Orchid Island Capital, Inc. Q2 FY2022 Earnings Call

Good morning and welcome to the Second Quarter 2022 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, August 5, 2022. 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. Welcome everybody to our call. Wherever you can join us on, if you can't join us live, I hope you're able to do so via recording. We're going to assume that everybody has been able to download the deck that we used every month, and once more, we'll be going through the deck as a driver of the agenda for the call. As always, I'll just give you a quick walkthrough to highlight the agenda. We'll discuss our highlights for the quarter and financial highlights briefly, and then as usual, we'll go through the market developments just to show you what shaped our performance, and then we'll go into our financial results in more detail, and then the portfolio characteristics, hedging, and so forth. So with that, our financial highlights for the quarter, we had a net loss per share of $0.34. This included net earnings per share of $0.12, excluding realized and unrealized gains and losses on our RMBS assets and derivative instruments, including net interest expense on interest rate swaps. We had a loss of $0.46 per share from these realized and unrealized losses on our RMBS-driven instruments, again inclusive of net interest expense on our interest rate swaps. Book value per share was $2.87, or was at June 30, 2022 versus $3.34 at March 31, 2022. In Q2 2022, the company declared and subsequently paid $13.05 per share in dividends. Since our initial public offering, the company has declared $12.77 in dividends per share inclusive of the dividends declared in July of 2022. The total economic loss for the quarter was $33.05 or 10%. Now looking to market developments on Slide 6. The one thing that really sticks out here is, and again, what we show here, the Treasury nominal curve and the swaps curve both at March 31 and June 30, but then also as of last Friday, which is June 29. One thing that sticks out very clearly here is that the front end of the curve has been moving the most. If you look at either curve on the left or right side, and you move from the blue line to the red line, to the green line, which goes through time from March through last Friday, you can see that the front end of the curve continues to move higher. The long end actually, especially through July, is lower than what it was at June, and the curve is quite inverted and has inverted even more so today. This basically reflects the fact that the Fed is going to continue to raise rates very aggressively because inflation is at very high levels. That notion was probably reinforced meaningfully this morning with the payroll number. And the market — more importantly, as importantly, it affects that these hikes are to be effective at containing inflation ultimately, and therefore you see the long end of the curve not selling off. This would not be the case if the market feared that inflation could become fully unanchored. The fact that the Fed is seeing even stronger data than they had as of yesterday further suggests that they'll have to hike as much as they probably will to contain inflation, increasing the chances that those hikes ultimately lead to a recession. This is another reason that the long hedge has rallied. Last week, when we did have the Fed meeting, the market's perception was that maybe the Fed had pivoted, that they saw some early signs of weakening in the economy, and perhaps they wouldn't hike as much as feared. But once they came out of their blackout period, pretty much every single Fed speaker since has pushed back hard on that notion. In essence, the market had to do its own pivot and now reflects the fact that they acknowledge that the Fed is going to have to be very aggressive and data dependent. As a result of that data dependence, days like today are going to tend to have outsized responses if the data is outside of expectations. Today, nonfarm payroll and CPI numbers will be very important for the market, and you're likely to see reactions as you did today. So that's really what's going on. You just see this meaningful inverting of the curve; 2s and 10s is getting to extreme levels. This morning, the meteoric reaction to the number—I think we got close to 40, and we backed off of that, but it's very inverted. Moving through the rest of the slides, Slide 7 shows you the 10-year trait and swaps and SOFR swaps. A longer look back shows a meaningful sell off into mid-June and then a subsequent rally when the Fed had to pivot. Turning now to Slide 8, this is a new slide that is very important. One thing we did was change the period basically to cover what I would call the pandemic period. The beginning of the slide is the end of 2019, where you had a huge rally when the pandemic started. Over time, it crept higher as we entered 2021. Rates started to move a little higher, but then in the second quarter, maybe even when the war started in Ukraine in late February, the data started to become even stronger, especially inflation data. The effect of the war and the lockdowns in China started to really grab the market's attention and focus the Fed on the fact that inflation wasn't transitory; it was becoming ingrained, and they were going to have to react. In fact, they did. You see the rates market selling off into the second quarter. The peak there was around the middle of June 10. You may recall that CPI number was very strong, and the University of Michigan data implied that inflation expectations had become very high, leading to a significant sell off. July has been a recovery month, but we'd come off those peaks driven by the Fed’s response. They hiked as much as they did; remember 75 in June and again in July. It seems likely they may do 75 in September. For us, as mortgage investors, on the right-hand slide, we show the spread of the current coupon mortgage to the 10-year Treasury. Various ways to look at mortgages versus swaps, LAS, but I like to look at this just because it seems to work better over long periods of time. What we don't show here, since this data only goes back to the beginning of 2020, is where these numbers were. Mortgages traded at a well-defined range between 60 and 80 basis points for years. There was a spike in March, a rally from the Fed buying, bringing it to a very tight level. Then we saw the sell-off. On the right side of the page, that spike was June, right after the CPI number; the following days even the 10-Year Treasury fell, but Fannie 3s were down multiple points—meaningful underperformance. They have since rallied in July, but the takeaway is that mortgages are trading around a 120 basis points spread, even though that's off the extremes, it's still very attractive versus long-term range of 60 to 80 basis points. This is why we're comfortable as managers of the mortgage portfolio; we really like the market going forward. Data like today, which implies the Fed is going to have to hike even more, probably just increases the chances that this hiking leads to recession, which will cause the long end of the curve to rally. As owners of mortgages, I think we're poised to do very well. They are trading at attractive levels versus long-term norms. They don't have any credit components, so if we enter a recession, unlike investment-grade corporates or high yield, which could widen further, mortgages should perform well. I don't think the Fed will be selling mortgages certainly next year if it looks like the economy is about to move into a recession. We believe the mortgage market is poised to do well for the remainder of this year and into next. Specifically, with respect to Orchid, we'll get into this more later in the call. Orchid has retained a high concentration in 30-Year fixed rates, what we call belly coupons, 3s and 3.5s, compared to 2s and 1.5s or higher coupons, current production coupons. We think they'll do well in a rally, and we also like the securities. The takeaway from this slide is that mortgages look attractive, and given the way we see things playing out over the next year and year and a half, we think mortgages could do well as an asset class, and we like the way Orchid is positioned for such outcomes. Moving through the slides, Slide 10 shows a proxy for the curve's shape. We are inverted; we are much lower than 33 basis points on the 5s, 10s spread and are likely to stay this way for the time being. Slide 10 is another slide that shows the holdings of agency mortgages by the Fed and commercial banks. As the Fed went through QE, they were depositing reserves into the system, meaning that the banks holding those reserves were investing in mortgages. These were the two largest buyers. With the Fed entering QT, they will be draining and not buying as many mortgages, meaning the onus to support the mortgage market will shift to money managers and rates, which we expect as we move into 2023. We very much like the market in spite of this and expect the mortgage market to perform well. On Slide 11, the top left shows performance of certain mortgages. These are all 30-year fixed rate mortgages, 3.5s, 4s, and 4.5s during the second quarter and into July. The scale on the left is normalized to 100. Notice that at the trough on June 14, 3.5s were down over 6 points; a considerable move in a short time. They have since recovered, but it was a big move for the mortgage markets in June. Below, the roll market shows the blue line as the 3.5 coupon, which has been special for several weeks. Other than that, roll levels aren't exceptional, and the lower coupon rolls are essentially zero. While still reasonably attractive, it's not as attractive as when the Fed was doing QE. On the top right, we show the 85-K loan pool, which reflects subdued payoffs. This week we had our origination cycles happen on a very volatile day, with a big selloff in the market leading to approximately 10 billion in spec pool auctions that did fairly well; a good sign for the spec market. We see a shift from the roll market towards specs, which may not play out fully in the upcoming months, but it should continue in the next year, especially if the economy enters into a recession. Slide 12 shows a proxy for three-month by 10-Year normalized volume. This remains elevated. Given where we are with the Fed's intentions and their statement of being data dependent, it means the market will be hyper-focused on meaningful data points. Any data printing outside of the expected range will likely see Vol bid. I would be surprised to see Vol decline meaningfully until the end of September and perhaps beyond. Looking at Slide 13, this is historical information. OES levels for production coupons are much more attractive than when the Fed was doing QE—back in 2021 when Fannie 2s and 2.5s were production coupons and OES levels were negative. Now we're at least producing 4s and 4.5s at positive levels. So the market looks much better in that regard. Moving on to Slide 14, the second quarter was a very challenging quarter for risk assets. Year-to-date, it is noteworthy to mention that it's unusual Treasuries had negative returns as did stocks. Typically they are negatively correlated. This emphasizes the odd combination of high inflation most likely due to the pandemic, leading to irregular responses from the Fed and government, resulting in high inflation not seen in decades and an aggressive Fed slowing the economy. This serves to explain why both asset classes performed poorly. With respect to mortgages, they were on the low end of the risk spectrum and while they did poorly, they outperformed other asset classes on a year-to-date basis. In July, there was a significant turnaround with risk; almost every asset class had a strong month, particularly higher-risk assets. Slide 15 shows the pandemic period data through today. Mortgage rates are high; the most recent data point was 4.99% on a 30-year fixed-rate, which is down from six but still higher than pre-2022. The percent of the mortgage market is very low. On the bottom chart, the percent of the mortgage universe in the money is essentially zero. While refi production has not been high, we have seen predominantly coupons in the 4%, 4.5%, and 5% range. It wouldn't take much of a rally for those securities to become refinanceable, which could impact the quality of carrying those assets positively. Lower coupons are discounts, and if we see a rally, there's upside via discount accumulation versus a premium. I'll now detail our financial results. On Slide 7, we decompose our results between mark-to-market gains/losses and carry. We were at about $0.12 versus the $13.05 dividend. These numbers don't capture premium or discount amortization and hedging costs. Our portfolio is all at a discount, which adds positively to earnings, given that we own seasoned bonds paying in the high single digits. Our hedges are in the money, helping from an income perspective despite a selloff and widening mortgage spreads. Slide 18 showcases how our yield on assets is trending slightly up. Our funding costs are rising, but the economic cost of funding is increasing at a slower rate, reflecting the help from swaps. As a result, our economic net interest spread is slightly increasing. How long that will continue is uncertain as the Fed's aggressive stance in the second quarter challenges the effectiveness of our hedges. But so far, performance remains strong. On Slide 20, our leverage ratio stands at 7.8 as of the end of the quarter. We have not reinvested pay downs of late, and our book value has recovered significantly. Our book value recovery quarter-to-date is in the mid to high single digits; it was close to 9%. Today, mortgages are having a rough day, and it is hard to ascertain, but we would assume that's on the high side, but can change at any given moment. We have enjoyed a nice recovery quarter-to-date. As a result, our leverage ratio is approximately under 7 now. On the right side, our leverage versus our peers indicates we are on the high end of the range. We aim to bring it down but not all the way to the level of peers; we want to eliminate some book value volatility. We will trend our leverage down and target the high sixes. In Slide 21, we see our dividend versus our peers. It is significantly higher, and we are anticipating an adjustment to the dividend soon, bringing it more in line with our book value. We need to position our yield closer to peers considering the leverage ratio, rate yield to book, and market conditions. This adjustment is likely to happen soon. Finally, I have a few more slides to discuss. Our capital allocation remains stable; the allocation between our two portfolios has remained the same. While the allocation across capital remains consistent, the portfolio size has shrunk slightly due to adverse market conditions. On Slide 24, not much has changed. We've eliminated our small position in 2.5s and maintained the 3s, which is the largest holding, and increased our allocation to 4s up to 6.9%. We may further increase that. Our small 15-year holdings shifted from 2.5s to 3.5s. As for the IO portfolio, we've harvested profits due to market sell-off leading to a lack of upside in IO positions. Other than this, the portfolio remains relatively the same as last month. Regarding speeds, everything is slow as expected. We had speed data come out last night, and while a significant drop was observed, we continue to see declines in speeds reflecting market conditions. Given we are moving into late summer, we don't expect significant changes. I want to highlight our portfolio's yield on the 10-year, which is significantly higher than in 2013 and 2014. Our portfolio is performing better than back then, as we own seasoned bonds paying a little faster. This allows us to accrete more discount, benefiting our earnings perspective. It's important to retain good carry bonds, which we believe is critical for going forward. Our spec pulls reflect a very attractive convexity due to depressed payoffs. In the case of a meaningful rally, these assets should do notably well and are relatively easy to hedge. The combination of owning more seasoned bonds enables better carry today, and we expect high-single-digit prepayments compared to low-single-digit new issues, offering substantial benefits. Thus, we are quite bullish on the portfolio moving forward for the rest of 2022 and into 2023. Moving on to our funding displayed on slide 27. We go back to the beginning of 2020, showing the gray line as the one-month SOFR. It's rising rapidly while our economic cost of funds is currently below the actual cost due to effectively executed hedges. Despite SOFR’s rapid ascent nearing 2%, we anticipate that our hedges will help mitigate the rise in funding costs. Concluding remarks summarize three basic points: we've seen some book value recovery. We like the portfolio going forward. The convexity of the portfolio is quite good, and the current challenges in the market bode well for us and mortgages in general. We expect to adjust the dividend to align it more reasonably with a lower leverage ratio and yield as well as the earnings available in the current market. Lastly, I'm considering a reverse split due to our stock trading at levels down to the 3s. We might implement a reverse split, as noted. That concludes my prepared remarks. Operator, we can open the call to questions.

We'll take our first question from Jason Steward with Jones Trading.

Appreciate all the color and remarks as always. Bob, where do you see terminal Fed funds ending up in this environment?

Well, it's probably going to be in the mid 3s or slightly higher. It's hard to say. Today, for instance, data looks strong, and the market reaction is obviously very strong, but diving deeper into the data reveals the establishment survey showed a gain of 528,000 jobs, while the household survey was only 179 last month. The household survey was negative, making it hard to believe the economy is truly adding jobs at that rate. Pervasive evidence shows the economy is slowing; it's too hard to ignore. Despite today's data, I believe we will continue to slow throughout the year. While the Fed must appear aggressive in the public's and markets' eyes, I find it difficult for them to tighten significantly beyond this year. So, will they see another 100 bps this year? Probably, but what's next is unclear. Perhaps one more hike, but getting to 4% seems challenging. That said, some inflation indicators are concerning. While commodity prices retreat, wage pressures are becoming ingrained, which poses risks that could force the Fed to tighten more than expected, leading to a potential scenario where rates could exceed 4%. Nonetheless, I’m sticking with my theory for the time being.

Jason, I think that plays into why we've held off on the dividend. Bringing or cutting the dividend back slightly also relates to the tremendous uncertainty right now. Six months ago, it would have seemed crazy to believe the Fed would hike by 75 bps in June and again in July. Now we find ourselves in this situation, so we need a bit more time to see how this affects the portfolio.

On the mortgage origination industry, what's your view on capacity right now and how that is going to impact prepayments going forward if that plays out as you expect?

I assume they're struggling to maintain it. The originated loans are low-hanging fruit, and we see a rapid decline in cash-out refinances. I believe they will struggle to maintain staffing levels. In Florida, we're in a very hot housing market, with people relocating from higher tax states to here. There are clear signs of inventory levels rising, though not yet troubling. They will likely be hard-pressed to maintain these staffing levels, which will eventually taper off.

Next we'll go to Mikhail Goberman with JMP Securities.

You mentioned some book value recovery; I was wondering if there's a number to that thus far in Q3?

It's like I said, it was high single digits until Wednesday. Yesterday, we saw softness, and today it is challenging to say. As I came in here, mortgages were underperforming by quite a few ticks—eight or ten ticks, that would bring it down to 6% or 6.5%. But it has been a good recovery. We own many belly coupons, and they've performed well, with most specs holding up fairly well, largely afield through the TBA front. Wednesday we were at high single digits; today's performance might take it down nearer to the 6-7% range due to mortgage underperformance.

Just one more question if I may, on expenses; I noticed expenses are up a little bit to just under 5 million this quarter versus about 4.7 last quarter. Are there any one-time items in there? Also, what sort of expense ratio or run rate level are you targeting? Are there any plans to reduce that 5 million down a little bit? Thanks.

We're probably on the high end of the range we'd prefer. The one-off changes we internalized are from repo operations and back office adjustments. We discussed earlier costs associated with getting that online; most are at the epiphany level. There’s an overhead reimbursement arrangement where some costs filter through. I expect that to come down; if we can recover more book value even with a lower leverage ratio, we might be able to maintain proper levels for the portfolio. At one point late last year or early this year, our portfolio surpassed 6 billion, which was comfortable regarding our expense ratio. Our portfolio has shrunk quickly due to market moves, so currently, we are at the high end of that ratio. We don’t envision any drastic necessity right now but would like to reduce that ratio.

Next we'll go to Christopher Nolan with Ladenburg Thalmann.

Bob, what's the leverage range you're thinking about? I know you referred to bringing it down.

Probably in the low 7s. It's not a hard number, but we are evaluating the market, our holdings, and hedges. We aim for the lower end of the range to manage book value volatility, which has been high recently. We believe we can operate at a lower dividend yield relative to book value. We've maintained a high premium to the peer average and don’t see that as necessary or prudent.

As a follow-up, what hints have you received in terms of how banks assess risk? Are they altering haircuts or similar aspects?

We haven't noticed any signs of that. We have plenty of balance sheet availability. No one in our space has faced significant trouble despite the market's erratic behavior over the past six months. We maintain constant communication with our lenders, and they all seem comfortable at this point.

There are no further questions at this time. Mr. Cauley, I'll turn the call back over to you for any additional remarks.

Thanks, operator. Thank you everyone for taking the time. As always, we’re available in the office for follow-up questions at 772-231-1400. In the event you need to listen to the replay and have questions, we’re more than willing to take any more questions. We look forward to talking to you next quarter.

This concludes today's conference call. You may now disconnect.