Orchid Island Capital, Inc. Q3 FY2021 Earnings Call

Good morning and welcome to the Third Quarter 2021 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, October 29, 2021. 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 provisions 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.

Thank you, Operator, and good morning. I hope everyone has had a chance to download the slide deck that we posted on our website last night, as I will reference it throughout the call. At the end of the call, we will open the floor for questions. First, I want to outline how we will proceed, which will be similar to previous calls. We'll begin with the financial highlights, then discuss market developments to provide context for our performance and positioning, followed by a detailed look at our results. Finally, we'll review our portfolio hedges and assets for a better understanding of our positioning. Regarding our financial highlights, Orchid Island generated net income per share of $0.20, with net income of $0.22 when excluding realized and unrealized gains and losses on our RMBS assets and derivative instruments, including net interest expense on our interest rate swaps. Net losses of $0.02 per share from net realized and unrealized losses on RMBS derivative instruments, which includes interest on interest rate swaps. Our book value per share rose by $0.06, from $4.71 to $4.77. The Company declared and paid dividends of $0.195 per share, bringing the total dividends declared per share since our initial public offering to $12.31, including one declared in October this year. The total economic gain was $0.255 per share, equating to 5.41% for the quarter, which is not annualized. Moving on to Slides 3 and 4, we always present our performance compared to our peers. The first slide shows our results alongside the stock prices of Orchid Island and our peers through September 30th. Total return is calculated using stock price and dividends paid. The bottom of the page features our peer groups, which have evolved over time as different companies have entered and exited our sector. The second page presents the same numbers using book value for total return calculations, capturing the change in book value plus dividends paid. This is shown with a one-quarter lag since we don't yet have all our peers' results for the third quarter. However, I will mention that based on early results, Orchid has performed well this quarter. These numbers are presented as a retrospective based on the end of the second quarter and broken down for various calendar periods. Moving on to market developments, I want to emphasize the significance of this analysis. Instead of merely discussing our results and positioning, we aim to provide a deeper understanding of why we achieved our results and how we are positioned looking forward. This exploration into market developments is crucial for grasping how Orchid is performing. Now shifting to slide 8, which we use each quarter to show a snapshot of the various curves of both the nominal cash curve on the left and the swap curve on the right, alongside Q1 data. As indicated on the right side, based on this snapshot, rates did not seem to change much. The only significant movement this quarter was a flattening of the curve. Observing the 5-year point in the curve shows that while long-term rates increased, they ultimately flattened. We've observed a meaningful flattening, which I will discuss further. I should also note that even though it appears rates didn't shift much, throughout most of the quarter, treasury rates were lower. While we finished the quarter with rates unchanged, most benchmarks reached their lowest yield of the year during this period. This drop can be primarily attributed to the severe emergence of the Delta variant, which caused significant uncertainty about earnings impact when it first appeared. I'd like to contrast the situations between Q3 and Q4, which I believe is important. The emergence of the Delta variant created considerable concern, yet consensus was strong that the market and economy would see robust growth once the variant faded and supplemental unemployment benefits ended in September. The prevailing belief was that once the Delta wave passed, strong growth—especially wage growth—would resume. The Fed had characterized inflation as transitory, believing it would dissipate as the pandemic receded and labor shortages improved. Fast forward to today, and we find rates rising at the end of the third quarter as expectations have shifted. People are beginning to realize that the situation may not unfold as previously anticipated. Although the Delta wave is retreating and supplemental unemployment benefits have ceased, job growth has not rebounded as quickly. While more jobs may come next week, they have not returned at the speed we expected. Additionally, growth expectations have steadily declined throughout the quarter. Initially, expectations were for strong growth in Q3, but we found out it was only 2%. There may be some rebound in Q4, but significant uncertainty looms for 2022. This represents a crucial change in our medium-term outlook that emerged over the quarter. Regarding inflation, current data, including today's release, challenges the notion of it being transitory. It appears that if it is transitory, it will last longer than anticipated, extending well into Q4 and likely into next year. Earnings calls from various sectors, including the S&P 500, reflect a similar sentiment regarding prolonged inflation. While the U.S. economy may not mirror global conditions precisely, our energy intensity has decreased over the years, meaning higher energy costs affect us less than in past decades. In contrast, other countries, such as Australia, Canada, and the UK, are reacting strongly to high inflation. Therefore, inflation has become a dominant narrative, with supply and labor shortages persisting longer than expected, which influences growth expectations not only for Q4 but also into 2022. This uncertainty impacts our immediate results but also informs our positioning, reinforcing our cautious approach as we await resolution on these uncertainties before reconsidering our risk profile. Moving to Slide 10, it illustrates the slope of the curve, showcasing a convergence between the yield on 5-year treasuries and 30-year treasuries. Historically, the 5-year treasury is most sensitive to rate changes. Currently, the market anticipates short-term rates to rise sooner, hence the reaction in the 5-year rate. Typically, long-term rates are more responsive to inflation, and we understand the reasons behind their movements. There are two prevailing views regarding current phenomena. One perspective, from an economist we follow at Cornerstone Macro, suggests that if the Fed intends to tighten policy sooner, the terminal funds rate may ultimately be lower, which could explain the decline in longer-term rates. The other perspective attributes fluctuations in long-term rates to substantial international capital flows, particularly in the rates market, which may not align directly with domestic economic trends but can still influence rates. Consequently, we have observed substantial movements in long-term rates that are not solely attributable to domestic factors. Regardless of the cause, we are witnessing a flattening of the curve that introduces uncertainty for leveraged bond investors like ourselves. We need to pause and observe how this situation evolves. Moving to Slide 11 and the mortgage market, I want to remind you that we entered this quarter and are currently defensively positioned. The top left of the slide shows the performance of various 30-year coupons, normalized to a price of 100 as of June 30th for comparison over the quarter. Mortgages performed well towards the quarter's end, as rates began to increase and the Fed indicated a near-term taper of asset purchases following their September 22nd meeting. Consequently, Fannie 2s and 2.5s fell in price, likely reflecting these two factors. The top two lines on the chart, represented in red and blue, highlight the strength of those coupon roles, while higher coupons have experienced weakness, particularly with negative roles for the 4 coupon. A few spikes occurred, but generally negative. The perception has shifted to suggest a 3% coupon may soon enter the production window and the Fed's purchase calendar, driving the recent improvement in that role. Moving to Slide 12, the market snapshot appears relatively calm in the third quarter. However, as we progress into the fourth quarter, uncertainty, particularly regarding central bank actions and rate hikes, has increased volatility. On Slide 13, OAS levels indicate that production coupons, 2s and 2.5s, remain rich, suggesting it is not the ideal time to significantly increase our allocations, especially considering potential tapering and possible adjustments in rates. Some broader market observations are presented on Slide 14. The top of the chart shows quarterly returns; on the left side, fixed-income markets such as mortgages and treasuries are depicted with modest returns, close to zero. However, riskier assets have performed better, notably the tips market, which exhibited strong gains as investors sought inflation protection, driving prices up. Nominal treasury yields increased modestly, resulting in real yields declining and the break-even spread widening, leading to a successful quarter. Examining year-end results shows that most fixed-income market sectors are slightly negative, while riskier assets outperformed. The key takeaway for the first 10 months is that riskier investments have generally fared better than low-risk assets. Transitioning to refinancing activity, which is crucial for us, the top left indicates the REFI index versus average mortgage rates. We observe a convergence of these lines, indicating subdued refinancing activity alongside creeping mortgage rates. The bottom chart shows the percentage of loans in the money, which is also declining. Lastly, the primary-secondary spread appears to have reached its floor, with minimal room for improvement, as originators have maximized efficiency. Examining our financial results in more detail on slide 17, we present our performance by breaking down portfolio returns relative to our expenses, alongside realized and unrealized gains. We experienced unrealized losses of just over $11 million in our mortgage portfolio, reflecting a slight rate increase and softened spec pay-ups. We continue to hold a significant allocation toward spec pools with no exposure to TBA rolls, hence the softness in pay-ups. The hedges indicate a slight decrease in value alongside modest rate increases, contributing to the $0.02 loss mentioned earlier. Our pass-through portfolio delivered a strong quarter, with NIM reflecting both an upward coupon bias and low realized speeds. Additionally, we saw strong returns from our allocation to structured assets, particularly IOs, which provide positive returns and carry benefits. Moving to slide 18, our NIM remained stable, with asset yields having decreased since the pandemic's onset, but began to stabilize this quarter. Our funding costs, affected by our hedges, gradually declined, leading to a stable NIM with a slight uptick this quarter. The near term appears positive as we head into the year's end. Slides 19 and 20 contain historical information illustrating our capital allocation. On slide 21, we highlight capital raised through our ATM this quarter, resulting in a 22% portfolio increase. As the portfolio expanded, our allocation to IOs grew by approximately 3% in percentage terms and nearly 50% in dollar terms. We believe increased allocations to IOs serve as a hedge against potential interest rate increases while being less sensitive to mortgage basis widening, prompting us to strengthen this position. On slide 23, despite lacking last quarter's slide deck, our portfolio layout in coupons and allocations has remained constant. The 3% coupon continues to represent our largest concentration, maintaining a weighted average coupon of 2.96, down slightly from 2.97 at the end of Q2. As we progress through three months, the portfolio wall actually decreased as we've added more assets and slightly increased our allocation to specs. Notably, our 30-year exposure is nearly $4 billion, with a prepay rate of 7.6 CPR, which is lower than turnover—a very favorable result. That yield from such assets aligns well with low funding costs, resulting in a strong NIM. As previously mentioned, we have increased IO allocations, and more details on our selections can be provided during the Q&A following the call. Slide 24 highlights a slight uptick in our specs allocation, which we've held historically instead of TBAs, with new higher-quality assets generally being lower loan balances that saw slight increases this quarter. Slide 25 emphasizes the critical performance of our 3% cohort, which has performed well against the overall sector due to low realized speeds and the higher coupons that boost our net interest margins and ultimately drive our economic performance and dividends. Slide 26 offers more historical context, showing that speeds remain subdued, significantly lower than 2019 benchmarks. As we prepare for the future, our outlook remains favorable, with seasonal trends indicating marginally lower speeds for the next few months. Our leverage ratio appears to have dropped, but that is misleading. As of September 30th, our leverage ratio was 7.2. However, after capital raising through our ATM towards the quarter's end, we added significant cash that helped increase leverage to around 8.2 since finalizing 30-year mortgage settlements in October. Thus, leverage remains relatively flat. Given our defensively positioned strategy amid continuing uncertainties, we anticipate maintaining our leverage ratio in the low to mid 8s. Our final slide covers our hedges, reflecting changes since the end of the quarter. This table reflects the period from June 30th to September 30th. Since quarter-end, we've added some TBA shorts and long-end shorts in the futures market and the 10-year treasury. Regarding our hedges, we have restructured and expanded some of them, increasing their sizes, raising strike prices, and extending maturity dates while managing some profit-taking. The hedge book has continued to grow as the portfolio expands. It's worth noting that we increasingly rely on IOs and, to a lesser extent, futures for hedging rather than swaps, as swaps directly impact our funding costs until the Fed signals a tightening environment. Most hedge allocations currently favor swaps and IOs, with less emphasis on futures. That's all I have for now, and I will now open the call for questions.

Thank you, sir. (Operator Instruction) Your first question is from Jason Stewart from Jones Trading. Your line is open.

Hey, good morning. Thanks for taking the questions.

Hey, Jason.

I wanted to start by discussing the funding cost and your outlook for the fourth quarter. There are a few indicators to consider, and we generally experience some pressure as we approach year-end. What’s your expectation for overnight repo, excluding swaps? Have we reached a low point, or do you anticipate any pressure, or do you think it will be relatively smooth sailing until the year concludes?

I would say a brief word, and I'll turn it over to Hunter. As we always, when we approach quarter end and year-end, we always anticipate that pressure. So, we always tend to try to start layering in some funding over quarter-end. So that's no different than this quarter. And I'll give it to Hunter to talk about levels. We continue to see a high amount of demand for collateral. So, we get tapped on the shoulder every few days or so with the counterparties looking for more assets from us that they can repo. I haven't seen a lot of pressure, honestly; just anecdotally, we're here two or three months from the turn. Third parties tend to try to take in a little bit of that uncertainty. It's no more than a basis point or two right now, so if we're rolling something at 12 basis points for one month, we could probably do it over year-end for 13 or 14. So, not seeing a lot of pressure and still seeing a lot of demand for assets to repo.

Thank you for the information. Regarding operating leverage, I understand there's a management fee calculation. What are your expectations as you grow the equity base in the portfolio concerning the other operating line items? Should investors anticipate seeing operating leverage, and are you expanding the platform in any way? How should we approach this moving forward?

I can't really say we have any plans for the platform. However, we should continue to benefit from scale. Our variable costs mainly consist of the management fee, which is the largest expense, and our repo funding costs, which are significantly smaller. As we grow, we will continue to benefit from this, and the management fee is currently fixed at 1%. Going forward, as we raise capital, our weighted average management fees should decrease, and most of our cost structure is fixed, leading to dilution. We expect to see continued dilution of our cost structure as we grow. The majority of the capital we raised recently was at this lower marginal management fee rate, and we do not anticipate any significant increases in our fixed costs. These factors will contribute to operating leverage in the future.

Great, thanks for that. And then last one for me, and I'll jump out. I didn't hear a book value update. I heard the update on the hedges, and it looks like, based on my math, you closed them out at nice profits. Do you have a book value update for us quarter-to-date in Q4?

We don't have a hard number, but I would say it's down somewhat. That would reflect increase in rates and spec softness.

The softness Bob mentioned on slide 11 relates to the specific pools he discussed, which we are heavily invested in. We are still noticing weakness in specified pool pay-ups during the initial weeks of the new quarter. This slight decline is due to the volatile market amidst ongoing uncertainty. It is difficult to assess value at this stage in the quarter, as conditions can shift rapidly, but we are experiencing a slight decrease overall.

Yes, it's crucial to observe our performance next week as we enter November, especially with the option cycles. We've noticed less trading activity in the latter half of October compared to last year. Typically, there's an auction cycle at the start of the month, followed by a mid-cycle list, and sometimes a Cash window list in the final week. We didn't see that this time, creating some uncertainty about pay-up levels. The market will be closely watching next week, particularly since the cash window is likely on Tuesday. We'll have a clearer picture of those levels then. No updates have been provided, but based on current observations, our book seems to be down, likely around 1% or 2%. I can't provide a more specific figure at this moment.

That's perfect. Thanks for the color. I appreciate that. Thank you.

Yes.

Your next question is from Christopher Nolan from Ladenburg Thalmann. Your line is open.

Hi, guys. Hey Bob, on your comments in terms of the overall yield curve environment, is it fair to say that your expectations are for a flatter yield curve?

Yes, it certainly seems that will continue to be the case. It's easier to understand what's happening at the front end of the curve, while the long end presents more challenges. I'll do my best to share my thoughts on that. This week has shown significant intraday movements. In the mornings before New York opens and during London hours, the market tends to be flatter, but then it swings back and forth throughout the day, leading to a very challenging week. Looking ahead, I suspect that if inflation remains persistent, it will keep the front end of the curve soft. As for the long end, it's uncertain, but it's difficult to envision a scenario where the curve remains completely still and flat. Additionally, I didn’t mention earlier that the spread between the 5s and 30s peaked at more than 150 basis points and has now decreased to just under 75; it's dropped significantly in a short time, and I expect that trend to continue. There appears to be some influence between the actions of various Central Banks and the Fed's decisions. It's advantageous that we have a meeting next week for further clarity, especially following the Central Bank of Canada's decision to halt quantitative easing and raise rates this week.

And then should we expect to increase capital allocation for IOs in the fourth quarter?

We had soft targeted 25; I think we're 21 and change. I would say we're probably going to continue to move in that direction.

Great. On page 23, you show your asset sensitivity in the portfolio characteristics. Are you planning to adjust this to have a more neutral sensitivity towards a 50-basis point rise in rates?

Yes. Short answer to that is yes. And I would say that one thing is we've been raising capital. It's been coming in quickly particularly this last quarter. So sometimes we add assets, and we try to do so uniformly, but get a little ahead or behind in one or the other. So, we will continue to add IOs, as I mentioned. Since quarter-end, we have increased the hedges. I mentioned we added to our treasury shorts, we added TBA shorts. We added some IOs. And we repositioned some of our swaptions. So, the profile would look differently today than it did at quarter-end. But the short answer to your question is yes.

Great. Thank you. I'll get back in the queue.

Yes.

Your next question is from Mikhail Goberman for JMP Securities. Your line is open.

Good morning. I appreciate you taking my question. Some of my inquiries have already been addressed, but I would like to hear your thoughts on the future of agency MBS spread widening or tightening and how you are planning to position the portfolio, assuming everything remains constant as it is now. We have seen considerable volatility recently, as noted. Do you anticipate a flatter yield curve moving forward? Additionally, in a more volatile scenario with increased spread widening, what are your expectations? Thank you.

I'll take that. I'll turn it over to Hunter in a moment. One thing to keep in mind is that we definitely experience good and bad days for mortgages, and we have a solid understanding of that. So, that will guide our expectations. However, it's important to remember that other sectors are also quite rich. There are numerous multi-sector asset managers in the market, and they engage in relative value trading. Therefore, mortgages typically won't get too rich or too cheap for an extended period. That's a fundamental principle. Mortgages are rich, and so is everything else. Tapering is approaching, and the market is aware of that. However, we also have bank demand, which acts as an additional support because, as the Fed injects reserves into the system, these reserves go to banks, and banks need to invest them. This is contrary to 2019 when they were reducing reserves, and we faced issues with repo due to banks hitting their liquidity ratios. Now, the situation is reversed; they have excess cash, so they’re buying. I would say tapering is crucial next week. If the announcement differs from market expectations, we could see a quick widening, but ultimately, that will just create a buying opportunity. Hunter, do you want to add anything?

No, I totally agree with that. I think that every buying opportunity has been well received over the last year or so, I guess. Obviously, we're in a state of free fall right after the pandemic outbreak, but that stepped in, shored up the market. And since then, any marginal lighting has been met with buying.

On the yield front, we consistently observe yield-based buyers entering the market whenever rates rise slightly, typically from unlevered money. Levered money usually follows when spreads widen. If we continue to fluctuate within this range, I don't anticipate any significant changes; we will likely keep witnessing a gradual emergence of burnout in the portfolio. Our primary concern is a potential inflation scare that leads to a spike in rates, although this appears to be less of an issue at present. We must always be vigilant about it. Given our positioning in premium MBS specified pools, in such a scenario, I believe the portfolio would perform reasonably well for the next 25 or 30 basis points. We might see spreads tighten on our assets because the refinancing incentives are fading. We have increased our exposure through the use of IOs and have focused on acquiring mortgage assets that will see significantly reduced refinancing incentives in the next 25 to 50 basis points. This is why our profile may often appear skewed negatively when rates rise by 50 basis points. Empirical evidence suggests that the types of assets we typically hold perform well in that situation. Additionally, we've been cautious about engaging with the Fed regarding production coupon TBAs, which makes us somewhat unique. We have been avoiding the temptation of the falling market in Fannie 2s and 2.5s due to their poor negative OAS relative value. We are concerned that those assets will be the first to widen during a taper. Those are my thoughts.

One additional point I would like to mention is regarding the market's evolution. If you analyze the current market pricing and compare it to what Paul indicated during the September Fed meeting about tapering potentially finishing by mid-summer, there is a notable contrast. The Fed Funds futures contracts show initial tightening, which differs significantly from the previous cycle where there was a lengthy pause between the end of quantitative easing and the first rate hike. The market appears to be misaligned with expectations of a scenario similar to the last cycle. If inflation were to worsen and the Fed decided to accelerate tightening, they would likely avoid raising the Fed funds rate concurrently with asset purchases, leading to a quicker tapering process. This potential outcome is not what the market currently anticipates, despite indicators from the Fed funds market. Consequently, we could observe production coupons soften rapidly, prompting investors to either sell those lower coupons or shift to higher ones. Our positioning reflects this possibility. I don’t foresee any scenario where they would delay tapering or extend it unless unforeseen economic changes arise. The risk lies in them being compelled to speed up tapering, which could lead to a decline in production coupons, ultimately benefiting us. In such an environment, we find ourselves in a strong position, as our leverage ratio is lower than usual, although not as low as some who are awaiting buying opportunities. We have room to increase leverage if a buying opportunity arises. More importantly, we have recently been effective in raising capital, which we plan to use judiciously to acquire assets at more favorable prices if such scenarios develop.

Got it. Thank you, gentlemen. That's very, very helpful.

Thanks, Mikhail.

Your next question is from Kevin Jones, Investor. Your line is open.

Hello? Hello, Kevin.

I didn't have a question. I just called in to listen.

Well, glad. Thank you for doing that.

I'm at a loss for words.

All right. Well, thanks for calling. Have a great weekend.

This concludes today's conference call. Thank you for participating. You may now disconnect.