Orchid Island Capital, Inc. Q1 FY2023 Earnings Call

Good morning and welcome to the First Quarter 2023 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, April 28, 2023. At this time, the Company would like to remind 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 the 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. Thank you for joining us today. I hope everyone has downloaded our slide deck from the website, as we will be reviewing it. I'll walk you through the agenda, starting with a brief overview of our quarterly results. Then, I'll discuss the market developments we experienced, our financial results, and provide more details on our portfolio characteristics and hedge positions. Additionally, I want to take some time at the end to discuss significant developments in Q2, particularly those affecting mortgage participants, which are important for our positioning and outlook moving forward. We're turning to slide 4 now. Orchid Island reported net income per share of $0.09 and net earnings per share of negative $0.24, excluding realized and unrealized gains and losses in RMBS and derivative instruments. We realized a gain of $0.33 per share from these instruments, including net interest income on interest rate swaps. Our book value per share as of March 31 was $11.55, down from $11.93 at the end of 2022. In Q1, we declared and paid dividends of $0.48 per share. Since our last initial public offering, we’ve declared $65.29 in dividends per share, including the April 2023 declaration. For the quarter, our total economic gain was $0.10 per share, or 0.84% unannualized. It's important to note that all assets and hedges of Orchid Island are held at fair value, and therefore, fluctuations in their value are reflected in our earnings as they occur. Now, let's look at slide 6 to discuss market developments. This slide illustrates that as time progresses, the peak of the curve has shifted further left, indicating the market's perception that the Fed is nearing the end of their rate-hiking cycle and that a recession may follow. However, the movement in the curves has been minimal, ranging 30 to 40 basis points, which downplays the significant volatility we have faced in the market, particularly in the mortgage sector. In the first quarter of 2023, we saw a continuation of the volatility from 2022, with shifting market conditions impacting everyone, especially in the mortgage market. The first phase of the quarter, ending in early February, reflected beliefs that inflation was decreasing and that the Fed was nearing the end of their tightening cycle. However, a strong non-farm payroll report in early February changed those expectations dramatically. The two-year treasury yield exceeded 5% in early March, and the market anticipated a terminal Fed funds rate above 550 basis points. Then, the failure of Silicon Valley and Signature Bank in early March prompted a shift in market perceptions, with a significant decline in the two-year treasury yield. The banking crisis raised concerns that the Fed would have to adjust monetary policy and tighten credit conditions. Despite efforts by the Fed and the Treasury to contain the fallout from these banking failures, the outlook remains sensitive to further developments, including the recent instability surrounding First Republic Bank. As we move to slide 8, we look at mortgage relative value measures, including the current coupon spread of the 10-year treasury. While we did experience a spike in spreads during 2020 with levels reaching 165 basis points, we surpassed that last fall with 190 basis points, positioning today in the low 170s. Moving quickly through the subsequent slides, you'll note that the 5 and 10-year points of the curve are less relevant due to the current shape of the curve. On slide 10, you can see that bank holdings of mortgages have fluctuated since the Fed's introduction of quantitative easing in April 2020, with current QT measures leading to reductions. Slide 11 shows the performance of select mortgages throughout the quarter, with an initial strong performance followed by struggles amid rising rates and bank failures, resulting in lagging mortgage performance. The anticipated supply from FDIC liquidations poses a risk to the mortgage market, along with softening roll markets. Turning to slide 12, there’s a notable movement in volatility implied in the 3-month by 10-year swaption, though still high compared to pre-pandemic levels. Slide 13 illustrates widening mortgage spreads, while slides 14 and 15 reflect on mortgage performance in Q1, where mortgages performed reasonably well compared to other fixed-income assets. On slide 16, we present our expectations for prepayment speeds, which remain muted. We anticipate this trend continuing until a clear pivot from the Fed occurs. In terms of funding, detailed on slide 27, we have stable access to funding without any issues. On slide 28, regarding hedges, we have made adjustments, including additions in TBA shorts and swaps, effectively managing our exposure in this high-volatility environment. Our strategy has allowed us to maintain a low coupon bias, positioning for stable total rate of returns moving forward. In summary, our first-quarter results showcase our robust strategy. We anticipate nearing the end of the Fed's hiking cycle with an impending slowing economy. Given our current positioning, we are well-prepared for the market landscape as it evolves and will continue to look for capital-raising opportunities to enhance our allocation. Thank you, and I’ll now turn the call over to questions.

Our first question comes from Jason Stewart from Jones Trading.

Hey, Bob. Thanks for again all the great comments. So, it sounds like you’re going to say up in the coupon stack…

We have a lower coupon bias and a high concentration in 3s. We've also added some 4s and 5s, but we are aiming to avoid the top of the stack. We anticipate that the markets and the economy will decline, and we expect duration to perform well in that scenario. Higher coupons seem to be quite vulnerable to this change and are the more obvious choices. If the mortgage bankers are looking to refinance, we expect those to see very high speeds. The lower coupons, which are relatively easy to hedge and have duration, should perform well in that context.

All right, agreed. And what’s your view on natural turnover in housing right now?

It’s very low. It’s gone down to the mid single digits and is trending lower. There are many issues right now, one of which is that affordability is extremely low. The combination of high prices and high rates makes affordability very challenging. This situation is tough for new homeowners. Many existing homes are owned by people with very low rates, which gives them little incentive to move, as they would be replacing their expensive home with another expensive one, and their mortgage would be much higher. Therefore, I expect existing home sales to remain quite stagnant. Additionally, new home sales will face challenges due to low affordability and high mortgage rates. Overall, I anticipate that activity will remain low and is unlikely to change significantly until we see a notable shift in the market.

The first quarter was quite slow, so we anticipate a slight increase in activity due to the seasonal transition into the summer months, which should lead to somewhat faster growth.

And then do you have an opinion on the MSR market right now?

We don’t follow that closely, but I know that a number of our peers are involved. I think it’s more downside than upside. You’ve seen a lot of the large banks that G-SIBs move away from the market. I’m sure you know more than I do. For instance, Wells has been selling some of theirs. That asset in the current market is very great carry. But I don’t see a lot of upside for it in the future. It’s very tricky to hedge right now. So, and I think that the new production would be particularly challenging to the extent that the MSRs that are created off of these new higher mortgage rates are going to be. If our view of the MSR market parallels what we’ve done in IO space, which I think it does, we’re not seeing that as a great asset class.

Our next question comes from Mikhail Goberman from JMP Securities. Please go ahead. Your line is open.

Hey guys. Good morning. Thanks for taking the call. Just a couple of real quick ones. Could you guys give an update on book value for the quarter thus far? And the 6.5-time economic leverage figure you guys gave, is that a March 31st figure or is that a current number?

Both factors are at play. The book value has decreased slightly, so in response to your first question, we experienced a decline of about 2% as of last Friday, with an additional drop of approximately 1.5% this week due to the situation involving First Republic. Mortgages have widened, and as I mentioned during the call, we are likely 5 basis points wider than we were last Friday. This situation is somewhat confusing because, unlike the cases with Silicon Valley Bank and Signature Bank, the information available suggests that First Republic's balance sheet holds very few agency mortgages, around $2 billion to $3 billion. Instead, it contains mostly unsecuritized whole loans, which makes liquidation challenging given the limited size of that market. However, it’s important to note that this week, the market has reacted to every news update regarding First Republic Bank. The impact is significant because liquidation began last week, and they stated that the process would take 30 to 40 weeks, which is understandably lengthy. The procedure has been adjusted, allowing some option lists to be increased. For example, they might offer $150 million of a specific coupon, with the option to add another $100 million. While many of these trades have occurred at favorable levels, many buyers are increasing their purchases. So, it’s possible this could progress more quickly, but it’s still going to take a significant amount of time. This situation is likely to persist for a while.

It’s going to get very technical within the agency mortgage class as well. For example, the 15-year list that came out yesterday was around 660 million. Everyone seems to have their own opinion about its performance, but it definitely put pressure on the 15-year sector initially, and that sector will have a tough time digesting all this volume because it's not as liquid as the 30-year sector. You might notice some nuances. We've experienced it in our portfolio as well since we focus on down in coupon. New developments like this can create pressure. In the first couple of days after the announcement, we saw significant volatility, with our book values shifting by 1% or 1.5% in a single day. However, in the last couple of days, we've seen some stabilization; yesterday marked a reversal, and today, at least before the call, it appeared there would be a continuation of that trend. By the end of the day, we might end up flat to slightly down for the week, but changes are happening very quickly, which is my observation.

Right. It sounds like a buckle up and enjoy the ride is the motto for maybe the rest...

It’s been this way for a while.

Yes. Well, with that in mind, best of luck going forward. Thank you. Thank you for the detailed comments as usual. As I say, I think it’s the finest slide deck in the agency MBS space. Thanks, guys.

Thanks, Mikhail. Have a good weekend.

Our next question comes from Christopher Nolan from Ladenburg Thalmann. Please go ahead. Your line is open.

Hey guys. How should we consider the common dividend moving forward? The insights you shared regarding the discount accretion income and the hedges were quite intriguing, and they seem to play a significant role in determining your dividend payout. But is that income sustainable?

Well, here’s the deal, Chris. We really want to maintain this positioning. We believe the economy is starting to decline and that eventually the hiking cycle will end and a pivot will be necessary. These are the assets we want to own when that happens. Even if there’s a slight over distribution, if you think of a total rate of return as a combination of coupon and price, we believe the potential price appreciation far outweighs any shortcomings in income. From a book value perspective, if we lose a little book value due to over distribution, we think when the market rallies, the price appreciation of these assets will more than compensate for that effect, and overall, we will be better off. The return opportunities are extremely high in that scenario, so we want to pursue that. However, if we find that inflation is not declining or even accelerating and that the Fed will not change course while the economy doesn't roll over, we will need to reassess. That said, we believe we are close to the end of the cycle and that the data is beginning to show signs of decline, so we must remain diligent and aware of the situation. We aim to maintain our strategy and keep the dividend stable, but if the circumstances change, we will need to reconsider and may need to adjust the portfolio, likely opting for higher coupons to generate more income.

Yes. I just want to add a few points. We frequently discuss this, and our efforts, particularly in the volatility space, have been focused on establishing positions that are highly geared and should perform well if the curve continues to flatten without realizing the inversion. Several nuances are important in our conversation regarding our earnings stream. We’ve outlined many of the more straightforward aspects, such as discount accretion and the value of our hedges that have become realized gains contributing to this dividend stream. However, there are also subtler elements at play. The portfolio is currently in a different situation compared to when we experienced extreme premium conditions. In the past, we would buy specified pools, and as they matured, we would see a decline in pool payups. This is simply how it works; newer pools are more desirable and have better carry than older ones. Presently, many of the highly discounted pools we own are aging and appreciating in value gradually. As I mentioned, we have more subtle factors within the portfolio related to our volatility positions. If the Fed maintains a higher for longer stance, those positions will perform well and help offset some losses from not realizing forwards. Additionally, as we start realizing forwards, we'll quickly accumulate more monthly income for the underhedged portion of the portfolio. That's how we are approaching it, and we feel comfortable at the current level for these reasons.

We have no further questions in queue. I’d like to turn the call back over to Mr. Cauley for closing remarks.

Thank you, operator. Thank you, everyone. As usual, to the extent you have follow-on questions and you wish to call us, please do so at the office. The number is 772-231-1400, or if you’re just listening to the replay and you have some questions, very willing and look forward to taking any and all questions. Otherwise, we look forward to speaking with you at the end of the second quarter. Thank you. Bye.

This concludes today’s conference call. Thank you for your participation. You may now disconnect.