Armour Residential REIT, Inc. Q2 FY2022 Earnings Call

Good morning, everyone, and welcome to the ARMOUR Residential REIT Second Quarter 202 Earnings Conference Call. Please note that today's event is being recorded. I would now like to hand it over to Jim Mountain, Chief Financial Officer. Please proceed, Jim.

Thank you, Jamie, and thank you all for joining our call to discuss ARMOUR's second quarter 2022 results. This morning, I am 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, www.armourreit.com. 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 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. That would be 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 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 required to do so by law. 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 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. Net interest margin for the quarter was 2.22%, an increase of 44 basis points compared to Q1 2022. ARMOUR's Q2 comprehensive loss related to common stockholders was $96.2 million, which includes $58.6 million of GAAP net loss. Distributable earnings available to common shareholders was $31.2 million. That's up 16.8% from Q1. On a per-share basis, that represents $0.29 per common share. That non-GAAP measure excludes gains or losses from security sales and early termination of derivatives as well as market value adjustments, but it does include TBA drop income. ACM, the company's external manager, continues to voluntarily waive $1.95 million of its management fee, which offsets Q2 operating expenses. ARMOUR paid monthly common dividends of $0.10 per common share during the quarter and has announced dividends at that rate for July and August of 2022. Taken together with contractual dividends on the preferred stock, ARMOUR has made cumulative distributions to stockholders of over $1.9 billion throughout its history. On the capital markets front, ARMOUR took advantage of the brief sell-off in Q2 to repurchase 248,000 shares of common stock at an average cost of $6.23 per share. The existing repurchase authority stands at just under 8 million shares, which will allow us to take advantage when and if future market dislocations present similarly compelling opportunities. The company also raised approximately $80 million worth of equity capital in Q2 by issuing 10.4 million shares of common stock at an average price of $7.65 per share through its at-the-market program. In July, the company raised an additional $28.5 million worth of equity capital with the issuance of about 4 million shares of common stock. Quarter-end book value was $7.25 per common share, down 10.7% from Q1 2022. Through the close of business on Tuesday, the 26th, we estimate that ARMOUR has picked up a nickel on book value at approximately $7.30 per common share. Liquidity remains strong at more than $650 million. At June 30, 2022, ARMOUR's portfolio consisted of $6.7 billion of agency securities plus TBA positions, representing another $700 million or so and $600 million, plus or minus, of U.S. treasury securities. With the sale of our DUS portfolio, ARMOUR's legacy available-for-sale portfolio now represents less than 4% of total specified pool positions. Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm, who will discuss ARMOUR's portfolio position and current strategy in further detail. Scott?

Thanks, Jim. Historical sell-off at bond markets continued through the second quarter of 2022, as global central banks set on a path of aggressive tightening of financial conditions to fight rising rates of inflation. The 2-year treasury yield reached 3.45%, its highest level since 2007 and up from just 20 basis points only a year ago. The 10-year benchmark yield rose to just under 3.5%, surpassing 2018's high of 3.25% to break out of a multi-decade trend of lower yields. Rapid tightening of financial conditions did not avoid the housing finance sector where the potential mortgage rates surged to 6%, driving mortgage refinancing activity to the lowest level since the early 2000s. Historically, wide agency MBS spreads and discount coupons on nearly all existing mortgages presented an exceptionally attractive environment for our agency MBS portfolio strategy. Continuing with our Q1 strategy to redeploy risk back into the MBS market. During the second quarter, ARMOUR sold U.S. treasury bonds at lower-yielding assets totaling almost $4 billion to purchase newly issued MBS specified pools with levered yields ranging between 15% and 18%. The asset sales included our entire DUS portfolio of just under $1 billion, which was sold at rich levels in the face of a widening in credit spreads and rising worries of a recession. The sale also included $1 billion in lower coupon MBS pools with particularly slow prepay characteristics to take advantage of tight spreads and to pare down the portfolio risk for potential Fed sales in those coupons. We believe the Fed will exhibit particular care and caution in approaching the question of portfolio MBS sales, both in terms of the announcement timing and the sizing of potential sales as to not produce an outsized impact on the mortgage market. We hold approximately 20% of the total portfolio by market value in 2% to 3% coupon pools with faster turnover prepayment speeds and very low negative convexity. At approximately 44% market value, our core portfolio holdings are in 3.5% and 4% coupon pools, which are shielded from both the risk of the Fed selling and of new origination supply. The remaining exposure is in MBS with 4.5% and 5% coupons, where nominal spreads are for a value proposition we haven't seen since the 2010, 2011 environment. As of the end of June, our net portfolio duration was 0.48 and our convexity was negative 0.91. This is indeed a great time to be an agency mortgage investor. Our overall reallocation of capital is reflected in a quarter-on-quarter increase in NIM by 44 basis points, a still historically low leverage of 7.6x as of the end of June and distributable earnings just slightly below our stated dividend amount. We estimate our earnings capacity to exceed the dividend of $0.30 for the third quarter and persist at least into the year-end. We anticipate that high volatility will produce many additional opportunities ahead. ARMOUR maintains a healthy amount of dry powder of over $700 million in U.S. treasury notes, capacity for at least 1 turn of additional leverage and ample excess liquidity. Despite rapidly rising rates, 104% of our repo book as of the end of June is hedged with current and forward starting swaps, which reset daily. This allows us to be relatively agnostic to sizing and timing of Fed moves which have been extremely unpredictable this year. ARMOUR continues to monitor the term structure in the repo market. But for now, we prefer to keep our MBS term repo a bump or shorter. As of 6/30, it stood at 22 days with an average rate of 137 basis points. We continue to believe that our current dividend rate is appropriate for current conditions and gains further support from the investment opportunities available. Thank you very much. We'd now like to open up for questions.

Our first question today comes from Doug Harter from Credit Suisse.

Can you talk about where you see incremental returns on new investments today? And then, I guess, if you were to truly mark-to-market kind of the entire portfolio from a return perspective would the returns be kind of comparable to that?

Sure. I'll defer to Mark Gruber, Chief Investment Officer. Mark?

Sure. Thanks, Doug. Currently, we see asset yields and levered yields in the mid-teens, specifically between 14% and 16%, on new investment opportunities. As Scott mentioned, we've significantly turned over the portfolio in recent months. We believe the return profile for the entire company and portfolio will also be in the low to mid-teens. Additionally, as Scott noted, we think our earnings capacity is higher than it has been over the past six to nine months.

I mean, regarding the dividend, if I calculate the current dividend against the current book value, it gives me a return in the 16% range. If you're suggesting that we need to earn that amount after expenses and mention that the returns are around 14%, I'm just interested in the discussion about the sustainability of the dividend.

This is Jeffrey. The dividend is highly sustainable at this point. It's important to note that our current amortization expense is very low. Prepayments in our portfolio are the lowest they've been since our inception, particularly for two reasons: higher mortgage rates near 6% lead to low prepayments on existing portfolio attributes, and more than 90% of our portfolio consists of specified assets where we pay a premium over TBAs to maintain characteristics that keep prepayments slow. If prepayments were to increase, it could hinder our ability to support the $0.30 dividend. Scott was clear in his comments that we believe our portfolio, after accounting for expenses, can sustain a $0.30 dividend per quarter in the foreseeable future. I hope that's helpful.

Our next question comes from Trevor Cranston from JMP Securities.

Can you talk about how you guys are thinking about the risk of any potential further spread widening from here? And kind of what you guys are looking for to maybe be a little more aggressive in terms of taking leverage up to a higher level?

Scott mentioned in his prepared remarks that we believe it is unlikely at this time that the Federal Reserve will sell mortgages and significantly widen the spread. We have reduced our exposure to those coupons owned by the Federal Reserve to protect ourselves. Therefore, should they decide to sell, our exposure to the risk of spread widening is very limited now. However, if the market conditions shift, all those values may decline slightly, and we recognize that. Currently, we are below our historical mid-leverage level. We are ready to acquire assets that we believe have solid long-term potential. Our portfolio includes a significant amount of treasuries, and this treasury position can also be converted into mortgages. Hence, we have two options to enhance our exposure to spread, but we are proceeding with caution. We are committed to maintaining our dividend for at least the next few quarters and do not see any justification for overextending ourselves. I hope this clarifies your question.

Sure. Can you discuss how much premium you're currently paying for prepaid-protected pools in the spec market as you are acquiring new securities?

Sure. And I'll hand it back over to Mark to give you some details on that. And before he starts, I will tell you, we're being very cautious about that because in March and April 2020, a lot of those premiums disappeared and it was painful for owners of mortgages. So Mark, do you want to give a little more specifics on some of those attributes?

Yes. So most of the spec pools we buy have pay-ups by 0.5 a point or under. And specifically, the reason is because of what Jeff just said is that prepaid volatility was kind of extreme a few years ago. So we've kept our pay-ups pretty low. Now we're also trying to find assets that have the right convexity characteristics. So there are cases when we'll pay more than that for really good assets. But I would say 0.5 a point and under is where we try to keep it.

And our next question comes from Matthew Howlett from B. Riley.

Just on hedging, I mean, with the curve inverted, Jeff, I know you've seen a lot of flat inverted yield curves over your time. Do you think about taking out the hedging longer? And there's been some talk or some forecast possibly the Fed cutting next year? Just talk a little bit about how you look at hedging today.

If we reach a point where we believe the Federal Reserve might start cutting rates, or even a bit before that, we may make adjustments. Currently, nearly all of our portfolio is hedged with paid fixed and received floating rates. Much of the paid fixed is at low single digits that we established in 2020. Therefore, we're paying a low amount while receiving rates in the 200s now as the Federal Reserve increases short-term rates. Looking ahead, we anticipate that short-term rates, specifically the federal funds rate, could rise another 150 basis points before the Fed reassesses the situation. We would benefit from these increases, which would also align with changes in our repo book. For now, we plan to maintain our hedge position as it supports our earnings. The structure of our hedging is across the curve, meaning that minor adjustments or a slight steepening won't significantly impact our book value as one might expect.

Yes, it does. Regarding capital, the stock is performing well and is above book value. Considering the preferred markets, although you don't have a clear prediction, what are your thoughts on why preferreds are trading below mortgage rates? As you've mentioned in your statements, this seems to be one of the best environments we've seen in some time. Do you have any insight on when the preferred market might open up? Would you consider accessing it? It appears you have the capacity to introduce some preferred securities into your capital structure.

We have focused on this topic every quarter. Let’s examine it now. When the 10-year note was trading between 1.25% and 2%, it was reasonable for preferreds with coupons of 6.5%, 7%, and 7.25% to trade around their $25 par value. However, as the 10-year climbed to 2.75% to 3.50%, it became clear that the return on preferreds was not competitive with risk-free treasuries. In our view, preferreds are trading at valuations that make sense. At this point, there are two approaches to consider for your preferreds. You could buy some back at $21 per share. I believe our peers with similar coupons are trading between $20 and $21.5. This isn’t as beneficial for book value as it might appear. The real yields on those preferreds are around $8.25 to $8.75 due to their trading under par, but Mark and his team can secure investments yielding 12%, 14%, 16%, or even 18% currently. Therefore, we see more favorable investment opportunities in agency mortgages rather than repurchasing the preferred shares. So what you commented on was that you thought we had a good balance between preferreds currently and the amount of common equity that we have outstanding. We agree with that 100%. Preferred start trading above par again, if our common equity is larger, we might look at issuing those, but that's not something that we're interested in doing right now for all the reasons I just mentioned.

Right. Yield at 7%, I think, on the current preferred, would you consider issuing at 7.5% or 8% if the returns available today were slightly tighter? Would that make sense? It seems like it would be beneficial given the returns for agency mortgages.

I think it's unlikely at this point we'd be issuing any coupons above where our current outstanding issue is. Once again, if we traded up to our par again and we felt we wanted to access the capital markets in that fashion, we'd probably increase the size of that issue. I will remind you that twice in our history, we bought issues out, we bought all the As back, bought all the Bs, it was a large issue too, bought all the Bs back. And so we'll see what the future presents itself, but we're actively used that class equity structure actively as part of the way we run our company. And yes, I really appreciate the question because not enough people understand the value of having an optionality.

Yes. It just looks like they're at incredible discounts today. But thanks for color that really helps.

And ladies and gentlemen, at this point, I'm showing no additional questions, I'd like to turn the floor back over to management for any closing remarks.

Well, we thank you all for joining us today...

Thanks for joining us today. Take it away Scott...

Thanks for joining us today. We appreciate your time, and we're always available to you guys ringing the office. Thanks.

And ladies and gentlemen, with that, we'll conclude today's conference call and presentation. We do thank you for joining. You may now disconnect your lines.