Orchid Island Capital, Inc. Q4 FY2024 Earnings Call

Good morning, and welcome to the Fourth Quarter 2024 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, January 31, 2025. 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 Security 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 today. Hopefully, everybody has had a chance to download the slide deck and they can follow along with us. During the call, as usual, we'll be following the slide deck loosely. And just to give you kind of an intro of how we plan to proceed, we are going to make one slight change this quarter. Jerry Sintes, our Controller, has joined us. He will go over the financial results. I'll walk you through the market developments, which are the things that occurred in the market that shaped our decision-making and the positioning of the portfolio. And then, Hunter, the Chief Investment Officer, will walk you through the portfolio and hedge positions and things that we did during the quarter with the portfolio. So with that, I will turn it over to Jerry and he will walk us through the financial highlights.

Thank you. Starting on Page 5, we are showing a net income of $0.07 per share for the fourth quarter, compared to $0.24 per share for the third quarter. Our book value decreased from $8.40 at Q3 to $8.09 at 12/31. Total return for the quarter was 0.6% unannualized, and that includes a $0.36 dividend that we declared during the period. On Page 6, we present some other portfolio metrics. At the fourth quarter, we had $5.3 billion in MBS assets. Our leverage ratio decreased slightly to 7.3x equity, prepayment speeds increased to 10.5 CPR compared to 8.8 CPR in Q3, and our liquidity at 12/31 was approximately 53% of equity. On Page 7, we present year-to-date full year income of $0.57 per share compared to a loss of $0.89 per share for 2023. Book value went down from $9.10 at the end of 2023 to $8.09 at the end of 2024. Our total return for the year was 4.73%, and our dividend for the year was $1.44. Our initial calculations show that 96% of that was paid out of taxable income and 4% out of return of capital. On Page 8, we present our financial statements for your review. We're not going to get into the detail of that here. And with that, I'll turn it back over to Bob.

Thanks, Jerry. Now turning to the market developments on Slide 10, the biggest development really was quite a pivotal quarter, the fourth quarter that is, in that the curve, the treasury curve, especially the cash curve, which had been inverted for two years, which, by the way, I believe is a record period of inversion, disinverted, if you will. The swap curve, as you can see on the right side of the page, is still slightly inverted, and that's just because swap spreads have been trending negative in a meaningful way for some time. And so that curve is still slightly inverted. But the cash curve did disinvert and is now positively sloped. So mechanically, how that came about was the Fed starting in September lowered rates, the overnight rate by 100 basis points. But more importantly, longer-term rates went up quite meaningfully in the case of the ten-year by about 80 basis points. So the question is why? And I'm just going to briefly highlight some reasons. First, the economy has been strong all through 2024. GDP has been 2% to 3%, 3%-plus. Retail sales as a proxy for consumer spending were very strong throughout the year. Retail sales reported on a monthly basis generally exceeded expectations by economists almost all year. The labor market, which had been weakening, stopped doing so as the year came to an end. The labor market appeared to be leveling off if not improving. The unemployment rate, which had been rising, stopped doing so and has settled at a low level. Inflation, which has been very sticky, is much lower than it had been when it peaked, but today it still seems to be stubbornly just above the Fed's target and not really making meaningful progress towards it. So it has kept the Fed from being overly aggressive in easing fiscal spending. Deficits are still very large, and we don't expect those to decline. Finally, with the election results in the fourth quarter, the new administration's Republican sweep has a very strong pro-growth agenda and may even use tariffs, which probably will be inflationary at least in the near-term. For those reasons, the curve has inverted. I want to walk you through some more macro variables, and then I'll summarize what these things mean for us specifically. You can see on Slide 10 the bottom, the spread between the 3-month treasury bill and the 10-year note as of January 24, last Friday, at 31 basis points. So it is now in positive territory. Moving to Slide 11, looking more specifically at the mortgage market, you can see a proxy for mortgage performance and trading levels. The spread to the 10-year treasury of the current coupon, while it's at maybe local lows, still remains very attractive on a historic basis as of last Friday at 125 basis points. Prior to the outset of COVID, trading levels were typically in the 80 basis point range. The reason this remains the case is that one of the largest marginal buyers of mortgages, banks, have not been huge buyers of late. To the extent that were to change, there's a good chance we could trade back to pre-COVID ranges. With respect to mortgage performance for the quarter, on the bottom left, these are normalized prices for each coupon normalized to 100. With higher rates, prices were down but have stabilized well since year-end. With respect to the dollar-roll market, things have improved. Most of these rolls are now positive, which is generally a positive sign for the sector. Even though many money managers are overweight the sector, the strength in dollar-rolls is generally a good sign for the mortgage market. In terms of volatility, it's a very big driver of mortgage performance. Looking at a long-term perspective, we're still somewhat elevated, but we're very much at local lows. We may see volume come off a little more in the near-term. This view is based on the market and the Fed being comfortable with the notion that they won't have to act very quickly and have time to normalize rates. If that were to pass, it would be a positive for mortgages. Slide 13 shows the mortgage bankers rate and the refi index. With rates now above 7%, refi activity is extremely low. The housing market is not performing well because of low affordability, which is likely to continue to keep refinancing activity and purchase activity low. The primary-secondary spread recently spiked down. We’ve seen that in the past but don’t think there's anything significant in that fact given the housing market state, I expect it to remain at that level. Finally, on Slide 14, this is just one of my favorite slides. I don't want to read too much into it, but I point out that with elevated money supply, we have seen GDP growth. I’m not saying there's necessarily cause and effect, but it does appear to be the case. We've had above-normal growth. The current growth rate is above the long-term trend. If that trend continues, you would expect the economy to remain fairly strong. Now, as I mentioned, I want to go through all these developments and what they mean for us. Before I turn the call over to Hunter, who will discuss the portfolio. First of all, with the curve steepened and funding levels lower, our cash interest expense has come down. Our net interest income is positive absent the effective hedges. We now have a positive net interest spread, which is obviously very good for income. Longer rates higher have been favorable because we have an up-in-coupon bias to the portfolio, resulting in slower speeds. As we will see later in the call, they have indeed been slowing, which gives us better carry out of those securities. The investment environment, as I mentioned, if you look at the spread of current coupon mortgages as a proxy, is still at very attractive levels. Positive dollar-rolls are another good development for the sector, and volatility has been low and coming off. If that continues, it would also be positive. We are very constructive on the outlook for the market for Orchid and our business model. Looking forward, any additional Fed cuts would obviously be a positive as they would lower our cash interest expense. If the curve steepens significantly enough and banks return to the market meaningfully, it could also lead to tightening in the mortgage basis, which again would be good for Orchid and our business model. With that, I'll turn it over to Hunter; he's going to walk us through developments with the portfolio during the quarter.

Thanks, Bob. I want to start by giving some background on the points Bob brought up. We're seeing a pro-growth agenda from this administration. The market has largely priced out many future Fed cuts. As of now, there aren’t too many more priced in, one or two last I looked. So keeping that theme in the background, I’ll discuss what we've done in the portfolio. We have been building a barbell strategy and continued with that in the third quarter. We bought assets that tend to be a little bit shorter in nature. Regarding our new positions, we put on a new 15-year five position which is $50 million in TBA, this TBA has been trading very special. It's been a good trade. We covered some Fannie III shorts. Basically, we sold some cheapest to deliver pools. We sold $190 million worth of New York and investor Fannie III's that were paying at sort of deliverable speeds. We covered $100 million of the short and reinvested the remaining variants in New York 5 and 5.5 as well as a new position in a social bond. We like those as good credit stories. Later in the quarter, we raised about $115 million of 200,000 max and FICO 6.5. Since year-end, we have purchased more five, approximately $183 million in 30-year 5.5s and almost $400 million in 225,000 max 6.5. We'll discuss the hedge position on those in a moment, but this is consistent with positioning our portfolio for higher-yielding assets. The Fannie III portfolio that dominated last year, we’re starting to lighten up on. Those assets performed well, and we liked them for a long time as they were easy to hedge. They were mostly fully extended and offered wide spreads. We could hedge some of them with TBAs because the dollar-rolls were negative. This picture has changed a bit; the Fannie III's have improved over the course of 2024, and dollar rolls have spiked and are now trading positive. So we felt it was time to take advantage of the fact that there's more spread in this market and have transitioned to a higher coupon focus. Again, we're positioning for a strong economy, with potentially more inflation spooking here and there, so we're trying to keep the assets relatively short. On the next slide, you can see the migration of our portfolio over the last six months. We have built a large position in 6, 6.5 as well as bolstering 7 to 5 and 5.5, but to a lesser extent. Briefly on funding costs, Bob alluded to our positive net interest income above our funding costs. In the third quarter, we averaged roughly 562 for a repo funding rate. That came down to 498 in the fourth quarter. More recently, we're trending down to 445-446 for new repos. Regarding the funding portfolio, we have lines and MRAs with 27 entities, and we executed our first indemnified repo in the fourth quarter. We are actively pursuing cash providers directly through this indemnified repo program, which is an exciting development for us. With respect to the hedge book, I discussed the new securities added during the fourth quarter. We focus on this idea of a bear steepener, with stronger economy being a big risk. We are addressing that risk by pushing some of the hedges farther out the curve. In the fourth quarter, we unwound some SOFR futures. We did a combination of some seven-year swaps and roughly $320 million in five-year and seven-year FEs, as well as TYs. We unwound what we saw as roughly $425 million of SOFR futures. We had put those on when the market was pricing in really deep Fed cuts extending out into 2025, 2026, and 2027. We unwound them after the December cut when there was not much by way of cuts priced into the market. If the market reverses course and the economic data weakens a bit, we will look to reload those positions to capture more implied Fed cuts. But right now, we are flat. Continuing with this theme into the first quarter of this year, we unwound legacy payer pay-fixed swaps with very low strikes, keeping with the theme of pushing hedges out to areas that adequately express our current outlook. There might be a bit of a duration mismatch with some things we added because they are shorter in nature. However, our goal is to have assets skewed incrementally towards the front to middle part of the curve, while pushing our hedges out slightly longer. This positioning reflects our view that a sell-off in a bearish steepening scenario could be painful for companies like ours. Conversely, in a strong rally, we believe mortgages will perform well, especially if driven by an equity market sell-off, which could be positive for bonds. I’ll leave discussion about the next slides for you, but on Slide 22, we are extremely flat from a model duration perspective with about a 0.28 duration gap. If hypothetical shocks are applied, I can easily estimate the resulting damage for our $5.3 billion portfolio. Again, we're flat model-wise and leaning into a bear steepener position because we think that scenario would be the most painful for our portfolio.

Thanks, Hunter. Just kind of reiterating what we've already discussed, we think the barbell strategy is very appropriate for the market. We have an up-in-coupon bias to it. We maintain a bullish view of the market and economy, and we believe the administration has a pro-growth agenda, leading us to think the risk of a recession is extremely low. All that being said, we also believe the Fed has made clear that they have no compelling reason to start or continue aggressive easing. We may see one or two cuts, but do not expect to see a hike. We expect long-term rates to be slightly higher under pressure. Deficit spending is likely to stay, and inflation has been sticky while the economy shows strength, providing good carry for the bonds we own. Higher rates favor premiums. As Hunter said, we've moved our hedges off the curve. Should there be a more meaningful sell-off in the long end with bonds extending, we have longer-duration hedges to help with that convexity. That's pretty much it. I will turn the call over to questions. Operator, please instruct, and we will answer any and all questions.

Our first question comes from Jason Stewart with Janney Montgomery Scott. Your line is open.

Hi, thank you guys for all the details today. If we could start with a book value update year-to-date, if you don't mind.

Sure. Just because some of our peers have already announced this week and I believe they all gave book value as of last Friday for an apples-to-apples comparison. Our book value was unchanged as of last Friday. In fact, our daily estimate, which is not a GAAP or audited number, was literally unchanged to the $0.01 as of last Friday at $8.09. Mortgages have had a good run, so we're up about 1% this week.

Got it. Okay. Thank you for that. And then if I could just shift to ROE, where do you see ROEs on a go-forward basis, perhaps on an economic basis? If you don't mind footing that, thanks for the taxable income number; that's helpful, putting that to where you see taxable income. I mean, I guess I'm coming at it. I'll just start there and we'll follow-up, if you don't mind.

Yes. Well, as I mentioned, the way we ended the quarter, net interest income is positive. For the year, the taxable income number nearly covered dividends, as I noted, 96%. The trend is positive. I think we ended the year in a strong position, maybe with ROEs possibly north of 150, maybe 200. If we could get to 200, obviously, our leverage has been on the low end of the range.

The swap curve is very flat. We will leverage as the basis moves around. Things have tightened a bit, we're at the tighter end. However, considering the investing environment, I think 200 basis points is achievable with the up-in-coupon strategy, especially in specified pools that will pay relatively slow. This approach allows us to target high-5s to low-6s. Therefore, I think 200 basis points is within reach.

The risk to that is a rally because we maintain an up-in-coupon bias. If there is a rally and the economy softens, those numbers may not be obtainable. However, we believe things are evolving favorably.

Got it. Okay. And then on the ATM program, what was the discount to book for the issuance in the fourth quarter?

No, I don't have that offhand. I think for the year we were around $0.17 for the book. Generally, when we’re close to or above book value, we will sell. We were typically in the 97.5% to 99.5% range when selling. We didn’t sell much stock in the third or fourth quarters, amounts totaling about $36 million. So we had done much more previous quarters. I estimate the impact on book is less than $0.01.

Okay. I guess, Bob, where I'm kind of coming to all this is I'm trying to figure out how much book value degradation you're willing to sort of accept. I mean, if we have an 18% to what is the dividend on book 17.8% dividend on book. I guess, based on the numbers you gave, you're very close on a taxable basis. Just sort of how your thinking about maintaining the dividend, which is obviously a great yield, but it's definitely north of where some of your peers are pegging ROEs and just trying to put together how you're thinking about the dividend versus maintaining or growing book value. And I understand there's a taxable income element to that, but this is a high-level question.

I’d say that the trend this year has been favorable. It obviously depends on how the stock is trading, and we don't want to sell at too much of a discount. We’re aiming to earn these kinds of levels on GAAP or taxable income, maintaining our dividend level. I don’t foresee an increase after a meaningful steeping of the curve. If we can maintain that level while earning what we pay out and with some upside, I believe we can keep earning this dividend on a taxable income basis with minimal cost to book value despite selling shares through the ATM.

I would add that the money we've been acquiring with the incremental capital is enhancing the portfolio's earnings power. We're not suggesting that the legacy portfolio is inferior. However, the lower coupon part of our barbells has been built and isn't expected to grow much. The growth has shifted to higher income-assets. Thus, we've significantly accumulated 6% and 6.5% coupons. The 6% level is primarily resting around par. Our current expectations between 200 basis points over a 7x leverage is nearly a 16.5% return plus almost 4.5% on unlevered capital in money market funds. High-teens is a plausible current assessment.

Wishful thinking, but ideally, the stock would trade at a lower yield reflecting price appreciation. Since we’re earning this dividend and paying out 96% of dividends on taxable earnings trending higher, it stands to reason the stock shouldn't trade at such a discount. While I do not control that situation, our peers have recently traded at premiums to book value, which, given the nature of our dividend, seems justified.

I agree. I don't believe the stock should trade at a discount to book either, especially if you’re utilizing front assets and shorter duration assets while hedging the long part of the curve. Thus, you should have a solid risk profile. The struggle I have is understanding why peers are recording ROEs close to 20%. They seem to range from 16% to 18%.

It’s what we pointed out before. Hunter mentioned 200 basis points over; I’d say we’re at 16%.

That assessment is of incremental capital. The entirety of the portfolio generally shows blended ROE slightly lower due to strategic decisions with higher-yielding assets. However, there is scope for continued asset acquisition in the upper coupon segment of the book. It aligns with our current strategy.

To clarify the return on marginal capital, swap spreads are around the very low 4% range, which is our hedge instrument. Yields on assets sit in the high-5s, if not 6%, approaching 200 over. Using a conservative leverage multiple of 7.25 yields a return in the 14%-plus range. Therefore, we believe the return on marginal capital today aligns close to 16%. We began 2024 with a lower-yielding portfolio while managing to pay out a $1.44 dividend, 96% which was taxable income. This trajectory, along with marginal capital return, makes us comfortable with our strategy. The stock's performance should reflect set valuation through profitability, regardless of external influences. However, we believe it should trade at a premium given our dividends.

I appreciate the clarity.

Thanks.

Thank you. Our next question comes from Jason Weaver with JonesTrading. Your line is open.

Hey guys, good morning. Thanks for taking my question. Bob?

Good morning.

I appreciate your comments on the outlook, but I'm interested in your views on what’s priced in. Could you elaborate on the incremental risk to spreads as the Fed moves towards a holding pattern versus possibly reversing to a more hawkish stance?

I think the market and the Fed are fairly aligned in terms of the number of eases currently priced in; it's been fluctuating between one and two eases throughout the year. The January inflation metrics we saw still hover in the low-2s range. Thus, what the market has priced in aligns with our expectations. The hawkish outcome could arise if inflation were to reaccelerate, leading the market to expect hikes, and consequently a sell-off in longer-term assets. That aligns with how we have positioned ourselves using our barbell strategy. The lower coupon, higher duration mortgages are hedging long, as Hunter pointed out — it's our primary risk factor.

In that case, if the Fed adopts a more hawkish stance, which could potentially lead to a decline in the equity market and initiate a flight to quality, could that be beneficial to MBS spreads as well? How do you foresee that developing?

The challenge with those scenarios is that you typically see a spike in volume, which is detrimental to mortgages. A market sell-off and re-pricing create yield spikes and plummeting demand aren’t good for our interests. However, long-term, with steeper curves, it presents great buying opportunities. The passage may indeed be painful.

Thank you. Our next question comes from Eric Hagen with BTIG. Your line is open.

Hey, good morning guys. Good to hear from you. Is there a point where you might deliberately extend your duration gap to better express a view on rates or spreads? Historically, what would you say is the widest duration gap you've employed?

Model duration gap, possibly about a year and a half. We've considered whether now is the time to extend duration due to mortgages showing some resilience. Still, in the current market, many will engage in profit-taking. It's very much a relative value asset space; considerable demand must come from banks for a traditional rally. The current situation has led to referencing the balance sheet constraints banks face regarding expansion, especially given the lasting deficits.

Sure. I believe I heard you say that you don't expect significant spread widening in current coupons if long-term rates decline. Can you elaborate on this expectation?

Convexity is quite poor. Thus, we've opted for spec pools. We've shown interest in higher quality loan volatility versus cheaper forms. High gross waivers can impact prepayment speeds. We've aimed for higher-quality assets.

Mortgage spreads are still relatively wide historically. The low coupon assets have slightly tightened. We’ve focused on 5 and 5.5 coupons, being wary of them while still favoring specified pool space. We have added quality assets yielding lower payoffs in that part of the portfolio. Moreover, a significant portion still leans towards loans around 3, 3.5, 4, 4.5, 5 and 5.5%, expecting improved performance in a rally scenario, while higher duration assets will simply grind tighter as rates reduce.

Indeed, certain discount loan balance pools have performed remarkably, especially once seasoned. Demand has significantly increased. Conversely, very low loan balances seem to lag as discounts provide attractive returns.

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

Thank you, Operator. Thanks, everybody. If anyone has questions post-call, feel free to reach out. If you listen to the replay, our office number is (772) 231-1400. We’re always open to discussions. Otherwise, we look forward to speaking with you at the end of the first quarter. Thank you.

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