Earnings Call Transcript - ARR Q1 2022

Operator, Operator

Good morning, and welcome to the ARMOUR Residential REIT's First Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. 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.

Jim Mountain, CFO

Thank you, Andrew. And thank you all for joining our call today to discuss ARMOUR's first quarter 2022 results. This morning, as usual, I’m joined by ARMOUR’s Co-CEOs, Scott Ulm and Jeff Zimmer, and Mark Gruber, our Chief Investment Officer. By now, everyone has access to ARMOUR's earnings release, which can be found on the ARMOUR website. 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, which have been 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. They 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 the most comparable GAAP measures 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 the website shortly and will continue for one year. Net interest margin for the quarter was 1.78%, an increase of 18 basis points over the 2021 year average and a three basis point increase compared with Q4 of 2021. ARMOUR's Q1 comprehensive loss related to common stockholders was $148 million, which includes $66.4 million of GAAP net loss. Distributable earnings available to common shareholders, which excludes gains or losses from security sales and early termination of derivatives, as well as market value adjustments, but includes TBA drop income was $26.7 million or $0.28 per common share. Because ARMOUR uses pay fixed interest rate swaps for hedging, distributable earnings includes the monthly running cash coupon costs or benefits of our hedging activities. This effect makes distributable earnings more stable as movements in repo funding costs and swap net coupon payments will tend to offset one another. ARMOUR paid monthly common stock dividends of $0.10 per share during the quarter and has announced dividends at that rate for April and May of 2022. Taken together with the contractual dividends on preferred stock, ARMOUR has made cumulative distributions to stockholders of $1.87 billion over its history. ACM, the company's external manager, continues to waive a portion of its management fee, which was initiated in the second quarter of 2020. This waiver offset $1.95 million worth of operating expenses in the first quarter of 2022. Quarter-end book value was $8.48 per common share, down $1.85 from December 31, 2021. As of the close of business on Tuesday, the 26th, we estimated book value to be approximately $7.63 per common share. At March 31st, ARMOUR’s portfolio consisted of $6.4 billion of agency securities, plus TBA positions representing another $750 million, plus $1.3 billion of U.S. treasuries. Now let me turn the call over to Scott Ulm, one of our Co-Chief Executive Officers. Scott, take it away.

Scott Ulm, Co-CEO

Thanks, Jim. The first quarter of 2022 was one of the worst quarters for bonds in nearly 50 years as investors grappled with the scope and magnitude of the monetary policy response necessary to halt rapidly rising inflation, while also worrying about its impact on economic growth. Over the course of the first quarter in 2022, two-year treasury yields rose 160 basis points and 10-year yields rose over 80 basis points, and the difference briefly dipped below zero, an ominous sign of the economic turbulence ahead. ARMOUR entered 2022 with a defensive posture as risk parameters and leverage were below historical averages in anticipation of increased volatility as the Fed declared the end of their QE program. Our net duration gap heading into year-end was 0.3x leveraged 7.5x, and liquidity was at a very healthy level of $840 million. ARMOUR allocated roughly 50%, $4.5 billion par of the portfolio to the production TBA contracts with superior market liquidity compared to the specified pool market, which struggled to trade in line with its fair value in times of heightened market volatility in early first quarter. Rapidly rising rates and quickly deteriorating market liquidity in early January flashed warning signals for mortgage spreads, prompting a response from ARMOUR to quickly and efficiently sell our entire TBA position on swap for duration-match treasuries, a move which greatly reduced the mortgage spread risk in the portfolio. In the first seven weeks of the quarter, ARMOUR decreased its agency MBS spread exposure by over 30%. By late February, when mortgage spreads and yields approached levels not seen in four years, ARMOUR began to steadily deploy its available leverage and newly purchased mortgage bonds back into par coupon MBS. Since the end of February, we’ve purchased $1.8 billion of production pools and $1.2 billion of TBAs, while selling $1.8 billion of longer duration treasuries. During the same period, we’re actively rotating into production MBS and out of our lower coupon 15-year and 30-year pools as those make up the majority of the Fed’s MBS portfolio and are most at risk due to potential active sales by the Fed. As of mid-April 2022, we’ve replaced the vast majority of our former treasury positions with newly acquired MBS with levered yields between 12% and 15%. While in the near term, there remains an elevated level of uncertainty ahead of us, we’ll be watching very carefully to invest with a longer time horizon in mind. With about 116% of our repo book hedged with current and forward starting swaps, we believe we’re adequately hedged for the nearly 275 basis point Fed funds rate increase that’s currently being priced in the market. Also note that our distributable earnings contain all the costs of our hedging and financing. ARMOUR continues to monitor the term structure in the repo market in light of the aggressive Fed. But for now, we prefer to keep our remaining average repo term short, currently at 21 days. Our average repo rate today is just about 50 days. 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. Now I would like to open for questions.

Jim Mountain, CFO

Andrew, do we have questions?

Operator, Operator

Yes. So we will now begin the question-and-answer session. The first question comes from Doug Harter with Credit Suisse. Please go ahead.

Doug Harter, Analyst

Thanks. Given the size of the book value decline in the first quarter and so far in April, how do you think about what the right size of the balance sheet is? And how much more capacity do you have to increase that if you see the opportunity?

Jeff Zimmer, Co-CEO

Good morning, Doug, and thanks for calling in. So when you do have a book value decline, the leverage goes up naturally, and we started the quarter at 6.1x leverage, and it has crept up to the mid to high 7s. We do own a number of treasuries still, and we have not reinvested April and expected May pay downs. So we do have on the table that amount of reinvestment opportunity into mortgages, which obviously Scott said are yielding between 12% and 15%. It would be unlikely at this point, unless the opportunities became extraordinarily good, and I’m talking like 18% or so for us to be above 8.5x to 8.6x leverage. So look at it that way, and I think that gives you a good tableau for how we’re looking at things.

Doug Harter, Analyst

Got it. And then just on the dividend comment, if I take the current dividend divided by your updated April book value, that gives me kind of a number north of 15% required return to generate that. And that would be kind of after expenses. You’re talking about 12% to 15% returns that you’re seeing in the market. Just curious as to your commentary around the comfort in that dividend level?

Jeff Zimmer, Co-CEO

Based on the historic assets that we own and based on the current investment opportunities, we definitely can support that dividend. We have not had a longer-term discussion with the Board in terms of the third or fourth quarter yet, but we could currently feel very comfortable with what we’re paying, and that supports Scott’s comments.

Doug Harter, Analyst

Okay. Thank you.

Jeff Zimmer, Co-CEO

Thank you very much.

Operator, Operator

The next question comes from Trevor Cranston with JMP Securities. Please go ahead.

Trevor Cranston, Analyst

Great. Thanks. There’s obviously a lot of volatility and spread widening in the first quarter. Can you guys talk about where you see things today? How much risk do you see of additional widening in the MBS market? And what are your thoughts on the potential for continued great volatility and policy going forward over the rest of the year? Thanks.

Jeff Zimmer, Co-CEO

So you wouldn’t have thought looking at February 15, 2020, that we’d be looking at investment opportunities 26 months later in the 12% to 15% area, because that’s about 500 basis points better than what we’re looking at then. And I think that those changes highlight the risks that are inherent in the current environment. The geopolitical risks, we can’t do anything about; they’re there. We respect them, we’re being cautious about them, and we understand that they could be existential. We just don’t know how crazy they could get. However, in the mortgage spread widening, we look back through the subprime crisis, which highlights how bad things can get. And we are within a standard deviation or so of being normal on that. So we are not fully invested, but we are adequately invested. As Scott said in his comments, we took more than $2 billion of treasuries and reinvested them in the mortgages, but we did it over a 10 or 12 week period. We caught some of the widest spreads, and we’ve also bought some assets a little tighter than we wanted to. We’ve left some cash on the table to reinvest if we do get a widener. But as I said, we are very respectful of the risks that are out there and we’re cautiously watching those. And we’re probably not investing that last opportunity of cash that we have as I said, are being respectful of that. In terms of the second question that you asked, I don’t think that the capital markets can let mortgage spreads get crazy wide for a long period of time. So if they get to levered returns of 18% to 20%, it would probably be very short-lived.

Trevor Cranston, Analyst

Yes. That’s helpful. And then in terms of the coupon positioning of your portfolio, you guys obviously have been moving up in coupon somewhat. Can you maybe just talk about what the pace you’d expect that rotation to continue at? And if you’re comfortable continuing down the larger discount loans that you could currently have in the portfolio?

Mark Gruber, CIO

Trevor, this is Mark. I believe we’re probably almost done rotating out of some of the lower coupons and into the upper coupons. Mainly, that’s because the lower coupons have pretty much fully extended. They have good convexity and they’re good assets. So I would say when you look at our portfolio at our next update, you’ll probably see us maintain most of those lower coupons. All our reinvestments are going to go into the upper coupons. But we’ve done for the most part, all the rotation out; maybe there’ll be some little things on the end. But we really like the assets in the lower coupon, just because they extended so much already. And the convexity is great.

Trevor Cranston, Analyst

Sure. Okay. That’s helpful. Thank you.

Operator, Operator

The next question comes from Christopher Nolan with Ladenburg Thalmann. Please go ahead.

Christopher Nolan, Analyst

Hey guys. Just a quick question for Jim. Net interest income in the quarter seemed to go up a bit quarter-over-quarter; just trying to get a clarification on why?

Jim Mountain, CFO

Well, it’s up to Mark.

Mark Gruber, CIO

Net interest income between Q4 and Q1 is that what you’re asking?

Christopher Nolan, Analyst

Yes.

Mark Gruber, CIO

It’s just going to be some rotation into some different bonds, but also amortization expense slowed.

Christopher Nolan, Analyst

Great. And then just I was checking out the Q and I just saw that your haircuts on your repo funding have actually gone down the quarter, which I found surprising given all the turbulence going on in the MBS market. Was that related to Buckler? Or is there any color you could provide on that?

Scott Ulm, Co-CEO

No, the clearing market in repo on haircuts has declined as I think more and more the counterparties are getting comfortable with the risk of holding MBS—Agency MBS. So we've actually got our counterparties to lower haircuts.

Jim Mountain, CFO

And as a result of some actual outreach and conversation, trying to make sure everybody was meeting the market leader and we are sort of in a most favored nation position with all of our counterparties.

Jeff Zimmer, Co-CEO

Yes, Christopher, I would note that in the treasury market, many of the dealers have no haircuts at all. And if you go back to the subprime crisis, it's interesting. Haircuts went from 3% to 4% up to 6% to 7%, 8% for three to six months. And we haven't seen that right now. So we would suggest that the banks are characterizing the current environment as not being as risky as that. And those haircuts—and despite the wiping that has happened in mortgages, the volatility they’re very comfortable with. And I think that's actually makes us somewhat comfortable with our increased investment in MBS.

Christopher Nolan, Analyst

Okay. So it sounds like there's a disconnect between how the banks are viewing the MBS market and what the credit spreads are saying.

Jim Mountain, CFO

Well, I think they've gotten more comfortable with the fact that over time, how often have mortgages dropped three or four points in a day because remember they have our collateral so they can sell at any time it's bankruptcy remote? I think they're just more comfortable that they're not going to see it greater than three-point drop in a day on a collaterally owned, which is very liquid. Perhaps a little bit too that as repo rates are going up from 5, 6, 7, 8, 9 basis points to 50 basis points, we've seen new entrants in the market. And so the attractiveness of repo as an asset to them seems to be increasing, and haircuts are just one of the terms upon which they can compete for balances.

Christopher Nolan, Analyst

Got it. Okay. Thanks, guys.

Jeff Zimmer, Co-CEO

Thank you.

Operator, Operator

The next question comes from Matthew Howlett with Nomura. Please go ahead.

Matthew Howlett, Analyst

Hey guys. Just a question on historical context where MBS spreads are on a nominal or OAS basis. I’d just like to hear where they are today versus different points in time, taper tantrum, financial crisis?

Scott Ulm, Co-CEO

So we've got to pull up a chart here. We think when we look at our analytics, on a Z-spread basis, any fours are about 110. OAS is obviously going to be lower than that just because of the way the metric works. DUS spreads are probably in the mid-50s. We would say that DUS is tighter than Agency MBS; it's definitely wider. On a treasury OAS basis, one of the charts we look at is treasury OAS on a historical basis. In general, the coupon stack is on the average of where the Fed has been buying, but it's below the long-term average of when they're not buying. That's why we do think there's still some widening when the Fed decides to really stop and maybe actually sell 10 or 15 basis points. In general, mortgages are much, much wider than they were just a few months ago. So that's why Jeff said earlier, they're attractive, and we've been slowly buying some over time.

Jeff Zimmer, Co-CEO

So we run a number of different charts, and those charts have a break-even still when the Fed is buying to when they're not buying, and then we look at the crisis. There was a period about eight or 12 business days ago where we were actually OAS spreads were well north of that. Mortgages have actually performed well net of one day over the last week. So we're just inside the net average of non-Fed buying over the last 12 years. Hopefully that's helpful to you. One of our largest counterparties actually puts out a chart of current coupons, and we follow that chart; I think that's the best way to look at it.

Matthew Howlett, Analyst

So when thinking about the current environment, if they stay at these levels or they go wider, that's going to be good for spread, and if they tighten, I mean, you'll pick that up in book value. I mean, how do I think about sort of the risk return trade-off if we just stay at this current environment or they widen, that's good for reinvestment, and good for shareholders, or if things do tighten, we'll see the big rebound in the book.

Scott Ulm, Co-CEO

So if things tighten, generally you would expect book value to go up. It doesn't always work that way because of the other events, but we would expect that to be the case. But we think the vast majority of widening has taken place here. Everybody knows the Fed’s out, and everybody expects the Fed to go ahead and sell some assets. I believe that that's priced into a mortgage OAS right now. But as I said earlier in my comments, we are extremely respectful of the fact that they could widen a little bit more, and we are ready if and when that happens to reinvest. That being said, when they do widen, book value generally has a proclivity to go down a bit. When they tighten, book value generally has a proclivity to go up, but the investment opportunities now and if things widen are better—that is correct.

Matthew Howlett, Analyst

Great. And then the last question, I mean, it looks like you got the liability side; you're pretty much termed out. I think you said 116% and you're good all the way up to the 275 through the derivatives. Is there anything else you’re looking to do on the liabilities side of the balance sheet as you enter what could be a rate hiking cycle, or do you feel like you’ve pretty much done everything and you're sort of well positioned for it?

Jeff Zimmer, Co-CEO

As Scott said in his comments and as well as our press release said, we have more than 100% of our repo balances swapped out right now. What that means is as repo rates go up, we pay fixed on our swaps, and our fixed rate is locked in, generally at lower rates than the market is right now. Then the receiver side would generally go up as well with repo rates, so they definitely offset each other. We look at that as very comforting in terms of our liability balance. As we increase our assets, and as we said, also at this point, we're not generally increasing our leverage until we see some great opportunities. We would put more swaps on the book to offset that risk.

Matthew Howlett, Analyst

Great. Thanks, Jeff.

Jeff Zimmer, Co-CEO

Thank you. Good to hear from you. It's been a while.

Operator, Operator

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

Jim Mountain, CFO

Let me end where we began and thank you all for joining us this morning and for your interest in ARMOUR Residential REIT. We're always interested in conversations with shareholders and analysts. So if anything comes up between now and the next time we're together in this forum, don't hesitate to reach out.

Operator, Operator

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