Orchid Island Capital, Inc. Q3 FY2024 Earnings Call

Good morning and welcome to the Third Quarter 2024 Earnings Conference Call of Orchid Island Capital. This call is being recorded today, October 25th, 2024. 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. Thank you for joining us. Hopefully, everybody has had a chance to download the slide deck so you can follow along with us. Just to start, I will go over our financial results for the quarter. Then I'll discuss the market developments that occurred during the quarter that shaped our performance and our decision-making with respect to the portfolio. Then we'll dive into the portfolio characteristics, what we did during the portfolio, how we positioned ourselves, and then our outlook, and then there's a substantial appendix. We have a lot of information that is in the appendix that you can use. We won't go through that; that's just for your reference. With respect to our financial results for the third quarter of 2024, Orchid had a net income of $0.24 per share, compared to a $0.09 loss during the second quarter. Book value declined modestly from $8.58 to $8.40. The total return for the quarter was positive 2.1%, and we declared $3.12 dividends. The portfolio, these are average balances, did increase quite a bit during the quarter. I'll have more to say about that in a few minutes. The leverage ratio did expand slightly, predominantly due to a slight tweak to the amount of TBAs that were short and a modest book value decline. Speeds increased modestly during the quarter from 7.6% to 8.8% with the rally in rates. Our liquidity is relatively in line, up slightly versus where it was in the second quarter. Slide 7 has our financial statements, which I’ll leave for you to review. We will be releasing our 10-Q later today, so you can have a much more in-depth dive into our financials at that time. Now, turning to the market developments that shaped our results. Looking back at the end of the second quarter, things were looking quite well for the mortgage market and for REITs in general. Most of the data the Fed paid attention to, inflation data and labor data, was trending down. Most people were anticipating substantial Fed eases. In fact, we got one: a 50 basis point cut in September. The curve was steepening and NIMs were expanding in the space, and the outlook was quite good for mortgages. The Fed reducing rates, the curve steepening, and the potential for banks to come in in a more meaningful way - things looked quite good. That was until late in the quarter when things changed. Late in September into October, we received data consistent with a quite robust, resilient economy, certainly not one that appears to be headed into a recession anytime soon. It's quite resilient. We may have a soft landing or possibly no landing; who knows? But it’s certainly not as dire as it looked a few months ago. Recently, as we approach the election, which is a significant wildcard for the markets, it seems that the market may be pricing in some probability of a Republican sweep. The significance of that is twofold. Traditionally, Republican administrations tend to be more pro-growth. The economy appears to be much more resilient and growing, which would contribute to that growth. Secondly, based on President Trump's pronouncements, we could expect an expanding deficit, which would exert upward pressure on rates. We're in this transition period now since the end of the quarter. There's a lot of uncertainty in the market, and we don't know how the election will play out or how the economy will evolve. It looks like the economy will remain resilient and strong. GDP data comes out next week, but it seems somewhere around 3%. So, it's not a weak economy and that means rates are probably not going to rally meaningfully anytime soon. Looking at Page 9, you can see that the red line indicates where we were at the end of the second quarter. The green line there on the top left represents where we were at the end of the third quarter, and the blue line shows last Friday. We are higher than that today; rates have continued to sell off, although there has been some kind of stabilization. The spread on the bottom has moved as we steepened but still has much further to go compared to traditional levels. Turning to Slide 10: This illustrates the spread of mortgages to the 10-year treasury in the current coupon mortgage. If you examine the extreme right, you'll see the downward sloping portion of that curve that was present in Q3. We had a very good quarter until about mid-September, after which we reversed. This number shows 132 basis points; that number is now north of 142 this morning. With all the uncertainty in the market, people are not buying mortgages meaningfully. Generally, we have seen widening every day. Monday of this week was particularly severe. Until this uncertainty is resolved, it is tough for rates and for mortgages in particular. Other spread products don’t seem to be as affected as mortgages; however, it hasn’t been a pretty run for mortgages lately. The bottom left of Page 10 shows you the normalized prices for select coupons. This data is through last Friday, and if you were to update that, those numbers would be closer to the 100 line, meaning that these coupons have given up a fair amount of the gains they enjoyed during the third quarter. Roll activity is somewhat better in the higher coupons, not so much in the lower ones; generally, rolls are a bit better than when we last spoke. Moving to volatility, which is a very important driver of mortgage performance, you can see we have been trending higher. If you were to update to today, it is still higher, near 130 on the MOVE index. We have significant events on the horizon: the non-farm payroll report next, the election on the 5th, and the Fed on the 7th, along with whatever other data comes in after that. The outlook for volatility in the near term is likely to remain elevated, which is generally not favorable for mortgages. Slide 12 shows refinancing activity. You can see we did have a small bump, either at the top left or the bottom right, but that could have been a short-lived phenomenon. During the third quarter, prepayment fears became very real. Spec pool pay-ups benefited from that, with people concerned about prepayment risk. Currently, that’s not as much of a concern, and it remains to be seen how this will play out going forward. As of now, those fears are clearly abating. Slide 13 illustrates the GDP in nominal dollars alongside the money supply. Growth, represented by the slope of the blue line, was incredibly stable for over ten years. Since the pandemic, we have seen the money supply expand far above its trend growth line as well as GDP, and the cause-and-effect can be debated. However, it is undeniable that with the current level of deficits, the elevated money supply, and strong consumer spending, it’s possible that we will continue to see elevated growth levels. If that continues, the economy is unlikely to weaken materially. The implications for rates remain to be seen, but I don’t see it supporting any substantial rally. Now, coming back to what we’ve done and how we've repositioned the portfolio, we were waiting for the Fed pivot we finally received. Unsure how much additional Fed easing we might get, we raised $110 million to our ATM during this quarter, representing a 20% increase in our share count. By deploying those proceeds, we grew our portfolio likewise by about 20%, which shows substantial growth for the quarter. We acquired higher coupon mortgages as we aimed to build out a barbell portfolio, which we have now fully achieved. Currently, the portfolio has a strong bias towards higher coupons. The proceeds were deployed into 6%, 6.5%, and 7% coupons. This raised our weighted average coupon by 22 basis points from 4.72% to 4.94%, and the yield on the portfolio expanded by around 38 basis points, from 5.05% to 5.43%. When we deployed these assets, much of this was front-loaded in the quarter. We hedged those with primarily longer duration swaps, seven and ten years. As a result, with the rally during the quarter, we kind of underperformed due to the rally in rates. Our hedges, which were longer-tenure swaps combined with shorter duration assets that widened during the quarter due to prepay fears, did not perform well; however, since quarter end and rates have sold off, it has likely allowed us to outperform a little bit. That summarizes the activity concerning our assets. Page 16 illustrates this visually, showing that we added upward coupons, and there's an evident bias toward upper coupons. However, we have retained a substantial holding of discount securities, which have great convexity characteristics, in case the market rallies back. So, the barbell strategy is still in place, but with an upper coupon bias. Regarding funding, one clear phenomenon with the Fed easing was an immediate benefit, approximately 30 basis points which was felt in September. This situation reflects the timing of the repo rolls; we do not see the immediate 50 basis points; nevertheless, it has allowed our funding costs to drop. They have been remarkably stable. The data represented in this chart seems misleading. For instance, although our average repo rate was 5.62% versus 5.34%, this is misleading due to our front-loaded portfolio growth this quarter, which resulted in a higher interest expense load. The average repo funding costs are lower than they were in prior quarters, roughly 40 basis points. However, it should be noted that we observed some expansion in the spread over quarter-end, month-end, and year-end. During repo transactions, these spreads tend to expand. While the Federal Reserve and various Board members express little concern, we hear from funding desks that there is evidence of emerging funding pressures, which, while not acute yet, are beginning to affect the situation. This offsets some benefits of the Fed cuts during those periods. Therefore, on average, the easing will essentially be offset to some extent. The exact extent of that remains to be witnessed, but it is certainly something to monitor. With respect to our hedge positions, we have not made significant changes. We continue to heavily rely on swaps that cover a very high percentage of our funding liabilities. Coupled with the transition to higher coupons, which are less rate-sensitive, our portfolio is now slightly more defensive than it was at the end of the second quarter. Slide 10 paints the details of our hedges. Notably, our SOFR futures, which we have been opportunistic in adding whenever we observed poor economic data that caused the market to rally, have helped us lock in lower funding costs. We have also shifted some of our five-year future shorts into a five-year swap and a combination of that with SOFR future shorts. The rest of the expansion, which is also a product of the growth in the portfolio, has seen us add to some seven-year swap positions, amounting to an additional $100 million. Slide 20 outlines expected returns across the coupon stack; it's something we always examine, but I won’t say more about it aside from pointing out that it informs our decision-making. Slide 21 illustrates our interest rate sensitivity. Based on this, we have a slight defensive bias in the portfolio presently. We tend to perform a little better in a rally or sell-off, which is atypical, with lesser performance in a rally. This is due to our positioning. Speeds increase as we have taken on more higher coupon exposure. By choosing lower quality spec pools and leveraging the newness of those securities, we found that they do not tend to prepay rapidly. Our 7% securities had a high print in August, but their three-month speeds relative to the previous quarter are not elevated. Considering rates have now sold off and we're approaching the summer, our higher-yielding securities are likely to experience slower speeds, resulting in better carry. Thus, the combination of increased coupons in the portfolio, alongside higher coupons that prepay slower, should benefit the yields we realize. Additionally, we have experienced slight improvements in our funding costs. Consequently, we predict some benefit to our NIM that we expect to realize going forward, albeit modestly. So, to summarize, in hindsight and looking ahead, we did receive the pivot, but it may not be what the market hoped for or what we once expected. With that said, we continue both to employ our barbell strategy, now with a bias towards higher coupons, which we believe is suitable for our current market conditions. For nearly two years, the market has consistently overestimated the economy's weakness and the extent and timing of Fed rate cuts. We have not observed these dynamics play out. In the fourth quarter, the developments have also led to mortgage spreads giving back much of the gains we achieved in the third quarter. Regardless, we remain confident in our positioning and hedge structure, expecting modest NIM expansion. There remains great uncertainty about our trajectory, but as rates potentially continue to rise, we hold a very high-yielding portfolio, which may allow us to maintain that yield and dividend level while potentially utilizing less leverage, assuming this situation continues. That covers it for the quarter, and that wraps up how we view things evolving. With that, I think we can turn the call over to questions, operator.

Thank you. At this time, we'll conduct a question-and-answer session. Our first question comes from the line of Jason Weaver of JonesTrading. Your line is now open.

Hey, good morning. Thanks for the time. First, Robert, you touched on this during your remarks, but taking into account the 30 years that you bought in the 6s and up into the 7s and the short TBAs and low coupons, does this reflect a view that you expect little relief in benchmark mortgage rates over the next 12 months? And does it change the favorability of the barbell strategy at all going forward?

We do have a bias toward higher coupons. It’s challenging to have a firm view of rates going forward given the volatility of the data. September showed us how whipsawing moods can be. However, one point we think, if you consider current rates and where they can go from here, they could easily rise. If the economy remains strong or inflation resurfaces, and deficits keep growing, rates can rise. Conversely, I don't foresee rates falling to the same magnitude. Even if we assumed that there will be a recession prompting cuts to neutral funding levels, it's difficult to forecast how the curve will react. For example, if the Fed were to cut to 3%, then the 10-year yield should be significantly less than 4%, while we currently sit just over 4%. Therefore, our outlook is asymmetric, which is why we favor the up-in-coupon bias. However, because of the uncertainty, we don't want to entirely abandon lower coupons; as we observed in Q3, rallies can occur and higher coupons may underperform. Would you like to add to that?

New lower coupon strategies tend not to yield favorable results in environments where spreads tighten, providing less yield and carry for the portfolio. However, the current environment, where mortgage spreads are approaching the year's widest, signifies that now is a time we particularly favor having those lower coupon positions. They will benefit most in a rally if rates reverse and spreads tighten; so we take a cautious approach at the moment while we maintain a strong portfolio.

Got it. That's helpful color. On the other side, looking at the swap position, it looks like your hedge ratio actually came down a bit even though dollar duration has not changed much entering September. Care to provide some insight on that regarding risk appetite heading into year-end around the election? Additionally, any comments on the expectations for higher volatility in the coming months?

Yes, we have added to our portfolio by 20%, but our swap positions did not grow correspondingly. Instead, we have shifted our focus on SOFR futures, aiming to lock in some of that funding. There has been substantial movement in swap spreads at the front end of the curve, which offsets the effectiveness of those hedges. As for volatility, it is challenging to envision it diminishing anytime soon. As long as volatility remains elevated, we will likely see mortgage performance suffer. Looking ahead, it’s difficult to have strong convictions. At a recent conference, Kevin Warsh, a former Fed Governor, pointed out that economic data is often an imprecise science, with frequent revisions leading to high volatility, especially as we rely heavily on data-driven decisions from the Fed. This year has demonstrated significant volatility and revisions in various economic indicators. Regarding the election, it has been chaotic. There are too many variables at play, and we cannot predict who will control the government. The result could be bumpy for a while.

As for the portfolio profile, we strive not to be myopic in our decision-making and to lean toward a certain general positioning. While we were leaning towards anticipating lower rates, we have also had to adjust and hedge as needed with the hedge ratios coming down. Hence, we did trim some hedges during the rally, ensuring we remain fine-tuned rather than reflecting a significant shift in our core position. Mortgages often shorten during significant rallies, and we need to ensure we do not drift too far offside with how our portfolio is hedged.

Got it. Thank you, and congrats on the quarter.

Thank you.

Thank you. Our next question comes from the line of Mikhail Goberman of Citizens JMP. Your line is now open.

Hey, good morning, guys. Hope everybody is doing well.

Good morning.

Rob, your recent statement just now that going forward, it's hard to have a lot of conviction in anything, I think, can apply to many things. If I can start with just an update on book value. I know you mentioned that you might have outperformed a bit since the end of the quarter.

Yes. We calculate an estimate every day. As of yesterday, we were down 3.7% quarter-to-date. Most of that decline occurred in the last five or six days.

The spread widening in the mortgage market has overwhelmed the slight duration bias we had.

Got it. Thank you. Just looking at your prepared remarks in the press release, you mentioned that you continue to view a fair steepening of the yield curve as the greatest risk to the portfolio. If you could elaborate on how that situation might affect your portfolio construction as well as the hedge portfolio?

The bear steepening poses risks, especially for higher coupon premiums, which could drift down and become discounts, potentially extending. That’s why we implemented hedges predominantly using seven and ten-year swaps. With our recent NIM improvement, we might aim to reduce leverage while maintaining our yield. Our existing yield is already among the highest in the space, so we have no need to stretch for further expansion, especially given the uncertainties we face. If we can maintain the dividend yield with less leverage, that would be favorable, especially if a bear steepening occurs. In the rally, the market had anticipated an aggressive easing that did not take place, reinforcing our perception of the steepening risk.

Got you. And just to follow up on that leverage question, the economic leverage at 7.6% at the end of the quarter; does that give way to your thoughts on drifting down to a 6% handle if a steepening scenario arises?

Yes, historically we manage that through a mix of adding TBA shorts or not reinvesting paydowns, letting the portfolio contract gradually. If it’s a swift event, it can happen rapidly without much foresight. However, if it is a more gradual rise, that's how we would approach it.

Regarding the portfolio profile, we have some cushion particularly in the 6%, 6.5%, and 7% buckets, which should continue to perform well. It's been a bit frustrating as those specific coupons underperformed leading up to the rally in the third quarter and have not significantly reversed during the sell-off. The uptick in volatility and uncertainty currently impacts this behavior. Yet, we still retain optimism, seeing potential for these assets recognizing that if rates stabilize, they will offer great assets with fantastic carry in a high-rate environment. The potential downside in a bear steepener scenario moves rates beyond even 5% on 10-year yields, and that movement would be substantial. Thus, we believe we have adequate time to prepare for such a case, as this would likely be a grind rather than a rapid shift.

All right. We live in interesting times. Thank you, gentlemen, and good luck going forward.

We certainly do. Thank you, Mikhail.

Thank you. Our next question comes from the line of Jason Stewart of Janney Montgomery Scott. Your line is now open.

Great. Thanks, guys. For clarification on repo cost at quarter-end: was the $524 rate an average? Could you provide the quarter-end number, or did I misunderstand?

No, the quarter-end average as of that date was $524 and would be coming down. The growth was so rapid, with the growth being front-loaded. Our method of presentation refers to total interest expense divided by the average balance. With our portfolio growing by 20% this quarter, I believe the average repo balance was a little under $4.8 billion. However, our actual repo balance was above $4.8 billion at the end of July. As a result, it appears that our average repo expense is inflated, but it has remained stable with the Fed rates for months. We were previously running around 5.5%, which dropped about 30 basis points in September. Funding spreads were raised over quarter-end, but we will further observe trends into October, November, and year-end.

To provide additional context, our funding levels had been anywhere from 14 to 16 over SOFR for several months, but this has now increased, possibly pushing toward 18 or 20. As the quarter progresses, the marginal repo should adjust to the 5% level, and we will see how that unfolds.

Let me give you some added color on this: this week, the market expects a high probability of a cut in November and less so in December, yet uncertainty remains. Fed fund futures curves throughout the year align with market projections; thus, we can anticipate something north of one ease. Nonetheless, we should prepare for funding pressure as the year-end approaches. The marginal repo today should account for both market anticipation of eases and potential year-end funding constraints. If you discuss with dealers, you can glean a wide array of levels dictated by this uncertainty.

Okay. That's helpful, thank you. With regards to marginal ROEs: despite Q3's favorable conditions for mortgages across different metrics, it appears to have a 17.1% dividend on book. Given that context, do marginal ROEs align with such levels or how are you thinking about them relative to the dividend?

Marginal ROEs have likely expanded slightly; however, we are not inclined to push our dividends. I don't have the exact figures on hand, but I suspect they hover around a high teen percentage range. Given our yield of approximately 5.5% against mid-2 yield assets, the difference is close to 300 basis points on a hedged basis based on leverage decisions we make.

For par coupon mortgages, we are hedging at a competitive spread of over 190 basis points against 10-year SOFR swaps, which reflects a robust operating climate.

One more question on your perspectives of building book value: If we're at a situation with 20% returns while paying out 17%, there is marginal growth in book value. Do you feel you receive adequate recognition for your dividend yield, or how do you weigh the potential of retaining capital?

This is an important discussion with the Board lately, especially looking ahead to 2025. Previously, we thought we would see a strong easing cycle, but the reality is shaping up differently. When we consider retaining funds, special dividends result in market discounting them, and tax implications appear similarly inconsequential. Thus, historically, we've leaned toward paying out earnings. If rates continue to climb, we will actively consider retaining earnings.

I believe we will transition from a phase of moderate over-distribution to possibly having under-distribution for a duration. By the end of 2025, we will have to assess our capital with respect to tax obligations while deciding how to handle possible under-distributions experienced throughout the year.

Thanks for the questions.

Yes, thank you.

Thank you. Our next question comes from the line of Christopher Nolan of Landenburg Thalmann & Co. Your line is now open.

Hi, guys.

Hi, Chris.

Following up on the yield, Bob, when discussing performance with the Board, how do you gauge overall performance? The dividend yield is relatively high while book value has declined somewhat due to your ATM activities. Any insights into how you determine shareholder returns?

We consider relative total return as a priority. When opportunities arose to grow the portfolio, we opted to use the ATM at slight discounts to book, which we believed was justified. Now that those conditions are not present, we will refrain from such activities. We actually repurchased some shares late in the quarter when pricing declined. We consistently evaluate total return on a relative basis. At times we desired to grow the portfolio for scale, thus operating with higher leverage. This strategy and having a high dividend allowed us to gain scale, something we do not believe we require anymore. As a result, we are now more defensive. The Board consistently considers the total return strategy but understands the context of aiming for portfolio growth through higher leverage or dividends, which could lead to underperformance and awareness of higher risk from such decisions.

Okay. Thank you. And Hunter, do you have an adjusted economic EPS number that encompasses hedge income and discount accretion?

We do not provide that in our tables, as previous attempts prompted more confusion than clarity. We have discontinued that practice. It may still be covered in the upcoming Q release later today. If you contact us, I could retrieve that information for you.

That would be beneficial. Thanks, guys, and congrats on your efforts.

Thank you, Chris.

Thank you. I'm showing no further questions at this time. I would now like to turn it back to Robert Cauley for closing remarks.

Thank you, operator. Thank you, everyone, for your participation. If there are any questions arising after the call or if you are listening to the replay and didn’t get to ask, feel free to reach out. Chris, I know you might want to contact us to obtain that number. We look forward to speaking with all of you again at the end of the fourth quarter. Have great holidays, and see you all.

Thank you for your participation in today's conference. This concludes the program. You may now disconnect.