Earnings Call Transcript - ORC Q1 2022

Operator, Operator

Good morning and welcome to the First Quarter 2022 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, April 29, 2022. At this time, the Company would like to remind the listeners that statements made during today's conference call relating to matters that are not historical facts are forward-looking statements subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good faith, beliefs 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, everybody. I hope everybody has had a chance to download both our press release as well as our slide deck, and I'm going to follow the similar format. So, if everybody is ready, I will begin. First, I'll just provide an overlay of what we are going to discuss. As usual, I will briefly touch on our financial highlights, then we'll go through market developments quickly and our financial results. And then talk about the portfolio positioning and so forth. With that, on Slide 4. Orchid Island Capital reported a net loss per share of $0.84. This was actually net earnings per share of $0.20 excluding realized and unrealized gains and losses on RMBS and derivative instruments, including net interest expense on interest rate swaps; a loss of $1.04 per share from net realized and unrealized losses on RMBS and derivative instruments, including the net interest expense on swaps; book value per share was $3.34 at March 31, 2022 versus $4.34 at year-end. In Q1 2022, the company declared and subsequently paid $0.155 in dividends. Since its initial public offering, the company has declared $12.635 in dividends per share, including the dividend declared in April. Total economic loss was $0.845 per share, or 19.5% for the quarter. Turning to Slide 5. This slide shows our stock performance for Q1. As you know, we did have reductions in the dividend twice and we did have book value decline, which obviously the market anticipated. As a result, the first quarter stock performance lagged our peers significantly, and this has changed all of the comparisons versus our peers on a 12/31/2022 look back. It reflects predominantly what happened in Q1. If you look at the calendar periods on the bottom of the page, you can see the results that we are very happy with. However, the first quarter is not something we are happy with, but it obviously happened and we have to live with it and move forward. Turning to the next page. This is our book value performance. Just as has been the case with us, there is always a one quarter lag, so you see through the end of 12/31/21. We don't have updated information now that'll again lag. Turning to market developments, just to give you a high level view of things before I go through the slides. If you look at the backdrop of where we were before the first quarter, inflation started to accelerate in the second quarter of last year, and that has continued well into 2022 already. Over that period, the Fed kind of gave up on their notion that inflation was transitory. The major developments in Q1 were two, and these were very meaningful and really caused everything to change. The first was the war in Ukraine between Russia and Ukraine. And the second is COVID-19 induced shutdowns in China, both of which have proven to be very inflationary and are expected to continue to be so for some time going forward. The net result of these events are three developments. The first, the Fed has pivoted and adopted a very aggressive tightening stance. They expect to get to neutral by the end of the year, which is somewhere in the 2.50% to 2.75% range. The second is that interest rates are much higher, and the curve is very much flatter. The third, and this is more germane to Orchid obviously, is that the MBS universe now is essentially all at a discount to us. In fact, most of the mortgage universe is at a deep discount, well below par. To add some color around this, there is only about 1% of the mortgage universe that is in the money or refinanceable. The current coupon mortgage represents about 1% of the entire outstanding universe. That is something we've never seen before. So, this is obviously a profound change this quarter. As I said, it has been brought about by these two significant events, which will play heavily in terms of what we see over the balance of the year. Now just turning to the slides, a couple of things I would point out. On the left-hand side, you can see the red line where we stood at the end of the year. The blue line is at the end of the first quarter. So, obviously a meaningful move. The green line is through last Friday. As you can see, the market has continued to both sell off and flatten. This is also reflected in the swap curve. At the bottom of the page, we show the change. And that's through last Friday; that's not through quarter end. Turning to Slide 9, you can see how things really pivoted in late February when the war began in Ukraine. We have had a selloff in the early parts of the first quarter, but this really accelerated when the war started. I just want to point out that many of these slides go through forward '22, not just the end of this quarter. Through forward '22, the nominal or cash tenure was up 139 basis points, swaps up 137 basis points. Turning to Slide 10. This is the slope of the curve 5 and 10. As you can see, we have flattened materially; the lowest previously were in July of '18 and that has now been surpassed. As we sit here today, we're actually toggling right around zero, it's actually been negative a couple of times this morning already. Turning now to the mortgage universe. Top left, you can see this is the same slide we've been presenting for some time. We've kind of normalized prices starting at the beginning of the period, so each line represents a respective coupon, and this shows just the price change relative to where the price was at the beginning of the quarter. These are not necessarily actual prices. As you can see, it has been a meaningful selloff. Again, this data goes through April 22nd, and you can see through the end of the first quarter, there was a meaningful selloff. In the case of the Fannie 2s, for instance, the longest duration assets, they were down about 7 points at the end of the quarter, but now they're down about 12. So, this April obviously witnessed even more selloff than what we saw in the first quarter. As the market is now in a discount composition, call protection as reflected in the specified pool payups has collapsed. Arguably, these payups just reflect option value, to the extent the market rallies. With respect to rolls, you can see there are only two rolls that are trading above the rest which are at very elevated levels. These are the current production coupons, the 4s and 4.5s. Really, what this reflects is that a lot of mortgage investors want to own the current coupon, and there just isn't enough supply. So, you have a big supply-demand imbalance, which even the Fed is exacerbating for the time being, and so the special is in the roll. The rest of those rolls are trading at or below carry on. Moving on to Slide 12 vol, as you can see, it’s very elevated, not quite as high as it was in March of 2020, when we were north of 160 in this particular index, but very elevated nonetheless. Moving through the rest of the slides, just accelerating now, I think we've made major points here. LIBOR OAS on Slide 13, obviously, we've had some cheapening, and specified pool payups as I mentioned have collapsed. Slide 14 gives you a picture of the whole financial markets. The top chart shows you the Q1 returns, and the bottom one is through the end of last Friday, and you can see all these returns are negative. Obviously, mortgages are the one that's in green; they had a rough quarter, but every sector did, including equities in the S&P 500. So, it's been a very difficult quarter for all financial market participants. Slide 15 is an important slide. As I mentioned, if you look at the bottom of this slide, you can see the shaded area. That represents a percentage of the market that's in the money. As I said, it's only 1%. We have really had a paradigm shift whereby the market went from very much premium, with the Fed buying and driving up prices, and everyone was concerned with prepays. You had two ways to avoid those: either you viewed the dollar rolled market or you owned specified pools. You were trying to minimize premium amortization. Well, now we’re at a discount, so now it's no longer premium loss due to paydowns for us. It's discount accretion, and fast speeds went from being a bad thing to a good one. High gross WACs on pools used to be a bad thing, and now it's a good one. If you look at the right side, I would just make one point here that is kind of germane for what we see going forward. You can see the primary-secondary basis looks very evolved. I think that speaks more to the volatility of the underlying, which has been rates because they've been so volatile. But it also points out the fact that originators, now that the universe is at a discount, are doing everything they can to maintain production volumes; that's primarily in the form of cash-out refinances or turnover. It also speaks to the fact that they are going to have a challenge to keep their production levels and their staffing levels higher. It really just points to the fact that all rate-sensitive sectors of the economy are going to be feeling these changes. Now, moving on to our financial results, Slide 17. As you can see, if you tried to dissect what happened, this left-hand slide shows our returns absent the unrealized gains and losses. These numbers were large. It was really all because of the pass-through portfolio. The pass-through portfolio had an annualized return of almost negative 40%, obviously a very big number. This was really driven by the performance of TBAs. If you look on that chart there, you see realized and unrealized losses of $378 million. Outside of realized losses, over 80% of our mark-to-market losses for the quarter were the result of changes in TBA prices, about 17% were the erosion of payups on specified pools, and the rest was just premium loss. You may wonder how we could have premium loss, but that's just because it's a function of prices at the beginning of the period when the portfolio was still at a premium. Turning to Slide 18. This shows our name over time alongside the dividend. It appears that our funding costs went down. That's really just some timing differences there. Obviously, our funding costs will be going up, even with hedges there's probably going to be some modest upward pressure. This number dropping down just kind of reflects the fact that our hedges started to move up faster than our funding costs. You should see that being stabilized, whereas you may see a slight upward trend in the funding costs net of the hedges and the net interest margin remains to be seen. That will be predicated on how the asset yields go. Slide 19, again, shows our proxy for core income. This red line, as you can see, has been running in the low 20s. Our ultimate low was back in '19 and '18, and it's been fairly stable since then. We expect it to remain so, but there are still a lot of bluff cards on the table. We'll have to see how things play out. Slide 20 shows you our dividend versus our peers. We will say that in this type of environment where the curve is very, very flat and liquidity is at a premium, this is not going to be a big emphasis. We're going to manage the portfolio as prudently as we can. We do not know what our peers will do dividend-wise. We have reduced ours twice just to reflect current market conditions, and we do not know what the future holds. We just hope that all of that is behind us. But again, there are just a lot of moving parts in the economy. So, there is a potential that you could have movements either with us or anyone else. It's really hard to say what's going to happen to relative dividend performance, but I don't think it's a primary concern for any of us. Slide 21 gives the two important things: the roll forward of each portfolio and the capital allocation. As you can see on the left side, the main development here is the allocation to IOs has increased, while pass-throughs have decreased. We mentioned last year that because of the current market conditions, our allocation to IOs would go up. We had mentioned on previous calls a target of around 25%. We actually got up to 38%, beyond that. Now what does that mean going forward? It's kind of hard to say, IOs have had a good run. While we would like to own some more, they are really becoming somewhat rich and it's hard to find value. There might even be some good sale candidates, and we haven't actually sold a few in early '20 in the second quarter. Some of the details of the change: the sales that we did in the quarter were predominantly in the pass-through portfolio. I'll discuss that in a little greater detail in a moment. We also had paydowns and mark-to-market losses. Suffice it to say, these asset sales occurred to maintain leverage but also to shed duration. We did not reinvest paydowns for the most part. So, that's how we migrated the portfolio to its current position. Now, we'll talk a little more detail about the portfolio. Before I do that, I just want to say a few words, kind of give some background. As you recall, last year, for most of the last three quarters, we talked about being positioned defensively. We thought that the Fed would end their tapering program and that we were trying to do everything we could to minimize the impact on us. Obviously, we are an all-agency REIT, so we are kind of locked in the building, if you will. We have to own mortgages. We tried to avoid production coupons and took our allocation up to IOs to a higher level and we own specs. Even to this day, we still see long-term value in them, even though they are trading at fairly distressed levels. As for the Fed, we were right; they did exit. However, the events of the first quarter, especially the second half, have changed things quite materially. This positioning, and the way we looked at things last year, really doesn't apply as much in the current environment. So, just to review the actions we took. We did reduce the portfolio. We had approximately 1.4 billion of sales of pass-throughs. Those were mostly lower pay-up specified pools, mostly lower coupons, 2.5s. We had about $147 million of paydowns and $10.5 million in return on investment on our IOs, which was not reinvested. All of this was enough to allow us to maintain very high levels of liquidity but also allowed us to lower our leverage ratio from the low 8s to the mid 7s; we're actually below that today, but we might not go much lower than this. This is probably the floor. With respect to post-quarter end, we have done some up-in-coupon trades, both 30-year and 15-year. We would continue to refine our hedge positions; I'll talk about that in more detail. The important thing and the key takeaway is that while it was a very difficult quarter, we were able to navigate through it successfully. We did have to shrink the balance sheet somewhat to maintain leverage at good levels. We also did so in a manner where we could maintain very high levels of liquidity. Our target is to maintain 50% cash, which does not even include unencumbered assets, just cash relative to equity because first and foremost, we need to be able to weather any of these storms. We've had some very volatile days in the market, days with mortgage underperformance versus hedges and margin calls. We always want to be in a position where we can deal with those quite comfortably, and we have. We know this is a difficult market environment, but we also know it's not likely to last indefinitely. Given the very favorable opportunities in the market today, we want to be able to take advantage of those once the market stabilizes, and we are in a position to do so. Now with respect to the portfolio on Slide 23. Just going through the column for fair market value on the pass-throughs, there were two big changes with respect to 30-year 2.5s; we took that down significantly, selling about $941 million, mostly, and again, in low pay-up specified. We sold over 900 million in 30 years, again predominantly in low pay-up pools. Our weighted average coupon is a result of relatively more sales to 2.5s versus 3; the weighted average coupon is a little higher and went from 2.93 to 3.01. We did not reinvest pay downs. Our portfolio aged by 4 months and speeds remain very subdued in the high single digits, and we would expect them to stay there; it might even decline. We made meaningful changes to the hedge book; we'll discuss that in a moment. If you look at the notional amount of the hedges versus the total mortgage assets, coverage went from about 45% to closer to 80%. That's notional and somewhat misleading because the DV01 of our hedges is quite high. In fact, we have a lot of alters in our swap positions, and so forth. If you look, for instance, on the far right column, our rate sensitivity to plus or minus 50 basis point shocks shows a very flat profile given the size of this portfolio; that’s much flatter than it was at the end of the year. This reflects what we are seeing. Even though rates have sold off quite a bit in April and mortgages have widened, our book value is probably down just a few pennies, and we really trade pretty much in line with the hedges net-net, so far. This reflects the fact that mortgages have expanded, and they trade in line with the hedges. Even though it's a high-rate environment, it's stabilized. This reflects the nature of the hedges we have in the assets we own. Slide 24 is interesting; this used to be something we took great pride in because it reflected well on our asset selection. Our prepayments versus the cohorts are, of course, backward-looking, so it's our legacy portfolio. As I mentioned, we have not been reinvesting too much. We've done some up-in-coupon trading, but it reflects the prior reality we lived in, where premium amortization was the thing to avoid, and everybody was trading at a meaningful premium. Now, obviously, we are at a discount. So, you will see these slides change going forward. On Slide 25, the same point holds; the red or orange line is the 10-year Treasury, this only goes through the end of the quarter; that number is now at 2.9 or so. The prepayments you would assume in this environment are expected to stay low, similar to what we saw in '13 and '14. I mentioned on Slide 26, our leverage ratio is down. It's actually down a little bit from where it shows here. We are probably pretty much where we want to be. Finally, Slide 27 discusses our hedges. On the top left, we have our Treasury Futures, and we've shifted those materially. These numbers are up higher. The 5-year sector is up by almost $1 billion and the Ultras by not as much, but $50 million. We have no TBA shorts in place at quarter end, although we have placed some on since then. We have some shorts in the Fannie 2s, and with respect to swaps, the belly or the 3 to 5-year has come down. We have moved our swaps out on the curve from about $950 million at the end of the year to about $300 million now, while expiries greater than 5 years have gone from about $400 million to $1.1 billion. You can see the average pay-fixed rates, and those all are very much in the money in this current environment, effectively helping us with our increased funding costs. We are dynamically hedging those positions. As our strikes move more or less in the money, we take action to ensure that they work as effectively as possible going forward. In this environment, that basically means taking some profits and extending strikes higher. This has worked very well for us and likely explains why we've had the stable performance we've had so far in April. With that, that concludes my prepared remarks. Operator, I will turn the call over to questions. Thank you.

Operator, Operator

Our first question comes from Mikhail Goberman with JMP Securities.

Mikhail Goberman, Analyst

I apologize I missed a good chunk of the call; I had a little trouble getting on. So, I apologize if you mentioned or covered something that I'm about to ask. But I do believe I heard you saying that IOs are becoming a bit rich. You've already sold some in the second quarter. If that's the case, how much have you sold?

Robert Cauley, CEO

So, in the first quarter, we sold $80 million worth of IOs backed by loan balance 3s. In the last month, we sold another $200 million, which corresponds to about $35 million of loan balance 3.5s. They had reached their limits, and the profile became very asymmetric. There isn't much benefit from further sell-offs, and there is downside exposure. It's similar to what we discussed about the hedges. Sometimes, we re-strike to a higher level; that's likely what we are aiming to do, but we need to find the right opportunities to make that happen.

Hunter Haas, CFO

Now that's exactly right. Unfortunately, I think as Bob alluded to earlier, I don't know if you were on or not, but only 1% of the mortgage universe is refinanceable at this point. So, it's tough to find IOs that don't have a great deal of extension already baked in, even if they're paying fast. So, just not something we're highly constructive on right now. We have been focused more on doing things in rate derivatives and trying to improve the complexity of our profile through an increased focus on options that will increase in value at an increasing rate into a continued sell off, and have limited downside if we were to rally from here, whereas the IOs are sort of the opposite of that with a tremendous amount of downside into lower rates. The durations on some of that stuff had gone from negative 15 to 20 down to negative 4 to 6; this won’t hold in a lower rate environment. They have a lot of value that can be lost at this point. So, we think it's prudent to reduce our exposure there, at least until some higher-rate mortgages have been produced. The CMO machines turned back on and focused on something that IOs can continue to extend.

Robert Cauley, CEO

And that's a good point. I'll just add specific to that. Production of new IOs is minimal. The CMO machines, as it's referred to, have shut down to a large extent, so new IO creation is very sparse.

Mikhail Goberman, Analyst

That makes sense. So, you said like about $200 million sold in the second quarter; that effectively kind of zeros out the portfolio almost at the moment.

Hunter Haas, CFO

No, that was the face amount. It was $35 million market.

Mikhail Goberman, Analyst

Okay, I got you. All right.

Robert Cauley, CEO

Sorry for the confusion there.

Mikhail Goberman, Analyst

No worries. No worries. And then you mentioned book value is only down a few pennies thus far in the second quarter despite the spread widening and the volatility. How would you guys describe that relatively strong performance in the month of April as well?

Robert Cauley, CEO

We did not make significant changes to the portfolio. As I mentioned, we've engaged in some minor coupon trades. We are primarily dealing with a lot of 3s, which are highly extended, making them easier to hedge. We have increased the duration of the hedges and continue to adjust our positions with the swaptions and swaps. Even though we have experienced some declines in our book value due to the widening spread, the fact remains that our exposure is easier to manage. Some companies have not reported their earnings yet, but we felt our quarter was particularly challenging, largely due to our significant focus on specified pools, while many of our peers concentrated more on TBA portfolios. This may have caused us to experience more pain in the first quarter, but we have managed to improve since then. This improvement is all linked to our focus on enhancing the convexity profile of our net asset hedge book.

Mikhail Goberman, Analyst

So beyond maybe stepping up further in coupon, you guys see yourself maybe stepping up to the 15-year mortgages as well?

Hunter Haas, CFO

Not. We've done some. We think there are some opportunities in the TBA space. We've rolled out some of those specified pools there that just looked fully valued. There are some specialness in some of the 15-year rolls. That could be an area where we add a little bit, but on the margin, that’s usually a relatively small part of our book.

Robert Cauley, CEO

The current flat curve means that 15-year production is limited and has been largely utilized. At this point, the market is increasingly focused on seasoning due to the discount environment. There's not much trading activity; we receive cash when production lists are released, but the new production specifications don’t see extensive trading. It’s important to note that seasoned pools are trading, but the market data can sometimes be unclear, making price discovery somewhat difficult. However, it’s evident that the market recognizes the value of seasoned pools as they typically pay out quicker. When they’re available at a discount, we benefit from the fact that we haven't significantly rolled our portfolio, so most of it is seasoned, which adds to its value.

Operator, Operator

There are no further questions at this time. I will now turn the call back over to Robert Cauley for closing remarks.

Robert Cauley, CEO

Thank you, operator. Thank you, everyone. To the extent there are those of you who were not able to make the live call and wish to call later with questions, we will be glad to take those. Our office number is 772-231-1400. Otherwise, we look forward to checking in with you next quarter. Hope everybody has a great weekend. Thank you.

Operator, Operator

This concludes today's conference call. You may now disconnect.