Armour Residential REIT, Inc. Q1 FY2020 Earnings Call

Greetings and welcome to the ARMOUR Residential REIT First Quarter 2020 Earnings Conference Call. During the presentation, all the participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. As a reminder, this conference is being recorded, Friday, May 1, 2020. I’d now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.

Thank you, Nelson. And thank you all for joining ARMOUR’s first quarter 2020 conference call. We hope that all of you have been able to remain safe and healthy. This morning, I’m joined by ARMOUR’s co-CEOs, Scott Ulm and Jeff Zimmer; and our Chief Investment Officer, Mark Gruber. By now, everyone has access to ARMOUR’s earnings release, which can be found on ARMOUR’s website. This conference call may contain statements that are not mere recitations of historical fact, and therefore 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 the outcomes and results expressed or implied by the forward-looking statements due to the impact of many factors beyond the control of ARMOUR. 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 ARMOUR’s periodic reports filed with the Securities and Exchange Commission. Copies of these reports are available on the SEC’s website. All forward-looking statements included in this conference call are made only as of today’s date and are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless required by law to do so. Also, our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to the most comparable GAAP measure is included in our earnings release. An online replay of this conference call will be available on ARMOUR’s website shortly and it will continue to be there for one year. Like other firms in our sector and across the economy, ARMOUR was impacted negatively by the sudden and historic levels of market volatility in March, resulting from the COVID-19 pandemic. On March 31, 2020, ARMOUR’s total assets stood at approximately $5.1 billion, down nearly 62% from a $13.3 billion level at the beginning of the quarter. This reflects ARMOUR’s successful results and actions to aggressively prune the investment portfolio, reduce risk and preserve liquidity. By comparison, ARMOUR’s total comprehensive loss for the quarter of $587 million represents only 37% of stockholders’ equity at the beginning of the quarter. Total equity was also reduced by $113.5 million by the Company’s January decision to replace its outstanding 7.875% preferred stock with a new 7% series as well as the payment of previously declared dividends. Having weathered what we expect to be the worst week of this emergency, ARMOUR ended Q1 with a book value per common share of $11.10, corresponding to total stockholders’ equity of $786 million. That included cash and unpledged liquid securities of approximately $470 million. Since March 31st, ARMOUR has done a number of things. ARMOUR has issued approximately 5.7 million shares of common stock through its at-the-market offering program, raising approximately $48.4 million of additional capital. We continue to enjoy sufficient access to repurchase funding and interest rate swaps with a diversified group of counterparties. ARMOUR’s affiliate BUCKLER Securities continues to play a major role in the Company’s funding strategy. ARMOUR has also taken advantage of relatively attractive opportunities to sell certain of its credit risk transfer and other non-agency positions. The Company is also selectively rebuilding its agency pass-through portfolio and is refreshing its swap book. We expect to continue on this course for the rest of Q2. As of yesterday evening, the ARMOUR portfolio stood at $5.6 billion, which includes $1.3 billion of TBAs and $308 million market value of CRT positions. They have a weighted average mark above 76, and 37% of those positions have investment grade ratings. The $4 billion of agency securities in the portfolio is a nice mix of legacy, higher coupon 30-year and DUS positions, combined with newer 15-year and 30-year products. When the last few legacy swaps run off in July, our hedge book will stand at $3.7 billion with the average pay rate of 22 basis points, based on our current positioning. In addition to anticipated improvements in portfolio composition and lower hedging costs, we expect future net interest margin will also be positively affected by favorable repo financing rates as term transactions roll off and are replaced at substantially lower current rates. For example, three-month term repos for agency collateral were priced just under 180 basis points in early March. Today, we’re seeing one-month repo prices inside of 30 basis points and less for overnight. Contractual management fee expense for Q2 will be reduced by 40% as further described in the company’s form 10-Q, which will be filed with the SEC shortly. Earlier this week, ARMOUR paid the April cash dividend on the Series C preferred stock and declared the May cash dividend at the rate of $0.14583 per share to holders of record on the 15th of May 2020. That dividend will be payable on May 27, 2020. As previously announced, ARMOUR is moving to a quarterly dividend on its common stock for the second quarter. Expect further announcement on the amount and timing of Q2 common dividend in the latter part of June. Now, let me turn the call over to Scott, Jeff and Mark to discuss ARMOUR’s portfolio position, strategies and view towards the future. Scott?

Thanks, Jim. Good morning. The world has changed significantly from our last earnings call in February. Our team has been working remotely since early March and our business continuity plan has worked well for us. While we’ll be talking today about the pandemic’s financial impact on us, we’re mindful of personal costs to so many of our customers and colleagues. We hope everyone joining us today stays healthy. March was a profoundly bad month for the mortgage investment industry. As a senior management team with each professional having about 35 years of average experience in the capital markets, March was the worst environment we’ve had to deal with in our careers. The market movement was more sudden and violent than 2008. Our results were driven by several phenomena that occurred simultaneously. Interest rates on 10-year treasury bonds whipsawed from 1.16% at the beginning of March, down to new historic lows of 0.54% and back up to 1.2% in a matter of days. Despite the historic risk-off rally in treasuries, mortgage-backed security and TBA prices declined. This resulted in the widest MBS spreads since the financial crisis. ARMOUR, as well as many others in our investment sector, experienced a double shock of both interest rate hedges and asset prices moving against us. Premiums on best criteria specified pools evaporated as forced selling by levered investors, mutual funds, and REITs quickly drowned out all available balance sheet of banks, the lack of which was further exacerbated by quarter-end pressures. In the Fannie Mae DUS 10/9.5 market, spreads exploded from approximately 100 price levels to as high as 110 price levels to as low as 60 to 80 points on the dollar price levels, if a bid could be found at all. Repo terms in the agency asset class were very stable, and in particular, ARMOUR has always found very sound funding through its broker dealer affiliate BUCKLER Securities. However, outside of the agency business, funding propositions degraded dramatically as haircuts and financing rates doubled or tripled on CRTs. Amidst the non-agency funding chaos, one large money center bank abruptly ended its financing on CRTs altogether, causing further turmoil as many investors were forced to sell at the same time into a tumultuous market, further lowering prices. Liquidity in many respects simply disappeared. Off-the-run treasuries sharply underperformed on-the-runs, indicated bid/offer spreads on current production TBA widened by multiples. 30-day commercial paper oscillated between 0.95% and 1.81%, even as Fed funds dropped to 0.05%. FX swap funding all but dried up in the middle of March. To reduce risk, leverage and free up available cash, we acted early by selling $1.7 billion of agency securities in the first two weeks of March; in the last two weeks of March, we sold another $7.4 billion of primarily agency securities. If we had not acted promptly and decisively, there’s little question that we might have found ourselves in the midst of forbearance discussions with creditors, like many others in our sector faced. The Fed’s announcement of unlimited support for agency mortgages on March 23rd caused prices to stabilize and increase. To increase liquidity for an uncertain future, we sold many agency mortgage assets and were not able to fully participate in the subsequent agency mortgage price recovery. Standing here today, we see a changed landscape from prior years. We believe that substantial uncertainties will surround mortgage credit for the remainder of the year and perhaps longer. Agency securities are again a bright investment spot but require careful selection. The Fed buying program has given definitive support to the market, but has also caused substantial increases in prices that are exacerbated by the low-rate environment. We believe close attention to credit characteristics in agency securities will be rewarded with superior performance. We believe elevated prepayments will return as a concern later in the year, not in the immediate future, and focused portfolio selection now can mitigate that medium-term risk. Currently, 85% of our agency specified pools have some kind of prepaid protection. We’re methodically investing and expect our leverage to increase over the coming few weeks with our emphasis on liquid agency securities that offer attractive risk-return profiles. We previously announced that we will declare a dividend for the second quarter in late June. We believe our ongoing dividend policy should be as stable as possible and reflect our medium-term view of our net profitability. We believe our dividends should not chase period-to-period net profitability. At this point in the investment cycle, we’re very constructive on our business for the following reasons. As we move through the pandemic and the economy revives, we expect to see the yield curve modestly steepen, providing improved opportunities for investment. At the same time, we believe the Fed will keep short-term rates low in order to nurture a nascent recovery, which will keep our funding rates low. The Fed has already begun to taper its MBS purchases, and we expect it will continue to do so as the agency market normalizes. Some spreads still appear to be naturally tight today and Fed tapering should allow more conventional pricing relationships. Prepayments will likely remain subdued until staffing and financial conditions are much closer to normal. There’s a great tailwind for doing investments. Financing for agencies is abundant and at the most attractive levels in years. We’re highly confident in our access to financing and excellent terms through our affiliate BUCKLER Securities, as well as the almost three dozen other relationships we maintain with other repo counterparties. There’s clearly uncertainty in the timing and realization of all these factors. That said, we believe that the medium-term net yield expectation should be in the high-single-digit to low-double-digit range. We’re delighted to be through the month of March and standing here with great liquidity, solid financing, and dry powder to continue to design our portfolio for the present environment. We’ll now be happy to take any questions.

Nelson, can you now open up the line for questions?

Thank you. Our first question comes from the line of Douglas Harter with Credit Suisse. Please proceed.

Hey, guys. This is actually Josh on for Doug. Good morning. We saw the large drop in leverage in the quarter. And you mentioned on the call that we should expect that to tick up going forward. But curious if you could talk a little bit about how you’re thinking about target leverage at this point, and if we should expect it to get back to where it was in 2019. Thanks.

Our target leverage at this point is around eight, give or take a half a turn, depending on the opportunities and how fast we can deploy our capital based on those opportunities.

Got it. That makes sense. And then, one on funding. Can you update us on how much of the agency repos are currently funded through BUCKLER and the average maturities, the average maturity of that funding?

So, approximately three-quarters of the agency book is with BUCKLER. I suspect as we regrow our agency portfolio, that number will come down a little bit. But we want to make sure that the capital at BUCKLER is completely utilized. And quite frankly, the rates that we get from BUCKLER and the trends we get from BUCKLER are fantastic, and particularly better haircuts than the market.

Are you able to quantify how much better those terms are versus market repo?

Well, sometimes it’s a couple of basis points better; sometimes it’s a couple of basis points worse. But if you add that with the fact that we have surety on overnight funding, I’m not going to do overnight funding with XYZ bank because you’re not sure if they’re going to be there the next day. We know that BUCKLER is going to be there the next day. And as you heard from some of the other participants in the sector, the overnight funding can be half the rate of some of the term funding. So, we have trust and an ability to know that they’re going to be there every day, and sometimes you can actually quantify that.

Thank you. Our next question comes from line of Trevor Cranston with JMP Securities. Please proceed with your question.

Hey, thanks. I apologize if I missed this in the prepared remarks. But, with the credit portfolio, can you talk about sort of how you’re thinking about that going forward? If your intention is to hang on to that portfolio or as prices have started to recover some in April, are you going to be looking to sell down that book? And as the second part of that question, can you give us some additional detail around where the financing market is for credit securities now in terms of haircuts and the cost of repo? Thank you.

Sure, good morning. So, the credit book, CRTs, had approximately in early March a $900 million market value. The value of the remaining securities on our balance sheet today, exclusively CRTs, is $308 million. So, we’ve reduced that by two-thirds. It is our intention over the next two to three months to sell the rest of that. And we’re doing it surgically. As opportunities and buyers come into the market and people have a better perspective on recoveries, we’re selling into strength and not selling into weakness. There are some companies and mutual funds, particularly those who had withdrawals that were forced sellers during March in the first two or three weeks of April, and the opportunities for us to move out of that product were not as profound. And yesterday, actually, we made a number of very nice sales and above marks. We’ll continue to look to do that. You should look at us by the time we get into the third quarter to be almost, if not all, agency assets, and that will be our portfolio platform in the future. Now, funding for the non-agencies is and seems to be very secure today, but did not feel that way even as of two weeks ago. As Scott said in his comments, one major central bank, one of the top five banks in the country, all of a sudden in the third week of March decided to pull out of all of their CRT funding, which meant that everybody that was funding with them had to sell bonds, because very few other lenders were taking on new CRTs at the time, and it created a real whirlwind of down pricing for a while. So we refrained from selling for a period. But today, haircuts are as low as 17.5%. Our average haircut on our CRT portfolio is right around 25% today.

Okay, great. That’s very helpful. Then, as you’re deploying capital back into the agency trade, can you talk about specifically what sector of the market you like and what coupons the portfolios are in today, and what coupons you’re mainly looking to buy? And maybe specifically, some color on whether or not you find roles attractive enough to be buying TBAs or if you’re really going to focus mostly on buying spec pools? Thanks.

Hey, Trevor. It’s Mark. So, we’ve been looking at both, the 15-year sector and a variety of coupons there. Also, the 30-year sector, more of the higher coupons. Most of our book is still at 4 and 4.5, the higher coupon stuff we had bought earlier over the last few years. We’re sticking to those sectors. We’re looking for more stable bonds that have good convexity profiles. We do like TBA roles in certain coupons, certain sectors, and we’re watching those carefully, having invested in some of that. But you’ll continue to see us do a variety of different sectors. We still like DUS. We like those profiles. So, in the same sectors we’ve always been in and agency, but probably on the 30-year sector, more on the higher coupons than lower coupons.

One of the reasons for this change is the Fed's recent adjustments. If you examine the Fed report from the past few days, you'll see they've altered their purchasing strategy. Previously, they focused on buying a significant amount of 3.5s, 4s, and 4.5s. Now, they will refrain from purchasing those and will shift towards lower coupons, indicating that those will remain expensive, even if they may not become more so. On the other hand, there might still be buying opportunities in the higher range, particularly in specialties like 125 loan balances. Is that clear?

Yes, very helpful. Thank you for that. And last question. It looks like there was some issuance through the ATM plan in April. Can you just provide some additional color around the rationale for that issuance, given where the stock was trading and where you’re at today in terms of the likelihood of any continued issuance?

Sure. As you know, our traditional approach to capital raising is kind of threefold. Basically, how can shareholders benefit based on a variety of factors? So, is it accretive? Is it beneficial to earnings? However, as we entered April, there was not clarity on how the world was going to turn out. Liquidity was at a premium. And we thought a modest amount of dilution was a very reasonable move for our shareholders to go ahead and raise up to $50 million, and we raised $48 million. The actual dilution was just around $0.20 all-in, to be clear. So, we felt that was a very modest amount to increase the assurance and survival factor of the firm during a period of time where some of our peers were addressing forbearance issues. We feel very good about what we did for our shareholders. I don’t anticipate, right now, turning that program back on. We’ll see how the future develops.

Okay, great. Thank you for that.

Thank you. Our next question comes from the line of Christopher Nolan with Ladenburg Thalmann & Company. Please proceed with your question.

Hey, guys. Hey, Scott. In your comments, you mentioned that net yields could be high single, low double digits. What do you mean by net yields? Is that core income relative to equity? Could you define that a little bit, please?

Yes. That’s correct. Current income relative to equity; core income.

Net to shareholders. That’s correct.

Okay, great. And then, from what I can gather from the press release, it looks like the investment spreads widened quite a bit this quarter. What’s sort of your anticipation for investment spreads going forward? I mean, is that just sort of an anomaly for Q1 or are we in a new world?

Just define investment spreads. Are you talking about investment opportunities, as we said, low double digits, or are you talking about NIM, or is there some other criteria?

NIM would be great.

No, NIM will be determined on an asset basis. I believe it will be higher than it was in Q1 because the spreads will be a bit wider than our current investments. I can't provide a specific number for NIM, but I can assure you it will be higher than it has been previously.

And Jim also mentioned a couple of other factors. We’ve got term financing that’s rolling off, and we’ve got higher rates and swaps that are rolling off too, both of which are going to give a little tailwind here to NIM.

Yes. Looking at it this way, Christopher, Jim mentioned that our swap book is projected to be 22 basis points by July 1st, as everything is rolling off. The repo is in the high single digits, with overnight rates ranging from 10 to 20 and term rates from 25 to 30. So, taking your 22 and adding 20 gives us 42. You can earn assets here in the mid to high ones, so you can do the math to see where you could end up. Frankly, as Mark pointed out earlier, we expect prepays to slow down in the coming months, which should keep NIM in a good position. I've noticed that others we work with on the broker side are seeing it the same way. I hope that helps.

Yes. No, it is great. And then, I guess the final question is, when should we expect the Q to be released?

We should be getting that out shortly. Ideally, that be on Edgar before it closes tonight. But in any event, we ought to be able to see it Monday morning.

Great. Final question is, given the changes in interest rates, do you guys change your thinking about preferred stock at all? I mean, is there consideration to pay that down further and go with more repo funding?

So, we have $132 million of our 7% out there. Based on investment opportunities today, that is accretive to the overall proposition of investing. However, you don’t ever want to have preferreds be too large a portion of your total capital structure. Currently, the firm is very comfortable with the capital structure amount of our regular equity versus our preferred. Also, there’s a very large buyer of our preferred yesterday, currently over 200,000 shares in the market at the close. But that’s still only trading at $22 a share, and we would not be interested, at least any consideration that we’ve been approached with now, of selling it under $25 a share.

Yes. Just let me amplify a little bit. In retrospect, the January decision to swap out $240 or $250 million, whatever it was, of 7.875% for Series B with slightly smaller amount of lower coupon, 7% Series C. In retrospect, in my mind, that looks like a really smart decision the way things have worked out.

All right. That’s it for me. Good show, guys. Thanks.

Thank you.

Nelson, do we have any more questions?

I am showing no further questions at this time.

Well, thank you all for joining us. We continue to work largely remotely but are completely connected. So, if anybody has additional questions, you’ve got our email, call the office, and we’ll get reconnected. And until next time, stay safe.

That does conclude the conference call. We thank you for your participation and ask that you please disconnect your line.