Western Asset Mortgage Capital Corp (WMC) 2016 Q2 法說會逐字稿

Welcome to the Western Asset Mortgage Capital Corporation second-quarter 2016 earnings conference call. Today's call is being recorded and will be available for replay beginning at 5 PM Eastern Standard Time. (Operator Instructions.)

Now first, I would like to turn the call over to Mr. Larry Clark, Investor Relations for the Company. Please go ahead, Mr. Clark.

Thank you, Andrea. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months ended June 30, 2016. We issued our earnings press release yesterday afternoon, and it is available on the Company's website at www.WesternAssetMCC.com. In addition, we have included an accompanying slide presentation that you can refer to during the call. You can access these slides in the Investor Relations section of the website.

With us today from management are Jennifer Murphy, Chief Executive Officer; Lisa Meyer, Chief Financial Officer; and Anup Agarwal, Chief Investment Officer.

Before we begin, I would like to review the Safe Harbor statement. This conference call will contain statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of the Company. All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice.

Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of the Company's reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.SEC.gov. We disclaim any obligation to update our forward-looking statements unless required by law. With that, I will now turn the call over to Jennifer Murphy. Jennifer?

Thank you, Larry, and thank you, everyone, for joining us today for our second-quarter call. I'm going to begin the call with some opening comments. Lisa Meyer, our Chief Financial Officer, is going to discuss our financial results. And then Anup Agarwal, our Chief Investment Officer, is going to provide an overview of our investment portfolio and our outlook. So after these remarks, we'll open it up for a brief question-and-answer session.

As this is my first earnings call as Chief Executive Officer of Western Asset Mortgage Capital Corp., WMC, I wanted to start off with an overview of the long-term goals of the Company on behalf of you, our shareholders, and the strategy that we are pursuing to achieve those goals.

WMC's goal as a hybrid mortgage REIT is to provide our shareholders with an attractive dividend that's supported by sustainable core earnings plus drop income, as well as provide the potential for higher total returns while maintaining a relatively stable book value.

As many of you know, the securities WMC invests in can range from relatively straightforward to complex, as can the tax and accounting rules that relate to them. In addition, the use of leverage and hedging in REIT portfolios may create the opportunities for higher returns and reduced volatility, but these tools can also introduce additional risks to be managed and mitigated. In our view, WMC's strategic advantage in pursuing these goals is its ability to draw on the deep investment experience and team at Western Asset, our manager, as well as the breadth of Western Asset's global investment, risk management, and operational infrastructure.

Western Asset is a global fixed-income specialist with more than $450 billion in total assets under management and over 800 investment, risk, finance and accounting, legal and compliance, operations, and other professionals in nine offices around the world. One of our most important goals as WMC's management team is to bring the strength of Western Asset to WMC for the benefit of WMC shareholders.

WMC's investment team, led by our Chief Investment Officer, Anup Agarwal, seeks to optimize returns for shareholders while managing portfolio risk by combining a diversified portfolio of agency, non-agency, whole loan, and selected other securities with effective leverage and hedging strategies. Anup is the head of the mortgage and asset-backed securities team at Western Asset. To build and manage WMC's portfolio, Anup is supported by Western Asset's experienced team of mortgage and asset-backed investment professionals. Anup and his team also draw on Western Asset's broad global fixed-income and credit teams for research, perspective, and insights.

We believe having access to Western Asset's depth and breadth of fixed-income expertise, its comprehensive operational platform, and its global institutional relationships provides WMC a key advantage in achieving our goals to create shareholder value.

On the business side, I'm joined by two relatively new members of our senior management team -- Lisa Meyer, our CFO, and Elliott Neumayer, our Chief Operating Officer. Lisa became our interim CFO in November 2015 and was appointed Chief Financial Officer in June 2016. Her strong background and experience in our industry has allowed her to quickly demonstrate the knowledge, skills, and capabilities to effectively lead our finance team. Elliott took over as WMC's Chief Operating Officer late last year but has been at Western for 12 years and plays a significant role in building and managing our mortgage-related efforts globally from a business perspective.

So in addition to our investment objectives, which I've already mentioned, we have some important corporate goals, which include achieving operational excellence and the highest standards of financial reporting and disclosure. Operationally, we're focused on best-in-class risk management and portfolio management practices, while increasing overall efficiency throughout our operations. We're continually reviewing the operational aspects of how we run the Company in order to ensure that we are implementing best practices and bringing the strength of Western Asset to WMC.

From a financial reporting standpoint, we're committed to ensuring that you, our WMC shareholders, are provided with disclosure and transparency that is comprehensive and relevant, which should enable you to make informed decisions when investing in our stock. As always, we welcome your feedback, as this is an ongoing process.

Finally, I'd like to make a few comments about our dividend policy. An important goal for us is to improve the stability of our dividend going forward. We recognize that the reduction in our dividend over the last several quarters has increased uncertainty about what shareholders might expect from us. So together with our Board, we've determined that future quarterly dividends will be based on a number of factors, including the current and expected earnings power of the portfolio, the sustainability of the dividend, and the expected full-year taxable income of the Company. While we may also weigh other things, such as potential tax, accounting, or regulatory considerations, we expect to give primary weight to the factors that I mentioned.

Consistent with this approach, on June 23 we declared a second-quarter dividend of $0.31 per share, which was roughly equal to our second-quarter core earnings plus drop income of $0.30 per share. Our current annualized dividend yield is about 12.5%, based on yesterday's closing stock price, and remains at the high end of the range of our hybrid mortgage REIT peer group.

With that, I will now turn over the call Lisa Meyer to discuss our second-quarter results. Lisa?

Thank you, Jennifer. We have provided quite a bit of detail in our earnings release and earnings presentation, so I will review our second-quarter performance. I'm going to limit my discussion to particular areas where some additional commentary is warranted.

I am pleased to report that we delivered improved performance in the second quarter of 2016, generating an economic return on book value of 3.9% and higher core earnings plus drop income of $12.7 million, or $0.30 per share. On a GAAP basis, we recorded net income of $17.3 million, or $0.41 per share, and increased our book value to $11.01, taking into account our dividend declared in the second quarter.

Our higher core earnings for the second quarter were primarily the result of higher gross yield on our assets, lower hedge-adjusted borrowing costs, and lower expenses when compared to the first quarter. Both our agency and non-agency holdings increased in value over the course of the quarter, which helped contribute to our book value gain in the quarter.

Looking at it from another perspective, we generated approximately $22.4 million, or $0.53 per share, in net portfolio income. We incurred $4.7 million in operating and general administrative expenses, excluding $346,00 of stock-based compensation, or $0.11 per share, and declared dividends of $13 million, or $0.31 per share, which all translated into an increase in book value of $4.6 million, or $0.11 per share. For clarification purposes, we define net portfolio income to be GAAP net income, excluding operating and general administrative expenses.

Breaking down by source, the $22.4 million second-quarter net portfolio income, approximately 7% of it was derived from our non-agency RMBS and CMBS holdings; 21% from our agency RMBS and CMBS holdings, which includes the impact of our hedge positions; and the remaining 9% from our residential whole loans and other securities.

Our average amortized cost of our investment was $2.6 billion, down 5% from the first quarter, as we reduced the average portfolio leverage during the second quarter. Our weighted average net interest spread for the second quarter of 2016, which takes into account the fully hedged cost of our financing, was 2.01%, reflecting a 4.45% gross yield on our portfolio and a 2.44% effective cost of funds. Our net yield increased from the first quarter of 2016 due to a modestly higher gross yield on our portfolio and lower effective interest costs, as I mentioned earlier.

Our expenses for the second quarter, excluding stock-based compensation of $346,000, was $4.7 million, decreasing 19% from $5.8 million in the first quarter of this year. While the decrease was mainly due to non-recurring expenses incurred in the first quarter, we continue to review our expenses to identify opportunities to operate more efficiently and further reduce our OpEx.

As of June 30, the estimated fair value of our portfolio was $2.7 billion, and we had borrowed a total of $2.3 billion under our existing master repurchase agreement. Our leverage ratio was 5 times at quarter end and 5.5 times when adjusted for our net TBA positions.

We continue to have refill capacity in excess of our current needs. At June 30, we had master repurchase agreements with 28 counterparties and outstanding borrowings with 20 counterparties. We continue to have excellent relationships with our bank counterparties.

As of June 30, we entered into $4.2 billion in notional value fixed-pay interest rate swaps, excluding forward-starting swaps of $1.7 billion and $4.0 billion in notional value variable-pay interest rate swaps, giving us a net fixed-pay swap position of $1.9 billion. We are comfortable with our current leverage. We have and will continue to adjust our implied leverage fairly quickly through the use of our TBAs, which enables us to optimize our earnings on a risk-adjusted basis.

With that, I will now turn the call over to Anup Agarwal. Anup?

Thanks, Lisa. Let me spend a few minutes discussing our portfolio management during the quarter and our outlook going forward.

As we entered the second quarter, we were operating with a view that both the US and major global economies will continue to be in a slow-growth environment and that inflation will remain subdued. We believe that this environment will cause the Fed to be slow to implement additional rate increases. We also believe that longer-term Treasuries and sovereign bonds will be underpinned by accommodative central bank policies in all major economies.

After experiencing a very volatile first quarter, most spread sectors of the fixed-income market staged a gradual recovery that began in late February and carried into the second quarter. However, credit-sensitive sectors in the mortgage market lagged relative to the recovery in broader fixed-income markets. We do expect that those spreads will tighten going forward.

In late June, global markets were surprised by the result of the Brexit vote, and the market's appetite for risk on assets decreased dramatically for a very short period of time, as investors were concerned about the eventual impact of the UK leaving the EEU. This led to a recovery in Treasury market and put pressure on the broader fixed-income credit sectors.

Markets quickly rebounded from the levels initially experienced right after the news broke. All in all, most of the credit sectors in the mortgage markets improved in value over the course of the entire second quarter, benefiting our portfolio, as Lisa mentioned. That being said, our current belief is that spreads across the entire mortgage sectors offer attractive value relative to the other fixed-income alternatives.

During the quarter, we kept our sector allocations on a percentage basis fairly consistent, although we moderately reduced our overall portfolio leverage and rotated some of our holdings within certain sectors. With respect to our agency holdings, we continued to hold a meaningful amount of longer-duration, lower-coupon securities, given our current view of lower-for-longer interest rates. Agency mortgages continued to be supported by strong demand, given their spread over nominal sovereign debt. In addition, we remained overweight in specified pools that have lower prepayment characteristics, as we believe that refinancing risk continues to exist in this extremely low interest-rate environment.

While we believe that agency spreads will tighten over the next 12 months, they may widen in the near term, and we are well positioned to take advantage of opportunity if it arises. The environment that we have outlined is constructed towards agency RMBS market, and we continue to see long-term value in the sector and expect it to be meaningful for holding.

In the credit-sensitive portion of the portfolio, we opportunistically rotated out of some fully recovered, lower-yielding legacy, non-agency RMBS into areas with greater recovery potential. We also continued to be constructive on GSE credit risk transfer securities, as we believe that they offer compelling risk-adjusted returns relative to other sectors at present, and we will continue to seek additional opportunities in this sector.

Our non-agency CMBS holdings have yet to fully recover from the sell-off that began late last year and continued into this year, but we remain constructive on this sector. We believe that these securities offer some of the most compelling spreads within our universe and also offer potential appreciation from what we believe are depressed levels. We expect that as new-issue CMBS supply continues to slow down and risk retention issues related to CMBS are resolved, CMBS spreads will tighten.

With respect to our holdings in residential whole loans, our exposure to this sector was stable during the second quarter. However, we would expect that as we see opportunities, we will increase our exposure to this asset class.

We are pleased with our financial results for the quarter, and we remain optimistic going forward. As we have mentioned in the past, we continue to position the portfolio to perform well over a longer investment horizon.

As Jennifer mentioned at the beginning of this call, our goal is to generate sufficient quarterly earnings to support an attractive dividend while also maintaining a relatively stable book value. We plan on continuing to implement this strategy by holding a diversified portfolio of securities that offer what we believe to be best risk-adjusted returns over our investment horizon.

With that, we will open up the call to questions.

(Operator Instructions.) Rick Shane, JPMorgan.

We really do appreciate the new slides. They're very helpful. I'd love to talk through two things. On is that on the agency book now, you're showing a modest negative duration. I'm curious how we should be thinking about that over the near term in an environment where speeds are, at least through the end of the year, likely to remain relatively high.

I think the way you should -- the way, I believe, look, and as we have mentioned that agency spreads -- my thinking is that agency spreads will continue to -- we may see some volatility in the short term, but ultimately, over a longer period of time, by year end or in six months, they'll be tighter. So in terms of duration, our plan is to continue to be close to home, pretty close to flat to slightly long. Again, as you know, we shift our duration position actively based on the current market conditions we see. But over a long-term horizon, I think the expectation and what I see it is it's pretty close to home in terms of our duration gap and opportunistically here and there, have some slightly positive duration gap, but overall, staying close to home.

Got it. And my second question -- and I apologize for this. I, frankly, probably should understand this better than I do. But you are somewhat unique in, at least as it appears to me, you show your swap position on a net basis. And rather than close out positions, you've historically chosen to net them out. I'm curious; is there a tax rationale for that in terms of avoiding realized and unrealized gains and losses? Why construct the portfolio, the hedge portfolio, in this way?

Hi. This is Lisa Meyer. Yes, there is definitely a tax implication, because if you unwind some of these swaps, you would recognize a realized loss. So it makes more sense to actually do offsetting transactions so that this way, you get the same economic impact but avoid the realized taxable losses.

Got it. But the tradeoff to that -- so I guess the advantage to avoiding the realized, the tax loss, is that it doesn't impact dividend. But to the extent you were realizing losses and closing out those positions, would it benefit shareholders in the form of lower management fees?

Yes.

Okay, got it. Okay, thank you.

Joel Houck, Wells Fargo.

Thanks for the additional disclosures and slides. So on the last call, we talked about, or I think you talked about how some of your assets, particularly in non-agency holdings, hadn't recovered as much as maybe people expected. And then in Q2, we saw that book value was up 1%. Can you maybe get a little more granular in terms of types of non-agency holdings that are improving in value, or i.e., responding to a tighter spread environment versus those that aren't? Because my understanding is WMC is fairly diversifying its holdings, and I'm just a little surprised that we didn't see a bigger bounce-back in book value in Q2 relative to how much it was down in Q1.

Yes, Joel, absolutely. Look, and I think if you think about our overall mortgage credit book, you have multiple segments of it. You have the legacy non-agency, then you have on the residential side, you have a non-agency legacy credit, then you have credit risk transfer securities. And then you have the commercial mortgage side, you have legacy CMBS as well as new-issue, CMBS Junior, and BBB, BB, and B securities or some of the mezz loans. And then you have the whole loans side.

So what you saw in the second quarter is significant movement in the legacy side as well as credit risk transfer. The sector which lagged quite a bit and is starting to pick up the pace is really the CMBS sector. And I think you've seen significant improvement on that sector in last, even one week.

I think one of the catalysts for CMBS or one of the technicals for CMBS has been on the positive side, there continues to be a very low, continued lower supply than expected. But also, the market was trying to figure out where risk retention deals will come out, how they will come out. And the benefit I have of speaking with you today is I can say that there is actually one transaction which is risk retention compliant which just came out. And the spreads on that, and actually, Wells Fargo is one of the managers in that transaction, and the BBB spreads for that transaction are 4.50 or tighter.

So I think those were the catalysts. That was a segment which was underperforming. We expect that ultimately that is a sector that used to be most opportunistic right now, and over the next three to six months, I expect that that's the segment where we will see a bigger recovery.

Okay, Anup. And prospectively, would you say that where you sit today, notwithstanding the temporary widening we saw at Brexit in early July, that things are tighter today in your asset classes than they were at June 30? Are there any -- ?

Yes, absolutely.

Okay.

Yes, Joel, things are tighter today than Brexit. I mean, look, I think as much as we were opportunistically ready for Brexit and we wanted to add a lot, but we just did not see that much of spread widening in the marketplace. But overall, things are tighter, tighter since 6/30.

Okay. And then lastly, maybe this is for Jennifer. As the new CEO coming in, we noticed that the duration has changed quite a bit from where it's historically been. Is that a function of more running a tighter book so we don't see as much book value volatility? Or is it more expresses a function of where you think rates or rate volatility could move from here?

Thanks. Whatever the duration positioning of the portfolio is entirely up to Anup and his team. So whatever you see reflected there reflects views their and their best positioning of the portfolio, given what they know and what they see in the environment.

Okay, so there's no change in terms of investment strategy or anything like that? It's still essentially Anup and his team are going to run that as they see fit?

Absolutely.

Okay.

So I think our role as the management team, what Lisa and Elliott and I are really focused on is, again, bringing the strength of Western Asset to WMC. That's been our focus. I think each of us has a role to play in doing that. And we're finding, as we focus on that, we've evolved, WMC has, and Western Asset continues to grow and evolve. And we're just seeing places where we could bring more of Western Asset's strength to WMC. So that's our focus, and we want to support Anup and his team so that they can focus on the portfolio as much as possible. So anything on portfolio strategies really reflects Anup and his team's best thinking.

Okay, thanks very much.

(Operator Instructions.) We have no further questions, Ms. Murphy.

Great. Thank you, operator, and thank you all for joining us for our call.

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