Orchid Island Capital, Inc. (NYSE:ORC) Q4 2019 Results Earnings Conference Call February 21, 2020 10:00 AM ET
Robert Cauley – Chairman, President, Chief Executive Officer
Hunter Haas – Chief Financial Officer, Chief Investment Officer and Director
Conference Call Participants
Christopher Nolan – Ladenburg Thalmann
Jason Stewart – JonesTrading
Good morning and welcome to the fourth quarter 2019 earnings conference call for Orchid Island Capital. This call is being recorded today, February 21, 2020.
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 Limitation 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 the 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.
Thank you operator and good morning everyone. Thank you for joining us today. I hope everybody has had a chance to print a copy of our slide deck. That will be the focus of discussion today. Assuming everybody is ready, I will be starting on slide three, as we give you all the rundown of the agenda.
First, we will have a brief highlight of our financial results for the quarter. Then we will spend a few minutes talking about market developments that affected the portfolio and guided our decision making. And then we will turn to our financial results. And finally, we will discuss portfolio characteristics, credit et cetera, hedges and changes we have made to the portfolio.
Starting with our financial highlights for the quarter. Orchid Island generated net income per share of approximately $0.29. This includes $0.06 per common share of net realized and unrealized gains and losses on our assets, our agency RMBS assets as well as our derivative instruments including net interest income on our interest rate swaps. Earnings per share of $0.23 excluding all those times I just mentioned. Book value per share was $6.27 at December 31, an increase of $0.05 or 80 basis points from $6.22 at the end of the previous quarter. In the fourth quarter, the company declared $0.24 per share of common dividends. And since our initial public offering, we have declared $11.025 of dividends. Economic return for the quarter was $0.29 or 4.7% unannualized, 18.6% annualized. And the return for the year was 5.7%, a very generous return.
Now before I move forward, I just want to provide some context for new investors and maybe reiterate in some basic facts for those who have been listening to us for a long time and just try and give you some background about Orchid. Orchid is an agency mortgage REIT. We do not take credit. Our portfolio is generally very fixed rate focused. We tend to be invested in conventional, so Fannie Mae and Freddie Mac versus Ginnie Mae. And we tend to have a bias towards 30-year securities versus 15, 20 or 10 years. We generally own our assets in pass-through form versus CMOs, although we do own those generally depending on market conditions. So for instance, late in 2018, when REITs were backing up, we owned some shorter sequentials. We generally do not have high concentrations of those. We use IOs and inverse IOs for hedging purposes versus carry generally. And those tend to be structured IOs.
To reiterate again, we do not use non-agency mortgages or for that matter, any other form of credits, although that could change at some point in the future. At this point, we view ourselves as being very late in the credit cycle and not wanting to add there. To which, the focus of the discussion, especially with respect to the market, will be on the conventional 30-year fixed-rate market and the market factors that affected those securities.
Turning now to slide six. As we always do, start with the interest rates. On the left hand side, you see movements in the treasury curve. And on the right, the swap curve. The green line represents the curve as of the end of the previous year. The blue line is where we were at the end of the third quarter and the red line is where we ended the year. So generally speaking, market conditions for Orchid and for leverage mortgage-backed investing were favorable throughout the quarter. And I am going to go through a number of examples. But one thing, one caveat, is the prepayment activity was high entering the quarter, remained high through the quarter and has continued to remain high into 2020.
So as you can see on the left, interest rates moved higher over the course of the quarter. But to put that into, where we sit today, the line would actually be below that blue line and by a meaningful amount. So the 10-year is more than 20 basis points lower. The two years is probably approaching 30 basis points, well over 25. So we have had significant movements since year-end. But generally for the fourth quarter, it was a very favorable market environment.
Turing to subsequent slides and I am going to spend a lot of time on all of these. And slide seven just shows you the movements in the 10-year treasury note, the tenure swap. Sam thing, you saw rates backing up. Generally, a good thing for mortgages.
You turn to slide eight, we show a proxy for the slope of the curve. And as you can see, after troughing, in this case, this is the spread between the five and a 30-year treasury note, treasury bond rather. We hit a in the summer of 2018. It’s noteworthy to point out though, that the re-steepening has been very, very gradual and very modest. Not much at all. In fact, today, it’s only about 58 basis points. So a very far cry from where we were back in 2013.
Now, changing our focus on slide nine to the mortgage market. In the top left, we see the performance of various 30-year fixed-rate coupons. As you can see, for instance, the bottom line, Fannie 3s, they are down four ticks given the selloff in treasury. That’s decent performance. But it’s even more noteworthy when you look at the lines for 3.5 and 4s. They are actually up in price. So while rates were backing up, these mortgages were up in price, although in the third quarter of 2019 they performed very poorly. In fact, in instances, on certain days they were down in price with the market up. So some of that’s just catch up.
And on the bottom left, we show the roll market for these various coupons. The blue line is the 3% coupon and you can see, it ran around two ticks, which is modest when it is positive. The balance of them were near zero or negative. And that reflects a very poor quality of what we call the TBA, the cheapest to deliver collateral, very, very fast prepaids. And as a result, the roll market was very unattractive.
As is often the case if not always the case, when the roll market is soft, the spec pool market is very strong and you can see that right side of the page. We have two examples, an 85k Max security and then also just a new or genetic new security. You can see those prepayments are elevated and that’s always going to be the case when the roll market is as soft as it was.
Just continuing with some more indicators of general market conditions on slide 10. On the left hand side, this is just the LIBOR OAS of various TBA coupons. And I just want to point out, if you look on the right hand side of that slide, over the course of the fourth quarter, we were tightening. So again, another instance of a favorable market condition.
Slide 11 is new for us. And I want to spend a few moments on this. This is a very decent backdrop for all discussions of mortgages. On the left hand side, by the way this is for all of calendar year 2019. The shaded area represents the mortgage rate available to the market. And as you can see for the first three quarters of the year, this was declining. The blue line represents the refi index, the aggregate refi index, which means it’s conventional and government. And as you can see, it crested over 2,500 in the third quarter. Over the course of the fourth quarter, though, it declined. So another instance where very favorable condition for mortgages. However, as we move into the first quarter of 2020 and with the rally, that number got over 3,000 two weeks ago. So that’s above the high end of range in this graph. So we have had a sharp reversal in that.
On the right hand side, another important chart. Again, the blue there is the aggregate refi index. The shaded area, in this case, just represents the percent of the 30-year universe that’s at least 50 basis points in-the-money, so refinanceable. As you can see, basically for the entire second half of the year, that number is running around 40%, in not higher. And that explains why we have had so much refinancing activity. As we sit here today, that number is close to 50% and the refi index, as I said, is moving materially higher.
Turning to the broader market on slide 12, we show returns here across the various components of the U.S. aggregate bond index. The top is for the year. The bottom is for the quarter. The takeaway here is simply the fact that the fourth quarter and really of 2019 is what we refer to as a risk-on period. So in other words, risk assets did well. So for instance, for the quarter, if you look at the bottom right, you can see that investment-grade corporate is at 1.18%, emerging market investment grade high-yield, emerging market high-yield and so forth, all did very well.
Mortgages did okay with a positive return of 71 basis points. And I do want to point out, for the year, the agency MBS universe returned 6.35%. That’s a very commendable return. The average coupon on 30-year mortgages is less than 6.35%. So that component or that total return has a component of price appreciation. So event though mortgages often don’t do as well in a meaningful rally, at least the total return had some price component. So it was a decent year for mortgages in general as a rule.
Slide 13 just shows implied vol on swaption, so a proxy for vol. And as you can see, again, it’s the same story. The fourth quarter vol was declining. That is, of course, reversed in the first quarter.
Finally on slide 15, just want to give you a picture of the market versus Fed expectations for the funding rate. We have four tables here. On the left, you see September 2018. That was in the midst of the tightening cycle when the market and the Fed expected several additional tightenings. But if you look at the bottom right, which is at the end of last year, you can see that that has changed dramatically.
One thing let me point out here that’s clear in every case is that Fed expectations for funding levels versus the market are drastically different. In all cases, the market is much lower. And as we sit here today, that gap would probably be even larger. Ironically, the only time they have actually been even close was in the height of the tightening cycle and that was on several years out.
Now I will turn to our financial results, slide 17. Let’s start off with kind of a high level look at the portfolio and our returns and eventually the discussion will evolve into a more detailed discussion of the portfolio. On the right hand side, we show the returns for the quarter. As you know, we bifurcate our capital into a pass-through strategy and IO and inverse IO strategy, the latter being for hedging purposes.
One thing that’s very obvious and notable is that on the bottomline, you can see that returns for all sectors were positive for the quarter, very generous returns. I will point out a few things with respect to each. For instance, in the pass-through portfolio and I will talk about our hedges more in a moment, but we had a very positive $10.8 million return on our hedges. Our hedge coverage using notional or hedges versus our repo balance has been reduced over the course of 2019, but yet we still generated a very positive return from that. The realized and unrealized gains and losses were negative $9.7 million.
Recall that Orchid uses fair value accounting which means that when our messages which we purchase generally at a premium prepay, we capture that premium amortization and mark-to-market. For the fourth quarter of 2019, that premium amortization, if you will, that proxy was actually north of $11 million, which means that this mark-to-market gains and losses, net of premium amortization, was actually a positive number. So a very strong result for the quarter. And then, of course, our interest-only and inverse interest-only securities which we use as a hedge were also positive. So for the portfolio, we generated a very significant positive return of 5.1%, which is unannualized.
Turning to slide 18, taking a longer term look at trends here. On the top, we have three lines. The top line, the blue line, represents the yield on our assets. The red line is our economic cost of funds, in other words it reflects the effect of hedges. And then finally, the green line is our net interest margin. As you can see, as we move from the far left back in the day when rates were near zero to the right, out funding cost have increased. They peaked during the summer of 2019 at 2.71% but with Fed eases in the second half of the year coupled with the hedges we have in place, that number has dropped substantially, almost 100 basis points in just six months to 1.78%. Out asset yields have dropped, although less so and as a result, our net interest margin has rebounded off of a near all-time low level of 1.55% to north of 2%. We don’t know what the future holds, but we do know that going into 2020, funding costs should stay low. The only question would be, asset yields and we will have more to say about that in a moment.
Slide 19 is the same thing, same picture, only in earnings per share versus yields and percentages. And as you can see, the third quarter was the local trough and we have since rebounded off of that level.
Now I will turn to slide 20, make a few comments about our capital allocation and activity in the portfolio. Starting with the right hand side, as you can see in the pass-through portfolio, the one number I want to highlight is the paydown number, almost $200 million, very significantly high number. It reflects what I said many times already. The fact that prepays have remained elevated, we had to take steps in the portfolio to address that and those are reflected in the securities purchased and securities sold. You can see those numbers are quite large by historical standards and that just reflects the fact that we had to take steps to address the new environment they were in.
On the left hand side we talk about our capital allocation. The only noteworthy thing to point out is that the IO and inverse IO allocation is reduced, not so much that it’s a strategic change. Two things. One, we did sell some of our IO positions. They were just simply positions that had gotten quite small. We were just cleaning up some of the line items. But also, more importantly, with respect to IOs in particular, with prepay activity at these high levels, there’s not a lot of opportunity for those cash flows to shorten much further than they already have but they have a lot of potential to extend if rates were to back up. So from a hedging perspective, especially with respect to the long end of the curve, those are very key assets to own and we will continue to do so.
Now I will delve into the portfolio in more detail and try to address what we just discussed in more detail. On slide 22, I realize there’s a lot of numbers here and I will try to make as much sense as I can of them and make this as clear as possible. One thing I want to point out very quickly, though, in the middle of the page for the pass-through portfolio, there is a column labeled net WAC.
And you can see, at the end of the year that was 3.92% for the pass-through portfolio. At the end of the third quarter, that was 4.22%. So we have reduced the net WAC on the portfolio by 30 basis points. And the reason we are doing this is, with this rally and with this high refi activity, what we are trying to do is add duration to the portfolio to allow the portfolio to try to keep up with the market but also to provide as much fee protection as we can and you can do that through either spec pools and/or lower coupons.
To which, if you look at the column labeled FMV or fair market value, the second line is fixed rate CMOs. We have added those in 2018 as a defensive position. Short sequentials unfortunately tend to prepay fast in this environment. The balance is a little under $300 million. That was over $600 million at the end of the third quarter and we have subsequently reduced that position even further.
Below that, you see a line labeled 15-year 4, a little under $20 million. That actually was almost $400 million at the end of the last quarter. It was predominantly low loan balance securities. We sold those, booked a very substantial gain and redeployed the proceeds into longer duration assets. Within the 30-year stack 3s, 3.5s and so forth, the 3.0 bucket has increased modestly, but the 3.5 bucket is approximately $775 million higher than it was at the end of the third quarter. The 4 bucket increased by approximately $350 million. The 4.5 bucket was basically allowed to run down and the 5 bucket shrank by $550 million.
So we are moving down in coupon and the securities we are adding in spec format and they tend to be in the very best forms of call protection. So low loan balance or New York securities. Again, we are trying to add duration to the portfolio to protect ourselves from prepayments.
At the bottom of the page, we show our hedge positions. I will discuss those in a minute in greater detail. I will just pass on those for now.
Slide 23, this is another new slide. I want to explain what we are showing here. This is kind of how we look at prepayments. It’s a rather simplistic approach. Well, what we look at here is, we look at the dollar amount of prepayments and this is reflected in this red line, the dollar amounts of prepayments in a given month just divided by the unpaid principal balance of the portfolio. And as you can see, the dotted line there kind of represents the average of that level over time at 91 basis points. That equates to a low double digit CPR. And that’s what we have experienced over the life of the company. So somewhere in the 10 to 12 CPR range.
The blue line represents the 10-year treasury. And what’s interesting to note is, as you see, back in 2016 we had the surprise result in the election, 10-year sold off, crested above 3% and then has since rallied meaningfully. But the significance of that is, with the 10-year and rates staying high for that long period of time, there was a lot of mortgages created in that period that were now in-the-money for the first time. And that’s why you see this red lines spike all the way outside of our norms and we show one standard deviation above our mean over this period.
And you can see, it got up from your 2% but has since come back down. And the reason that is because, as I mentioned, we have shifted the portfolio down in coupon and added duration and prepay protection. And now this most recent reading which was for this month is back to within one standard deviation of our norm at 1.15%. So it’s responding to the market. But one thing we also have to keep in the back of our mind, at least, is it is an election year again in the fall of this year.
There is the potential for another surprise outcome potentially. So when we position the portfolio, we have to be mindful of the fact that rates can and have turned around rapidly. And with respect to at least some of the changes we made in the portfolio in the first quarter, we have had that in mind. And also as I mentioned, our IO portfolio is well positioned to protect us in that kind of an outcome.
Slide 24 is just historical information. I won’t say anything about that today.
Slide 25, I just want to make a couple of points. On the left, we list our credit counterparties. And the takeaway from this is simply the fact that Orchid retains ample access to funding. We have more funding available to us than we need and from a very diverse group of counterparties, both geographically, the number of names and the type of names. For instance, we have the Wells Fargo Bank, which is a large money-centered bank. But our second largest counterparty is more or less a repo focused shop. So a diverse mix of counterparties and more than ample supply.
On the right side, we show our leverage ratio. And I want to note that in the fourth quarter, we did take our leverage down as the rates backed up. Since year-end, that number is back up again slightly, not as high as it was. But we have taken the leverage back up slightly with the rally.
I will now say some words about our hedges. We show the four buckets here. The top left is our Eurodollar positions. To the right of those are our TBA hedges. On the bottom, we have some treasury futures and then our swaps. The Eurodollar as a hedge instrument, which at one point in our life was our only hedge instrument, have basically been running off and as you can see, the contracts we have in place all run off this year. At the moment, we have no intention of adding to that. We are basically allowing those to run off.
With respect to TBAs, we have been using the 4.5% coupon versus some lower coupons. And as I mentioned earlier, those rolls are actually negative. So we can use a short position in 4.5% TBAs and actually get paid to do so because the drop is negative.
With respect to futures, it’s run down somewhat from where it was at the end of the third quarter and it really reflects our decision to one, reduce the exposure there in that instrument and add it in the swap bucket.
On the bottom right, we show our swap positions. As you see, we have it broken down between one and three years and three and five years. That’s where our swaps lie. We do not have any swaps outside of that. The big change was in the one to three year bucket and that really just reflects the fact that most of that change is just swaps that were running off in 2020. And we have actually, since year-end, added to the three to five year bucket.
The belly of the curve typically is the most sensitive to the market’s expectation for Fed activity. And as is often the case, what we are seeing today is a rally in that point of the curve. The most meaningful rally in the treasury curve has been in the three to five year area, reflecting the market beginning to price in more Fed eases and we think that’s the most effective hedge area because, to the extent that market expectation changes, you tend to get an equal in magnitude reaction the other way. And it also lines up fairly well with the duration of the mortgage assets that we own.
Finally, I just want to show another new slide that we have, slide 27. And it’s really just for illustrative purposes. It shows that our repo expense on the far right column per share has been declining. I want to point out, in the second to the last column, shares outstanding, Orchid did grow over the course of the year. As a result, capital being deployed at various times throughout the year, sometimes at the beginning of the month, sometimes the end of the month.
If you look at the repo rate column, it’s kind of noisy but that just reflects timing issues more than anything. I just wanted to point out that repo expense per share has been declining. And we did have some funding issues in the repo markets in the third quarter resulted in repo rates being just over 2% at the turn of the year. But since then, those issues have abated and our funding costs have dropped back into the generally 1.70s. And so this number has room to decline. Again to the asset side, we don’t know, but we are realizing the benefit of the Fed eases and our funding costs have been declining.
With that, I will turn the call over to questions, operator. You may go ahead.
[Operator Instructions]. Your first question comes from the line of Christopher Nolan from Ladenburg Thalmann. Your line is open.
Hi Bob. Can you comment, sorry, I missed it, but did you indicate that the higher asset yields were due to higher prepayment and amortization?
No, not that. Our yields on the portfolio have been coming down slightly because of the basically the shift down in coupon coupled with some realized higher prepayments and they have been coming down.
All right. And then I guess the second question I have is on the portfolio characteristics. Obviously, you have been investing, it seems like a big jump into 3.5 and 4s. And this seems to be, I mean, given the jump, how should I look at this in terms of your coming down from 4.5 and 5s to 3.5s and 4s? Because I am comparing the portfolio quarter-over-quarter and I see the big jump. It’s just not clear to me exactly where you are taking stuff out of, aside from the 15-years.
Well, the CMOs. CMOs were reduced by half from, I think it was $605 million to a little under $3 million. 15-year 4s went from $403 million to less than $20 million. The big jump was in the 5 bucket. It was $808 million, $809 million. That was reduced by about $550 million. The 4.5 bucket basically just ran off. That went from $460 million to $430 million. So the CMO bucket, the 15-year 4 bucket and the 30-year 5 bucket were the big ones that shrank. And the adds, as you mentioned, were in the 3.5s and 4s.
And that’s we are just, like everybody else, we are trying to get some duration, while at the same time protecting yourself from prepay. So even though we bought lower coupons and we were buying a lot of low loan balance or 110k, 125k or New York. So the dollars are still somewhat high, but you do get good prepay protection from those assets, because at this point, today, as we speak, the 10-year is now broken through 150. We would expect prepay activities to remain very robust.
Yes. Chris, over $900 million of those purchases, those new purchases were in either 85k or 110k Max and that collateral is just simply not available in 4.5s and 5s. We did want to add some duration in the lower coupons as well because we think those are going to serve us well into a rally environment. And in general, the theme is just very simple. We expect, as I think Bob had a great new slide he was talking about showing the percentage of the mortgage universe that’s on the cusp of being refinanceable.
And so we want to improve the convexity of the portfolio in case we get a rally. So increase the duration, improve the convexity, invest in assets that will continue to increase in value, if and really frankly, as we have rallied. And then on the hedge side, stay very light and nimble. And we have done a few things on out-of-the-money payers that I think would serve us well in case we are wrong in that view, we will get a quick reversal to higher rates.
Okay. And thanks for the color. I guess the final question really is on your interest rate sensitivity. It seems to change so much dramatically quarter-over-quarter where a 50 bip increase can really impact the portfolio. How high should we expect the duration to go? Or do you expect the duration to stay at current levels in the first quarter? What do you think? What do you think about that?
Well, yes, I noticed what you are seeing in the sensitivity table, a negative $13 million in a selloff. Now it’s positive $400,000 negative. And that of course reflects the down in coupon shift. Empirically, we have actually traded to a slightly positive duration on these.
And let me just back up to what is the question. We have seen very consistently year-to-date and really throughout the last six months, when the market rallies we tend to bull flatten and when we selloff, we steepen. And so every time you get these rallies, where the market flattens, obviously mortgages do tend to go wide and do very poorly. And we have positioned the portfolio such that we don’t do as bad as we used to when that happened. It’s not ever a good thing, but we may have modest losses. That’s with the empirical duration.
The model duration is going to be, the model is going to capture the fact that we have longer duration assets on the books plus they are specified pools. So we are going to model and that’s why these numbers are what they are. Who knows what the future holds, certainly with respect to the long end. But I think it’s really, really hard to see a scenario where the Fed is going to tighten in the near term. So that’s one risk we feel very comfortable taking. So we have to worry about the long end.
And so Hunter had mentioned some of the swaptions we have done. And as I said, we have the IO book. When speeds get this fast, at some point prepay expectations with respect to IOs can only get so high. So those cash flows or expected cash flow shorten, it really can’t shorten anymore. But in the meaningful backup, they can extend quite a bit. And so we feel comfortable owning those as a hedge against the move in the long end.
And then the other thing which is more of a local move. What we have seen is, even in the fourth quarter when rates backed up, the market is, I would say, it has a bearish or a bullish bias to it. And that means that the market ignores economic good news and rallies when we have bad news. And that’s reflected in the past for spec pools. Even though the market sold off in the fourth quarter, those payoffs did fairly well.
Now we have an option coming up, options in two weeks and we are back at where we were during the January. I don’t think that those are going to do very robustly. And they will outperform their hedge ratios in a selloff, as long as it’s not too severe.
Okay. Thanks for taking my questions.
Your next question comes from the line of Jason Stewart from JonesTrading. Your line is open.
Great. Thanks. Good morning guys. My question is on the expectation for the cadence of prepayments. Bob, you noted that they were still high in the first quarter. But is your expectation that they decline sequentially, even if it’s moderate decline? And then tick back up? I guess any color you could give us on how you expect that cadence to work out through the middle of this year, would be helpful.
I don’t expect them to drop much at all. I mean, the drivers are day count and things like that. But certainly with the rally lately, I don’t expect them to drop much. The only thing that’s going to cause them I think to drop much is going to be burnout, really. It’s just that these borrowers are exposed to refinancing opportunities now. There, I would assume, the various mortgage originators out there are ramping up capacity to refi more and more. And it’s just a question of how fast they can work through the process.
Yes. I would just add to that. I think some of the incremental changes we have made in the portfolio might help us. If we are talking about a static set of assets, I don’t actually expect them to be ramping up here in the next few months. But we have taken actions in the fourth and first quarter to improve the prepay profile of our portfolio. So I think we might see a modest downtick just related to that type of rotation. But in general, if we are talking about assets that were originated in 2018 or 2017 even, I think you could expect to see them increase speeds sequentially.
Okay. That’s helpful. And then I just want to make sure I put some of your comments. so I see you little bit of equity in the first quarter. I think you noted that you added some assets, the basis is wider and leverage went up. So you have added better economic return assets in the first quarter to-date in excess of the equity that you have issued. Is that correct?
Yes. Slightly more, yes.
[Operator Instructions]. I am showing no further questions at this time. I would like now to turn the conference back to you, Mr. Robert Cauley, Chairman and Chief Executive Officer.
Thank you operator. Thank you everybody for the time. I appreciate you listening in today. To the extent you have additional questions or you happen to hear the replay, didn’t hear us live, we will be in the office all day. You can field your questions. Our number is 772-231-1400. Otherwise, we look forward to talking to you next time. Thank you.
Ladies and gentlemen, this concludes today’s conference. Thank you for participation and have a wonderful day. You may all disconnect.