Armour Residential REIT, Inc. Q1 FY2021 Earnings Call

Greetings, and welcome to the ARMOUR Residential REIT, Inc. First Quarter 2021 Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. As a reminder, this conference is being recorded Thursday April 22, 2021. I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.

Thank you, Kelly. And thank you all for joining our call to discuss ARMOUR’s first quarter 2021 results. This morning, 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, 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 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. 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 are required to do so by law. Our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to our most comparable GAAP measures is included in our earnings release. ARMOUR continues to concentrate its portfolio activities in Agency MBS for the foreseeable future. Quarter-end book value was $12.40 per common share, up $0.08 from Q4 2020. As of the close of business this past Monday, we estimate book value to be approximately $12.15 per common share. ARMOUR’s portfolio consisted exclusively of specified agency mortgage-backed securities valued at approximately $4.3 billion plus agency TBA positions representing another $3.6 billion in underlying securities. ARMOUR’s Q1 GAAP comprehensive income was $29.1 million, which includes $71.3 million of GAAP net income and represents an annualized return on equity of 12%. Let me make a brief comment on prepayment accounting and core income. We recognize the amortization expense of prepayments as they occur. Given the recent ramp-up in prepayments, we estimate that using the forecast method for this quarter, amortization would have been $0.06 to $0.07 lower per share or about 29% of core income. We paid dividends of $0.10 per common share for each month in the first quarter, for a total of $20.1 million. We’ve also declared the April and May common dividends at the rate of $0.10 per common share. Series C preferred stock dividend for each month in Q2 and continuing is at the contractual rate of $0.14583 per share. ARMOUR’s common and Series C preferred stock ATM programs were active in Q1 and through Friday, April 9, they raised approximately $107.7 million in total capital. Common stock represented about two-thirds of that total and preferred stock represented the remaining third. We saw no discernible effect on share prices and dilution to common stockholders was negligible—that equates to just over $0.04 per common share for the entire program. Our current projections for 2021 show that 100% of both common and preferred dividends will likely be treated as tax basis adjustments rather than current taxable income when distributed to our shareholders, due to the tax shield provided by the amortization of hedging costs that were previously deferred for tax purposes. This is consistent with the results for 2020. ACM, the company’s external manager, continued to waive a portion of its management fee, initiated in the second quarter of 2020, offsetting $2.4 million of operating expenses for Q1 2021. On April 20, 2021, the company’s external manager notified ARMOUR that it intended to adjust this fee waiver to the rate of $2.1 million for the second quarter of 2021 and continue at the rate of $700,000 per month thereafter, until further notice. The Annual Meeting of ARMOUR Residential REIT is scheduled for Thursday, May 13, at 8:00 AM Eastern Time. By now, all shareholders of record of ARMOUR common stock should have received their notice and access cards in the mail. If not, they should contact their broker. Full proxy statement and Annual Report are available electronically. Stockholders of record may also request paper copies by following the instructions on their notice and access card. The Annual Meeting will be webcast and it will be virtual-only again this year. We encourage all ARMOUR common stockholders to log into proxyvote.com and register their votes in advance. I’ve already voted my ARR shares and the process is painless. Shareholders wishing to vote their shares during the Annual Meeting will need to obtain a legal proxy in advance. Now, let me turn the call over to our Co-Chief Executive Officer, Scott Ulm, so that Scott you can discuss ARMOUR’s portfolio position and current strategy.

Thanks, Jim. The first quarter of 2021 delivered the first raise of optimism in a nearly year-long fight against the pandemic and its impact on the economy. Positive sentiment was fueled by the largest fiscal stimulus in U.S. history of $1.9 trillion and rapid distribution of effective vaccines. The financial markets saw this as a potent fix to reinflate and reopen the economy ahead of the expected timelines. Higher projections for inflation and treasury issuance have quickly repriced the yield on the 10-year treasury higher by 82 basis points to touch as high as 1.75%. While the yield spread between twos and 10s treasury has expanded by 78 basis points. Despite a rise in treasury yields at a quicker pace than in 2013, mortgage spreads avoided a repeat of the 2013 taper tantrum, largely due to the Federal Reserve’s unwavering commitment to keep the mortgage purchase program going well into the economic recovery cycle. Over the course of the first quarter, the option-adjusted spreads on 30-year, Fannie 2% TBAs have tightened by eight basis points, while zero volatility OAS tightened as much as 19 basis points for this cohort. Despite sharply lower treasury bond prices, ARR delivered a positive 3.1% or 12.4% annualized economic return in the first quarter, illustrating strong risk controls around the portfolio’s duration and convexity. ARMOUR was active in managing its hedge book, exposure, and production coupons in a very dynamic market. Over the course of 2021, ARMOUR’s implied leverage declined from 7.6 times at the end of the fourth quarter to 6.9 times as it sits today. This took place through capital raises through our ATM program and sales of assets with either rich valuations or less favorable prepayment profiles. Our lower leverage provides us with ample dry powder to take advantage of market opportunities ahead. We will continue to be very selective in the prices we accept for the risks on offer in the current market. ARMOUR’s duration as of year-end was 0.62 and is currently 0.30 with a negative duration exposure to the 10-year plus part of the yield curve. We like this duration profile, which matches our long-term buys for higher interest rates in the second half of 2021. First-quarter prepayments remained elevated as originators were slow to increase mortgage rates in order to protect their market share. ARR’s portfolio averaged 17.4 CPR in the first quarter, slightly above 17.3 CPR from the previous quarter. Note that both are still significantly below speeds on more generic MBS cohorts. We expect prepayment pressures to subside in the second quarter of potential tailwind earnings. We’ve allocated approximately 45% of our portfolio to dollar rolls in 15-year and 30-year TBAs. Ninety-seven percent of the remaining portfolio assets have favorable prepayment protection characteristics, including prepayment penalties, lower loan balances, and seasoning. Nominal specified pay-ups have declined by nearly 50% quarter-over-quarter but still performing well on a duration-adjusted basis. TBA roll specialness was also notably weaker in the first quarter as origination supply remained robust, while investor demand cooled relative to the fourth quarter. Today, we’re again observing an increase in roll specialness as higher mortgage rates reduce the available supply to be delivered into the Fed portfolio. Although current MBS QE purchases are clearly favorable to the supply-demand balance near term, markets are continuously challenging the timing of the Fed's eventual exit from MBS, something that we see as a key driver to book value performance this year. As we’ve noted before, we set our dividend policy based on the medium-term outlook on our business. We continue to see our dividend level as appropriate. In summary, we’re just not comfortable putting our shareholders extensively into very high price securities. This degrades return, increases risk, and threatens book value. Long term, this business makes a lot of money, but we clearly have a distortion on the market from the Fed. Delighted they’re there, but we need to be a bit cautious. With that, we would be delighted to take questions.

Thank you. And our first question comes from Doug Harter with Credit Suisse. You may proceed with your question.

Thanks. I was hoping you could give a little more context to the amortization expense comment you gave. I think you said it was kind of around the $0.60 drag this quarter versus kind of model prepay speeds. How would that compare to the prior quarter?

Prepayments were up, as you could see from the monthly company update that we put up last night, as much as 25% over a year ago. The exact difference in amortization I actually don’t believe we released those numbers yet, so I need to be careful about releasing that public information. So, I’ll have Jim double-check on that, and we’ll get back to you. Prepayments are up 25%, and that’s the biggest drag on earnings—two things: higher prepayments leading to greater amortization. As Jim said in his comments, and I think everybody knows, we don’t do modeling or forecasting and then do catch-ups; the catch-up runs through book value. Actually, in some cases, make current core earnings, a non-GAAP measure, appear to be higher than perhaps they are. We take amortization as it occurs. As prepayments have ramped up here, we’re getting a larger hit to core earnings, even though if you kind of look at the returns over the quarter, the comprehensive income was quite substantial and honorable. The other thing that I think you need to be aware of is what's around the corner and expectations. Most of the street expect May prepayments to be down by 18% and expect June prepayments to be further down another 11%. If interest rates which have rallied a little bit do stay here, then of course, you’ll see a little catch-up and maybe they’ll increase as we get into the late summer. Now, the other element is, as Scott Ulm said in his comments, our leverage is in the high 6s now when we target 8.5, so almost two full turns. I can tell you, we had two full turns of TBA 2s right now, and you're going to have $0.15 a quarter to income. So, a little bit of reinvestment can add a lot of income. That being said, also to Scott’s point, OASs are negative here, and I’m looking at a chart left to right; it’s negative 20, some OAS is on 2s and 2.5s. We’re not going to do heavy reinvestment at these kinds of levels. We’re going to be patient. However, as Scott also indicated, it’s highly likely that we maintain our dividend structure as it is now—we look at dividends in the medium-term, not just on a month-to-month basis based on our perspective on reinvestment and occurrences of prepayments.

Just to drill down on the prepay, I guess industry-wide prepays were down in the first quarter relative to the fourth quarter. Can you just talk about what pieces of your portfolio and what kind of drove you to have higher sequential prepays in the first quarter?

Our prepayments are well under our peer group prepayments. Our prepayment rate for the last month was in the high to mid 18 CPR level, you compare that to the peer groups that are going to be at least 10 CPR higher. Our individual securities that prepaid represented our higher coupons, our positions in 4s and 4.5s. We own those positions at very low prices, but they continue to have some higher prepayment levels, but we’re going to maintain those securities in our portfolio. I would also note, to be exact, the CPR in Q1 was 17.4, not 18.

Our next question comes from Trevor Cranston with JMP Securities. You may proceed with your question.

Hi, thanks. I was wondering if you could elaborate maybe on sort of the thought process behind the dividend level. I know you said it’s based on your medium-term view. But is the way to think about that sort of—that’s where you guys see your earnings level, if you were at your target leverage, as opposed to running a lower risk, lower leverage strategy in the near term, or are there other things at play as well?

That’s exactly correct. And as a matter of fact, we could probably earn a little bit more than our dividend rate if we were fully invested, as I just indicated. Investing long term on core incomes that have negative 20 OAS is going to lead to some book value dilution. At some point, we’re going to be very cautious. I expect, you know, for the remainder of this quarter, there will be great opportunities to reenter, and we have lots of dry powder.

Okay, got it. That makes sense. And then in terms of your rate positioning, you mentioned, I think in the prepared remarks that you have some overall positive duration, but negative duration further out the curve. Can you have any comment on how that’s changed as rates go up? And if you guys see any value in sort of adding some additional optional protection into the portfolio as well to protect against large moves in the 10-year?

So, the DV01, we don’t release our DV01s. But as Scott said, the whole duration pattern is 0.28 as of this morning, it was slightly negative in the 10-year, and that will defend us against a steepening that has occurred. We as a firm expect more steepening. We feel that the Fed will keep the short end of the curve, see, overnight funding rates low and don’t see an increase for potentially as much as another two years. As the economy expands and banks have opportunities to provide credit in other areas, you’ll see higher tenure rates. We’re positioned for that. At some point, the Fed will also reduce their buying of mortgages, and that is a hopeful period where we can do some more reinvestment. I know Mark and his team have only reinvested paydowns—only one full round in the last three months, so they’re not only underinvested in paydowns, but of course, in our full leverage target. By the way, you saw yesterday that Canada announced that they’re starting to reduce the amount of purchases they’re going to make, and many people’s comments on that, at some point, will be next. I think the expectation is that if the Fed wants to maintain the same level of purchases, they would reduce in the mortgages and put it into treasuries.

Okay. To follow up on that comment about reinvesting paydowns, I guess, with OASs negative here, would you guys continue to let leverage drift lower, valuations remain those tight or even potentially get tighter, or are you at a level where you’d like to keep leverage where it was at the end of the quarter?

I don’t think leverage will get much lower. Maybe you could see debt to equity get a little bit lower if we put more money into TBAs. You can do TBA 2.5s right now, May, June rolls at 17% change. TBA 2s are 11.5%. Even 15 year, 1.5s are 11.5%. So, there are areas to put money there. However, when we look at the risks associated with that and the potential spread widening of negative 20 OAS investment opportunities today, we’re just being cautious. We will do some reinvestment in specified, and I would note this: the pay-ups per specified, interestingly enough, have come off quite a bit from their highs; some stuff that was like 80, 90 ticks over, 60 ticks over now. But interestingly enough, the OASs have come in. So pay-ups over TBAs have come down, but the OASs are more negative. The dynamics of that, Mark, maybe you want to speak to that element because we discussed that in our investment meetings.

Sure. The fact is that as rates declined, the option cost to hedge out the mortgage portfolio has increased. So, even though you see a little bit of some nominal spread widening, the option-adjusted spread is just continuing to decline. That’s why we continue not to reinvest a lot of our paydowns back into the mortgage product, as we’re seeing negative OASs, we’re seeing single-digit kind of yields—mid single-digit yields on spec pools, and TBAs, like Jeff said, have some specialness and are interesting but have a lot of convexity and risk in different spots. So, the investment opportunities, when we look out on the outlook are not super attractive to reinvest all of our paydowns.

These opportunities come out very quickly. The difference between the investment opportunities on May 10, 2013, and July 10, 2013 were like six points of difference. These things arise quickly. We’re trying to set ourselves up so that if the marketplace provides an opportunity for larger reinvestment, we can ramp up our leverage very quickly two times. Otherwise, we will continue to reinvest. We want to maintain a dividend and we have the power to create earnings.

Okay, appreciate the comments. Thank you.

Our next question comes from Christopher Nolan with Ladenburg Thalmann. You may proceed with your question.

Hey, guys. The lower waiver, does that indicate more confidence in the earnings momentum outlook for 2021?

It’s actually probably more reflective of the capital raise and the way that our fee changes with capital raises. To Jim’s point on that, the entire raise of the equity and the preferred combined was a total of $0.04 diluted—paid an underwriting fee between 1% and 1.5% versus peer groups paying underwriting fees for 4.75% to 5.75%. So, sometimes you raise capital not that you necessarily needed at the moment, but because it benefits shareholders so greatly to raise capital at a very cheap level. And that’s the way we look at that.

Well, and Jeff, you also didn’t mention the absolute zero effect on market trading price through the ATM program that we’ve seen, whereas, in addition to underwriting discount, you often can see some negative overhang on market trading from block offerings, which we did not have here.

No, Jeff, is that $0.04 to book value?

Yes, all in. So what is that? 0.03%?

Yes. Paying back fairly rapidly through expense savings on a larger capital base.

Going forward, is it some—you guys generated 12% core ROE in the quarter. I mean, is that type of momentum that we should see, or should we say improve given your comments?

That was an economic return. That’s a combination of the dividends paid and change in book value. So, the change in book value, I have trouble predicting. The dividend, I can probably give you a little more confidence on.

But yes, you can earn that in today’s market. As I just said, we’re right now doing dollar rolls and 2s and 2.5, 30 years and 1.5, 15 years, combining and hedging that out and earning 12%. You can do it. It’s just those securities that have negative 20 OAS have risk. I think the profile you might see in the future is as the Fed reduces their purchases of mortgages, and OASs get back to some prior investment levels, you might see us owning less TBA or have less TBAs on our balance sheet and more securities that would be funding in the repo market on our balance sheet. Now, I think that might be the difference you see in the future. But the business model will still and should still produce those kinds of returns.

Great. Thanks for the color, Jeff.

Mr. Mountain, we have no further phone questions at this time. I will now turn the call back over to you. Please continue with your presentation of your closing remarks.

Thank you, Kelly. And thank you, everyone for joining us. We look forward to speaking again next quarter. In the meantime, if anything comes up if you have questions or comments, give us a call at the office and we’d enjoy the conversation. Until next time, keep safe.

That does conclude the conference call for today. We thank you for your participation. And we ask that you please disconnect your lines.