportunities and we can achieve a fair price, all factors considered, including whether it would lower per share expenses and minimize a negative impact on our stock price. But we'll always look for prices that make sense for our shareholders. At this point, we're less likely to be involved in the preferred market. As you know, our preferred remain fixed once they enter the call period, a feature we're very pleased with given where today's floating levels would be. We look at our dividend over the intermediate term rather than focusing on short-term market fluctuations. We continue to believe that our dividend is appropriate for today's environment. You can also expect us to continue the fee rebate we've had in place. Thank you for joining today's call. That wraps up our prepared remarks for the second quarter of 2024. We'd be happy to answer any questions. Operator.
Q - Doug Harter: Thanks, Desmond. Hoping to just go into a little bit more about some of the potentially bullish kind of outlook for MBS. It's obviously priced in that the market is going to have cuts. Just how much of that do you think is kind of already reflected in MBS? Or does the actual kind of current carry cause more incremental investors? So just trying to get a sense of how MBS markets are already thinking about those cuts.
Sergey Losyev: Yeah. Good morning, Doug. This is Sergey Losyev. I'll try to answer your question and see if Desmond has any follow-up. But yeah, currently we, as Desmond mentioned, our view is very constructive on kind of medium and long-term horizon. Near term, we do see like the markets have priced in a lot of easing already. So we feel like the inflation slowdown has been digested by the market. Right now, we're watching the labor markets to give us a sign if more aggressive Fed cuts on the horizon should be in play. But in terms of interest rate markets, we feel like that's very well priced in. In terms of mortgage spreads, we also feel like near term, we are trading year-to-date tight. But we have very strong conviction that as we start the journey on the Fed easing cycle, that's going to really impact the spread tighter. Additionally, one other thing maybe is not being talked a lot about yet is the potential end to quantitative tightening program. We feel like the markets could start pricing it in sooner. Then later, bank reserves could continue to wind down. So a couple of these factors is what we're looking for in terms of really giving a boost. It's going to be a long journey. In terms of banks entering the market in full force, they've already seen it this year, finally turning the net demand positive. But the first cut will actually turn their carry positive. So I think that will be a real big boost to the spreads. As you know, there's a ton of money market funds sitting on sidelines ready to enter fixed income markets as well. So we're looking for signs of the first cut to really change that equation additionally, too.
Doug Harter: I appreciate that, Sergey. And then just one other question, on the Treasury hedges you have, what is the duration of those hedges?
Sergey Losyev: Yeah, so on the Treasury specific, we have Treasury shorts in the 10-year part of the curve, and we use Treasury futures, and those are kind of bar belled between the 2 and the 10-year part of the curve. As you know, our swap spreads are really tightening in here. So we're starting to see owning swaps more favorable. As you know, we have really big hedge book and interest rate swaps as well.
Doug Harter: Great, appreciate that. Thank you, Sergey.
Operator: The next question comes from Jason Weaver from JonesTrading. Please go ahead.
Jason Weaver: Hey, good morning. Thanks for taking my question. Can you just briefly discuss how your leverage trended intra-quarter in 2Q and whether that was greater at the beginning or nearing the end?
Sergey Losyev: Good morning. Yeah, thank you for your question. Yeah, our leverage has increased towards the end of the quarter as we saw confirmation in economic data that the Fed is enroute to begin cutting rates potentially later this year. So as we saw economic data come in, as we saw FOMC meetings express the fact that we're getting closer to the target for the Fed, we began to increase leverage into the quarter end and are currently running 7.7, as Desmond has mentioned.
Jason Weaver: All right, and that's down from the 7.8, I guess, just due to a little bit of spread tightening since then?
Sergey Losyev: I'm sorry. I was -- hard to hear. Could you repeat that, please?
Jason Weaver: No worries. I'll actually move on. And then alongside with Desmond's comments, this is a little bit difficult task, but where is the range you see as the real inflection point for prepays on benchmark 30-year mortgages? And I'm really asking about the post-2022 vintage paper.
Sergey Losyev: Yeah, so on the production coupons, 5.5s and 6s, it would take usually 25 to 50 basis points of incentive to begin refinancing. So we're still quite a bit away there. So I think when we see rates rally towards those levels, we'll re-evaluate the coupon positioning. As we mentioned, a few things we're doing right now is kind of adding specified pools that have better convexity in prepay protection versus more generic cohorts. And then the other step would be to migrate lower coupons. Now our book is very well diversified. We have 10% to 8% discount coupons across the stack. So we remain very liquid and tactical across the coupon stack.
Jason Weaver: All right, thank you. That's helpful color.
Operator: The next question comes from `. Please go ahead.
Jason Stewart: Hey, good morning. Thank you. I wanted to go back to the capital raising question. And if we look at your outlook for mortgages and the one to two turns of leverage and where the stock's trading, I mean, how likely are you to take leverage up before raising capital, sort of let book value drift higher? Or are you more likely to capitalize on where the stock is now in the investment environment, given your view?
Scott Ulm: I think we're fortunate we've got some flexibility. We're not tied to capital raising to manage the portfolio. As Desmond mentioned, we feel we've got some dry powder there that we could take advantage of things. And as we all know, capital raising opportunities come and go. So I think the two are fortunately a little bit disconnected, not ultimately disconnected, but a little bit disconnected, within the concept of a turn or a bit more of leverage.
Jason Stewart: Okay. All right, thank you for that. And then so far in 3Q obviously we use pretty stale data from 1Q to project where book value is. But 2037 [ph] is a little light. Is there any meaningful moves in July on the portfolio or the hedge side that would be notable?
Scott Ulm: I don't know. Yeah, go ahead.
Sergey Losyev: Sorry, Scott. Yeah, nothing to report as of yet. Our hedge book tactic is very dynamic right now. As you know, our hedge ratio is very close to one. If you assume that our TBAs follow the path of repo on the pools as well. But we continue evaluating every day. But right now there's no changes to report.
Jason Stewart: Okay. Thanks for that. Last one for me and then I'll jump out. The increase in coupon, increase in CPRs on real discounted coupons, I'm going to call it fours and below would be my likely guess, is the most impactful. Is there any way to quantify that increased quarter-to-quarter on net interest spread or earnings?
Sergey Losyev: This is a number we'll probably have to come back to you on, but just roughly speaking, yeah, 4.5 and 4s contributed kind of close to a third of the increased quarter or quarter in CPRs. And we're starting to see other coupons pick up there as well. But in terms of specific accounting income impact, I don't think we have that analysis just ready just right now.
Jason Stewart: Yeah. No, it's okay. Thanks for that. And I think conceptually your expectation would be that most of that move in discounted coupons has happened. And maybe you get some migration in CPRs up in coupon, but I wouldn't expect you to think that, you know, 4s and 4.5 have that sequential increase again in 3Q. Is that fair?
Sergey Losyev: It's a fair question, but also, we're keeping in mind the fact that the housing market is at record lows, right and the prepayments are near record lows as well. So we feel like there's nothing but upside to a lot of these discount prepays. It's just a matter of timing, and as Desmond mentioned, it's when the housing begins to thaw and the turnover activity picks up. That's what we're looking for.
Jason Stewart: Yeah. Yeah, I agree with you, and thanks for taking the questions. I appreciate it, guys.
Operator: [Operator Instructions]. And our next question comes from Christopher Nolan from Ladenburg Thalmann. Please go ahead.
Christopher Nolan : Hey, guys. Gordon, were there any non-recurring items in earnings this quarter?
Gordon Harper: No. You recall we had that discussion back in Q1 of the Special Committee costs, but no, nothing this quarter.
Christopher Nolan : Okay. And then also as a follow-up on that topic, just to reconfirm that you don't expect any restatements as a result of this Special Committee activity since the current Q indicates the material weakness continuing into the quarter?
Gordon Harper: Correct.
Christopher Nolan : Great. And then I guess the final comments, and I guess it's really for Scott, is given the expectations for earnings to cover the dividend in the second half of the year, what are the thoughts on the direction of book value, given your outlook on the market?
Gordon Harper: Well look, if our outlook comes true and we get demand returning particularly from the bank sector, I've got to tell you, there's nothing like actually getting cash spread rather than seeing it reflected in the forward curve to motivate buyers. That's real. The other one is a little different. We could see some spread tightening here. You look at the charts over the last 10 years, and we are at elevated levels. It's not to say the last 10 years was normal in any way. We all know that. But certainly, while we might have flirted with a bit of tights for the year, let's just remember how wide '23 was. Look we take spread risk for a living here. We're in the spread business, and tightening spreads would be a very, very strong element for us for book value.
Christopher Nolan : Great. Thanks, guys.
Operator: There are no more questions in the queue. This concludes our question-and-answer session. I'd like to turn the conference back over to Scott Ulm for any closing remarks.
Scott Ulm: Great. Thanks, all, for joining us this morning. As you know, we're always available. Ring the office, and we will be back to you usually within the day, if not faster. Thanks so much for joining.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
