Armour Residential REIT, Inc. Q1 FY2023 Earnings Call

Good morning, and welcome to ARMOUR Residential REIT's First Quarter 2023 earnings conference call. Please note, this event is being recorded. I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.

Thank you, Andrew, and thank you all for joining our call to discuss ARMOUR's first quarter 2023 results. This morning, I'm joined by ARMOUR's Co-CEOs, Scott Ulm and Jeff Zimmer; and by Mark Gruber, our CIO. By now, everyone has access to ARMOUR's earnings release, which can be found on ARMOUR's website. This conference call includes forward-looking statements, which are intended to be subject to the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995. The Risk Factors section of ARMOUR's public reports filed with the Securities and Exchange Commission describes certain factors beyond ARMOUR's control that could cause actual results to differ materially from those expressed in or implied by these forward-looking statements. Those periodic filings can be found on the SEC's website. All of today's forward-looking statements are subject to change without notice. We disclaim any obligation to update them unless required to do so by law. Also, today's discussion refers to certain non-GAAP measures. These measures are reconciled to comparable GAAP measures in our earnings release. An online replay of this conference call will be available on ARMOUR's website shortly and will continue for one year. ARMOUR's Q1 comprehensive loss related to common stockholders was $22.8 million, which includes $31.4 million of GAAP net loss. Net interest income was $12 million, and net interest margin for the quarter was 1.97%. Distributable earnings available to common stockholders was $49.3 million or $0.27 per common share. This non-GAAP measure is defined as net interest income plus TBA drop income adjusted for the net coupon effective interest rate swaps and then minus our net operating expenses. ARMOUR Capital Management is continuing to waive a portion of their management fees. They waived $1.65 million for Q1, which offsets operating expenses. The waiver will continue until further notice. ARMOUR paid monthly common dividends of $0.10 per share for January, $0.10 for February and $0.08 for March for a total of $0.28 for the quarter. We have maintained the $0.08 per share common dividend rate for April and May. As we've discussed in our previous calls, our aim is to pay an attractive dividend that is appropriate in context and stable over the medium term. We keep an eye on economic conditions and the ARMOUR Board believes that this dividend rate achieves those objectives. Taken together with contractual dividends on the preferred stock, ARMOUR has made cumulative distributions to stockholders of more than $2 billion over our history. During the first quarter, we issued 29,862,647 shares of our common stock through our ATM program, raising $181.2 million of capital after fees and expenses. That represents average net proceeds of $6.07 per share. During the first quarter, we also repurchased 842,927 shares of common stock at an average net cost of $5.11 per share. That was under our outstanding repurchase authorizations. By acutely managing our common share count, we were able to add $0.06 per share of value for common shareholders. In addition to providing capital to take advantage of appealing current investment opportunities, share issuances build a larger base over which to spread our mostly fixed running costs. So far in Q2 2023, we issued 3,509,700 shares. That brings our common share count to 192,512,577 as of today. Quarter end book value was $5.44 per common share; our most current available estimate of book value is as of Monday night, April 24, and we estimate that book value was $5.30 per common share. We increased the regulatory capital at our broker-dealer affiliate, BUCKLER Securities to $203 million; BUCKLER continues to represent a strategic advantage for us by providing repo funding, ATM placement, and other capital market access. Finally, I'd like to remind all of our shareholders of the annual meeting for ARMOUR Residential REIT. It will be held at 8 a.m. Eastern Time next Thursday, May 4. We received proxies representing a quorum of shares eligible to vote, and all matters have strong support. However, a number of shares eligible to vote have not yet provided their proxies. We encourage all shareholders to return their proxies and to participate in your annual meeting next week. Shareholders, contact the brokers if they need another copy of their proxy materials. Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm.

Thanks, Jim. In January 2023, the Agency MBS index delivered the third-best monthly total return since 1989, reflecting the value proposition of mortgage spreads after their worst one-year performance on record in 2022. Despite positive fund inflows back into MBS and the broader fixed income markets in the first quarter of this year, the elevated levels of volatility and deep concerns along the treasury yield curve are keeping many investors on the sidelines. This is evidenced by the significant increase in the sizes of money market bonds and the Federal Reserve's reverse repo program. Moreover, the failure of Silicon Valley Bank and Signature Bank this spring resulted in an FDIC portfolio with more than $100 billion of MBS to be liquidated over the course of the next 10 months. As of this week, the sales of the bank bonds and FDIC receivership of plans appear gradual and orderly. However, Tuesday's headline that First Republic may sell up to $100 billion in assets to raise liquidity stoked additional fear of a lingering banking contingent. While most of these assets are presumed to be non-agency mortgage loans, the headlines caused MBS spreads to widen approximately five to 10 basis points. This has left investors demanding an additional discount to absorb the unanticipated supply. Despite all these challenges, the spreads on MBS have remained tighter versus the wide seen last fall, implying that there is a significant appetite for mortgage assets near their current valuations. We're confident that highly liquid U.S. government-sponsored mortgage-backed securities, trading at multi-decade widespreads with muted refinance activity, will grow increasingly attractive to the investor base in 2023. ARMOUR continues to pursue favorable investment opportunities while growing the portfolio, adding $3 billion of mortgage-backed securities since year-end, bringing total portfolio size to just over $11.9 billion. Visual and tight valuations and relative richness in deep discount coupons, ARMOUR sold the remainder of our Fannie 2 and 2.5 coupon positions early in the first quarter. Proceeds were reinvested into new higher-yielding current coupon mortgages. Sales proved to be well-timed as lower coupon MBS accounted for most of the securities transferred into FDIC receivership from the two failed banks. ARMOUR continues to hedge our exposure to FDIC-held assets by decreasing our 30-year 3% MBS bucket from 7.1%, down to just about 1% of total portfolio value. We are closely monitoring the ongoing FDIC liquidation for the opportunity to buy back lower coupons once spreads are at a discount versus that in the higher coupon production MBS. Our leverage flows the quarter at 8.7x and currently sits at 9x. A number of attractive valuations, yet it is prudent enough to stand still elevated in the highly unpredictable levels of daily market volatility. Additionally, ARMOUR maintains healthy levels of available liquidity at $590 million, which includes cash, unleveraged securities, and principal and interest as of the 24th of April. Our purchased MBS are concentrated in the most liquid, low premium bank service production coupon pools featuring more favorable geographics, LTVs, FICO scores, and loan balance characteristics versus generic production cohorts. We continue to favor these lower payoff premium specified stories, which we believe will perform best when volatility reverts to its historical norms. These investments also reflect historically low prepayment risk as the MBA Finance Index has remained at suppressed levels. ARMOUR's average prepayment rate for all MBS assets in the first quarter of 2023 was 4.7 CPR and still a very low 6.7 CPR for April. Although mortgage rates have already declined from the highs of 7.2% in early November last year to 6.5% in mid-April 2023, a substantial refinancing wave would require mortgage rates to fall below 5%. ARMOUR continues to fund just over 50% of our borrowers through our broker-dealer affiliate BUCKLER Securities. Despite margins' precipitous drop in liquidity within the interbank lending community, Agency repo funding remained on strong footing throughout the quarter, with spreads ranging from 10 to 20 basis points above the several benchmarks. The enormous supply of cash for money market funds combined with a growing shortage of Treasury bills have created incredibly liquid conditions for overnight agency repo and term agency repo funding that benefit ARMOUR. The weighted average haircut on our repo book remained exceptionally low at 2.6% as of the 24th of April. As we've always noted, we set our dividend to be appropriate for the medium term. We will, as always, continue to evaluate the level of dividend. We are also mindful that this environment can deliver upside surprises that can move our metrics. So thanks for that, and over to you, Jim.

Let's take some questions. Andrew?

The first question comes from Trevor Cranston with JMP Securities.

You guys talked a little bit about the pending sales of the failed bank portfolios. And you briefly mentioned the prospect of another bank selling assets. Can you comment in general on how you guys are thinking about the potential risk of maybe some other banks needing to sell MBS as a risk on top of the sales that we already know about happening?

It's Jeff Zimmer here. Thanks for dialing in. As long as volatility stays where it is and the Federal Reserve continues to tighten, which we do expect another 25 basis points at the next meeting. There is a risk of a bank having to sell more assets, and we are strictly aware of that. And that's why we continue to keep large amounts of liquidity on hand, as Scott mentioned in his comments, and we will continue to approach the mortgage market as long-term investors. We will take advantage of some of these wider spreads, and we also have dry powder if we want to use it, but we are very aware that there are risks out there.

Okay. Got it. And then it looks like you guys added some swaps during the quarter. Can you just give the details on kind of what the maturity of the newly added swaps?

Sure. And this is Jeff. It's interesting because we were talking about this in our Board meeting the other day. So two things going there. The average weighted maturity of our OTC swaps is 75 months right now. But we have been managing off of OTC swaps over to exchange traded swaps, and they're a little shorter that we've been putting on, apparently because they're much lower haircuts. And Mark, you could perhaps provide some detail on the recent exchange rate swaps that we put on the books.

Sure. So the cleared swaps are 1- to 3-year swaps we put on really to protect the front end of the curve. The bilateral swaps, the existing book is mainly longer term.

The next question comes from Doug Harter with Credit Suisse.

You just mentioned keeping dry powder. I guess how would you size the amount of dry powder in terms of leverage that you think you could add? And what would be the conditions that would cause you to want to deploy some of that dry powder?

Thank you for your continued coverage of ARMOUR. We appreciate it and wish you success with the Credit Suisse merger. We have additional capacity to invest in mortgage-backed securities. Our team prefers a tighter market, which would suggest that many of the available securities have been incorporated into the pricing of the MBS market. If the market widens further, we will monitor the situation and may consider investing at that time, but we want to see others making investments first. We believe large banks will not be significant investors; instead, the funding will come from private managed funds or hedge funds. We keep in touch with our counterparties to gauge market involvement and conditions before deploying our funds. I expect this will not happen this month but will take a longer-term view over the next couple of quarters. I hope that clarifies your question.

Yes, absolutely. And then just on the funding market, what are you seeing around debt ceiling debate, anything around those maturities? And how does BUCKLER help kind of in that context?

BUCKLER helps a lot, and that's why we went ahead and started in 2016 of putting together the BUCKLER structure. And we are very fortunate to have direct access into that whole system. And we also get very, very good color from BUCKLER. Now I'll hand it over to Mark to talk about specific rates and where they are out in the curve. But generally, we feel very comfortable doing a lot of overnight with BUCKLER we wouldn't feel as comfortable doing it with our other 20 some other counterparties in the repo market because the will and changes probably may approach the markets could happen in any single day. So we have great security in the fact that we can go through the banking system with BUCKLER. And then Mark, perhaps just talk a little bit about different maturities and where we are there and the cost of those maturities and the access to it.

Yes, sure. So we don’t see any issue with repo both overnight or term. Obviously, we do a lot more overnight with BUCKLER than we would with anybody else just because of our relationship, but that funding has been great. I haven’t heard really any talk on from our repo counterparties about the debt ceiling and its impact. I think because of the debt ceiling, because of the banks, a lot of people want to be in repo. So it’s actually helped us. Like Scott said in his remarks, SOFR plus 10% to 15% is kind of what we’re seeing across maturities. It widened a little bit at one point when we were kind of in the middle of the SVB and Signature Banking crisis, but it came back with no issue. So we see plenty of liquidity in the repo and financing markets.

The next question comes from Christopher Nolan with Ladenburg Thalman.

Can you provide an update on the investment spreads, specifically regarding funding costs for the second quarter so far?

Sure, Mark. You want to detail that?

So low 5s is where we're seeing repo. So somewhere 5.15, 5.10, somewhere just depends on the surety in counterparty for about a 30-day term.

Okay then. Given that, how should we think about the earnings power for the company in terms of sustaining the current $0.28 dividend, excuse me, $0.24 dividend?

Good morning. So right, as Jim said in his comments and quite frankly, as we’ve said in the last 10 to 12 earnings calls, we set the dividend based on the medium term. And right now, we think that the $0.08 dividend on a monthly basis suits the investment opportunities on the medium term. Now as actually, Doug Harter reflected in an earlier report on ARMOUR some of the earnings and quite a bit of it actually comes from our well-managed swap position that we put on in April and May of 2020 when rates were very low. As a matter of fact, it was noted in the Board meeting on Tuesday that we actually had a swap where they had paid us on both sides that just rolled off as we’re starting to see that go. But Fannie 6s are trading around par. So they’re yielding 6%. Funding is at 5%. So it gives you 100 basis points times 8; there’s only 8% right there, and then you have some overhead costs as well, correct? So where does that funding power come from that large swap position. But 75 months left on that swap position, as I noted earlier, on the over-the-counter swaps. So it does provide earnings power. And the reason you set up those swap positions exactly for situations like this, okay? If we sense that rates for some reason, we’re going to go dramatically lower both on the short end or even on the 10-year, we might actually unwind some of those swaps. But right now, we put on those positions three-plus years ago. Exactly where we want to be, and we’re getting the benefit of it today. So I hope that answers your question.

The next question comes from Matthew Howlett with B. Riley.

Jeff. On the prepayments outlook, I just things already ticked up, obviously off a very, very low rate in the winter. Is it seasonal in nature? And then what's the outlook for speeds? It just seems like the housing market is much stronger than I think people would have imagined at this point in the cycle. Any sort of update on where speeds to go for 5 or 6 coupon?

Sure. We as a company, Mark, please go ahead.

Sure. We expect prepayments to increase over the next two months, likely by 20%. That's what we anticipate for our portfolio based on current rates and trends. So we are prepared for that and it won't be unexpected. However, mortgage rates are lower than their peak.

Is there any insight on how dependent this is on the Fed? There have been some recent changes at the FHFA GP, so I'm curious about your thoughts on those, particularly regarding investment selection. Additionally, are you still focused on specified pools or credit impaired assets? How are you approaching investments in higher coupon segments today, especially since there is a possibility of rate cuts in the latter half of the year, which could lead to significantly lower mortgage rates at some point?

We have structured the portfolio with higher coupons due to the wider spreads. Additionally, our duration is higher than it would be in a typical environment with ongoing rate increases from the Fed. This adjustment is intended to counterbalance the potential impact if rates decline and prepayments rise more than anticipated. We aim to maintain that balance.

And you can get that duration on your balance sheet by also using treasuries in the future. So you have your mortgage core position, you have your hedge core position, then you can manage it with very liquid other products. I believe your duration today, Mark, is 0.82 to 0.88 area. So that's the benefit that he's talking about that.

Right. You guys have been very active with that. And then just any comments on the changes with the g-fee.

This concludes our question-and-answer session. I would like to turn the conference back over to Jim Mountain for any closing remarks.

Thank you, Andrew, and thanks to everyone who’s joined us this morning and one final shout out to all the shareholders that have dialed in on the internet or hear this shortly on replay. We look forward to having you join us this time next week for our annual meeting. Until then, stay safe.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.