Orchid Island Capital, Inc. Q3 FY2020 Earnings Call

Good morning, and welcome to the Third Quarter 2020 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, October 30, 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 and are subject to risks 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. Robert Cauley. Please go ahead, sir.

Good morning, everyone and welcome. I hope everyone had a chance to pull our slide deck off our website last night. As usual, I'll be going through the deck; I won't necessarily touch on every slide, but they're all there for your reference as needed. As always, I'll start on slide three, which is just the table of contents. Just to give you an outline of the agenda for today. The first thing we'll do is just give you a summary of our financial highlights for the quarter. Then I will spend some time talking about the market developments in the background for the quarter and how that influenced our results. And then I'll go into our financial results, in more detail, and then finally delve into our portfolio credit hedge positions in some detail. With that, I'll get started. With respect to the quarter, we generated net income per share of $0.42 and earnings per share of $0.33, excluding realized and unrealized gains and losses in our RMBS and derivative instruments, including net interest income on our swaps. We had a gain of $0.09 per share from net realized and unrealized gains on our RMBS and derivative instruments, including interest on our swaps. Book value per share at the end of the quarter was $5.44. This is an increase of $0.22 or 4.21% from the value at June 30th. During the quarter, the company declared and subsequently paid $0.19 per share in dividends. Since our initial public offering, the company has declared $11.525 in dividends per share, which includes our most recent $0.065 dividend declared in October, payable in November. Total economic return was $0.41 for the quarter or 7.9%. That is not annualized. Turning to slide five. In this slide, we show our performance on a stock basis. This calculates total return based on the change in the price of the stock and dividends paid. This is through September 30 of 2020. The peer group that is listed in the middle column is actually described on the next slide. I apologize for that. We typically show these slides in the opposite order. But the peer group is described on the next page. And what we show here is Orchid return in the first column. On the top, we show to-date returns. In other words, year-to-date with a one-year look back two-year and so forth. And in the middle column, our peer average, and then our performance versus the peer average. So, as you can see looking back year-to-date, one-year, two-year, three-year, all the way back to inception, we've had very strong performance relative to our peer group. The bottom of the page, we show these returns for calendar periods. So, for instance, the top row is the third quarter of the current year. And then we go back through the various calendar years, all the way back to 2013, which was the period when we had our IPO, again very strong relative performance. The next slide basically shows the same thing. This is book value based total return. So, total return would be calculated as the sum of the change in book value plus dividends paid. As we as often the case, we do not have all of the return data for our peer group for the third quarter. So we tend to show this data with one-month or one-quarter lag. And in this case, the most recent day will be the second quarter of 2020. And it's the same format. On the top, we show one-year through six-year look backs, including inception to date. And on the bottom, it's for the calendar periods. With respect to the most recent look back data, again from the second quarter of 2020, all the way back to inception. As you can see very strong returns relative to the peer group and even with the calendar periods strong as well. Now, I'd like to talk about market developments on slide eight, and we have a few slides here to give you a picture of what happened in the market. The most important thing is the fact that rates are relatively stable. As you can see on this slide, both cash and swaps were relatively unchanged for the quarter. This makes for a very favorable rate environment for levered MBS investors. We have reason to expect that this will probably continue into 2021 given the state of the economy and Fed policy. If you turn now to slide nine, you see the same kind of thing in pictures only this year. In this case, we're showing 10-year treasuries and 10-year swap rates, both for the quarter and with a two-year look back. If you focus on the right side of the page, as you can see, really since March, we've been in a very stable rate environment, which is again very favorable for both leveraged investing and mortgage-backed securities as well. Turning to slide 10, we show the spread between the five and the 30-year treasury. What's notable here is the simple fact that even though rates have been stable, where we have seen movement, it's been on the long end, as the front end of the curve is anchored by Fed policy. So, we've seen a steepening of the curve, which is favorable for mortgage investors because it has positive implications for both carry and also prepayments. Although, I have a lot more to say about prepayments in the next few minutes. Now, let's turn to slide 11 and look at the mortgage market. There are several slides here that are very important and this is really what drives the decisions we make with respect to the deployment of our capital. I want to start by saying that the market today is very much dominated by the Fed. As we all know, the Fed is a very active purchaser of mortgages. They typically... they do not buy spec pools and they tend to focus their purchases on the production coupons. Most production has been drifting down. In fact, the day before yesterday, the Fed announced they would be buying 1.5 starting in the next cycle. What typically happens is they add one coupon and drop another. The one that gets dropped suffers. If you look in the bottom left, you can see the dollar loan market for various coupons. Notice that red line there, that was for Fannie 3s, when they dropped out of the Fed's purchase bucket, since then 2.5 were expected to be dropped. It turns out they were not just reduced, but that coupon has languished over the last few weeks. That all being said, the two mark... Fannie 2s, Fannie 1.5s, those roll markets are very strong. The net interest margin in that market is very attractive. These bonds were implied financing that is materially negative, and the all-in spread is 200 to 250 basis points, making it a very attractive market to invest in. As I said, the Fed is dominating through their purchases of the production coupons, which basically means the coupons they're not buying are languishing. If you look at the top left, you can see these lines for various coupons, and the TBA form, they have not done particularly well. With respect to 4s, 4s are not produced anymore, and so, it's not a current production TBA coupon. Really, what you're seeing there are more seasoned bonds, which have been beaten up so badly that they did recover somewhat this quarter. What this means is given that the TBA market, other than the production coupons, is so weak. The alternative area to invest in is the area that we invest heavily in, which is the spec market. If you look on the right side of the page, you can see the low loan balance, $85K Max, 3.5s and 4s, those pay ups are at extremely high levels. Just now going through the most recent cycle, they remain very elevated. In the bottom right, we show pay ups for just new production coupons. Those are less desirable because the advantage of that carry is usually fleeting and only lasts a few months. But in the spec pools, especially the higher quality ones, they have very attractive carry versus TBA. And as a result, those pay ups remain very much in high demand. Moving on to slide 12, we just show a picture of implied Vol in the market. As you can see, it's at quite a subdued level at the end of the quarter. Since quarter-end, in anticipation of the election, there has been some movement higher. Although, I would suspect that once the outcome of the election is determined, which may or may not be on Election Day, I would expect that to fall off as well. The next slide is basically historical information, which is not irrelevant for today's discussion, so I am going to skip that. Slide 14 shows you, as we always do, returns across various asset classes. Many of the investors we compete with are investing across multiple asset classes. This gives you a nice picture of the roll market. As you can see on the top of the quarter, on the right-hand side, the riskier sectors high-yield, emerging market high-yield, and the S&P 500 did very well. It's been generally a risk-on environment. This has been a result of Fed policy, fiscal policy, although we haven't quite seen much of that lately, but generally it's been strong or rumored to be strong in the near future. As a result, risk has done well. Safe haven assets have done a little less well. If you look at the entire year, year-to-date, you can see that S&P at least to the end of September is only up modestly. Emerging market high-yield is negative, and a lot of them were safe haven or less risky assets still look very attractive on a year-to-date performance basis. Now turning to slide 15. This is a little more relevant for us. A couple of things I want to point out. If you look at the top left, the blue line is the level of the mortgage bankers association refi index. As you can see, it's quite elevated. It's moving in a very narrow range, but at a high level. The red line is the mortgage rate available to the borrower, and you can see it continues to drip down and is now under 3%. We expect that to continue. If you look at the right side, you see the primary-secondary spread and for the period over say 2019, that spread was a 100 or a little over. It's still quite elevated, and as a result, there's still room for that spread to continue to come down. We expect that it will. Originators are adding capacity. The mortgage origination business is very robust. The housing market is very, very solid. In spite of all of the impact that COVID has had on the economy, it's not really reflecting the performance of either the housing market or the mortgage finance market. They are both very robust. This spread has implications for us in that we continue to focus on the spec pools. The reason is, as I've mentioned, even if rates were to go higher, this spread could compress. Therefore, the red line on the left-hand side of the page could still be very low, which would keep refinancing activity very high. We expect, with a high degree of confidence, that speeds will remain fast for some time. This gives us comfort with all-in spec pools realizing that rates could probably go up to 100 basis points, probably as high as 110 or 120 before we think you'd see a meaningful impact on speeds. I just want to let the listeners know that I was told that the link to the presentation materials was not working or was missing from the website. That's been remedied and is now there. If you're trying to follow along and did not have the materials, they should be on the website now. I apologize profusely for that. Sorry. Thank you for bringing that up, Hunter. I'll give everybody a moment here to catch up to the extent they're just getting the slide deck. My next slide, I'm going to discuss slide 17. We're going to start talking about our financial results. As usual, we continue to use the same format. Hopefully that makes it easier for our listeners to follow quite easily. On the left-hand side, this is the decomposition of our earnings. You can see we show at the bottom our earnings per share, our proxy for core; although, it's not exactly akin to what most of our peers report, but it does disaggregate the $0.42 per share and show the realized and unrealized gains on a separate column. As you can see, it's noteworthy that the realized and unrealized gains on our RMBS assets and our hedges that they're all positive. That's not typical. Obviously, it's something we welcome, but it just shows that the quarter was very favorable for us. On the right-hand side, we show the returns from our respective strategies, pass-through and our structured securities, mainly IOs. As you can see, the 9.6% return was very strong, not quite as strong as the second quarter, but nonetheless, a very high number that we expect to continue as long as this current environment remains. We expect to do so. Looking at slide 18, we've kind of described this environment, which we see is very favorable and expect to continue going forward. Nonetheless, if you look at the green line on the top of the page, we can see that the economic return has stabilized and improved from the troughs of recent past. We expect NIMs to remain quite strong, especially relative to the absolute level of rates. That's why we're bullish on our performance moving forward. Slide 19 is just another picture of the same story showing our core versus all-in earnings per share. Slide 20 shows our capital allocation, which continues to drift more towards pass-throughs, deemphasizing IOs of late, and using other hedge instruments, which has not materially changed. As I mentioned, the IO position has continued to dwindle. We may replenish that, although we are not looking to build that in a meaningful way. In the near term, we'll be using a Vol related rate products, such as swaptions and combinations of swaptions as effective hedge instruments for us. Turning now to the portfolio on slide 22. This picture does not look materially different than what you saw at the end of the second quarter. In fact, if anything, we probably made more changes since the end of the quarter than you saw during the quarter. So, since the end of the third quarter, the TBAs, as I mentioned, are a very attractive investment area. We have increased those positions, we are now up to about $465 million. With respect to our pools, which are almost all backed up, or all spec pools nearly, we have reduced our exposure to some of the higher coupons, 30-year 5s, and 30-year 4s, and have added to 30-year 3s. Otherwise, not a lot has changed in that regard. Slide 23 again just shows that our allocation to the spec pool market, which is high quality specs, remains very high. This is a cornerstone of our strategy with conjunction with the TBA market, and we expect this to remain high for the foreseeable future. The next slide shows the benefit of doing so. In this slide, we're showing our prepayment speeds for the most recent three months, the three months of the third quarter, in comparison to the Fannie Mae fixed rate coupon cohort. For each respective column, it's as indicated, 30-year 3 or 30-year 3.5. These are all Fannie Mae cohorts. Some of our securities are, in fact, Freddie, but the results would not be materially different if we were to combine them. As you can see, our securities have been prepaying at a very small fraction of what the cohort has. Looking at the bottom right, you can see the rolling four quarters, the most recent four quarters in each case, what we're showing here is how our securities have prepaid as a percentage of a cohort. With the exception of 30-year 5s, which we've since reduced, they are very low in most cases, well under 50% of the cohort. That's critical for us to maintain the carry and the returns that we've been able to generate. Slide 25 is just one point I want to make. Here, you can see the orange line is the 10-year treasury. As you can see, it's dropped and stabilized at the current level. The green line is our prepayments. This is shown to normalize the effects of changes in the portfolio side. All we're really doing here is dividing prepayments and dollars by the unpaid principal balance of the portfolio. As you can see, with an extremely low level of 10-year, while it's elevated versus norms and slightly outside of one standard deviation above the mean, it's still lower than it was in 2019. Our allocation to spec has paid off, and we've been able to realize attractive returns as a result. A few more points before we wrap up and start the Q&A session. Our leverage ratio continues to be in the high 8s, low 9s. We anticipate that being the case going forward, given the environment that we're operating in. Moving on, our interest expense, as you can see, is basically bottomed at $0.01, and it looks like we'll probably stay there for some time. Finally, on slide 28, I want to say a few points on our hedges. In the top right, we show our swaptions positions. As you can see, we've added to that slightly. We like these as hedges for two reasons. One, obviously, they give us positive performance in the event of a rate increase, but they also benefit to the extent volatility increases. We strongly suspect that if or when we do get a meaningful move higher in rates, it will be accompanied by a commensurate increase in volatility, and these instruments tend to benefit significantly when that happens. Our Euro/dollars on the top left are at pretty much a flat level. We do not anticipate adding to those. We have a modest position in treasury futures, and our swaps were stable, as you can see for the quarter. We may add to those, but not in the very near term. So, otherwise, that is it. I've run you through the market environment, our results, and our positioning. With that, we will open up the call to questions.

Thank you, sir. Your first question will come from Jason Stewart from JonesTrading. Please go ahead.

Hey, good morning. Thanks. Good quarter. How are you doing today?

Not too bad.

Good.

Yourself?

Good. Good. Thank you for taking the question. I wanted to dig in a little bit more on spec pools and wondering if you could give us some more color on the types of pools you own that you're favoring versus deemphasizing given your comments on primary, secondary in the current rate environment.

Sure. Yeah. This is Hunter, Jason. As we alluded to in that slide towards the end of the deck, we have a high concentration of very high-quality specified pools. These would be lower loan balance, $85,000 maximum balance within a pool, up to $110,000, $125,000 to a lesser extent. The higher loan balance stories have just not really been performing very well. So, 175 or 200K Max, while they're better than TBA, they're just not slow enough to avoid putting pressure on earnings if we have many of those in our mix. Therefore, 175 or 200Ks have never been much of a poorly positioned for us, and we have actually reduced some of that position even further. So, that's predominantly in the up-in-coupon space, 3s, 3.5s, 4s, 4.5s. We even have a few 5s, but it's not a huge position. In the lower coupon space, as Bob alluded to, we've been allocating more towards TBA trades and lower pay up stories. By virtue of the fact that they have relatively low note rates to the borrowers, they will tend to prepay a little bit slower. So, we've been transitioning a little bit of the portfolio into that bucket as well. To sum it up, I would characterize it as up in coupon, very high-quality specified pools, with more generic types, LTV, FICO stories, which just aren't going to really have much of an incentive to refinance from this point.

I have one brief point to that, Jason, is we probably deemphasized the New York story because of credit forbearance seen those elevated.

Okay. That makes sense. And when you pull that together with the big allocation of 3.5s recently, while it's pretty new, the CPR is quite impressive. When you pull all that together, where do you think CPR is trying to... assuming a constant state, that you don't make major changes, are we talking about a CPR that’s going to stay in the teens, do you think, or does it migrate into the 20s over time?

No, I think we're going to manage the portfolio in such a way that we would target those teens. The speeds that were released in October reflect paydowns that would have occurred during the month of September were on the fast side. I think it caught most of the market off guard as it was a bit of a surprise to the upside, just in terms of how fast the speeds were. I think going into the end of the year, we'll see speeds remain elevated. Going into next year, I think you'll finally start to see a little burnout kicking in. That, coupled with the fact that the GSEs aren't going to be buying out delinquent loans until they're 24 months delinquent, as opposed to 90 days, should give us a couple of CPR relief—which doesn’t sound like a lot, but for this portfolio, it has a meaningful impact on earnings.

And by the way, I did mention, Jason, that we had done substantial trading since quarter end. Most of that has been focused on bringing down the WAL (Weighted Average Life) of the portfolio. So, our WAL is probably lower than that number in the slides today.

Okay. Fair enough. One more, and then I'll jump in and let other people ask questions. When you think broadly about TBAs, where they're trading in terms of specialness, how high of an allocation of the portfolio could that get to, given how special they are today?

We're probably nine or ten to one specs to TBA. I could see it getting higher. I mean, they do carry extremely well, but there's a lot of duration with those. Of course, there's duration with specs as well. In a stable rate environment, they're probably a little more efficient from a cash management perspective because you don't get paid downs. You can get margin calls if rates move higher or lower, as the case may be. I could see it going higher. I know some of our peers—those allocations are quite high, probably more like a two to one ratio of specs to TBA. I don't know that we would get that high, but I could see it going higher. I don't have a set number in mind; it's more as we go through the month and see how the load is performing and what we're looking to... maybe unload, and where do we go into it. The market dictates how we do that.

Own pools if we can, but to the extent that the specialness in the roll markets is just so great, then we're obviously going to shift our allocation of capital towards that portfolio. I think it's around one and a half turns of leverage now. Yes, I could see that becoming double the position that it is now, if not more.

Thank you. Your next question will come from Christopher Nolan from Ladenburg Thalmann. Your line is now live. Go ahead please.

Hey, guys. Bob, did you indicate in your latest comment that TBAs could double from the current level or just clarify?

Yes.

Okay. Also, I mean, the EPS, the core EPS is very strong, much stronger than expected. It’s well above the mid-teen ROE target that you guys were discussing earlier. Given your outlook for continued stable rates and everything else, should there be any sort of update in terms of what your core ROE target would be?

It’s certainly stable. I don't see it dropping. I did try to mention that on one slide. We expect it to be stable. I know a number of our peers have had strong numbers. It just reflects the environment we're in. Like I mentioned, the TBA roll market and all-in NIMs are north of 200 bps in the specs pool space. They may not be quite that high, but also very strong. I wouldn't want to guide it much higher, but I would say that I see a high level of competence in staying where it is.

Okay. And then what does that mean for the dividend outlook?

Well, we've been raising it. Speeds are the biggest driver. Hunter mentioned that we did get a bit of a surprise this month. I think that was probably a combination of things that caused that. We did have, for instance, the first six months forbearance period, and there may have been some buyout activity related to that. Otherwise, the fundamentals—if you look at the refinance index, those kinds of things, those have been very stable. They wouldn't have implied an increase in the speed. I would expect them to normalize back to where they were. Another indicator would be origination. The third quarter, especially in that early fourth, origination was picking up, indicating that mortgages are being originated because of speeds, presumably. They are still elevated. It's not going to change. That's all I can say.

And final question. Do you have any sort of update to the book value since September 30th?

It's modestly higher, but it's not materially higher. I want to say a nickel, something like that, if that.

Great. That’s it for me. Thank you.

All right, Chris.

Thank you. Presenters, I'm seeing no questions on the phone line. Please continue.

Thank you, operator and thank everyone. Once again, we appreciate your time. To the extent you come up with a question later, or you didn't catch, I have a chance to catch the call live. Please feel free to reach us in our office. Our number is (772) 231-1400. Always look forward to your questions, and otherwise look forward to speaking with you at the end of the year. Everybody, please stay safe and talk to you again. Thank you. Bye.

Thank you so much, presenters. And again, thank you everyone for participating. This concludes today's conference. You may now disconnect. Thanks again and have a lovely day.