Q4 2019 Earnings Call
Ladies and trying to ma'am. Please stand by your orchid Island capital fourth quarter earnings Conference call will begin momentarily.
I guess piece can buy.
Well begin to call shortly thank you.
[music].
Good morning, and welcome to the fourth quarter 29, <unk> earnings Conference call for Orchid Island Catholic Health. This call is being recorded today February 20, 120 training I.
At this time the company will 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 I've been management's good faith belief with respect to future events and are subject to risks and uncertainties that could cause actual performance or results could differ materially from those expressed and such.
Forward looking statements.
Factors that could cause such differences are described in the company's filings with Securities and Exchange Commission, including the Companys. Most recent annual report on form 10-K. The company assumes no obligation kept the such forward looking statements to reflect actual results.
Changes in assumptions or changes in other factors affecting forwardlooking statements.
Now I'd like to turn the conference over to the company's Chairman and Chief Executive Officer Mr. Robert colleague. Please go ahead Sir.
Thank you operator, and good morning, everyone. Thank you for joining us today.
But he's had a chance to.
Printed copy barks wide dark Oh that will be the focus of our discussion today.
Oh, assuming everybody's Randy I'll be starting on slide three as we always do let's give you off though what does the agenda first won't go above street, so highlight a bar <unk> financial results for the quarter.
They will spend a few minutes talking about market developments that affected the portfolio with guided our decision, making and then we'll turn it to our financial results and finally, we'll discuss portfolio characteristics, our credit funding as such our hedges. It changes we've made to the portfolio.
Oh, starting with our financial highlights for the quarter will drive a generated net income per share of approximately 29 cents. This includes six cents per common share of net realized and unrealized gains or losses on our assets. Our agency RMBS. Its watch our derivative instruments, including net interest income or interest on our interest rate swaps.
For sure 23 cents, excluding all those items I just mentioned.
Book value per share with $6 in 27 cents at December 31st an increase of five pennies or 80 basis points from 622, and you had in the previous quarter.
Fourth quarter, the company declared 24% 24 cents per share a common dividends and since our initial public offering we have to current $11 and shouldn't have sense of dividends.
Economic return for the quarter was 29 cents were 4.7% on an annualized 18.6 annualized and the return for the year was 5.7%.
Very generous return.
No before moving forward I, just want to provide some context for new investors and maybe where do you reiterate some basic fracs were those have been listening to us for a long time I'm just trying to give me some background about work and work it isn't all agency mortgage riet.
Oh, we do not take credit to our portfolio is generally very fixed rate focused oh, we tend to be invested in conventional so Fannie Mae Freddie Mac versus Judy bug and.
And we kind of a bias towards 30 year securities versus 15, 20, or 10 years, we generated on our assets in pass through form versus Cmos, Although we do all nodes generally depending on market conditions. So for instance, late in 2018 when rates were backing up we own some shorter sequential generally do not have a high cost.
Tracer surveys, we use iOS and inverse iOS for hedging purposes versus Kerry.
Finally, and those tend to be structured iOS Oh to reiterate again, we do not use non agency mortgages or for that matter or any other form of credits, although that could change at some point in the future.
At this point, we'd be ourselves as being very late in the credit cycle and not went out there.
To where the focus of discussions, especially with respect to the market will be on the conventional 30 year fixed rate market. The market factors that affected those securities turning now to slide six shows we always do start with low interest rates on the left hand side, you see movements in the treasury curve.
And on the right the swap curve ball degree line represents the curve is up do you have to the previous year. The Blue line is where we worked into the third quarter and the Red line is where we ended the year generally speaking market conditions for orkin in for leverage mortgage backed investing were favorable throughout the quarter and I'm going to go through a number of examples.
But one thing that one caveat.
The prepayment activity was high entering the quarter remained high through the quarter and has continued to remain high into 20 Twond.
So as you can see I'm aloft interest rates move higher over the course of a corridor.
But to put that into context, where we sit today.
The why would actually be below that blue line, Oh and by meaningful amount saw the 10 year Treasury was is more than 20 basis points lower the two year as probably pushing 30 basis points Libre 25.
Well, we had significant movements since year end.
No, but generally for the fourth quarter Oh, it was a very favorable market environment.
Turning to the subsequent slides that I'm can spend a lot of time on all of these on slide seven just shows you the movements in the tenure Treasury note the tender swap.
Same thing you saw rates backing up generally a good thing for mortgages.
Oh, you turn to slide eight we show a proxy for the slope of the curve and as you can see after traffic. This isn't this cases the spread between five and a 30 year Treasury note Treasury bond, rather Oh, we hit a trough in the summer of 2018, it's.
Noteworthy to point out, though there's the re steepening has been very very gradual and very modest but not much at all in fact today, that's only about 58 basis points out very far cry from where we were back in 2013.
Well 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 or as you can see for instance, the bottom line Fannie threes, they're down for checks or given the sell off in treasuries, that's decent performance, but even more noteworthy when you look.
At the large for three and a house enforce are actually up in price.
So while rates were backing up these mortgages were up in price, although the third quarter of 2019, they performed very poorly.
In fact in incidence in certain days when they were down in price with the market off some of that just catch up.
It's not a 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 to Texas, which is modest at least positive the balance of them or near zero or negative.
That reflects the very poor quality of what we call the TV area of the cheapest to deliver collateral.
Very very fast Prepaids and as a result, though the roll market was very unattractive as is often the case if not always the case when the roll market is shop. The spec pool is market is very strong and you can see that on the right sorry. The page we have two examples and 85 came back security and then also just they knew where generic news.
Security you can see those prepayments are elevated and that's always going to be the case when the roll market. It's a softness was just continuing with some more indicators of general market conditions on slide 10 on the left hand side. This is just the LIBOR all layoffs of various tape TV, a coupons and I just want to point out if you look on the right hand side of that.
Slide over the course would afford corps fourth quarter, we were tightening.
So again, another instance of a favorable market conditions.
Slide 11, this new for us and I want to spend a few moments on this this is very decent backdrop for all discussions of mortgages.
On the left hand side.
Oh, probably this is for all of calendar year 2019, the shaded area represents the mortgage rate available to the marketing as you can see for the first three quarters of the year. This was declining the blue line represents the Rifai index.
Good refi index, which means it's conventional and government and as you can see it crossed over 2500 or 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 moved into the first quarter of 2020 and with the rally.
That number got over 3002 weeks ago. So that's above the high end of the region. This graph. So we've got a sharp reversal and not on the right hand side. Another important chart again.
The Blue line, there's the aggregate refined index the shaded area. In this case just represents the percent of the 30 or universe. That's at least 50 basis points in the money. So refinance board you can see basically for the entire second half a year that number's running around 40% if not higher than that explains why we've had.
So much refinancing activity as we sit here today that number is at close to 50% and the refi index as I said is generally 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 or the take away here simply the fact that the fourth quarter and really all 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 looked at the bottom right you can see an investment grade corporates at 1.18 emerging market investment grade high yield emerging market in high yield and so forth all that very well mortgages did okay with a positive return of 71 basis points and do you want to point out for the year.
MBS 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 even 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 as John as a rule.
Slide 13, just show saw implied wall on swaption, so proxy for ball and as you can see against the same story the fourth quarter ball is 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 of 18 that was in the midst of the tightening cycle.
When the market in the fed expected to several additional tightenings.
But if you looked at the bottom right, which is at the end of last year. You can see that that has changed dramatically. One thing that pointed out here. That's clear in every case is that fed expectations for funding levels versus the market our 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've actually been even close was in the height of the tightening cycle and that was only several years out.
Now I'll turn into our financial results Slide 17.
Start off with kind of a high level look at them at the portfolio at our returns and eventually what the discussion will evolve into a more detailed discussion of the portfolio on the right hand side. We show the returns for the quarter odds you know, we bifurcate our capital into a pass through strategy in a.
Well the numerous io strategy that latter being for hedging purposes as well one thing that's very obvious a notable instead on the bottom line you can see that returns for all sectors were positive for the quarter.
Very generous returns I'll point out a few things saw with respect to each for instance in the past few portfolio.
And I'll talk about our hedges more in a moment, we had a very positive $10.8 million return on our hedges are hedged coverage using notional our hedges versus our peers. Our repo balance has been reduced over the course of 19, but yet we still generate a very positive return from that.
The realized and unrealized gains and losses the negative 9.7.
Recall that orchid use is fair value accounting, which means that when our mortgages, which we purchased generally at a premium prepay, we capture that premium amortization in 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 very strong result for the quarter.
And then of course, our interest only an investor interest only studies, which we use as a hedge we're also positive so for the portfolio. We generated a very significant positive return of 5.1% which is on annualized.
Turning to slide 18 take a longer term looked at trends here on the top we have three lines. The topline the blue line represents the yield on our assets.
The Red line is our economic cost of funds in other words that reflects the effective 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. Our funding costs have increased they peaked during.
The summer of 2019 at 2.71%.
The fed eases in the second half of the year, coupled with the hedges we have in place that number's drop substantially almost 100 basis points in just six months to 1.78% art asset yields of drop although less so and as as a result, our net interest margin has rebounded off of the all time low level.
A near all time low level of 1.55%.
North of two.
We don't know what the future holes, but we do know that going into 2020 funding costs should stay low the only question would be asset yields and we'll have more to say about that the moment.
Slide 19 is the same things think picture only an earnings per share versus yields percentages and as you can see a third quarter was the local trough and we've since rebounded off of that level.
Now I'll 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 past two portfolio. The one number I want to highlight is the paydown number almost 200 million.
Very significantly high number reflects what I've said many times already the fact that prepays that remain elevated we've had to take steps in the portfolio to address that and those are reflected in these securities purchased and security sold you can see those numbers are quite large by historical standards and that just reflects the fact that we get to take steps to address.
Just a new environment that we're in on the left hand side, we talk about our capital allocation only noteworthy thing to point out is that the Io inch.
Versatile 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. It had gone quite small we just cleaning up some of the line items, but also more importantly, with respect to aisles in particular with prepay activity at these higher levels.
Theres not a lot of opportunity for those cash flows to shorten much further than they already have but they have a lot of our potential to extend if rates would have backed up so from a hedging perspective, especially with respect to the long into the curve. Those are very key assets to own and we will continue to do so.
No 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'll try to make as much sense as I kind of them and make this as clear as possible one thing I want to point out very quickly, though in the middle to pay.
For the past few portfolio Theres, a column labeled a net whacked.
You can see if you ended the year that was 3.92% for the past few portfolio at the end of the third quarter that was 4.22, so we reduced the net whacked in the portfolio.
By 30 basis points and the reason we're doing this is what this rally in which is high rifai activity.
We're 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 speed protection. As we can you can do that through either spec pools and or lower coupons to wit. If you look to be column labeled FNV are fair market value the second.
Line is fixed rate Cmos, we had added those in 2018 as a defensive position short sequentials. Unfortunately tend to prepay fast in this environment.
Balances a little under 300 million that was over 600 million at the end of the third quarter and we have substantially reduced that position. Even further below that you see a line labeled 15 year for a little under 20 million. That's actually was almost 400 million agenda last quarter was predominantly low loan back.
Securities We sold those booked a very substantial gain and redeploying the proceeds into longer duration assets within the 30 year staff Threexthree in house and so forth.
The three year bucket has increased modestly.
The three to have bucket is approximately 775 million higher than it was at the end of third quarter. The four bucket increased by approximately 350 million.
The four and a half bucket was based go out the rundown in the five bucket shrank by 550 million. So we're moving down and coupon and the securities were adding inspect format and they tend to be in the very best forms of call protection, So low loan balance or New York Securities.
When we tried to add duration of the portfolio protect ourselves up from prepayments the bottom of the page we show our hedge positions I'll discuss those in a minute in greater detail just pass on those for now.
Slide 23. This is another new slide I want to explain what we're showing here. This is kind of how we look at prepayments as to rather shouldn't holistic approach, but what we look at here as we look at the dollar amount of prepayments and this is reflected in this red line the dollar amounts of pre.
Payments in a given month just divided by the young.
Unpaid principal balance of the portfolio and as you can see the dotted lines, you're kind of represents the average at that level over time at 91 basis points that equates to a low double digit CPR and that's what we've experienced over the life of the company. So somewhere in that 10 to 12 CPR range the Blue line.
Represents the tenure Treasury and what's interesting to note is as you see back in 2016, we had the surprise result in the election tenure sold off crested above 3%.
And then has since rallied meaningfully but the significance of that is with the tenure and rates staying high for that long period of time. There was a lot of mortgage is created in that period that we're now in the money for the first time and Thats why you see this red line. Despite all the way outside of our norms and we show.
One standard deviation above our mean over this period you did see it got up to near 2%, but is since come back down and the reason that is because as I mentioned, we have shifted the portfolio died coupon and added duration prepay protection and now this most recent reading which was for this month is back to within ones.
Standard deviation of our norm at 1.15%.
So its responding to the markets, but one thing we also have to keep in the back to bottom line that leases is an election year again.
In the fall this year, there's the potential for another surprise outcome potentially so when we positioned the portfolio we have to be mindful of the fact that rates can have turned around rapidly and so with respect to at least some of the changes made in the portfolio in the first quarter. We've had that in mind and also as I mentioned the Io portfolio.
Well positioned to protect us and that kind of an outcome.
Slide 24, as just historical information I won't say anything about that today slide 25, I just wanted to make a couple of points on the left we list our credit Counterparties and the takeaway from this is simply the fact that orphan 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 center bank, what our second largest counterparty is more or less a repo focused shop. So.
A diverse mix of counterparties in 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 rates packed up.
Since year end that number is back up.
Again slightly not as high as it was that we have taken the leverage backed up slightly with the rally.
I'll now say some words about our hedges.
We show the four buckets here the top left is our euro dollar positions to the right of those are TV hedges on the bottom we have some treasury futures and then our swaps.
The euro dollars as a hedge instrument, which at one point in our life was our only hedge instruments have basically been running off and as you can see the contracts we haven't place all run off this year.
At the moment, we have no intention of adding to that they're basically alone, allowing us to run off.
With respect to TV A's, we've been using the four and a half coupon versus some lower coupons and as I mentioned earlier those rules are actually negative. So we can use a short position in four and a half TB AIDS and actually get paid to do so because the drop is negative.
With respect to futures its run down somewhat from where it wasn't did a third quarter and it really reflects decision to.
One reduced exposure, there and that instrument and added in the swap bucket on the bottom right. We show our swap positions as you see we havent broken down between one and three years in three and five years, that's where our swaps lie we do not have in swaps outside of that.
The big change was in the one to three year pocket and that really just reflects the fact that most of that changes just swaps that we're running off in 2020.
And we've actually since year end added to the three to five your buckets.
Facility at the curve typically is the most sensitive to the market's expectation for fed activity and is often the case, what we're seeing today is a rally and have pointed at curve than most meaningful rallied in the treasury curve has been in the three to five year area, reflecting the market beginning to price and more fed it uses.
And we think thats, the most effective hedge area because to the extent the 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 wanted to show another new slide that we have slide 27.
It's really just for illustrative purposes. It shows that our repo expense in the far right column per share has been declining I want to point out in the second to last column shares outstanding work. It did grow over the course of the year.
As a result capital being deployed at various times throughout the year, sometimes the beginning of the months. Sometimes you ended 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 know 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 of drop back into that generally one seventies.
So this number has room to decline again with respect to the asset side, we don't know, but we are realizing the benefit of the fed eases in our funding costs have been declining.
With that I'll turn the call over two questions. Operator, you May go ahead.
Thank you, Sir ladies and gentlemen, if you have a question at this time. Please press the star the number one on your Touchtone Telesales and if your question is been answered you wish they move yourself from the Q. Please press the pound.
Your first question comes from the line of Christopher Nolan from Ladenburg.
The line is open.
Hey, guys.
Hi, Bob and his comments.
And your comments I missed it but did you indicate that the higher asset yields were due to higher prepayment amortization.
No no no not that.
Our yields on the portfolio I'd been coming down slightly because of that.
Basically the shift out in coupon.
Coupled with realize some realized higher prepayments and they've been coming down.
All right and then I guess the second question I have is on the portfolio characteristics, obviously, you've been investing.
It seems like a big jump into three that happened force.
And this seems to be.
Yeah.
Given the jump it.
How should I look at this in terms of your coming down from four to five Rehabs force.
Because in comparing the portfolio quarter over quarter and see the big jump. It's just not clear to me exactly where you're taking stuff out of aside from the 15 years.
Well the C malls.
She most were reduced by half from I think it was 605 million to little under three.
15 year fours went from 403 million to less than 20, the big jump was in the five bucket was 800 809 million that was reduced by about 550 million.
Before the half bucket Basi, just ran off that went from 460 to afford 30.
So the CMO bucket, the 15 year, four buckets and the 30 year, five bucket, where the big ones that shrank.
And the ads as he mentioned we're in the three in house and for and that's where just like everybody else you're trying to get some duration while at the same time protecting yourself from prepay. So even though those we bought lower coupons and we were buying a lot of low loan balance or one 10-K, 125, K or New York So the.
Callers are still somewhat high.
But you do get good prepay protection from those assets because at this point.
Today as we speak the tenders now broken through 150.
We would expect pre pay activities remain very robust yeah, Chris over 900 million of those purchases Doesnt purchases were in either 85 care, one 10-K, Max and that collaterals, just simply not available in four and a haves and fives.
I 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 is just.
But fairly simple, it's we expect as I think Bob had great New slide he was talking about.
Showing the percentage of the.
Mortgage universe, that's on the cost of being refund ansible and so we want to improve the convexity of the portfolio in case, we get a rally so increase the duration improving the comeback city.
In invested assets that will continue to increase in value. If if anat really frankly, as we have rallied and then on the hedge side.
State stay very light nimble and.
We've done a few things on out of the money payers that.
Have.
I think would serve us well and case, we're wrong in that view it will get a quick reversal to higher rates.
Okay. Thanks to the color I guess the final question really is interest rate sensitivity, who seems too.
Change, so much dramatically quarter over quarter, where.
50, but increase.
Impacting the portfolio.
Yes, hi, how how should we expect the duration to go or do you expect duration to state.
Levels.
First quarter.
We think well.
Yes, I notice what you're seeing in this into sensitive Tivity table, you had a negative $13 million to sell off now it's ER.
Positive 400000 out negative and that of course reflects the down in coupon shift in particularly we've actually traded to a slightly positive.
Duration, so on these inhibitors backup.
What is a question what we've seen very consistently year to date and really throughout the last six months when the market rallies, we tend to bull flattening and when we sell off we steepened.
So every time, we get these rallies, where the market flattens, obviously mortgages do tend to widen the very poorly and repositioned 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 tend to.
We may have modest losses.
So that's why the political duration the model duration, that's going to be is the models going to capture the fact that we have longer duration assets on the books plus their specified pool. So we're going to model. That's why these numbers are what they are.
Yes, its who knows what the future holds I'll 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 thats one risk, we we feel very comfortable taking.
So we have to worry about the long end and 700 and mentioned some of the Swaptions. We've done in light as I said, we have the Io book when speeds get this fast at some point prepay expectations with respect to eyes can only get so high right. So those cash flows are expected cash will shorten it really can shorten anymore, but in the meaningful.
Back up they can extend quite a bit so we feel comfortable owning nodes as a hedge against the move in the long end.
And then the other thing which is more of a local move what we've seen is even in the fourth quarter when rates backed up.
The market is I would say it has a bearish are bullish biased 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 pay ups for spec pools.
Even though the market slowed off in the fourth quarter those those pay ups did fairly well now we have an option coming up you know options in two weeks and went back to where we worked in the January I would think that those those are going to do very robustly and Onyx belt.
Outperformed our hedge ratios in a sell off 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 Jones trading your line is open.
Great. Thanks. Good morning, guys. My question is on the expectation or the cadence of prepayments. Bobby you noted that they were still high in the first quarter, but is your expectation that they declined sequentially, even if its moderate declined and then pick back up.
Hi, just 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 draw much at all I mean, the drivers or day, count and things like that but.
Just with the rally lately I don't expect them to drop much.
Thats going to cause them I think to drop much is going to be burn out really is just.
Saw these borrowers are exposed to refinancing opportunities now there I would assume the various mortgage originators out there are wrapping up capacity to re Fi more and more and just a question of how fast it can work through the process.
I would just added I think some of the incremental changes. We've we've made in the portfolio might help US you know we're talking about a static set of assets on actually expecting to be ramping up here in the next few months, but we have taken.
Actions in the third quarter I'm, sorry in the fourth and and first quarter to improve the.
Prepay profile of our portfolio. So I think we might see modest down tick.
Just related to that type of rotation, but in general we're talking about.
Assets that were originated in 2018 or or 2017 event I think you can expect to see.
Them increase.
Speeds sequentially.
Okay. That's helpful and then that would make sure I put that from your comments. The other you issued a little bit the equity in the first quarter. I think you noted that you added some assets the basis is wider.
And leverage went up so.
You've added better economic return assets in the first quarter to date.
In excess of the equity that you've issued is that correct.
Yes.
Yes, okay.
Okay. Thanks.
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Again, if you'd like to ask a question. Please press Star then the number one on your touched Todd Thomas Allen.
I'm showing no further questions at this time like note to turn the conference back to Mr., Robert Kelly, Chairman and Chief Executive Officer.
Thank you operator, thank everybody for their time appreciate you listening in today to the extent you have additional questions already happened here. The replay don't hear us life will be in the office all day can field your questions. Our numbers 772 to 311 400, otherwise we look forward to talk into next.
Thank you.
Ladies and gentlemen. This concludes today's conference. Thank you for your participation and have a wonderful day you may all disconnect.
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