Western Asset Mortgage Capital Corp (WMC) 2016 Q4 法說會逐字稿

Welcome to Western Asset Mortgage Capital Corporation's fourth-quarter and year-end 2016 earnings conference call. Today's call is being recorded and will be available for replay beginning at 5:00 PM Eastern standard time today.

(Operator Instructions)

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

Thank you Laura. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months and the year ended December 31, 2016. We issued our earnings press release yesterday afternoon and it's 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 Sean Johnson, Portfolio Manager. In addition, Anup Agarwal, our Chief Investment Officer is joining us on the call from Western Asset's offices in London. 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 or 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 fourth-quarter conference call. I'm going to begin the call with some opening comments.

Lisa Meyer, our Chief Financial Officer, will then discuss our financial results; and Anup Agarwal, our Chief Investment Officer, will then provide an overview of our investment portfolio and our outlook. After our prepared remarks, we're going to open it up for a brief question-and-answer session.

2016 was a challenging year for the fixed-income markets with significant periods of high interest-rate volatility and fluctuating asset values, and the fourth quarter was no exception. In November and December, markets were particularly challenging as investors began to assess and price in the implications of a new Trump administration.

Our Company also had a challenging fourth quarter. We did generate solid-core earnings both in the fourth-quarter and for the full year, more than covering our dividend in both instances. Generating those core earnings, which enabled us to maintain our $0.31 quarterly dividend, is consistent with our commitment to our long-term goal of generating a strong total return for our shareholders. However, maintaining a stable book value, also part of that goal, proved to be more challenging during the quarter and for the year.

During the quarter our book value declined 10.5%, as we were positioned for a less volatile environment in the fourth quarter. While we were disappointed with the decline in our book value in the fourth quarter and for the full year, we continue to focus on repositioning our portfolio to reduce its volatility as we seek to fulfill the second part of our overall goal of book value stability.

We made some significant changes to our portfolio in the fourth quarter of 2016 and continue to do so in the first quarter of 2017. We've included a summary of our updated portfolio, which you can find in the recent developments section of the management's discussion and analysis portion of our Form 10-K, which we filed last night. You will see the summary on page 76.

We are encouraged by the improvement in our book value, subsequent to year-end and through February, as interest rates have stabilized and credit spreads have tightened based on an ongoing favorable outlook for residential and commercial real estate. We'll provide a specific estimate of our book value as of February 28 when we announce our first quarter dividend later this month.

Our strong core earnings performance was driven by broad-based contributions across our holdings and reflects the benefit of our strategy of investing in a diversified portfolio across a number of subsectors of the mortgage market. It also speaks to our ability to draw on the team at Western Asset, our manager, as well as the breadth of Western Asset's global investment, risk and operational platform, which we view as a strategic advantage.

We anticipate that interest rates and fixed income markets will likely continue to see periods of significant volatility in 2017, based on the widespread anticipation of increased US fiscal stimulus, a move towards a more normalized Federal Reserve monetary policy and ongoing concern about global economic growth outside of the United States. We believe that our balanced approach positions us to deliver long-term shareholder value and Anup we'll talk about this more in his remarks.

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

As we've discussed on previous calls, we also have some important corporate goals which include a focus on operational excellence and the highest standards of financial reporting and disclosure. Operationally, we are focused on best-in-class risk and portfolio management practices while increasing overall efficiencies throughout our operations. In 2016 we made measurable progress on these goals, particularly with respect to improved operational efficiencies. We continue to review opportunities to bring best practices and the strength of Western Asset to WMC always with a view towards creating long-term shareholder value.

With respect to our dividend policy, and as I have mentioned before, an important goal for us is to continue the stability of our dividend.

When determining our dividend, the board and our management team consider a number of factors including: primarily, the current and expected earnings power of the portfolio; the sustainability of the dividend; and the expected full-year taxable income of the Company. Consistent with this approach, on December 22, we declared a fourth-quarter dividend of $0.31 per share, the same level as in the last two quarters. Our current annualized dividend yield is 12.4% based on yesterday's closing stock price and remains at the high end of our hybrid mortgage REIT peer group.

Finally, earlier this morning our Company filed a universal shelf registration statement to replace our existing shelf registration statement. The universal shelf registration expands the menu of public securities the Company may offer including debt securities. We also filed a prospectus supplement for an "at the market" continuous offering program of common stock.

While we have no immediate plans to issue stock, this "at the market" program provides us with additional flexibility and a cost efficient source of capital for managing our balance sheet and funding our investment activity. In accordance with the terms of the program, we may from time to time offer and sell up to $100 million of our common stock to or through one or more sales agents at prevailing market prices or agreed-upon prices.

With that, I will now turn the call over to Lisa Meyer to discuss our financial results. Lisa.

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

As Jennifer mentioned, we delivered strong core earnings plus drop income in the fourth quarter of $0.52 per share, up significantly from $0.35 per share in the third quarter.

The increase in core earnings plus drop income was due to a combination of a larger average portfolio; a higher average gross yield on our investments; a lower effective cost of funds; and higher drop income. The higher gross yield on our investments was primarily the result of higher yield on our Agency portfolio, as a result of lower projected prepayments, coupled with a modest shift in our portfolio allocation, which Anup will discuss in greater detail. Our lower cost of funds was due to lower hedging costs, as compared to the third quarter.

On a GAAP basis we recorded a net loss of $0.92 per share and our book value declined to $10.27 from $11.48 in the third quarter. The GAAP loss was primarily driven by realized and unrealized losses in our portfolio, most notably our Agency and non-Agency RMBS. Partially offsetting these declines, were gains on our hedge positions and, to a lesser extent, higher net interest income.

As illustrated on page 5 of our investor presentation, the decline in book value of $1.21 can be broken down into a declared dividend of $0.31 per share; net interest income of $0.54 per share; realized and unrealized losses on our investments and derivatives of $1.31 per share; and $0.13 per share in operating and general and administrative expenses, which excludes stock-based compensation.

Our net interest income for the quarter, including the cost of our hedges, was $22.6 million, up from $15.8 million in the third quarter. Looking at net interest income by source, approximately 52% of it was derived from our non-Agency RMBS and CMBS holdings, 36% from our Agency RMBS and CMBS holdings, which includes the impact of our hedge positions, and the remaining 12% from our residential whole-loans and other securities.

Our expenses for the fourth quarter were $5.1 million as compared to $4.8 million in the third quarter. The increase is primarily due to one-time charges in the fourth quarter. However it is important to note that our quarterly expenses in the second half of the year average $4.9 million, which were significantly lower than the $5.7 million average in the first half of the year and down 5.5% from 2015. The decrease in expenses was due to lower professional fees and operating expenses. We continue to review our expenses to identify opportunities to operate more efficiently.

As of December 31, 2016, the estimated fair value of our portfolio was $2.8 billion. We had borrowed a total of $2.2 billion. We continue to have repo capacity in excess of our needs. We have master repurchase agreements with 27 counterparties and outstanding borrowings with only 20.

To mitigate our exposure to the effect of increases in interest rates in connection with our repurchase agreements, we enter into interest rate swaps. At year-end, we held $4.7 billion in notional value fixed-pay interest rate swaps, including forward starting swaps of $1.7 billion and $2.7 billion in notional variable-pay interest rate swaps, giving us a net fixed-pay swap position of $2 billion. We will adjust our hedging strategy based on the composition of our portfolio and our view on interest rate movements.

Our leverage ratio was 5 times at year-end, down from 5.2 times at the end of the third quarter. The decline in our leverage was even greater when adjusted for our net TBA positions. Adjusted leverage was 7.1 times at September 30, declining to 5 times since we held no TBA positions at the end of the fourth quarter.

We have and will continue to adjust our implied leverage fairly quickly through the use of TBAs. We expect to remain at lower leverage levels than we have in the past, given our view of anticipated interest rate and Agency RMBS volatility going forward.

Anup will discuss this in further detail. With that, I will now turn the call over to Anup Agarwal.

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

As we entered the fourth quarter, we were operating with a view that both the US and major global economies would continue to be in a slow growth environment and that inflation would remain subdued. We believed that this environment would cause the Fed to be measured in its approach to increasing interest rates. We also believed that longer-term treasuries and sovereign bonds would be supported by accommodative central policies in all the major global economies.

That all changed with the unexpected election of Donald Trump which, like Brexit, was a potential watershed event. The election triggered a repricing in the financial markets as investors became more optimistic that US economic growth will accelerate, based on anticipated stimulative fiscal policy comprised of tax cuts, infrastructure spending and deregulation. This optimism led to a "risk-on" investor sentiment and exerted upward pressure on interest rates. This market environment put pressure on our book value as Lisa already discussed.

Despite the market's continued exuberant expectations, we believe that the current slow growth and low inflation backdrops, both in the US and abroad, have not materially changed.

While we don't dismiss the possibility that US growth could ramp up and that the Fed could become more aggressive in raising rates and reducing its balance sheet, we recognize that there is an increased level of policy uncertainty going forward, which we believe will lead to ongoing interest-rate volatility. It is against this backdrop that we implemented some portfolio changes during the fourth quarter and have continued to do so in the first quarter of 2017.

Let me address the primary changes that we are implementing and why. In fourth quarter, we sold a significant portion of our lower coupon, longer duration 30-year fixed-rate Agency RMBS and replaced it with Agency CMBS.

We did this for two main reasons.

First, while the Agency CMBS that we purchased has slightly longer duration than the RMBS, it has lower convexity and is therefore more cost efficient to hedge, which translates into a higher relative all-in net yield than the Agency RMBS.

Second, given our expectations of continued interest rate volatility, combined with the possibility the Fed will bring forward the end of its reinvesting of principal prepayments in its Agency RMBS portfolio, we believe that Agency RMBS could experience significant spread widening over the course of the year. Agency CMBS is not part of the Fed's portfolio and therefore would be less subject to technical pressures that Agency RMBS may experience when the Fed stops reinvesting.

In 2017, we have accelerated this shift from Agency RMBS into Agency CMBS; and as of February 28, Agency CMBS, including IOs, represented 36% of our portfolio, up from 13% at year-end and from less than 1% at September 30. Conversely, Agency RMBS, including IOs, only represents 33% of our portfolio at the end of February, down from 52% at year-end and 63% at September 30.

Consistent with our view that Agency RMBS may experience increased volatility and higher spreads going forward, we eliminated all of our TBA positions as of year-end. This has resulted in lower overall adjusted leverage as Lisa pointed out. While we can adjust our leverage quickly if we believe that the market conditions warrant it, for now we are choosing to operate with less leverage. We don't expect this to have a material impact on our core earnings, as we are generating high net interest spreads on our reallocated portfolio, which should be able to offset the impact of lower leverage.

In the credit-sensitive portion of the portfolio during the fourth quarter, we continued to opportunistically rotate out of some fully recovered lower-yielding legacy non-Agency RMBS into areas of credit with more attractive risk-adjusted spreads.

In 2017 we accelerated this shift and have sold the vast majority of our non-Agency RMBS positions including inverse floaters and inverse IOs and have reallocated the capital into a combination of Agency CMBS, whole- loans and GSE credit risk transfer securities. We did this, not only because we saw better relative value in the assets that we purchased, but also because we've seen that some of our non-Agency RMBS holdings, specifically inverse floaters and inverse IOs tend to underperform in an environment of heightened interest-rate volatility.

As we pointed out last quarter, our non-Agency CMBS holdings had not fully recovered from the sell-off that began late 2015, but we were constructive on the sector, as we believed that these securities continued to offer attractive spreads within our universe, as well as the potential for appreciation. We remain constructive on this asset class and expect there to be further spread tightening going forward, particularly in the double B and single B rated sectors of the market, as the underlying fundamentals remain positive.

With respect to our holdings in residential and commercial whole-loans, we would expect that as we see opportunities, our exposure to this sector will increase in 2017 relative to 2016, as it already has in the first two months of the year. We continue to look favorably upon non-QM residential mortgages, as well as short-term bridge loans, both in the residential and commercial markets.

At present, we believe that our portfolio is well-positioned to provide greater stability to our book value, while generating attractive risk adjusted returns to our shareholders, which is consistent with our stated long-term goals. With that, we will open the call to questions.

(Operator Instructions)

Joel Houck, Wells Fargo.

Thanks and good morning everyone. There's been a lot of repositioning in 2016; and obviously, as you point out, the book value is obviously not what you want them to be, but the core earnings power remains strong. How should investors think about, with the repositioning you have done, what potential book value volatility looks like going forward if we continue to see rate volatility we have experienced in the past? In other words, if you were take a 50, 75 or 100 basis-point increase in rates, what does your model suggest book value would decline for those of various cutoff points in rates?

Great thank you, Joel. Anup, do you want to address that question?

Sure. Thanks Jennifer. Hi Joel. The purpose of repositioning is for exactly the reason that we expect that rate "vol" (volatility) to be there for a period of time. And with the rate vol, the other part, as you know, the significant aspect of the Agency RMBS market appears to be that with rate vol and with the Fed expected to raise rates -- our expectation is at least two times, maybe three and March very much in play -- that could result in, at some point in time, an end to the reinvestment period.

So you have a combination of two things which are impacting the book value. And with repositioning, a large part of the segments which get impacted by interest-rate volatility, we have reduced them quite significantly. Both Agency RMBS, as you have seen from our recent developments section, as well as our non-Agency side of the book, we have reduced quite dramatically. So I think that investors should expect significantly lower volatility from our portfolio going forward -- and our goal, which is why we are also planning to grow our bridge residential and commercial loan exposure which tend to be shorter duration -- similarly, growing our non-QM book, because those asset classes tend to be much less sensitive to rate vol.

Okay. So on a different note, on March 15 obviously the debt ceiling comes back into play. I guess it was temporary suspended by the previous administration, but we are bumping up against that. Have you noticed any or-- I guess a two-part question. One, have you noticed any idiosyncrasies in the fixed-income markets ahead of March 15; and if so, how are thinking about repo and kind of rolling repo as we get into that -- I guess it is a couple of weeks away now or I guess it's next week?

Anup. Please. Go ahead.

Thank you. So Joel, I think two things here. One, in terms of repo, we haven't seen any impact to our repo positioning or the market. We continue to have more providers of repo and continue to grow our repo providers. I think the debt ceiling on March 15 is one of -- our views are that policy uncertainties relative to President Trump's agenda continue to be the largest uncertainty, including the debt ceiling on March 15. So I think you would expect that we continue to be very much protective of the book, from looking at what some of these disruptions can cause, not only to increased rate volatility, but also credit. So we continue to run reasonable hedges to our portfolio to protect it.

Okay. Thank you.

Merrill Ross, Wunderlich Securities.

Good morning. Could you describe what the levered return is like on the Agency CMBS that you are buying? It looks like Freddie Mac K-series, but I haven't seen the detail yet in the K. I would be interested in how you look at that in terms of duration.

Anup, do you want to take that or do you want to Sean to?

Sean, you want to take a stab?

Sure. The stuff actually that we are is more of the "DUS" pools. And we are seeing a spread of around 65 to 70 over swaps and we've got, call it an unlevered yield, right of around 3%. The repo costs are right around where Agency RMBS pools finance. Our levered returns are right around, I would say, 15% to 17%.

Okay. Do you think that is sufficient to maintain the dividend with that asset rotation at the lower leverage ratio?

Yes, Sean, I'll let you go ahead.

Sure. In combination with the other assets that we have, we feel it is plenty sufficient. It adds a big stabilizing and solid positive convexity position to the portfolio.

Thank you. That's what I wanted to hear.

Eric Jaschke, JPMorgan.

Hello thanks guys. Can you expand upon how the shift towards Agency may affect your hedging strategy going forward? Is there any meaningful changes that we should expect there?

Anup, do you want to take that?

Sure. Keep in mind for Agency CMBS, it is a little longer duration and we do hedge it with swaps; but keep in mind that the convexity hedging is just not needed. And second, so in terms of our hedging for Fannie "DUS" or Agency CMBS pools, it will be very similar, utilizing swaps to hedge our book. But the benefit of the asset class is, as Sean pointed out before, is that you just don't have the convexity hedging issues or the broader issues from the Fed stopping reinvesting.

Okay. Great. And then, thanks for the additional detail on the developments in the portfolio so far this quarter. Is this kind of what we should expect steady-state moving forward? How much -- or I guess a different way to ask this would be, how much do you think you could increase Agency CMBS to, moving throughout the year?

Anup, go ahead or if you want Sean to take it.

This is reasonably close to where steady-state is. Our views are that at some point in time, you'll see Agency spreads widen out because the market will adjust to the Fed stopping reinvesting. And, as that happens, you will see us actively reallocate back to the Agency RMBS sector. But, as you know, that could be six months away or that could be 15 months away. Our goal in the process, to where we have shifted, is to reduce our overall book value volatility.

Okay great. Thanks for answering the questions.

(Operator Instructions)

I am showing no further questions. This will conclude the question-and-answer session. I would like to turn the conference back over to Jennifer Murphy for any closing remarks.

Great. Just want to thank you for your questions today and thank you for joining us for the call.

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