Armour 住宅房產信托 (ARR) 2019 Q4 法說會逐字稿

Greetings, and welcome to the ARMOUR Residential REIT Fourth Quarter and Year-end 2019 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded, Thursday, February 20, 2020.

I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.

Thank you, Nelson, and thank you all for joining our call to discuss ARMOUR's fourth quarter 2019 results. This morning, I'm joined by ARMOUR's Co-CEOs, Scott Ulm and Jeff Zimmer; Chief Operating Officer, Mark Gruber; and today, we're welcoming Co-Chief Investment Officer, David Sayles. By now, everyone has access to ARMOUR's earnings release and Form 10-K, which can be found on ARMOUR's website, www.armourreit.com.

This conference call may contain statements that are not mere recitations of historical fact and, therefore, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the safe harbor protections provided by the Reform Act. Actual outcomes and results could differ materially from the outcomes and results expressed or implied by the forward-looking statements due to the impact of many factors beyond the control of ARMOUR. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of ARMOUR's periodic reports filed with the Securities and Exchange Commission. Copies of these reports are available on the SEC's website at www.sec.gov.

All forward-looking statements included in this conference call are made only as of today's date and are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless we are required to do so by law. Also, our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to the most comparable GAAP measure is included in our earnings release, which can be found on ARMOUR's website. An online replay of this conference call will be available on ARMOUR's website shortly and will continue for 1 year.

ARMOUR's Q4 2019 comprehensive income was $58.5 million. That includes $108.7 million of GAAP net income. The GAAP net income was driven primarily by an $80.4 million increase in the mark-to-market movements or interest rate swaps, while $42.2 million of unrealized loss on Agency Securities flow through other comprehensive income. Core income, which include -- which excludes those mark-to-market items but includes TBA Drop Income was $36.5 million or $0.55 per common share. Based on stockholders' equity at the beginning of the quarter, core income for the quarter represents an annualized ROE of 10.5%.

Quarter end book value was $20.84 per common share, up 2% for the quarter. ARMOUR's year-end mortgage-backed securities portfolio consisted of over $12.8 billion of securities, including $11.9 billion of Agency Securities and $900 million worth of credit risk and non-agency securities.

In our update presentation as of January 31, 2020, available on our website or EDGAR, we said that estimated ARMOUR book value was $21.04 per common share. We plan to update ARMOUR's estimated book value as of February 29 when we release the next company update in mid-March. After that, we plan to provide book value estimates and the updates for months coinciding with our quarterly reporting cycle, which are March, June, September and December.

On January 28, 2020, we issued 3,450,000 shares of our 7% Series C Preferred Stock and through February 14, 2020, we have issued another 1.2 million shares of the Series C Preferred Stock through our at-the-market offering program, which we established on January 29. This results in total current Series C net proceeds of $113.4 million after allowing for commissions and offering expenses.

We also announced the redemption of all 8,383,344 shares of the outstanding Series B Preferred Stock effective on February 27, 2020. That will be redeemed at $25 per share for a total of $209.6 million of redemption proceeds. The final full monthly Series B Preferred Stock dividend will also be paid on that date to the holders of record as of February 15, 2020. During the fourth quarter, we also purchased 45,000 common shares at a discount to book value.

We paid dividends of $0.17 per common share during the month for each of the months in the fourth quarter of 2019. That's a total of $30.2 million or $0.51 per common share. We've also announced monthly common dividends for February and March of 2020 at the rate of $0.17 per share and the Series C Preferred Stock dividends for February and March 2020 at the contractual rate of $0.14583 per share.

Now let me turn our call over to David, Jeff, Mark and Scott, who will discuss ARMOUR's portfolio positions, current strategy and other matters. David?

Good morning, everyone. In the fourth quarter of 2019, the Federal Reserve's well-coordinated actions delivered a sharp boost for risk markets, with a lower and consistent overnight rate policy, new purchases of short-term treasury debt aimed at replenishing bank reserves as well as its commitment to support repo liquidity far into 2020. Major U.S. equity indices climbed to record highs, corporate credit spreads tightened to precrisis levels and interest rate volatility declined below its recent trends.

The yield on a 10-year U.S. Treasury maintained a trading range between 1.5% and 2% throughout the quarter, pushing the spread between 2-year and 10-year treasuries to 34 basis points, it’s widest in 2019. The prevailing 30-year home mortgage rates stayed between 3.5% and 4%, supporting the MBA refi index at somewhat elevated levels. The average prepayment rate on our mortgage securities portfolio was 17.1 CPR in the fourth quarter, up from 13.3 CPRs Q3 average.

Headlines around declining borrowing rates and an easing Federal Reserve policy generated a strong media effect responsible for healthy refinancing activity, while technological advances in the mortgage origination industry expanded its operational capacity to process applications more efficiently. We expect seasonally muted prepayments in the first quarter to ramp up in Q2, reflective of these trends, along with the recent decline in mortgage rates.

With that in mind, it is important to note that over 92% of ARMOUR's January 31, 2020 agency portfolio, excluding TBA dollar rolls, have characteristics that mute prepayments. These include prepayment penalties, loan balances less than or equal to $225,000 max, seasoned collateral, low FICO scores and favorable loan-to-value ratios.

2019 was an extremely favorable year for specified pools and supply, convexity and the introduction of the UMBS market have had a sharply adverse impact on TBA roll-carry, which serves as an alternative to owning specified pools. Although we view specified premiums as fully valued, we don't foresee this dynamic changing at current levels of expected supply and refinance ability.

As of January 31, our portfolio consists of a well-diversified asset mix: 19% market value in multi-family DUS pools; 17% market value in 15-year MBS with a very low negative convexity; and nearly 30% in 30-year MBS, with gross coupons of 100 basis points above current new origination rates. Our analysis suggests a high level of prepaid burnout in these latter securities. Our focus on greatly improving our portfolio's aggregate negative convexity through a more defensive asset mix and collateral selection has served us well so far in Q1 2020 when lower-coupon mortgages underperformed their treasury hedges.

During the fourth quarter, ARMOUR's balance sheet averaged a positive duration gap of approximately 0.7 years and saw approximately 7 basis points of OAS tightening across its holdings on average. Benefiting from the decline in interest rate volatility, 30-year pass-throughs were the primary drivers of book value performance, with the spread tightening ranging between 12 to 21 basis points across the coupon stack. 15-year pass-throughs benefited from the steeper curve and produced 22 basis points of OAS tightening, while our DUS portfolio recorded minimal changes to spread as gains on lower-priced bonds were offset by somewhat weaker performance in bonds with extremely high premiums.

In the fourth quarter, our seasoned credit risk transfer holdings tightened approximately 22 basis points. In addition, the intra-quarter volatility in spreads presented us with opportunities to add seasoned CRT vintages when the market's prepayment fears exceeded our own projections. Additionally, during the fourth quarter, ARMOUR purchased bonds in the first-of-its-kind commercial mortgage-backed CRT deal and Fannie Mae's first-ever seasoned HARP CRT deal. Given the continued flattening of the credit curve in mortgage-backed product, we saw great value in the M2 tranches. There has also been considerable tightening in these asset classes in 2020.

We continue to hold the majority of our seasoned CRTs as they offer excellent credit protection, deriving from home price appreciation and deleveraging. Our legacy non-agency portfolio is small relative to the size of our portfolio but continues to perform well and is additive to overall income. The Fed's actions to alleviate year-end funding pressures and remove questions around this efficiency and availability of banking reserves were effective enough to avoid a repeat of the funding crisis in September and make the year-end a relative nonevent.

Our affiliated broker dealer, BUCKLER Securities, allowed us to capture low-cost overnight funding during the year-end turn. This was an excellent alternative to the considerably higher-priced longer-term repo available elsewhere in the funding markets. The positives of having our affiliate Buckler for funding activities becomes stronger every quarter.

During Q1 of 2020, we called all $210 million of our Series B Preferreds with a 7 7/8% coupon. Between January 28 and February 14 of this year, we issued a fixed-fixed 7% Series C Preferred issue, with total net proceeds of $113.4 million or 54% of the amount we called in the Series B issue. The reason we replaced just 54% of the Series B with Series C is because spreads in our investable asset classes had recently tightened and appeared moderately -- modestly less attractive than they had been in the middle of Q4 2019, a time when we were increasing our exposure. However, instead of selling mortgage assets, due to our slightly smaller capital base from the Series B call, we maintained the vast majority of assets we already had on the balance sheet associated with the Series B capital. These assets purchased in a wider spread environment are providing a nice breeze for earnings.

As opportunities for investments avail themselves, we can issue more Preferred Cs to increase capital. Whenever we can invest at a leverage yield exceeding the cost of the preferred, the net result is accretive to earnings for our common stock shareholders. Our new 7% fixed coupon makes that a relatively modest goal. Over the next couple of quarters, we expect the Fed to keep the Fed funds rate steady, providing us with very attractive funding rates. We also expect the yield curve to maintain its recent trading range. We believe this environment should play out very well for our shareholders who wish to see consistent earnings and low book value volatility.

Operator, that concludes our prepared remarks. We'll now take any questions.

(Operator Instructions) Our first question comes from the line of Douglas Harter with Crédit Suisse.

Just on one of those last points you made about kind of the timing to issue more of the preferred. Can you talk about, as January and February have unfolded, how yields have performed? And kind of how you see the attractiveness of the investment opportunity today versus kind of when you were doing the preferred issuance?

Doug, it's Jeffrey here. So a couple of things on preferred. I believe you would be aware, when you do an initial underwriting on the preferred, you are paying a full underwriting fee of approximately 3.15%. So internally, we thought it would be more cost-effective for our shareholders to just issue $75 million of that issue. And then as we saw some opportunities to do at-the-markets, which we spend about 1% issuing, we did, as you can see, subsequently after the initial $75 million plus issue, issue another $30 million worth.

Spreads are tighter now than they were in the fourth quarter, as David just discussed, and we're not aggressively adding to the portfolio right now. I might note, there has been a lot of discussion about what's going on in the DUS market. I think it's a good time to bring that up and probably answer some of your questions. As you know, some people have engineered, and there's been DUS resecuritizations where you've been selling it at the money par coupon pass-through and keeping the IO. We have reverse-engineered this numbers of times and recently actually sold some DUS to a reverse inquiry from a broker-dealer who then subsequently went ahead and did a deal. Having looked at all the numbers on it, we felt we were better off selling some of that.

So by not issuing the $210 million of full B shares with the new Series C shares, it's given us some flexibility to take advantage of areas that are tighter. And when things loosen up a little bit, we can sell some stuff, make some dry powder or issue some more series C to go ahead and buy some assets.

That makes sense. And if you could just sort of help with the thought process of -- that you went through between kind of reducing the balance sheet in terms of assets versus when you redeemed it, when you issued the new, why not just kind of reduce the balance sheet, kind of just the thought process there, if you thought spreads were a little bit less attractive than they had previously been?

Maybe less attractive to invest in at that moment in time but maybe not completely attractive enough to start selling assets. So as you can see, actually, leverage is down at the end of the year. And if you look at the January numbers, it's just slightly back up. If you look at the numbers at the end of February, which we will go ahead and release in mid-March, you'll see the leverage is up a little bit because, of course, we didn't back-hold the whole Series B fulfillment. And Mark, could you improve on it, please?

Just one other, typically -- we do expect prepayments to increase, so instead of selling assets, we'll delever naturally just as those increase.

Our next question comes from the line of Trevor Cranston with JMP Securities.

A question on the net duration gap on the balance sheet. It's obviously running somewhat modestly positive throughout the fourth quarter, and it looks like it's come down to a slightly negative number in the first quarter as rates have rallied. Could you share your thoughts around how you're managing that as rates have come down? Are you comfortable with keeping it somewhat negative on the view that rates are going to be kind of range-bound or just generally, how are you thinking about that?

We did permit the duration gap to run a little bit negative. We did add some duration explicitly to avoid getting too negative. We wanted to keep that pattern moderated. We're comfortable at this point with a shorter, call it, targeted duration. Of course, one varies from that target when you've got a mortgage portfolio with rate movements. But our target has definitely shortened, and part of that is motivated by the risks of sharp interest rate movements, which have risen with the virus problems and so forth, but also the increase in curve inversion at the front end of the curve. So the incentive for maintaining the 0.7 target is somewhat less right now than it might have been last quarter.

And I would note that with the work that the team has done here, we've got a nice book value performance so far through the year, and I think it's been very helpful. At one point, we added some treasuries when the market started running, and we still own the vast majority of those, albeit in small size.

Okay, got you. And then you just made the comment that you're expecting prepay speeds to increase. Can you provide any additional color around that in terms of how fast they're likely to get over the coming few months kind of relative to how fast they got, I guess, last fall when they peaked?

One way to get a handle on that is to take a look at estimates that the sell-side participants are coming up with. And there's a fairly hefty increase projected for April prepayments arising out of the rate declines that we've seen recently. And that number is around 30%. Effectively, we'll likely have somewhat similar experience, probably not quite as dramatic, given that we already had quite a bit of refinancing. The primary mortgage rate is not lower in any material way than it was in the fall. So a lot -- the majority of those people probably don't have much incentive at this point to refinance. So it will definitely pick up some, both because of the lower rate environment and the seasonals. But I don't think it's going to be the nosebleed kind of level that we saw in the third quarter.

And of course, you have to translate that for the amount of prepayment protected securities we have in the portfolio as well, which clearly represents a significant proportion, and we'll probably view the effect compared to generic estimates.

Yes. I mean, 20% more of the portfolio is prepaid protected in some way than it was 3 quarters ago, big number.

We -- most of our purchases since the third quarter have been in prepayment protected paper.

Okay, got you. And then last question, you guys commented that you're anticipating discontinuing the monthly book value disclosure after the first quarter. Can you just provide any commentary you have around why you've chosen to make that decision going forward?

Trevor, it's Jeffrey. Look, consistent with industry practice is what we're trying to be doing here, all right? We did have reports from people who -- bankers at firms like yours and other, people saying that, "You publish this every month and we noticed your stock is quite a bit more volatile than those who don't publish, and we're not sure that shareholders actually benefit from that volatility. So as a result, we are going to be consistent with what the rest of the industry does and just produce these numbers quarterly. We do, however, occasionally, have to go on roadshows and make presentations, and at those points in time, we'll see if it's in the best interest of shareholders to go and release that information.

Our next question comes from the line of Jason Stewart with JonesTrading Institutional Services.

One follow-up on the preferred. Could you just give us an update on where, over time, you would target preferred as a percentage of the capital stack?

I believe we've had it as high as 22.5% of the total capital structure, and where it is right now is the lowest it's been since 2012. We've talked internally amongst the management team, of course, the Board. We can't see it being very favorable, I think, much more above that 22.5%, certainly 25% level.

And if you look at the current issue when we established it, I think, we established, if memory serves, a reservoir of 10 million shares total of the Series C. Now certainly, if we decided that there was a reason to go beyond that, you could add to that number with new corporate action. But I think that's where the current reserve is, the reservoir is.

One question you haven't asked, and I think it's an interesting topic is, we were a little bit different than what the rest of the group is doing in terms of preferreds. We're issuing a fixed-fixed. If we were to issue a fixed floating, we actually probably could have done that deal 6.75% or 25 basis points lower. We think that's a little risky. It seems like rates will never go up at this point and perhaps they never will, but we like kind of knowing what our future holds for our shareholders. So we like issuing the fixed-fixed. If we were buying, we'd want to buy the fixed floating, of course.

Right. That's a good distinction. And then on the repo rate, it looked like there was a nice drop in January relative to the end of the fourth quarter. Is that something you'd expect to continue to drop? Or is the January rate sort of what's baked in for February?

So are you referencing the monthly update in January for the December 31 number?

Correct.

Yes. So that incorporates the turn. So that's a spot number as of January 31. And we did have some open repos just for the 1-day turn. So that is just the spot rate for the whole portfolio as of January -- as of December 31. So it incorporates some year-end turn numbers in there. That -- it doesn't incorporate -- what that number is not, is the weighted average for the entire quarter. So the number will definitely be down in Q1 from there. And if you look at the K, the overall number for the Q4 was way lower than that number also reported.

Let me explain a little bit more on that. What we did, and a couple of analysts called us actually, and we walked them through this. So in October-November, we did some 2-night trades that were forward trades. In other words, they started on December 31 and then ended on the next business day, which I think was 3 days later, 2 nights. Up to that period, we took billions of dollars of bonds and did them in overnight financing at very, very low rates. So you don't see those high-$170 million, low-$180 million numbers in that number because that's a snapshot of what we're paying on December 31 for just 2 nights. And those 2 nights were anywhere between 3% and 4%, depending on when we did it. But we did it way in advance because we didn't want to take any over year-end risk, particularly on the events of September 16 and 17, highlighting what can go wrong. This also highlights the benefit of BUCKLER because we would only trust it through an affiliated broker-dealer to take billions of dollars on overnight financing.

Right. So I guess, I understand where 4Q played out. The $181 million in January relative to GC and like the mid-$170 million, maybe a little lower. I was just -- I guess, I was asking more so, is there anything in 1Q that you would expect to change that trend relative to where GC is?

The numbers you should see probably at the end of February would kind of be our straight-line numbers. And once again, we'll put those out in March because all the trades we did to get over year-end, all were done by early February and they rolled off. And right now, by the way, rates are 1.73%, 1.75%, 1.76% for short term and it's pretty flat.

Repo right now is very benign. There's no -- has been no real issues. And like Jeff said, the curve is very, very -- just flat.

Our next question comes from the line of Matthew Howlett with Instinet.

Just on the trajectory of that margin done pretty well, fairly well, we're looking at. Again, it looks like the funding cost rate to come down in 1Q, we'll wait for your February numbers. But is there anything to believe that, that would be sustained, if not go higher here early in the year?

So I think you're correct on the cost of fund side. On the asset side, it's a little harder to say only because like we said, in Q4, we bought a lot of assets when spreads were wider. And in Q2, we do expect prepayments to increase. So I wouldn't expect it to go higher a lot, but I definitely wouldn't see our NIM go -- come crashing down.

One other thing to keep an eye on as you think about this is the curve shape. And part of what we do is capture term premium, and there's less of it right now. We don't control rate, of course, but that's going to be a determinant. We were in a better place in Q4 on that count.

Right, got it. Now Jeff, just on your comments, I mean, we look out in the springtime and we could get this prepayment wave and we could also get a lower tenure. I mean, is there -- are we sort of waiting for more relative value to emerge across the coupon stack when you look at sort of adding, at some point, growing this portfolio?

Well, so right now, because we -- as I discussed earlier, because we did buy all the Series B back but we didn't issue as much Series C, we have the ability to just run off for a couple of months while still maintaining a good source of core income. However, we do believe and has been the case most of the times in the past that a faster prepayment wave provides opportunities to go ahead and add mortgages, and we will certainly want to take advantage of that. That could include selling some other mortgages that we have and buy more. It could include issuing more Cs or could include upright, increasing our leverage if we think that opportunity and the risk profile adjusted looks good.

Got it. Makes sense. And then the CRT, I mean, that's interesting, you're doing the Fannie commercial CRT. Talk about sort of the difference between the commercial and the residential CRT. Would you like to someday get larger in that space, move down the capital stack? I know that the GSEs are constantly innovating that program, extending terms and doing seasons. I mean how much more involved would you like to get in? Or is it just spreads are just so tight that it's limited at this point?

We do look at it in the context both of relative value as compared, say, to the traditional residential exposures as well as a source of diversification. The structures of deals are very different. Convexity characteristics are very different. So there are core benefits to staying in that market and continuing to be active. There are also total return opportunities. It's been a terrific sector. Historically though, with the rally we've seen in all kinds of credit product ranging all the way to corporates and high yield, it is getting compressed.

So we are going to stay very active in the sector. We have stepped back from a couple of transactions that have come to market, where we just felt that we didn't want to be the last man buying. So it is -- we've continued to allocate resources to it. And in fact, just allocated some more -- I mean, human resources. This is a focus for us.

We do like the commercial space. And the HARP deals are very interesting because they're shorter pieces of paper. So you're looking at versus a 2.5-year kind of paper versus the longer part. The commercials are actually longer than the residential. So the last deal came quite a bit wider than the residentials, and new deals due in the next 10, 14 days, and we'll see how that thing pretalks.

How is liquidity -- or how is financing rates in haircuts in that space? Is it still holding steady?

Well, for our portfolio, it's gotten better. In general, portfolio was unrated when we bought it. It's now, I think, everything except maybe one tranche we own is now investment-grade. So all the financing has gotten better over time for our existing portfolio. For the new stuff, it's -- financing is still great for that. It works.

So I mean, originally, we're buying unrated paper. We're financing at 1.60%, 1.75%, even 1.80% at some of the earliest years in early 2016 -- and now I think well more than 50% of our portfolio has been upgraded to some sort of investment-grade. So you're funding at 75, 80, 85 haircuts or half, in some cases, what they used to be. So that benefits us in every way.

Yes. I know it's been a terrific trade acquisition for you guys.

(Operator Instructions) Our next question comes from the line of Christopher Nolan with Ladenburg Thalmann & Co.

Just had a clarification on Matt's question. Are you guys intending or thinking about expanding your portfolio in non-agency type of securities?

Yes, we'd love to. We like -- we've had a tremendously positive experience with credit securities. We view the environment as still quite benign on the mortgage credit front. We'd just like to see a little more yield there. We look at everything all across the stack, all across the asset categories. And I can assure you that when we see opportunity, we're going to be the first guys to show up there.

Great. And am I correct that for these non-agency securities, they're not -- they don't really lend themselves to repo funding? Or am I incorrect on that?

Oh, repo's plentiful for non-agency securities these days. And indeed, in many ways, the somewhat higher yield available to dealers on non-agencies makes them somewhat more attractive as a product on the street than agencies.

We've always funded our non-agencies ever since we began buying them in the old JAVELIN portfolio.

Yes. I mean the reverse inquiry on non-agencies, people saying, "Your Ginnie Mae IIIs are cute, but I'd rather lend against your CRTs," better balance sheet proposition for them, as Scott discussed.

Interesting. Okay, last question. Where do you think leverage is going, including TBAs? I mean...

So I've noted this earlier. If you look at leverage just versus our equity common shareholder capital base, it would not go down from here, flat to slightly up. If you look forward, inclusive of our Series Bs, which we called and only issued half as much, approximately 54% of the Series Cs, you would see the leverage would be slightly up if you look at all the capital holistically.

As I also indicated earlier, we will use -- if there is indeed a widening due to faster prepayments, we'd like to utilize that opportunity to go ahead and invest in some securities at wider OASs, assuming that we can hedge the convexity appropriately. David?

Leverage isn't so much a target, though there's a range in which we operate. It's not a dial that we turn independently. It's a dial we use in conjunction with the other decisions we're making. And so I think we're glad to be where we are right now because we've got the flexibility to take on more leverage when we start to see some more attractive product, which we anticipate will happen probably in the next month or 2.

I am showing no further questions at this time.

Well, thank you all for joining us this morning. We very much appreciate everyone's interest in ARMOUR Residential REIT. And as always, if other questions occur to you later on or throughout the quarter, give us a call at the office and we'd enjoy the conversation. Until next time, goodbye.

That does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.