Capstead Mortgage Corporation
Q2 2018 Earnings Call Transcript

Published: 26 Jul 2018

[Operator:]

Good morning and welcome to the Capstead Mortgage Second Quarter 2018 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Lindsey Crabbe. Please go ahead.

[Lindsey Crabbe:]

Good morning. Thank you for attending Capstead's second quarter earnings conference call. The second quarter earnings release was issued yesterday, July 25, and is posted on our website at www.capstead.com under the Investor Relations tab. The link to this webcast is also in the Investor Relations section of our website and an archive of the webcast will be available for 90 days. A replay of this call will be available through October 26, 2018. Details of the replay are included in yesterday's release. With me today are Phil Reinsch, President and Chief Executive Officer; Robert Spears, Executive Vice President and Chief Investment Officer; and Lance Phillips, Senior Vice President and Chief Financial Officer. Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management. For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC which are available on our website. The information contained in this call is current only as of the date of this call, July 26, 2018. The company assumes no obligation to update any statement including any forward-looking statements made during this call. With that, I'll turn it over to Phil.

[Phillip Reinsch:]

Thank you, Lindsey. After making a few remarks, Lance will give us a quick recap of the quarter and then we’ll open the call up for questions. Periods of rising interest rate pose a numbers of challenges for mortgage portfolio firms like Capstead. We attempt to manage interest rate risk by investing solely in short duration ARM securities. Today, just over half of our portfolio will reset in rates inside of 18 months in an average of 6.4 months. With the remainder resetting in rate between 18 and 60 months or so, with an average reset in about 43 months. As a result, coupon interest rates on a portion of loans underlying our portfolio are resetting to more current rates every month which together with new acquisitions allows us to benefit from higher cash yields over time. This in turn affords us the opportunity to eventually recover financing spreads diminished by rising short-term interest rates. This also serves to protect our book value because from a valuation perspective, ARM securities are considerably less considered to changes in interest rates than longer duration [MDS]. That said, one of our challenges in the present environment in which the Fed has increased rates three times in the last seven months is these improvements in our cash yields occur over time, while our unhedged borrowings typically adjust in rate within 30 days. So, our higher cash yields have blunted increases in our borrowing rates. We will continue to play catch-up in the coming quarters. In a pause by the Fed and it’s tightening campaign would be helpful which could come later this year or in early 2019. What also would be helpful would be a increases in longer term rates kept pace with increases we are seeing in short-term rates, something we lost ground on this quarter. As it stands today, many homeowners whose loans are resetting the higher current rates have opportunities to refinance even as the longer reset portion of our portfolio remains out of the money from a [REIT by] perspective. Generally speaking, higher long-term rates will provide us with more relief from mortgage prepayments which suppress our portfolio yields through faster investment premium amortization. We are facing both of these challenges while also dealing with the typical seasonal factors that give a boost to prepayments and way on earnings in the second and third quarters of the year before slowing with the end of the summer home buying season. Even with these headwinds, our economic returns defined as change in book value plus dividends were only marginally negative for the quarter and we look forward to the opportunity to produce stronger returns later this year. With that, I'll turn the call over to Lance.

[Lance Phillips:]

Thank you, Phil. We generated earnings of $13 million this quarter or $0.09 per diluted common share and had a $0.14 common dividend. Book value declined by $0.25 ending the quarter at $9.85 per common share. Year-to-date we earned $0.24 per diluted common share distributed $0.30 in common dividends and incurred book value declines of $0.40 per common share. Importantly, $0.05 of our dividend decline was actually capital return to our stockholders in the form of dividends in excess of earnings this quarter. And we generated $0.06 in book value accretion from first quarter common stock buybacks. As a results in a challenging environment characterized by rising interest rate, we produced a negative economic return of 1.09% in the second quarter and a negative 0.98% year-to-date. Higher mortgage prepayments contributed approximately $0.05 to the decline in second quarter earnings with the remaining $0.02 attributable to 15 basis points in higher borrowing rates partially offset by 8 basis points in higher cash yields, a shift to using three-month LIBOR, index swap agreements for hedging purposes rather than one month LIBOR instruments and lower platform cost primarily related to compensation accruals. With that, we will open the call up to questions.

[Operator:]

[Operator Instructions] The first question comes from Steve DeLaney with JMP Securities. Please go ahead.

[Steve DeLaney:]

And Phil I just had to say, I appreciate your candor about the tough environment and admire the discipline you guys are showing by sticking to your long-term strategy despite the headwinds. [Style] drift probably is not - would not serve you with your shareholder base? Just one man's opinion. So having said that, the spread obviously compressing 38 basis points. Robert I wondered if you could comment on the 930 million of new investment. Can you comment on isolating that as you bought those bonds, did you have in mind sort of what a spread would be on that new investment and what type of levered ROE would you expect on your new investments? Thanks.

[Robert Spears:]

We're right now at a margin. We are trying to buy bonds that have spread of 65 to 75 basis points and so using roughly 9 times leverage that would grow our returns in the kind of 9% to 10% area.

[Steve DeLaney:]

And it struck me this quarter, I never really thought of the concept of cash spread but just the fact that I think 293 basis points drops to 2% asset yield on a GAAP basis. Do you guys actually think like in terms of dividends in ability to cover dividends, your cash spread obviously would look more like a 130 basis points if you didn't have the amortization expense. Does that concept something that resonates with you all internally and is it part of your discussion with the Board with respect to the dividend level?

[Robert Spears:]

We have - that's the true cost of the company over the life of the portfolio is to amortize off the premium we have so far. So, we're not just looking at our cash flow to establish the dividend.

[Steve DeLaney:]

It does - when you do get the pay off you get the pay off back at par and you don't recover your premium right. So I mean, it's just the timing of when you lose the cash. So - okay, I was just curious if that was - if that was something that was considered and we should we should consider when we try to project where you might go with your dividend going forward?

[Phillip Reinsch:]

Looks really what I try to emphasize in my opening comments to some extent it just the seasonality of our earnings. Yes, there were some headwinds on the rate front but seasonality always comes into play in the second and third quarter and there are typically weak earnings relative to where we might take the dividend which is more of a perspective of what can we do with this portfolio longer term.

[Steve DeLaney:]

And my last question would just be you know the buyback you were active in the first quarter doesn’t appear you did much of anything in the second quarter. I'm just curious how you look at that going forward into the second half of the year. The allocation of capital and where are the best use of your capital might be going forward?

[Phillip Reinsch:]

We'll definitely have that available to us. We certainly trade better, have been trading better relative to our book value in the second quarter. And so you saw that we went back to just replacing portfolio filings for the most part, that could change. We are not been externally managed, it certainly isn't a factor for us on how much capital we are running. So we'll use that it seems to be the appropriate thing to do.

[Operator:]

[Operator Instructions] Our next question comes from Eric Hagen with KBW. Please go ahead.

[Eric Hagen:]

I'd like to ask your views on ARM pricing in just the life cycle of ARM pricing. I think we've discussed - we've discussed in the past. It looks like the Fannie Freddie longer reset ARMs in your portfolio are priced just above par. The current reset ARM is to carry a mark closer to a better 5% premium to par. And typically, of course you know we've seen longer reset ARMs trade up as they get closer to current reset status and I assume that's mostly due to the expectations that prepays will be more behaved. My question is just how we should think about that relationship going forward given the environment of faster speeds on current reset paper. Thanks.

[Phillip Reinsch:]

Sure. I’ll take that. So our short reset book if you include our Ginnie ARM as marked just under one or three quarters as you said our longer reset book is marked to par handle. If you look at the seasoning ramp of ARMs right now one cohort is getting a lot of attention, our 51s is going through their first reset. And those are trending 50 to 60 CPR that’s a small percent of our book, but we do have some of that paper. And so just kind of as a proxy, those bonds as they’re resetting even as the speeds are still trading around one or two. After they go through that first reset and then season six to 12 months, that cohort is then trading in the upper one or three after that security goes through a second and third reset then it is trading up to around one or 4.5. And so those bonds are creed up and priced over time. And the reason is when you're running the cash flows on those bonds you factor the speeds and so you may run the bond at 60 CPR for 12 months and then 35 for 12 months and then 25 et cetera and it gives you a market yield. And so, obviously the biggest problem of those bonds trading 50 or 60 they have negative carry in the short run, but they’re still creed up in price. And so just as a general proxy in the ARM market right now, depending upon you’ve got bonds trading in anywhere from 98 to 105.5 depending upon the coupon, the seasoning, the speeds et cetera. So it’s a very wide range of prices whereas traditionally where the ARM market may have traded in a call it 101 to 105 area. So we’ve got a much lighter band of pricing now but it’s all based on the cash flows and the speed and the basic math behind it. I don’t if that answers your question entirely but I’m more happy to talk more about it in the future.

[Eric Hagen:]

Thanks, no it is helpful. I mean I guess going one level deeper. A follow-up might be in the last Fed tightening cycle when the yields curve was effectively inverted. Did that relationship hold in line with basically the commentary that you just gave?

[Robert Spears:]

Our book was so different during that tightening cycle, but one thing that was interesting our speed back then actually peaked as the curve was flattening. And then started slowing down after it inverted and a lot of that was the Feds it’s a great thought way up to 5.25 and then just sat there. So lot of this - one of the main things that drives ARM speed is not just slow to the curve it is the absolute - the rates continue to increase and so people after their ARM they don’t get notified that their payments moving up some people won’t refinance. And at that point when funds were 5.25 yet fully indexed ARMs at 7.25 and fixed rates were 6.5 and so that Fed was inverted by 75 basis points but speeds were slower then. Then when the Fed was at 4.5 and the curve flattened for the first time. And once again our book was entirely different back then maybe mostly seen key base, we didn’t have any longer reset bonds et cetera back then right now our speeds are running about 10 CPR slower than they were during that period. I mean so we’re kind of peaking in the mid-20s whereas back then we’re peaking in the mid-30s, but by the time the curve had inverted even back then speeds had drifted back down into the high 20s. And so it’s really difficult to compare because the type of securities were very different back then. So I mean that’s about - with answering that because it’s kind of comparing apples-to-oranges. But I think the most interesting thing is it's not just the flow to the curve that drives ARM prepay it also just rate continuing to rise and the immediate effect. And people getting a notice that their ARM payment is going up et cetera. And so once the Fed stops, you start to see burn out in the portfolio regardless of the floating curve.

[Eric Hagen:]

My second question is just on the swap book, it looks like more than half of your swap book is going to roll over in the next year that's not atypical just given the duration that you guys run. But there are a lot of maturities in the middle of next year, I guess how should we think about the hedge ratio that you guys want to run in the portfolio going forward especially if two-year swap rates are moving higher and the yield on your assets just simply aren’t rising as quickly.

[Robert Spears:]

So, I think we’ll - we always maintain a duration - we usually maintain a duration gap anywhere from two to 12 months. Right now we’re at four months. Obviously to your point, it may not make as much sense to hedge as much as these levels when so much of the tightening is already priced in. So there is decent chance we may let our duration gap drift just a little bit and maybe potentially get a little longer if it makes sense.

[Eric Hagen:]

But do you think keeping it within a year would be the most prudent…

[Robert Spears:]

Yes, it will be within a year but there is a good chance we could be a little bit longer than four months potentially.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Lindsey Crabbe for closing remarks.

[Lindsey Crabbe:]

Thanks again for joining us today. If you have further questions please give us a call. We look forward to speaking with you next quarter.

[Operator:]

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.