Q2 2022 Orchid Island Capital Inc Earnings Call

become fully unacred.

and also the effect that

Especially now, as the Fed seeing even stronger data than they had yesterday, the fact that they're gonna have to hike as much as they probably will to contain inflation, just increases the chances that those hikes ultimately lead to a recession. And that's another reason that the long edge is rallied. In fact, last week when we did have the Fed meaning the market's perception, was it maybe that the Fed had pivoted?

that they saw some early signs of weakening the economy, and that maybe they wouldn't hike as much as feared. But once they came out of their blackout period pretty much, you, every single Fed speaker since, has pushed back hard on that notion. In essence, the market had to do its own pivot, and now reflects the fact that the knowledge that the Fed is going to have to be very aggressive. And also, they depend. And as a result of that, data dependence days like today are going to tend to have outsized.

responses if the data is outside of expectations. So today's non-planned payroll, CPI numbers, it will be coming between now and the next meeting are going to be very important for the market and you're likely to see reactions as you did today. So that's really what's going on. You just see this meaningful inverting in the curve. Two stands is getting to extreme levels. This morning the meteoric reaction to the number, I think we got close to 40. I'll be back off of that but very inverted.

Just moving through the rest of the slides. Slide seven, we just show you the 10-year trade, the great in swaps and so forth swaps, and then longer look back. And just as you can see, it's meaningful stuff off in the mid-June and then a subsequent rally when the Fed had to pick.

Turning now to slide eight. This is a new slide. Our pin is very important. And one thing we did here was we changed the period basically to cover what I would call the pandemic period. So if you look at this slide on page 8, the beginning of the slide is the end of 2019. And as you can see, with respect to the 10 year you had the huge rally when the pandemic started. And of course, over time it crept higher because we entered 2021.

rates started to move a little higher. But then in the second quarter, maybe even when the war started in Ukraine in late February , the data started to become even stronger still, especially inflation data. And then also the effect of the war and the effect of lockdowns in China started to really grab the market's attention and focus the Fed on the fact that inflation wasn't transitory, it was becoming ingrained, and that they were going to have to react, and in fact they did.

And so what you see in the rates market is the sell-off into the second quarter. And that peak there was right around the middle of June . Jun 10th, you may recall the CPI number was very, very strong. University of Michigan data implied that inflation expectations had become very high. And then the market sold off very meaningfully. July was a, has been a recovery month, but we didn't come off those peaks. So that was driven by the Fed.

very strong response to those numbers and the fact that they hiked as much as they did number 75 in June , they did 75 again in July and it looks like they may do 75 in September . But more importantly for us since we are mortgage investors, on the right hand slide what we are showing here is the spread of the current coupon mortgage to the 10-year treasury. Now there are a lot of different ways you can look at mortgages versus swaps versus a 510 Bled. You can look at OAS.

But I like to look at this just because it seems to work better over a long period of time. And what we don't show here since this data really only goes back to the beginning of 2020. Is where these numbers were, this is the spreading into the 10-year treasury, where that spread was in the year prior to that. And if you do look at that data, you can go back five, six, seven years and mortgages traded and an extremely well-defined range between 60 and 80 basis points for years.

And so then you have the spike in March and in Rally because of course the Fed was buying HQE and you got to a very, very tight level and then we started to see the sell off. And as you can see on the right hand side of the page that spike up, that was June . Right after the CPI number that day and the next two days, more of you just did horribly, just to give you some numbers. I think the tenure treasury over that three day period was down, something like a point, but not even a point and a half.

and friends of Fannie Freeze were down, you know, multiple points. So, you know, meaningful underperformance. They've since rallied in July . But the point I want to make is if you look at where mortgages are trading in around 120 basis points for that, even though that's off the extreme, it's still very attractive versus long-term range of 60 to 80 basis points.

That's why we're very comfortable where we are as the managers of a mortgage portfolio because we really like the look of the market going forward. Data like today which implies the Fed is going to have to hike even more.

Probably just increases the chances that that hiking leads to recession, which is gonna get the long end of the curve ultimately to rally. And being the owners of mortgages, I think mortgages are poised to do very well. As I just mentioned, they are trading at attractive levels versus long-term norms. They don't have any credit components, so to the extent we do enter into recession, unlike in recent great corporates or high yield, which could widen even further the event of a recession mortgages to do well.

And I don't think that the Fed is likely to be selling mortgages certainly next year if it looks like the economy is about to move into a recession. So we think the mortgage market is poised to do well for the balance of this year into next. And then more specifically with respect to ORC, and we'll get into this more a little bit further in the call, ORC has retained high concentration in 30-year fixed rates, what we would call belly coupons.

three and three and a half as in contrast to say two's and one and a half or two and a half or higher coupons current production coupons and We think they'll do well in a rally and we also Like the securities again. I'll say more about that than mom that we take away from this slide is that mortgages look attractive And give away. We see things playing out over the next year year and a half We can move it just as an asset class could do quite well and we like the way working the tickters

position for that health account and to extend it happens. This movie through the bouts of the slides.

We've shown this life for a long time, it just gives you a proxy for the shape of a curve. As you can see, we did get inverted as we speak. We're much lower than 33 basis points on the 510 spread. And I'd like you to stay this way for the time being.

Why the TKN is another slide that's kind of new, and the reason we just threw this in here, what we're trying to show is the holdings of agency voltages by, in the case of a red line, the Fed, and in the case of the blue line, that's the commercial banks. This is predominantly the 25th largest banks, and the US. The commercial banks in the US.

And as the Fed went through QE and added AD, they of course were depositing, putting reserves into the system. System means that the banks that hold these reserves were investing those reserves in mortgages. And so these were the two largest buyers of mortgages by far up until not long ago. Obviously with the Fed entering into QT, they are going to be draining, not only not going to be buying as many mortgages, but they are going to be draining reserves from the system which means that the banks will probably be...

relatively not necessarily selling, but buying a lot less. And this means that the onus to support the mortgage market is going to shift to money managers and REITs. And we expect that to be the case as we move into 2023. But again, we very much like the market in spite of this, and are expecting the mortgage market to perform well. Just to give you a little more history on slide 11, the top left just shows you the performance of certain mortgages, and these are all 30-year fixed rate mortgages.

They're since recovered quite a bit, but still a big, big move for the mortgage market in June . Below that are the roll markets. The blue line is the three and a half.

coupon that role has been special on a non-mouth for several weeks. Other than that, these track role levels are not necessarily exceptional. Nothing like we saw in the Fed was doing QE. And I think that's the takeaway. Lower coupon roles are essentially zero. So the role market, well, it's still reasonably attractive. It's not as attractive as it was back in the days, the heydays of QE. In such as the case with the specified market where, you know, those levels still remain quite.

I think there's a shift underway, away from the roll market and more towards specs and maybe not playing out to the extent we would like in the next few months, but as we think going forward in the next year, especially if the economy were entering into a recession, that trend would continue.

Slide 12 of the ball market. We're using three month by 10 year normalized ball. It's a proxy here. As you can see, it's elevated. I think it still is. This ends on June . Ball today is high. And given where we are with respect to the Fed, and the chairman's statement that they're going to be dated dependent, just really means that the market will be hyper focused on meaningful data points such as today, next month's non-fond payroll number, CPI.

And so any time any lattice data prints come outside of the expected range, you're gonna see wall be well-bed. And I would be surprised as wall were declined meaningfully, at least through the end of September , but it could stay elevated for the bounce of the year. Beyond that, who knows, that's too hard of a call, but I would expect wall to be remained well-bed.

Slide 13, I'm not going to spend a lot of time on this. This is just historical information. OAS levels are, at least for production coupons. I guess it would be to take away here are much more attractive than they were when the Federal Society in QE. That would have been, for instance, in 2021 when Panytunes and two in a house were the production coupons and you can see those OAS levels were negative. Now we're producing fours and four in a half and they're at least positive. The Federal Society of QE. The Federal Society of QE.

The market looks much better in that regard and then just more on-specful stuff. Moving on to slide 14, it's got to be to say a lot. Obviously, the second quarter was a very bad quarter for risk assets. Well, it's a quarter in the year. I think one thing that's very noteworthy and this has been talked about quite a bit. It's very unusual. If you look at the bottom side of this page, if you look at the year-to-day returns to the end of the second quarter, you see that Treasury's had a very negative return as it stocks. The third quarter was a very bad quarter. The third quarter was a very bad quarter.

Those two things are normally negatively correlated, at least to some extent. It's very unusual that they would not move in the opposite direction, but they did, meaningfully so. And that just goes to show you that we have this odd combination of high inflation, probably a byproduct of something that is likewise unusual, the pandemic, which required an outsize in the irregular responsible from the Fed and the government, which eventually led to outsized inflation, something we haven't seen in decades.

which then led to a very aggressive Fed and probably a slowing of the economy. I think that's the only way you can explain how both of that asset classes would do so poorly. With respect to mortgages, obviously they're on the low end of the risk spectrum. They did poor, they were negative, but especially on a year-to-date basis, relatively well compared to other asset classes. It's also notable that in July , Situation Russians did eat emotional and sexual eggs on their own.

There was a big turnaround with respect to risk on how those numbers in the slide deck were pretty much every asset class.

across all of the financial markets, inclusive commodities had a very, very good July . August obviously remains to be seen, but July was a recovery month in a big way, especially in the higher risk asset categories. As it will see what happens beyond that.

Turning to slide 15, again we're showing you kind of what I call the pandemic period, trying to grab this data over the period that more or less coincides with you on set of the pandemic through today. And as you can see in the top left, for instance, you know, mortgage rates are high. The most recent data point was 4.99% on a 30-year fixed rate mortgage. So it's come well off the highs at 6, but still well above where it was prior to 2022.

and in the percent of the mortgage market or the refi index is very, very low. One thing I would say on the bottom chart there where it shows the percent of the mortgage universe that's in the money is essentially zero. There hasn't been high production so far in 2022, but what we have seen is predominantly coupons in the 4, 4.5, 5% range, even some 5.5s. It wouldn't take much of a rally for those securities to get in the money. So...

So we could in the event of a recession in a rally in the London that occurred, start to see a decent size of the market become refinanceable, which of course would in fact the quality of the carry of those assets, lower coupons are discounts and so the fact that we could rally is just upside to them just because you're a creating discount versus amortizing premium.

Now I'll just go ahead and finance the results.

On slide 70, we always show the slide, kind of decompose our results between work-to-market gains and losses and just carry, we were at about 12 cents. Versus the dividend of 13.5 cents, these numbers don't capture premium or discounted in the organization and hedging costs. I'll say a little bit more about the latter in a moment. But now that we are in a position where our portfolio is all at a...

Discount and we tend to own season bonds that are paying in the high single digits. So we're actually at creating discount which adds to these a little bit. And in our hedges are now finally in the money. So those are helpful from a million to a prospective. Obviously with respect to the returns for the quarter with the meaningful sell-off and the widening of mortgage fixed rate mortgages, they're very, very poorly. And the high-osts get well but not nearly enough.

to compensate for the poor performance and past report volume. Slide 18, this is kind of where you start to see the impact of our hedging and see that the... the impact of our hedging and see that the...

The blue line there is just the yield on assets and it's trending slightly up. Obviously our funding costs are going higher but the red line is our economic cost of funding. And you can see while it's increasing, it's increasing a slower rate, just captures the fact of swaps and so forth kicking in. And as a result, our economic net interest in spread is actually increasing slightly. We'll see how much longer that can go. Obviously the Fed is going to be very, very aggressive.

and has been so far in the second quarter and will be probably in the third. So, definitely we'll challenge the effectiveness of our hedges, but we are seeing so far that the performance is holding in place. So, the performance is holding in place. So, the performance is holding in place.

Slide 19 again, I really don't have to dwell on that, that's just the same thing, you can see some slight degradation in the coordinates per share, but I kind of addressed that already.

Finally, a couple slides that are new.

The leverage ratio on slide 20, that number is 7.8 as of the end of the quarter. We have not reinvested pay downs of the late and our book value has recovered. Our book value recovery quarter to date is in the mid to high single digits.

was close to 9% approximately 9% as Wednesday. Today I don't know if mortgages are having a very rough day. They didn't have a great day yesterday. So I won't say that's why I kind of say mid-the high single digits. A big get it can change on any given day. But we have had a very nice recovery quarter date. And as a result, our leverage ratio was probably just under seven as we speak. So it's in the highest 6th.

On the right side, we show our leverage ratio versus our peers.

And as you can see, we're the blue line there, and we are on the high end of the range.

Going to take steps to bring it down, maybe not all the way as far as our peers, but we are going to bring it down slightly. But we are going to bring it down slightly.

and try to eliminate some of the value volatility. So we will be trending down. I mentioned we're at 6.8. We may let that get back up about seven, but we're not looking to get that number up to eight. So we are going to bring bringing the leverage ratio down back closer to our peers over the balance of year and the quarter.

Friday, 21, you see our dividend versus our peers. Today is our condOctizing year.

quite a bit higher and we describe who our peers are on the bottom of the page. I will say that we are anticipating an adjustment to the dividend in the near future and the rationale is to bring the dividend into line with our book value. We think we need to get that into the lower double digits, maybe not as low as our peers but much closer. So that's just really reflective of a few things.

earnings environment. So that is likely to occur in the near future.

Finally, I'm going to finally, quite moving on. A few more slides. Our allocation of capital just stable. I don't need to get into details here. Our allocation between the two portfolios has remained the same. And the portfolio on the right-hand side.

just reflected the fact that we had adverse market conditions and the portfolio did shrink some. I mentioned we have not been reinvesting pay down so even though the allocations across capital are the same, the portfolio is slightly smaller. Now moving on to the portfolio itself on slide 24. I'm gonna skip right to the takeaway. The takeaway is not much has changed. There have been some changes in the 30-year fixed rate portfolio.

We basically eliminated our small position in two and a half. The three, which is by far the biggest holding, is roughly the same percentage wise. Three and a half maintained, and we've added our allocation to fours itself.

to 6.9 percent. So that's quite an increase. We may increase that a little bit further. We did shift our small 15-year holdings from two and a half to three and a half.

And with respect to the IO portfolio, we basically just harvested some profits because the market had sold off. And we got to the point where these IO positions really didn't have much upside left in them. So we just harvested those profits. So we just harvested those profits.

And so other than that, the portfolio is relatively the same as it was last month.

With respect to speeds, everything is slow as you would imagine. The universe, we had speeds come out last night. They dropped quite a bit. High teens, we continue to see meaningful declines in speeds reflecting rates.

We did have a rally in July , but now we're selling off in August and net of all that, I don't think you know given the fact of removing it in the late summer is likely to be meaningful so I would expect speech to stay on the soil side.

One thing I do want to point out though is respect to a portfolio if you look on slide 26.

Obviously the yield on the 10-year is very high, it came to where it was back in 2013 2014.

But if you look at the green line which represents our portfolio performance, back in 13 we were very, very low. Now it reflects the fact that at the time we owned a lot of discounts that were new.

Now still on discount securities, but they're seasoned. So they're paying a little faster. And as a result, we're able to create a little more discount, which is beneficial from an earnings perspective. And it's always good to have good caring bonds. And we also like these bonds, as I said, going forward.

What we tend to own in fixed rate space are a lot of spec pulls. As we said many times, the payups on those specs are quite low. This all leads to the fall and conclusion that the convexities assets is very attractive. The payups have been basically depressed to zero, and these securities have extended for the most part. In the rate sell-off, they should do fairly well and they're fairly easy to hedge.

In the event of a rally, obviously their duration can extend because the spec pull pay-ups will increase in value. Obviously that's not a small rally, that would have to be something.

decent size, but in a meaningful rally they would do very, very well.

Combination of only these more season bonds, you will be get better carry today. The portfolio was pre-paying in the high single digits versus new issue, which are in the low single digits. But also we have retained very good convexity. And as a result, we're very bullish on the portfolio going forward for the BALAS 2022 and into 23.

Turning on to our funding. This slide here on page 27. This again goes back to the beginning of 2020. We show the gray line, which is just one month so far. As you can see, it's rising rapidly. The blue line or the red line is our cost of funds. But as you can see, the blue line is our economic cost of funds, which is now below our actual cost of funds. It just reflects the fact that the edges are kicking in.

Obviously SOFR is going to continue to rise quite a bit. This only goes through the end of June . Needless to say, SOFR is up near 150 and over 2%. So this number is going to continue to rise, but our hedges are effective and they're basically minimizing or counteracting to the extent possible this rise in our funding costs.

With respect to our hedges on the next slide, again the takeaway is not much has changed. We did add some TBA shorts and Fannie 2s, very very minimal adds to our futures.

And some of the swaps just rolled down. We have two buckets there, kind of a three to five year, a gray and five year. A few of them rolled from over five to under five years.

And that's pretty much it.

So that's pretty much it. I just want to make a few concluding remarks.

Three basic points. One, we've had some book value recovery. We like the portfolio going forward. We think the convexity of the portfolio is quite good. We think what's going on in the market bodes well for us and mortgages generally. We are going to be adjusting the dividend, as I mentioned, to bring it into line with a combination of a lower leverage ratio, a more reasonable yield to our book value and more in line with the earnings available in the market today.

call to questions.

Thank you. At this time, if you would like to ask a question, press star then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster.

We'll take our first question from Jason Stewart with John Strading. Your line is now open.

Thanks for taking the question and appreciate all the color and remarks as always. Bob, where do you see terminal fed funds ending up in this environment?

Well, it's probably going to be in the mid-3s or slightly higher. It's hard to say, though. Today, for instance, the data looks to be so strong.

And the market's reaction is obviously very strong, but a dive deeper into the data, the establishment survey showed a gain of 528,000 jobs. The household survey was only 179 last month. The household survey was negative.

So it's hard to believe that the economy can really be adding in my opinion jobs like that. I think you're starting to see.

The pervasive evidence that I see that the economy is slowing is too hard to ignore. And again, in spite of today's data, I think we're gonna slow and continue to slow to the balance of the year. And while the Fed, I think has to be aggressive, this certainly has to maintain that image in the eyes of the public and the markets.

I just think it's going to be hard to be tightening aggressively beyond this year. So, do we get another 100 bips this year? Probably. It's just a question of what you get next year. Maybe you get one more, but I just, I have a hard time seeing it getting up to 4%. That being said, some of the evidence on the inflation side is troubling. You're seeing commodity prices come off, but you're seeing evidence of wage pressures becoming ingrained.

That would be the risk to my thesis, if you will, that they can't go that much more. The extent I'm wrong there and you really see inflation become fully ingrained, then you get more like that Volcker kind of scenario where they have to really slam on the brakes and that'll get you to 4% maybe beyond. But I'm sticking with my theory for now.

And I think that Jason, I think that plays in the why we've held off on.

on the dividend, you know, bringing the dividend back a little bit as well is just a tremendous amount of uncertainty right now. I mean, six months ago, people would have told you you were crazy if you didn't said that they were gonna, the Fed was gonna hike 75 in June and July and then pay me our, so as it relates to that, I think we were trying to get a little bit more time to pass and see how that played out and how that affected the portfolio.

Yeah, now that makes sense. Thanks for that.

on the mortgage origination industry, what's your view on capacity right now and how that's gonna impact pre-paste going forward if that plays out as you expect?

Well, I would assume they're struggling to maintain it.

What's been originated is the low-hanging fruit now, to the extent we see a rally. Catch-out refis are, as you know, declining very rapidly. I think they're going to struggle to maintain it. And I think that you're already seeing evidence of that. We're in a very hot housing market here in Florida for many reasons, not just the economy, people moving away from some of the high-tech states to here.

We're clearly seeing signs of it slowing, very clear signs. Inventory levels are rising. They're not troubling yet, but they're rising. So I think they're going to be hard-pressed to maintain staffing levels.

and eventually that's going to come off.

Yeah, okay. Thanks for taking the questions.

Certainly.

And everyone I'd like to remind everyone if you'd like to ask a question press star one on your telephone keypad. And next we'll go to Mikkel, Robert Men with JMP Securities. Your line is now open.

Hi, good morning gentlemen. I hope everybody's doing well. You mentioned, Good morning. Some book value recovery. I was wondering if there's a number to that.

Good morning, gentlemen. I hope everybody's doing well. Good morning. Good morning. Some book value recovery. I was wondering if there's a number to that. That's fine. Q3 . That's fine. Q3 .

Well, like I said, it was high single digits until Wednesday. Yesterday we were soft and then today I really hard to say. When I came into your mortgages were underperforming by a lot of ticks, 8 or 10 ticks, that would bring it down closer to 6 or 6.5% maybe, but it's been a good recovery. We own, as I mentioned, a lot of belly coupons. They've had a good run. There's mostly specs and specs have hung in fairly well, but it's been mostly on the TBA front.

I would have, you know, lengthy, like I said, it was very high single digits, but it's probably more than the six to seven percent or maybe today with the underperformance of mortgages. The underperformance of mortgages.

Thank you for that. Just one more question if I may on expenses. Okay.

Expenses up a little bit to just under 5 million this quarter versus about 4.7 last quarter but there are any one-time items in there and and also kind of a second part to that

Given your comments on the dividend probably coming down and and a small portfolio of the core earnings rate, core earnings run rate trending lower.

What sort of expense ratio or expense run rate level are you targeting if it all?

Is there any, are there any plans in the works to kind of get that 5 million down a little bit? Thanks. Well, it's probably on the high end of the range where we'd like to see it. The one off change is that we internalized our reputal operations and back office. So we talked about that last year and early this year. And there are some costs associated with getting that online. This is mostly at the Bimini level though, but there is an overhead reimbursement of the arrangement. So some of the dust filter through.

I would expect that to come down. But to the extent that we can recover some more book and even with a slightly lower leverage ratio, we'll probably net net be able to get the portfolio a little larger, which covers some of that. We were at a point late last year, early this year when the portfolio was more of a 6 billion. Obviously, that was a very comfortable point from an expense ratio perspective. We had obviously strength relatively quickly.

because of the market so it's now on high into the range but

I don't think we have to do anything drastic at the moment, but we would like to see that ratio come down.

All right, thank you very much and best of luck going forward.

Thank you, Michael.

As a reminder, ladies and gentlemen, to ask a question, it's star 1 on your telephone keypad. Next we'll go to Christopher Nolan with Lattenberg-Bolman. Your line is now open.

Hey guys. Bob, what sort of leverage range are you thinking about?

referred that was coming down but

Anything? Probably low sevens. I think low sevens. It's not.

It's not a hard number. I mean we look at it the market. We're looking at our holdings. We're looking at our hedges. I'll let Hunter talk about this as well.

Just a little on the lower end of the range, we'll just try to maybe bring some of the value volatility down which has obviously been high of late.

We think we should be able to run with a lower dividend yield as a percentage of book value. We've been in a very high premium to our peer average and don't think that that is necessary or prudent. So that's kind of what's going on here.

And then we follow up.

Oops, it's good.

Nah, yeah, I would just add the trillion byproduct of...

for the time we're in. And when we see, I think his mom was a little too a moment ago, Wednesday, our book value is high single digits on the quarter. And a couple of bad days can put that back to mid single digits. That's an incredibly volatile operating environment. And we tend to take our cues from the market and adjust our leverage ratio accordingly.

As a follow-up on the repo financing, are you guys getting hints in terms of where the banks are thinking about how they're trying to manage their risks? I mean, are they changing their haircuts or other things? That's it for me. That's it for me.

We haven't seen it.

Sorry, I didn't mean to step on your toes. No, we haven't seen any signs of that. We have ample balance sheet availability. I don't think anyone in our space has been in trouble as sloppy as this market has been over the last six months.

And you haven't seen any agency REITs stub their toes in the way that they did in the early days of the pandemic. And we're always in constant contact with our lenders and all seem to be pretty comfortable at this point in time.

and you haven't seen any agency REITs stub their toes in the way that they did in the early days of the pandemic. And we're always in constant contact with our lenders, and all seem to be pretty comfortable at this point in time. Great, thank you.

Expense, K.

And there are no further questions at this time. Mr. Colley, I'll turn my call back over to you for any additional or closing remarks.

Thanks operator. Thank you everyone for taking the time. As always we're available in the office for follow up questions. Our number is 772-231-1400. Sixth day to get half those into the replay. And you have questions again. We'll be more than willing to take any questions. And otherwise we look forward to talking to you next quarter.

This includes today's conference call. You may now disconnect.