Orchid Island Capital Inc (ORC) 2017 Q4 法說會逐字稿

Good morning and welcome to the fourth-quarter 2017 earnings conference call for Orchid Island Capital. This call is being recorded today, February 9, 2018. Before we begin, the Company would like to direct you to their corporate website, www.OrchidIslandCapital.com. Here under the Events and Presentations section of the website, you can find the supplemental materials that will be referenced during today's call.

At this time, the Company would like to remind the 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 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 over to the Company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead, sir.

Thank you, operator, and thank you, everybody, for joining us this morning. I'm going to be going through the slide deck. I hope everybody's had a chance to visit our website, the Events section of the website and pull down the slide deck. As I go through, I'm going to be flipping from page to page. I won't necessarily go in the order that the slides appear in the deck and accordingly, I will move slowly so everybody has a chance to catch up and follow with me.

As I've done in the past, I'm going to follow the same rough outline. I'll start by giving a brief overview of the highlights of our results for the quarter. I'll then move on to a discussion of events that took place in the markets during the quarter, with an eye towards focusing on the events that were most relevant for us. And then I'll transition to a discussion of how we were positioned going into the quarter, what we did during the quarter with respect to the portfolio and how the events that unfolded during the quarter affected us giving our position.

Then I'll discuss the results in more detail with respect to the portfolio, which again will be with a focus on what happened and how we were positioned. I'll talk briefly about the events that have unfolded since the end of the year, which as you all know are quite substantial. Then I'll have a discussion of our dividend. We did lower the dividend in January. I'll give some background information on what went into that decision.

And then, finally, I will talk about our share repurchase program. Yesterday, the Board authorized an increase in that repurchase program and I will give you some details on that.

With that, I'll turn to slide 4, which is the highlights of our results for the quarter. I'll give everybody a second to get there. Our top-line number was earnings per share. We had a net loss of $0.12 per share. As always, unrealized and realized gains and losses on all of our holdings in our portfolio, as well as our hedges are reflected in that number. Those were a $0.61 loss.

Focusing on just our proxy for core earnings, excluding those mark-to-market gains and losses, we had earnings of $0.49 per share. Book value was down in the quarter; it was moved down $0.44 to $8.71. We declared dividends totaling $0.42 per share for the quarter. The economic return was a negative $0.02 -- annualized 20 basis points or 90 basis points on the year. The total return for the year was 2.9%.

Now I'll go through some of the events that unfolded during the quarter, and as I said, I'll try to give everybody a moment to keep up with me. My next slide is going to be 6, page 6. And what we have here are basically what happened on the long end of the curve. The 10-year Treasury and the 10-year dollar swap. That is the most relevant point on the curve for mortgage investors generally speaking because it tends to have the greatest influence on mortgage rates and agency mortgages are driven by movements in rates and prepayments, so obviously a very relevant point.

As you can see, during the quarter, there was very little movement on the long end of the curve, either swaps or in just straight treasuries. There was a selloff in September associated with Fed actions and the data turning around, but basically nothing much happened on the long end of the curve.

However, if you turn to slide 7, same thing. We have the Treasury curve on the left and the dollar swap curve on the right. You can see that the curve flattened quite a bit, both curves. This had to do with the market starting to price in more hikes by the Federal Reserve in 2018 and possibly beyond. As you recall, the Fed hiked twice in 2017 in March and June, and then in September announced they were going to let their portfolio start to wind down.

But more importantly there was a statement to the effect that the Fed was looking at most recent negative inflation data, or soft inflation data, I should say, and looking beyond that, they were of the opinion that inflation would head back towards a 2% target and that these events were driving inflation to be soft or transitory. And as a result, the market started to price in more hikes. Then, of course, the data was strong and most significantly the administration and Congress were able to get the tax package done. And it's quite fiscally expansionary, a $1.5 trillion estimate deficit spending over the course of the next 10 years. So that was what caused the curve to flatten.

Slide 8 gives you a pictorial representation of this. As you can see, as we ended near the end of the year, the 5s/10s curve, which has become the market's favorite proxy for the shape of the curve, reached the very low 50 basis points towards the end of the year. Had been as high as 253 in November of 2013 after the taper tantrum.

I'll say something about this a little more as it pertains to our positioning, but for now I just want to point this out that this was -- the most meaningful development in the fourth quarter was the almost daily drop in the slope of the curve into early 2018.

Now turning to slide 9, we have several things in -- pictures on this page I want to talk about. The top left shows you the performance of Fannie 30-year fixed rate, Fannie 4s and 4.5s. These are the TBAs. If you are familiar with us and our positioning for the last year or -- several years, actually, these tend to be our core holdings. And as you can see, prices of Fannie 4s were down 29 ticks and -- I'm sorry, 20 ticks -- and Fannie 4.5s were down 29 ticks.

In comparison, Fannie 3s were down 6.5; Fannie 3.5s were only down 10. This was a result of the flattening of the curve. These coupons duration wise, the 4s and the 4.5s, are more in the belly of the curve and that's where we had the greatest selloff. The long end of the curve, as we discussed previously, really didn't move so much.

So our positioning with a heavy concentration of 30-year 4 and 4.5s was not ideal for this quarter. We've been positioned defensively, especially since the fourth quarter of 2016 and even beyond. That did well on a relative basis then, but throughout a lot of 2017 was not as ideal a positioning, especially in this quarter with the big flattening.

The bottom left just shows you the performance of the rolls of those coupons. You can see that the 4.5 roll spiked in early December. We actually took advantage of that and put on some long Fannie 4.5 TBAs. We did so by delivering some pools into that and that was a means by which we could shed some somewhat faster paying pools and take advantage of the pop in the roll.

On the right-hand side, we show the payups for a few representative securities. On the top is the 85k Max. These are the highest payup premium pools. Below that is just new production, which would be the lowest of those. So we're kind of showing you the bookends. And this really goes back all the way to our inception in early 2013.

Just focusing on events for 2017, and in particular the fourth quarter, you can see that these payups were very stable, if not slightly higher. Now keep in mind I mentioned the fact that those two coupons had a really rough quarter, underperformed, so net-net in total dollar price, these were still somewhat down. But they did show very significant resiliency during that period. And even into January of this year when they still remained strong. The February cycle is a bit challenging because that's when the turmoil in the market that started last Friday really started to kick in.

With that, now I'm going to move on and talk about how we were positioned in greater detail and then we'll get back to how the [inter-wind] of our positioning and developments in the market affected our results. So I'm going to turn to slide 16, give everybody a second to get there. This is the most -- the big-picture view of how we were allocated.

Starting with the top left, you see the allocation between -- of our capital between pass-throughs and structured. And they've been running in a fairly steady range for some time. It started to change in the second or late in 2017 when we started to add -- appear to add more pass-throughs versus structured securities. But really I'll explain in a moment, that's somewhat misleading. We did reduce the positions in the structured portfolio. We sold two inverse IOs. Those were in response to basically developments with respect to Fed expectations. That has since changed; I'll get into that in a few moments in terms of the first quarter of 2018.

On the top right, you just see the size of the overall portfolio. And you see now that we've been growing as a company for some time since inception, especially starting in early 2014. And the allocation to fixed rates, as you can see, has resulted in a pretty sizable portfolio.

One final note on the bottom right hand, as I said, we did lower our inverse IO holdings during the quarter and I'll get into that in a little greater detail in a moment.

Slide 15 is just something you are familiar with. This is basically our portfolio. And I don't have a lot to say here, other than, as you can see, on the top lines, adjustable rate securities, ARMs, and even 15-year, we have been reducing those holdings and continue to do so. The portfolio is again predominantly 20-year fixed-rate mortgages and 30-year 4s and 4.5s.

And as you look to the right, you can see that the average coupon on the 30-year fixed rate is 4.29%. That just reflects a slight skew towards 4.5 versus 4, but that has been coming down. It used to be more of a greater skew, if you will.

Slide 19, I'll give you a second to get there. This is where we talk about our hedge positions. We have made changes to those, which I'll get into in a moment, but let me just go through where we were at the end of the year. On the top left, you see our eurodollar positions going back to our inception when we were a very small company.

Eurodollars were the only hedge instrument available to us. They've been a core part of our hedge strategy since then. We have gotten away from that somewhat, but, as you can see, we still have substantial eurodollar shorts in place through the end of 2020. Hence the weighted average entry rate, which is listed there in the middle of the table, as you can see, and particularly for the next two years, is either in or close to in the money. That's -- was not been the case historically as the forward curve has never been really realized for some time.

With respect to our [TY] hedges, we did make some changes to that, actually in August, so that was in late third quarter when the curve was flattening -- before it started flattening and when the 10-year was on the verge of going through 2%, we moved our hedges more towards the belly and reduced our TY short.

Top right, we talk about our -- we show our TBA positions. We have traditionally shorted 3% or 4% coupon TBAs. I mentioned earlier, when the 4.5 roll popped, we added a long position there and delivered pools. Note also that net-net we are still short TBAs.

And then, finally, our swap positions. We have a little over $1 billion in swaps in place at the end of the year, and those are now in the money, weighted average rate of 1.43%. That is finally in the money. It's been a long time coming.

With that, I'm going to move on to slides 13A and B. I'll give you a second as always to get there. This shows you in detail what we did in the portfolio. And I'm going to start on the left-hand side of the page. And as you can see, the allocation to pass-throughs went from 63.7% to 73.5%. And as I said, that's somewhat misleading. And the reason that it went up so much -- in fact, if you look on the right-hand side, you can see that the market value of our pass-throughs is actually down on the quarter, even though the capital allocation is much higher.

And the reason is that while the capital allocation to pass-throughs went up $80 million, most of that is because our cash balance went up by $65 million. So the way we do this capital allocation calculation is we include cash in the pass-through strategy. It's predominantly there available to support margin calls on the portfolio. We typically don't apply as much leverage to the structured securities and so we include it there. And we were raising capital during the quarter and we basically allowed that cash to accumulate. As a result, our leverage ratio, which I believe is on slide 18, dropped pretty precipitously.

And so even though we had it long in the TBA 4.5 I mentioned, I also mention that we're net-net short TBAs. And so unlike, say, some of our peers who use a lot of dollar rolls, their economic leverage is often higher than their GAAP leverage ratio. In our case, that's not the case. Our economic leverage ratio is actually lower.

We did appear to increase the allocation to pass-throughs, but that's really misleading. It was just the cash allocation predominantly. And as I mentioned, we have allowed our leverage ratio to drift down.

Now I will go to slide 11 and we'll talk about how this impacted us in terms of results. We've talked about what happened in the market, how we were positioned and what we did with respect to the portfolio during the quarter. On the right-hand side, you see our returns by sector. The pass-throughs had a negative return. That basically was driven by the fact that we were positioned in higher coupons and the curve flattened and they underperformed. As you see, the realized and unrealized losses were over $43 million. Almost $9 million of that is what we call premium loss due to paydown.

Under our accounting methodology, we do not explicitly amortize the premium on our fixed-rate pass-throughs. It's captured in the mark-to-market, so $9 million of that $43 million is just premium lost due to paydown. But there was still obviously a sizable move in the portfolio. The hedges were unable to offset that.

With respect to the structured securities, as you would expect, IOs did fairly well with stable long-term rates, but inverse IOs did poorly as a result of the movement on the front end of the curve and an increase in Fed expectations. And as I mentioned, we sold two of those positions, which also helped cause the allocation to shift to the extent that it did. So that's basically our results.

Now I'd like to talk about what's happened since the end of the year and what we've done as a result. As far as 2018 goes, it's really a tale of two periods. Up until last Friday when the payroll number was released and average hourly earnings had spiked much more than the market expected and caused quite a bit of turmoil, as we all know, but up until that point, it really had just been a long end selloff.

The yield on the 10-year had moved from the low, mid-2.40%s, which is where it ended 2016, and moved into the 2.80%s. So that was a meaningful selloff and a steepening of the curve, but then, as I mentioned, last Friday, things started to change dramatically. Volatility has spiked. Obviously, as mortgage investors, volatility increases are negative for mortgages. There's evidence that we may have some inflation.

Obviously, the equity market has been extremely volatile. The curve 2s/10s has steepened although the 5/30 curve has remained more or less -- it's up only slightly from where it ended the year, but that -- mostly that -- it's because it flattened end of the year and then steepened in the last week. So it appears to be almost (inaudible) for the year, but that doesn't reflect what's happened since last Friday.

What is notable, though, is that starting last Friday and with the large equity move and what we've seen over the course of the week, as of yesterday's close, we're at a point now where the equity market has sold off approximately 10%, but rates are back where they were after the hourly earnings number. So the 10-year is well into the 2.80%s and I think what that means is from the perspective of the bond market, that's significant because it means that rates are where they were a week ago even though there's been a 10% correction in the equity market and a big uptick in vol.

So I think that one thing that may portend is that the rates market believes that this turmoil in the equity markets is temporary. The economic fundamentals are extremely sound, fiscal policy has become very, very stimulative, as you all know.

President Trump signed a bill that was hammered out overnight and that's going to increase federal spending by almost $300 billion over the next two years, coupled with the tax cuts. So we've got very, very stimulative fiscal policy in the US. The economy was very strong coming into this and of course, globally, everything is strong as well. So I think unless the equity market really rolls over, the bond market seems to be of a mind that this correction is not a material lasting effect and it seems like it's going to continue to sell off, and in fact has so far today.

So what does that mean for us? What have we done? Up until last Friday, volatility was fairly low and we took advantage of that. We put in place a couple of swaptions along the long end of the curve. Or I should say one large position, so we were able to put that out at a very attractive price. We put in place a receiver in the belly in case we were wrong to kind of offset that, but only partially.

The volatility induced by the equity markets and the resulting rally earlier in the week when rates rallied, the two-year rallied below 2%. We took advantage of that by adding to our eurodollar positions. We moved those shorts up fairly substantially and we repositioned our TY hedges. They are a little more balanced between the belly and the long end of the curve.

We have also added to our IO positions. I talked about how that had come down somewhat in the fourth quarter. We have moved that much closer to it being in balance, taking advantage of some attractive IOs that were available at the time. So that's what we've done post year-end.

Now I'd like to talk about our dividend, and I'm going to start with slide 8. As you'll recall, I mentioned the fact that the curve has been steepening -- has been flattening, rather, for some time. Really kind of reached a peak after the taper tantrum, but has trended down ever since and that accelerated late last year.

If you look at slide 12, I'll give you a second to get there, you can see two lines here. On the one hand, you have the blue line, which is our reported earnings per share by quarter. As you can see for the fourth quarter, we were down $0.12. And then you see a red line, which is simply taking the earnings per share as reported and removing the unrecognized and recognized gains and losses. That's our proxy for core earnings, although it's -- I use that with a small P. It's really not a pure example of what our core earnings are, but it does get the point across. As you can see, at the end of the March quarter, we were at $0.72 and it has drifted down substantially. And that is reflective of what we have realized in the portfolio.

Finally, let's go to slide 17. This is a little more accurate picture. And we have several lines here on the top. The blue line represents the yield on our assets. And as you can see, for instance, going back to March of 2013, was around 2.5%. That was before the taper tantrum. That's when we were in an extremely low rate environment and really seemed like we would potentially be there forever.

Then we did have the taper tantrum. And as you can see, that trend -- that line has continued to trend up and as of the end of 2017, it was over 400 basis points, so a substantial move. However, if you look at the red line, which is our economic cost of funds, you can see that that, while it was extremely low for a long period of time, approximately 35 basis points, has since moved up to almost 200. So a very substantial move. The green line is the net of the two. As you can see, early in our life, that number moved materially higher and eventually got to be north of 300 basis points.

And if you look at the bottom side of the page, you can see we had a substantial dividend increase, from $0.135 to $0.18. However, that green line in the post taper tantrum world started to slowly come down as a combination of things, depending on the time in the year, but has substantially come off that peak, and first resulted in a dividend cut in the middle of 2015. And now as we ended 2017, that number was all the way down to barely over 200 basis points, and the dividend was unsustainable at that level and we were required to reduce it from $0.14 to $0.11.

Going forward, obviously, as you can see, the shape of the curve matters. Up until a few weeks ago when the curve was on a, seemed like, a never-ending flattening trend and there were many pundits out there thinking that it would eventually get inverted. That scenario is not good for a NIM type business model such as ourselves. However, since then, the market seems to have turned around, at least for now, and is re-steepening. That is a more favorable environment.

As for the balance of this year and Orchid Island Capital's dividend, it's really too hard to say at this point because we don't know, we don't have a crystal ball, we don't know where the market is going to go with any high degree of confidence simply because the volatility here is still very much at play. And as I mentioned earlier, if the equity markets were to roll over and really cause problems to the financial system, then the Fed may in fact pause and that could change everybody's outlook on rates going forward.

Absent that, we would probably continue to sell off, the Fed will continue to hike rates, and the curve may not flatten as much as it appeared that it was going to a few weeks ago. Time will tell.

And then, finally, I would like to talk about our share repurchase program. That's on slide 22. This basically shows several things. The red bars are our book value per share over time and the blue line just reflects the price of the stock. Now, in this case, we started with the end of 2013. 2013 was the year of the taper tantrum, but it was also our first year of operations and we did basically no capital raising of any kind, nor did we do any share repurchases.

But as you can see as we entered 2014, rates were a lot higher. We did a couple of secondary offerings. We were able to grow the Company substantially, get to a point where we were S-3 eligible and institute an ATM program, which is what we did in the middle of 2014. As you can see, that the blue line was pretty much constantly above the book value. There's a few moments where it's not; that's simply on our X dates, and we were able to start to raise capital through our ATM program. And it was very, very -- an attractive way to raise capital because the cost is so low.

As I mentioned earlier, we had reduced our dividend in the middle of 2015. At that moment, our stock traded materially below our book value and we put in place a share repurchase program, which we -- 2 million share program. We used about 60% of that.

Mid-2016 things started to recover. Even though the stock wasn't completely above book value on a consistent basis, investment opportunities were attractive and we started to use the ATM on a limited basis. In the later half of that year, the environment was extremely attractive. We raised a lot of capital and at a very nice premium to book, and that continued throughout 2017 where we were trading above book and we were able to utilize our ATM program.

But now it's 2018 and we're trading substantially below book value. As a result, yesterday afternoon, the Board voted to increase the size of our share repurchase program. It is now up to 10% of our outstanding shares and we hope to put this in place as soon as we exit our blackout period in the very near future.

To the extent the stock continues to trade at a material discount to book, it will probably be the case that our best use of our capital is to repurchase our shares at that discount. If at some point that's not the case and the discount goes away or is substantially reduced, then we may back off from the program.

But one thing I did want to demonstrate when walking you through this slide in such detail is to show you that our -- one of our primary goals in running the Company is to take advantage of these opportunities when they present themselves. So when the share price is above book value and we can sell shares accretively, we do so. And when the share price is substantially below book value and we can buy them back accretively, we will do so. So the idea is to try to take advantage of these opportunities when they present themselves.

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

(Operator Instructions). David Walrod, Jones Trading.

Good morning, guys. A couple questions around one theme. You raised a lot of capital in the fourth quarter. You mentioned that the capital allocation to the pass-throughs was skewed due to the cash. Also that your leverage was down at quarter-end. Can we expect you to, number one, bring the leverage back up closer to the high 8s, low 9s? And two, then that capital allocation to be more where it has been historically?

Well, as I mentioned, we've already taken a step to do that so far this quarter. The leverage ratio is not quite up to that level. We're watching that closely because with the selloff and the -- there's two things that mortgages don't like. One is an increase in volatility, which we've had, and obviously an increase in rates, which is where the negative convexity of mortgages can kick in and the extension of mortgages.

And as a result, we are mindful of what's developing in the market and whether or not we should be increasing the leverage. As of now, that decision has not been made. There was a slight uptick but not to that range. You want to say something, Hunter?

No, I -- David, in the fourth quarter, we sold a rather large proportion of our inverse IO portfolio. It was one trade consisting of a few securities that really threw that number off, so it was -- I think I believe we'd sold like 15 million and we ended the year with a $121 million portfolio, so it's a relatively large percentage.

Since year-end, we've ticked up the portfolio, both because the IOs are appreciating in value and because we are explicitly adding them. So we're getting back to a more normal -- I think we went from the derivative portfolio being $121 million to just under $140 million now. So that's a combination of an increase in the market value of some of the negative duration bonds into the selloff and some adds that we've done. So it's trending back towards a more normal level.

Okay. And also with the capital raise, can you talk about any drag on your effective earnings as you guys raise capital and then deployed it?

Well, it was particularly late in the year and that's really when we had to lower the dividend. The curve was flattening; it was just too much. We were selling shares early in the year. Even really into the very earliest fourth quarter, it was somewhat of an attractive opportunity, then it just really went away from us. And that's why we had to basically collect dry powder waiting for a better entry point, which presented itself, as I mentioned, in the early 2018 when that money was put to work. But it was a bit of a drag. Presumably now that drag has been removed, assuming the curve doesn't continue to flatten. And so that's basically that.

Okay. And then my last question is if you can just speak to -- when you think -- when your capital is fully deployed, the earnings power of the portfolio, do you think it's in line with your revised dividend? Or just what are your expectations there?

It is as of January and February, but, as I mentioned, it really is TBD because we don't really know how things are going to unfold. With this steepening, that's a very strong positive for us, and to the extent that -- even with the Fed hiking, if the long end continues to move and we can maintain our NIM, and we've also, don't forget, concurrent with that steepening is probably a slowdown in speeds. And we still have a high coupon concentration, so that's obviously a very big positive for us.

Also, as Hunter mentioned, the IOs that we've added are very much benefiting from that move. So to the extent that trend continues, then that dividend seems or would appear to be very sustainable.

To the extent that things go the other way, say for instance if the equity market really rolls over and the Fed has to pause and the curve resumes its flattening trend, then that would be a negative. That would be a negative for several reasons. One, because our NIM would be compressed simply because of the gap between funding and yields on our assets, but it would also probably cause refinancing activity to pick back up and it would also be a negative for the IOs that we've added.

We really have to just be careful to watch how events unfold over the balance of the year to determine what we do going forward.

David, I just wanted to add a couple of points there. We're really at sort of a pivot moment here where we are going to see what the earnings power of the portfolio looks like in a market where mortgage rates to borrowers is in the 4.50% -- I don't know, call it a range of 4.40% to 4.65% over the course of the last several weeks.

So as you know, our theme has been to maintain a relatively short duration asset mix through buying high premium mortgage-backed securities. So the one thing that pinched us in the fourth quarter was that we saw the rate movement in the belly of the curve, which lines up with the durations of those bonds work against us. So 4s and 4.5s, if they are in the 3 to 5-year duration kind of bucket, that's where the curve moved the most.

So we saw the negative price action associated with that rate move, while at the same time we didn't get the benefit of mortgage rates to the borrowers underlying those bonds moving to a point -- or mortgage rates more broadly moving to a point where those borrowers did not have an economic incentive to refinance any longer.

That has since changed in the first quarter. So the -- a large portion of our portfolio is now out of the money, so to speak, so those borrowers do not have an economic incentive to refinance. That's especially true of our derivative portfolio, including our IOs. So we're going to see over the next couple of months how much the yield on the asset side of the portfolio has extended. Thus far we've really only seen the negative impact of the increased yields on the funding side of things.

So it will be an interesting couple of months. We have an idea obviously of where we think that's going to settle in. That's generally consistent with the distribution rate that we're making, but I think the earnings -- as it relates to your question, the earnings power of the portfolio is in a state of change and a lot of that state of change will ultimately depend upon where mortgage rates to borrowers settle in here.

Okay. That's it for me. Thanks, guys.

(Operator Instructions). Christopher Nolan, Ladenburg Thalmann.

Hey, guys. What was the weighted average price of shares that were issued in the fourth quarter, please?

I don't have that in front of me. I want to say it was in the high $9s, but I don't have that in front of me. I can get you that information.

Okay. But it looks like it was accretive to book value?

Yes.

Great. All right. And then if I'm reading this right, Bob, if the longer duration on the portfolio, that's actually working to your advantage as the curve steepens, because I thought it would be the opposite. I'm just -- I was a little confused by your comments to David a minute ago.

No. Well, what we were talking about, and especially what Hunter was stressing, was the borrowers' rates. So the backing up of rates is good from the perspective of prepayments, it's good from the perspective of the performance of our IO securities. But as mortgage durations extend, that's a negative for the pass-throughs all else equal because they're going to extend, be down in price and the payout premiums to the extent we own specified pools will be hurt. So that can be a negative.

There's the convexity component of a pass-through portfolio.

So we have adjusted our hedges accordingly. We have increased a percentage of the liability stack that is hedged in response to that. So we're trying to mitigate the effect of that.

So it really depends on what perspective. If you are talking about book value, that increase in rates is a negative or potentially a negative. If you're talking about earnings, it can be a positive because it's going to mean slower speeds and the gap between your asset yields and your funding cost is maintained.

So it's really -- it depends on your perspective. If you are talking about earnings, it's a positive. If you're talking about book value, it's probably going to be a negative, especially because we don't have -- we typically don't hedge 100% or something less than 100% and mortgage cash flows are -- you can hedge them with IOs and you can use different types of instruments, but they are a challenge to hedge perfectly in any environment.

Great. Thank you for the clarification. Final question is -- I know you're just talking about the spreads between 10 and 30 years, but should we really be looking as to where the 1 to 3 or 5 year -- where the curve is going from 1 to 5 years or so? Because that's sort of the belly of the curve. That really sort of matches where your duration is at the moment. Is that the area of the curve that's really going to affect your earnings power in terms of spreads?

Well, yes and no. As we've mentioned, the duration of our assets is in the belly and we fund obviously on the front end. However, prepayment speeds are driven by the 10-year area. And so if the 10-year is moving down and prepayment speeds are staying high or increasing and we own a lot of high coupon mortgages, there are durations in the belly of the curve, but the prepayment on those is sensitive to the long rate.

That's what we were seeing in the fourth quarter where those assets -- as the belly of the curve sold off, because that's where they laid on the duration spectrum, their prices were hurt. But also because the long end wasn't moving, prepayment speeds weren't slowing. So here's an asset that's going down in price, it's a high coupon mortgage going down in price, and prepayment activity is staying the same, so that's kind of a double negative.

On the other hand, when you have a steepening of the curve, that means prepayment activity on that instrument is slowing. If the five-year is continuing to sell off, its duration -- it's going to cause it to go down in price so book value, negative; earnings, positive because speeds are slowing. Yes, that part of the curve -- that's really not relevant for us, even though on a duration basis it appears that's where those assets [shear]. The earnings perspective is 10s and 2s or 10s funds.

As 10s move, the duration of our portfolio is going to get -- of our pass-through portfolio is going to get longer as well. So it will be a transitioning, it will target. So yes, that might be -- going back to the fourth quarter when mortgage rates were relatively low because the 10-year was stubbornly low as well, our assets were lining up on the belly of the curve. As we transition into a higher yield environment on the longer end of the curve, our mortgages we would expect to extend some, and in fact we've seen that happen.

The flipside of that, the IOs have negative durations and line up very much on the long end of the curve, so they have a lot of room to expand, both in terms of income-generating potential as well as book value increase.

I just want to summarize. If you are talking about earnings, it's that 2s/10s or funds 10s that really matters because that movement on the 10-year affects prepayments and movement on the front end affects our funding costs. If you're just talking about book value and the movement in the price of our assets for it, our assets are predominantly in the belly of the curve. So that really matters in terms of price movements, book value.

Of course, what Hunter just said is as rates go higher and higher, they extend. So they maybe move from a 4-year to a 6-year or potentially in a big enough selloff even longer.

So in terms of movements in the curve, it really depends on whether you're talking about earnings or book value because the relevant part of the curve is different for earnings and book value.

Understood. And just by the long end of the curve movements, which is pretty modest, I would say, since the fourth quarter, it's -- I mean from -- on a 10 to 30-year basis, it would seem that your CPRs are likely to go down in the first quarter just the way things are heading.

Yes. And then also there's the seasonal slowdown. This is typically when prepayment activity is muted and turnover is muted. So if you look at any prepayment model that's out there, they are going to tend to show, all else equal, prepayment activity is going to trough in the first quarter. And we've seen that this year. So it's been a double whammy, if you will. We've had rates sell off now in the long end and it's the seasonal part of the year where speeds are their slowest.

So our portfolio, the last two months -- we didn't mention this on the call yet, but our pass-through portfolio over the last two months have been in the mid-single digits.

How many Fed hikes are you assuming for 2018? And I'll end it with that.

Sure. I would assume three, maybe four. A lot of it has to do with whether or not the equity markets change that. But based on fundamentals alone and assuming the equity market hangs in there, I would say three or four. In fact, I would say based on the fact they passed that bill this morning, probably four.

We've positioned so that -- just as added color -- we've positioned so that if we get more than three this year -- but maybe more broadly, if we get more than three or four over the next couple of years, the curve gets really flat really quick, and so we've struck a lot of new funding hedges out in the area of, say, late 2019 through late 2020.

2018 and 2020.

I'm sorry, late 2018 through late 2020. So to the extent that we get one or two or three more hikes over that period of time than what's currently baked into the market, in particular, our swaps and eurodollar hedges will benefit from that pretty greatly.

Got you. But if the forward end of the curve remains pretty flat, it could be a negative earnings issue?

It definitely would go against us if we get only, say, three. But we feel like there's an asymmetry to that risk profile in that we just -- unless we just don't get any, that's really the downside to us. But if we get one or two or three over the course of the next few years, that has a very minimal negative impact to us at this point, the way the market is pricing in future Fed hikes.

And again, I want to stress this. Three hikes, four hikes, who knows? And obviously, our funding cost goes higher, but our dividend is a function of the NIM. And so if we get four hikes and the 10-year stays here and goes lower, that's going to be a big negative for our earnings. If we get four hikes, but the 10-year ends the year at 3.20%, we may not be at all because we'll be able to maintain that NIM.

Yes, prepayment speeds (multiple speakers)

Yes, yes. Going into -- I mean this was a very perplexing thing. I'll spend a moment and talk about this. And not a lot of people in our space understood this is -- was the incredible outperformance of the long end of the curve, the 30-year. The 30-year Treasury had a remarkable run until very, very recently.

Why was it? Well, there's several theories put forward. One was because equities had such a phenomenal run that anybody that runs a balanced portfolio between equities and bonds was simply just reallocating to rebalance. Equities had had a big run, they became a proportionally higher part of the portfolio, sell some equities and buy some bonds and bring it back into the target allocation.

The other -- and predominantly in the case of asset liability managers and pension funds. So there were this -- someone was a big buyer of the 30-year, and that's why the 5s/30 curve just kept flattening and flattening. That seems to have finally reversed.

And then also we have to consider what's going on abroad, what's going on with ECB and their asset purchases because our longer rates have been very attractive to long rates there. To the extent the market starts to think they are going to taper their asset purchases and maybe reverse them, then yields on the long end in Europe would move higher. That relative attractiveness would go away. That could cause the long end to sell off.

So that's really what matters from an earnings perspective. It's not just how many hikes. It's just how many hikes in relation to what moves -- what happens on the long end of the curve.

Understood. Okay. Thank you very much for taking the time and answering my questions.

You're quite welcome.

Thank you. And I'm showing no further questions over the phone lines at this time. I would like to turn the call back over to Robert Cauley for closing remarks.

Thank you, Glenda. Everybody, I thank you for your time. Appreciate the chance to get on the phone and talk about what we've been doing and field your calls. To the extent somebody has a question that didn't come up during the call or comes up afterwards when you listen to the replay, feel free to call our office. Our phone number is 772-231-1400. Very glad to take your call. Otherwise, look forward to talking to you next time. Thank you.

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