Earnings Call Transcript - ORC Q2 2023

Operator, Operator

Good morning and welcome to the Second Quarter 2023 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, July 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 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.

Robert Cauley, CEO

Thank you, Operator. Good morning. Hopefully, everybody had a chance to download our slide deck, and I will be going through that over the course of today's call. As usual, I will be following the same format of our on Slide 3 just a table of contents to give you an outline of the agenda. The first item will just be a quick overview of our results of operations for the quarter, and then I will talk about market developments and what we dealt with over the course of the quarter, and then our financial results before finally describing our current portfolio positioning with respect to the portfolio, the hedges, and so forth, and then say a few words about how we see things going forward. So with that, turning to Slide 4. Orchid Island generated net income per share of $0.25 for the quarter. Net earnings excluding realized and unrealized gains and losses on RMBS and derivative instruments, including interest income on interest rate swaps, was $0.34 negative per share. Gain of $0.59 per share from net realized and unrealized gains on RMBS and derivative instruments, again including interest income on interest rate swaps. Book value per share at 6.30 was $11.16 versus $11.55 at March 31, 2023. In Q2, 2023, the company declared and subsequently paid $0.48 per share in dividends, and since our initial public offering, the company has declared $65.77 per share in dividends, including the dividend declared in July 2023. Total economic gain was $0.09 per share for the quarter or 0.08%, that is an unannualized figure. Now going to market developments, there were basically four notable developments that occurred during the quarter. The first, which occurred in late May, was the debt limit impasse between the administration and Congress. While that was resolved, we did see very negative performance for risk assets generally, but more importantly, mortgage-backed securities in particular. It was during that period that most measures of mortgage pricing, in other words, in terms of spread to some comparable duration treasury, reached a cycle high in late May, and that was significant of course and triggered some actions on our part, which I'll get into in a few moments. The second development was the recovery of mortgages in June. Obviously, we haven't recovered all the way back and we're close to where we were pre-pandemic, but the mortgage sector had a very good recovery in June. The third item which really has gone on for two-plus months now is restricting, if you will, of economic data, both inflation data and strong labor market data, which resulted in a reaction on the part of not just the Fed but central banks across the globe which had become very even more hawkish, and as we saw this week, another hike with the potential, at least potential, maybe not ultimately realized, but even more hikes to come. The fourth item, which occurred in the second quarter, were the bank failures in March. The FDIC took over those banks, and the options of the assets, well over $100 billion, approximately $61 billion of pass-through mortgages, started on April 18 and it's still ongoing, although it is going much faster than initially anticipated and it’s also going quite well. So those are the four major macro developments we dealt with. Now, just to go through the slides to give you some of these things and pictures. Slide 6, this has looked the same for a year and a half. The red line there is where we were at the end of the last quarter, and the lines above it are the most recent ones, and you can see the curve as the Fed has continued to hike, the front end has moved higher, but the curve has remained very inverted. For any levered investor, that’s meaningful, and I’ll say more about that in a minute, but basically it tells you through hedging and using, say, for instance, swap insurance, you can lock in very attractive interest margin levels using those types of insurance. So, in any event, the curve has continued to steepen, or invert rather, and that's true in both the Treasury nominal curve and the swap curve. Slide 7 shows pictures of the 10-year notional and cash, nominal cash, and the 10-year super swap over the course of the quarter rates drifted higher and, despite that, as I said, mortgages have had a decent quarter even with the rise in rates. Moving on to Slide 8, I'll focus on the bottom of this page. This is the spread of a current coupon mortgage to the 10-year Treasury. There are many such measures that people look at, you can look at the 510 blend or just the curve, and they're all pretty much the same picture. If you look at the bottom, this goes back to 2010, and it gives you some very good perspective. You can see from 2013 through the pandemic, the spread was fairly stable. We had a spike in March but more meaningfully if you look at the most recent history last fall in October, that spread got as high as $190, but in late May we reached $200. As I said, when we had the debt limit impasse, it didn’t appear to be something that you would consider mortgage market-related. It was during that period that mortgage spreads hit their widest level in cycle high through this current episode, and that was meaningful and caused us to take several actions which I'll describe in a few moments. Moving on to Slide 9, this just shows you the 530 curve. There are many points on the curve you can pick. The most common would be 2s, 10s or the spread between Fed funds and 10s. They're all inverted. In the case of 2s, 10s, the cycle high so far is negative 110. We were as high as 105 this week, although in the last two days in particular, that has steepened as in less negative, but still very much inverted. Moving on to Slide 10, this shows the size of the Fed balance sheets and bank holdings. We described the details of what we mean when we refer to bank holdings in the note below. The takeaway is you’re seeing a normalization as the Fed likes to refer to it, of their balance sheet. They expanded their balance sheet in response to developments that occurred in 2020, and they're now, through quantitative tightening, letting that balance sheet run off or normalize. Bank balance sheets just follow, because, after all, when the Fed is reducing their balance sheet, they're reducing reserves in the system, and banks tend to mimic what they do both on the way up and down. Now turning to slide 11, this is more mortgage market specific. In the top left, remember, these are absolute price changes, not total return versus some benchmark, but just price changes with all prices normalized to 100 at the end of the last quarter. You can see all coupons are down in price, which makes sense given the moving rates. The performance was not uniform and as I mentioned in late May, the spreads got quite wide and have since recovered somewhat. You could argue that these price movements are exaggerated to the downside, reflective of that spread widening. On the bottom left, you can see rolls on the dollar roll market, off any source of income in the levered mortgage space, and you can see that all of these rolls are essentially non-economic. The only roll that has any positive drop is a six-and-a-half coupon as of this morning; the rest are all negative. The alternative to TBAs is usually a specified pool market, so if you look in the top right, you get a picture of that. Keep in mind that as I said on April 18, the FDIC liquidation started, so substantial selling of mortgages by the FDIC has occurred, and almost every bond they sell is of some form of a specified pool, even if it's just seasoned. You’ve had tremendous supply. The initial reaction to the FDIC liquidations was that TBAs widened, as you would expect. So the pay-ups initially didn’t look so bad, not just because the benchmark was lower, but they’ve since stabilized, and those liquidations are going very well. We’re probably 80-plus percent through and will be done comfortably before this quarter is over, and it will be interesting to see how those markets behave once we don’t have $3 billion or $4 billion of supply every week. But again, that market has held up quite well considering those sizeable liquidations. Again, it was over $61 billion of supply just in the pass-through market. Turning to Slide 12, this measures volatility, three-month-by-tenure vol. Obviously, mortgages are an asset that is very much impacted by levels of volatility. The takeaway here is that vol is normalized or moderated somewhat since late March or late May. This level is still over 100, and for reference, during the last decades, up until the pandemic occurred, the average level for that period was about 72, so we’re well above that. Volatility is still elevated, just at a local low as opposed to a local peak. Turning to Slide 13, as I talked about mortgages earlier, you can see on the left-hand side, these are LIBOR/SOFR OAS levels, and as you can see, they're extremely elevated as of late, appearing to peak in late May, and then recovering in June. Keep in mind that prior to the pandemic, these levels were all negative. After the pandemic, when the Fed was in the midst of QE, these numbers were negative. So we moved a long way, and as a result, while the mortgage market has been painful at times of late over the last year and a half performance-wise, the asset class is very attractive. Turning to Slide 14, these are just returns across our markets and other components of the aggregate index, and even the S&P. Mortgage investors, certainly ones focused exclusively on mortgages, a number of investors are invested across multiple asset classes. Therefore, the returns across these things matter to them, and therefore us, because they are large players in our market. As you can see in the second quarter, the best returns were the riskiest assets, high yield, emerging market, high yield, and the S&P 500. All the other components of the fixed income markets were either very modestly positive in the case of emerging market investment-grade debt or negative, but not materially so. Looking at the year-to-date numbers, again, the riskiest assets have had the best returns. Otherwise, everything is fairly uniform. The spread between the best and the worst is quite small. The best returns year-to-date are investment-grade corporates, and while that's not been mortgages, going forward, because investment-grade corporates have done well, mortgages look fairly attractive versus that asset class. Perfect segue to the next slide, which shows spread levels across the same large investment-grade and sub-investment-grade fixed-income market. Here, I'll focus at the top of the page. If you look at agency MBS and corporates, the reason I focus here is that, to the extent money managers are active in the market and they are the largest, most active at the margin player today, because the bank community and the Fed are largely absent, so money managers are relevant for us. Looking at spread products, in other words, assets that trade with spread to treasuries, the two largest buckets are the agency mortgage market and the investment-grade corporate market. Relative attractiveness is important. If you look at the column labeled 2021 year-end, corporates were quite a bit wider than mortgages. Following the stressful 2022, those spreads were much wider, but they converged. December 2022 shows that while they're off the tight or the wide, they tightened, they’re still very much in line with one another. But looking at the current level, you can see mortgages are quite a bit wider, which hasn’t been so good for performance year-to-date, but going forward, the mortgage asset class does look relatively attractive, which should bode well for the sector going forward. We are very constructive on the market over the balance of 2023 and beyond. Slide 16 shows you the refinancing picture on the bottom of the page. You can see the percent of the market that's in the money is essentially zero, about 2%, not surprisingly, given where mortgage rates are. The top slide on the right is the primary-secondary spread, the spread between newly originated mortgages and a benchmark treasury or swap. It’s been volatile of late, but it’s also at fairly high wide levels. Should the market turn and see the Fed moving from a tightening bias to an easy bias, it would be beneficial for the mortgage banking universe, since they would be in a position to start refinancing, which has been negligible. The spreads are wide, which have ruined them. We've said throughout our last few earnings calls that we have a very negative view on current coupon recently originated mortgages. So that’s another reason we think that convexity could prove to be a real challenge, especially in this case, the ability of this primary-secondary spread to tighten and allow mortgage rates available to borrowers to come in and just make that section of the universe that much more refinanceable. I just wanted to point that out. Now turning to our financial results on Slide 18, I will focus on the left-hand side. This is the same slide we've had for several years. The net income excluding realized and unrealized gains and losses shows that number is negative $0.34. We’re paying a $0.48 dividend, so the question in your mind is how can that be the case? Starting with the net portfolio income of negative $8.7 million, that’s roughly $0.22 negative, and the expenses of $4.819 million, that’s another $0.12, leading to negative $0.34. We use fair value accounting, meaning we do not capture premium amortization or discount accretion in our income figures, but that’s still very much relevant because we do all these securities generally at a discount in the current environment. The accretion to par of our discount securities was approximately $4.9 million in the current quarter. So that's a positive $0.12. More materially, our hedges; again, we don't use hedge accounting, even though we do actively hedge. We use hedge accounting for tax purposes only. Our hedges are in the money, adding about $23.5 million of income or offset to interest expense, which is about $0.59. When you factor in those two items, that gets you to a positive $0.37 versus the $0.48 dividend, so there's still a shortfall. During the quarter, we did issue a little under $50 million of equity through our ATM program to increase our leverage by approximately one churn, using the proceeds to buy a combination of 30 and 5.5 and 6 securities, and we were able to hedge those positions using interest rate swaps predominantly. As I mentioned earlier, with the curve inverted, we could lock in funding through those hedges such that we had a blended net interest margin on those newly acquired assets of just over 100 basis points. That will add about $0.25 to $0.30. That’s going to close that gap some, and I’ll speak more to this in a few moments, but I want to point out that the gap obviously is $0.34 negative were much, much less than that. This was done in the very late stages of the quarter, so it's not reflected in these numbers at all. Going forward, all else equal, we would be at around $0.40 versus the negative 34, even the $0.37 we had this quarter. The one thing I want to point out is what we're able to do at the end of the quarter. I’ll speak more about our current positioning and how we see things going forward in a moment. Running through the bounds of the slide, Slide 19 shows our net interest margin, and as the curve is inverted and the Fed raises rates, we’re at a local trough and actually a long-term trough in that regard. Slide 20 is more or less the same. Slide 21 is our leverage ratio. This represents what we call adjusted leverage. That’s simply our repo balance divided by our shareholders' equity. It was 8.6 at the end of this recent quarter, but we also use TBAs, or in our case, hedges of TBAs, so shorts of TBAs to adjust that figure. Late last year and earlier this year, we shorted a substantial number of TBAs, so our economic or at-risk leverage was much lower. We indicated that we could reduce our TBAs shorts, in effect increasing our leverage, which we did in this quarter. By simply buying back these TBAs shorts and the most recent ad I mentioned, we were able to take our leverage higher, which we did to take advantage of extreme attractiveness in the mortgage market. We do have some small additional room to do so, but we did take a substantial step this quarter. Moving on to Slide 22, our positioning on the left side is unchanged with rates as high as they are. There's not much value in IOs, yielding very little ability to offer a hedge component of their performance. As a result, we have a heavy skew towards pass-throughs. I’ll talk about our portfolio characteristics. On Slide 24, we show our portfolio on the top half of the page. It remains heavily skewed toward fixed-rate 30-year mortgages, approximately 97.5%. We have added five and a half and sixes. All other coupon buckets are unchanged from last quarter other than payoffs. The change in the outstanding balance reflects paydowns over the course of the quarter. We added substantially to the five and a half and six bucket, and we took our weighted average coupon from about 3.56% to 3.83%. We've taken that higher and may do so more in the future, but I’ll table that conversation for a moment. There have been no changes in the post-quarter end. We haven’t done anything in Q3 yet. Slide 25 shows our speeds. In a substantial discount environment, these levels are quite low. If you look at the most recent quarter, that’s the bottom left. Reasonable speeds show our securities were paying around six CPR in the 3% coupon and a little higher in the three and a half bucket. That may be the cycle high since we're kind of at the peak seasonal turnover. You get decent yields out of the assets with those speeds, but I wouldn’t expect those to change meaningfully in the near term. Slide 26 shows mortgage rates are very high. The orange line there in our turnover or paydowns expressed as a percentage of outstanding principal balance are quite low. You can expect that to remain the case until rates turn around. Slide 27 shows a picture of our repo borrowings by counterparty. We have quite what I call effective spreading of the exposure across many counterparties, a diversity of over 8%. For a number of years, we’ve tried to avoid concentrations while maintaining access to adequate funding across a broad range of counterparties. On the right-hand side, we see our funding costs. One month's SOFR is hard to make out as the light gray line. The red line represents our cost of funds. It's risen steeply and continues to rise as we move through 2023, although at a slower rate. If you look at our economic cost of funds, this is where the impact of hedges comes into play. That number has peaked and stabilized, and unless we grow the portfolio substantially, that number would be expected to stay. I’ve spoken at length in prior calls about the dollar amount of hedges that we have closed out, which for federal income tax purposes still impact our taxable income this year and next, and actually years after. We have substantial gains from those hedges available to offset increased interest expense, so this number can stay stable for quite some time. Now, I’ll turn to our hedges, an important slide. As we mentioned in late May, when mortgages got very wide, I said that we took some steps, I mentioned the fact that we bought some assets. What we did was on the hedge side was modify many of our hedges, moving away from mortgages and TBA shorts, reducing from negative $875 million to minus $350 million. We shifted to rates, thinking that mortgages could not meanfully widen. So we wanted our hedges to be more rate-driven than mortgage-driven, also moving further out the curve. What we’ve seen over the past couple of months, whenever you get some softer data, like a softer CPI number last month or non-farm payroll, the most reactionary point on the curve is the five-year. We think that when and if the Fed does pivot and starts easing, you’ll see a steepening of the curve, which will be led by the five-year. We wouldn’t want to use the five-year as a hedge. We prefer longer-dated treasuries, less of them because they have more duration. On the top left, in our futures position, you can see the allotment of the five-year Treasury note future reduced substantially. We moved our TBA hedges to 10-year note futures or ultras or swaps. The top right side shows our swap position increased from $1.674 billion to $2.15 billion, approximately a 40% increase. We shifted our hedges away from mortgages into rates and further out the curve, believing that is ideal positioning for an eventual pivot and reversing direction of rates. Given that the curve is inverted, you can lock in attractive funding even in a high Fed funds environment, well north of 100 basis points is available. It's not as bad of a market as it appears on the face of it. Post-Q ends, we've done little. There were some slight changes to our swap positions; we converted one of our forward ball pairs into a forward starting 10-year swap, consistent with what I just described. That’s basically it. In summary, our portfolio positioning remains low or low coupon bias. We added opportunistically to some higher coupons, may do so again at the margin in the future if conditions are favorable, though we don’t view those assets as long-term core holdings because we think they will do poorly if the market turns around and rates rally. We’re comfortable with our current hedge positioning, moving mostly from mortgages to rates for where we are in the curve. We have a constructive view on the market, certainly over the long term. Mortgages have the potential to perform extremely well over the balance of this year and next. It may not occur in the very short term, but we have a constructive long-term view on the sector with our positioning and hedges. With that, I will turn the call over to the operator and I'll take any questions.

Operator, Operator

Thank you, Mr. Cauley. We will take our first question this morning from Matthew Erdner of JonesTrading.

Matthew Erdner, Analyst

Good morning, Bob. Could I get your thoughts on the supply-demand and spread dynamics after the FDIC sales are complete, given that the banks are kind of out of that market at this point?

Robert Cauley, CEO

Yes, that's a hard one to guess. The market, as I said, has gone well; the options have gone well. From what we can gather, the money manager community is kind of the critical marginal buyer of mortgages with banks and the Fed on the sidelines. They appear to be a pretty extreme overweight. That being said, the sector is still attractive on a relative basis versus at least investment-grade corporates if not other sectors. I don't think you'll get whipsaw tightening, but probably some gradual tightening. I just don't think there'll be a lot in the near term.

Hunter Haas, Analyst

Yes, I totally agree. No matter what measure you look at, just nominal spreads like our current coupon to yield to 10-year Treasury yield slide, or on an OAS basis or relative to other spread products, mortgages are obviously still wide. Once some of this uncertainty around the FDIC goes away, as it has over the last month or so, we would expect to see gradual tightening. To your point, banks have yet to reemerge and become players. I don't think we will see anything dramatic, but we still really like mortgages here. We don't think they've had the opportunity to perform, particularly on a spread duration basis. That's why we keep our focus on lower coupon and longer-duration assets that can benefit from spreads grinding tighter over time.

Matthew Erdner, Analyst

Thank you. That's helpful. And then sorry if I missed this, but did you provide a book value update quarter-to-date?

Robert Cauley, CEO

No, we did not. I'm sorry. It is very close to unchanged. As of Wednesday, we were probably slightly positive. Yesterday, we had a widening, especially in the afternoons. We gave back some probably took us to slightly negative on the quarter. Before I came in here, it looked like we were green. I would say plus or minus 1% is where we've been for about the last week.

Mikhail Goberman, Analyst

Hey, good morning, guys. Hope everybody's well. Just wanted to get quick thoughts on how you see the specified pool market going forward versus TBA in roles.

Robert Cauley, CEO

Well, it's been under duress, so to speak. With the FDIC liquidations, everything that's being auctioned is essentially a specified pool. We’re seeing cash window lists from Fannie and Freddie, insane amounts of supply and levels held in. Also all that occurring while rates are very high. I think it bodes well. We don’t have the technical squeeze that we had when the Fed was doing QE to keep the TBA market hot. That’s probably not coming back. We're left with the specified pool market. Given they've weathered quite a storm, I'm reasonably optimistic. There won’t be a material move, but it’s more of a slow, gradual positive performance.

Hunter Haas, Analyst

Yes, I agree. There’s a large bifurcation in the specified pool market between lower coupon universe produced over the last 10 years and the more recently produced current coupon assets. I don't have a high degree of confidence that what's been produced in the last year and a half will be particularly great in terms of convexity protection both in a rally or a sell-off. The older stuff is very attractive from a convexity viewpoint.

Robert Cauley, CEO

Yes, they're easier to hedge. We talked about the ability to use the inversion of the curve to lock in longer-term funding. When you're owning something of an $86 or $84 price, it literally can’t extend a lot, so you can use longer-term treasuries to hedge. With respect to more recent production current coupon, if you look at the collateral being produced, the gross whacks are extremely high. They’re running 95 to 105 basis points over the net coupon. The primary and secondary spreads are very wide, and they may be for a while. That said, if the market turns and the mortgage banker industry re-engages, there’s a lot of low-hanging fruit to go after. The more recent production current coupon will exhibit poor convexity, inhibiting their upside, especially relative to the lower coupons which have favorable convexity. It's somewhat painful in this environment to continue having such a bias.

Mikhail Goberman, Analyst

I'm thinking about leverage and seeing your eight turns right now, in between the historical range of 6 and 10. If you see the opportunities you hope to see going forward, could we potentially see a sort of drift toward a 9 and 10 range if we get spread tightening?

Robert Cauley, CEO

Yes, you can. 10, maybe not, but we've been in the mid-nines before. We could do that. We've done it in two ways. The big step we already took was where we got rid of a lot of the TBA shorts when mortgages got very wide levels. We raised some equity, but also added to our balance sheet just through purchases. Yes, we could go higher, not meaningfully higher, but we could.

Christopher Nolan, Analyst

Hey, guys. Bob, on your comment, you mentioned $0.40 per quarter going forward. Was that including the discount accretion and hedge income?

Robert Cauley, CEO

Yes. Basically, I walked you through from the negative $0.34 added back accretion. I think it was $0.12 added back to hedge, which was $0.59. That got you to $0.37 for that quarter. This quarter is not necessarily going to be a mere image of that. With the additional assets we added, that got you to about $0.40. There’s still a slight gap there, but for tax purposes, we have a lot of legacy hedges that were closed years ago that still cover this period. We had open positive interest in those hedge positions, so they are available to offset interest expense in those periods. We provided those at year-end; they're in the low hundreds of millions for all those hedges. They apply so much per year for the next few years. If you look at our hedge positions, we have a book of $1 billion worth of T-Note futures shorts. That's a consistent part of our portfolio mix forever. Those instruments don’t play out quite like a swap where we have swaps put on at cycle lows around 100 basis points pay-fix. We're receiving so far well into the fives now. When those swaps go into money, we're realizing that positive income value. We’ve had those gains in our T-Note futures as well. The nature of the beast is you don’t have an income component to those. You're just rolling them, and every time you roll them, you have a capital gain to offset against interest expense.

Christopher Nolan, Analyst

Given all of that, where do we stand with the dividend? Should we view the dividend sustainability to be somewhat detached from core EPS or GAAP EPS?

Robert Cauley, CEO

Yes, we haven't said anything. Our dividend has certainly changed in the past, but given where we are at the moment in terms of our portfolio positioning, we're comfortable with this lower coupon bias. We may add at the margin some higher coupon securities to close that gap over time if we see an opportunity, but we think the modest shortcoming is offset by much greater price appreciation potential of those assets versus higher coupon securities. We think that over the next year, lower coupon securities may give you a little less income, but they offer much higher total returns, and that can change if we think we're looking at Fed cuts in the next, say, 6 to 12 months. If we think it'll be higher for a long period, and we're perpetually under-earning, there’s some latitude in how we think about cuts. It doesn't always have to be targeted; we can pull forward some of the Fed expectations.

Operator, Operator

Thank you, Mr. Cauley. It appears we have no further questions this morning. I'd like to turn the conference back to you, sir, for any closing comments.

Robert Cauley, CEO

Thank you, operator, and thank everybody for taking the time to listen in. If another question comes to mind later, feel free to call our office. If you listen to the replay and have questions, we’ll be glad to take any and all questions. The number of the office is 772-231-1400. I look forward to your questions. If not, we look forward to talking to you at the end of the next quarter.

Operator, Operator

Thank you, Mr. Cauley. Ladies and gentlemen, that will conclude the Orchid Island Capital Second Quarter Earnings Conference. I’d like to thank you all for joining us and wish you a great day. Goodbye.