Arlington Asset Investment Corp (AAIC) 2022 Q2 法說會逐字稿

Good morning. I'd like to welcome everyone to the Arlington Asset Second Quarter 2022 Earnings Call. (Operator Instructions) I would now like to turn the conference over to Richard Konzmann. Mr. Konzmann, you may begin.

Thank you very much, and good morning. This is Rich Konzmann, Chief Financial Officer of Arlington Asset. Before we begin this morning's call, I would like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations and any other guidance on present or future periods constitute forward-looking statements that are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances. These forward-looking statements are based on management's beliefs, assumptions and expectations which are subject to change, risk and uncertainty as a result of possible events or factors. These and other material risks are described in the company's annual report on Form 10-K and other documents filed by the company with the SEC from time to time, which are available from the company and from the SEC, and you should read and understand these risks when evaluating any forward-looking statement. I would now like to turn the call over to Rock Tonkel for his remarks.

Thank you, Rich. Good morning, and welcome to the second quarter 2022 earnings call for Arlington Asset. Also joining us on the call today is John Murray, our Portfolio Manager. Over the last 2 years plus, we set a course and have successfully repositioned Arlington into an investment platform built to produce attractive returns with low volatility. Through one of the most challenging quarters in the financial markets since the first quarter of 2020, a quarter in which we saw broad equity markets draw down over 16% and benchmark short-term interest rates rise over 100 basis points, Arlington's diverse noncommodity investment channels of mortgage servicing rights, single-family residential rental properties and mortgage credit investments continue to produce positive results during the quarter. Its fourth consecutive quarter of positive economic return.

Arlington's differentiated investment strategy with low leverage and multiple sources of return is well suited for various market conditions and positioned to generate strong returns for shareholders over time. Overall, we are pleased with the progress and results we have made towards the company's objectives, including consistent economic returns, a 10% economic return among peers for the second quarter, a 6% positive economic return in the last 12 months versus peers of negative 11%, 41% annualized total return from the MSR portfolio for the second quarter and 51% since inception, building out our SFR portfolio to our $200 million goal, a 10% total return in our credit portfolio during the second quarter through quite challenging market conditions and shifting the credit quality of the company's credit investment portfolio to nearly 60% senior AAA-rated securities.

In the current Fed versus inflation-focused market, we have constructed a low-levered portfolio with the primary goal of protecting shareholder capital. The company continued to maintain a significant investment allocation in MSRs, single-family rentals and opportunistic credit investments that collectively should perform well in current volatile markets.

The company's low coupon MSR portfolio once again produced exceptional results during the second quarter in both current net interest yields of 15%, and through further multiple expansion, resulting in a 41% total annualized return.

Since we acquired our first MSR investment 1.5 years ago, strong current cash yields, along with asset appreciation, through multiple expansion have resulted in an annualized total return of 51% while employing modest leverage. As of quarter end, the company's MSR investments had $176 million of underlying mortgage servicing rights valued at a multiple of 5.39 with leverage of 0.5x.

Importantly, with a weighted average coupon of only 3.09% in the underlying mortgage servicing rights, the company's MSR investments are well positioned to mitigate declines in value if interest rates should fall. A significant appreciation in value of the company's MSR investments has contributed -- it contributed to it becoming the company's largest investment allocation at 41% of capital at quarter end. And the company may look to harvest some of those gains and reallocate the capital to other attractive return opportunities that we see available today.

We continue to make significant progress in our strategy of acquiring, operating and leasing single-family residential homes. The company's goal has been to invest up to $55 million of capital to acquire $200 million of homes, and we have essentially achieved that objective. As of June 30, the company had acquired or committed to acquire 611 homes for $192 million. And as of today, we have acquired or committed to acquire a total of 622 homes for $197 million.

The company continues to experience strong lease demand for its properties with a net unlevered yield of 4.8%. Importantly, to finance the acquisition of our SFR properties, the company has a $150 million 5-year secured term debt facility with a draw period through the end of March '23 at an attractive fixed rate cost of funds of 2.76% and with limited recourse to Arlington.

As we previously announced, the company entered into an agreement to sell 376 of its SFR properties for a sale price of $131.9 million. This opportunistic sale would capture a strong bulk premium for a portfolio of leased homes we constructed from individual purchases with strong rental yields in attractive markets. The sale is scheduled to close later this month, subject to standard closing conditions. And if consummated, we would expect the sale to have an additional positive impact to the company's June 30 book value of approximately $0.50 a share.

Importantly, the buyer has also funded a $5.3 million earnest money deposit with an escrow agent to secure its obligations under the purchase and sale agreement. Assuming the sale closes, the company intends to continue to reinvest the company -- the capital back into SFR properties to once again reach its goal of 200 million homes and to take full advantage of its below-market 5-year fixed rate funding facility.

However, we expect to take a disciplined approach in purchasing new properties in the near term as the residential housing market evolves in the current economic environment. Within the company's credit investment strategy, widening of credit spreads has created compelling new investment opportunities in high-quality assets. Late in the second quarter, we made several investments in floating rate, AAA-rated senior SASB securities in commercial real estate with unlevered spreads of 250 to 300 basis points over SOFR and solid double-digit levered returns with final maturities of 5 years or less.

We are continuing to evaluate similar investment opportunities in highly rated assets and may increase our capital allocation towards these opportunities in the near term. The agency mortgage market also saw wider spreads during the second quarter, increasing potential current carrier returns in levered agency MBS. However, based on current conditions, the company does not expect to materially increase its investment allocation to Agency MBS. As in our assessment, the potential risk to capital remains in excess of the current hedge carry return.

Turning to the actual results for the quarter. The company reported book value of $6.30 per share as of June 30, a 1.8% increase from the prior quarter end. That does not include any markup for the potential gain of approximately $0.50 per share associated with the SFR bulk sale, which would represent an increase of about 8% over second quarter book value.

The company continued to operate with overall low leverage and significant financial flexibility with its overall at-risk leverage ratio standing at 1.6:1 at June 30. For the second quarter, the company reported a GAAP net loss of $0.01 per share and earnings available for distribution formerly referred to as core operating income of $0.05 per share, unchanged from last quarter.

We continue to believe there is far greater value in Arlington's business than the public markets recognized. During the second quarter, the company repurchased over 3% of its outstanding shares of common stock that accreted $0.09 per share to book value. Subsequent to quarter end, the company has repurchased over 1% of its common stock outstanding and accreted an additional $0.04 per share to book value in that period.

Since reinstituting its current common stock repurchase program in 2020, the company has repurchased 25% of its outstanding shares. And the company has a substantial remaining authorization of 10.7 million shares from its Board to repurchase shares of its common stock.

The company has been able to consistently produce solid economic returns during a period of challenging market conditions. As our investor presentation illustrates, compared to our peers in the FTSE NAREIT Mortgage Home Financing Index, the company has significantly outperformed our peers in total economic return in both recent quarters and the last 12 months while also experiencing among the lowest volatility of quarterly economic returns over the last year.

Having successfully positioned Arlington to preserve capital and grow book value per share through various market conditions, the company now has the opportunity to capitalize on substantially wider investment spreads by deploying incremental capital to new investments with superior risk-adjusted returns in the low to mid-teens in the high-grade residential and commercial mortgage securitized products, among other improved return opportunities that are available.

We expect that the redeployment of capital into these higher return investments can drive increased overall earnings potential, which can be used to increase equity capital, support share repurchases or reinstate a dividend to common shareholders. We have a strong conviction about Arlington's differentiated strategy and as significant owners of Arlington stock, we believe that the company's diversified investment platform can generate attractive returns to shareholders that the market will recognize and value over time. Thank you. And I'd like to open the call to questions.

(Operator Instructions) We'll take our first question from Doug Harter with Credit Suisse.

Rock, can you talk about the return opportunity you're seeing in SFR today as you redeploy that, assuming the sale goes through to redeploy that capital and how that would compare to the cap rates that you acquired those assets at?

I'd say, Doug, that today, what we see is that, that market is evolving, shifting. And I think to the extent that we expect to be an ongoing buyer to refill the $200 million allotment, we would expect to be patient in that and watch how the market unfolds here a bit. We may see the possibility of cap rates moving up a little bit. And to the extent they do, then we will capture the benefit of that in new purchases laid up against our 2.76% financing remaining for 4 years after that point. So we wouldn't be surprised to see spreads be consistent, but we also -- with where we bought them, but we also would not be surprised to see the spreads against our financing to be a little wider and the return opportunity a little higher on the follow.

Great. And you talked about some of the opportunities in the securities, do you view those as kind of long-term holdings? Or would that be kind of a placeholder as you deploy the $200 million of proceeds?

No, I think -- well, first of all, that will depend on how that -- how markets evolve. First of all, the spreads we're seeing on the security side -- the new opportunities we're seeing on the security side have evolved based on changes in market conditions over the last 6 months, right? These are conditions that I think in these markets, we hadn't really seen for a long time, in some cases, since the start of QE. So they're relatively unique and it's not clear how long they will endure as fresh opportunities. Having said that, we see those -- given those returns in the low teens, mid-teens and even in some cases, high teens on very senior floating rate securities, we see those as a holding that we'd like to have. And to the extent that we can invest in incremental capital and additional opportunities like that, with those types of returns relative to their risks, we think those are very attractive and we would plan to do so. So we think the type of securities that we purchased have a spot in our portfolio over the longer term. To the extent we're able to build that position, we expect to do some of that under the limits of our available capital. And to the extent that we'll be having fresh liquidity in when the SFR sale closes, we'll invest that more on a more sort of short-term basis with the notion that, that will go back into SFR over time and refill that $200 million bucket as we repurchase homes ahead of the March end '23 time line. That makes sense?

It does.

Our next question comes from Tim (sic) [Jason] Stewart of JonesTrading.

Great. I got a new name. A quick question as a follow-up on SFR portfolio. For leased and occupied, do you have a sense for what your year-over-year rent growth is there?

I think -- well, remember, this portfolio is relatively early, Jason. But what I think we're seeing is consistent with what others in the industry are seeing sort of high single digits. Maybe a little higher than that, but sort of in that high single digits range. And -- but it's a relatively small number of homes because it's a relatively newer portfolio, right? It hasn't turned over a lot. But in those circumstances where it has turned over, which is some reasonable level of sample size, we're seeing consistent rent growth with other firms, the public guys and other firms that are investing in the space are seeing.

Okay. Got you. And can you just remind us when you purchased this, how much of the portfolio was in rehab? Just roughly.

Really none of it. The rehab we're doing is very minor. That's going in there and replacing a carpet or replacing a refrigerator. These are all relatively newly built homes. So the rehab period in terms of time and dollar commitment is very minor.

Got it. Okay. And then on the credit side, what would make you want to go down in credit? And what kind of opportunities are you seeing there right now?

Well, it's a great question. That's a great question. And you can see we're sort of doing the opposite, right? We see this opportunity that developed in the last quarter in the AAA space as fairly unique over time. And so we wanted to take an opportunity to capture that while it was available, not knowing how long it might continue to be available. And so we did that to the extent we could late in the second quarter. And what we've essentially accomplished is shifting out of down in credit over time, which provided very reasonable returns even through the challenging markets here over the last 6 to 12 months. It generated acceptable returns and rotating that down in credit capital to be up in credit capital with comparable returns. So if 1 year or 2 ago, we were investing in a BPL or a non-QM down in credit piece, and that was going to be mid-teens or high teens, something like that. But we can now do that. We've now done that in these AAA securities with comparable returns. So we have been in the process of shifting up credit in that portfolio with an eye to be potentially opportunistic for really outsized returns. So what would draw back to -- down in credit would be significant outsized returns, but we would be really cautious about that. We're very focused on the up in credit opportunity here as we go through this part of the cycle and potentially into a recession. We're more focused on the up in credit. It would take something more exceptional to bring us down in credit at this stage.

Got it. Last one for me. On the agency market, what's your view of capacity today? I mean given the rallying rates and the impact on prepays going forward.

Capacity for us?

No. Just industry capacity to originate loans and then how that impacts prepay speeds?

Well, I mean there's a massive adjustment going on out there. I mean we think about it -- look, we're -- at this stage, our agency exposure is relatively modest, right? And that's because of the uncertainties and risks we continue to see in that space, number one, despite the fact that spreads widened and it's more attractive now than it was. But relative to other opportunities that we see, we still tend to be a -- we still are trying to be a modest investor on the agency side from a capital allocation standpoint. I think overall, we feel like prepay speeds are probably pretty benign here. And we watch them, obviously, very closely as it relates to our SFR portfolio, in particular, which is a significant capital allocation for us. So we're more insulated in that portfolio with a 3.09% coupon level than a new issue agency security today for sure. But we feel like we're -- we've got a pretty benign view on prepayment speeds from here.

I think, there's one piece here, Jason, that -- I want to follow up on your question about the securities composition of the portfolio and Doug's question about the securities composition. I think these types of opportunities added incrementally to the earnings power of the company. It gives us a -- gives the company a fresh opportunity. And to sort of reiterate what I said at the end of the script, having come through this challenging period with book value up and capital generally preserved we see fresh opportunities that we think have the opportunity over time to potentially grow the earnings power of the company in a way that can improve our ability to grow capital, buy stock, repurchase shares or potentially reinstate a dividend at a future point. And I would say, as it relates to that last point, we have spent a good deal of time thinking a lot more seriously about that potential dividend reinstatement opportunity down the road and, in fact, spent a significant amount of time in discussion with our Board about it at the last meeting. I wouldn't say that that's something that would be imminent because we'll see how the SFR process unfolds. That will impact the growth in earnings over time. But as that process unfolds, I think our Board is very mindful that we have the tools and the flexibility, particularly with increased earnings power from these returns available today to consider fresh opportunities for the deployment of our capital beyond just the buyback.

(Operator Instructions) Our next question comes from Trevor Cranston with JMP Securities.

On the MSR portfolio, obviously, the returns there have been very strong as rates have increased. Where multiples stood at June 30, have you guys contemplated starting to hedge the fair value of the MSR, given that it would seem like further upside from there seems kind of less likely and then there could be some potential retracement if there's a big rally in rates.

Well, the agency position is there in good part to hedge -- to complement and hedge the MSR portfolio. I think a couple of other things there. I think, one, we mentioned in the script that as that appreciation has occurred, the capital allocation to that asset has grown over time. And I think as a concentration matter, combined with the appreciation levels, acknowledging the valuation question you're raising, I think it shouldn't surprise people if we trim that over time and harvest some of those gains for repatriation to some of these other also high-return opportunities. So I think one answer is that -- number 2 is we're seeking to keep the leverage on their modest. And three, the agency hedge is there to offset the price moves. One of the things we've done, Trevor, more recently is we've sort of -- we've reduced the hedge positions a bit on the agency's portfolio side in order to -- for -- in order for it to respond more effectively to downgrade scenarios, which could potentially affect the valuations on the MSR side, alongside a further shift in markets down rate as we head toward potential recession. So that's all part of our shifting assessment of markets and positioning into the next phase of market and economic developments and policy developments with the Fed is increasing our down rate hedge posture on that MSR portfolio by a few different means, selling down portions of it as well as increasing the agency exposure to offset down price moves in the MSR in the down rate move.

Got it. Okay. That make sense. And do you have an update on where you think book value is currently?

Our best assessment now is about flat.

There are no further questions at this time. This will conclude today's call. Thank you for your participation. You may now disconnect.

Thank you.