Orchid Island Capital, Inc. (NYSE:ORC)
Q2 2014 Earnings Conference Call
July 30, 2014 10:00 AM ET
Robert Cauley – Chairman, President and CEO
Hunter Haas – CFO and Chief Investment Officer
David Walrod – Ladenburg
Michael Diana – Maxim Group
Good morning and welcome to the Second Quarter 2014 Earnings Conference Call for Orchid Island Capital Incorporated. This call is being recorded today Wednesday, July 30.
At this time, the company would like to remind the listeners that statements made during today’s conference call, relating to matters that are not historical facts are forward-looking statements subject to the Safe Harbor provisions on the Private Securities Litigation Reform Act of 1995. Listeners are cautioned that such forward-looking statements are based on information currently available on the management’s good faith, belief with respect to future events, and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements.
Important factors that could cause such differences are described in the company’s filings with the Securities and Exchange Commission, including the company’s most recent Annual Report on Form 10-K. The company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements.
Now I would like to turn the conference over to the company’s Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead sir.
Thank you, operator. This year the market has not followed the script most market participants had drawn up in their heads last December. The yield on the 10-year US Treasury note exceeded 3% at year-end and the overwhelming majority of market participants expected rates to rise further. So we rallied – during the first quarter and again in the second. However, prepayment speeds remained subdued through the spring and have not rebounded materially during the summer months. The Mortgage Bankers refinance index has remained below 1500 most of the second quarter and was below 1400 for the week of July 25, 2014.
The housing market has continued to recover but at a much slower pace than what we observed in 2013. The commercial banking sector has been retaining originated mortgage loans on their balance sheets in lieu of securitizing them at a much higher rate than in 2013. The combination of all of these factors has resulted in gross and net supply of Agency MBS falling well below market expectations. In fact, the net supply of Agency MBS was only $10 billion for the first six months of 2014. The Federal Reserve started to taper their asset purchases in January and has announced reductions of their monthly MBS and Treasury purchases by $5 billion each at every meeting since. They currently plan to stop their asset purchases in October of this year. The reduced demand on the part of the Federal Reserve was supposed to cause mortgages to widen, and many asset managers were underweight the sector as a result. However, the dramatic reduction in supply has led the sector to outperform and mortgage yield spreads over comparable duration Treasuries narrowed. In fact, the permanent production 30-year Fannie Mae securities; 3.0%, 3.5% and 4.0% coupon, outperformed their comparable duration Treasury benchmarks by over two points for the quarter. The 15-year current production Fannie Mae coupons outperformed as well, although less so in absolute terms to which it certainly paid to maintain our exposure of the MBS market, especially the 30-year specified sector. As we all know, during the second quarter of last year we had just the opposite positioning.
We continue to grow our portfolio. Orchid completed the deployment of the proceeds of our first quarter secondary offering in April, we initiated an At-The-Market program in late June and raised approximately $8.4 million through this program by July 7. We completed the deployment of this capital after the end of the second quarter. As a results of the deployment of the new capital, the RMBS portfolio grew by approximately 17% during the quarter and has grown by almost 150% year-to-date. Our returns for the second quarter certainly benefited from our good fortunes of being able to raise new capital during the first quarter.
With the growth in the portfolio, we have shifted the exposure towards fixed rate RMBS and 30-year securities in particular. We have also been increasing the weighted average coupon of the pass-through portfolio from 3.7% at December 31, 2013 to 4.14% at June 30, 2014. During the first quarter, when we were deploying the proceeds of options, secondary offerings, we favored specified pools, predominantly low balance pools. The premiums paid on these securities appreciated during the second period, and they are all – and they are less attractive from the total rate of return perspective. We now favor other forms of core protection and added securities collateralized by loans made to lower credit borrows.
During the second quarter we sold approximately $279.5 million of pass-through securities, predominantly low balanced bonds and in all cases, 30-year securities, they conveyance of change in relative value offered by the markets. The capital allocation was shifted from 55.8% pass-throughs and 44.2% structured securities at March 31, 2014 to 59.9% pass-throughs and 40.1% structured securities at June 30, 2014. The capital numbers of December 31, 2013 were 44% pass-throughs and 56% structured securities. Before in late, we have shifted the capital allocation materially towards pass-through securities since year-end 2013. To compensate for the added duration of the pass-throughs, especially 30-year securities, we have added to our funding hedge positions by increasing our Eurodollar shorts and adding a 1-year by 5-year payer swaption.
With the structured securities portfolio, we added IO securities collateralized by higher coupon 30-year fixed rate collateral. During the second quarter, IOS performed well versus their benchmarks in the face of lower rates and a flatter treasury curve. The benefit of slow prepayment speeds were the reason. Performance of our structured securities, while still negative on a total return basis did not offset as much of the positive performance of the pass-throughs portfolio while still providing the upgrade protection we need. While on balance, our structured securities did not offer positive carry in this environment, we’ve been able to acquire selected assets that offer modest income while still providing upgrade protection. Nonetheless, we continue to own these securities for their upgrade protection, did not look to them as income producing assets. We certainly long for the days when the current rate of fresh environment ends and these assets can be used in conjunction with levered pass-through portfolios, income with price appreciation potential or more balance.
Our leverage ratio, leaving unsold securities purchases were approximately 6.3 to 1, at June 30, 2014, and with the deployment of the ATM proceeds in quarter end is still approximately 6.3 to 1 as we speak. We have added a substantial IO position recently, so our capital allocation has shifted closer to 50-50. We currently anticipate basic capital allocation will remain skew towards pass-throughs for the balance of the third quarter, but not as the 60:40 ratio we had at the end of the second quarter.
As we move into the second half of the year, we have been confronted by geo-political events, strengthening economic data, and higher inflation levels. The Treasury curve has bull-flattened as most of the flight to quality trading into US Treasuries has occurred in the long end of the curve – 10-year notes and 30-year bonds – as opposed to the front end of the curve as is more typically the case. This has been exacerbated by considerable yield spread of longer dated US Treasury yields over comparable maturity German yields – resulting in relative value trading out of German Bunds and into US Treasuries, this continues the flattening trend that began in the first quarter.
The market has also become very focused on communications from the Federal Reserve. The market is especially concerned with the Feds perception of the strength of the economy, the strength of the economy’s recovery and inflation levels. Once the Federal Reserve ends their asset purchases later this year, the market will anticipate the initial move away from the zero level in the Fed Funds target rate, as well as their exit strategy generally from the current interest rate regime. The Agency RMBS market will also be closely watched as the market still anticipates there may be some impact of the end of Fed purchases on mortgage spreads. Most multi-sector asset managers and most of our mortgages peers remain well underweight the MBS sector based on available positioning surveys or SEC filings in the case of our peers. For this reason, we continue to expect wide linking [ph] mortgages relative to their Treasury benchmarks will be limited.
We have positioned the portfolio for increased funding levels and a continuation of modest prepayment speeds. Mortgage borrowers have been exposed to very low levels of rates for extended period and show a reduced sensitivity to refinancing opportunities. Mortgage lenders have reduced their capacity and new regulations imposed by the Dodd-Frank Act has impaired their ability to quickly ramp up their staff capacity levels – further muting refinancing activity. We see the greatest risks to the market as two-fold. The first would be an outbreak of inflation resulting in a more aggressive Feds and elevated volatility in the rates markets. The second would be the outcome least expected by market participants, a rally, just as we feared at the end of first quarter.
To address the first risk we have added a swaption on the 5-year sector, so if volatility moves meaningfully higher, and the market expects more substantial Fed tightening, our hedge will benefit. Of course, we also continue to allocate a significant portion of our capital to interest-only and inverse interest-only securities for this purpose as well. We have guarded against the second by maintaining a material allocation to call protected securities that continue to offer very good carry and protection from higher prepayments if the market rallies. So following – in the third quarter this seems to have been nullifies just like in the second quarter.
Operator, that concludes my prepared remarks. We can now open the call up for questions.
(Operator Instructions) And our first question comes from the line of David Walrod from Ladenburg. Your line is open.
David Walrod – Ladenburg
Good morning, David.
David Walrod – Ladenburg
I just had a couple of questions. It looked like in your press release from the – that your hedges, you took off the hedges that were expiring in 2014. Is that just your thought that you expect rates to be fairly stable throughout the end of the year?
Yes, exactly. We have been actually trying to maintain the start of our hedge coverage period if you will – we’ll further out over the course of the last year or so but that’s probably the end of that type of set. I think the next earnings call, unlikely to be that case.
David Walrod – Ladenburg
Okay. And then, I believe you said in your commentary that you’re buying higher coupon, lower credit quality agency assets, what kind of premium are you paying for those in this environment?
I’ll say a couple of words and I’ll turn it over to Hunter. Lower is the answer. What we saw in the first quarter, especially the very beginning of the quarter was that pay ups are all specified, pools have gotten extremely low. When we put our mind [ph] to work, we brought a lot of those assets. It may have moved substantially higher since then. And I’ll turn it over to Hunter, he can try and go into more detail.
Sure. David, we’ve been adding in terms of pay ups amongst the benchmark pools that we’ve been acquiring. The lower credit score pools tend to have a pay up, somewhere between up 14 takes and up, to up 20 or so takes. In contrast Bob alluded to the fact that we were selling low loan balance pools, those got as high as – upwards of around 60 takes. When we were adding them on, I think we were putting a norm somewhere in the context of up three quarters before, it’s up about 24 takes. We lie to them when they have a more balanced profile but as you know, if rates fell off from here, those pay ups evaporate. In terms of the actual coupons that we are putting on, our focus has been primarily in four [ph] although in July we’ve added a few five’s as well. So those – the premium levels tend to be somewhere around 1.07 in three quarters today for 4.5 and then another, say 0.5 for the pay up, and the 5’s are bit higher than that, some of those – they can be around 1.10 sort of level. But that’s a relatively small portion of the portfolio, the 5’s, but we’ve just been able to find a few off-late. So – and they sort of blend themselves to that low credit score trade as for reasons I’m sure didn’t deduce all kind of scores borrowers tend to have higher coupons. So that’s been the focus though.
David Walrod – Ladenburg
Okay, I appreciate it. Thanks a lot guys.
Thank you. (Operator Instructions) And I have a question in the queue from the line of Michael Diana from Maxim Group. Your line is open.
Michael Diana – Maxim Group
Michael Diana – Maxim Group
You seem to have been actively shifting the portfolio around in a very prudent and meaningful manner here. And what does your positioning right now imply for the dividend?
I don’t think that would have any impact – I wouldn’t change it. What we’ll try to do is maintain the same bias which is into higher coupon 30-year securities. If you look at our press release, we show the portfolio versus prior period, you see that for instance hybrids in absolute dollar terms have stayed the same, so have shorter resetting ARMs, while the portfolio has more than doubled. So all of the incremental capital for the most part has been added to either structured securities or 30-year fixed rate pass-throughs. There is two ways to play the 30-year fixed rate trades, some of our peers buy the lower coupons called the production coupons and take advantage of lower financing in the dollar roll market. We’ve been buying specified pools simply because they were very cheap, net-net, which one’s offer better carry, we think these do. They also have the potential to do well on a rally which is what we saw in the second quarter.
With respect to the structured securities it’s been about the same thing, the yields are obviously not very attractive but they do offer the upgrade protection we need. And as we said, the second quarter structured securities tightened quite a bit and so, even though they were on a total rate of return basis negative, it wasn’t that much. So, long story short, it’s – the fixed rate 30-year trade has been appealing to us. The 15-year structure is very tight, and part of the reason is that a lot of recent particular brought 15-year securities because there is less extension risk and it’s been reflected in the tightness. So I think I mentioned in my prepared remarks that 30-year mortgage has outperformed the comparable duration Treasuries by over 2 points but 15-year did well too but not as much but – I’ll turn it over to Hunter, he can time it as well.
No, I’ll just add to that – we think from a risk store perspective. We’d rather be in the high coupon 30-year fixed rate space as opposed to something like a hybrid ARM or a 15-year three – lower coupon 15-year but as we think there is a lot of negative convexity in the 15-year’s, not so much because they can extend but just because the sector is sort of grossly overweighed in that space, so we’re fearful that in a sell-off environment the 15-years will come under pressure which adds to the negative convexity of an already negatively convex instrument. Not to say the 30-years don’t have that as well but with the superior income earning potential on the 30-year high coupon trades, we can do some more creative things on the hedging front and hedge out some of that convexity risk, a little better with the proceeds from the higher income and still maintain a correct income earning potential.
Just one follow-up Mike, the reason for the trade and the repositioning, really which is – we’ve put a lot of capital to work in the first quarter and we bought a lot of low balance pools because the pass were very, very low. Second quarter, the rally just continued until very late in the quarter, those payouts got very, very high, and as we had new money to put to work, we just didn’t want to payout for that, in fact we thought we would lighten up on our allocation. So, we just went into other forms of specified pools that were much cheaper, that’s like – we talked about 5 [ph] pools, in other words, if prevailing rates are 4%, some guy has very weak credit, can’t get a 4% mortgage, can they get a 4.5% or 5%, and so we bought those as the pay-ups were lower and they still offer good protection because that borrower, because of it’s being credit impaired is much more difficult for them to refinance. So that was really the gist of what happened, it was just which specified pools we owned.
And in one final comment I’ll say about the different assets we have available to us, we’re not very likely to add a lot of short reselling ARMs. Through 2013 when the markets slowed off materially, that raised [ph] short duration assets, so they performed well, they’ve actually have a different type of risk and that is the funds level. So for instance, when the Feds start to raise rates and LIBOR moves up accordingly, the reset to those ARMs could come under pressure. We don’t know what will happen. In 2004, 2005 and 2006 the Fed raised rates very gradually and predictably, and those ARMs did fine but next year when the Fed decides to tighten presumably – if they do the same things then they will be fine but if they raise those rates very quickly, those assets could come under a lot of pressure. And since we don’t know how it’s going to play out next year, we’re not likely to own a lot of those types of assets.
Michael Diana – Maxim Group
Okay. Well, your approach certainly sounds very well thought out and better yet it’s been working.
We’ll fight with it [ph], thanks Mike.
Michael Diana – Maxim Group
Thank you. (Operator Instructions) And I’m seeing no other questionnaires in the queue at this time.
Alright operator, thank you very much to our listeners and thank you for your time. To the extent if you any questions that don’t come to mind now but do come to mind over the course of the day or tomorrow, please call our offices, we’ll be very glad to take your calls. Otherwise, we appreciate your interest in Orchid Island and we’ll talk to you next quarter.
Ladies and gentlemen, thank you for your participation in today’s conference. This now concludes the program. And you may all disconnect. Everyone have a great day.
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