Armour Residential REIT, Inc. Q3 FY2020 Earnings Call

Greetings and welcome to the ARMOUR Residential REIT Inc. Third Quarter 2020 Earnings Call. During the presentation, all the participants will remain in a listen-only mode. Afterwards, we will conduct a question-and-answer session with instruction to follow. Please note as well, today's conference is being recorded, Thursday, October 22, 2020. It is now with pleasure that I turn today's presentation over to Mr. Jim Mountain, Chief Financial Officer. Please go ahead, sir.

Thank you, Bridgette, and thank you all for joining our call to discuss ARMOUR’s third quarter 2020 results. This morning, as usual, I’m joined by ARMOUR’s co-CEOs, Scott Ulm and Jeff Zimmer, and by our CIO, Mark Gruber. By now, everyone has access to ARMOUR’s earnings release and Form 10-Q, which can be found on ARMOUR’s website. This conference call may contain statements that are not merely 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 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, which can also be found on ARMOUR’s website. An online replay of this conference call will be available on our website shortly, and it will continue to be there for one year. Quarter-end book value for ARMOUR was $11.74 per common share, up $0.63 from Q2 2020. ARMOUR's Q3 comprehensive income was $61.9 million, or $0.91 per common share, and that includes $58.4 million worth of GAAP net income. Core income, on the other hand, was $25.4 million or $0.35 per common share. Core income includes TBA drop income and excludes market value adjustments. A complete definition and reconciliations showing how we compute core income is included in yesterday's press release. Core income for the quarter represents an annualized return on equity of 12.6% based on per share book value at the beginning of the quarter. ARMOUR's portfolio consists exclusively of agency MBS, totaling over $5.5 billion. Since the beginning of Q2, we have continued to designate any agency MBS purchased as trading securities, and the fair value changes for these investments are reported in net income. Commencing with the second quarter of 2020 and continuing until further notice, the Company's external manager is waiving 40% of its management fee. This waiver offset $2.95 million of operating expenses in the quarter. ARMOUR paid dividends of $0.10 per common share for each month in the third quarter. We've also declared October and November common dividends continuing at that rate of $0.10 per common share. And the Series E preferred stock dividends for Q4 2020 at their contractual rate of $0.14583 per share. Now let me turn the call over to our Co-Chief Executive Officer, Scott Ulm, to discuss ARMOUR's portfolio position in further detail and give us insight into our current strategy.

Thanks, Jim. In the third quarter of 2020, we saw the ARMOUR conditions across the mortgage market and dramatically improved sentiment. The Federal Reserve flooded the market with funding and agency and treasury markets, and their outright purchases helped drive the bond markets' recovery and stabilization. We completed the previously announced strategic transition of our investment portfolio to solely agency mortgage-backed securities issued or guaranteed by U.S. government-sponsored enterprises, treasury securities, and cash. With ARMOUR's common equity closing at $9.43 yesterday, a 20% discount to the third quarter ending book value, the current yield on the common is 12.7%. Our core income for common share of $0.35 was 16.7% higher than the $0.30 in dividends we paid in the quarter. The Federal Reserve's large footprint in the agency MBS markets continues to be a major factor in MBS performance during the third quarter, driving OAS tighter, volatility lower, and greatly improving liquidity. The Fed purchased about $330 billion of agency MBS throughout the third quarter, absorbing almost the entirety of new net agency MBS supply. Following treasury yields and tightening mortgage spreads drove primary mortgage rates to all-time lows during the quarter. ARMOUR's continued strategy of focusing its investments on prepaid-protected, lower coupon mortgage pools is designed to protect its MBS portfolio from the expected refinance wave created by lower rates. In addition to stable income, these specified pools delivered considerable results in book value appreciation for the quarter. As of September 30, ARMOUR held 94% of its MBS portfolio securities with favorable prepayment protection characteristics. These include 58% in bonds with loan balances less than or equal to $225,000, 22% in agency CMBS with lockouts and prepayment penalties, 11% in bonds with loan-to-value ratios greater than 95%, FICO scores less than 700, and seasoning of more than 24 months, and 4% in bonds where 100% of the loans are in states with additional taxes on refinancing and cash-out transactions such as Texas, Florida, and New York. We saw strong dollar roll performance in the production coupons where the Fed's purchases matched new supply throughout the quarter. We expect dollar rolls to continue yielding double-digit returns over the medium-term horizon. ARMOUR's duration at the end of the third quarter was 0.86. We're comfortable with the portfolio's interest rate risk in both up and down rate scenarios. Our portfolio's convexity profile is significantly more favorable than that of newly issued MBS. We manage our net duration gap within a tight range dictated by our team's outlook on the rates market. It should be noted that a significant portion of the portfolio's duration is in the key rate buckets inside of 3.5 years, where we expect yields to remain close to zero for the foreseeable future. Our exposure to the long end of the curve is considerably less than our overall duration. While our third quarter ending debt-to-equity was approximately five times, we maintained our all-in leverage, which includes the implied leverage of dollar rolls between 7.5 and 8 times throughout the quarter. This provides us with ample dry powder as new investment opportunities arise. We expect this leverage range to persist at least through the fall absent some attractive opportunities arising. The repo market continues its benign course with financing costs at all-time lows with little to no term premium for longer dated repo. Ample year-end funding as we see it today reinforces that. Our broker-dealer affiliate BUCKLER Securities continues to provide us with attractive terms and, perhaps more importantly, reliable financing. Our earnings outlook remains constructive despite the REIT investment market and cash securities with attractive convexity characteristics. As noted, the high returns available in the PBA market are very attractive but will remain a distinctly smaller portion of our portfolio than specified pool cash securities. Based on these investment opportunities, we believe that our core earnings will cover our dividends in the fourth quarter. While the third quarter of 2020 marks a bright spot in a bleak year, ARMOUR continues to monitor and plan for what lies ahead. The Fed's statement suggests a strong commitment to lower rates in the medium term and continued support for the mortgage-backed securities markets. Over the longer term, the timeline and future sizing for the Fed's security program remains in question, as does the shorter-term uncertainty surrounding next loan selections. Prepayment speeds have stabilized but remain elevated as lenders continue to streamline their technology and grow staff to capture the refinancing business. We believe our portfolio is balanced considering these uncertainties with a convexity profile with the right amount of exposure to QE buying and enough dry powder to take advantage of opportunities ahead. Operator, we'll now take any questions.

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

Hey, guys. This is Josh Bolton on for Doug. Good morning. I appreciate the comments, Scott, about leverage from the fourth quarter update you gave. It looks like leverage was up a little bit from the end of the third quarter. Is that intentional or is that just the result of book value moving around? And I guess how are you thinking about target leverage going forward? Specifically, what would you have to see to take that level either up or down?

Good morning. It's Jeff Zimmer here. So, our leverage is exactly where we want it to be. We recently settled some forward purchases, which had the leverage slightly tick up. The book value today is actually almost unchanged since the end of the quarter. So, the leverage has not changed because the book value is moving around. In fact, the number we published yesterday is actually up a little bit since then. The opportunities in the marketplace, and we talked about this in our morning meeting, are kind of important. So, they're bifurcated right now, right? Zero volatility OAS or Fannie 2s is around 65, while zero volatility OAS on Fannie 3s where the Fed is not buying anything or up to 93. So when Scott in his comments talked about keeping powder dry for buying opportunities, if we start seeing some on-the-run stuff or TBA, non-TBA stuff where the payoffs come off a little bit, perhaps going into a steepener, you could see that leverage pop up from 8 to 8.5 to 8.75, but only because we see good opportunities. Otherwise, our target leverage will stay in the range that it is right now. As you can see from the month the Company update that we published last night, we continue, as Scott also said in his comments, with the barbell strategy, meaning we bought a lot of specs at low pay ups in early to mid-April. Those are up two times or even more from what we paid for them, and we offset that with about 27% of our portfolio in the TBA market, where, as he also said, we're seeing returns in mid-teens to even low 20s. So I hope that addresses your question.

Yes, thanks, Jeff, for those comments. My second question: Last quarter, you talked on the call about the percentage of repos through BUCKLER Securities getting closer to 50% down from what it is. Just curious if that's still a goal or if there's any update? I know it's running higher than that today, but any comments you can give about the BUCKLER brokerage deal? Thanks.

Yes, Josh, BUCKLER is running a little above the proportion we did over the last few years, mostly because there's a little unutilized capital at BUCKLER and we want to make sure it is working. I would expect that percentage may drift down a bit, but I think it's still at a reasonable amount, basically determined to keep a balance of being able to utilize the advantages we get from BUCKLER while at the same time staying active with the 17 other counterparties that we're operating with. Our execution at BUCKLER is on par with what we're seeing elsewhere, and we get better terms principally in haircut and the ability to access some different types of financing there. So, that's a little higher than we have been for the last few years, and it's there just because BUCKLER has had some capital we want to make sure we use it.

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

You guys mentioned a couple of times the return opportunity that’s available within the TBA market being quite attractive. Can you say where you're seeing returns in specified pools compared to TBAs? And also, can you maybe talk about how much larger you'd be willing to take the TBA position as a percentage of the overall portfolio going forward?

Hey, Trevor, glad to have you dialed in. So, we can see returns as low as 4% in some of the specified pools; that's how high these prices have gone. We haven't purchased anything like that, but there are returns also in the low double digits, just exceeding 10% to 11.5%. Now, that would imply an 8 times leverage and duration of between 0.5 and where we are right now. If you increase that leverage to where others in the sector have done, which would be 9 to 9.5, those numbers go up proportionally from there. What we were discussing earlier, just to repeat on the leverage: if we get spreads to widen or pay us to come down, we will use that opportunity to go ahead and make some additional investments in the space, but that is not the case today. So, we'll keep that target leverage where it is right now, and as opportunities arise, we could be up to 8.5 to 8.75 in quarters, but only if great opportunities come along. As Scott said in his comments, as it is right now, we estimate that our core income will equal or exceed the dividends for the fourth quarter.

And then, on the multifamily portion of the portfolio, spreads have obviously recovered pretty well in that sector. In light of that recovery, are you guys thinking about that part of the book? Is this something that you still see value in holding and sort of a prepaid diversification? Or given the spreads have recovered so much, is this something you'd potentially look to partially sell and reallocate to the agency RMBS market?

If you go look at monthly updates, you can see the positions come down a little bit; currently, on the information we published last night, it stands at $1.19 billion. We did sell some over the last 60 days to take advantage of really tight spreads. But if you refer to Page 4 on that publication, you can see that the weighted average net coupon is 369, and the estimated effective duration is 7, which means that most of those are going to have a maturity north of 7.5 to up to like 9 years from now - great convexity paper, earning a lot for our shareholders. So, we would be very selective about selling in that asset class in the near future. It has no extension risk; market rallies would lead to price increases. It's paying our shareholders a large dividend. It finances similarly to specify in the TBA market. And once again, there is just insatiable demand for banks for that asset class; I don't see that going away. So the answer is, we probably won’t sell a lot, but occasionally, we see opportunities to sell. I would also note that one of the reasons we sold is we wanted to make sure we cleaned ourselves out of any potential assets in that asset class that might be subject to forbearance or bankruptcy, or some of the negative factors that have occurred since COVID. We believe we've done a really good job of that so far, and so that protects the premium in that asset class.

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

Given the EPS guidance to cover the dividend in the fourth quarter, it seems like your core ROE is going to be at the higher end of your guidance, which was high single digits or low double digits, at least in the fourth quarter. I guess my question is, should the core ROE guidance be low double digits to mid-double digits going forward? Or are you going to keep it the way it is?

If you have the publication that I just referred to a minute ago that we put out last night, you go to Page 6, the monthly portfolio CPR, and you can see that the October CPR was up 11% over the average of Q3. Now, we expect CPR for our portfolio to remain relatively flat over the next two months in November and December from that up 11% level. So, as a result of higher prepayments, you would expect the core earnings to be up modestly from what they were in Q3. That doesn't mean they will be, but our expectations are to be a little lower, yet covering our dividends. The change in earnings based on the reinvestment opportunities is really two different things to look at. With the great convexity and the low amount of actual dollar prepayments we have that month or each month, our exposure to reinvestment risk is quite limited and well under $100 million a month. So, is that helpful in your analysis?

Yes, very good point you made. On a different topic, any thoughts on buybacks given where your stock is trading?

We are always looking at buybacks. As we discussed on the last two earnings calls, there are times where you really need to protect your capital, and that benefits shareholders greatly. And then there are times when we're trading at a really cheap level, and that's accretive to book value to go ahead and buy. We haven't executed that second step yet, but it's clearly out there if we want to and need to. We're still watching capital. Let's get through the election; let's see if any buying opportunities arise. For example, if you get OAS to widen out and you get a steepener in the curve, we might be earning so much more money taking leverage up from 8 to 8.5 or 8.75 that it might benefit shareholders more than doing a buyback. But these are the things that we look at every day, and obviously, we just had our board meeting in order to publish our Qs, and these are things that are discussed at all levels of the corporation. So, I hope that addresses your question.

And there don't appear to be any further questions in the queue. And there are no further questions. At this time, I'll now turn the call back to you. Please continue.

Thank you for your help, Bridgette, and to all our friends in the analyst community, thank you for joining us this morning. We very much appreciate your time and interest in ARMOUR. And as always, you know where to find us. So, if there are any questions that come up between these calls, feel free to reach out. Give us a call, send us an email, and we'll try to get back to you before the sun sets, if we can. Until next time, stay safe.

And that does conclude today's presentation. We do thank you for your participation and ask that you please disconnect your lines. Have a great rest of the day, everyone.