Earnings Call Transcript - ORC Q4 2023

Operator, Operator

Good morning and welcome to the Fourth Quarter 2023 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, February 2, 2024. At this time, the Company would like to remind the listeners that statements made during today’s conference call relating to matters that are not historical facts are forward-looking statements subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The 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. And now I would like to turn the conference call over to the company's chairman and chief executive officer, Mr. Robert Calley. Please go ahead, sir.

Robert Cauley, CEO

Thank you, operator, and good morning. I hope everybody's had a chance to download our slide deck. As usual, I'll be going through the deck over the course of the next 30 minutes or so. Give everybody a moment to pull up the deck. I will, as usual, start on slide three, just to give you an outline of what we'll discuss. The first thing we'll do is go over our financial results, briefly hint at the market developments that occurred during the quarter, which obviously shaped our results, and then talk about our portfolio and hedging positions, and then give you an outlook of how we're positioned and how we see things going forward. So with that, I'll turn to slide five. These are the high-level critical metrics for the company for the quarter, where we reported a net income of $0.52 per share for the fourth quarter of 2023. Our book value increased approximately 2% from $9.02 at the end of the third quarter to $9.10. The total return for the quarter was 6.05%, and we declared and paid $0.36 in dividend. As you recall, the dividend was reduced late last year from $0.48 to $0.36. Now I'll turn to slide six, kind of the second-level metrics. And these largely reflect steps taken during the quarter. I won't spend too much time going through the details of what happened in the quarter, but as we all know, in October, rates were selling off very violently, and the outlook for rates going forward was a lot different than it was in the last two months of the quarter. The market pivoted severely, turning around and rallying in November and December, but nonetheless, during October, with the market selling off the way it was, we had to reduce the portfolio in order to maintain our leverage and liquidity. So if you look at the top left, you can see that the average balance is down. That's slightly misleading because we did reduce the portfolio by almost 16%, and I'll get into the details of how we did so, but it was a fairly decent-sized reduction. We also brought leverage down from 8.5% to 6.7%. In terms of our liquidity, we took steps to raise our liquidity. And over the course of the balance of the quarter, we did not change a lot with respect to the hedges, and I'll delve into that in greater detail in a few moments. But in any event, those are the big picture views of what happened. Our speeds declined slightly. That merely reflects seasonal declines, nothing noteworthy concerning that. Slide seven shows our financial statements. We have not yet filed our case, so these are still somewhat preliminary, although we do not anticipate changes. I will leave those for your review. Next, I'll move on to slide eight. We've been incorporating this slide lately. This shows you our net income focus. We're looking at the NIM here. We're trying to take into account the effect of our hedges and discount accretion or premium amortization. The idea here is to make this data look a little more like our peers who also report either core income or earnings available for distribution. As you can see in the top right, these are dollar amounts. The bottom are just presented in percent or per share amounts. The headline number was relatively flat, but if you look at the interest expense on repo, you can see a decline. That reflects the decrease in the size of the portfolio. What's noteworthy is that the income number did not change very much. One reason for that is that even though we did reduce the portfolio, we did so mid-quarter. The third quarter is somewhat misleading because we added a lot of assets late in the quarter, so we did not have a full quarter's worth of income. Nonetheless, the combination of the two leaves us with a relatively attractive NIM. As you can see, discount accretion was actually larger, which simply reflects the fact that we calculated accretion based on the market value at the end of the previous period, and with the third quarter's sell-off, the values of assets were down, and discounts are larger. So even though prepayment speeds were slightly low, we had larger accretion. The effect of the hedges continued to move in our favor. Bottom line is there was a fairly substantial increase in adjusted net income. Again, this is non-GAAP. We're presenting this just for comparison purposes to our peers, and we're trying to, as I said, take into account the effect of hedges and discount accretion, which under our method of accounting we did not use in the fair value option. On a peer-shared basis, you can see income was up fairly substantially, even with a slight reduction in the portfolio. And just want to say a word or two about the numbers on the bottom. As you can see, we had been paying a $0.48 dividend while earning less, and now that’s kind of flipped. To go back to where we were in 2023, we were at the time willing to accept slightly lower current income because we wanted to own securities that we had. We thought we had much better total rate of return potential with mainly lower coupons, especially if the economy was going to pivot and turn around and we were going to end the tightening cycle and potentially go into an easing cycle. So we were willing to make that sacrifice. The events in this last quarter led us to a decision regarding reducing the size of the portfolio. It was easy. We could shed basically TBA-like 3% coupon securities that had a negative NIM and in fact, increased the income of the portfolio while still leaving us with a decent overweight to that sector. So to the extent we get a move in the other direction rate-wise, we stand to do quite well. We're happy with this positioning. We have a comfortable level of income and we still have the potential to do well in the event of a rally, although today's numbers may call into question how soon that's going to happen. I'll say more about that later. Anyway, moving on, just to discuss market developments, the top left is interesting because this shows you the curve over the course of the last few months. As you can see, the red line represents September 30, the green line is the end of the quarter, and the blue line is actually where we were last Friday. If we had done this at the end of close of business yesterday that blue line would have been pretty much on top of the green line, and we did it at close of business today, it might be right back where it is. So the long and short of it is that the market still remains quite volatile. The outlook continues to change. The data this week is obviously significant, but we also had developments away from that with respect to regional banks. We had a Fed meeting, and the volatility we've been experiencing for a couple of years continues. If you look at the bottom right, you can just see a proxy for the shape of the curve. I just point to the bottom right, you can see late in the year, we had a significant move from the end of October and then it reversed. The shape of the curve continues to gyrate as data comes in and factors outside the market impact the shape of the curve and rates. Turning now to slide 11, the top line is one of our favorites. It shows a proxy for the attractiveness of the mortgage sector, the basis, if you will. As you can see, we've been at very wide levels. If you look at the right side of that chart, you can see it's November and December. We tightened in quite a bit. I want to emphasize two points on this. First, quarter-to-date, we've been trading sideways; we haven't tightened much or widened much. That said, we're still at very attractive levels, and the mortgage space is still appealing. We're eager to put money to work in this environment because we are excited about the retain opportunities that are out there. Regarding how mortgages performed on the bottom of the page, we normalized prices to give you a feel for how they changed over the last quarter. Obviously, there was very strong performance towards the end of the quarter, and to a large extent, it has been maintained into the first quarter of 2024. In terms of Gini roles, these are generally weak. Certain roles that are attractive are Gini roles, Gini May securities. We typically don't operate in that space, but the roles there are attractive and present a slightly different picture than what you see here. Moving on, let's review some more market color. Volatility on the top is a recent look back, only going back a year. There are three points I want to make here. At the time this was presented, as of last Friday, we were at local lows over the last year. We have certainly rebounded this week. Every day this week has been choppy with respect to either incoming data, the Fed meeting, or regional banking news. Volatility is still relatively high compared to historical standards and even more so this week versus what's depicted here. A few more slides, and then we'll get into the portfolio. At the top of slide 13, you see the red line indicates that mortgage rates rallied toward the end of the year, but still at extremely high levels, around 7%, and probably, if anything, going up from there. One thing worth noting is that primary secondary spreads are still fairly elevated historically. The takeaway is that in the event of a more welcoming market, mortgage originators could definitely enhance refinance ability by tightening those spreads. Right now, it doesn't look like that will become an issue, but the potential for that to happen in the future is definitely there. Moving through the deck, slide 15 gives me a chance to go into more detail about what we did during the quarter. Obviously, I mentioned at a high level we experienced a severe turnaround in the market from October into November and December. In October, it looked like rates would sustainably remain above 5%, and the Fed would keep rates relatively high through 2024, which then violently reversed in November and December. We took steps to address that. Specifically, we reduced our allocation to the 3% coupon by 38%. We also added some higher coupons. In doing so, alongside our previous approaches, we continue to raise the weighted average coupon. It's up to 4.33%, with the realized yield up to 4.71%. Additionally, our economic net interest spread increased significantly. The reason for that is we reduced the portfolio during October, but did not reduce our hedges nearly as much. We reached a position where we're more fully hedged, and we accomplished this in a way that our swaps, which are our most effective funding hedge, became a larger percentage of our hedges. Consequently, we saw a meaningful pickup which, coupled with the higher coupons on the portfolio, resulted in a wider economic net interest margin. This explains why, in the previous slide, you saw the $0.54 versus the previous values. Slide 16 visually represents the changes to the portfolio. As you can see, we've been adding to the higher coupons and reducing our exposure to threes, while maintaining a decent overweight, which means that in the event of a rally, we have a chance to perform well, while also maintaining good hedge coverage and solid levels of income. On slide 17, we discuss our funding in general. As previously mentioned, the reason the blue line ticked down is the hedge portion of our baskets, specifically the swap portion, has become larger as we had reduced all the hedges but not the swaps. The swaps now constitute a larger percentage of the total. These are effective hedges from a funding perspective and our average pay-fixed rate is quite low. Consequently, in combination with higher coupons, our net economic interest income is higher and our funding costs are lower. A few points on the left side, our funding level is quite stable with the Fed reaching a state of being done, hopefully. Regarding the average days of maturity, it remains relatively stable, with the main change regarding the economic cost of funding which has improved. Slide 18 dives into the details of the hedging positions, reiterating that we're now more fully hedged because we believe the market had advanced ahead of itself toward the end of the year. Looking back, we feel comfortable with that decision, which has proven to be fortuitous. Our portfolio is relatively rate neutral. In fact, the value increase during the quarter resulted more from mortgage basis tightening rather than just being long without cover. We've positioned ourselves well, with our attractive income and upside going forward. On slide 19, late in December, we added some SOFR futures to secure what were at the time extremely aggressive market pricing for Fed easing. This should bode well for us going forward. Since quarter end concerning the TBA hedges, we have adjusted those slightly. The belly coupons of the mortgage stack have generally become richer in January. We transferred some of those hedges into the 4.5% coupons. Some small positions in threes remain, while the balance is in what we call the belly coupons, which would be 4.5%, 5%, and 5.5%. They've performed well. We see them as having more room to fall. Lastly, concerning the swaps, we did not significantly reduce those, and the fixed rate is even better now than it was at the end of the last quarter. This has also contributed to improved economic funding costs and interest margin. Slide 20 showcases shocks concerning the various coupons. We frequently monitor these to gauge how the coupons would perform in different scenarios, aiding our decision-making process concerning portfolio construction. It indicates that lower coupons typically perform best in a Rally or a Bull Steepener and worst during a Bear Flatener or sell-off, providing valuable insights despite its non-relevance to the broader discussion. Moving on to slide 21, I mentioned our relatively rate-neutral portfolio. Our hedge level is quite high, reflected in the bottom right where changes in equity value respond to a plus or minus 50 basis point rate shock. This indicates a benign reaction to those moves. We implemented that mostly in December under the assumption we had more upward movement in rates than downward. That seems to have mainly held true but has been choppy. Slide 22 illustrates our prepayment speeds by coupon, aiming to provide a granular overview relative to the whole portfolio. I will leave that for your review and discussion. Moving to wrap-up on slide 23, I want to emphasize three points. Certainly, this was a pivotal quarter with the dramatic transition from October to November and December. We believed the market had advanced too far. In retrospect, it appears that may have indeed been the case. The portfolio's current income positioning is quite attractive. We believe we have potential upside if the Fed eases. Whether or not that's imminent is uncertain given recent developments. That being said, inflation seems to be moderating. Provided we don’t see a resurgence in inflation, it is likely the Fed will gradually remove the tightening bias. If they were to do that, it opens opportunities for our net interest margin to expand even further. In the event of a recession, we could perform exceedingly well due to our portfolio's positioning, particularly in a bull steepening scenario. Even if the status quo remains, we are in a favorable position from an income standpoint. We believe the intense book value pressure we've faced for the last two years is likely over. We feel secure in our forward positioning. A final note before I turn it over to questions on slide 25: this presents anecdotal data we share quarterly. The blue line signifies bank holdings of mortgages, which represent a welcome development recently as banks have begun returning to the mortgage market. They play a significant role here— the Fed continues reducing their portfolio, and banks have been following suit. This trend has seen some improvement recently. Still, the recent events with regional banks notwithstanding, we were starting to see banks re-enter the market—this would be a very positive development for the sector as they can strongly support the mortgage market. With that, operator, I will turn the call over to questions.

Operator, Operator

Thank you. Your first question comes from Mikhail Goberman from Citizens JMP Group. Your line is open.

Mikhail Goberman, Analyst

Hi, good morning, guys. Just a couple of questions here. Could you give an update on what your economic leverage stands at currently? Sort of piggybacking on that, assuming we don't get any rate cuts until the second half of the year and we sort of stay at this level of primary, secondary spreads, what's your appetite for that leverage going forward? I know obviously leverage went down meaningfully in the fourth quarter. And also, if you could, a book value update as we stand now. Thanks.

Robert Cauley, CEO

Sure. I'll do a quick one and then I'll turn it over to Hunter. The leverage is, if anything, slightly lower. Probably just pay downs for the month, not being reinvested. Our book value is approximately unchanged as of yesterday, up or down a few pennies from where it was at year-end. Concerning primary, secondary spreads, that's a tougher one to call. I'm uncertain how that will evolve today; it has thrown a wrench into the outlook. Prior to these developments, we thought the Fed would ease at some point, maybe not March, but as long as inflation kept trending down, we believed they would gradually ease. However, if we do see an acceleration in wage growth, there's a risk we could encounter a wage-price spiral that could change our expectations. Our view was to take leverage back up a little bit, but now we may need to wait and see how the situation unfolds.

Hunter Haas, CFO

Yes, I think we'll look to increase leverage gradually, doing so in a measured pace as we observe how the data develops. We came into the tightening in the fourth quarter that occurred from the wides at the beginning of the quarter into the third while being quite defensive. We lowered the economic leverage. We sold a few bonds at the peak of widening, which was unfortunate. We're seeking opportunities to increase our basis exposure a bit by reducing TBA shorts and possibly adding some pools as well. We'll be cautious in that regard. Opportunities have presented themselves recently, and we have been considering various options for gradual additions. In general, we remain neutral on the basis. We've been more focused on effective hedges rather than rushing into asset-side increases. Since the December Fed meeting, the market seemed to advance prematurely in anticipating quick eases through 2024, and we've taken steps to lock in this process through funding hedges while waiting to leverage asset opportunities.

Mikhail Goberman, Analyst

Got you. Obviously, we're going to get a portfolio update in a week or so. But I guess we can expect you guys to keep adding the same sort of coupons at the margin that you've been adding the last couple of months?

Hunter Haas, CFO

Yes, I think, as we said, the belly coupons have been the most favored location because they're right below par. They're somewhat insulated from potential future rate extensions and are not affected by prepayments significantly. They've become attractive, but it's challenging to add there due to their current value. We would likely look to add some higher coupons given the recent price changes. However, I need to reassess based on how today's changes unfold over the rest of the day. We came into last year with a significant bias towards lower coupons, and we've been shedding the legacy portfolio items that were acquired in a lower rate environment during pronounced widening periods throughout 2023. We don’t feel that we've sacrificed much in absolute value from a relative perspective. If we intend to add some positions back to TBA form, we can do so easily. The pools sold last year did not significantly add to our income, being more of a trade aligned with tightening basis, hence why we moved focus onto lower-coupon sections. We’ll monitor how the index performs, as money managers generally move in and out of that space, which will be relevant for this year's trends.

Operator, Operator

Your next question comes from the line of Christopher Nolan from Ladenburg Thalman. Your line is open.

Christopher Nolan, Analyst

Good. How are you? Bob, the comments you made on your cost of funding were interesting. Should we imply from this that your negative spreads are a thing of the past going forward?

Robert Cauley, CEO

On a hedge basis, they are. Yes. We're pretty fully hedged. While it may appear negative on an absolute gap basis since we do not use hedge accounting or report premium and discount, the underlying reality is it’s far from negative— in fact, it’s actually north of 200 basis points when considering the hedges. The only potential change would arise if we began expanding the portfolio significantly and needed to add new hedges, but even then, it’s possible to secure favorable funding. For instance, with the recent rally, 10-year swap spreads were approximately 350 basis points. Thus, if we were to add any coupon north of 3%, we can achieve positive spreads. It's not hard to maintain a net interest margin, and while expanding it may be more challenging, we're in a good place with locked-in funding hedges to sustain attractive levels going forward.

Christopher Nolan, Analyst

Okay. So that's positive for the dividend in terms of incremental decreases, right?

Robert Cauley, CEO

Yes. Furthermore, if we do experience any eases, it would be almost completely upside, as this would lower our absolute repo interest expense, thereby impacting the bottom line positively.

Christopher Nolan, Analyst

Great. Final question. The comments you made about banks were interesting. Given that we're facing potential challenges in commercial real estate, based on your experience, how have mortgage backs performed during past corrections in commercial real estate?

Robert Cauley, CEO

I can't provide specific answers. However, typically, the absence of credit exposure in this sector tends to bode well during such environments. When there’s a credit event—be it commercial real estate or corporate—the asset sector often performs well. Hunter and I attended a recent conference where numerous investors managed endowments or pension funds and were quite bullish on mortgages. Asset managers currently view them attractively. If there’s a negative credit evolution, it makes them even more appealing given their historical attractiveness and lack of credit risk. I believe this situation would favor us. The downside with banks, however, is that many have acquired a lot of lower coupon mortgages. Last year, those being underfunded may need to liquidate, potentially leading to selling pressure. That could be why lower coupons have struggled recently, as evidenced by the New York Community Bank issue.

Hunter Haas, CFO

I'd add that in our last three pronounced episodes affecting agency REITs— post-global financial crisis, the early pandemic days, and the taper tantrum— agency mortgages generally performed quite well. During severe liquidity pinch periods, when investors felt pressure from other sectors, agency mortgages became the relief valve to enhance liquidity. Although this practice can potentially create brief selling pressure, it's essential to recognize that in recent years, some people have been selling more liquid assets rather than ideally trading what they should. Over the past year, we've seen this phenomenon, which affected our performance. We reached levels that were wide enough that money began flowing in rapidly when we approached those extremes.

Operator, Operator

With no further questions, I'll turn the call back to Mr. Calley.

Robert Cauley, CEO

Thank you, operator. Thank you, everybody, for tuning in. To the extent anybody has any questions that come up after the call, please feel free to call us. Or if you have a question that comes up after you listen to the replay because you couldn't make it this morning, again, feel free to call. The office number is 772-231-1400. Otherwise, we look forward to speaking with you again at the end of the first quarter. Thank you.

Operator, Operator

Thank you. And this does conclude today's conference call. You may now disconnect.