ORC (2019 - Q2)

Good morning, and welcome to the Second Quarter 2019 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, July 26, 2019. At this time, the company would like to remind the listeners that statements made during today's conference call relating to matters that are not historical facts are forward-looking statements, subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good faith, belief with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements. Important factors that could cause such differences are described in the company's filings with the Securities and Exchange Commission, including the company's most recent annual report on Form 10-K. The company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements. Now I would like to turn the conference over to the company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead, sir. Robert C

Thank you, Operator, and good morning, everyone. I hope everybody has had a chance to download our slide deck that we put up on our website, last night, and had a chance to review our earnings. I will now start to walk through the slide deck. Starting on Slide 3 with the table of contents, just an outline of what we will discuss today. As usual, we'll discuss highlights of our results for the quarter. Then we'll go into market developments, our financial results, our portfolio characteristics, credit counterparties and hedge positions and then give a brief -- speak a few words about our outlook and our strategy going forward. It's usual, kind of, the 4-step process. We try to highlight the developments in the market over the course of the quarter. And then with a particular focus on how those developments affected our results and positions that were made in the portfolio and then kind of conclude with how we see things going forward from here. Starting with the highlights of our results. We had net income per share of $0.07. We incurred $0.15 loss per share on net realized and unrealized gains and losses on RMBS and derivative instruments, including net interest income on our interest rate swaps. Earnings per share of $0.22, excluding realized and unrealized gains and losses on RMBS and derivative instruments, including net interest income on interest rate swaps. Book value per share was $6.63 on June 30, a slight decline of $0.19 from $6.82 at the end of the first quarter or 2.79%. In the second quarter, the company declared and subsequently paid $0.24 per share in dividends. Since our initial public offering, we have declared $10.545 in dividends per share. Economic return for the quarter was $0.05 or 73 basis points for the quarter, 2.9% annualized. Year-to-date economic return is 3.95%, 7.9% annualized. And over the course of the quarter, we issued 4,337,931 shares. On Slide 5, we show our results versus our peer group. The peer group is listed on the bottom, has changed somewhat over the years as certain REITs have either joined or left our space. Again, this data is on a book value basis, not stock price. As a result, the results tend to lag simply because we do not have all the book value numbers for our peers for the second quarter, the last quarter, and this report will be the first quarter of this year. On an inception to date basis the top line, Orchid has returned 12.3% versus the peer average. The peer average for that period has only 5 names: would be Annaly, AGNC, Anworth, Capstead and Armour. So we've outperformed that peer group by 6.4% over that period. Turning now to the market. The developments that started really in the fourth quarter of last year and continued into the first, accelerated in the second. We've seen a material turnaround in the outlook for the markets and the economy, more of the markets and the economy frankly at least with respect to the domestic economy, but nonetheless, the market has made a material pivot. The green line at the top left shows the curve -- rate's curve at the end of last year. On the right-hand side, we showed the swap curve. The blue line represents where things were at the end of the first quarter and the red line is second quarter. And as you can see, we made a material downward shift in the rates market over the course of the year. The primary drivers were trade-related in May, in particular. Early in May, over the course of a weekend, there were some tweets issued by our President with respect to trade negotiations with China. They appear to break down. There was a subsequent effort to restart those talks at the G20 meeting later in the quarter, doesn't appear much traction was made. They continue to be ongoing, although I would say, at this point, at least market sentiment wise, the outlook for meaningful trade negotiations -- or sentiment, I should say, between now and election are pretty low. The other development was right around Memorial Day when we had another series of tweets from the administration regarding Mexico. This was all part of the President's attempt to deal with the issue at the border, but it really unsettled the markets, especially with respect to Mexico because the administration has really reached an agreement, at least in principle, with respect to NAFTA and this seemed to cast doubt on the reliability of those agreements, and then reverberations of that are still being felt. If you look at the swaps market, you can see that the trend in the swaps curve is a full 70 basis points through fund. So the curve is inverted, and the market is fully expecting the Fed to ease monetary policy. Current pricing is somewhere between 2.5 or so hikes between now and the end of the year. We'll see. I think it's almost a certainty that we'll see an ease next month or next week rather. Beyond that there's quite a bit more uncertainty. With respect to rates, turning to Slide 8. As you can see over the course of the quarter, both in the rates -- cash rates market and the swap market, we had a very meaningful move. A decline of 40 or 44.5 basis points. So if you put that in perspective, looking back 2 years, you can see we're at the low end of the range for this period and, in fact, we're at the low end of the range since the election in the fall of '17. Since quarter end though, the rates markets have sold into a range, call it 2% to 2.1% on 10s, and the selling of the rate volatility has been a good thing for mortgage investors. We all know when we have volatile movements in rates that tend to be bad for mortgages and applied volatility tends to spike up both bad developments, and those seem to have settled down. Looking at some perspective on Slide 9. As you can see, after a very long multi-year flattening trend, it hits its trough in mid '18. The spread between the 5 and 30 year treasury hitting bottom of 20 basis points has since rebounded to 76. Just want to point out that most of that movement is on the five year, the front end of the curve is the market prices in Fed accommodation. The long end is kind of lag, so the curve has steepened with the bold steeper, if you will. Now transferring to mortgage markets and is often the case, developments in the rates market lead developments in the mortgage market. On Slide 10, we show the hedge performance of various fixed rate 30-year coupons. Our benchmark here is the JPMorgan hedge ratio applied to the movements in the tenure. One thing that's very -- stands out very clearly here, and if you look at these lines, the bottom line is the Fannie, 30-year 4.5%, the gray line is 4%, the red line is 3.5% and the blue line is 3%. The higher the coupon the worse the performance, and that was a product of a couple of things: One, is the continued deterioration of the TBA deliverable. We've seen this play out now for well over a year. Basically, TBA securities have very high growth lags, which is a bad prepayment characteristics -- characteristic. They tend to have higher loan balances and higher FICO scores. As a result, higher coupon mortgages have done very poorly in this rally. 30-year 3s have benefited from the convexity needs of the various servicing hedging community among others, and so convexity-related buying has allowed their performance on a hedge-adjusted basis to materially outperform higher coupons. Taking a little deeper dive. On Slide 11 on the top left, you see the performance price-wise over the quarter. Again, as you can see, the duration is king here. The lowest line is the 30-year 3 and materially outperformed higher coupons. Turning now to the bottom left. We see the roll market. As you can see, this very poor quality of the TBA deliverable has led to very, very poor performance of the rolls of those coupons. They're at or near 0. The 3 roll has hung in somewhat, but it really reflects the poor quality of the TBA deliverable and this often is a case when rolls do poorly, specified pools do very well. So if you look to the top right, you can see the Wells Fargo pricing for an 85k Max pool, in this case, 4s and 4.5s have shot up very materially. Even new pools traded very high pay-ups relative to recent past. But it's worth noting the following: we've had a very significant moving rates. But given the current level of rates, TBA securities are trading at low prices because of this poor deliverable. The pay-ups for specified pools are very high given the level of rates, but on balance the net of the 2, spec pools actually trade at slightly lower all-in dollar prices given the level of rates versus history. Moving on to the balance of developments in the mortgage market. On Slide 12, we show OASs for the various coupons. You see a meaningful spike there towards the end of the period. That was really just caused by a spike in vol. As a result of vol spiking, the convexity cost of the mortgage goes up, and therefore, the LOAS goes down. It really didn't look like any development in the market per se. If you look at the right, you can see OAS numbers have kind of crested and started to roll over. That kind of reflects the fact that as we past quarter end, the market has settled into a range and vol has come off. But they also, I think, it's worth noting that mortgage is still in spite of these developments look fairly attractive versus other alternative investment classes. To which, on Slide 13, we see returns for the quarter. And an interesting development that took place in this quarter, and it's really the market's reaction function. For a long period of time, it was kind of a -- the market's reaction function was, if there were good developments, risky assets would do very well. If there were poor assets, risky assets would do poor, and there would be a fight to quality, so we would refer to it as either a risk on or a risk off. What changed in this quarter, as John Briggs, a strategist we follow at NatWest markets like to say, it's no longer risk on or risk off, its policy on. So the reaction function now is such that if there's bad economic data, that increases in the market size the chance of more aggressive intervention by the world central banks and risk assets do well and vice versa. And that was very evident in this quarter. If you look at these results, the asset classes that did the best are the riskiest asset. The S&P emerging market high-yield, domestic high-yield and investment grade corporates all did very well. Less risky assets, treasuries, ABS and mortgages lagged, and you can see there that mortgages lag treasuries simply as the market rallied sharply. We had a meaningful move in rates in a short period of time, always bad for mortgages, involve spikes. Also you have growing concerns over prepayment protection, and they lag treasuries in the quarter. And that really throws the emphasis on us as portfolio managers to take steps to protect the portfolio from excessive levels of prepays, and we'll get to that in a minute. Just to finish out the market development section, Slide 14 just shows the changes involved over the period. As you can see, starting in early May, vol started to rise and has since tapered off. Slide 15 just shows you the level of short rates and what's interesting to note here is simply the fact that short rates have stopped going up and are ever since slightly starting to come down. Slide 16 to me is the most critical one in terms of summarizing, which taken place. And this is the dot plot of the Fed published at the end of each of their meetings versus market implied pricing of Fed funds going forward. If you look at the top left, this was back before the election. As you can see, it was the very early stage of the tightening cycle. The Fed was pricing in many tight hikes over the period future years, but the market was extremely skeptical, pricing in very little in the way of hikes in the future. Fast forward to last fall when we were kind at the height of the hiking mania, the Fed was still anticipating taking a few more hikes. The market had moved a long way. Just look where we are in absolute levels, we're approaching 3% in market implied pricing versus barely over 0.5% in late third quarter '16 and that market itself was pricing 2 additional hikes. That all changed in the fourth quarter when the Fed, for curious reasons, was still thinking they were going to hike some more, but the market completely turned and began to price in the fact that the next move actually might be an ease and that was reflected in the Fed Funds Futures market at the end of the year. Now you look at where we are in June. The Fed itself is pricing in an ease and the market is pricing in a lot more. So the outlook for the markets at least, and the economy, presumably have changed with respect to which, while domestic data still remains fairly strong. And given today's GDP number, I would say it's very unquestionably still strong. Europe is very weak, China is weak, emerging markets are weak, but maybe most importantly, inflation is still weak. And that seems to be what's driving the Fed and all the central banks. It seems that the strength of the domestic market at least for now the economy is not what's driving the Fed and that's why we see this pricing by the market of future Fed activity. Turning to our financial results. In other words, what does this all mean for us? How does it impact us? On Slide 18, I want to start on the right side of the page. This is where we showed the returns of our portfolio by sector. I'm going to start in the left-hand column with the pass-through market. As you can see, with the rallying rates, our realized and unrealized gains were pretty significant, almost $28 million. But as I mentioned, mortgages underperformed our hedges and the derivative losses were greater. As a result, it took a lot out of our total return. But that being said, whether it's on ending capital or beginning capital or average, we still generated returns between 2.5% and 3%. In the structured market, of course, the IO market with the rally did quite poorly, generated return of negative 3%. But the inverse securities did very, very well, even though they are only about 25% of the size in market value terms and the IO securities with the market pricing in meaningful Fed eases, the return of the inverse securities were very strong. And on balance, the structured securities portfolio generated return of a little under 0.25%. So in a market where we have the curve inward, long-term yields rally significantly and funding levels remained stubbornly high. Both of ours -- both asset classes generated positive returns on balance 1.8% roughly. So a very good quarter. Okay. On the left side of the page, you can see our interest income was impacted slightly down because of yields and interest costs are stubbornly high. As a result, we generated 0.21% -- over $0.21 -- a little over $0.21 is kind of our proxy for core earnings. We were just backing out mark-to-market gains and losses which as you can see were negative, little under $0.15. Just to gain some perspective on this. As you can see on the next slide, we show our dividend over time versus the shape of the curve. The red line is our cost of funds. It has moved continuously higher. And the net interest margin, which had kind of settled in, in the low 2% range, finally broke below 2%, it was at 1.7% for the quarter. But again, the market, the curve is inverted. Yields on our asset have been impacted in a negative way and funding continues to go higher. I will say, now as we kind of transition into the portfolio, the yield did not decline as much as you may have thought and that's because of the steps we've taken to kind of immunize to the extent possible the portfolio from these developments. Slide 20 just shows you our core -- the trend in our proxy for core earnings. As you can see, it's been declining. But we believe it's probably near the bottom. The curve is inverted. It's kind of hard to imagine, the curve becoming meaningfully more inverted. At some point, either the Fed is going to ease to reward the market for this pricing or the market's going to back off. But it seems that this trend appears to be nearing an end. Turning to Slide 21. I wanted again to start on the right-hand side of the pages, and I want to talk about what we've done to address the portfolio, these developments. And the first thing that we did, the emphasis of the changes in the portfolio were on the positive size. So you can see that we started with a little under $3 billion market cap. We ended the quarter with approximately $3.4 billion, so not only did we add, but more importantly, there were a lot of buys and sells as you can see, and this is because we changed the composition of the pass-through portfolio quite a bit to reposition it for the new market environment. The only changes in the securities market -- structured securities market where we added about $12.3 million of IOs, and those are mostly types of IOs that are very negatively convexed. And so we view those very effective long end of the curve hedges. In other words, these are our assets that are going to do very well to the extent the long end of the curve sells off. These are cash flows that can extend quite a bit. So on balance, if you look to the left-hand side, you can see that pass-through allocation of our capital has moved up slightly. It's right around 2/3. And the structured securities, even though we did grow them in absolute size, are slightly lower percent of the portfolio. More specifically with respect to the portfolio that's detailed on Page 24, as we approach the end of 2018, and the Fed was very aggressively hiking rates, we had gotten very defensive. So our allocation to short sequential CMOs, our 15 year securities, 20-year securities was very, very high. That balance over this quarter alone declined by approximately 11%. So roughly 44% of those asset class is down about 33 and the 33 -- 30-year allocation went from 52.3% to 62.8%. More specifically, if you look through the various asset classes, even though we don't show the changed numbers for the quarters, the fixed rate CMO bucket declined by 4%. The 15 year core bucket declined by 5.5%. If you look at the 30-year bucket, you can see, it's at 62.8%. That's a 10.5% increase. We materially reduced our allocation to 30-year 4.5s, basically spread that between 30-year 4s and 5s. And in all cases here, these are specified pools. So remember, again, I mentioned that the absolute price of the specified pools were actually low for the level of rates. Nonetheless, we still have to try to protect or minimize the impact at faster speed. So we do allocate all of our higher coupons securities to the specified pool market, although we've also meaningfully added to our 30-year 3.5 and 30-year 3 positions. So that's where we grabbed some convexity. And as a result, if you look at the current price there, you can see all the 30-year 5s are priced at $109. Most of these assets are much lower than that. In the case of 4s, you're are at $105. And, of course, 3s when you're par. So that's one of the ways we can protect the portfolio from high speeds. A combination of just lower absolute dollar price securities and specified pools that while they might have higher prices have lower prepay speeds. And so going forward, this is the kind of a portfolio construction we anticipate using for the foreseeable future. Slide 24 is just a history about positioning. I won't go into that. It's merely a reference point. I will turn to Slide 25. I want to point out the fact that our leverage ratio remains in the high end of our range, and we anticipate that continuing to stay at that level, especially with the higher allocation to the pass-through portfolio. Finally, with respect to the portfolio in our hedge position, Slide 26, I just want to make a few comments here. Top left is where we show our Eurodollar positions. And as you can see, our allocation to each contract is $500 million. I want to point out a couple of things: One, in late 2018, each of those buckets was approximately $1.75 billion, so we've taken off a lot of our front-end hedges, but also you'll note that the last contract there is December of 2020. We have not yet extended those out. We may -- I think at some point, we anticipate the market may get a little too aggressive in pricing in the Fed. We're kind of looking for that development in which point we would then try to add some Eurodollars. Our five year note future on the bottom left remains in place, that hasn't changed quite some time. On the right-hand side, there have been some changes. The top of the page, we have our swaption position. This is another long end hedge where we take a longer tenure of tail as a means of protecting against a surprise move of highering rates. Although frankly, we don't see that as a high probability given developments abroad. Our TBA position is a slight typo there. It clears that we were still short 30-year 3s, it's actually 3.5 as of June. And then finally, in the swap position, we have a -- really it's barbell position, so we have a combination of just some very old swap positions, very much in the front end of the curve inside a year, when it will put on an extremely attractive level. And the balance are in the belly of the curve, the 4 and 5 year part of curve, and the reason being there is that we've had such a movement in the belly of the curve, as the market moves the price and Fed eases. If there's going to be retracement, we expect that that's where the magnitude will be the greatest and so that's why we've put the hedges there. So that's where the lines throughout these hedges lie. Our long-end hedges are the TBAs, the swaption, and of course, the IO securities that I talked about. So that's kind of what we've done in terms of market developments, what those developments meant for our results and what we have done to change the portfolio. Looking forward, at this point, as I said, I think it's very high likelihood the Fed will ease next month and that will help our funding costs, which has been stubbornly high. Repo rates have come down over the last month or 2, but there's still, of course, pricing in less than 1 ease. Generally, repo is in the low to mid 2.50s, occasionally in the 2.40s. In this slide here, on Slide 28, all we're trying to show you is, what would happen if the market implied pricing were to be realized. And as you can see, in the bottom page, you can see an expansion of our NIM. Whether or not this happens, it remains to be seen. We did take some actions in that regard with respect to our ATM program, which we've had in place for a number of years. We did issue some shares in the second quarter. Typically, we only use the ATM when those shares -- when our share price is above book value. In this case, these shares were issued at a slightly discount. It raised the all-in cost of that capital to a little over 3%. We didn't do it with a lot of capital, but we think it's justified on the grounds that with the churn in the Fed outlook that the accretion to earnings will justify the slightly increased cost of that capital. And that's as a result, that's the step we took. Otherwise, these slides are basically just for historical reference. And there's really nothing more to be pleased in those. So with that, operator, I will turn the call over to questions.

[Operator Instructions]. Your first question comes from the line of Gary Rieve [ph].

You mentioned the ATM program towards the end of your presentation. You guys are kind of nearly at the end of what you're authorized to do there. Is there any talk or thought on the part of the Board of upping that as you go -- as we go into the easing cycle?

Yes, I think that's likely. We exhausted the program early in Q3. So we would anticipate, at some point, putting in place a new one and ATM has been an excellent vehicle for us.

Okay. Great. And then in the quarter, I saw a couple of your competitors' quote, sort of, a prototype security. Any thoughts on that as a source of funding?

We did look at those. Unfortunately, given our size, the coupons on those, whether it be preferred or convertible debt, they're pretty pricey. I think the bar for those to make a lot of sense is still a little too high. That could change, especially, if we were to have an aggressive easing cycle. But for now I think we're -- we don't really too excited about the potential returns from those.

Got it. Got it. And you guys are a little bit above book today. Any thoughts on doing some type of placement potentially?

You never know. We generally don't like to speak about those things, the dividend policy, capital raising. But as I said, it looks like the outlook is about to change and to the extent that it does. Obviously, it would be -- a steeping of the curve would be an attractive for us -- opportunity for us, and we would probably consider that.

Yes. It seems like an opportunity to cash and leverage ahead of a more favorable cycle.

Thank you.

Your next question comes from the line of Christopher Nolan.

Bob, what was the issuance prices for the ATM, please?

I don't have those in front of me, but our book was 6.82% at the end of the third -- or the first quarter and 6.63%. I want to say, it was somewhere in the high 6.50s on average, but don't quote me on that yet.

Yes, I am getting 6.60% or so.

Yes, so it was slightly below book. As I said, the typical cost of capital in the ATM is about 1.8%. So it added about 1% that quarter, 1.5% to that.

Got you. Also, I saw that you had an increase in allocation to 30-year 5% coupons, was that the specified pool that you were talking about?

Yes, very much so. And it's -- in these cases, we're going to buy higher quality call protection because of the prices. And another thing is, we've been looking for some bonds that are little more seasoned so they're off the ramp, so they're much more predictable. We don't have to take that ramp risk, if you will. And so that's what we added in that bucket there, loan balance and season pools.

Final question. Reading the management commentary in the earnings release, it seems like you guys are very much in the camp that there will be a rate cut. What happens if there's not a rate cut?

Well, as we said, and I quote, like I said it was a calculated risk and it was. I think at this point -- well, if there isn't one, obviously, something has to change. The market pricing today is for about 2.5 eases by the end of the year. It would have to -- it's really a function of -- if the Fed doesn't cut next week, and it not much of that, but what would they say. So in other words, when Chairman Paul has his press conference, what does he say in the statement, how does he respond to questions. If he could convince the market that we've changed our thinking again, and we don't really care about what's going on in Europe or trade tensions, we're just focused on the domestic economy and the data we've seen in this month, whether it's GDP today or durable goods yesterday, payrolls at the beginning of the month, even the CPI number in the middle of the month, if they change back to that and they say, based on that there's no need to ease, the market has to move. The five year treasury can't be 50 basis points or 40 basis points inside Fed funds in that case. So you would have a meaningful sell-off in the belly and in probably the long end of the curve. And as I mentioned, while that might not be great for our capital raising, our NIM or anything, ATM and that kind of stuff, that is how we've hedged ourselves. So our hedge is concentrated in the belly and in the long end of the curve. So that would have to be -- that's certainly a nonzero probability, but that would do I think a lot to undermine the credibility of the Fed. And then I think the subsequent effect of that would be a much higher risk premium being priced into the market. Because now the market would have to price in the fact that the Fed is somewhat of a random unpredictable animal that can change its thought process on a dot. And they did do that for some extent in the fourth quarter, but that I think was a result of a lot of market pressure. There's certainly no market pressure for them to do so now, so if they were to do so, I think the risk tenure would be materially higher than it is now, and that would not be a good outcome.

So is it fair to say that you guys are assuming a 50 bp cut in the second half of the year?

I wouldn't say -- we'll see how it goes. I think 25 is a very high probability. And there's likely to be more beyond that, but it remains to be seen. The other thing, I think, is while the market pricing is looking out through the balance of this year, even in the 2020, my view is that once we get to second quarter of 2020, I think the market focus is going to shift to the election and the expected outcome. In my mind, the outcome of next year's election is binary. In other words, the outcomes depending on which party takes the White House are materially different. One being more pro-growth, the other not so pro-growth. And I think the market will start to price that in, as I said mid next year. So I think the Fed's in the driver seat until then, but after that, I think it will change. So whether we get 1, 2 or 3 remains to be seen. I suspect we'll probably get 2. Because I think the Fed is focused on the fact that inflation is low, global economies are weak, and there's a lot of uncertainty with respect to trade. And it's not for so long now, we've been talking about trade tensions between U.S. and China or U.S. and Mexico and Canada. And now you have tension between U.S. and Europe or between Japan and Korea. So it's spreading and it's not generally a good thing for the global economy.

[Operator Instructions]. I'm showing no further questions at this time. I would now like to turn the conference back to Robert Cauley.

Thank you, operator, and thank you, everyone. Appreciate you taking the time to listen in today. To the extent other questions come up after the call, please feel free to call us or if you're listening to the replay, our number in the office is 772-231-1400. Thank you for your time. We'll speak to you next quarter. Thank you.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day. You may all disconnect.