ARMOUR Residential REIT, Inc.
Q1 2021 Earnings Call Transcript

Published: 22 Apr 2021

[Operator:]

Greetings, and welcome to the ARMOUR Residential REIT, Inc. First Quarter 2021 Earnings Conference Call. During the presentation all participants will be in a listen-only mode. As a reminder this conference is being recorded Thursday April 22, 2021. I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.

[Jim Mountain:]

Thank you, Kelly. And thank you all for joining our call to discuss ARMOUR’s first quarter 2021 results. This morning, I’m joined by ARMOUR’s Co-CEOs, Scott Ulm and Jeff Zimmer; and by our CIO, Mark Gruber.

[Scott Ulm:]

Thanks, Jim. The first quarter of 2021

[Operator:]

Please stand by the conference call will begin momentarily. We thank you very much for your patience and we ask that you please remain on the line. I will try to get the line of Mr. Mountain back on to the call. Please stay connected. I have resumed the call sir, you may proceed.

[Scott Ulm:]

Thank you. Apologies, we were disconnected. Scott Ulm, Co-CEO of ARMOUR REIT continuing with my remarks. The first quarter 2021 deliver the first raise of optimism and a nearly year-long fight against the pandemic and its impact on the economy. Positive sentiment was fueled by the largest fiscal stimulus in U.S. history of $1.9 trillion and rapid distribution of effective vaccines. The financial markets saw this as a potent fix to reinflate and reopen the economy ahead of the expected timelines. Higher projections for inflation and treasury issuance have quickly repriced the yield on the 10-year treasury higher by 82 basis points to touch as high as 1.75%. While yield spread between twos and 10s treasury has expanded by 78 basis points. Despite a rise in treasury yields at a quicker pace that in 2013, mortgage spreads avoided a repeat of the 2013 taper tantrum, due in large part to the Federal Reserve’s unwavering commitment to keep the mortgage purchase program going well into the economic recovery cycle. Over the course of the first quarter, the option adjusted spreads on 30-year, Fannie 2%, TBAs have tightened by eight basis points, while zero volatility OAS tightened as much as 19 basis points for this cohort. Despite sharply lower treasury bond prices, ARR delivered a positive 3.1% or 12.4% annualized economic return in the first quarter, illustrating strong risk controls around the portfolio’s duration and convexity. ARMOUR was active in managing its hedge book an exposure and production coupons in a very dynamic market. Over the course of 2021 ARMOUR’s implied leverage declined from 7.6 times at the end of the fourth quarter to 6.9 times as it sits today. This took place through capital raises through our ATM program, and sales of assets with either rich valuations or less favorable prepayment profiles. Our lower leverage provides us with ample dry powder to take advantage of market opportunities ahead. We will continue to be very selective in the prices we will accept for the risks on offer in the current market. ARMOUR’s duration as of year-end was 0.62 and is currently 0.30 with a negative duration exposure to the 10-year plus part of the yield curve. We like this duration profile, which matches our long-term buys for higher interest rates in the second half of 2021. First quarter prepayments remained elevated as originators were slow to increase mortgage rates in order to protect their market share. ARR’s portfolio averaged 17.4 CPR in the first quarter, slightly above 17.3 CPR from the previous quarter. Note that both are still significantly below speeds on more generic MBS cohorts. And we expect prepayment pressures to subside in the second quarter of potential tailwind earnings.

[Operator:]

Thank you. And our first question comes from Doug Harter with Credit Suisse. You may proceed with your question.

[Doug Harter:]

Thanks. I was hoping you could give a little more context to the amortization expense comment you gave. I think you said it was kind of a around the $6.10 drag this quarter, versus kind of model prepay speeds. How would that compared to the prior quarter?

[Jeff Zimmer:]

Prepayment…hi, Doug this is Jeff. Prepayments were up as you could see from the monthly company update that we put up last night, as much as 25% over a year ago. The exact difference in amortization I actually don’t believe we released those numbers yet. So, I need to be careful about releasing that public information. So, I’ll have Jim double check on that. And we’ll get back to you. And if indeed, we haven’t, we’ll go ahead and we’ll release that where everybody could see that. But prepayments are up 25% and that’s the biggest drag on earnings would – are two things, higher prepayments, which is greater amortization. As Jim said in his comments, and I think everybody knows, we don’t do modeling or forecasting and then do catch-ups, the catch-up to run through book value. And actually, in some cases, make current core earnings, a non-GAAP measure appear to be higher than, perhaps they are. We take amortization as it occurs. So as prepayments have ramped up here, we’re getting a larger hit to core earnings, even though if you kind of look at the returns over the quarter, the comprehensive income was quite substantial and honorable.

[Doug Harter:]

Just to drill down on the prepay, I guess industry-wide prepays were down in the first quarter relative to the fourth quarter, can you just talked about kind of what pieces of your portfolio and what kind of drove you to have higher sequential prepays in the first quarter?

[Jeff Zimmer:]

Our prepayments are well under our peer group prepayments. Our prepayment rate for the last month was in the high to mid 18 CPR level, you compare that to the peer groups that are going to be at least 10 CPR higher. Our individual securities that prepaid represented our higher coupons, our positions in 4s and 4.5’s. We own those positions at very low prices. But they continue to have some, higher prepayment levels, but we’re going to maintain those securities in our portfolio. I would also note to be exact, the CPR in Q1 was 17.4 not 18.

[Doug Harter:]

Right, thank you.

[Jeff Zimmer:]

Thank you very much.

[Operator:]

Our next question comes from Trevor Cranston with JMP Securities. You may proceed with your question.

[Trevor Cranston:]

Hi, thanks. I was wondering if you could elaborate maybe on sort of the thought process behind the dividend level. I know you said it’s sort of based on your medium term view. But is the way to think about that sort of – that’s where you guys see your earnings level, if you were at your target leverage, as opposed to running a lower risk, lower leverage strategy in the near term, or are there other things at play there as well?

[Jeff Zimmer:]

That’s exactly correct. And as a matter of fact, we could probably earn a little bit more than our dividend rate, if we were fully invested, as I just indicated. Investing long term on core incomes that have – for core income with assets that have negative 20 OAS is going to lead to some book value dilution, at some point, we’re going to be very cautious. And I expect, you know, for the remainder of this quarter, there will be great opportunities to reenter and we have lots of dry powder.

[Trevor Cranston:]

Okay, got it. That makes sense. And then in terms of your rate positioning, you mentioned, I think in the prepared remarks that you have some overall positive duration, but negative duration further out the curve. Can you have any comment on how that, how that’s changed as rates go up? And if you guys see any value and sort of adding some additional optional protection into the portfolio as well to protect against large moves in the 10 year?

[Jeff Zimmer:]

So, the DV01, we don’t release our DV01s. But as Scott said, the whole duration pattern is a 0.28 duration as of this morning was slightly negative in the 10 year, and that will defend us against a steepening that has occurred. And we as a firm expect more steepening. We feel that the Fed will keep the short end of the curve, see, overnight funding rates low, don’t see an increase for as many potentially as much as another two years and as economy expands. And banks have opportunities to provide credit in other areas, you’ll see higher tenure rates. And so we’re positioned for that, at some point, the Fed will also reduce their buying of mortgages. And that is a hopeful period where we can do some more reinvestment. I know Mark and his team have only reinvested paydowns, I think one, the full round of the last three months, so not only underinvested in paydowns to maintain the underinvested, of course, in our full leverage target. By the way, you saw yesterday that Canada announced that they’re starting to reduce the amount of purchases that they’re going to make, and many people’s comments on that, as you know, at some point will be next. I think the expectation is that if the Fed wants to maintain the same level of purchases, they would reduce in the mortgages and put it into treasuries.

[Trevor Cranston:]

Okay. To follow up on that comment about reinvesting paydowns, I guess, with OAS is negative here. Would you guys continue to let leverage drift lower valuations remain those tight or even potentially get tighter, or are you at a level where you’d like to keep leverage and where it was at the end of the quarter?

[Jeff Zimmer:]

I don’t think leverage all it’ll get much lower. Maybe you could see debt to equity get a little bit lower, if we put more money into TBAs, you can do TBA 2.5s right now, May, June rolls at 17% change. TBA 2s are 11.5%. Even 15 year, 1.5s are 11.5%. So there’s areas to put money there. But when we look at the risks associated with that, and the potential spread widening of negative 20 OAS investment opportunities today, we’re just being cautious. So, we will do some reinvestment in a specified, and I would note this – the pay-ups per specified, interestingly enough have come off quite a bit from their highs, some stuff that was like 80, 90 ticks over, 60 ticks over now. But interestingly enough, the OASs have come in. So pay-ups over TBAs have come down, but the OASs are more negative. And the dynamics of that, Mark, maybe you want to speak to that element, because we talked about that in our investment meetings.

[Mark Gruber:]

Sure. I mean, it’s just the fact is, is that rates declined, I mean the option cost to hedge out the mortgage portfolio has gone up. So, even though you see, a little bit of maybe some nominal spread widening, the option adjusted spread is just continuing to decline. And so that’s the reason why we continue to not reinvest a lot of our paydowns back in the mortgage product, because we’re seeing negative OASs, we’re seeing, single-digit kind of yields, mid single-digit yields on spec pools, and TBAs, like Jeff said, have some specialness and are interesting, but they have a lot of convexity in risk in different spots. So, the investment opportunities, when we look out on the outlook are not super attractive to reinvest all of our paydowns.

[Jeff Zimmer:]

These opportunities come out very quickly. The difference between the investment opportunities on May 10, 2013, and July 10, 2013 were like six points of difference. These things come at you. We’re trying to set ourselves up. So, if the marketplace provides an opportunity for larger reinvestment, we can ramp up our leverage very quickly two times. Otherwise, we will continue to reinvest. We do want to maintain a dividend and we have the power to create earnings.

[Trevor Cranston:]

Okay, appreciate the comments. Thank you.

[Jeff Zimmer:]

Thank you.

[Operator:]

Our next question comes from Christopher Nolan with Ladenburg Thalmann. You may proceed with your question.

[Christopher Nolan:]

Hey, guys. The lower waiver does that indicative of more confidence in the earnings momentum outlook for 2021?

[Jeff Zimmer:]

It’s actually probably more reflective of the capital raise and the way that our fee changes with capital raises. By the way to Jim’s point on that that entire raise of the equity and the preferred combined was total $0.04 diluted paid a underwriting fee between 1% and 1.5% versus peer groups paying underwriting fees for 4.75% to 5.75%. So, sometimes you raise capital not that you necessarily needed at the moment, but because it benefits shareholders so greatly to raise capital at a very cheap level. And so that’s the way we look at that.

[Mark Gruber:]

Well, and Jeff, you also didn’t mention absolute zero effect on market trading price through the ATM program that we’ve seen, whereas, in addition to underwriting discount, you often can see some negative overhang on market trading from block offerings, which we did not have here.

[Jeff Zimmer:]

I’m sorry, Christopher, you’re about to also ask a second set follow-up question.

[Christopher Nolan:]

No, Jeff, is that $0.04 to book value?

[Jeff Zimmer:]

Yes. All in. So what is that 0.03%?

[Mark Gruber:]

Yes. Paying back fairly rapidly through expense savings on a larger capital base.

[Christopher Nolan:]

Going forward, is it some – you guys generated 12% core ROE in the quarter. I mean, is that type of momentum that we should see, or should we say improve given your comments.

[Mark Gruber:]

That was economic return. So, that’s a combination of the dividends paid and change in book value. So, the change in book value, I have trouble predicting that, the dividend, I can probably give you a little more confidence on.

[Jeff Zimmer:]

So – but yes, you can earn that today’s market, as I just said, we got right now and do dollar rolls and 2s and 2.5, 30 years and 1.5, 15 years and combine and hedge that out and, earn 12%, you can do it. It’s just those securities that negative 20 OAS have risk. So, I think the profile you might see in the future is, as the Fed reduces their purchases of mortgages, and OAS is, get back to some prior investment levels, you might see as own less TBA or have less TBAs on our balance sheet, and more securities that would be funding in the repo market on our balance sheet. Now, I think that might be the difference you see in the future. But that the business model will still and should still produce those kind of returns.

[Christopher Nolan:]

Great. Thanks for the color Jeff.

[Jeff Zimmer:]

You’re welcome.

[Operator:]

Mr. Mountain. We have no further phone questions at this time. I will now turn the call back over to you. Please continue with your presentation of your closing remarks.

[Jim Mountain:]

Thank you, Kelly. And thank you, everyone for joining us. We look forward to speaking again next quarter. And in the meantime, if anything comes up if you have questions or comments, give us a call at the office and we’d enjoy the conversation. Until next time, keep safe.

[Operator:]

That does conclude the conference call for today. We thank you for your participation. And we ask that you please disconnect your lines.