Orchid Island Capital Inc (ORC) 2014 Q2 法說會逐字稿

Good morning and welcome to the second quarter 2014 earnings conference call for Orchid Island Capital, Inc. This call is being recorded today, Wednesday, July 30.

At this time the Company would like to remind 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, belief with respect to future events, and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements.

Important factors that could cause such differences are described in the Company's filings with the Securities and Exchange Commission including the Company's most recent Annual Report on Form 10-K. The Company seems 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.

Thank you, operator. This year the market has not followed the script most market participants had drawn up in their heads last December. The yield on the 10-year U.S. Treasury note exceeded 3% at year-end and the overwhelming majority of market participants expected rates to rise further. So, we rallied during the first quarter and again in the second.

However, prepayment speeds remained subdued through the spring and have not rebounded materially during the summer months. The Mortgage Bankers Refinance Index has remained below 1,500 most of the second quarter and was below 1,400 for the week ended July 25, 2014.

The housing market has continued to recover, but at a much slower pace than what we observed in 2013. The commercial banking sector has been retaining originated mortgage loans on their balance sheet and little securitizing them at a much higher rate than in 2013.

The combination of all these factors has resulted in gross and net supply of agency MBS falling well below market expectations. In fact, the net supply of agency MBS was only $10 billion for the first six months of 2014.

The Federal Reserve started to taper their asset purchases in January and has announced reductions of their monthly MBS and treasury purchases by $5 billion each at every meeting since. They currently plan to stop their asset purchases in October of this year. The reduced demand on the part of the Federal Reserve was supposed to cause mortgages to widen, and many asset managers were underweight in the sector as result.

However, the dramatic reduction in supply has led the sector to outperform and mortgage yield spreads over comparable duration treasuries narrowed. In fact, the current production 30-year Fannie Mae securities -- 3%, 3.5% and 4% coupons -- outperformed their comparable duration treasury benchmarks by over 2 points for the quarter. The 15-year current production Fannie Mae coupons outperformed as well, although less so in absolute terms.

To wit, it certainly paid to maintain our exposure to the MBS market, especially the 30-year specified sector. As we all know, during the second quarter of last year we had just the opposite positioning.

We continue to grow our portfolio. Orchid completed the deployment of the proceeds of our first-quarter secondary offering in April. We initiated an aftermarket program in late June and raised approximately $8.4 million through this program by July 7.

We completed the deployment of this capital after the end of the second quarter. As a result of the deployment of the new capital, the RMBS portfolio grew by approximately 17% during the quarter and has grown by almost 150% year-to-date. Our returns for the second quarter certainly benefited from our good fortune in being able to raise new capital during the first quarter.

With the growth in the portfolio, we have shifted the exposure towards fixed-rate MBS and 30-year securities in particular. We have also been increasing the weighted average coupons of the pass-through portfolio from 3.7% at December 31, 2013, to 4.14% at June 30, 2014. During the first quarter, when we were deploying the proceeds of our two secondary offerings, we favored specified pools, predominantly loan balance pools.

The premiums paid to own these securities appreciated during the second period and they are less attractive from a total rate of return perspective. We now favor other forms of call protection and have added securities collateralized by loans made to lower credit borrowers.

During the second quarter we sold approximately $279.5 million of pass-through securities, predominantly in low loan balance pools and in all cases 30-year securities, take advantage of the change in relative value offered by the market.

The capital allocation was shifted from 55.8% pass-throughs and 44.2% structured securities at March 31, 2014, to 59.9% pass-throughs and 40.1% structured securities at June 30, 2014. The comparable numbers at December 31, 2013 were 44% pass-throughs and 56% structured securities.

Accordingly, we have shifted the capital allocation materially towards pass-through securities since year-end 2013. To compensate for the added duration of the pass-throughs, especially 30-year securities, we have added to our funding hedge positions by increasing our Eurodollar shorts and adding a one-by-five-year payer swaption.

With the structured securities portfolio we had added IO securities collateralized by higher coupon 30-year fixed-rate collateral. During the second quarter IOs performed well versus their benchmarks in the face of lower rates and a flatter treasury curve. The benefit of slow prepayment fees were the reason.

The performance of our structured securities, while still negative on a total return basis, did not offset as much of the positive performance of the pass-through portfolio while still providing the up rate protection we need. While on balance our structured securities did not offer a positive carry in this environment, we have been able to acquire selected assets that offer a modest income while still providing up-rate protection.

Nonetheless, we continue to own these securities for their up-rate protection and do not look to them as income producing assets. We certainly long for the days when the current rate repression environment ends and these assets can be used in conjunction with levered pass-through portfolios (technical difficulty) the income and price appreciation potential are more balanced.

Our leverage ratio, excluding unsettled securities purchases, was approximately 6.3 to 1 at June 30, 2014. And with the deployment of the ATM proceeds through quarter end, it is still approximately 6.3 to 1 as we speak.

We have added a substantial IO position recently, so our capital allocation has shifted closer to 50/50. We currently anticipate that capital allocation will remain skewed towards pass-throughs for the balance of the third quarter, but not at the 60/40 ratio we had at the end of the second quarter.

As we move into the second half of the year we have been confronted by geopolitical events, strengthening economic data and higher inflation levels. The treasury curve has both flattened as most of the flight to quality trading into US treasuries has occurred in the long end of the curve, 10-year notes and 30-year bonds, as opposed to the front-end of the curve as is more typically the case. This has been exacerbated by considerable yield spread of longer dated U.S. Treasury yield over comparable maturity German yields, resulting in relative value trading out of German bonds and into US treasuries.

This continued the flattening trend that began in the first quarter. The market has also become very focused on communications from the Federal Reserve. The market is especially concerned with the Fed's perception of the strength of the economy, the strength of the economy's recovery, and inflation levels. Once the Federal Reserve ends their asset purchases later this year, the market will anticipate the initial move away from the zero level in the Fed funds target rate, as well as their exit strategy generally from the current interest rate regime.

The agency RMBS market will also be closely watched as the market still anticipates there may be some impact of the end of Fed purchases on mortgage spreads. Most multi-sector asset managers and most of our mortgage REIT peers remain well underweight in the MBS sector based on available positioning surveys or SEC filings in the case of our peers.

For this reason, we continue to expect widening of mortgages relative to their treasury benchmarks will be limited. We have positioned the portfolio for increased funding levels and a continuation of modest prepayment fees.

Mortgage borrowers have been exposed to very low levels of rate for extended periods, and show a reduced sensitivity to refinancing opportunities. Mortgage lenders have reduced their capacity, and new regulations imposed by the Dodd-Frank Act have impaired their ability to quickly ramp up there their staff capacity levels, further muting refinancing activity.

We see the greatest risks to the market as twofold. The first would be an outbreak of inflation resulting in a more aggressive Fed and elevated volatility in the rates market. The second would be the outcome least expected by market participants, a rally, just as we feared at the end of the first quarter.

To address the first risk, we have added a swaption on the five-year sector, so if volatility moves meaningfully higher and the market expects more substantial Fed tightening, our hedge will benefit. Of course, we also continue to allocate a significant portion of our capital to interest-only and inverse interest-only securities for this purpose as well.

We have guarded against the second by maintaining a material allocation to call protected securities. They continue to offer very good carry and protection from higher prepayments if the market rallies. So far in the third quarter, it seems to have been well-advised, just like in the second quarter.

Operator, that concludes my prepared remarks. We can now open the call up to questions.

(Operator Instructions). David Walrod, Ladenburg.

I just had a couple of questions. It looked like in your press release from the -- that your hedges, you took off the hedges that were expiring in 2014. Is that just your thought that you expect rates to be fairly stable for -- throughout the end of the year?

Yes. Exactly. We have been actually trying to maintain the start of our hedge coverage period, if you will, a little further out over the course of the last year or so. But that's probably the end of that type of step. I think the next earnings call that's unlikely to be the case.

Okay. Then I believe you said in your commentary that you were buying a higher coupon, lower credit quality agency assets. What kind of a premium are you paying for those in this environment?

I'll say a couple of words and I will turn that over to Hunter. Lower is the answer. What we saw in the first quarter, especially the very beginning of the quarter, was that pay-ups on all specified pools have gotten extremely low. When we were putting money to work we bought a lot of those assets, and they have moved substantially higher since then. I will turn it over to Hunter. He can go into more detail.

Sure. David, we have been adding -- just in terms of pay-ups above the benchmark pools that we have been acquiring, the lower credit score pools tend to have a pay-up somewhere between up 14 ticks to up 20 or so ticks.

In contrast, Bob alluded to the fact that we were selling low loan balance pools. Those got as high as upwards of around 60 ticks. When we were adding them on, I think we were putting them on somewhere in the context of up 0.75 points, so up about 24 ticks. We like them when they have a more balanced profile, but as you know if rates fell off from here those pay-ups evaporate.

In terms of the actual coupons that we are putting on, our focus has been primarily in [4 1/2s], although in July we have added a few 5s as well. Those -- the premium levels tend to be somewhere around [107 3/4] today for [4 1/2s] and then another, say, 0.5 points for the pay up. And the 5s are a bit higher than that. Some of those they can be around the [110] sort of level, but that's a relatively small portion of the portfolio, the 5s, but we have just been able to find a few of late.

They sort of lend themselves to that low credit score trade for reasons I am sure you can deduce. Lower credit scores, borrowers tend to have higher coupons. That's been the focus, though.

Okay, appreciate it. Thanks a lot, guys.

(Operator Instructions). Michael Diana, Maxim Group.

You seem to have been actively shifting the portfolio around in a very prudent and meaningful manner here. What does your positioning right now imply for the dividend?

I don't think it would have any impact -- I wouldn't change it. What we tried to do is maintain the same bias, which has been to higher coupon 30-year securities. If you look at our press release, we show the portfolio versus prior periods. You see that, for instance, hybrids in absolute dollar terms have stayed the same, still have shorter resetting ARMs, while the portfolio has more than doubled. So, all of the incremental capital, for the most part, has been added to either structured securities or 30-year fixed-rate pass-throughs.

There is two ways to play the 30-year fixed-rate trade. Some of our peers buy the lower coupons called the production coupons and take advantage of lower financing in the dollar roll market. We have been buying specified pools simply because they were very cheap -- net-net which ones offered better carry? We think these do. They also have the potential to do well in a rally, which is what we saw in the second quarter.

With respect to the structured securities, it's been about the same thing. The yields are obviously not very attractive, but they do offer the up-rate protection we need, and as we said, in the second quarter structured securities tightened quite a bit. And, so, even though they were on a total rate of return basis negative, it wasn't that much.

Long story short, the fixed-rate 30-year trade has been appealing to us. The 15-year sector is very tight. And part of the reason is that a lot of REITs in particular bought 15-year securities because there is less extension risk, and it's been reflected in the tightness.

Like I mentioned in my prepared remarks, that 30-year mortgages outperformed their comparable duration treasury by over 2 points. The 15-year did well, too, but not as much, but I will turn it over to Hunter. He can chime in as well.

I would just add to that we think from a risk/reward perspective we would rather be in the high coupon 30-year fixed rate space as opposed to something like a hybrid ARM or a 15-year -- lower coupon 15-year space. We think there is a lot of negative convexity in the 15 years, not so much because they can extend, but just because the sector is grossly overweight in that space. We are more fearful that in a sell-off environment that 15 years will come under pressure, which adds to the negative convexity of an already negatively convex instrument.

Not to say that 30-years don't have that as well, but with the superior income earning potential on the 30-year high coupon trades, we can do some more creative things on the hedging front and hedge out some of that convexity risk a little better with the proceeds from the higher income, and still maintain our current income earning potential.

Just one final thought, Mike, the reason for the trading and the repositioning, really was just -- we put a lot of capital to work in the first quarter and we bought a lot of low, low balance pools, because the payoffs were very, very low.

Second quarter, especially with the rally that has continued until very late in the quarter those payoffs got very, very high, and as we had new money to put to work we just didn't want to pay out for that. In fact, we thought we would lighten up on our allocation.

We just went into other forms of specified pools that were much cheaper. That's like we talked about what we call FICO pools, in other words, if prevailing rates are 4% some guy who has very weak credit can't get a 4% mortgage. He's going to get a 4.5% or a 5%, and so we bought those, because the payoffs were lower and they still offer good protection because that borrower, because it is being credit impaired, is much more difficult for them to refinance. That was really the gist of what happened. It was just which specified pools we owned.

Then one final comment I will say about the different assets we have available to us, we are not very likely to add a lot of short resetting ARMs. From 2013 when the market slowed off materially, they are very short duration assets, so they performed well. They have actually had a different type of risk, and that is the funds level. For instance, when the Fed starts to raise rates and LIBOR moves up accordingly, the reset to those ARMs could come under pressure and we don't know what will happen.

In 2004, 2005 and 2006 the Fed raised rates very gradually and predictably and those ARMs did fine. But next year when the Fed starts to tighten, presumably, if they do the same thing then they will be fine. But if they raise those rates very quickly, those assets could come under a lot of pressure. Since we don't know how it's going to play out next year, we are not likely to own a lot of those types of assets.

Okay, well, great. Your approach certainly sounds very well thought out, and better yet it's been working.

So far, so good. Thanks, Mike.

Yes, thanks.

(Operator Instructions). I am seeing no other questioners in the queue at this time.

All righty, operator. Thank you very much. To our listeners, thank you for your time. To the extent you have any questions that don't come to mind now, but do come to mind over the course of today or tomorrow, please call our offices. We'll be very glad to take your calls. Otherwise, we appreciate your interest in Orchid Island and talk to you next quarter.

Ladies and gentlemen, thank you for your participation in today's conference. This now concludes the program and you may all disconnect. Everyone have a great day.