Armour 住宅房產信托 (ARR) 2022 Q1 法說會逐字稿

Good morning, and welcome to the ARMOUR Residential REIT's First Quarter 2022 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

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

Thank you, Andrew, and thank you all for joining our today to discuss ARMOUR's first quarter 2022 results. This morning, as usual, I am joined by ARMOUR's Co-CEOs, Scott Ulm; and Jeff Zimmer; and Marc Gruber, our Chief Investment Officer. By now, everyone has access to ARMOUR's earnings release, which can be found on the ARMOUR website, www.armourreit.com.

This conference call may contain statements that are not 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 periodic reports, which have been filed with the Securities and Exchange Commission. Copies 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, they are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless we're 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 the website shortly and will continue for 1 year.

Net interest margin for the quarter was 1.78%, an increase of 18 basis points over the 2021 year average and a 3 basis point increase compared with Q4 of 2021. ARMOUR's Q1 comprehensive loss related to common stockholders was $148 million, which includes $66.4 million of GAAP net loss.

Distributable earnings available to common shareholders, which excludes gains or losses from security sales and early termination of derivatives as well as market value adjustments, but includes TBA drop income, was $26.7 million or $0.28 per common share.

Because ARMOUR uses pay fixed interest rate swaps for hedging, distributable earnings includes the monthly running cash coupon cost or benefit of our hedging activities. This effect makes distributable earnings more stable as movements in repo funding costs and swap net coupon payments will tend to offset one another.

ARMOUR paid monthly common stock dividends of $0.10 per share during the quarter and has announced dividends at that rate for April and May of 2022. Taken together with the contractual dividends on preferred stock, ARMOUR has made cumulative distributions to stockholders of $1.87 billion over its history.

ACM, the company's external manager continues to waive a portion of its management fee, which was initiated in the second quarter of 2020. This waiver offset $1.95 million worth of operating expenses in the first quarter of 2022.

Quarter end book value was $8.48 per common share, down $1.85 from December 31, 2021. As of the close of business on Tuesday, the 26th, we estimated book value to be approximately $7.63 per common share. At March 31, ARMOUR's portfolio consisted $6.4 billion of Agency Securities plus TBA positions representing another $750 million plus $1.3 billion of U.S. treasuries.

Now let me turn the call over to Scott Ulm, one of our co-Chief Executive Officers. Scott, take it away.

Thanks, Jim. The first quarter of 2022 was one of the worst quarters for bonds in nearly 50 years as investors grappled with the scope and magnitude of the monetary policy response necessary to hold rapidly rising inflation while also worrying about its impact on economic growth. Over the course of the first quarter of 2022, 2-year treasury yields rose 160 basis points. And 10-year yield rose over 80 basis points and with [2, 10s] difference briefly dipped below 0, an ominous sign that the economic turbulence ahead.

ARMOUR entered 2022 with the defensive posture as risk parameters and leverage were below historical averages in anticipation of increased volatility as the Fed declared the end of the QE program. Our net duration gap heading into year-end was 0.3x, leverage of 7.5x, and liquidity was at a very healthy level of $840 million.

ARR allocated roughly 50%, $4.5 billion par of the portfolio to the production TBA contracts with superior market liquidity compared to the specified pool market, which struggled to trade in line with its fair value in times of heightened market volatility in early first quarter.

Rapidly rising rates and quickly deteriorating market liquidity in early January flash warning signals for mortgage threats, prompting a response from ARMOUR to quickly and efficiently sell our entire TBA position on swap for duration match treasuries, a move which greatly reduced the mortgage spread risk in the portfolio.

In the first 7 weeks of the quarter, ARR decreased its agency MBS threat exposure by over 30%. By late February, when mortgage resi yields approach levels not seen 4 years, ARMOUR began to steadily deploy its available and newly purchased mortgage bonds back in the part of coupon MBS. Since the end of February, we've purchased $1.8 billion of production pools and $1.2 billion of TBAs while selling $1.8 billion of longer duration treasuries.

During the same period, we're actively rotating into production MBS and out of our lower coupon 15-year and 30-year pools as those make up a majority of the Fed's MBS portfolio and our most at risk as reading due to potential active sales by the Fed. As of mid-April 2022, we've replaced the vast majority of our former treasury positions with newly-acquired MBS with levered yields between 12% and 15%.

While in the near term, there remains an elevated level of uncertainty ahead of us. We'll be watching very carefully to invest with a longer time horizon in mind. With about 116% of our repo book hedged with current and forward starting swaps, we believe we're adequately hedged for the nearly 275 basis point Fed funds rate increase that's currently being priced in the market. Also note that our distributor earnings contained cost of our hedging and financing.

ARMOUR continues to monitor the term structure in the repo market in light of the aggressive Fed. But for now, we prefer to keep our remaining average repo term short, currently in 21 days. Our average repo rate today is just about 50 basis points.

We continue to believe that our current dividend rate is appropriate for us and gains further support from the investment opportunities available.

Thank you. Now I would like to open for questions.

Andrew, do we have questions?

(Operator Instructions) The first question comes from Doug Harter with Credit Suisse.

Given the size of the book value decline in the first quarter and so far, in April. How do you think about what the right size of the balance sheet is? And how much more capacity you have to increase that if you see the opportunity?

Doug, so when you do have a book value decline, the leverage goes down naturally. And we started the quarter at 6.1x leverage, and it is crept up to the mid- to high 7s. We do own a number of treasuries still, and we have not reinvested April and expected May paydowns. So we do have on the table that amount of reinvestment opportunity into mortgages, which, obviously, as Scott said, are yielding between 12% and 15%. It would be unlikely at this point unless the opportunities became extraordinarily good, and I'm talking like 18% or so for us to be above 8.5x to 8.6x leverage. So look at it that way. And I think that gives you a good table for how we're looking at things.

Got it. And then just on the dividend comment. If I take the current dividend divided by your updated April book value, that gives me kind of a number north of 15% required return to kind of generate that, and that would be kind of after expenses. You're talking 12% to 15% returns that you're seeing in the market. Just curious as to kind of your commentary around the comfort in that dividend level.

So based on the historic assets that we own and based on the current investment opportunities, we definitely can support that dividend. We have not had a longer-term discussion with the Board in terms of third or fourth quarter yet, but we currently feel very comfortable with what we're paying and that supports Scott's comments.

The next question comes from Trevor Cranston with JMP Securities.

There's obviously a lot of volatility and spread widening in the first quarter. Can you guys talk about kind of where you see things today? How much risk you see of additional widening in the MBS market? And what your thoughts are on the potential for continued great volatility and policy going forward over the rest of the year?

You wouldn't have thought looking at February 15, 2020, that we'd be looking at investment opportunities 26 months later in the 12% to 15% area, because that's about 500 basis points better than what we're looking at then. And I think that those changes highlight the risks that are inherent in the current environment.

The geopolitical risk, we can't do anything about, they're there. We respect them. We're being cautious about them, and we understand that they could be existential. We just don't know how crazy they could get.

However, in the mortgage spread widening, we look back through the subprime crisis, which I think highlights how bad things can get, and we're within a standard deviation or so of being normal on that. So we are not fully invested, but we are adequately invested.

And as Scott said in his comments, and as we've said in our monthly company update, we took more than $2 billion of treasuries and reinvested them in the mortgages, but we did it over a 10- or 12-week period, and we caught some of the widest spreads and we also bought some assets a little tighter than we wanted to.

We've left some cash on the table to reinvest if we do get a widener. But as I said, we are very respectful of the risks that are out there, and we're cautiously watching those, and we're probably not investing that last of opportunities of cash that we have as we -- as I said, are being respectful of that.

In terms of the second question that you asked, I don't think that the capital markets can let mortgage spreads get crazy wide for a long period of time. So if they get to a levered returns of 18% to 20%, it would probably be very short lived. Even the high-yield indices have not -- we've gone out, like, what, 110 basis points or so. So anyway, that's our thoughts on that. I hope that answers your question.

Yes. That's helpful. And then in terms of the coupon positioning of the portfolio, you guys, obviously, been moving up in coupon somewhat. Can you maybe just talk about kind of what the pace you'd expect that rotation to continue at? And if you're -- or if you're comfortable continuing to own the larger discount volumes that you guys can currently have in the portfolio?

Trevor, this is Marc. So I believe we're probably almost done with kind of rotating out of some of the lower coupons and the upper coupons. And mainly that's because the lower coupons are pretty much fully extended. They have good convexes and they're good assets. So I would -- when you look at our portfolio at our next update, you'll probably see us maintain most of those lower coupons.

All the reinvestments are going to go in the upper coupons. What we've done, for the most part, all the rotation out. Maybe some -- there'll be some little things on the end. But we really like the assets in the lower coupon just because they've extended so much already and the convexes are great.

The next question comes from Christopher Nolan with Ladenburg Thalmann.

Just a question for Jim. Net interest income in the quarter seemed to go up a bit quarter-over-quarter. I'm just trying to get a clarification why.

Well, I'll pitch that to Marc.

Net interest income between Q4 and Q1? Is that what you're asking?

Yes.

It's just going to be some rotation into some different bonds, but also amortization expense have slowed.

Great. And then just I was checking out the Q, and I just saw that your haircuts on your repo funding has actually gone down in the quarter, which I found surprising given all the turbulence going on in the MBS market. Was that related to BUCKLER? Or is there any color you can provide on that?

No. That is -- the clearing market and the repo on haircuts has declined. As I think more and more the counterparties are going to be comfortable with what's the risk in owning MBS -- Agency MBS. So we've actually got our counterparties to lower haircuts.

And that as a result of some actual outreach and conversation trying to make sure everybody was meeting the market leader and their sort of most favored nation positions with all of our counterparties.

Yes. Christopher, I would note that in the treasury market, many of the dealers have no haircuts at all. And if you go back to the subprime crisis, it's interesting, haircuts went from 3% to 4%, up to 6% to 7% to 8% for 3 to 6 months, and we haven't seen that right now. So we wouldn't suggest that the banks are characterizing the current environment is not being as risky as that and those haircuts.

And the despite the widening that's happened in mortgages, the volatility, they're very comfortable with. And I think that actually makes us somewhat comfortable with our increased investment in MBS.

Okay. So it sounds like there's a disconnect between how the banks are viewing MBS market and what the credit spreads are saying.

Well, I think they've gotten more comfortable with the fact that over time, how often have mortgages dropped 3 or 4 points in a day. Because remember, they have our collateral so they can sell at any time, it's bankruptcy remote. And so I think they're just more comfortable that they're not going to see a greater than 3-point drop in a day on the collateral that we own, it's fairly quick.

Well, perhaps a little bit too that as repo rates are going up from 5, 6, 7, 8, 9 basis points to 50 basis points, we've seen new entrants in the market. And so the attractiveness of repo as an asset to them seems to be increasing and haircuts, just one of the terms upon which they can compete for balances.

(Operator Instructions) The next question comes from Matthew Howlett with Nomura.

Just a question on historical context where MBS spreads are on a nominal or an OES basis. I just like to hear where they are today versus different points in time, paper tantrum, financial crisis?

Yes. So I think we've got to pull up the chart here. But we think when we look at our analytics. On a Z-spread basis, any 4s are about 110. OAS is obviously going to be lower than that just because of the way the metric works. Dust spreads are probably in the mid-50s. And so we would say that DUS is tighter than Agency MBS. It's definitely wider.

On a treasury OES basis, one of the charts we look at is treasury OAS on a historical basis. In general, the coupon stack is on the average of where the Fed has been buying, but it's below the long-term average of when they're not buying. So that's why we do think there's still some widening if when the Fed decides to really stop and maybe actually sell 10 or 15 basis points.

And so -- but in general, mortgages are much, much wider than they were just a few months ago. So that's why Jeff said earlier, they're attractive, and we've been slowly buying some over time.

So we run a number of different charts, and the charts you have a break even. So when the Fed is buying to when they're not buying, and then we look at the crisis thing. There was a period about 8 or 12 business days ago where we were actually OAS spreads were well off north of that or we just actually performed well net of 1 day over the last week. So we're just inside the net average of the non-Fed buying over the last 12 years. Hopefully, that's helpful to you. And one of our largest counterparts actually put out a chart of current coupons. And we follow that chart. I think that's the best way to look at it.

So I think about the current environment, if they stay at these levels or they go wider, that's going to be good for spread and core ROE. And if they tighten, you pick that up in book value. I mean how do I think about sort of the rich return trade-off if we just stay at this current environment or they widen that? Is that good for reinvestment and good for shareholders? Or if things do tighten, we'll see the big rebound in the book?

So if things tighten, generally, you would expect book value to go up. It doesn't always work that way because of the other events, but we would expect that to be the case. But we think the vast majority of widening has taken place here, okay? Everybody knows the Feds out. And everybody expects the Fed to go ahead and sell some assets, and I believe that that's priced into mortgage OAS right now.

But as I said earlier in my comments, we are extremely respectful of the fact that they could widen a little bit more. And we are ready if and when that happens to reinvest. That being said, when they do widen the book value, generally has a proclivity to go down a bit. The tighten book value generally has a proclivity to go out, but the investment opportunities now and if things widen are better, that is correct.

Great. And then last question. I mean it looks like you got the liability side pretty much termed out with, I think you said 116%. And you're good all the way up to the 275 through the derivatives. Is there -- you mentioned long dated repo maybe -- is there anything else you're looking to do on the liability side of the balance sheet as you enter the -- what could be a rate hike cycle? Or do you feel like you've pretty much done everything and you're sort of well positioned for it?

So as Scott said in his comments and as well as our press release said, we have more than 100% of our repo balances swapped out right now. So what that means is as repo rates go up, we pay fixed on our swaps and our fixed rate is locked in, generally at lower rates than the market is right now. And then the receiver side would generally go up as well with the repo rates. So they definitely offset each other. So we look at that as very comforting in terms of our liability balance.

As we increase our assets. And as we said also at this point, we're not generally increasing our leverage until we see some great opportunities, we would put more swaps on the book to offset that risk.

This concludes our question-and-answer session. I would like to turn the conference back over to Jim Mountain for any closing remarks.

Let me end where we began and thanking you all for joining us this morning and for your interest in ARMOUR Residential REIT. We're always interested in conversations with shareholders and analysts. And so if anything comes up between now and the next time we're together in this forum, don't hesitate to reach out.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.