Western Asset Mortgage Capital Corporation
Q3 2016 Earnings Call Transcript

Published: 5 Nov 2016

[Operator:]

Welcome to the Western Asset Mortgage Capital Corporation's third-quarter 2016 earnings conference call. Today's call is being recorded and will be available for replay beginning at 5 PM Eastern Standard Time. [Operator Instructions] Now first I would like to turn the call over to Mr. Larry Clark, Investor Relations for the Company. Please go ahead, Mr. Clark.

[Larry Clark:]

Thank you, operator. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months ended September 30, 2016. We issued our earnings press release yesterday afternoon and it's available on the Company's website at www.WesternAssetMCC.com. In addition, we have included an accompanying slide presentation you can refer to during the call. You can access these slides in the investor relations section of the website. With us today from management are Jennifer Murphy, Chief Executive Officer; Lisa Meyer, Chief Financial Officer; and Anup Agarwal, Chief Investment Officer. Before we begin, I would like to review the Safe Harbor statement. This conference call will contain statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the safe harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of the Company. All forward looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the risk factors section of the Company's reports filed with the SEC. Copies are available on the SEC's website, www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law. With that, I will now turn the call over to Jennifer Murphy.

[Jennifer Murphy:]

Thank you, Larry, and thank you, everyone, for joining us today on our third quarter conference call. I'm going to begin with some opening comments. Then Lisa Meyer, our Chief Financial Officer, is going to discuss our financial results, and then Anup Agarwal, our Chief Investment Officer, is going to provide an overview of our investment portfolio and our outlook. After our prepared remarks, we're going to open it up for a brief Q&A. We are pleased with a solid performance that our team delivered in the third quarter. Our economic return on book value of 7.1% was among the highest of our peer group who have reported thus far. We also generated higher sequential core earnings plus drop income. Our strong performance was driven by broad-based contributions across our holdings and reflects the benefit of our strategy of investing in a diversified portfolio across a number of subsectors of the mortgage market. Given our ongoing views that US and global growth will remain slow and steady and that global central bank policies will continue to be accommodative, we believe our balanced approach best positions us to deliver long-term shareholder value. Anup is going to talk about this further in his remarks. But to put Anup's comments into context, I want to briefly review our long term goals on behalf of you, our shareholders, and the strategy we are pursuing to achieve them. WMC's goal as a hybrid mortgage REIT is to provide our shareholders with attractive dividend that is supported by a sustainable core earnings plus drop income as well as provide the potential for higher total returns while maintaining a relatively stable book value. In our view, WMC's strategic advantage in pursuing our goals is our ability to draw on the deep experience and teams at Western Asset, our manager, as well as the breadth of Western Asset's global investment, risk, and operational platforms. Western Asset is a global fixed income specialist with approximately 445 billion in total assets under management, a team of over 800 professionals, and nine offices around the world. One of our most important goals as WMC's management team is to bring the strength of Western Asset to WMC for the benefit of WMC's shareholders. Anup leads our investment program and is supported by Western Asset's experienced team of mortgage and asset-backed investment professionals. Anup and his team are able to draw on Western Asset's global macroeconomic and credit teams for research, for perspective, and for insights. They seek to optimize returns for our shareholders while managing risk, by combining a diversified portfolio of Agency, non-Agency, whole loans, and selected other securities with effective leveraged and hedging strategies. As we discussed last quarter, we also have some important corporate goals which include a focus on operational excellence and the highest standards of financial reporting and disclosure. Operationally, we are focused on best-in-class risk and portfolio management practices, while increasing overall efficiencies throughout our operations. I'm pleased to report that we made measurable progress this quarter, particularly with respect to enhanced risk tools and improved operational efficiencies. We continue to review opportunities to bring best practices and the strength of Western Asset to WMC, always with a view towards creating long-term shareholder value. From a financial reporting standpoint, we are committed to ensuring that you, our WMC shareholders, are provided with comprehensive and relevant disclosure and transparency, which should help you make informed decisions when investing in our stock. We welcome your feedback as this is an ongoing process. Finally, with respect to our dividend policies, and as I mentioned in our last call, an important goal for us is to improve the stability of our dividend. When determining our dividend, the Board and our management team consider a number of factors including primarily the current and expected earnings power of the portfolio, the sustainability of the dividend, and the expected full-year taxable income of the Company. Consistent with this approach, on September 22 we declared a third-quarter dividend of $0.31 per share, the same as last quarter's levels. Our current annualized dividend yield is 12.6% based on yesterday's closing stock price and remains at the high end of the range of our hybrid mortgage REIT peer group. With that I'm going to turn the call over now to Lisa Meyer to discuss our third-quarter results. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. We have provided a great deal of detail in our earnings release and investor presentation, so as I review our third-quarter performance I will focus my discussion in particular areas where additional commentary is warranted. As Jennifer mentioned, we delivered another solid performance in the third quarter of 2016, generating an economic return on book value of 7.1% and higher sequential core earnings plus drop income of $14.8 million or $0.35 per share. On a GAAP basis we recorded net income of $32.3 million, or $0.77 per share, and increased our book value to $11.48, up from $11.01 in the second quarter. Our larger average portfolio, coupled with lower expenses led to an increase in core earnings in the third quarter. However, this increase was partially offset by a slightly lower yield on our assets. We generated approximately $39.3 million, or $0.93 per share, in net portfolio income; incurred $4.3 million, or $0.10 per share, in operating and general administrative expenses, which excludes stock-based compensation; incurred an income tax decision of $2.2 million, or $0.05 per share; and declared dividends of $13 million, or $0.31 per share, which all contributed to the increase in book value of $19.7 million, or $0.47 per share. Breaking down the $39.3 million of third quarter net portfolio income by source

[Anup Agarwal:]

Thank you, Lisa. Let me spend a few minutes discussing our portfolio management during the quarter end and our outlook going forward. As we entered the third quarter, we were operating with a view that both the U.S. and major global economies will continue to be in the slow growth environment and that inflation would remain subdued. We believe that this environment would cause the Fed to be slow to implement additional rate increases. We also believe that longer-term treasuries and sovereign bonds would be underpinned by accommodative central bank policies and in all the major economies. After experiencing a very volatile start to the year, most spread sectors of the fixed income market staged a gradual recovery that began in late February, carried into second quarter, and continued through the third quarter. Despite some interest rate volatility at the beginning and at the end of third quarter, spreads both in Agency markets and the credit-sensitive sectors of the market rallied. And our portfolio benefited as a result, with nearly all of our asset classes appreciating in value. In addition to the higher value of our assets contributing to our gain in book value, our liability hedges made a positive contribution as well. The value of our interest rate swaps, which are based on LIBOR, increased relative to cost of our financing, which is based on [indiscernible] market. This was driven both by a modest increase in absolute level of interest rate over the course of the quarter, but also the return to a more favorable spread between LIBOR and repo rates. During the quarter we shifted our sector allocations on the percentage basis towards a higher proportion of Agency securities and we increased portfolio leverage both directly and through the use of TBAs, as Lisa mentioned earlier. However, our leverage has come down moderately here in fourth quarter as we have become more cautious in the near-term outlook for mortgage spreads. With respect to our Agency holdings, we added a meaningful amount of longer duration, lower coupon securities during the quarter, particularly Ginnie Mae. Agency mortgages continued to be supported by strong market demand given their spreads over nominal spread, nominal sovereign debt. In addition, we remain over-weight specified pools that have lower prepayment characteristics as we believe that refinancing risk continues to exist in this low interest rate environment. We believe that current market environment remains constructive towards Agency RMBS and we will continue to look to replace some of our TBA holdings with specified pools. We have also continued to taper down our Agency [IO] and inverse [IO] holdings as we believe that they offer less relative value when compared to other opportunities. We continue to see long-term value in Agency RMBS sector and expected it to be a meaningful core holding. In the credit-sensitive portion of the portfolio, we continue to opportunistically rotate out of some fully-recovered, lower-yielding, legacy non-Agency RMBS into areas with more attractive risk-adjusted spreads. One of the areas where we increased our exposure was in GSE credit risk transfer securities, particularly in equity classes, as we believe that they offer attractive risk adjusted returns relative to other sectors. You may recall that last quarter we pointed out that our non Agency CMBS holdings had not fully recovered from the selloff that began late last year, but we remain constructive on the sector as we believe that these securities offered some of the most compelling spreads within our universe and the potential for appreciation from what we believe were depressed levels. We experienced some of that appreciation in the third quarter and we reduced some of our holdings of higher dollar price legacy CMBS as a result. We remain constructive that there will be further spread tightening going forward, particularly in the BB and B rated sector of the market, as the fundamentals remain positive and the technical pressures are abating. With respect to our holdings in residential whole loans, our exposure to this sector increased moderately during the third quarter. As we have said in the past, we would expect that as we see opportunities we will increase our exposure to this asset class, both in (inaudible) mortgages and potentially in other segments of the market. We are very pleased with our financial results for the quarter and we remain optimistic going forward. As always, we continue to position the portfolio to perform well over a long investment horizon. As Jennifer mentioned at the beginning of the call, our goal is to generate sufficient core earnings to support an attractive dividend, while also maintaining our relatively stable book value. We plan on continuing to implement this strategy by holding a diversified portfolio of securities that offer what we believe to be the best risk-adjusted returns over our investment horizon. With that we will open the call to your questions.

[Operator:]

[Operator Instruction] The first question comes from Merrill Ross of Wunderlich Securities Inc. Please go ahead.

[Merrill Ross:]

I was wondering, as you had allocated a lot more capital it seemed to the TBA dollar roll positions in the quarter, to what extent can you really move that money around? I mean, is there a limiting factor or just because obviously that was the best return in the Agency space in the quarter, although it lacks that long-term capital appreciation potential. But I just wondered how flexible you view your balance sheet.

[Anup Agarwal:]

That's a great question. I think with TBAs we have always been very opportunistic and I think moving around that capital, even in the current environment is the market is very liquid on that end of the world and moving around that capital is incredibly flexible for us. Look, in the short term we are not as positive. In near term, our outlook is that we see the mortgage spreads -- there's some probably of widening and you would kind of see that TBA positions will get moved around. I think as you've seen from us in the past, we use those TBA positions more opportunistically, especially when we see mortgage spreads tightening in the short term, and generally hold it for a short period of time. So I think there will be some TBA positioning over consistently in our portfolio, but in general, larger part of our holdings in TBAs is really very much opportunistic.

[Merrill Ross:]

Great, thank you.

[Operator:]

The next question comes from Max Meyer of Wells Fargo. Please go ahead.

[Max Meyer:]

Good morning and thanks for taking my question. I didn't see it anywhere, but did you guys disclose the overall portfolio duration anywhere?

[Anup Agarwal:]

Yes, I think if you look on page 8 of our presentation.

[Max Meyer:]

I see the Agency RMBS swap net duration, but do you have the overall portfolio including non-Agency, CMBS, everything else?

[Anup Agarwal:]

I think the reason we don't for the rest of it is because a lot of our non-Agency holdings are floaters. Similarly the CMBS, a lot of it is floaters, as well as you know our whole loans are primarily all hybrid ARM kind of loans. So the way I look at a large part of the duration contribution in the portfolio, really I kind of think that it comes from our Agency pools.

[Max Meyer:]

That makes sense. But I mean even floating-rate loans have a little bit floating-rate securities have a little bit of duration. I guess what I'm really wondering is when I look at your Agency portfolio quarter over quarter I think leverage on a risk-adjusted basis went up almost 2 turns, 1.5 turns. I think you took down your swap notion a little bit, so the Agency duration or net duration went up about a year. Is that more like a rate for you or is that something that you designed to offset maybe potential spread widening in credit securities or is it something else?

[Anup Agarwal:]

There are two parts in it. I think one part is that you saw the leverage, you have two things in it and I think the first part is that leverage went up. I think it's been more of a framework offset that we were constructive on mortgage spreads. You have seen it in the past from us that leverage goes up, especially as you said that we increase our proportion of Agency securities, just based on our view that mortgage spreads will tighten. I think in the past you've seen that that leverage growth moves around a little bit by that same about a turn, turn-and-a-half levels based on our view on mortgages. The second part, in terms of having a little bit of duration, positive duration gap, is more driven by a little bit of a hedge to our credit securities. Look, I think there have been a little bit of interest rate volatility at the time. There's a lot of anxiety around elections and year-end; there's always some choppiness around it. We're not expecting, I'm not expecting a significant credit spread widening, but having a little bit of a hedge as we are closer to the end of the year is kind of more prudent.

[Max Meyer:]

Okay, that's helpful. Then I guess just one other note or question. Can you tell us how much your book value has changed since quarter-end?

[Jennifer Murphy:]

Our book value is relatively stable since quarter-end.

[Max Meyer:]

Do you have a specific number or a specific (multiple speakers)?

[Jennifer Murphy:]

No, at this time we can't actually disclose that number.

[Max Meyer:]

Okay. All right, no problem. Thank you guys very much and congrats on the quarter.

[Operator:]

[Operator Instructions] This concludes our question-and-answer session. I would like to turn the conference back over to Jennifer Murphy for any closing remarks.

[Jennifer Murphy:]

Great. Thank you all for joining us on today's call and have a great day.

[Operator:]

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