Earnings Call Transcript - FBRT Q2 2020

Operator, Operator

Good morning and welcome to the Capstead Market Second Quarter 2020 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 Lindsey Crabbe. Please go ahead.

Lindsey Crabbe, Investor Relations

Good morning. Thank you for attending Capstead's second quarter earnings conference call. The second quarter earnings releases issued yesterday, July 29, 2020, are 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 this call will be available through October 28, 2020. 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. To support the health and wellbeing of our employees and community and address the risks associated with the global COVID-19 pandemic, we have implemented our business continuity plan that enables our employees to work remotely. As such, please be patient with us as we answer questions. 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's work 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 as of the date of this call, July 30, 2020. The company assumes no obligation to update any statements, including any forward-looking statements made during this call. With that, I'll turn the call over to Phil.

Phil Reinsch, CEO

Thank you, Lindsay. And thanks everyone for your interest in Capstead. After my remarks, Lance will give a recap of the second quarter and then we'll open the call up to questions. We're pleased to report excellent results for the current quarter. We out-earned our $0.15 common dividend run rate by 20%. Even with significantly lower portfolio balances and less leverage producing an annualized return on common equity of 10.8%. The common dividend itself was unchanged for three quarters now and our core earnings met or exceeded the dividend in each of these quarters. We're likely the only mortgage REIT that can make that claim, given the market disruptions experienced in March. As importantly, our portfolio recovered strongly in value over the course of the second quarter, contributing the lion's share of a $0.72 increase in book value to $6.79 per common share. This 11.9% increase together with the common dividends resulted in an economic return for the quarter of 14.3%, which we expect to be one of the best performances in the sector as well. Making these returns more compelling, we anticipate that our common and preferred dividends for 2020 will be characterized as 100% return to capital, due in large part to reductions in our derivative positions last quarter. Looking forward, we expect to continue adding to our short-duration agency-only portfolio in the coming quarters, provided risk-adjusted returns remain attractive. With unhedged repo borrowing rates in and around 25 basis points currently and with swap rates at cycle lows, we should continue to see lower borrowing rates in the coming quarters even as we absorb higher levels of mortgage prepayment. Longer-term, the Fed has made it clear that they intend to remain very accommodating, as the country grapples with the uncertainties of the pandemic. This means keeping longer-term rates under control via Treasury and Fixed Rate Agency MBS purchases and short-term interest rates low. As the economy recovers, we would expect reduced support for longer-term rates potentially allowing more steepness to the yield curve to the benefit of our business. Wrapping up, we believe that our agency-only short-duration focus is serving us well, and we are well positioned to generate attractive returns at lower leverage levels than we have employed in the recent past. For investors seeking risk-adjusted returns with a comparatively higher degree of safety from interest rate and credit risk, we believe Capstead represents a compelling opportunity that is difficult to find elsewhere in the market. With that, I'll turn the call over to Lance.

Lance Phillips, CFO

Thank you, Phil. We reported a GAAP net income of $22.7 million this quarter or $0.19 per diluted common share. Our core earnings were $21.9 million or $0.18 per diluted common share. Our core earnings excluding realized and unrealized losses on our portfolio related interest swap agreements. We include a reconciliation of GAAP before earnings on Page 9 of our press release. As Phil mentioned, book value increased $0.72, or 11.9% per share during the second quarter ending at $6.79 per common share, primarily due to $0.67 in portfolio-related increases in value. Portfolio yield averaged 2.33% during the quarter, a decrease of 16 basis points from the 2.49% reported in the prior quarter. Yields declined primarily due to lower cash yield as a portion of our portfolio reset to lower prevailing interest rates and lower coupons on recent acquisitions. Our portfolio-related borrowing costs, after adjusting for our hedging activities, averaged 1.09% during the second quarter, 63 basis points lower than in the prior quarter, leading to a 48 basis point improvement in our net interest spreads. The benefits of lower unhedged repo rates and lower fixed rates on our swap book were partially offset by the declines in the receive leg of these derivatives based on lower 3-month LIBOR and OIS rates. At June 30, the fixed pay rate on our swap book was 1.27%, a decline of 17 basis points from the rate in effect on March 31. These lower fixed rates should benefit future earnings. With that, we will open the call up to questions.

Operator, Operator

Our first question comes from Jason Stewart at JonesTrading.

Jason Stewart, Analyst

Nice work navigating a tough environment. I was hoping you could share your thoughts on mortgage credit availability and how you think it factors into model prepay speeds.

Phil Reinsch, CEO

One thing that's become pretty apparent is that the originators aren't having as much trouble closing loans, whether refis or not, during this pandemic like folks were speculating all spring long. So prepays are running pretty hot now with mortgage rates fairly low. At the same time, underwriting standards are pretty tight. And you do have folks that may be having trouble qualifying given their personal circumstances.

Jason Stewart, Analyst

Got it. That makes sense. And if I missed it early on, please forgive me. Did you share incremental ROE numbers? Where do you think the market is today?

Phil Reinsch, CEO

On purchases at the margin right now we're looking at kind of 10% tight returns on a levered basis, between 7.5x and 8x in the short-duration products that we're focusing on.

Operator, Operator

The next question is from Steven Delaney at JMP Securities.

Steven Delaney, Analyst

On book value, despite about $0.20, you've got much better visibility into arms than we do. Just curious, Robert, how you're seeing arms trend here, we're almost one month into the third quarter. Have they been stable or trended higher? What are you seeing recently?

Robert Spears, CIO

They're trading very, very well, Steve. There's a really strong bank bid out there for both new issues and seasoned arms, and they continue to trade well. If you think about it, with the fixed-rate universe pricing in aggregate well more than one out of five arms are somewhat compelling to the banks in particular so they have continued to grind in as such into the quarter, both quarter end and supply sticking up which is a good thing, new issue supply and I think that's even helping more because arms can be kind of funny; actually increased volume can improve liquidity. And guys can buy paper in size. I feel very positive from a standpoint of valuations going forward.

Steven Delaney, Analyst

So yeah, I'm just curious about your supply. I mean, gosh, given where new rates are. I think we fell down to like 5% to 6% of the market. Are you actually seeing new production volume picking up in arms despite the low record low 30, 15 year rates?

Robert Spears, CIO

Yes, I mean, there's enough steepness in the curve where production is starting to increase and actually, second quarter new arm production doubled from the first. We have new issue, 71s being originated with gross lags and opportunities as it goes to a lot of refinance rates; on no cost basis, they're still around 3.25 for fixed-rate bonds. The steepness in the yield curve definitely helps. And at all-time rates, get this low, people don't try to reach for as low a yield as they can. So from that standpoint, we're very positive on new issue and secondary selling with a lot less in the second quarter, obviously, but we are way off acquiring bonds going forward.

Steven Delaney, Analyst

I'm reviewing your swap book and trying to understand the implications of the faster speeds. I believe Lance has likely adjusted the lifetime assumption based on the current curve, which means the Fed can't lower the short-end rates any further. It seems to me that the potential improvement from your swap runoff might help alleviate some of the pressure on your spread due to the faster speeds. It appears you have a $400 million runoff expected in the second half of this year, averaging around 180, but could drop to 25 basis points. Looking at the schedule, a notable figure is $2.5 billion in the third quarter next year at 125 basis points. What are your thoughts on that? Have you already done some swap terminations, and what is your view on that specific swap position and the possibility of trading out of it?

Phil Reinsch, CEO

Yes. I mean, we look at that on a regular basis and there's a decent probability that we could terminate some shorter duration swaps and go out the curve a little bit. Quite frankly, right now we're able to essentially finance everything about it on two-year money cheaper than we can 30-day repo. And so I think we're very, very cognizant of what's going on there. And there's a decent probability that we do some of that.

Steven Delaney, Analyst

Yes, the four-year swap is approximately equivalent to a two-year swap, which gives you a lot of flexibility. Additionally, I want to clarify that the roll-downs are around 2% on one-year resets, likely in the range of 190 to 210.

Phil Reinsch, CEO

Yes. And if you just think about our margins on our arms, and when LIBOR at 50, you kind of get in the low twos for short reset flow. The positive thing about that, obviously, is coupon going lower is slightly negative, but the positive is those resetting mortgages are in the 2.5, two and three-quarters area, and so they're probably not going to be as primed to refi. We're seeing that on our book right now; the prepaid pressure that we're really seeing right now on our newer issues comes from the last couple of years. Our shorter seasoned book is presenting very, very well right now. I think that trend is going to continue even if a new issue 71 originated two years ago was 50 to 75 basis points in the money right now and it's got clean credit. So I think that trend will continue for the next few months where we have better street performance out of our seasoned short resets than we do our longer reset bonds.

Operator, Operator

Next question is from Eric Hagen with KBW.

Eric Hagen, Analyst

You are the only mortgage REIT with a somewhat meaningful Ginnie portfolio. I feel like these thoughts could be really valuable on the pace of buyout activity as a result of higher delinquencies and its impact on prepaid speeds in your portfolio.

Phil Reinsch, CEO

Sure. Most people are aware that in the Ginnie space, we saw a huge spike in speed across the board fixed-rate arms last month, and it was buyout-related. We are kind of early in the process. The question on buyouts is, does it behoove the servicer to buy out and they're looking at being able to resecuritize the loans potentially? One thing that caught the spike I think was initially 90 days for parent loans could be bought out and immediately pre-pooled to CBA-type collateral. Many took advantage of that window to buyout as much as they could, and then immediately resecuritize going forward. They're going to have to hold on to that paper for six months, so the decision isn't as easy. It comes down to banks having capital that may be more prone to buy out loans versus non-bank originators that don't have as much capital. Buyouts definitely drove a big spike in speeds last month, but that could continue for another month or two. However, I think long-term ultimately Ginnies will start slowing down. Right now, it's pretty passive. We don't have as many Ginnies as we used to do; we sold a decent chunk back in the first quarter. Even bonds you can tell, you could pick out a couple of banks, for instance, that obviously had big delinquent buyout programs in place over the last couple of months. We think that will subside in the next few months, though.

Eric Hagen, Analyst

As most of your Ginnie portfolio serviced by banks or non-banks?

Phil Reinsch, CEO

Well, the really seasoned paper from back in the day was the biggest component of seasoned Ginnie. Newer issues have shifted more to the non-bank originators, that quicken the freedoms, etc. The line of demarcation is kind of like, if you go back loans originated more than six or seven years ago, it's primarily bank servicers. The newer issues are primarily non-bank servicers.

Eric Hagen, Analyst

That's really interesting color. Thank you for that.

Phil Reinsch, CEO

If you look at our portfolio, we've got 2% in agencies that are bank serviced, if you will, that are not pre-reset classification; they're seasoned. And then another 8% or so that's longer reset newer issues. Fairly, not a component of the portfolio these days.

Eric Hagen, Analyst

That's really interesting. Thank you again for that.

Phil Reinsch, CEO

One of your peers was just talking about the term premium for repo having flattened considerably over the last few months. Is the idea to keep rolling 30-day repo or could you put on some funding for the rest of the curve? Yes. You're almost right; that's exactly correct. I mean, 30-day repo is pretty much the same as 90-day repo with most of our lenders. So we are doing more 90-day repo than we have in the past. We haven't really extended beyond that, but if it becomes more favorable, we wouldn't have a problem going out beyond that 90 days at this point. It's been primarily 90 days, but we saw an opportunity to take it out further, we definitely would.

Operator, Operator

Our next question is from Hal Granger at Great Quarter Research.

Hal Granger, Analyst

Thank you for taking my question. Congratulations on a strong increase in your book value of 11.9% during the quarter to $6.79. Can you give us a sense of where your book value is now?

Phil Reinsch, CEO

It's fairly flat to quarter end at this juncture.

Operator, Operator

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

Lindsey Crabbe, Investor Relations

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

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