Earnings Call Transcript - FBRT Q4 2020

Operator, Operator

Hello and welcome to the Capstead Mortgage Corporation fourth quarter 2020 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today’s presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your touchtone phone. To withdraw your question, please press star then two. Please note today’s event is being recorded. I now would like to turn the conference over to Lindsey Crabbe, Manager of IR. Ms. Crabbe, please go ahead.

Lindsey Crabbe, Manager of IR

Good morning. Thank you for attending Capstead’s fourth quarter earnings conference call. The fourth quarter earnings release was issued yesterday, January 27, 2021 and is posted on our website at www.capstead.com under the Investor Relations 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 the call will be available through April 28, 2021. Details for the replay are included in yesterday’s release. On the call 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 the company 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 on this call is current only as of the date of this call, January 28, 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.

Phil Reinsch, President and CEO

Thank you, Lindsey, and thanks everyone for your interest in Capstead Mortgage. After I make a few brief remarks, Lance will give a quick recap of the fourth quarter and Robert is going to provide us with some current market color, then we’ll open the call up for questions. We’re pleased to report another steady quarter with lower borrowing costs offsetting the effects on portfolio yields of continued high mortgage prepayments as Americans continue to take advantage of generational lows in mortgage rates to refinance or purchase a new home. On a core earnings basis, we have again earned our $0.15 common dividend, producing an 8.85% annualized return on common equity. For all of 2020, we earned 9% by this measure. We accomplished these returns with lower leverage and portfolio balances post-pandemic. The common dividend itself was unchanged for five quarters now and our core earnings met or exceeded the dividend in each of these quarters, despite the market disruption experienced in March. We are the only mortgage REIT that can make that claim. In fact, looking at peers in the residential mortgage REIT space, on average their dividends currently stand at about 50% of what they were pre-pandemic, and that’s a stark contrast to our steady performance. Our book value is down $0.04 in the fourth quarter which, together with a $0.15 common dividend, resulted in a three-month economic return of 1.6% or 6.5% on an annualized basis. Since the pandemic-induced fixed income disruption in March and through year end, book value was up $0.69 which, together with $0.45 in common dividends, resulted in an economic return of about 19% or 25% annualized. Thus far in 2021, book value is little changed, down a penny to $6.75 a share. Looking forward, we are optimistic that we will not see a repeat of the market disruptions experienced in March given the lower leverage levels in the market and the Fed’s bond buying programs; however, mortgage prepayments remain at high levels in no small part due to the Fed’s continued heavy involvement in the markets. This is having the effect of lowering returns and crowding out private capital, making it harder to reinvest capital made available from portfolio run-offs at attractive levels. We expect prepays to moderate over time as run-off is replaced with slower paying new production, with the seasoning of existing holdings, and with lower coupon interest rates on our currently resetting bonds. Given these market conditions, we’re being judicious in deploying our liquidity, building flexibility to potentially take advantage of opportunities as they unfold in the coming quarters. With that, I’ll turn the call over to Lance and Robert.

Lance Phillips, SVP and CFO

Thank you, Phil. We reported a GAAP net income of $23.3 million this quarter or $0.19 per diluted common share. Our core earnings were $19.7 million or $0.15 per diluted common share. As a reminder, our core earnings exclude realized and unrealized losses on our portfolio related interest rate swap agreements. We include a reconciliation of our GAAP to core earnings on Page 9 of our press release. Book value decreased $0.04 per share during the fourth quarter, ending at $6.76 per common share with derivative related increases of $0.10 being offset by $0.14 in portfolio related declines largely due to run-offs. Portfolio yields averaged 1.55% during the quarter, a decrease of 30 basis points from the 1.85% we reported in the prior quarter. Yields declined due to lower coupon interest rates on acquisitions and on existing loans that reset to lower current prevailing interest rates, as well as higher yield adjustments for investment premium amortization due to continuing high levels of mortgage prepayments. Our portfolio-related borrowing costs after adjusting for our hedging activities averaged 0.37% during the fourth quarter, 30 basis points lower than in the prior quarter, leading to approximately a one basis point improvement in our net interest spreads. As a result of pair outs during the quarter at December 31, the fixed pay rate on our swap book was 0.04%, a decline of 65 basis points from rates in effect on September 30. These lower fixed rates going forward will benefit future earnings.

Robert Spears, Executive VP and CIO

Thanks, Lance. The yield curve steepened significantly during the fourth quarter with 10-year yields increasing 23 basis points while two-year yields declined about a basis point. Longer term, this trend is positive for ARM valuations and refinancing. There was, however, short-term disruption in new issue RMBS originations due to the transition from LIBOR to SOFR indexes. Many originators quit taking LIBOR applications early in the quarter but didn’t get SOFR product rolled out. As a result, fourth quarter production was skewed to the downside and was at the lowest level of the year at roughly $1 billion. At the same time, an extremely strong demand for new issue ARMs of all shapes and sizes caused spreads to tighten dramatically on the lowest coupon, newest paper that is perceived to be immune from prepayments. Also, secondary selling was very light in the quarter. As a result of these crosscurrents, we’re currently seeing more value in the seasoned ARM space as opposed to new issues. Prepayments remain elevated. We expect this trend to continue for the next several months. As we move into 2021, the yield curve steepening trend has remained intact. We’re starting to see new SOFR ARMs coming out, which is encouraging. As a matter of fact, we’ve already seen over $200 million of this new SOFR paper in January. While spreads are relatively high on this paper, the fact that supply is starting to come out in a more normalized fashion is positive nonetheless. I would expect the market to become much more normalized in terms of production and volume around March. With that, we’ll open the call up for questions.

Operator, Operator

Operator instructions. The first question today comes from Steve DeLaney with JMP Securities.

Steve DeLaney, Analyst

Hey, good morning everyone. How are you?

Phil Reinsch, President and CEO

Morning.

Steve DeLaney, Analyst

Thanks for the comments and the good release last night. Robert, you talked about the tightness in the market - a lot of that sounds like just supply and demand, but help us get a sense for as you see the market today, give us a range or an idea of what your minimum ROE hurdle is to invest new cash - it sounds like you’ve kind of stepped back, and that minimum hurdle, how does that change between, say, current reset and fresh paper, longer duration paper?

Robert Spears, Executive VP and CIO

Yes, we have a preferred return rate of 7.5%, so we will not invest unless we can achieve at least an 8% return. Currently, we're seeing leverage ratios between 7.25 to 8 times, and in some areas, returns are reaching 9%, particularly in the seasoned market. For new production, it's falling within that benchmark, but I expect those spreads to adjust as production increases, even though fixed rates have also tightened. Adjustable-rate mortgages don’t operate independently. The current uncertainty revolves around how long the bank's interest will last, as they often engage heavily in the first quarter and then reduce their involvement, which is unpredictable. For the next couple of months, I anticipate that new issue paper will remain tighter, and we might not be very active in that area. However, we are optimistic as we progress through the year, especially observing that larger originators are already issuing $25 million to $30 million block-sized bonds for March and April. While the first month or two of the year may not be as active, new issue ARM paper is currently difficult along with fixed credits, making the situation less appealing. We believe this could improve in the next few months, so we will likely focus more on seasoned paper in the short term.

Steve DeLaney, Analyst

Got it, that’s helpful. Thank you. Lance, one for you. Your kind of expanded disclosure these days on fair value swap maturities disclosures, and just looking at your table here for December 31 versus 9/30, you’ve gotten rid of obviously some much higher cost swaps; but also, I think you’ve switched to OIS swaps. Should I interpret this that when you say you’ve got an averaged fixed rate in any particular quarter, let’s say third quarter of 2022 and it’s only one basis point, is that just your net between what I would normally think of as a fixed pay versus received spread on that swap contract?

Lance Phillips, SVP and CFO

No, that’s actually our average fixed pay.

Steve DeLaney, Analyst

That’s your average fixed pay?

Lance Phillips, SVP and CFO

Yes, so using that third quarter example, that swap notional amount of $1.2 billion has an average fixed rate of one basis point.

Steve DeLaney, Analyst

Okay.

Robert Spears, Executive VP and CIO

To follow up on that, the current two-year OIS swaps are at about eight basis points, so that one is currently in the money.

Steve DeLaney, Analyst

Okay, thanks. I’m going to do a follow-up with you, Lance, in the next day or two, just to make sure I’m clear on that for modeling purposes. Thanks for the comments, guys.

Operator, Operator

Thank you. The next question comes from Jason Stewart with Jones Trading.

Jason Stewart, Analyst

Hey, good morning, and congratulations on a great 2020. I think good kudos for a good performance in a tough year. I have a question on the yield adjustment in the fourth quarter. Lance, if you could quantify it, if possible, and then maybe set expectations for anything that would occur again in the first quarter, if that sort of level set the numbers there.

Lance Phillips, SVP and CFO

Regarding the yield adjustments in the fourth quarter, we haven't been disclosing the breakdown, but it has generally been consistent with a seven basis point yield adjustment over the last half of the year. For the first quarter, it's worth noting that some of our peers frequently adjust life speeds and then exclude those from core earnings. We typically perform this adjustment on an annual basis and take a long-term approach to life speeds, although there is no obligation to do so. We have done this in the first quarter in recent years, and I anticipate we will follow the same approach this year. With the increase in prepayments, there is a possibility we may adjust those speeds upward, and if we do, we will disclose the resulting impacts, often referred to as the catch-up. We will ensure to disclose the life speed adjustment in the first quarter and provide a detailed breakdown for you.

Jason Stewart, Analyst

Okay, thanks. Then obviously we’ve seen a little bit of a whipsaw in rates in the first quarter so far. If you wouldn’t mind just walking us through a little bit of how the portfolio has performed in terms of duration, extension, and I appreciate the comments on new issue, but just in the way that the legacy has traded so far given the short duration nature of it and what we’ve seen happen in rates. I think that would be helpful.

Robert Spears, Executive VP and CIO

Sure. As Phil mentioned, our book value decreased by a penny as of our last mark, which was at the close of business last Friday. If you look at the curve, the two to three-year segment remains mostly unchanged. Considering the duration of our book, there hasn't been much movement, although spreads on newer issue lower coupon paper have tightened, leading to improvements in prices on some of the lowest coupon paper we own by as much as a quarter of a point. Most of the other comparable paper is fairly flat, showing limited movement overall. In general for the ARM market, most newer ARM paper is trading between 104.25 and 105.25, with a lot of price compression similar to fixed rate, making it a speed play at the moment. In this environment, like the fixed rate market, the best performing paper is either lower coupon or very seasoned with a strong speed story. Does that answer your question?

Jason Stewart, Analyst

Yes, that’s super helpful. I just think that with the context in terms of portfolio performance and the moving longer term rates, it’s helpful to stratify the way that the portfolio is performing, so that’s helpful, thank you.

Robert Spears, Executive VP and CIO

Sure.

Operator, Operator

Thank you. The next question comes from Jon Evans with SG Capital.

Jon Evans, Analyst

I was wondering if you could discuss your thoughts on the current valuation of your stock, especially considering you are the only mortgage REIT that maintained the dividend. You're currently trading at about 81% of book value. Given that you're reducing leverage, are you considering using some of that capital to repurchase shares at these levels?

Phil Reinsch, President and CEO

Yes, that’s a great question. We are trading at a lower multiple than we think we deserve, obviously, and considering that we’re 100% agency book, and we have performed well from a cash flow perspective. With the leverage coming down a little bit in the fourth quarter, with the supply and demand dynamics that Robert described, we’ll see how that plays out; but we would probably run leverage potentially even lower by the end of the first quarter if we don’t see good opportunities to deploy capital, so that gives us a lot of flexibility to look at buybacks or other maneuvers to use that capital. We’re certainly open to doing what’s best for our stockholders in that regard.

Jon Evans, Analyst

Okay. Then the other question that I have for you is AGNC on their call, I know your book is different, etc., but they were talking about how they think there’s potentially getting to some kind of burnout on refis and that we’re getting closer to that, etc. Can you give us any insights into what you see in refis relative to the ARM market?

Robert Spears, Executive VP and CIO

Sure. I think over time, most segments of the MBS market start to exhibit burnout, and ARMs are not different in that regard. I would think that prepayments will remain elevated throughout most of this year and then after that, you get to a point where pretty much everybody out there that could have refinanced has done so, and so the dynamics right now over the next six to nine months look like speeds are going to be elevated. I think after that, you should start to see some burnout exhibited. Also, the difference too in an ARM book versus a fixed rate book, we have securities that are resetting lower in yield. A fully indexed ARM on this seasoned short reset paper to the borrower now is around 2.5%, and so as those loans reset downward, they will slow down as well. That’s not necessarily burnout, but it’s a nice feature of our portfolio. The cohorts that remain somewhat fast would probably be no different than if you think about the fixed rates in terms of coupons that we have, three and higher for instance. Those guys are going to remain fast for a while. But all in all, after we get through the first six to nine months of this year, we think we could see speeds starting to moderate.

Jon Evans, Analyst

Okay, yes, please go ahead. I apologize.

Phil Reinsch, President and CEO

Well just a real quick aside to Robert’s point about our current resetting portfolio, we had a request to increase our disclosure relative to how those bonds will reset in the coming year or so, so we added a sentence to that effect on the last page of the press release.

Jon Evans, Analyst

Thirty-six percent, right? Thirty-six percent the next six months?

Phil Reinsch, President and CEO

Yes, there’s 36% on average set to reset in six months. We improved our disclosure to indicate that 22% of that total will reset in the next quarter, and another 33% in the third quarter, with the remaining 40% resetting over the following six months. We provided additional details on this.

Jon Evans, Analyst

As investors, though, we should just think about that as positive ramifications, as obviously it’ll reset, the yield will come down, but there won’t be run-off because most likely it’s not going to refinance, correct?

Phil Reinsch, President and CEO

Yes, those folks will have a whole lot of incentive to refinance after their coupon resets down. That part of the portfolio is already paying slower than the bonds Robert was referring to, that have a fixed coupon with years to go, because they already know, or they should know, that they’re going to get something out of a coupon reset without having to do anything about it. It will just happen, so they won’t necessarily refinance in anticipation of a lower coupon on their bonds, but it will certainly be affirmation of that when their mortgage payment goes down.

Jon Evans, Analyst

Got it, and could I.

Robert Spears, Executive VP and CIO

Without getting into the math, the decrease in speeds on an established bond may result in a higher yield at the lower coupon than what it currently is, so speeds are significantly impacted in that type of bond. Overall, I believe the decline in speed would more than counterbalance the negative impact of the coupon loss.

Jon Evans, Analyst

Got it. Then if I could just ask just a bigger picture, obviously we’ve seen this steepening significantly into the 10s, which eventually should have positive ramifications for your portfolio. Can you just talk a little bit about what we need to see maybe in fixed rate mortgages before ARMs really start to explode from a production standpoint? You talked about what was going on in LIBOR versus SOFR, and that’s kind of a mechanical issue, but what are we rooting for to happen?

Robert Spears, Executive VP and CIO

Well already with the steepness that we’ve seen, originators are out there with, say, 7.1 ARMs at as much as three-eighths of rate difference cheaper than a 30-year fixed, and from what we’re hearing from guys that are in contact with big originators, they’re seeing a big pick-up in ARM production versus the fourth quarter, albeit from a very low level. That steepness alone is causing an increase. Any steepness from there would only increase supply, liquidity and attractiveness, I think, of the ARM market, so we’re optimistic about supply going forward. In the environment we’re in now, if it steepened further, it only gets better.

Jon Evans, Analyst

Okay. Thank you so much for answering my questions. I really appreciate it, and I hope you buy some of the stock back.

Phil Reinsch, President and CEO

Thank you.

Operator, Operator

The next question comes from Derek Hewett with Bank of America.

Derek Hewett, Analyst

Good morning everyone. Given those near-term headwinds on new issue yields and the portfolio trending modestly lower, and presumably lower leverage if you don’t buy back any stock in the near term, how should we think about the sustainability of the current dividend? Are these headwinds in the near term and things should start to normalize in Q2 and beyond, or what are the expectations around those trends?

Phil Reinsch, President and CEO

There’s a lot of moving parts, right, and a whole lot of optionality in where we could be from an earnings perspective quarters down the road. A lot of it can depend on what we were just talking about, how much the yield curve steepens, if any, and if we can buy bonds at decent ROEs, whether we maintain leverage at the levels we’re at, if we don’t, what do we do with the capital, do we keep it as dry powder or do we deploy it through buying back our own capital or otherwise. There’s a lot of unknowns this year. It’s probably more uncertain in terms of some of those factors than you might ordinarily have at this stage, so we’re not really prepared to say a whole lot about where that goes. But we will strive to hold onto our dividend level if it looks to be a temporary decline in core earnings. We don’t want to disrupt our pattern of dividends for something that’s transitory.

Derek Hewett, Analyst

Okay, great. Thank you.

Operator, Operator

Thank you. Once again, please press star then one if you would like to ask a question. The next question comes from Eric Hagen with BTIG.

Eric Hagen, Analyst

Thanks, good morning guys. A follow-up on originators rolling SOFR ARMs. Can you just shed some light on the product itself, what are the margins and caps and floors being offered to borrowers?

Robert Spears, Executive VP and CIO

So far, most of what has been released is in the 7.1 range. The previous 7.1 LIBOR had net margins of about 160. The new SOFR paper that has emerged has margins around 212. It operates under a 1.5 cap structure, as it resets twice, allowing for a reset of up to 5% at the first reset and then 1% every six months thereafter. Looking at its trading so far, it is not significantly different from how a similar LIBOR ARM would trade. Essentially, it is trading based on the coupon, with market participants expecting a margin adjustment of approximately 50-plus basis points over time compared to the SOFR index, which seems like a reasonable adjustment.

Eric Hagen, Analyst

Great, that’s really interesting color. Thank you. Hope you guys are well.

Robert Spears, Executive VP and CIO

Sure, thank you.

Operator, Operator

Thank you. As that was the last question, I’d like to return the floor to Lindsey Crabbe for any closing comments.

Lindsey Crabbe, Manager of IR

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

Operator, Operator

Thank you. This concludes the question and answer session as well as the call. Thank you for attending today’s presentation. You may now disconnect your lines.