ORC (2019 - Q3)

Good morning and welcome to the Third Quarter 2019 Earnings Conference Call for Orchid Island Capital. This call is being recorded today October 25, 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. Sir, please go ahead. Robert C

Thank you, Operator and good morning, everyone. I hope everybody has had a chance to download our slide deck or at least view online and that will be the focus of today's call. As always, I will start on Page 3, the table of contents. Just to give you an outline of what we will be discussing today and this is the standard format. I will start off by going over our financial highlights for the quarter ended September 30, 2019. I will then review market developments during the quarter and summarize at the end and provide us an overview of our outlook of the market as we see it going forward. And then, of course, I will talk about our financial results, portfolio characteristics, credit counterparties and hedge positions. And then a final few words about our outlook and capital raising activity. Turning to Slide 4, our financial highlights for the quarter. Orchid generated a net loss per share on a GAAP basis of $0.14. We incurred $0.32 in losses from net realized and unrealized gains and losses on RMBS and derivative instruments, including net interest income on our interest rate swaps. Earnings per share were $0.18 excluding these same realized and unrealized gains and losses on RMBS and derivative instruments. Including net interest income on interest rate swaps. Our book value per share at the end of the quarter was $6.22, a decrease of $0.41 or 6.18% from $6.63 at June 30. During the third quarter of 2019. The Company declared and subsequently paid $0.24 per share in dividends and since our initial public offering, we have declared $10.705 of dividends per share, our economic return for the quarter was negative $0.17, or 2.6% which reduced the year-to-date return to 1.5%, 1.9% annualized. The Company issued 8,771,301 shares during the quarter. The bulk of which were on a fall on offering of seven million shares in late July and I will speak about that specifically near the end of the presentation. Turning now to Slide 5. As always, we will provide our results versus our peer group. The peer group is listed below in the footnotes. It has changed somewhat over time as firms that have either left the space, been acquired or new entrants who fit our, the makeup of our strategy a little closer have been included in the peer group. We do not have Q3 data as always, since we are one of the first companies to report. So it's somewhat back we are looking at the bottom of the table, we show the first and second quarter results for us and our peer group. The first quarter we trailed the results of our peer group by 1.4%, in the second quarter, we outperformed by 3.4%. Since our inception in February of 2013, Orchid generated return of 12.7% versus our peer average of 4.8%. The calculation methodology described in the notes as well. Turning now to market developments. Slide 7, what we observed in the quarter is really a continuation of what is been going on all years, as you can see on the left side what we show the treasury curve, the nominal benchmark treasuries. On the right side is the swap curve. As you can see the green line, which was the end of the year, down in the blue line and the red line, which is the end of the quarter is a continuation of the inversion of the curve with lower and lower longer term rates and as a result, since we are mortgage-backed securities investors. This means that rates available to borrowers have become progressively lower. This really doesn't tell the full story. And what we are showing here is kind of the beginning and the ending level of rates. Throughout the quarter the market was extremely volatile and for levered mortgage investors who dynamically hedged, this presented some meaningful challenges and that is what we had to deal with. Now if you look at Slide 8. Slide 8 just shows you, on the left side, the changes in these benchmark rates for the quarter and on the right side with a two year look-back. I think the two year look back is somewhat more illustrative of what happens. You can see in either case, whether it's in the treasury - 10-year treasurer swap over the course of the quarter, you had meaningful volatility with the case of the 10-year treasury note, the range, high to low was 68 basis points, which is quite a bit for any quarter but the distance traveled throughout the quarter was much more. As you can see we had a meaningful rally in August. In the early September subsequently sold off and then rallied right back. So it's been a very volatile quarter and as again as a mortgage investor. This means that the cash flows of the securities we own, the projected cash flows can change meaningfully as you rally, mortgages lose their duration, the cash flow shorten, turn around and sell off, the opposite occurs also hedge ratios change and your profile on, when you run your shocks can change dramatically as this occurs as a result, as you attempt to dynamically hedge, it can be quite challenging. We also realized very fast speeds during the quarter not just Orchid but across the mortgage universe and in particular certain cohort coupons 3.5s and fours especially of 2018 and 2019 which paid at 50, 60 plus CPR. We haven't seen speeds like that in those kind of production coupons since 2003 and they were big drivers, they are very poor performance of the sector, the asset classes TBAs did quite poorly. Turning now to Slide 9, we had this table for quarters now, which just shows you the slope of the curve as represented by the five year note, the 30-year treasury bond. As you can see on the bottom, the green line, this is the spread. Way back in the 2013 era that was north of 250 basis points and it hit a trough, a little over a year ago. Approximately 20 basis points. As you can see, it's only recovered very modestly. In fact, in the most recent quarter, it actually started to decline again. So we are still doing with a very flat curve environment. Slide 10 talk a little bit about performance of TBAs for the quarter. In this case, we are showing four 30-year fixed-rate coupons, the blue is the 3% coupon. Then the red is the 3.5% and so on. Two things I want to highlight first. The first is the 4.5% coupon, which was the star for the quarter. Had modest outperformance versus a very low hedge ratio for the 10-year. The blue line is the Fannie three coupon. As we were in the second quarter of the year. That was the slight discount coupon. And so to the extent we had rallies in the market and people were chasing duration in this asset class. That would be the coupon of choice. We have got into August, and the market rallied. The 3% coupon became progressively higher premium approach to $102 price and performed quite poorly and then of course, as I mentioned 3.5s and fours did extremely poorly because of speeds. So really it was kind of the tale of two stories there. 4.5s is the upward coupon, it was the coupon of choice, others were shed, so their performance is quite bad. If we look on Slide 11, the top left, we show these same four coupons in total price change over the quarter. As you can see threes were up 25 ticks, 4.5s were actually up 27 and the two belly coupon 3.5s and fours did quite poorly but keep in mind over the core, the 10-year treasury, it was up in the neighborhood of 100 ticks. So meaningful underperformance, which we just saw on the previous table versus the hedge ratio. Since quarter-end, the market has sold off slightly and they have given up some performance. On the bottom left, we show the same four coupons in the roll market, typically with not so much with Orchid but with many of our peers, the roll market is used quite a bit. It's really a source of cheap financing when rolls are special, coupons can trade at implied financing rates well through LIBOR. That is not the case now, predominantly those are speeds And each of these lines you see here the implied financing for these coupons is at best equal to a repo, in most cases, much further above it. And so that really, that strategy is more or less off the table now as in terms of a cheap source of financing for owning mortgages. As you would expect with the performance of TBAs. On the right hand side, specified pools have done very well, pay-ups for any form of call protection - whether it's very robust or not so robust and fleeting, those pay ups have done very, very well and will probably continue to do so. Finally on Slide 12, with respect to mortgages. This is a one-year look-back. We are looking at TBA LIBOR OAS and as you can see, we are at or near the very high-end of that range. And this is really just one way of looking at mortgages. If you look at for instance the spread of the current coupon mortgage to a blend of five year or 10-year treasuries or 10-year treasury, the current coupon even the $102 priced mortgage are at multiyear wide, so actually the widest levels we have seen since early 2012. In the case of the current coupon mortgage, so mortgage is very much cheapened out in this quarter. Turning now to returns on Slide 13 across sectors. The top we show year-to-date returns and if there is a theme here. It's just very much that risk assets have dominated, the highest performing sectors, investment grade corporates, emerging market corporates, a high yield S&P 500 have done very well. Treasuries, mortgage agency, mortgages, less so. Q3 was slightly different, much less of a risk on sentiment while the best performing sectors investment grade corporates and emerging market corporates have still done well, some of the other riskier assets like the S&P and emerging market or high yield have done poorly. In fact, really the star has been the investment-grade corporate market. In fact, most recent data from DTCC, the client positioning data, which is a dollar denominated measure, the dollar amount long and those asset classes are at 95% or 100% dollar ranking. So mortgages, obviously were not in that same category. Final measure, I guess of the market for the quarter is the Vol market on Slide 14. As you can see especially starting in early August. Vol has spiked and has since come off some but all measures of Vol were elevated, very much so in the quarter. Slide 15. We talk about the short-term rates market, really I think at this point, it's been opportune time to talk about what has happened in the funding markets versus just LIBOR in one month Fed funds. This all started on September 16. This is obviously very meaningful development for us as a mortgage investors and levered basis. As we all know back in 2017, the Fed began to reduce their bloated balance sheet taking it down to what they would deem to be a more appropriate level. Nobody really knew exactly what that was. But I think that on or around September 16, we found out, when in fact we had a shortage of liquidity in the market and we saw overnight funding rate spike in the case of [SOFOR] (Ph) and repo, 7% overnight repo rates were not uncommon. And really this reflects, not so much unwillingness to lend which is what we saw during the financial crisis. This was just an inability to lend, just there was a reserve scarcity that was an inability to get funding to end users, and this is to a large extent just driven by regulatory developments since the end of the financial crisis, whether it's a supplemental liquidity ratio or high quality liquid asset test whatever the case may be or in the case of year-end the G-SIB test. There is really just not an ability to get enough liquidity into the appropriate hands and of course funding rates have been risen as a result. The Fed has responded when this first started on September 16. The Fed had a meeting that week, they announced some measures at their meeting, since then on several occasions, they have made announcements. The Chairman gave a speech at the NABE Conference on the October 8th, outlines some steps they were considering, those were more formally announced a few days later, even this week there has been more steps taken. So while the Fed has been reactive to what is going on. I wouldn't characterize the response is extremely aggressive. They are not appearing to take steps like they did during the financial crisis to get very much in front of this. And so going forward, there is still some doubt in terms of just how effective they will be, I think, I don't see this evolving into a crisis. But I think most market participants wish they were just a little more aggressive in that regard. In terms of what it means for us. It has resulted in elevated funding levels. If you go back to the first half of the year before the Fed had started their easing cycle, Fed funds was running around 240 basis points, 241 basis points and we were funding on a one-month basis points about 20 basis points to 25 basis points higher. Since then, now the Fed is in place, so Fed funds is somewhat of a moving target. But where funding levels are 40 basis point, 42 maybe basis points above that for one month, so the spread has increased. So while the Fed has eased around 50 basis points. We have only been able to pick up about 30 basis point and lower funding costs. Going forward. I would assume that that would stay more or less the same. So in other words, if the Fed were ease of third time and the total reduction were 75 basis points. I think we would still kind of keep that same spread around 50 to 55. So we still get some benefit, but the net effect is we have effectively lost most of ones as a result of these developments. Slide 16 just shows you the evolution of the outlook for the Fed. The top right is the kind of the nearing the end of the tightening cycle, the Fed at that time. Still expected to raise rates up in the mid-threes, the market never really got much beyond additional two hikes and ultimately. Of course, we know that didn't occur, now in September of 2019 at this most recent meeting, is Fed still sees rates stripping $1 up slightly over $2, the market strongly disagrees with that sentiment, it has the Fed easing at least one times or two more times. Although I would say with respect to the Fed going forward, especially next week. There is still a fair amount of uncertainty. I think most market participants are kind of expecting what you would call a hawkish ease, in other words the Fed will likely ease that they may provide guidance that implies that they are close to - they are done for now. And I think this is all driven by some lack of consensus within the Fed. There is two schools of thought, one kind of focuses simply on the domestic economy, the level of inflation. The unemployment rate and so forth, GDP growth, which is still strong and the other half is a little more global with global outlook and looking at financial market stress and growth abroad and other factors, which can ultimately affect the domestic economy. So the outcome of that kind of remains to be seen. So to summarize all this, I would say that it was very much a tough quarter for mortgage investors, especially if you are levered and dynamically hedged, as a result, our results for this quarter, our year-to-date return is only 1.5%. However, I think the opposite side of that coin is that I think we are at an attractive point in terms of mortgage valuations. I think most people view this asset classes at the extreme cheap. There may be some room for additional cheapening and the mortgage space is cheap for good reasons, we have had speeds and very high levels, TBA performance is poor, supply of mortgages is three billion to five billion a day. For those multi-sector asset managers out there chasing duration, mortgages are not a good place to find it. And the sector is out of form and plus we have some repo issues. But as I said, I think there is a growing sense that we are at or near the bottom and that we are bought to turn the quarter. I think that speeds, the bar for speeds to get meaningfully higher is quite high. We have been at low rates, record low rates essentially for quite a period of time, the seasonal effect ahead of us, the burn out and I think that while it's not necessarily easy to time when exactly it's going to turn. I think the outlook going forward is very asymmetric and favorably asset class, coupled with some of the other points I made about sister asset classes which have done extremely well. As a result, we feel very comfortable owning mortgages in this environment. As a result of the book value decline. Our leverage ratio creep up a little higher than it had been, but we are comfortable keeping it there. So we have chosen not to reduce the balance sheet and intend to keep it at this type of a leverage ratio. For these reasons. At this point, I would like to pivot and start talking about our results for the quarter. Slide 18. I will start with the right side. This is the return by sector, starting first with pass-throughs. We generated return in this, the pass-through portfolio of 3.28%, speeds were the big driver here. Speeds and pass-through space were 15% plus for the quarter. As a result, amortization, premium amortization was high, of course, the asset class performed poorly. With respect to the structured securities in particular IOs with the market rallying and speeds, very, very fast. The sector did very poorly, in fact you could argue that at some point around Labor Day, IO classes kind of at a point of maximum pain. We actually got to a point where they was arguably positively convex and then since that they really couldn't get any cheaper and to the extent that the speeds increased, people just view them as such extreme level of cheapness that they were desirable to buy from us as a hedging instrument we view them as attractive now because they offer very good extension potential, which is what we look at them, when we use them as a hedge. Turning now to the left hand side, this is our proxy for core income that most of our peers use. We do not present core in the same sense that they do. We just basically take what you see here, which is, if you look to the last column, that is effectively our income statement. And we just parse out the realized and unrealized gains and losses from everything else, which would be interest income and expense, and our total G&A expenses. That number was $0.18. The dividend was $0.24, somewhat light, but again it's due to extremely high levels of speeds and premium amortization and as I will say in a few moments, we don't see this as persisting. I think we are kind of at a trough. I think the worse is probably behind us. If you turn to Slide 19. This is kind of the same thing in words are in picture, several lines here, the blue line at the top is just the yield on the assets. The red line is our economic funding cost and the green line is our NIM. We have been in the low 2% for a while and most two recent quarters drifted below that. Reflecting the higher level of speeds and access to premium amortization. But as I said, I think the worst of that is behind us and I would expect this to recover Slide 20 just basically the same picture. On here, we are showing our proxy for core, the same exact conclusion to be drawn from that is in previous page. Slide 21, we get into our portfolio activity. I want to start on the right hand side, as I mentioned, we did do a capital raise, the follow on offering at the end of July. I want to focus here on the right hand side, the two lines, securities purchased and sold. As you can see, all the activity was in the pass-through side. So all the marginal capital was deployed in the pass-through portfolio. We did not buy any IO securities and in fact if you look at the IO interest only column. You can see that a combination of return on investment in mark-to-market losses reduce the allocation of that space, as a result, when you look to the left hand side, you can see that the pass-through allocation, capital allocation increased from 66% to 75% reflecting the combination of the fact that the marginal capital was invested exclusively in pass-throughs and the run-off of the IO portfolio. Now turning to Slide 23. This is the outline of the portfolio versus snapshot where the portfolio was at the end of the quarter. With respect to ARMs in 15 years. There was no - 20 years no meaningful changes. We did do a few changes in the 30-year space, we shifted some 30-year, three exposure into 3.5s that wasn't so much of a duration calls on relative value trade and we added two fours and 4.5s. Again there was marginal capital deployed as a result of the capital raise. This is mostly relative value trading and intends to increase the call protection of the portfolio. And as I see you can see the allocation to IOs is 2.07%. That is just reflects the run-off. When we did do the capital raise in July, we have put in place some swaps. As you see our swap position increased this quarter and we also put on some five year treasury futures, which I will say another word or two about in a moment, and we no longer have any TBA hedges. Since quarter-end, we have done a few more trades, again trying to add call protection to the portfolio, and some of the addition was through subtraction by just parting ways with some higher-paid and lower yielding assets. So we think going forward. The portfolio is positioned to do better in this low rate, high speed environment. As I mentioned, our leverage ratio. Slide 25 is at the high end of our recent range approaching 10. And then finally on Slide 26, just few words about our hedge positions. As I mentioned the swaps we put in place some new swaps we did the capital raise. Most of the capital raise was through that follow-on offering. We did run our ATM program in July. But the incremental capital through that capital raise. We have put in place a $410 million notional swap at about 1.77%. The notional amount of that swap essentially reflected all the marginal borrowing. So in effect, we have locked in the funding cost of the marginal borrowing and in doing so more or less locked in the NIM on the marginal capital at about 125 basis points to 30 basis points. So it is an accretive capital raise and not affected by the turmoil on the repo market, since we did lock in the funding. We also added some Fed fund futures positions as you can see in the top right. We chose Fed funds futures because at the time they had the most amount of Fed eases reflecting in the futures market. As you can see the blended rate there is 1.49% and the contracts themselves reflect about 50 basis points of additional easing. So we will see what the Fed does. They may be done after next week, they may not, but we have locked in a fair amount of funding. And then just finally, a few words on the cap rates. We did this at the end of July. In anticipation of a Fed easing cycle then really seeing what was going to happen starting in August with the turmoil in the market, but fortunately, we were able to deploy the proceeds very quickly two days or three days. And as I said, through the swap position, we entered into, we were able to lock in a NIM that it was modestly accretive to earnings. So even though the timing wasn't quite as fortuitous that we hope, because we are able to deploy the proceeds and lock in the funding quickly, it was an accretive capital raise. That is basically it, operator, from my prepared remarks. At this point, we can turn the call over to questions.

Hey, guys.

Hey Chris.

Bob, on Page 10, you are showing there hedge updates and you are showing that the 4.5s were outperforming. Could you explain that a little bit and that is surprising.

Well, I think it's to a large extent, it was the desirability. I will just give my answer and I will let Hunter speak. I think it was the less of evils, 3.5s and fours during this quarter - very, very poorly. They were basically shunned enforced - this is versus a hedge ratio, and 4.5s and we are very low hedge ratio versus the 10-year and it was more of just a what would you want to call it a - people ran from the other coupons to these, threes did poorly simply because they went from being the convexity play when they are at a discount to a premium and did poorly. So it was really just a lesser of evils now. Hunter, you want to add to that.

Yes, I would just, I think in particular, we use the hedge ratios that we use for that slot are from a firm who modeled 4.5s to be very, very short. So I don't remember off the top of my head what it was at the beginning of the period, but I want to say somewhere around like 12% to 15% of a tenure. So you have the 4.5 going up in price by

Five or seven ticks. On the next page, I think it was 27 ticks.

27 ticks versus the tenure going to up [100] (Ph). So that seems consistent with that math. The other using like a 15% hedge ratio.

And I would just add, when you get into periods like this. You can see a large disparity and hedge ratios that people use. The fact of the matter is a lot of times, the empirical duration shrink, very, very low. So mortgages just don't behave well in a sharp rally or sell off generally. But in this case, it was a very meaningful rally and there was a psychological significance too in late August early September we were getting very close to the all-time low in 10-year yields and when people are chasing duration, they are not looking to mortgages and therefore that is why they can typically such in a lower coupons do so poorly. And I think the higher coupon really just benefited from the math as Hunter alluded to just the fact that the hedge ratio was so low.

Great. And then on Page 23, I'm looking at your interest rate sensitivity in the lower right hand corner.

Yes.

Which has changed dramatically from the last quarter. And is it fair to characterize that you guys are basically not baking in any possibility of a rate increase on your hedge position, you are just looking at.

Yes, we definitely try to add duration to the portfolio, we think that the bar for rate increases is or at least dramatic ones is fairly low right now. So we are trying to flatten that out as much as we can. We are delta hedging the portfolio to a certain extent. So while in times when we get to the upper end of the range, we will try to add a little more duration. It was quite frankly very hard to come by, last quarter there was mortgages widening on a spread basis and then volatility increasing. So even if it's a little wider in term in OAS terms and we were also lower dollar price, because volatility was increasing. Yes, the speed dynamic at play, which was more of an income event for us, but then also you had also the funding squeeze so that coming in at quarter end, certainly didn't help our marks out. So we are at the higher end of the range, I think we feel comfortable trying to flatten that portfolio out. We tend to perform a little better than modeled then the down shock scenario that is just because when on a model. Some of the higher coupon assets and some of our more seasoned IOs empirically have performed better than models in those down scenarios. So I would think that we are actually a little bit flatter than what is suggested here. So anyway, I think the goal is yes to have less exposure to sharp moves downward in rate and willing to take on a little more of a flat profile onto a rising rate environment.

And also I would add, Chris, and I tried to make the point earlier was that the volatility in the market was really extreme. When you went - kind of all started right after the Fed ease on the 31st and then following day, there was a tweet by President Trump. [indiscernible] escalated the trade war with China and August was very chaotic, it's very sharp rally. And by the end of the month mortgages pretty much lost all their duration. And when you trying to maintain a relatively flat profile. You have got to find a way to do so, and then we have this sharp reversal in early September, we sold off, I think it was 44 basis points on 10s in like eight days. And then on Saturday, whatever was September 14. We find out that they have attacked oil fields in Saudi Arabia and the market turns right around and rallies again. And so when you are trying to adjust your hedges with rates whipsawing that fast, it gets very challenging. That was really a lot of the reason for the pain in the quarter. And then going forward. You know when you get these extremely low levels of rates, what you are seeing in this table on the bottom right is the market - the models basically telling you that if you have a meaningful rally from here at 50 basis points, mortgages are going to underperform. And the sell-off, the way we are positioned, we would probably do better in a sell-off. I mean, obviously that is not a large positive number. But again, I think that we are at a point where at least from a speed perspective, I think, it's just very asymmetric going forward. Yes, you could see speeds get a little faster. But I think the bar is pretty high. I think in all likelihood, they may be a slow trend lower, but they really can't, I just find it heartedly, they could get meaningfully faster from here.

We have taken steps in October also to flatten that out even more on the down rate scenario. So we have sold some of the really short low-yielding assets and we have added some quality call protection that exhibits more duration.

So is it fair to say that given all that, it sounds like you guys are sort of - and sort of reflect Bob's comments, speeds to start, slowing down a little bit, maybe some of this volatility settling down. And that is the reason for going out for the 4.5, 30-years, which is a change of strategy from the last couple of quarters.

Yes. We were definitely adding the duration in threes and 3.5s. And a lot of this is just relative value, it's two things relative value in the sense that the longest duration mortgages got extremely rich because everybody was trying to add that duration. And two, this is kind of a nuance. But when we talk about the performance of the TBA over the last year and a half, we haven't really, I didn't speak it at all about it today, but part of the reason is, what we see that is very high gross WAC pool. So in other words, historically, when I went out about a 3.5% mortgage. The gross WAC was around 4% give or take. So normally the spread was like 50 bps, now it's 80 bps to 110 bps. So Fannie threes have a 4% gross WAC, so they prepay like a 3.5% So it's like you have shifted the S-Curve, so to speak and not only that, but they tend to have higher average loan balances and very high FICO scores. And so TBA pays at extremely fast speeds, some of the major pools that were produced, even this year, there is a one pool, I think it's a four, that it paid 55 CPR the first month and 58 and 59 or something like that. They have been terrible. But what we did finally find recently, where some originator bid less where the gross WAC was 340 on a three year, 390 on a 3.5. Those are very attractive. So that is, to some extent, which attracted us to those, it wasn't an explicit desire to add that coupon. It was where we could find value and that really like I said, that was more relative value trading driven versus duration chasing driven. If that make sense.

Yes, great. Thanks for taking my questions, guys.

Thank you.

[Operator Instructions] There are no further questions at this time, please continue. Sir.

Thank you, operator and thank you everyone for taking the time to listen in or to the extent you are listening in on the replay. If you do have questions that come to mind after the fact. Please feel free to call us in the office, our number here is 772-231-1400 we will be very willing to take any and all questions. Otherwise, we look forward to talking to you next time. Thank you.

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