Armour Residential REIT, Inc. Q4 FY2020 Earnings Call

Thank you, France, and thank you all for joining our call to discuss ARMOUR’s fourth quarter 2020 results. This morning, I am joined by ARMOUR’s Co-CEOs, Scott Ulm and Jeff Zimmer, and ARMOUR’s Chief Investment Officer, Mark Gruber. By now, everyone has access to ARMOUR’s earnings release, which can be found on ARMOUR’s website, www.armourreit.com, along with our Form 10-K and most recent company updates. This conference call may contain statements that are not 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 protections 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 at www.sec.gov. 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 we’re required to do so by law. Also, our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to our most comparable GAAP measure is included in our earnings release, which can be found on ARMOUR’s website. An online replay of this conference call will be available on ARMOUR’s website shortly and will continue for 1 year. U.S. financial markets continued to stabilize and improve during the fourth quarter and ARMOUR continues to concentrate its portfolio activity in Agency MBS, which we will do for the foreseeable future. Quarter end book value was $12.32 per common share, up $0.58 from Q3 2020. As of the close of business last Friday, February 12th, we estimate book value to be approximately $12.90 per common share ex-dividend. ARMOUR’s Q4 comprehensive income was $60.2 million or $0.89 per common share. We pay dividends of $0.10 per common share for each month in the fourth quarter for a total of $19.6 million. We’ve also declared February and March common dividends at the rate of $0.10 per share and Series C preferred stock dividends for Q1 at the rate of $0.14583 per share. Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm, to discuss ARMOUR’s portfolio position and current strategy in a bit more detail.

Thanks, Jim, and good morning. The fourth quarter of 2020 provided favorable conditions for mortgage investors and ARMOUR REIT. A one-two punch of fiscal action from Washington and all our commitment from the Fed to the U.S. Treasury and mortgage-backed securities markets created a wave of liquidity that drove asset spreads significantly tighter in the fourth quarter. The trends have continued into the first quarter of 2021, as markets anticipate a new wave of fiscal stimulus from Congress in the near future. The demand for yield from private investors combined with the official QE purchases delivered a strong MBS performance during a period when longer-term Treasury yields rose significantly after 2020 lows. Echoing the positive market sentiment, repo financing also improved over the quarter dropping from 20 to 25 basis points in the third quarter for 30-day tenures down to 15 to 20 basis points currently. The flip side of all the good news is that historically low mortgage rates helped create the largest wave of home loan refinancing since 2003. Faster prepayments at higher prices tamper down new yield opportunities in the market. The TBA dollar roll market remains the most attractive proposition as the Fed’s growing footprint in the sector generates significantly higher returns versus those on Agency CMBS or specified MBS pools. We expect the Fed’s presence to persist at least for the first half of 2021, if not longer. While we do allocate approximately 36% of our portfolio to dollar rolls in 30-year and 15-year TBAs, 94% of the remaining portfolio are assets with favorable prepayment protection characteristics, including pre-payment penalties, lower loan balances, and seasoning. Such pools held up very well as expected. The average CPR in our portfolio was 17.3% as of the fourth quarter versus 16% in the third quarter, which were both significantly below the aggregate speeds on more generic MBS. Year-to-date, the portfolio is averaging 17.9% CPR. Our response to the tighter spread, higher prepayment mortgage environment has been to exercise caution. This is reflected in our implied leverage ratio of 7.7 at the end of the fourth quarter, and 6.9 implied leverage ratio currently. These numbers are considerably lower than our historical leverage levels and provide two or more terms of additional dry powder to take advantage of market opportunities. ARMOUR’s duration as a year end was 0.62 and is currently 0.76. As a result of our early investment in specified pools, the portfolio's convexity profile remains significantly more favorable than that of newly issued MBS. ARMOUR continuously monitors its hedge book and manages the net duration gap within a tight range dictated by the 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 of less than three years, where we expect yields to be close to zero for the foreseeable future. Our exposure to the long end of the curve is considerably less than our overall duration. While we accept the apparent market consensus with the Fed’s presence and support for the market is here to stay for a prolonged period, we also have a keen appreciation for the unexpected. We will continue to shape our portfolio to protect book value. We will not reach for yield at the expense of much higher risk. This means that metrics like core earnings may trend a bit lower, but should work to optimize total economic return. As we’ve noted before, we set our dividend policy based on the medium-term outlook on the business. We continue to see our dividend level as appropriate. We’ll be glad to take any questions.

Thanks and good morning. You mentioned that you kind of brought down leverage to take advantage of potential better opportunities. It seems like the mortgage market this week is starting to give you some of that opportunity. I guess, if you could just talk about how you view the opportunity today and whether that is enough to start kind of building back that position, or would you be looking for more volatility and still potentially better entry points?

So Doug, this is Jeff, good morning. In mid-August, Fannie 2s, for example, had an OAS of 83, zero volatility OAS of 83. On our last earnings call, they had come into 65, when we last spoke to you, and they’re at 31 today. I listened to Leon Cooperman this morning being interviewed on Bloomberg news. Leon said about stocks, I like to go down, but I don’t want to buy anymore here. I think that’s the way we feel as well. We like what we own. We’ve done some selective selling, as you may have heard got as wide as 250 off Zs and swaps. Excuse me, in March. Now we are trading in the mid-20s. We’ve done a little pruning there, done a little pruning of our 3.5 position where prepayment speeds had gone so wild that the yields on those assets were actually negative, and we’ve done some pruning in the lower coupon assets as well. We’re not in a position to say that we will increase our exposure or our leverage quite yet. We’re watching very carefully, and we do think the opportunities will come and we’re going to be patient.

Got it. And I guess just philosophically, how do you kind of weigh the trade-off of potential lost carry by being lower levered versus the potential for book value volatility?

So between the beginning of the second quarter of 2013 and the end of that quarter, many of the firms in this space lost between 10% and 25% of their book value. Those numbers and reflections of OAS’s tightness and demand during that period of time are too dissimilar from what we’re seeing today. We look at ARMOUR, and we sit down at our meetings and we go, gosh, book value is up 4.5% so far this quarter, and mortgages are really tight while the list looks like another party that got a little sloppy at the end of it. We’re just going to be patient and watch, and we think we’ll be better off long-term looking at our book value this period.

I’d also add that it’s relatively often that we find opportunities to create earnings may come at some risks, but opportunities to create book value are harder to achieve.

Thanks. Good morning. Follow-up on the question about leverage, would you guys say at this point that you’re finding opportunities to reinvest paydowns or, given your views on the market, are you sort of letting portfolio runoff not be replaced at this point? And would that apply to leverage may continue to tick down a little bit going forward?

Good morning, Trevor, this is Jeff. We can invest in $2 and $2.5 rolls and get mid double-digit returns, 12%, 13%, 14% double-digit returns, but that comes with a price, and the price is that these assets are becoming increasingly poor convexity assets. That’s why the TBA market trades at way lower levels than the specified market. The specified assets are now trading at four or five points over TBAs numbers—about a hundred years of experience sitting at this table, and these are new levels stretching that out. We will selectively add, and we have added some dollar rolls over the last quarter when we see some opportunities, but we want to be very cautious of the convexity. That gets back to our point to Doug Harter that you can blow up a lot of book value by just reaching for a little bit of extra earnings. At the end of the day, we’re better off not reaching and protecting book value. That’s how we will proceed in the immediate future. Those earnings opportunities will come, and it’s pretty easy to buy $1 billion or $2 billion of them when opportunities are there. But Scott just boldly stated, it’s very hard to find those opportunities to increase book value.

Got it. Okay. And then actually my second question is related to, you just commented on the convexity of some investments. How do you guys think about the extension risk within the portfolio? Obviously, we’ve seen the tenure move higher over the last, in the fourth quarter, and again, in the first quarter. So I was curious how you guys think about the extension risk in your book and how you’re approaching that on the hedge side as well.

So 94%, as Scott said in his comments, of our non-TBA position are assets that have qualities that have improved convexity, and as a result, improved convexity means improved extension characteristics. I mean, that’s like almost 100%, right? So when rates go up, we don’t extend. I would also say that model-wise, most of the DVO1 exposure we have is in the very short end of the curve. The Fed was very clear in their minutes yesterday that it’s not going anywhere. Our exposure out to the tenor area is well, let’s look at this. When we last spoke, what was the tenor 45 basis points, 50 basis points lower in yield than it is now? Since we last spoke, our book values up like 8%. Pretty good performance; mortgages haven’t extended yet. They will get out. That term, the S-curve; you get like a 160 kind of tenor note, and mortgage banker pipelines are going to get very bloated, and all of a sudden they’re going to need to sell. Other people needing to sell will also cause some extension, but those are going to be reflected on the TBAs and the TBA securities where, as I said, we’ve generally reduced our exposure and are being very cautious. I hope that’s helpful.

Yes, that is very helpful. Appreciate the comments. Thank you.

Hey guys. Based on Scott’s comments, I wanted to follow up on the notion of just not reaching for earnings and protecting book value. In the past, you guys indicated that you’re targeting high single-digit and low double-digit core ROE. How would you characterize the target now?

So we’re paying a dividend of $0.10 a month based on our stock prices, about 10% dividend yield, right? We’ll continue to pay that dividend, and we would hope by the end of the year that total 2021 earnings and book value will exceed the dividends paid. That’s our goal for comprehensive income.

Again, I’d like to thank everybody for joining us. We look forward to continuing our conversations with you individually over the next – over the rest of the quarter. So as always, if there’s anything that comes up that you want to talk about in more depth, we’re here. Give us a call. Until next time stay warm, stay safe.

Thank you. This does conclude the conference call for today. We thank you all for your participation and kindly ask that you please disconnect your lines. Have a great day, everyone.