Orchid Island Capital, Inc. Q2 FY2020 Earnings Call

Good morning, and welcome to the Second Quarter 2020 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, July 31, 2020. At this time, the company would like to remind the listeners that statements made during today's conference call relating to matters that are not historical facts are forward-looking statements subject to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good-faith belief with respect to future events that are subject to risk and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements. Important factors that could cause such differences are described in the company's filings with the Securities and Exchange Commission, including the company's most recent Annual Report on Form 10-K. The company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements. Now I would like to turn the conference over to the company's Chairman and Chief Executive Officer, Mr. Bob Cauley. Please go ahead, sir.

Thank you, operator, and good morning, everyone. I want to point out that our slide deck was uploaded this morning, not last night. I hope everyone has retrieved a copy to follow along during today's presentation. We'll stick to our usual format, starting on Page 3 with the table of contents. The first item will cover our quarterly results at a high level. After that, I'll provide some insights on the market we operated in during the second quarter. Then, I'll delve into our financial results in greater detail and spend the remaining time discussing the changes in our portfolio positioning, our outlook for the market's evolution, and our strategies for managing risk and leverage. So, moving to Slide 4, let's review the financial highlights for the quarter. First, I want to highlight that Orchid had a very strong quarter, achieving an economic return of 15.8% that is not annualized. Consequently, our performance against our peer group, which I will detail shortly, has been impressive when looking at the total rate of return reflecting both stock price and dividends. We are now in a favorable environment, which has not always been the case given the series of Fed rate hikes we previously endured. However, the current environment is quite conducive for our business model. We have recently increased our dividend and feel confident maintaining it at this level. As long as interest rate speeds do not rise significantly, we anticipate room for earnings growth in the future. The key factors will indeed be how we manage those interest rate speeds. Now, looking at our results, Orchid achieved a net income per share of $0.74. Excluding realized and unrealized gains and losses on RMBS assets and derivatives, net interest income from interest rate swaps resulted in earnings of $0.43 per share from these gains and derivatives. Our book value per share was $5.22 as of June 30, reflecting an increase of $0.57 or 12.3% from the end of March. As of July 29, our estimated book value per share was between $5.23 and $5.33, marking an increase of 0.1% to 2.1% since the end of June, and factors in the dividend payment in August with a record date of July 31. In the second quarter, we declared and paid dividends of $0.165. Since our IPO, we have declared total dividends amounting to $11.33, which includes the $0.06 dividend declared in July. Our total economic return for the quarter stood at $0.74 or 15.8%, which is not annualized. For our third quarter year-to-date results, we expect returns between 1.3% and 3.3%, consisting of that $0.06 dividend and an increase in book value of $0.01 to $0.11. On Page 5, we display our results compared to our peer group, as described at the bottom of the page. It's important to note that Orchid was launched in February 2013, just before the taper tantrum that summer. Since then, we have been operating in a rising interest rate environment. The Fed raised rates for the first time in December 2015 and continued through 2018, with only about a year where rates fell before the recent market turmoil due to the pandemic. Despite these challenges, our total rate of return compared to the average of our peer group demonstrates that we have performed exceptionally well over these periods. On the next Slide, we present similar data that includes comparisons based on book value. Unfortunately, we do not have all the peer book values for Q2, so this information may be lagging. When we established Orchid and positioned it as an agency-only model, it coincided with the emergence from the financial crisis. Many of our peers engaged in credit at that time, which paid off during the strong economic periods of 2017 and 2018. However, as the cycle evolved and credit lagged, it has become clear that our strategy has proven effective. We have discussed in prior calls the possibility of expanding our investment strategy to include some credit, although we believe now is not the right time to do so. Given the ongoing evolution of COVID and the uncertainties surrounding it, we prefer to hold off for now. In terms of market dynamics, I'll address these points quickly on Slide 8. The rates market has remained essentially unchanged, with no significant movement during the quarter in either the nominal Treasury curve or swaps—this is in stark contrast to the volatility observed in many risk assets. The stability in the rates market is favorable for our mortgage strategies. On Slide 9, we show the performance of the 10-year Treasury and swap rates over the quarter, noting that apart from a brief spike in early June due to surprising nonfarm payroll figures, rates have remained stable. Slide 10 illustrates some recovery in the slope of the curve, with the 5-30 spread briefly exceeding 100 basis points before dipping back below that level more recently. Funding conditions in this environment are advantageous for our business strategy. Slide 11 provides insights into the mortgage market, showcasing TBA performance, with Fannie 2.5 rates increasing despite unchanged rates. The performance in lower coupon rolls is strong, while higher coupon rolls are experiencing declines in price, a direct result of the Fed's purchasing strategy that has focused predominantly on production coupons. This has created a higher demand in the spec market for those higher coupon pools, with more favorable payout conditions than previously expected. In terms of volatility, Slide 12 shows that after a spike during earlier market shifts, swaption volatility has significantly decreased, presenting a beneficial opportunity for our hedging strategies, which we will discuss further. On Slide 13, we summarize LIBOR OAS, and on the right, we present pay-ups for specified pools with the 3.5% coupon showing elevated levels. On Slide 14, we analyze returns across the aggregate index, revealing that risk assets performed strongly in Q2. However, when contextualized over the entire year, high-yield and emerging market assets still reflect negative returns year-to-date, contrasting with the strong performances of mortgages and treasuries. As we move to Slide 15, we highlight refinancing activity and its significance for our performance moving forward. Mortgage rates have been steadily declining, and although refinancing index levels are elevated, they have not maintained that status over time. Similarly, we are monitoring primary-secondary spreads, which we anticipate will normalize, supporting continued robust refinancing activity. On Slide 17, we examine our quarterly returns, segregating them into mark-to-market results and net interest income. During the quarter, we posted $0.31 in net interest income alongside $0.43 in net mark-to-market gains, underscoring a strong recovery of the asset class relative to our hedges. Moving to Slide 18, we display our net interest margin and dividends. While asset yields have decreased, funding costs have fallen even further, expanding our net interest margin and allowing potential for future growth. Slide 19 conveys a similar message about recovery in core earnings, and Slide 20 reflects our capital allocation strategy pivoting more towards pass-through securities while deemphasizing structured securities. On Slide 23, we show our concentration of high-quality spec pools, which dipped slightly during the quarter but has been restored since quarter-end. Slide 24 illustrates the relationship between speeds and returns, highlighting our securities’ performance against various cohorts. Our relatively low prepayment speeds reflect our securities' strong positioning. Slide 25 reviews the prepayment amounts realized relative to portfolio balances, demonstrating improved performance even in a low-rate environment compared to previous years. On Slide 26, our repo position highlights our leverage practices, currently situated at the high end of our targeted range. Finally, Slide 27 emphasizes our decreasing interest expense per share, reflecting significant drops that contribute to the strength of our earnings potential going forward. We aim to maintain a dividend that results in a low-double digit yield, with room for growth, suggesting possible returns in the low to mid-teens if we can effectively manage speeds. To conclude, we've had a strong quarter with outstanding performance relative to our peers, reflecting a favorable environment for returns. With ongoing control over speeds, we foresee potential for enhancing our dividend. Now, I will pass the call back to the operator for questions.

I see our first question comes from Jason Stewart from JonesTrading. Jason?

So I was wondering if you could opine or share your thoughts on how credit availability may impact speeds that you're thinking about versus models and how that puts you in a position in the portfolio that you have today and going forward.

So when you say credit availability, you're meaning to just borrowers generally?

I'm considering whether restrictive requirements are evident in the GSE world. We are clearly outside of the GSE world, but I want to know if this impacts your perspective on speeds in that area or if there has been no change.

This is Hunter, Jason, we really hoped to see and thought we were going to see a benefit in the wake of the crisis and pandemic in terms of job losses equating to slower speeds and the forbearance programs that were rolled out around the time the CARES Act came out. We haven't really seen that show up much at all. It looks like borrowers are quite able to refi into this new environment. And we'll expect that they will continue to do so in the coming months as our expectation is the primary-secondary spreads are going to narrow. We can see mortgage rates drop well into the 2s, and that just opens up an enormous bucket of borrowers who have really never had the potential to refi. And so I guess the short answer is no. We don't really expect to see it slow speeds down. And in fact, we would expect there to be continued robust speeds going into the next several months.

I would add that the government-sponsored enterprises have become more accommodating. One thing that has become more common is the property inspection waiver, which essentially waives the need for an appraisal. The GSEs are working hard to support the origination of mortgages as part of the government’s efforts to stimulate and sustain the economy. Borrowers are finding it easier to secure loans, especially in the non-bank sector, which has gained a larger market share. There were previous concerns about servicing because it was thought non-banks might struggle with financially managing delinquent loans. Many anticipated an increase in forbearances and questioned how servicers would handle the advances. However, the GSEs stepped in and have limited the advance requirement to just 4 months, after which they will cover the advances. There has been an increase in agency debt issuance to support this approach. Generally, it is not expected that pools will be bought out or that delinquent loans will be purchased during the initial forbearance period of 6 months, likely extending to 12 months. The most probable outcome is a payment deferral, meaning unpaid interest and principal will just be added to the end of the mortgage, not necessarily leading to a buyout. Additionally, it appears that many borrowers who enter forbearance are still making their payments. The overall credit impact from the COVID pandemic has been significantly lower than expected. Prepayment speeds have surprised us and the market positively since April, and we expect this trend to continue moving forward.

The prepayment waivers, in particular, are something that are cause for concern within the way we manage our assets. And Bob alluded to the fact in his prepared remarks that we are migrating down in coupon. So there's been a proliferation of Fannie 2.5s that have hit the market over the course of the last few months since rates have come down, but those loans still have gross WACs often into the low to mid 3s. And so I'm particularly skeptical about those in the coming months. If and when we do see that primary-secondary spread decrease, that could just be very low-hanging fruit for the mortgage, especially like the non-bank lenders who are getting more and more aggressive every day.

I would expect just at this point, just to reemphasize, as we move through the balance of the year, and let's say the primary mortgage rate moves below 3, the paid's going to be felt in the more recently originated 2s and 2.5 because, as Hunter said, they have high gross WACs, fresh docs, they're very low-hanging fruit. Conversely, the higher coupons, the more seasoned pools, they just go from 200 in the money to 250, and they will start to exhibit some burnout. So I would expect a lot of the higher coupons, and especially seasoned bonds, would do commensurately better in that environment. One thing we didn't mention, I mentioned that payoffs on spec pools had risen, but what I didn't say was that you've seen a huge gap between new issue and seasoned. And the reason, initially, was well-founded, and that is that seasoned loan balances in the like pools paid quite fast and, therefore, much faster than new. And so the pay-up changed dramatically. Actually, it probably got too big. And I would expect, going forward, if what we just said is true, and you start to see more and more burnout amongst those pools, that that gap would narrow. And therefore, those securities would be behaving quite well. So if you did own the seasoned loan balance, you could see some pay-up appreciation and speed decline. And so the returns there, we feel are very attractive. And we're more leery of the lower coupons, absent the roll, of course. As long as the Fed's buying, the rolls should be strong. But if you own those in pool forms, I think those are very vulnerable pools.

We've been focusing on purchasing. What we have purchased in lower coupons have been those that are either stories that have such a low dollar price that we could quickly deliver them into a TBA if and when they start paying fast, or loans that would not qualify for the inspection waiver, like investor properties and different unique collateral types that would not qualify for that type of refi.

Right. Well, and kudos to a nice view on positioning in the agency book. You took a very convicted view and have paid off, so kudos on that. But if we pool way up, and then I'll jump out here, do you have a thought on yield curve control and what that means for mortgage?

There's a wide range of opinions on this topic. If they do implement it, I believe it will mainly affect the short end of the curve, possibly up to the 3-year mark. The market seems to be acting as though this is already in effect. For instance, the 2-year yield is slightly above Fed funds, and the 3-year yield isn't much higher. I don't anticipate that whether they proceed or not will have a significant effect; it's more about the longer end. Currently, the curve is flattening, and I've observed that the dollar is weakening, making the long end of the curve attractive to Asian investors who are investing in it without hedging. These market dynamics appear to be independent of the Fed's actions and could continue for a while. If yield curve control is introduced, I think it will predominantly impact the short end, and the market is almost behaving as if it is already in place.

Thank you. I see our next question comes from Christopher Nolan from Ladenburg Thalmann.

On the ROE, you're talking about low to mid-turn returns. Is that for the second half of the year? Or is that for a full year?

I do have a specific period. I would just say that's what's available today. The higher end of that range is going to be predicated on better speed performance. We just mentioned on Jason's question. We think lower coupons in pool form are a little more vulnerable, so returns there are going to be on the low end of that range and some of the higher coupon, especially seasoned pools, probably going to be more on the high end of that range, unless we're wrong and speeds do accelerate across the board meaningfully, and then, in which case, those returns probably won't be there. But if we can manage speeds, I think those returns are very doable.

The TBA's a great alternative, as well, for us if we become overly concerned with the potential performance of the pools. Buying TBAs is a great option. The rolls are great. The Fed is going to continue to buy production coupons, and they're going to trade special for the foreseeable future, in our opinion.

And I'm just sort of doing back-of-the-envelope on the new dividend of $0.06 per month. That equates to roughly a 14% of book value, so that sort of falls within that range. Is that a fair way to look at you're setting your dividend consistent with your view in terms of ROE?

Yes.

And then, I guess the other thing is really everything just sort of turns on speeds. By the way, very nice quarter, but that is the key question here. I just want to make sure that's the key takeaway.

Yes, absolutely. And we tried to make that point as strong as we could. And you saw how so far we've behaved versus the cohorts, and it's how you position in terms of what spec pools you own or what vintage you own. TBA, of course, always offers attractive returns. You see that, especially a lot of our peers use the TBA market more than we traditionally do. But in those coupons the Fed's buying, implied financing cost is very, very low. And if you listen to the Fed, it doesn't sound like they're going to back away from the market anytime soon. But it does create opportunities for everybody.

We are currently holding over 80% of our portfolio in what we consider to be very high-quality specified pools, particularly in the higher coupon categories we possess. This includes a good number of loans in the 3s, 3.5s, 4s, and 4.5s. We have mostly loans valued at $85,000, $100,000, $110,000, with a few at $125,000 and $150,000, and predominantly in New York in the 3s and 3.5 range. We are confident about the quality of our portfolio. We have maintained these assets and observed significant increases in their value, but we have a solid cost basis. While we could realize quick profits by selling, it would create a replacement issue for us. Therefore, we plan to hold onto them for a while. As they pay down, we will explore lower coupon options while ensuring we remain in a safe position.

Yes. And we did also own some 15-year TBAs as well, too. That trade, we actually got in and out of that trade a few times, has done very, very well. So there's a lot of opportunities in the marketplace today. That's for sure. And funding looks like it's readily available. We didn't really dwell on this. We're in the mid-20s, and we can even term that out, if we like, in most cases, at around the same level or very, very modest increase in rate. And we don't have any of the issues that some of our credit peers do. We didn't have to go through any forbearance or anything. We maintain adequate liquidity throughout. And so that allows us to be nimble to the extent we want or need to be. And we've got the leverage ratio back up to the high end of the range. That was not a challenge to do so, and we're not going to go higher, but we see very comfortable maintaining it at that level, as long as the recent returns are available.

I guess on the question of leverage box, I guess your lenders are assuming that the Fed backstop will not allow another liquidity trap like we saw in March.

Yes, I think that's safe to say. I mean, the Fed.

Yes. And if that's the case, and if you're really dealing with a one-dimensional risk here, which is namely prepayments, why not take the leverage as high as can bear?

You need a lot of conviction to do that, and it would be very costly if you were wrong. I guess the one thing that would drive me away from that is that a lot of people have the view that we do, that rates are going to be low for longer. And there's no reason to think they won't. It's just that, whenever you get the market so offside on one view, it can be very painful when the market goes the other way. It doesn't have to be a meaningful move. It just has to be enough to trip a few people to shift, and that in and of itself can drive the market higher. So that would keep us from doing that.

I show no further questions in the queue at this time. I'd like to turn the call over to Mr. Bob Cauley, Chairman and Chief Executive Officer, for closing remarks.

Thank you, operator, and thank you, everybody, for joining us. As always, we appreciate you spending the time with us. To the extent you aren't able to, you want to listen to the replay of the call or you just want to call in with questions, we are more than happy to take your calls. The office phone number is 772-231-1400. Otherwise, we look forward to talking to you next quarter. And our next dividend announcement will be out in mid-August. I hope everybody stays safe, and look forward to talking to you next time. Thank you.

Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.