Orchid Island Capital Inc (ORC) 2016 Q3 法說會逐字稿

Good morning and welcome to the third quarter 2016 earnings conference call for Orchid Island Capital. This call is being recorded today, [October 30, 2016]. At this time, the Company would like to remind the listeners that the 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 the from 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 call over to the Company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead.

Thank you, operator. The economic trends in place over the course of the first and second quarters of 2016 reversed in the third quarter and into the fourth. The broadest measure of economic growth in the United States, gross domestic product rebounded back to 2.9% and the year-to-date growth annualized appears to be returning to the 2% level, the level widely considered to be at or slightly above trend growth in United States in this post great recession world.

Interest rates, after falling precipitously early in the year and again after passage of the Brexit referendum have since stabilized and earlier last month moved back to above levels seen just before the Brexit vote on June 23, 2016. In fact, the yield on the US Treasury reached an all-time low yield shortly after the Brexit vote. However, while the slow growth witnessed in the US over the first half of the year has ended, economic growth is by no means robust. Many of the drags on growth, predominantly in the manufacturing and energy sectors have stabilized, but have not recovered meaningfully.

The strongest sectors of the economy, the housing, consumer and labor markets continue to perform relatively well and drive economic growth. However, the net of all this activity appears to be modest growth accompanied by increasing, but not excessive inflation. Second quarter GDP growth was 1.4% and GDP growth for the third quarter was initially reported last Friday at 2.9%. Inflation, especially the Federal Reserve's preferred measure, personal consumption expenditures was reported at 1.7% on the core level late last week as well. Base line effects resulting from the sharp drop in oil prices in late 2014 and 2015 should cause this measure to continue to move towards 2%, the Fed's target level.

These conditions should allow the Fed to remove accommodation at a very gradual pace. To wit, the market now expects the Fed to raise rates before year end, probably at its December meeting. Public comments by various Fed governors and committee members have been consistent in supporting this expectation. Assuming incoming economic data remains supportive and financial conditions do not deteriorate, we expect the Fed to move rates higher by 25 basis points at its December meeting. Nonetheless, it is equally likely, in the eyes of most market participants that the Fed will not raise rates aggressively in 2017 and beyond. Public comments by certain Fed officials are also consistent with this expectation. Accordingly, we expect the level of the U.S. Federal Funds rate and funding levels generally to only move modestly higher over the next few years.

With this backdrop in the economy and rates market, the mortgage market has performed well over the course of the third quarter of 2016. From a price perspective, a slight back-up in rates over the course of the quarter, the U.S. Treasury curve flattened modestly as 2-year yields increased by approximately 17.5 basis points, while the 10-year Treasury yield increased by approximately 12.5 basis points, coupled with expectations that prepayment speeds would moderate, enabled 30-year fixed-rate mortgages to tighten in spread to comparable duration treasuries. In fact, with rates up, prices of 30-year fixed-rate 3% through 4.5% securities increased. The same is true of higher coupon 15-year fixed rate securities, although to a lesser extent.

From a prepayment perspective, speeds accelerated into the late summer post-Brexit and appeared to have peaked in August, based on the report issued in early September. However, speeds moderated only modestly in September, based on the report issued in early October. Going forward, the combination of higher rates -- the MBA survey rate issued on October 20 was the highest since just before the Brexit vote; coupled with the seasonal slowdown of prepayments, should cause prepayment rates to decrease further. This in turn should be supportive of mortgage valuations.

In addition, the Fed appears intent on continuing to reinvest pay-downs on their MBS holdings and banks; particularly large banks continue to add to their MBS holdings, both in securitized and whole-loan form. Both of these trends are supportive of mortgage valuations as well. A potential pitfall would be if the Fed, in an effort to steepen the curve, terminated, or slightly reduced or significantly reduced their reinvestment of pay-downs. Governor Eric Rosengren of the Boston Fed recently hinted at this possibility, although the Fed leadership, Chair Yellen, Vice Chair Fischer and New York Fed Governor Dudley, have not.

A second consideration for mortgage valuations is pay-up premiums on call-protected securities. Orchid has a significant allocation of its portfolio to these securities. In spite of the back-up in rates during the third quarter and continuing into the fourth, such pay-up premiums remain elevated consistent with prepayment speeds. Going forward, if prepayment speeds continue to moderate further, call-protected security pay-up premiums could diminish.

The monthly auction cycle set to commence this week should shed some light on the market's view of anticipated prepayment levels. The Company has been reducing exposure to such securities gradually over the course of the third quarter and to date in the fourth, while weighing the potential risks of continued pay-up erosion, versus the need for prepayment protection as speeds have moderated only modestly so far. Portfolio positioning remains concentrated in higher coupon, fixed rate securities with various forms of call protection. Exposure to increasing rates is mitigated by interest only and inverse interest only securities coupled with various forms of funding hedges, short positions in euro dollar futures, treasury futures, pay fixed interest rate swaps and short positions in TBA securities.

However, as discussed above, pay-up premiums for call-protected securities remain elevated. As mentioned, to address the exposure to a more dramatic increase in rates and likely erosion of these premiums, we have sold securities with some of the highest forms of call protection to the dealer community for purposes of structuring them into agency CMO structures whereby we took back an inverse IO position, thereby allowing us to maintain the favorable prepayment protection while removing the exposure to high premiums. This activity was the primary reason that capital allocation shifted slightly from pass-through to structured securities. The allocation to pass-through declined from 62.1% at June 30, 2016 to 58.9% at September 30, 2016.

Returns for the quarter reflect a strong quarter for MBS securities as the mark-to-market on our pass-through portfolio was positive as was the mark-to-market on our funding hedge position, not a common occurrence. As a result, the pass-through portfolio generated return on average invested capital of 14.7% for the quarter on an un-annualized basis. The structured securities portfolio generated return of negative 0.6% for the quarter, as movements on the front-end of the rates curve driven by increased expectations of Fed rate increases caused our inverse IO securities to separate negative mark-to-market adjustments in spite of higher rates. The combined portfolio has generated return of 8.6% for the quarter, not annualized.

The Company's book value increased from $10.86 at June 30, 2016 to $11.21 at September 30, 2016. Book value was up slightly again so far in the fourth quarter given the continued increase across the rates curve, coupled with continued strong performance by mortgages generally. Finally, we reduced the leverage ratio on the balance sheet to 7.8 to 1, excluding unsettled security purchases at September 30, 2016 from 8.5 to 1 at June 30, 2016. With reduction in specified [cash] positions mentioned above leverage is down slightly more as of today.

Going forward, the exposure to the high forms of call protection is likely to continue to decrease absent a reversal of the upward trend in rates. To the extent possible, we will also reduce such exposure via the structuring option whereby we retain the IO portion, likely in the form of an inverse IO owing to the demand for floating rate CMOs. Otherwise, the portfolio will rely on lower forms of call protection when redeploying pay-downs or investing new capital, when and if available.

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

(Operator Instructions) Steve DeLaney, JMP Securities.

Great, good morning Bob, and congratulations on a really strong quarter.

Thanks Steve.

With the Fed obviously -- I think pretty much everybody is looking at December. I'm just curious about how you're thinking about 2017, the uncertainty of what they might do next, if anything. But are you guys thinking about maybe shifting more to fix pay swaps? I know you've got about what $600 million in swaps currently, but any thoughts towards shifting some of the futures into actual -- receive LIBOR swaps?

We're actually considering probably doing some of both. The euro-dollar curve is extremely flat, out through 19 December, I think it's only about 150 basis points, 160 basis points and of course the swap curve -- the swap spreads have been volatile given all investment-grade corporate issuance, but they're still at very attractive levels as well.

As far as our expectations of the Fed, I would say we probably expect and we don't sit down and try to etch this in stone, but I would say probably two hikes next year and I mentioned in my prepared remarks, the baseline measures are going to probably drive reported inflation numbers up slightly, will probably go to 2% and maybe beyond.

Now, it's also interesting to note Steve that the Fed in their remarks, they always try to give themselves lots of room. They always talk about being data dependent, but they were concerned about -- initially it was events overseas or financial conditions. Now that inflation is starting to head towards 2%, they're saying that they're open to allow the economy to run hot, which implies that they'll probably be patient and allow inflation to run above 2% without hiking.

So the way we read the Fed coupled with the fact that the composition is going to change next week, three of the more hawkish members are going to leave, I think there is only one that's going to be replaced by a similarly hawkish member. I think the Fed will maintain a dovish bent and so, I think 2 is probably about it and beyond that it's hard to say, I mean you just really can't have much clarity beyond that. I'll let Hunter talk a little bit more about the hedging strategy.

Hi, Steve. We have been looking at adding to the both Eurodollar position, really for positions on the shorter end of the curve say inside of March 2020 and swaps for duration slightly longer than that, maybe another year or two. There's really not a lot of, I guess, in our minds downside risk in the Eurodollar. The Eurodollar position is going out through say the end of 2019, just because if you -- if we get a hike in December and then only say one or two more throughout the next couple of years, the downside of those trades is really pretty limited going all the way out to even these 2019 Eurodollar futures. So even if the Fed doesn't go more than one or two times after December, we're only looking at losing like 25 basis points, so long as we don't rotate into an environment where they're actually -- it taking an easing posture in that same period of time.

Exactly, yes. And your pass-through portfolio I noticed -- you guys like specified pools and your CPR really held in single digits, which is remarkable compared to some, but you are carrying I guess $1.09 per average purchase price. Should we assume that virtually all that pass-through portfolio has some degree of prepay protection in it -- reflected in that high-dollar price?

Predominantly, yes, it does. There are some with lower forms of call protection, but we have started to strategically shift into forms of call protection that don't cost quite as much as say the loan balance pools, which were something we started acquiring back in the spring of this year. We felt like rates have moved enough that we should start and the [pay-ups] were cheap enough that we should start layering on that type of call protection and we did and have since started kind of going back to the other way; although reluctantly so, we do spend quite a bit of time trying to acquire these pools and we are really happy with their results and the way they performed in this post Brexit rally. So the way that we've gone about shedding that pay-up duration if you will is by putting them into CMO structures and retaining a derivative off of them, which lowers our pay-up risk and our explicit duration per unit of capital, but it enables us to maintain the positive attributes of the underlying collateral in mortgage derivative form.

And just one final thing. In terms of -- a lot of things were working, obviously on your book value this quarter in terms of the way things were positioned and Bob, you mentioned that the inverse IOs were a little negative, but in terms of just your straight IO, did sort of the natural hedge there in terms of rising rates, did you see the kind of positive marks you would have expected on the IO securities?

The one thing, I will Steve, it's yes and no. It's more delayed. The problem with an IO position is that, it is like this a perfect example of what we witnessed this year, where speeds remained fairly elevated even in the most recent report and so you don't really start to get your satisfaction if you will out of the IO marks until speeds in fact do slowdown. You get initial pop when rates start to move higher, but you really need to see speeds realize before you get that. So, it kind of plays out over several months (multiple speakers) market it tends to be more instantaneous, but not in the actual securities.

Got it, that's a good point. I had not considered that because we were worried about what in July, we were down below 140 and all that people wanted to think about was speeds going higher. Good quarter. Thanks for the comment --

Sorry. Our (multiple speakers) IO, but tends to be more generic in nature because we're looking for -- or at least a large portion of it, because we're looking for large negative durations in those. So when we have many refi waves, the pay downs are always a headwind to the mark-to-markets.

(Operator Instructions) All right then, at this time I'm not showing any further questions and would like to turn the call back over to Mr. Cauley for any closing remarks.

Thank you operator. Thank you everyone for your time. To the extent anybody does come up with a question later or to the extent you listen to the replay and then have an opportunity to ask questions live, please feel free to call us at the office. The number here is 772-231-1400, we are available all day to answer any and every question you might have, otherwise we will speak to you at the end of the year. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.