Orchid Island Capital Inc (ORC) 2021 Q2 法說會逐字稿

Good morning, and welcome to the Second Quarter 2021 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, July 30, 2021.

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 provision 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 obligations 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, good morning. Welcome to the Second Quarter Orchid Island Earnings Call. I hope everybody's had a chance to download the slide deck from our website. And as usual, I will proceed through the slide deck as I go through our remarks before we open up the call for questions.

I'll just lay out the agenda for today's call. I'll start off with a review, a brief review of our financial highlights, and then I will go through a review of the developments in the market for the quarter and, more importantly, how Orchid reacted or interpreted these developments and the decisions that were made regarding the portfolio in our hedges and leverage ratio. I'll start off by just giving a brief review of how the company and the portfolio are positioned coming into the quarter and then also provide some comments on our outlook to see how -- in terms of how we see things evolving over time in the future. And then I'll return and go through the financial results in more detail as well as the portfolio and our hedges. And then finally just wrap it up with some closing comments and our outlook and then turn the call over to questions. So with that, I will turn to Slide 4.

So the results for the second quarter 2021. Orchid Island had a net loss per share of $0.17. Our net earnings were -- per share were $0.24, excluding realized and unrealized gains and losses in our RMBS and derivative instruments, including net interest expense on our interest rate swaps. We had a loss of $0.41 per share from net realized and unrealized losses on our RMBS and derivative instruments, again including net interest expense on our interest rate swaps.

Book value per share was $4.71 as of June 30, 2021, versus $4.94 at March 31, 2021. In Q2 2021 the company declared and subsequently paid $0.195 per share in dividends. Since its initial public offering, the company has declared $12.11 in dividends per share, including the dividends declared in July of this year. Total economic loss of $0.035 per share for the quarter or 0.7%.

Turning to Slide 5 and 6. We give the results of Orchid versus our peer group, which is defined on the bottom of the page in the note on each page. And you can see our results, both with a year-to-date and 1, 2 and 3, several year look back as of June 30, as well as for the calendar years. This is both on the case of Page 5 using stock price and dividends to compute total rate of return. In the case of Page 6, we use book value. I'm going to have a few more comments on these slides at a later point on the call. So for the moment, I'm just going to move on and turn to market developments.

As Orchid entered Q2 and as we positioned the portfolio towards the later stages of Q1, we had shed a lot of our exposure to lower coupons, production coupons in 30-year space predominantly. And our TBA positions. We had added to our hedge positions. And we started to deploy capital more towards IOs. That allocation has gone actually inside of 10%. And then since Q2 end it moved to 18% and it's since actually slightly higher. In that we were positioned quite defensively entering the quarter. So now just to kind of go through the developments that took place in the quarter and how we responded and how we view these developments. I think, if you see on Slide 8, you see the movements in the Treasury curve, obviously the blue line there on the left or right represents the market as it existed at 3/31. The blue line or the red line is June 30. And then the green line is as of last Friday. So obviously the market has rallied.

I think you can break down the developments in the market into 3 phases for this year. The first quarter through early April, the economy was recovering rapidly. Stimulus was being administered by the government. We saw growth in any measure of surge. And we saw the emergence of meaningful inflation worries. The market slower off and the curve steepened very rapidly.

In early April it started to change. And the events of Q1 led the market to adopt a very, very defensive, extremely defensive short positioning in the rates market. This was evident in the future as open interest markets and so forth. But also one other development that started to push things that kind of counter to one's intuition. For one, the Fed was very skeptical in terms of their views and inflation. Chairman Powell stressed over deliver, that he thought inflation was going to be transitory, and that he did not think that it would persist.

And also, while the economic data was generally very strong. There was one notable exception, which was job growth. It was definitely lagging expectations. We had a number of nonfarm payroll reports that were below expectations. And as we heard Wednesday from the Chairman, something that's very important to them in their outlook in terms of gauging whether or not we made "substantial further progress". And there are few other outside factors that kind of caused this pain trade, if you will, or conundrum, as the markets seem to rally in the face of ever-stronger economic data. Some of these outside factors were simply things yen-denominated investors were able to deploy capital into the Treasury market and realize very strong returns. And we also heard of insurance companies deploying capital from equities into bonds. And so all of this kind of led to what one might call very counterintuitive development of the rates market.

Then the third phase was really kind of mid-June when we had the Fed FOMC meeting. And a few things emerged from that meeting. One, we saw that there was some disagreement amongst the members of the committee, even though the Chairman was very much in charge. We saw that they had, indeed, have inflation concerns. They were starting to think that maybe inflation might be a little stronger than then they first expected. And I guess, more meaningfully, we saw in their dots that at least some members of the committee felt the Fed would have to hike much sooner than the market had thought previously. So this seemed to kind of all quest together to form what we would call very hawkish meeting. And then also in around that time, we saw the Delta variant, which we're all very much aware of is beginning to emerge. And that very much caught into question the growth outlook, not just in the U.S. but on a global basis. And so the market, since rally began and has rallied as we speak today. So clearly, yes, we've gone through quite a shift from where we were in Q1.

But in terms of our view of Orchid Island and how we position both at the end of Q1 and today, we are still positioned defensively. We're not convinced that inflation isn't temporary. We think that that's somewhat of an oversimplification in the sense that while there are clear elements of the price pressures we've seen that are transitory, lumber prices among some of the more popular ones. But some of the developments on the inflationary side are clearly not. (inaudible) just an oversimplification to just dismiss it's (inaudible).

That being said, the delta variant does pose a risk to growth. But even as much as it's -- as bad as it's been, we do think that eventually we will see growth recover and start to see the economy resume the growth trend that we were on up until a few weeks ago. And in fact you could maybe argue that the delta variant in a sense could prove inflationary in the sense that as more and more people are reluctant to go back to work or for instance to the Federal Government to extend the supplemental unemployment insurance, that would extend and exacerbate the job shortage and wage growth that we've seen. So that's possible that, that may have a kind of counterintuitive outcome as well.

But generally speaking, as the Fed eventually does taper their quantitative easing, they will stop pumping reserves into the system. And the sources of downward pressure on rates will start to abate. And as a result, we remain defensive, and we kind of knew the balance of risk skew towards higher rates. And also, it's important to note that we do have an inflation outbreak especially if it is a significant one, and we're something not calling for that, but if it does occur as levered bond investors we know that can have a very meaningful impact on our portfolio and our book value. Whereas a continuation of low rates, while it can put pressure on our earnings and maybe generate faster speeds, it doesn't tend to have a devastating impact on book value that a slight higher rate can generate.

So moving on to the slide deck, Slide 9. I really don't have the saying much. The picture tells a thousand words. Obviously we've been rallying.

Slide 10. I do want to make a couple of comments here. And the one notable development we saw this quarter reflected in the green line at the bottom of the page, as the curve has flattened. Obviously, we've had a bull flattener in the second quarter and into the third. And we had, as I said earlier, added to our IO position. So obviously this did not -- is not a good outcome for them. But that being said, we do view this movement rates as an opportunity to add to those positions at attractive level.

That all being said, we have maintained significant allocations to rolls and specs in particular. And as we'll see in a few moments, those have behaved extremely well in terms of prepayments. And that's very important for protecting our net interest margin and of course ultimately our dividend.

Turning to Slide 11. Starting with the top left. You can see the performance of the various TBA coupons this quarter. It's really a minor image of what we saw in the first. In the first quarter you saw lower coupons suffer and meaningfully down in price. And the higher coupons were flat to slightly up. This quarter we had slightly pretty much the opposite. Now that being said, this slide does end at the end of the second quarter. Since quarter end, higher coupons have actually done a little bit better. Big driver of that has been most recent prepayment things.

We have started to see the emergence of some burn out. But I would say that remains very much an open question going forward with this rally in rates and compression in primary spreads, secondary spreads, which I'll talk about in a minute. I think it very much remains to be seen just how much burn out we do see in higher coupons. And of course, that will affect the performance of both the TBA and the rolls as well as specs in those coupons.

As you can see on the bottom-left, the rolls in the production coupons remain very, very strong, which is not surprising given the presence of the Fed. What is surprising is that roll of the, particularly the 3 coupon, which, as we speak is trading -- is almost -- is big a drop as we see in the 2% coupon, and that's very much counterintuitive. It's clearly being driven by a squeeze in the front month as the back month rolls is still positive but much lower.

And then finally on this page, just point out the fact that spec payoffs have recovered. Sometimes this reflects a combination of factors. For instance if the TB -- underlying TBA is stronger or weaker, you may see movement in the payoffs which kind of captures some of that. But generally speaking, we have seen recovery in TBA or specified full payoffs this quarter, and it remains reasonably healthy into Q2, not necessarily meaningful strengthening but versus say duration expectations, but still attractive.

Turning to Page 12. This is our proxy for implied vol in the market. I think the one point I want to make here is if you look at this picture you can see that while vol spoke -- spiked quite dramatically late in the first quarter and has since come off, it does still remain above the level we saw for the last 9 months of 2020. So vol is still modestly elevated, although, as we know that, maybe not likely to persist absent another shock because we have generally been in a very low vol environment for a number of years for the most part.

The next slide I want to talk about a little more depth because this is really germane to both what happened in this quarter, but much more importantly how we position Orchid's portfolio and how we see things evolving over time. And I want to really focus on the left-hand side here. This is the TBA LIBOR OAS. And I want to make a few observations. You see all these various lines. They correspond to different coupons. The gray line on the bottom, that represents [FN] 2.5. And if you look at where that line was back in June 2020, it was north of 50 LIBOR OAS. And as you can see, in April and May of this year, it got all the way to negative 20. So obviously that is a very big move. Other coupons have made similar moves, maybe not necessarily getting into negative territory, but clearly a big move. And of course this is all driven by quantitative easing and the Fed by in combination with paydowns, north of $100 billion a month of mortgages. So obviously mortgages have gotten very tight. Now it's since rebounded, especially when the Fed first started to hint it possibly tapering.

And so on a -- locally they look more appealing than it did then. But I think if you look at a much longer horizon, they are still not quite all that attractive. Then you would assume that once we're completely out of the quantitative easing and rate hikes and so forth, that eventually those levels will tend to migrate back towards where they were. It may or may not get all the way back to those levels, but you would assume that they would tend to do so. And that really drives our thinking with respect to the mortgage market.

So I think you can make the following statements. I think it's very likely, not certain ever, but likely that the following 3 things will occur. One, I think it's very likely that we will not see (inaudible) tapering before the end of the year. We'll certainly, given what we heard this week, end of the year, at the absolute earliest, probably next year, early next year. And then also that it'll be pro rata. Mortgage market participants were worried that the Fed might start to taper mortgages before treasuries. And it seems pretty clear when Chairman Powell was speaking Wednesday that he does not share that mindset. He thinks their impact on the market is pretty (inaudible) the same. So I think it's safe to say that will be pro rata.

I think the second point you can make with fairly high degree of confidence is that once it starts, it's likely to be very gradual. They're not going -- they're going to telegraph it before it happens and when it happens, they're not going to do it in such a way that it's going to have a violent impact on the market. So it's probably going to play out over 6 or 12 months.

And then the third point is that assuming -- and maybe you can't say this following point within much conviction. But assuming the Fed follows their previous course of action whereby they first taper (inaudible), then they enter a period of rising rates. And then the third leg of that is quantitative tightening where they stop reinvesting the paydowns in their portfolio and remove reserves from the system. If that does in fact play out, then that means that the Fed will be buying mortgages at least in the form of reinvesting paydowns probably in the late 2023 and maybe beyond.

So all of that kind of paints a fairly benign picture in terms of the impact of tapering on the mortgage market. But that being said, and this is where we go back to this slide at top of the page, we are coming off extremely tight levels. And while it's true that many sectors of the fixed income markets are equally tight, the fact that you had so much buying pressure in the market, not just by the Fed, don't forget that the Fed pumps reserves into the system, the banking system, those funds are invested again. So we've seen the banks be very large buyers of mortgages for some time now. And is that a base, you're going to take a lot of that pressure, downward pressure off. And I think this decline sponsorship. Well, as I said, I think we'll start to see these levels back off.

And as a result, while we don't think this is going to be extreme (inaudible) move, we do in fact think it will play out fairly benignly over time. But it will in fact occur. And so we will position so as to avoid or minimize our exposure to the coupons we think are the most vulnerable, and those would be 30 and 15-year (inaudible) production coupons. And so we will continue to stick with our overweight, if you will, to polls predominantly higher coupons and inspect form so that we can protect ourselves for prepayments and protect our net. So I think that's a very important slide.

Slide 14. On the top of the page just shows returns for the quarter from the U.S. Aggregate Bond Index. And it's -- the picture that this paint is very obvious. It was very much a risk on quarter, risk-taking, and is obviously animal spirits are very, very robust. You can just look at the returns for the quarter here, the high-risk sectors. Emerging market, high yield; the S&P 500, high yield; emerging investment grade, investment grade and so forth have all done very well. And a lot more risky or risk-averse asset class is treasuries, mortgages and (inaudible) they're relatively poorly in comparison to those sectors.

Turning to Slide 15. A couple of important points here. I think I'm going to start on the top right. And what we see here is the primary secondary spread. We've talked about this at length for some time. Obviously this kind of represents the difference between rates in the Treasury market and rates available to borrowers. And we started at a very high level. And we knew that there was a lot of room for that to compress. In fact it has. And it has come down close to 100. It seems to have leveled off some. We also know that part of the reason that, that couldn't compress quite as rapidly is just simply the fact that originators didn't have the capacity to handle more mortgages so they had to increase their headcount. Well, in fact, they have. And now we're at a position where they're very responsive to movements in rates.

Also recently, there was a regulatory change. The adverse market fee was removes. And this basically just represented another fee that was paid on new mortgage originations that was typically passed on to the borrower. So in effect, it's kind of just a onetime shift down in rates available to borrowers. We refer to this as an elbow shift. But it just means that rates can go lower. And in fact, they have. And if you look at the left side of the page, to the 2 lines there, one is the refi index, the red line is the rate, mortgage rate that has since quarter end, not that this ends at the end of the second quarter, it has moved lower. As you would expect, the refi index has responded, although not as strongly as you may have expected, it's still only in the mid-3,000. It may go higher.

But so far we've taken rates back down close to where they were at their trough late last year. And the refi index is not back to the peak that we saw at that same timeframe. How that trades out in balance of the year remains to be seen. But as it does occur, obviously, or doesn't, this will also coincide with what we see in terms of burnout and higher coupons, how much of it we see. And obviously that's a big driver of performance of the TBA versus spec polls. So that remains to be seen.

And now I'd like to speak about our financial results in a little more detail. Slide 17. As always, we present this slide. It kind of decomposes our income statement into I guess our proxy for core earnings, which is simply our net interest expense, net of repo in expenses. And in the middle column are realized and unrealized gains and losses. And as we said at the onset of the call, we had a $0.17 loss for the quarter, $0.41 loss on our realized and unrealized gains and losses on our MBS assets and derivative assets, inclusive of interest rate swap accruals. And then $0.24 absent that.

And one thing to note is, as I mentioned, that we were positioned defensively coming in, in the quarter, and we remain so. So there wasn't -- virtually nothing done to the hedge book over the course of the quarter and essentially very little done since. So most of these losses, this $0.41 in losses that you say most are unrealized. And while that -- who knows exactly what the future holds, it's possible since most of these losses are unrealized that to the extent that the market will move in the opposite direction, there is some potential for those losses, unrealized losses to go away. And that -- in reverse, that impact that they had on our results and book value. Again, that's just the potential, not making any predictions.

With respect to the right side of the slide, we just show the returns of our allocation of capital between pass-throughs and structured securities, modestly negative return in the pass-through portfolio this quarter. Really just reflects the fact that mortgages lagged our hedges. We did have a positive mark-to-market on the pass-throughs. But we do reflect premium amortization in our mark-to-market, so it did decrease it. And then of course with the bull flatter in the rates market had an adverse effect on our IO positions. And we generate a return of negative 50%. But we do -- as we said, we still have the same view of the market going forward, and view that as just creating better entry points for those assets.

Turning now to Slide 18. This kind of captures the economics of the portfolio net of our hedges in pictures. I'll point out the green line, I'll just identify what we have. The blue line is the average yield on our assets. The red line is our funding cost, our economic funding cost, which means it's incorporating our hedges. We don't use a hedge accounting per se. We do reflect it in these numbers. And then the net of the 2 is the green line. And there's some obvious conclusions we can draw from this. One, this green line, as you can see, has been quite stable. And that kind of translates into what you see in the dividend. But also, the blue line, while it has been declining rather sharply, it also is starting to stabilize.

And then finally, the red line, I think given where we sit market-wise and the outlook to the Fed, especially the leadership of the Fed, I think it's reasonable to expect that our funding cost will remain low, probably certainly through the end of this year and quite possibly through the most of the balance of next year. So the sum of all these streams makes us optimistically constructive on the dividend. This appears to imply that we should be able to maintain this level for at least the next 6 to 12 months, maybe beyond.

Slide 19 just shows the same thing slightly differently. This is in earnings per share where we disaggregate the mark-to-market gains and losses from our proxy for core, even though it's not exactly the same as what you see from our peers.

And then finally, Slide 20, in terms of the results. And as I said earlier, I wanted to defer the discussion of our results versus our peers. And the reason is I wanted to kind of go through this first. And what you see in this chart, these 2 graphs, we've never shown this in our presentation before. The top one just shows you our annual dividend yield in the top half of the page using the book value at the beginning of the period as the denominator. And in the bottom we see the beginning stock price. And in both cases the blue line represents Orchid's organ yield. And in the bottom it's the peer. And I apologize, on the bottom of the page we don't define the peer group. But if you go back to Page 5 and 6, it's the same, that's the exact same group. So that's what we're comparing.

And I think what you want to distinguish to see is that Orchid has clearly paid a higher dividend versus the peer group, basically all the way back to 2014. And that's reflective of the strategy. And we tend to have a high dividend yield. We tend to have a higher leverage ratio. And we tend to put a lot of emphasis on higher-yielding assets, which are in many cases, spec polls, high-quality spec polls. And as a result we can generate those yield both speeds and high income. So that's -- as you might expect, it's a very high-yielding portfolio, and it's reflected in these charts.

And that being said, as is the case with anything in the financial markets, when you have a slightly higher risk portfolio you're going to tend to have higher volatility as well. And that's reflected, for instance, in the first quarter of this year, the fourth quarter of 2016, we have had episodes where our book value volatility, our performance has lagged out of our peers. And as reflected in those results back on Page 5 and 6.

Now that being said, we did just have such a quarter in the first quarter. Fortunately we don't have those episodes too often. They tend to occur not even within a quarter, often within a matter of weeks. But otherwise, the higher yield of the portfolio tends to make up for and, often in most cases, lead to outperformance versus the peers. And as a result, that's why we continue to pursue this strategy.

So while the result as of Q1 or Q2 aren't as good as they were prior to that quarter, again, I think it just reflects the proximity to Q1. And I think barring another shock to the market in the near term, the higher yield of the portfolio, we'll close that gap and ultimately hopefully lead to outperformance, not underperformance. So that's that for that.

Moving on to Slide 21. We've talked in the past about the reposition of the portfolio. Here are the numbers. On the left-hand side you can see that, the allocation of the structured portfolio. At the end of the first quarter it was 9.5%. It's now 18% as at the end of Q2. In fact even higher now as we speak.

And then again, on the right side, we just show you the actual numbers that we invested in the various sub portfolios. And then the details of the changes in those in terms of asset purchases, sales and so forth.

And now with that I'm going to move on and talk a little bit about the characteristics of the portfolio as we sit here today on Slide 23. As usual, we go through the composition of the assets and the hedges on the bottom of the page. The structured assets are in the middle. Weighted average coupon has actually not changing very much in the pass-through portfolio, it's 2.97%. It was 2.95% at the end of the first quarter. So it didn't change much. The price is slightly higher just because of a rally. But I will make a few observations, some small, some large. First with the small.

You can see the lower duration assets, 20-year and 15-year assets. They essentially are unchanged from last quarter. The changes just reflect runoff. And in some of these highest coupons, 4.5, again pretty much unchanged, and our 30-year 3.5. Since quarter end we have made a change to that bucket. But the more notable developments that is really meaningful are in our exposure to the 2.5 and the 3% coupon. One, we reduced our exposure to 2.5 coupon from north of $1.1 billion to under $700 million. And we've also increased our exposure to the 30-year 3s. That was about $1.85 billion, now it's $2.725 billion. So that growth there reflects 2 things. One, allocation out of the lower coupon, and as I just mentioned. But also we were able to grow the portfolio through our ATM, as were many of our peers this quarter. And most of that growth is reflected in that coupon.

One other point I'll make with respect to the pass-throughs. Our exposure to the 30-year 4 coupon is reduced by about $140 million. And that really was the case where we sold polls to a structuring desk and took back in IOs. So that was actually part of the allocation of capital from pass-throughs to IOs. And of course in the middle the page you see our positions in structure IOs. That reflects trades such as the one I just described, but also just the acquisition of new IOs. With respect to the hedges, notable change. If you look at our TBA shorts, it was $400 million at the end of this quarter. That number was $1.3 billion at the end of the first. So we took off TBA hedges, and we added to our shorts in 5-year treasuries and 10-year ultras. Otherwise, pretty much everything is the same. Since quarter end we have done some trades.

We sold -- we bought a new 2.5 with the intention of selling some of our existing assets that are just ramping up the curve and prepaying pass. So the net effect on that, on our allocation of that refund will not change. But what we have added, again, we've kind of been growing and kind of investing with somewhat of a like trying to pick out points, trying to maximize our entry points. We have added to the 3% exposure. And again, some IOs we've added. And one of the things, as I mentioned, we could sell some 3.5 and took back in IOs some of kind of trade, I mentioned. With respect to the hedges, there have been no changes.

Slide 24. As you can see, our allocation to very high-quality spec has come down, but some specs generally has not. We're just trying to change the mix. And these are obviously very important for us because we don't use the TBA dollar roll market, so we have to generate our income to our pass-through polls, and that's really critical that we maintain our speeds, realized speeds as low as possible.

And if you turn to Slide 25, and you'll see on this slide and the next one, we've been successful. What we show here on Slide 25, 4 graphs or charts, the first top left is June and May and April and then quarter-by-quarter going back several quarters. And I want to point out that our greatest exposure in 30-year space is the 3% coupon. And if you look in both June and May and April, you can see our performance versus the cohort has been very good. Our pass-through portfolio prepaid at 10.9% CPR in the third quarter. Obviously, very good results. It was 9.9% in the first quarter when rates were much higher. So the strategy is working in that regarding and that's critical to our ability to generate income and pay the dividend.

The next page is just the same kind of story in different pictures. I will apologize. This does end at the end of the second quarter. Obviously since then the orange or yellow, whatever we call that line, which represents the 10-year yield has declined back into the 120s. But importantly, the green line, which is our prepayment speed, which again we depict in this picture is basically just defined doing the following mathematical calculation. We just divide the total dollar amount of prepays by the principal balance of mortgages. And so it's kind of normalized for its size. And as you can see, we've been in a range. We continue to be in the range as we enter this quarter. And it's even below where we were back in '19. So even with rates both touching all-time lows in 2020 and rallying back towards those levels this year, prepayments have been well-maintained.

Moving on to Slide 27 we show our leverage ratio. As you can see, it's down, reflects a combination of 2 things: one, more allocations to IOs. But then also somewhat defensive posturing. And as we have raised capital, kind of taking our time somewhat deploying it so that we can make sure that we pick our -- what we view are optimal entry points. And so it's probably somewhat lagging. It may migrate up slightly from there, but it's not going back to the mid- to high-9 range that we saw in prior years.

Slide 28 just shows our hedge positions. As I said, very little, essentially nothing has changed with respect to those since quarter end.

And with that, that concludes my long-winded prepared remarks. And we can open up the call to questions, operator.

(Operator Instructions) Your first question comes from Jason Stewart from JonesTrading.

Bob, thanks as always for the commentary and prospectus. I appreciate that. So I love the increase in the IO exposure. Maybe you could talk a little bit about what the levered ROE looks like in terms of the IO strategy versus just a core agency strategy?

It is -- well, the IOs, which would (inaudible) chiming here too. First of all, one of the IOs that we've added are defensive in nature, so they're currently -- they're collateralized by assets that's in the money of prepaying fast. So those tend to be some negative yielding assets. The idea being that in the backup in rates, those cash flows will extend, and those will become positive yielding assets. With respect to the pass-through portfolio, I would say they're comparable. I don't remember which slide it was, but the NIM is very comparable to where it's been. And so the combination of the 2 is site compression in the overall ROE available, but very much predicated on how rates in the market evolve over time. If we were to stay here, we would probably stay near those levels as you would expect, and then with upside in the event of rate back up. And then I'll open that up to Hunter if he wants to say anything.

Sure. Just with respect to the IOs specifically, I think we've been targeting really 2 types of asset classes. One is call-protected securities with good underlying pool convexity. We have been sort of mostly focused in the 3, 3.5%, the occasional 4%, primarily backed by loan-balanced collateral, some of which is paying a little bit faster, but where we're putting those on, those faster speeds and faster speed expectations are built -- already built in. And our effective yields or option-adjusted yields on that -- those types of assets are generally kind of in the 2.5% to 3.5% model projected range. The front carry might be a little bit lower than that just because there is some earn out that's being baked into the model. So any time you have a yield over a cash flow, a lifetime of cash flows or the remaining life of the bond's cash flows to the extent that seeds are going to slow down in the later years, it tends to be kind of back-loaded.

But I think that the ROEs, based on where we are putting on -- we're repoing some of these anywhere about 50 to 65 basis points sort of area. And so as we said, just as kind of a generic target, we were able to achieve a 3% yield on these IOs and 55 basis points. You're getting into that sort of low double-digit return on capital after taking into effect the haircuts, which are a little bit higher, say, predominantly. I think the majority of our portfolio is on the 20% haircut. So you're looking at maybe a maximum of 5% leverage and maybe 2.5% NIM above funding there. But I think more importantly, the benefit for us is that we're able to decrease our reliance on rate hedges. And that's particularly important. Bob spent a fair amount of time talking about how we always need to guard against [SAP] hiring rates because that could be very devastating to us.

But one of the things that we're also focused on is the fact that if we get something crazy and unexpected that causes us to rally of if the rates to stay low, that IOs tend to -- mortgage rates in general tend to sort of bottom out into a widening event. So it's very simple mechanics. It's -- to the extent that mortgages widen, then that means that the rates to borrowers are only -- are not going down as quickly as, say, the risk-free rates, like treasuries or swaps or whatever. And so while we may experience some short-term pain, owning IOs in a basis widening move, ultimately the cash flow streams are better because fewer borrowers are able to refinance. Or at least they're not refinancing at the same sort of clip that we would have modeled into a lower rate environment. So that's -- the removal of those costly rate hedges and the ability to preserve a cash flow stream into a rally is something that we really like here.

Right. And so maybe Bob or Hunter, how do we put what you just said with the disclosure that plus 50 still leads to a $45 million loss to book value? Because it seems like that there might be some discrepancy between like a perfectly parallel shift up and some sort of elbow or seeping in the curve?

Yes, that -- we've for a long time that we've been empirically trading much, much shorter than those rate shocks would imply. And so we like to look at those and certainly pay attention to them. But really the last couple of years we have been empirically much more flat than those rate shocks would imply.

And I would say that the -- just going back to the dollar amount of the losses, you had a very modest positive number on pass-throughs, but then you have -- we capture premium amortization in that market. We also had a very big negative number on the IO book. So the net of the -- the portfolio is net negative. And then the biggest position in the hedge book that was the swap book and also our swaptions. We had a very meaningful erosion in those over the course of the quarter. And so the bulk of the loss was in the hedge book. But unfortunately, that was not offset by gains in the pass-through/IO book but in fact a loss, so it exacerbated it. So again, it was all -- if you had to summarize it one phrase, it was just a meaningful underperformance of mortgages versus their hedges. And that's it. I mean, we were -- we got it both ways. The assets were down in price, as I said, mainly because of the IOs. But obviously the hedge is rallying across the curve. But our exposure, we don't have as much exposure to the long end of the curve, but the belly the current we have plenty, and it was felt there. So that we…

Okay. I got it. It just seems to me like that number may be overstating the projected net loss, but I'll leave it at that. And then that -- maybe the most important question (inaudible) my peers keep going. When we talk about levered ROEs sort of high single digit, low double digit kind of range versus the 17% payout on book value, what's the reason for keeping the dividend at that level versus just changing into a level that's consistent with levered ROEs?

Well, I mean, I will say this. I mean the dividend $0.650, it's certainly not because we earn $0.650 every quarter or every month. And we do have episodes where we earn above and below that. And what we're trying to do when we set the dividend is try to pick kind of the center of mass, if you will, of where we think we're going to earn going over longer periods of time. And there are episodes where you're above the line and there are periods where you're below the line. And unless we feel that that's a permanent shift, then we're not typically going to change the dividend. And given our outlook and what I said earlier about how we view the IO positions, we expect that we'll be at that number on average going forward.

If something were to change, we were to see a meaningful deterioration of the economy or the outlook, and it looks like we're going to stay in this low rate environment, then obviously the allocation to IOs will probably not be warranted. The composition of the hedge book would not be warranted. And the allocation of the pass-throughs will go back up. So there would be a second transition in that direction. But if you go back to where we were in '19 and '20 and when we entered, even in early the first quarter when we had a very high allocation to pass-throughs.

Last year, over the last 1.5 years, I mean, we were generating very attractive ROEs through that period. It's just -- when you go through these periods of transition like we did in the first quarter and even this quarter, sometimes you get these outcomes. But we don't think that's going to change the long-term outlook. And so -- and like I said, barring a change in such outlook, we will continue on this path even if it means we're slightly under-earning for a few months.

Your next question comes from [Tim Deliel] from 7 Canyons.

I echo his sentiment, you guys give a great call. You have a lot of information on where you are and where the market is and (inaudible) quarter for that. Can you refresh me, can you refresh me what you came into this quarter (inaudible) booked value (inaudible).

Into the second quarter, it was 494.

Into the -- well, the end of the second quarter?

471.

All right. Can we have an update as to where -- what you expect to be right about now…

Yes, we're probably up -- yes, we were up slightly from that number.

All right. And you were (technical difficulty)...

Tim, you're breaking up a little bit.

I apologize. Have you updated, let's see, your -- let's see, your release of about a week ago or so showed you to have been very active going into quarter end with your ATM as well as into this new quarter. Is it still active? Or will it be as soon as this call is done?

We would have -- yes, we're probably likely to do so, yes.

All right. So -- and -- how much accretively, how much of the book value maintenance so far this quarter in a quarter where objectively it looks like rates have moved in, I think you're moving in, in the wrong direction. How much (technical difficulty) this quarter so far can be laid at the feet of the accretive offerings you've been able to make so far this quarter?

In Q3?

Yes.

I would have to -- well, I mean we're only off slightly. I want…

Yes, but…

We had -- our equity issuance this quarter is modest. So I don't think -- I don't have that number, I apologize, but I do not think it's significant just because we have an issue (inaudible). Now we did -- some of the sales that occurred at the end of the second quarter settled in the first. So they're not reflected on the June 30 balance sheet. But the share issuance in this quarter, obviously, is much, much less than Q2. And by the way, equity issuance through the ATM in Q2, I wouldn't say it was so much backlogged. We announced a new ATM on June 22. But we had sold quite a few shares under the previous program in Q2 up till that date.

So yes, we just -- there are programs at a certain size that ended, and we started a new one on June 22. But we -- at that point, we had already sold quite a few shares. So we were selling shares accretively to book throughout most of Q2 and much lesser amount early in Q3. And we would assume after this call, depending on market conditions and the price of the performance of the stock that we may sell in the future. But I wouldn't say that (inaudible).

I would attribute it to the -- most of the gains this quarter in the portfolio is being from, very specifically, the Fannie 3 specified pools. The pay-ups for those have really done very well, especially into the end of the first 3 weeks of July, they really ratcheted tighter versus where they were at the end of June and have outperformed -- in general, mortgages have outperformed over the last week or 2. We're seeing a lot of tightening in the last week or so, even in the TBA markets, but specified pools for the first few weeks of the quarter did quite well.

I think I had…

Thank you for the correction.

Yes.

(inaudible) thank you for the correction. I completely disregarded the earlier ATM. And will your (inaudible) be being able to give a little bit better run down as to the characteristics of the collateral to the IO and inverse IO acquisitions?

I don't know…

Back now.

Yes, it's not in the Q. And so we can do it now that it's not in the Q. Haas, you want to add to that?

Well, just what the general WAC is and what kind of seasoning characteristics (inaudible) I'm sure you would grant me that IOs tend to be a little bit more leveraged selection of security selection and general pass-throughs.

So there's really sort of a barbell approach. And so we have some higher coupon predominantly -- really predominantly 4s with gross WACs and, say, the 4.30 to 4.50 range, there's a handful of 4.5 in there that are really more generic in nature. These are pools that have very, very large negative durations and very high positive convexity. And then the other side of the barbell is really the collateral types that we've been adding over the last -- really starting in the second quarter and then continued through the third, which are loan balance, predominantly loan balance, higher loan balance, say, 150, 175k Max 3s. 350 to 375 pier gross WACs off of, that are paying a little bit on the faster side, that priced in to continue to pay on the faster side. And then some really pristine collateral that these IOs were ones that we made off of specs that we used to own. So 83k Max 4s.

New York, slow pay New York, 3.5, but those were in the kind of the 20s wallet, good gross WACs, so less than 40 -- I'm sorry, less than probably 50 basis points of spread above their coupons. So for the 3.5, call it in the 3.90 and for the 4s in the 4.45 sort of area. And so the idea is pairing positively convex, fast paying IOs with slower paying is that have a much flatter S-curve that also have good convexity characteristics in the underlying pools. I don't have the combined gross WAC. I think that will actually be in the -- I do have it. I take that back.

It's 421 for all of…

421 for the combination.

And IOs -- IOs 419, in the inverse of 440, but they're much small.

The inverse IOs book is relatively small. It's a little bit of a carry play. We've added some kind of, some higher-risk structures there with that. I think there's only like $5 million worth of on the books, but they're like low strike inverse IOs off of custody collateral. So it's sort of the same concept. They have very high sensitivity to interest rates and are going to do well. Most of -- the majority of that position was put on in one trade, and it was basically sort of fading the Fed in the short term. So by a relatively short cash flow that was very dependent upon money market rates staying low or LIBOR staying low. And so that cash flow is working its way off pretty quickly and going our way so far. So it's been on the books for a while though.

Your next question comes from Christopher Nolan from Ladenburg Thalmann.

What was raise in the ATM in the quarter?

Which quarter?

Second quarter?

Don't have it front of me, I want to say 125 million, but at an average price of $5.40. Like give me a second, I can get that number. But it's almost 125 at an average dollar price of $5.40.

Okay. Is that net or gross?

Net.

Net. And follow-up on the previous question in terms of the -- using the ATM going forward. Given -- Bob, given your comments in terms of you're keeping the leverage ratio, it seems to be not that much changed. But given the outlook it sounds like it's a somewhat attractive environment for you. Is the capital plan to continue to grow equity aggressively through the ATM?

If conditions warrant, so to speak. If price of the stock versus book value and the investment opportunities are there, we will because obviously it's accretive to book value in doing so. And then hopefully it's maintaining earnings. If it's not -- if it's hurting earnings then it's kind of a short-term gain, long-term loss. So I don't want to do that. And as I said, the leverage ratio may be down. It probably will go back up slightly. There's somewhat of a lag as you raise capital and deploy the proceeds and you don't earn the income on the assets right away. So that -- and as far as the IO allocation, which is part of the reason why the leverage ratio is lower, we're not at but nearing kind of the target range for that. So at some point that will level off. And then I think from there it really is just a question of how the market looks at the time and where we want to deploy the capital.

Right now it's the 3% coupon and to a lesser extent 2.5% and 3.5%, and those 3 coupons are the vast majority of the portfolio. And the IOs, and as Hunter alluded to IO strategy, it's kind of something like barbell in terms of 2 different strategies, simplifying, but that's kind of where it is. And then the other thing that might affect net income and earnings would be substituting IOs in for rate hedges because those IOs have the potential to be obviously positive field versus paying something. So and if our outlook on rates materializes over time, and we're pretty confident that it will, but it's been a rough year-to-date. But if it does, that will bode well for us, book value and earnings. And that would be -- in fact, again, happens, then that would be a very attractive time to be raising capital because we would be raising capital into a raising return environment given our portfolio, which would be higher coupon and IOs.

So if we see whatever drives it, but if we see rates moving up over the balance of the year into next year, that's good for us in terms of our positioning, and also good for our earnings outlook. So yes, we would love to be able to raise capital into that scenario.

And on the top of IOs, I mean given your comments will you expect at least for the next 12 months or so short-term rates remain somewhat low and the yield curve steepened. Given that, are you planning to keep your IO allocation capital, allocation at current levels?

Yes. That's the idea, right? It's -- we see that steepening occurring, which would be good for that -- those positions. So I mean if -- you never know how it's going to play out. I mean we saw in the first quarter it can play out very quickly and very violently. And so we don't know that. We kind of knew where we think we're going to hit, but we don't know necessarily how that plays out. If at some point we thought we were kind of seeing the full extent of the sell off, then yes, you want to start getting rid of some of those because you would have been monetizing those gains and maybe going into pass-throughs.

But yes, I mean, that's -- I don't -- I mean you never say never, and I heard (inaudible) this morning thinking that the Fed would start raising rates early next year. But I also heard Powell on Wednesday and I don't see them raising rates anytime soon. So as a result, that means the curve since we take it on the front end has to steepen. So you never know, but I think that's the way it's going to play out. I think it's going to take a while before they start raising rates.

Your next question comes from Mikhail Goberman from JMP Securities.

You mention in your prepared remarks that you've seen some element of prepayment burnout so far in the third quarter. I was wondering if you could briefly just sort of expand on that a little bit. And also on the question of prepays, how do you think they will respond to the removal of this [ad market] refi charge?

I'll say a few words, then I'll turn it over to Hunter. Well, just in the speeds that were reported, most of the -- what we see is an acceleration in speed in the lower coupons, production coupons, like 2.5s. And the reaction to the movements in rates has been much more muted in higher coupons. You have to factor in some other factors and day count, things like that, which vary from month-to-month, but not so much the last report but the one before that, you did see some slowing in higher coupons and somewhat of a continuation of that this month. And so you -- like I mentioned on the call, you've seen some very good performance of higher coupons late June and into July. Whether that's sustained or not remains to be seen. But it seems that the focus for now of the originators is back to the production coupons because obviously they're the much easier refi or execute, right? The docs are fresh, everything is fresh. It's the low-hanging fruit. So that's where you're seeing those as they ramp up.

Don't forget, in 2020 when primary secondary spreads were high and sales were high, a lot of the 1.5, 2s and 2.5 that were originated, had very high gross net rack spreads, typically 100. So all the 2%s or 3% coupons to the borrower, all the 2.5% or 3.5% coupons to the borrower and now available rates are in the high 2s. So those people are the target. When we saw the first quarter and rates spiked higher, then those borrowers weren't in the money, so the originators turned their focus to more seasoned higher coupon bonds or high [sato] bonds. And we saw those speeds accelerate, but now it's kind of -- that's reversed. And so that's what we're seeing. If we stay here at this level of rates for a long period of time eventually they'll refi all the 2s and 2.5s and then they'll turn their attention to the higher-coupon borrowers again. And now I'll turn it over to Hunter just to add his thoughts.

Yes. I think that we've been investing with a little bit of a baseline philosophy that rates aren't going to get materially below, call it, 2.80s the borrower. And so one of the trades we've been putting on and have done so in quite large size or elbow shift strategies with low gross WACs, so call it collateral from certain (inaudible) properties line in the state of New York that are, say, 3.30, 3.40 gross WAC where that (inaudible) is taking the (inaudible) refi away from those borrowers at 2.75, 2.85, call it, refi opportunities. And also we've gone fairly deep into agency investor pools. There was some -- a release earlier in the year that agencies were going to strictly limit the number of investor pools that could come through -- that can come through in agency form.

We've seen a dramatic drop-off in terms of production that production has really shifted over to more private label, the private label side of things. And so, so far it's been a strategy that is also, fits with [elbow shift] strategy where those are typically the ones that we added, I think, were 3.30 to 3.50 gross WAC. But the GSEs really don't want to be focusing on those at the moment. And so it's proven to be a good strategy for us. And we'll continue to look at other things. We had a little bit of a discipline in our loan balance collateral. I think that was about in July. That was, I think, a byproduct of the [Refi Now] initiative, which is looking to refinance lower income borrowers. Obviously, that's one of the risks you take when you invest in low loan balance collateral, is that it tends to be some low-income borrowers in those schools as well. I think that's going to maybe have 1 month or 2s worth of negative impact and then all of the borrowers that really qualify for that new program or that are at least receptive to refinancing as a result of it.

That will work its way through the system pretty quickly, I think, and through our pools pretty quickly. So we continue to be pretty bearish and hence the allocation to, I think, similarly, I guess, 2%, 3%, 3% -- 2% to 3% bucket. So we've been very, very picks about the gross WACs and the pools that we've acquired in the 3% bucket, and we'll continue to do so, trying to keep it somewhere under 3.5%, which really in conjunction with whatever specified characteristic we're layering on to that collateral makes it at least at this point not really worthwhile to go through the trouble of refinancing loan.

And Mikhail you mentioned the adverse market fee.

Yes.

That is a sheet cut to the rate of the borrower and assuming they're passed on to borrowers (inaudible) so that reduction or elimination of that fee is off-savings to borrowers and just lowers the available rate (inaudible).

(Operator Instructions) There are no further questions at this time. Presenters, please continue.

Thank you, operator, and thank you, everybody. Again, we appreciate you taking the time to listen in on our call. To the extent that any other questions come up after the call or you listen to the replay and you want to call, as always we're available at the office to take those calls. The number is (772) 231-1400. Otherwise, we look forward to speaking to you at the end of the current quarter. Thank you.

This concludes today's conference call. Thank you, everyone, for participating. You may now disconnect.