Earnings Call Transcript - ORC Q2 2021

Operator, Operator

Good morning, and welcome to the Second Quarter 2021 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, July 30, 2021. At this time, the company would like to remind the listeners that the 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, and good morning. Welcome to the second quarter earnings call. I hope everybody's had a chance to download the slide deck from our website. As usual, I will proceed through the slide deck. As I go through our remarks before we open up the call for questions, I’ll just lay out the agenda for today's call. I'll start off with a brief overview of our financial highlights. Then I will go through a review of the developments in the market for the quarter and, more importantly, how Orchid reacted to these developments and the decisions that were made regarding the portfolio, our hedges, and leverage ratio. I'll start off with just giving a brief review of how the company and the portfolio are positioned coming into the quarter. I will also provide some comments on our outlook, in terms of how we see things evolving over time. I will then return to the financial results in a bit more detail, as well as the portfolio and our hedges, and finally, just wrap it up with some closing comments and our outlook, and then turn the call over to questions. So with that, I will turn to Slide 4, so the results for the second quarter of 2021. Orchid Island had a net loss per share of $0.17. Net earnings per share were $0.24, excluding realized and unrealized gains and losses on our RMBS and derivative instruments, including net interest expense on our interest rate swaps. We had a loss of $0.41 per share from net realized and unrealized losses on our RMBS and derivative instruments, also including net interest expense on our interest rate swaps. Book value per share was $4.71 as of June 30, 2021, versus $4.94 at March 31, 2021. In Q2 2021, the company declared and subsequently paid $0.195 per share in dividends. Since its initial public offering, the company has declared $12.11 in dividends per share, including the dividends declared in July of this year, with a total economic loss of $0.035 per share for the quarter or $0.07. Turning to Slides 5 and 6, we give the results of Orchid versus our peer group, which is defined on the bottom of the page and the note on each page. You can see our results with a year-to-date and one, two, and three-year look back as of June 30, as well as for the calendar years. This is reported on Page 5, using stock price and dividends to compute total rate of return, and on Page 6, we show book value. I will have a few more comments on these slides at a later point in the call. For the moment, I'm just going to move on and turn to market developments. As Orchid entered Q2 and as we positioned the portfolio towards the later stages of Q1, we had shed a lot of our exposure to lower coupons in the 30-year space predominantly in our TBA positions. We had added to our hedge positions and started to deploy capital more towards IOs, and that allocation has increased to actually inside of 10%. Since then, we achieved two and it was 18, and it's since actually slightly higher. We were positioned quite defensively entering the quarter. Now, I'll just kind of go through the developments that took place in the quarter and how we responded and how we view these developments. If you see on Slide 8, you see the movements in the treasury curve. The blue line on the left represents the market as of 3/31; the red line is at June 30; and then the green line is at last Friday. Obviously, the market has rallied. I think you can break down the market at this moment into three phases for this year. The first quarter through early April saw the economy recovering rapidly, with the government administering stimulus, leading to growth figures that surged, alongside worries about meaningful inflation. The market sold off, and the curve steepened very rapidly. In early April, it started to change. The events of Q1 led the market to adopt a very defensive short position in the rates market. This was evident in interest futures markets and so forth. Moreover, one other development it started to push was counterintuitive. The Fed was skeptical regarding their means of inflation; Chairman Powell stressed this over. He believed inflation would be transitory and would not persist. While economic data was generally strong, there was one notable exception: job growth lagged expectations. We had a number of non-farm payroll reports that were below expectations. As we heard Wednesday from the Chairman, that was significant in their outlook regarding substantial further progress. Other outside factors led to what I would call 'pain points' in the markets rallying in the face of very strong economic data; yen-denominated investors were able to deploy capital in treasury markets and realize very strong returns. We also heard of insurance companies deploying equity capital into bonds. All of this led to a somewhat counterintuitive development related to the market. The third phase kicked off around the mid-June FOMC meeting when we saw some disagreement amongst the committee members, despite the Chairman being in charge. Some members had inflation concerns; they thought inflation might be stronger than initially expected. More meaningfully, we observed in their dot plot that at least some members believed the Fed would have to hike much sooner than the market had anticipated. This came together to form what we would characterize as a very hawkish meeting. Around that time, the Delta variant emerged, which raised concerns over the growth outlook both in the U.S. and globally. The market rallied again and continues to rally as we speak today. We have experienced a significant change since Q1. Regarding our perspective at Orchid Island and our positioning at the end of Q1 and now, we are still taking a defensive stance. We do not believe that inflation is just a temporary issue; simplifying it that way is not accurate. While some price pressures are indeed temporary, like lumber prices, other inflationary trends are more persistent, and we cannot ignore that. The Delta variant presents risks to growth. However, despite the challenges, we believe growth will eventually recover, and the economy will get back on the growth path it was on a few weeks ago. It's possible that the Delta variant could inadvertently increase inflation, as many might hesitate to return to work. If the federal government were to extend supplemental unemployment insurance, it could worsen the job shortage and wage growth issues we are facing. In general, as the Federal Reserve starts to reduce their quantitative easing, they will halt the influx of reserves into the system, leading to a decrease in downward pressure on interest rates. Consequently, we maintain a defensive stance with a risk balance leaning towards higher rates. We are mindful of a potential inflation surge, especially if it's significant, as it could substantially affect our portfolio and book value, particularly for leveraged bond investors. The persistently low rates are pressuring our earnings and may accelerate certain speeds, which could adversely impact our book value. A spike in rates could result in varying outcomes. Moving to our slide deck, Slide 9 illustrates our rally. On Slide 10, I want to highlight a key development this quarter, which was the flattening of the yield curve, indicating a bull flattening in Q2 and into the third quarter. As I noted earlier, this was not beneficial for our IO position. Despite that, we see this rate movement as an opportunity to acquire positions at appealing levels. We have kept substantial allocations to production inspection, which have performed exceptionally well in terms of prepayments, an essential aspect of safeguarding our net interest margin and, ultimately, our dividend. Turning to Slide 11, starting with the top left, we can see the performance of various TBA coupons this quarter. It's a mirror image of what we saw in the first quarter. In the first quarter, lower coupons suffered significantly while higher coupons were flat to slightly up. This quarter we experienced the exact opposite. Our coupons have actually performed better since the end of the second quarter, driven primarily by the most recent prepayment fees. We have started to identify some burnouts, but this remains an open question moving forward. As you can see on the bottom left, the rolls in the production coupons remain very strong, which is not surprising given the presence of the Fed. What's surprising is the roll for the three coupon, which as we speak is trading at almost the same drop as we see in the two percent coupon, which is counterintuitive. It's certainly driven by the compression of the front month as the back month rolls remain positive but are much lower. Finally, on this page, you can see that spec pay-ups have recovered across the quarter; this reflects several factors. For instance, the underlying TBA could be stronger or weaker, as those movements sort of play into the payoffs. Turning to Page 12, this serves as our proxy for implied volatility in the market. I want to point out that while volatility spiked quite dramatically late in the first quarter, it has since decreased but remains above the levels we observed in the last nine months of 2020. Thus, volatility is still modestly elevated, although we do recognize it may not likely persist absent another shock, as we have generally been in a very low volatility environment. The next slide, I want to discuss in more detail, as it pertains both to what happened in this quarter and how we are positioning Orchid’s portfolio going forward. I want to really focus on the left-hand side here, which is the TBA LIBOR OAS. You see various lines that correspond to different coupons; the gray line on the bottom represents the thin two and a half. Back in June of 2020, it was north of 50 LIBOR OAS. As shown, in April and May of this year, it got all the way to negative 20, which is a significant move. Other proofs showed similar movements, and while not necessarily in negative territory, it’s quite indicative of a major shift; of course, all driven by quantitative easing and the Fed combined with paydowns worth of 100 billion dollars a month in mortgages. The mortgages are currently guiding very tight; they have since rebounded, especially when the Fed first hinted at tapering. When considering a longer horizon, those levels remain comparatively unattractive. One might assume that once we are fully out of quantitative easing and subsequent rate hikes occur, those levels will tend to migrate back towards their previous levels. I would assert the following: it is unlikely we won't see tapering before the end of the year. The tapering will also be pro-rata, as market participants were worried the Fed might taper mortgages before treasuries. Based on Chairman Powell's comments on Wednesday, that doesn’t seem to be the case. The second point of confidence is that once tapering starts, it will be gradual—a telegraphed event that won’t produce a violent impact on the markets, likely playing out over six to twelve months. I think the third point is less assured, but presuming the Fed maintains their historical pattern of tapering QE first, followed by rising rates and then quantitative tightening—i.e., stopping reinvestments and removing reserves from the system—mortgage purchases in the form of reinvesting paydowns might continue until late 2023 or beyond. This paints a relatively benign picture regarding tapering's impact on the mortgage market. However, we must note that we are coming off of extremely tight levels. It is true that many fixed income market sectors are equally tight, but there has been considerable buying pressure in the market, not just from the Fed. We must consider that when reserves are injected into the banking system, those funds tend to be reinvested. Banks have been large buyers of mortgages for some time now which could ease downward pressure on pricing. I believe that this decline in sponsorship will eventually cause levels to back off. While we don’t anticipate violent moves, they will indeed occur, and we need to position and minimize exposure to the coupons most vulnerable—namely, 30 and 15-year production coupons. We will continue our overweight in the pools with higher coupons and inspection forms to inhibit prepayments and safeguard our net interest margin. Slide 14 shows returns for the quarter from the U.S. Aggregate Bond Index. The picture here reveals a very much risk-on quarter, demonstrating that animal spirits are robust. As you can surmise from the returns for the quarter, high-risk sectors, including emerging markets and high yield, along with the S&P 500, have performed exceptionally well. Alternatively, more risk-averse asset classes, such as treasuries and mortgages, have relatively poorly compared to those sectors. Turning to Slide 15, I'd like to make important points here. I’m starting on the top right, where we see the primary secondary spread, which has been the difference between treasury market rates and rates available for borrowers. We started out at a very high level, knowing that there was considerable room for that to compress, which indeed has occurred down to close to 100, though it now seems to have leveled off. A contributing factor to that compression was simply the capacity constraint among originators to handle more mortgages, leading to increased income. Recently, a regulatory change removed the adverse market fee, which represented a one-time shift downward in rates available to borrowers; we refer to this as an elbow shift, meaning that rates can go lower. And indeed they have. Recently, with respect to the left side of the page— if you look at the refi index, the red line represents the mortgage rates, which has moved lower since the end of the second quarter, as expected, though the refi index has not responded as strongly as might have been anticipated. How these dynamics will play out over the remainder of the year remains to be seen and will clearly influence our view on burnout in higher coupons, a significant driver of TBA versus spec pool performance. Moving on to financial results in Slide 17. As always, we present a slide that dissects our income statement using a proxy for core earnings—namely our net interest expense netted with repo and expenses—while the middle column reflects our realized and unrealized gains and losses. As noted at the onset of the call, we had a $0.17 loss for the quarter and also experienced a $0.41 loss on realized and unrealized gains and losses on our MBS assets and derivative assets, inclusive of interest rate swap accruals, producing a net $0.24 thereafter. Notably, we were positioned defensively entering the quarter and remain so. Most of the losses—particularly the $0.41—are unrealized, so there is potential for these losses to reverse if the market moves in the opposite direction. We can’t make any predictions, but that potential exists. On the right side of this slide, we show returns allocating capital between pass-through and structured securities. There was a modestly negative return in the pass-through portfolio this quarter, reflecting that mortgages lagged behind our hedges. A positive mark-to-market occurred on the pass-throughs, but premium amortization reflected in our mark-to-market caused reductions. Moreover, the bull flattening in the rates market adversely affected our IO positions, generating negative returns. Despite that, we remain convinced of the market's trajectory, viewing this as advantageous for those assets. Transitioning to Slide 18 shows the economics of the portfolio after accounting for both hedges and costs. The green line represents the net yield on our assets, while the blue line shows average asset yield and the red line depicts economic funding costs, incorporating our hedges—important in determining our net interest margin. As can be discerned, the green line remains relatively stable, reflecting in our dividends as well. The blue line indicates a sharp decline but is showing signs of stabilization. Given our current market view and the Fed's outlook, especially regarding leadership at the Fed, we expect funding costs to remain low through the end of this year and potentially into most of next year. This leads us to a relatively optimistic outlook for our dividend—indicating we should maintain this level for at least the next six to twelve months, possibly beyond. Slide 19 illustrates earnings per share, segregating marked-to-market gains and losses from our proxy for core earnings—identical to what is presented by our peers. Finally, as discussed on Slide 20, I wish to contrast our results versus our peers. The top graph demonstrates Orchid’s annual dividend yield using book value as a denominator, while the lower one demonstrates the same using the beginning stock price. The blue lines reflect Orchid’s yield compared to the peer group, although I apologize as the peer group definitions are not included here. If you refer back to Slides 5 and 6, they contain the necessary peer group information. Orchid consistently paid higher dividends compared to the peer group since 2014, reflective of our strategy—a high dividend yield resulting from a higher leverage ratio, emphasizing higher yielding assets, particularly spec pools that allow generating higher yields and income. As expected, higher risk portfolios often exhibit heightened volatility, as observed during specific periods reflected in the first quarter. We rarely experience such episodes, typically contained within weeks. However, our high yielding portfolio generally compensates for volatility, resulting in overall outperformance versus peers. We remain committed to our strategy despite variances in quarterly results. Market conditions remain favorable, creating an opportunity for high yield versus higher volatility, and we anticipate closing that gap with potential outperformance now that significant volatility episodes are less frequent. Moving to Slide 21, we’ve discussed portfolio repositioning and the numbers are shown on the left side, with structured portfolios starting at 9.5% and ending at 18% by the end of Q2 and even higher now. The right side presents actual investment numbers across sub-portfolios, providing details on asset purchases and changes. Now let’s discuss asset compositions and hedges in Slide 23. The last page illustrates the structured assets’ composition with minimal change in weighted average coupons on the pass-through portfolio, now at 2.97, slightly higher than 2.95 at the end of the first quarter. Out of the lower duration assets—20-year and 15-year—they largely remained unchanged, reflecting runoff. However, we made changes to higher coupon 4.5s with adjustments showing a decrease in exposure overall to lower coupons. We notably reduced exposure to the 2.5 coupon from 1.1 billion to under 700 million and increased exposure to 30-year 3s from approximately 1.85 billion to 2.725 billion. This growth reflects a strategic shift from lower coupons and the growth of the portfolio through our ATM, which our peers also undertook in Q2. The majority of this growth is in that coupon. We've also reduced exposure to the 30-year 4 coupon by about 140 million, which stemmed from asset restructuring and allocation from pass-throughs. The middle page outlines our positions in structured IOs; these adjustments reflect trade maneuvers and new IO acquisitions. Regarding hedges, notable changes occurred in our TBA shorts, dropping from 400 million at quarter-end to 1.3 billion at the first quarter. We took off TBA hedges while adding shorts in five-year treasuries and ten-year ultras. Overall, there have been few other changes, and since quarter-end, we’ve engaged in trades, buying new 2.5 coupons to sell existing assets that were ramping up and prepaying while maintaining existing allocation. Slide 24 captures our allocation in high-quality specs, which has diminished, though the specs remain stable. We need to generate income through our pass-through pools, crucial for maintaining speeds and managing realized speeds. On Slide 25, notice the first graph showing monthly performance across various coupons. Notably, our primary exposure in the 30-year space rests with the 3% coupon. Comparing recent performance against our cohort, we've noted positive trends in the first three weeks of July, indicating strong results. Our pass-through portfolio prepayment figures show excellent results at 10.9 CPR in the third quarter, significantly improved from 9.9 in Q1 despite higher rates. This strategy galvanizes our ability to generate income and pay dividends as desired. The next page illustrates similar themes but in different visuals. I’ll pause here; this concludes the remarks up through the second quarter. Of note, since the last quarter-end, the yield has dipped back into the 120s while prepayment speeds remain steady. Moving to Slide 27, we see that our leverage ratio has decreased due to both allocations to IOs and a defensively cautious posture. The average now reflects a slower deployment of capital, allowing for selective entry and maximizing opportunities. We anticipate slight upward migration but not returning to the mid-high nines observed in previous years. Slide 28 reviews hedging positions, showing that our strategies have remained virtually unchanged since the quarter's end. That concludes my lengthy prepared remarks; let’s open the call to questions, Operator.

Operator, Operator

Your first question comes from Jason Stewart from JonesTrading.

Jason Stewart, Analyst

Bob, thanks as always for the commentary and perspective. I appreciate that. I love the increase in the IO exposure. Maybe you could talk a little bit about what the levered ROE looks like in terms of the IO strategy versus just the core agency strategy?

Robert Cauley, CEO

Well, the IOs we’ve acquired are largely defensive in nature. The collateralization relies on assets that are prepaid slightly faster, which tend to yield negative cash flows initially. However, if rates rise, those cash flows could extend, becoming positive yielding assets. Comparatively, the pass-through portfolio yields are similar. If the market were to stay where it is, we likely remain at these levels. Additionally, we’ll experience upside if rates move back up, which should enhance performance.

Hunter Haas, CFO

With respect to the IOs specifically, we've been targeting assets with solid underlying pool convexity. We primarily focus on 3, 3.5, and occasional 4% bonds that are backed by loan balance collateral. Some are paying slightly faster; our effective yields on those types are generally in the 2.5 to 3.5% projected range. With a generic target of achieving a 3% yield, we can underwrite returns around low double digits on capital after accounting for haircuts, which may be higher due to the 20% standard. Moreover, the strategic shift decreases our reliance on rate hedges, an important aspect given our historically cautious approach to rising rates, which can be detrimental to our position. If unexpected rate rallies occur, IO ownership can preserve cash flows as fewer borrowers would refinance promptly, enhancing our cash flow streams overall.

Jason Stewart, Analyst

So maybe Bob or Hunter, how do we reconcile what you just said with the disclosure that plus 54 leads to a $45 million loss to book value? There seems to be a discrepancy here between a perfectly parallel shift and some sort of elbow or steepening in the curve.

Robert Cauley, CEO

Yes, historically we’ve traded much shorter than those rate shocks indicate. We closely monitor these metrics but have empirically been shorter than predicted during this period.

Hunter Haas, CFO

If we consider the dollar amount of the losses, we had only a modest positive return on our pass-throughs. The recapture premium amortization manifested a negative number in the IO book while the hedges primarily—specifically, swaps and swaptions—exhibited significant erosion. As such, the bulk of the losses stemmed from the hedge book, with a net negative result on the overall portfolio. Essentially, we encountered pronounced underperformance across the board.

Jason Stewart, Analyst

It seems to me that that number may be overstated in terms of the projected net loss. Hopefully that is the case. My most important question revolves around the levered ROEs exhibiting high single-digit to low double-digit ranges versus a 17% payout on book value. Why maintain the dividend at this level rather than adjusting it in line with levered ROEs?

Robert Cauley, CEO

In response, maintaining the dividend at $0.065 is not predicated upon earning this every quarter. We aim to identify a center of mass where we predict earnings over more extended periods. We do experience fluctuations above and below that line based on varying conditions. Unless we discern permanent shifts, our dividend approach remains steady. With our positive outlook surrounding IO positions, we anticipate reaching that $0.065 mark on average going ahead. If economic forecasts change substantially, we may consider reallocating between allocations.

Operator, Operator

Your next question comes from Tim Delisle from Seven Canyons.