Franklin BSP Realty Trust, Inc. Q1 FY2021 Earnings Call

Good morning. Thank you for attending Capstead's first quarter earnings conference call. The first quarter earnings release was issued yesterday, April 28th, 2021, and is posted on our website at www.capstead.com under the IR tab. The link to this webcast is also in the Investor Relations section of our website. An archive of this webcast and a replay of this call will be available through July 28th, 2021. Detail for the replay are included in yesterday's release. On the call with me today are Phil Reinsch, President and Chief Executive Officer; Robert Spears, Executive Vice President and Chief Investment Officer; and Lance Phillips, Senior Vice President and Chief Financial Officer. Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management. In addition, certain terms used in this call are non-GAAP financial measures, reconciliations of which are provided in the company's earnings release and accompanying tables or schedules, which have been filed on Form 8-K with the SEC and may also be accessed through the company's website. For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are available on our website. The information contained in this call is current only at the date of this call, April 29th, 2021. The company assumes no obligation to update any statements, including any forward-looking statements made during this call. With that, I will turn the call over to Phil.

Thank you, Lindsey, and thanks everyone for your interest in Capstead Mortgage. After I make some brief remarks, Lance will give a quick recap of the first quarter and Robert is going to provide us with some market color, then we will open the call up for questions. Our core earnings were $0.13 per share for the first quarter of 2021, returning 7.7% on common equity capital, which includes the effect of adjusting prepayment speed estimates that Lance will describe further in a moment. Including these adjustments, this breaks our string of five quarters going back to the fourth quarter of 2019 and throughout the pandemic, where our core earnings met or exceeded our $0.15 quarterly dividend with average returns on equity of about 9%. While down modestly quarter-over-quarter, mortgage prepayment rates remained at high levels as homeowners took advantage of historically low mortgage rates available late last year to refinance their mortgages. We now see prepayment rates cresting in April as most mortgage refinancings with 2019 loan locks were closed by the end of March. Recall, April portfolio runoff reflects March loan closings. And with fixed mortgage rate increases of about 50 basis points during the first quarter, the refinancing indices are softening, indicating a fall in prepayment rates in the coming months and quarters. Of course, should the yield curve steepen further and mortgage rates resume trending higher, prepayment rates should recede faster. We do not replace all of our portfolio runoff in the first quarter or in the fourth quarter, for that matter. This was primarily due to the transition of ARM production to SOFR from LIBOR indices and strong demand for agency-guaranteed MBS in general, including agency ARMs. This was due in large part to buying programs at the Federal Reserve and the commercial banking sector, seeking to deploy ever-increasing bank reserves. This crowding out of private capital has had the effect of lowering returns to levels we view as unacceptable in many instances and making it harder to reinvest capital available from portfolio runoff at attractive levels. All that said, we have ample amounts of dry powder and continue to pick our spots, having already made more portfolio acquisitions current quarter-to-date than we did in the entire first quarter. Looking forward, we remain committed to generating attractive risk-adjusted returns and we will be judicious in deploying our liquidity, building flexibility to potentially take advantage of opportunities as they unfold in the coming quarters. With that, I will turn the call over to Lance and Robert.

Thank you, Phil. We reported a GAAP net income of $18.9 million this quarter or $0.15 per diluted common share. Our core earnings were $17.4 million or $0.13 per diluted common share. As a reminder, our core earnings exclude realized and unrealized losses on our portfolio-related interest rate swap agreement. We include a reconciliation of GAAP and core earnings on page eight of our press release. Book value decreased $0.10 per share or 1.4% during the first quarter, ending at $6.66 per common share, with derivative-related increases in value of $0.17 being offset by $0.22 in portfolio related declines, largely due to runoff and $0.05 in declines related to capital activity. Portfolio yields averaged 1.38% during the quarter, a decrease of 17 basis points from the 1.55% we reported in the prior quarter. Portfolio yields were negatively impacted by $2.3 million in additional premium amortization, approximately 12 basis points, as we made adjustments to our lifetime prepayment fees in line with current and expected future market conditions. We do not anticipate making any further life speed adjustments this year, but we will monitor and adjust as conditions require. Yields also declined due to lower coupon interest rates on existing loans that reset to lower current prevailing interest rates. From a volume perspective, as Phil mentioned, we do not fully replace runoff in the first quarter, resulting in our average portfolio balance being down approximately $500 million from the previous quarter. Our portfolio-related borrowing cost, after adjusting for our hedging activity, averaged 0.2% during the first quarter, 17 basis points lower than in the prior quarter, resulting in consistent net interest spreads from the fourth quarter. The average fixed pay rate on our swap book was only six basis points at March 31st, an increase of two basis points from the rate in effect on December 31st. Now, I will turn it over to Robert.

Thank you, Lance. The recent trend of a steepened yield curve remains a factor in the first quarter, with 10-year yields increasing 82 basis points to 1.74%, while two-year yields only increased four basis points to 0.16%. Longer term, this trend is extremely positive for ARM valuations and ARM supply. In the short term, however, the LIBOR to SOFR transition and record low fixed-rate mortgage rates at year-end caused new issue ARM supply to plummet to an all-time low of $360 million in the first quarter. In addition to this $360 million new issue paper, there was also $560 million of seasoned secondary sales. It should be noted that the new issue supply is picking up dramatically in the second quarter. In April alone, over $1.25 billion of new issue agency ARMs were sold in front-month and forward-settle transactions. Many originators are now actively pushing ARM products due to the relative attractiveness of an adjustable-rate mortgage compared to the fixed-rate mortgage. There is still a very strong bank bid for front-month new issue paper, keeping spreads on this cohort at extremely tight levels. As a result of this, we currently see more value in seasoned paper as well as forward-settle new issue transactions. Current repo rates are extremely attractive in the 10 to 12 basis point area from one month term repo. Looking ahead, we're very encouraged by the recent pick-up in ARM supply, the dynamics of the steeper yield curve, and how that can translate into attractive risk-adjusted returns going forward. With that, we'll open the call up for questions.

Thank you. We will now begin the question-and-answer session. Your first question comes from Steve DeLaney from JMP Securities. Please go ahead.

Hey, good morning everyone and thanks for that introductory summary. I think that must have been the most comprehensive layout of the quarter that I can recall. We had Phil, we had Lance, and Robert, so appreciate the overview. You kind of answered all my questions there right with that, but we will find something to talk about. Phil, if you can, you mentioned that the relationship, a pickup in second-quarter purchases versus all of first quarter, are you willing to quantify that for us? And could you describe the type of securities that you are currently buying? Is it new production or seasoned? Maybe you could just give us a little flavor for what the second-quarter investment looks like? Thank you.

Well, we only bought about $400 million in the first quarter versus almost $900 million of runoff. And we're well ahead of that $400 million at this stage. I hate to throw a number out there, because people might want to try to annualize or compare it quarter-on-quarter and that’s probably really not fair to either of us. So, I'm not going to do that, but I'll let Robert speak to what he is seeing and what he is actually buying.

Yes, so Steve, we continue to buy seasoned securities. There were a couple of positions late in March, which settled in April, where we picked up some bonds. We still don't see, as I mentioned in the commentary, much value in front-month new issue paper. You have a handful of names, so those in that sector are very rich, but the good thing is production has ramped up so much that we’re seeing stuff in the back months, 36 weeks out that to us is much more compelling than new issues in the front month. That's mainly because some of these buyers that are driving spreads are only buying for immediate settlement. So, we're seeing a lot more to choose from than we have over the last three to six months.

Yes. Do you notice lower prices when purchasing three months out compared to aggressive banking?

Yes, both on absolute dollar price and also on the spread basis or OAS basis or any way you want to look at it. Obviously, you don't get immediate settlement, but from the perspective of accretion from going 60 to 90 days out versus the front month, it’s pretty compelling right now.

Okay, got it. Lance, regarding the $0.02 dip, as Phil mentioned, you've been consistently covering the dividend, which is an important observation. It seems that something changed this quarter, and it appears to be related to the life speed. I'm curious if this dip is due to being slightly underinvested, as Phil mentioned with not covering runoff for two quarters, or if the $0.02 drop is primarily due to the adjustment you made to the life speed, which reduced the yield by 12 basis points. Could you clarify if you attribute the $0.02 drop to the life speed change, being underinvested, or a combination of both?

Yes, I mean, this quarter certainly the $2.3 million could translate to the $0.02 drop in earnings. I think the underinvested situation obviously didn't help this quarter's earnings, but I would attribute the $0.02 directly to the $2.3 million of additional amortization.

Okay, great. Thanks for the comments guys.

Thank you.

Thank you. Your next question comes from Jason Stewart from Jones Trading. Please go ahead.

Thanks. Good morning. As we think about the portfolio growing again in Q2, can you talk a little bit about how you're going to adjust or take the hedge portfolio up, leave it as it is or just sort of that interplay and how you're thinking about it?

I think from a duration gap standpoint, we'll keep that fairly constant. We're a little over three months right now. I wouldn't look for that to drift materially. Obviously, the newer issue paper that's out there is lower coupon and has a little more duration risk than the rest of our portfolio. So, we need to be mindful of that, as we acquire those types of securities. They obviously offer the most prepayment protection, but they also have the longest duration. So, we will hedge those accordingly and in aggregate, we look for a duration gap to remain fairly flat around three months.

Okay, great. That's helpful. I would like to discuss the temporary difference between core earnings and the dividend as we navigate through this period. Could you elaborate on whether you believe it is temporary that we remain at this $0.13 level? Looking at the yield curve today, it appears to be steeper; I assume that will influence how the rest of Q2 unfolds. I'm interested in the temporary nature of the decline in leverage, the additional amortization, and how you view these factors when determining the dividend policy.

Yes. You can consider the adjusted lifetime speed as a unique occurrence since we don't usually adjust speeds every quarter. While it may not fit the strict definition of a one-time event, it is certainly infrequent. Additionally, our smaller portfolio will impact our quarterly results until we can rebuild it, which depends on finding good reinvestment opportunities. Given the Fed's buying and bank purchases, this is increasingly challenging. We have made some progress this quarter, but we don't want to suggest that we will grow the portfolio in the second quarter. At the very least, we should be able to stop the losses we've seen recently. Therefore, you will need to consider the average portfolio outstanding to evaluate our near-term results until we can improve our leverage. Regarding dividends, the Board assesses this taking a longer-term and medium-term view of our earnings. We appreciate having maintained a $0.15 dividend for the past five quarters until this quarter, where we still declared $0.15 but fell short mainly due to the speed adjustment. We need to be realistic about this situation as well.

Okay. Thanks for taking the question. Appreciate it.

Thank you for joining us today. If you have any further questions, please give us a call. We look forward to speaking with you next quarter.

Thank you. That does conclude our conference for today. Thank you for participating. You may now disconnect.