Earnings Call Transcript - ORC Q4 2022

Operator, Operator

Good morning and welcome to the Fourth Quarter 2022 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, February 24, 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

Good morning and welcome, everyone. I hope you had the opportunity to download our slide presentation from the website. I apologize for the oversight; we released our press statement last night, but the financial statements were not included due to an extended audit process this year. We expect to file our 10-K next week, which is typically released today, so thank you for your patience. The numbers in the press release are accurate and remain unchanged from our preliminary results shared in January. I'll start with the slide deck, following the usual outline beginning on page 3. I'll cover financial highlights, market developments and their impact on our performance, as well as our results and outlook. Then, I'll delve into our financial results in more detail, discussing our portfolio, hedge positions, and our outlook for the market ahead. To begin with the highlights, Orchid Island reported a net income per share of $0.95, with net earnings per share of negative $0.09, excluding gains and losses from our RMBS derivative instruments and interest income on interest rate swaps. We experienced a gain of $1.04 per share due to net realized and unrealized losses on our RMBS and derivative instruments, factoring in net interest income on swaps. Our book value per share rose to $11.93 as of December 31, 2022, compared to $11.42 at September 30, 2022. In the fourth quarter, the Company declared and paid a dividend of $0.48 per share. Since our IPO, we have declared $64.97 per share in total dividends, adjusted for splits, including distributions in January and February this year. Our total economic gain for the quarter is $0.99 per share, which translates to an annualized gain of 8.67%. Now, moving to market developments on slide 6, I should note that we have incorporated metrics from 9/30, 12/31, and February to reflect the notable changes during a volatile quarter. The cash curve has remained very flat since September 30th. Although the swaps curve is still relatively flat, it is slightly downward sloping, indicating negative SOFR swap spreads that grow more negative as we extend further out the curve, which has significant implications. For example, 10-year swaps were at about 360 as of last night, making them an attractive hedge level for lower coupon securities that can be effectively hedged with longer-dated swaps. On page 7, I'll make a brief comment. Despite the movement primarily occurring in the front end, rates in the long end have not changed much. There's an expectation that the Fed may continue to raise rates into the middle of the year, driven by recent data. Now, moving to slide 8, which is critical for mortgage investors. We analyze the spread of current coupon mortgages against 10-year treasuries. This graph provides both long- and short-term perspectives. In 2022, mortgage prices decreased significantly, peaking around a 190 basis point spread in late September to early October—wider than the 160 basis points experienced in March 2020. More recently, spreads have settled around 160 basis points. Although spreads were stable for a seven to eight-year period at high-70s, it’s reasonable to believe we won't maintain those extremes and most investors arrive at the conclusion that mortgages present attractive total rate of return opportunities. Slide 9 highlights the spread between five-year and thirty-year points, which reflects slight inversion, primarily at the front end. Slide 10 outlines our holdings by large commercial banks and the Fed, addressing our withdrawal of reserves. This trend recalls 2019's tightening, though it might not be an immediate concern. Slide 11 reflects specific mortgage market data normalized for several coupon types, revealing poor performance early in the quarter but significant recovery towards the end. While the bond funds have recorded eight weeks of inflows, indicating a return to market interest, the overall market is experiencing decreased performance across various cohorts. On slide 19, we see our financial results. The quarter shows a core income proxy of negative $0.09, with the $0.48 dividend prompting questions about coverage. A deeper examination reveals that components of core income may be reflected in realized and unrealized gains. In addition to a gain of $6.75 million, which indicates an offset to our core income figure, we have hedge positions contributing positively, showing a balance with our interest expense. Next, on slide 20, we present historical interest cost data. Our economic interest cost reached 226 basis points, acknowledging that while elevated, it remains lower than levels in 2019 and early 2020. This speaks to our hedge strategies and tax accounting principles regarding legacy hedges. Pages 22 and 23 illustrate our GAAP leverage at the lower end of our range, highlighting our position against TBAs and the potential for future leverage as market conditions change. As we continue, on slide 25, our positioning reflects a weighted average coupon of 3.47%, with minor changes resulting in a still heavy lower coupon bias. This conservatism contrasts our peers, who have transitioned to higher coupons to generate income, while our focus lies on pass-throughs rather than IOs, which show limited upside currently. In conclusion, slide 26 discusses our speed metrics, uncomfortable at the moment but indicative of broader trends. Importantly, as we assess our future through slide 28, our funding costs continue to diverge from the aggregate cost of funds, which enhances our position. We maintain strong and flexible hedging strategies to take advantage of market conditions as they evolve, responding quickly to opportunities that may arise. Overall, our outlook is cautiously optimistic, awaiting the inevitable pivots—our well-structured portfolio positions us favorably to capitalize on emerging opportunities whenever they occur. Thank you, and with that, we can open the call for questions.

Operator, Operator

Our first question will come from Jason Stewart with JonesTrading. Please go ahead.

Jason Stewart, Analyst

Thanks for taking the question. And I appreciate all the comments on the portfolio, especially on the coupon stack. Do you have a thought on where natural turnover is in the market today?

Robert Cauley, CEO

It's, I would say, single digits. The one thing that I'll say about that is that in the past when someone asked you that question, you would look to whatever discount security there was, and there typically would only be one or maybe two, and say, okay, what is the two or three-year-old Fannie or Freddie X. And what's it prepaying? And that's my proxy for turnover. Now, the entire universe is at a discount, and we have seasoning. But it seems that everything is tending towards mid to even low-single-digits. Some of the low loan balance pools that are seasoned, as discounts can prepay around 8 to 10. But that's the range, I would say, call it 3 to 10, depending on the security, but very low.

Jason Stewart, Analyst

Yes. Okay. When considering the coupon stack in relation to capital allocation, what do you find more appealing, dividends or stock buybacks? How should we approach that comparison?

Robert Cauley, CEO

Well, we did do some share buybacks in the fourth quarter, about 2.5 million shares. The weighted average price was like 9.30. So, when we're at a 90%, that's kind of our threshold book. When we get below that, we start thinking about buybacks. I think when we did those, we were closer to 80%. So, 90 to 100 is the gray area. If we're in the high-90s and the investment opportunities are very good, we may even issue shares. Obviously, if we’re above book and the investment opportunities are decent, we will issue shares. When we get below $9, then we start thinking of buying back shares. We think the lower coupons, even 5 CPR for life, which you may not realize for the next six months, but for life, the yields on those are still 100 over bridges 10-year swap or more depending on which coupon you buy, 3 or 3.5 or 4. So, those are not bad returns, with decent potential for price-related performance. You can get total returns in the double-digits; it may just not be all in the form of current carry, but you may realize that carry down the road just won’t be front-loaded.

Hunter Haas, CFO

And with tremendous upside to the extent that rates move, they're much easier to hedge into a sell-off. To the extent that we rally and spreads tighten even further, which we would expect, a lot of that spread duration is going to play out through a longer cash flow and we would see a potential benefit there as well.

Operator, Operator

Our next question will come from the line of Mikhail Goberman with JMP Securities. Please go ahead.

Mikhail Goberman, Analyst

Good morning. I hope you gentlemen are doing well. Those extensive comments pretty much covered all the questions that I had, and the question of buybacks versus share issuance was just covered as well. I just have a question about if you could provide a current book value estimate. That's it for me.

Robert Cauley, CEO

Yes. I meant to mention that. Using the mark-to-market on the portfolio and hedges, we were up about 10% at the end of January. So obviously, we had a good run in January. We had a lot of low coupon exposure. But with the sell-off since then, we’ve given up at least half of that. My most recent estimate, again, just using mark-to-market of the portfolio, it's not a purely GAAP number; we were about 4% year-to-date. So, we gave back a little over half of that. We'll see what the future holds. So far, we're up on the quarter.

Operator, Operator

Your next question will come from the line of Christopher Nolan with Ladenburg Thalmann. Please go ahead.

Christopher Nolan, Analyst

Hey Bob. Could you give a little detail as to the logic behind the increased TBA short position, please?

Robert Cauley, CEO

Yes. What we did there was, as I mentioned in January and the very earliest days of February, lower coupons had a really good run, performed very well. And we just thought it was kind of a way to lock in some gains if you will. Hunter, do you want to add to that? But that was kind of...

Hunter Haas, CFO

No, I think we will use that tool as a lever to the extent that we believe a certain coupon, particularly the TBA, has experienced significant movement. We will implement some duration-related hedges through TBA shorts instead of other rate hedges. Essentially, it's more of a basis trade. Given our strong exposure to Fannie 3s, I don’t anticipate this situation to last indefinitely. However, as we've mentioned, the mortgage sector performed well in the fourth quarter, and that success continued into the first quarter. Consequently, we have slightly lagged in our basis hedge. If we observe wider gaps, which we have, we might shift our allocations toward rates.

Christopher Nolan, Analyst

I have a follow-up question about the dividend. I know it was reduced this quarter. Considering the volatility in the interest rate market and your comments about the taxable carry forward, what are your thoughts on the sustainability of the current dividend?

Robert Cauley, CEO

We believe it is sustainable. Although we fell short in the fourth quarter based solely on income, the total return of our portfolio exceeded the dividend due to price appreciation. I also pointed out that our hedges began to take effect in the second half of 2022 and they will continue to do so this year, providing a significant advantage. Even though the lower coupons may not fully cover the dividend on their own, the combination of the legacy hedge benefits and their strong total return potential makes us optimistic, even if there's a slight shortfall in the near term, which may not happen. It's important not to focus solely on capturing more interest income through coupons, as that approach can be short-sighted. The assets in question are difficult and costly to hedge, with unattractive total return prospects.

Hunter Haas, CFO

Yes. I believe this environment is more complex than simply evaluating economic income or net interest margins. There are many sources of income that are not captured in that straightforward approach. For instance, in our portfolio, the deep discounts and pay-downs, especially when they provide 12 to 14 points of value, represent an income aspect, although they manifest as fair value adjustments. It’s quite challenging to distinguish the changes in market value. Much of the book value growth we observed in January and year-to-date, as well as in December, is due to a positive roll-up effect in our hedges and the movement towards par in our deep discounts. Therefore, assessing our situation solely through the traditional lenses of NIM or economic income is somewhat difficult in this context.

Operator, Operator

We have no further questions at this time. I will now hand the conference back to management for any closing remarks.

Robert Cauley, CEO

Thanks, operator, and thank you everybody for your time. To the extent additional questions come up, please feel free to call us in the office, or to the extent that you aren't able to listen to the call live and want to call us afterward, after listening to a replay, the number in the office is 772-231-1400. We’re always willing and able to take your questions. Otherwise, have a good day and have a good weekend. Thank you.

Operator, Operator

That concludes today's meeting. Thank you all for joining. You may now disconnect.