Orchid Island Capital, Inc. (NYSE:ORC)
Q1 2016 Earnings Conference Call
April 28, 2016 10:00 AM ET
Robert Cauley - Chairman and Chief Executive Officer
George Hunter Haas - Chief Financial Officer
David Walrod - Ladenburg Thalmann
Christopher Testa - National Securities Corporation
Good morning, and welcome to the First Quarter 2016 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, April 28, 2016.
At this time, the company would like to remind the listeners that statements made during today's conference call, relating to matters that are not historical facts are forward-looking statements subject to the Safe Harbor provisions of the Private Securities Litigations 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 from 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 call over to the company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead, sir.
Thank you, operator. My prepared remarks. The global interest rate and capital markets volatility we experienced during the fourth quarter of 2015 continued for the first six or seven weeks of 2016. Economic data for the fourth quarter appeared weak and, as we moved into 2016, early reads on the state of the economy for the first quarter appeared weak as well.
Global financial markets were rocked by a new leg lower in oil which touched a multi-decade low in late January, early February. Global equity markets reacted negatively and reached lows last seen in August of 2015, when events in China roiled the markets.
Both the oil and equity markets have since recovered, but the impact of these events had a meaningful impact on the Federal Reserve or the Fed and their outlook for additional rate hikes. At the conclusion of the Federal Reserve Open Market Committee meeting in March and again in a public speech at the Economics Club of New York shortly thereafter, Chair Yellen made it clear the Fed was keenly focused on overseas events, the condition of the financial markets and their impact of the domestic economy.
Financial markets took these words to heart and current market pricing implied by the Fed Funds futures and Eurodollar futures markets is for at most one additional hike in 2016. This is in sharp contrast to the four 2016 rate hikes signaled by the Fed last December. This deal was reinforced yesterday when as expected the Fed left rates unchanged in the last single another hike was imminent at their next meeting in June.
The events of the first quarter had a significant impact on Agency RMBS market. Spreads on mortgages wideness, the market rallied reaching the widest level seen since the taper tantrum in the spring and summer of 2013, while spreads contracted somewhat by quarter end and more so since the end of the quarter, our premium oriented pass through portfolio underperformed our hedges significantly. IOs had a tough quarter as well and even with inverse IO doing quite well as the Fed was prices out of the market, our structured securities portfolio generated a negative 6.7 return for the quarter.
Making matters worse was the fact that the majority of our hedges right on the front end and belly on the curve. Our short positions in Eurodollar futures extend all through March of 2019 are roughly three years and a new swap position we put on in February matures in four years. The balance of our hedge positions outside of our IO portfolio are shorts in ten year treasury futures. These declined as well although the mark-to-market losses were only half the declines in the Eurodollar swap futures.
This is because the ten year future positions our less than half the notional balance and because the market move was greater in the belly of the curve the three to seven year part of the curve as market expectations for future Fed rate increases in 2016 were almost eliminated. The aggregate effect of these mark-to-market developments was reduction book value of 5.4%.
In addition to the changes in our hedge position I mentioned, we also reduced our leverage ratio slightly as the marry rally impart to reduce our exposure to potentially faster speed and also to position our self in the case that market subsequently showed off, which had has today. Net of unsettled securities sales and purchases and of associated repo funding, our leverage ratio declined from approximately 7.9 at the end of 2015 to approximately 7.75 at the end of the first quarter of 2016.
We accomplish this price in several summer season five [ph] and 20 year maturity pools and replacing them with newer pools of both types. The net effect was the lower the aggregate prepayment rate on the pass through portfolio from 6.8 CPR for the quarter of 2015 to 5.5 CPR for the first quarter of 2016. Our pass through portfolio prepaid 7.2 CPR March, speeds may remain slightly elevated for the next month or so but we do not expect speeds to approach levels we saw in the spring of 2015 when the pass through portfolio prepaid at 13.8 CPR.
Speeds on the structured securities portfolio decreased as well from 13.4 CPR in the fourth quarter of 2015 to 12.4 CPR in the first quarter of 2016. The structured securities portfolio also increased to March to 15.0 CPR.
Our capital allocation remained in the same rage we’ve been in for several quarters as the pass through allocation increased slightly from approximately 58% at the end of 2015 to 59% at March 31st, 2016. We did not anticipate material changes to our capital allocation, our portfolio positioning for the balance of the year.
Our portfolio remains bias towards high coupon, fixed rate securities with various forms of comp prepayment protection, interest only and inverse interest only securities and funding hedges positioned primarily on the belly of the curve and to a lesser extend to ten year part of the curve.
As we entered the second quarter of 2016, the U.S. economy generally appears to be on a trajectory of slow, sustainable growth. However, many production based economic indicators were less positive in the fourth quarter of 2015 and the consensus forecast for first quarter of 2016 economic growth in the U.S. has dropped substantially from approximately 2.5% at the onset of the quarter to well under 1% as of yesterday and was reported at 0.5% this morning.
Most market participants expect a slight rebound over the course of the year. The outlook has become somewhat less clear of late as output and production based measures of economic growth remain quite weak, reflecting the severe slow-down in mining and oil production as well as manufacturing slow down resulting from the strong dollar.
Employment based measures remain quite strong, however, and indicate the economy may be approaching full employment. This divergence in economic indicators has contributed to the volatility in the markets and, as the Fed appears quite concerned with financial market volatility, reinforced the market's conviction that the Fed will raise rates at an even slower rate than the Fed itself believes.
As mentioned the Fed announced yesterday - the announcement yesterday was consistent with this view, while they acknowledge financial conditions have improved since March, they also noted that the economy and the performance of the economic data and therefore concluded they could remain patient in removing accommodation.
We do not share the market's confidence that the Fed will raise rates such the terminal rate will be well under 2%. While the rate of increases may be slow at first has been the case today, this is not likely to persist much beyond this year. While there is ample evidence in the data that the economy is weak, in the aggregate the data is clearly inconsistent and employment based measures are unanimously strong.
Moreover, the employment data is much less prone to revision and generally more accurately derived as the inputs are fewer and obtained directly.
Further, inflation data seems to be reversing, due in some part to baseline effects at the headline level, and should continue to trend towards the Fed's target of 2% over the balance of the year. While the global economy remains somewhat weak and both the European Central Bank and Bank of Japan continue with easing programs, we do not expect that the Fed will be able to dismiss economic considerations if the data warrant tightening for long. While we do not expect aggressive rate hikes, we do expect the pace of tightening to follow the Fed's current expectations as evidenced by their Dots. As a result, we intend to maintain our current positioning with the portfolio.
Operator that concludes our prepared remarks and we can now open it up to questions.
[Operator Instructions] And our first question comes from the line of David Walrod from Ladenburg. Your question please.
Good morning, guys. Couple of corporate issues, Bob, you said speeds where, what was - 12.5%, was that just for the month of March or what was that?
Hold on we go back. The structures portfolio was 15 in March and pass throughs were 7.2, so 5.5 for the entire third quarter, 7.2 for March which of course was reported earlier this month.
Okay, alright. Okay. And then on the leverage, you quoted 7.75 in the special issue say 8.1. I just wanted to clarify that?
George Hunter Haas
Yeah, there is a slight adjustment there. We had significant unsettled security purchases and sales and the number quoted in the press release they disregard the unsettled security purchases. I just adjusted for the sales because the sales were much larger. I think on balance it was like a 125 in sales and 23 in purchases something like that.
Right, okay. And then I guess could you give us some indication obviously book value was down in the first quarter, could you give us some idea of how that’s trended you know quarter-to-date so far in the second quarter?
George Hunter Haas
Well the markets reverse, so it’s up, it would - guess it’s up, yesterday was off a little bit $0.25 maybe.
As we said today probably somewhere in the low 30s.
Okay, thanks a lot guys.
Alright, thanks Dave.
Thank you. Our next question comes from the line of Christopher Testa from National Securities. Your question please.
Hi, good morning. Thanks for taking my questions guys. Just touching on the leverage you know even net of the securities so to be settled, it seem to be a bit higher given the capital allocation, is there a sort of level where you are comfortable taking it down or you comfortable running where it is now, could you just give some guidance on that?
Sure. We have been kind of at the higher end of our range which call it you know 6.5 to 8. And I think we just kind of spoke about this at end of the last quarter. So the allocation at the past was - is approaching, it’s kind of the higher end of the range we’ve been in. And of course we apply leverage there. We don’t apply so much leverage to the structured portfolio. And therefore that just moving the capital allocation and itself takes the leverage ratio higher. And it’s mostly a lot of comfort level with speeds and the carry we are running on the past it’s - you want to add to that if you want to?
George Hunter Haas
Well, I think that’s exactly right. The - going into the rally that we saw in the first quarter really you know the last thing we wanted to do was pair back the duration of the portfolio that was the component that was not keeping up with hedges. So you know we either want to stay long or you then pair back some of the hedges. But - you know this market has been very volatile and we had what we thought like was solid fourth quarter of last year and then we are - had a rough book value quarter in the first quarter is coming back. We remain focused on preserving the company’s value in that upper rate scenario because we think that the earning environment in the lower rate scenario is very good for us.
So we find mechanism that we’ve been talking about for the last three years is still you know not running and its optimal level when we see rate incentive, borrowers don’t jump right in. You know over the last three years, we’ve paid over $6 in dividends and we’ll continue to - we think have attractive earnings profile that we remain in this rate environment. And the other side of that is that we want to be continued to maintain a cautious position with respect to a rapidly rising rate environment and we’re just - the market is not focused on that at this moment, but it has been bouncing around from the same range for several years now.
Yeah, I would want to add one other thing to that Chris, in that - you know if you look at our portfolio, we’re obviously concentrate in not just fixed rate you know pass throughs, but generally around the 4.5% coupon on 30 years and 4% 20 years, so we have a very high premium pass through portfolio. And obviously you know there is negative convexity in mortgages. So in a quarter like the first quarter when you rally, those securities not going go up much in price but you know they are low duration assets which then applies that the hedges are going lie in the similar part of the curve.
So they are going to bias towards the belly in the front end of the curve. And quarter like we just had where in our view and I think there is many market participants when the Yellen came out at a press conference in March and that at the Economics Club in New York couple of weeks later and you know just said we’re implied, not going to tightening much at all. I think that caught the market of got a little bit but for us since that’s where lot of our hedges lie, you know pricing out of the Fed for the balance of the year almost entirely caused us to have $18 million mark-to-market loss on our Eurodollar and swap position which you know with less 22 million share, that’s almost a buck. That’s a GAAP measure, doesn’t mean anything for tax obviously which is where we pay the dividend but you know that makes it challenging to manage through that because we don’t really view the Fed is being as I said in our prepared remarks you know maybe they are going to slow this year but you know for incidence today, the personal consumption expenditure data was 2.1%. And just because of base line effects, we need - inflation is going to be starting to print higher numbers over the balance of the year, so we don’t think that the Fed can ignore that date forever. So we are not willing to capitulate and change our positioning.
So we’ll continue to focused on you know fairly decent allocation the pass throughs which will keep the leverage at the high end of the range and those pass throughs will be you know in the higher coupons, because we are comfortable taking the prepayment risk but you know we have to live with the fact that our hedges are prone to this kind of pricing. Frankly I don’t see how the market could price out less Fed hike. So hopefully we’ve seen all of that paint we can but that’s the way we indented go forward.
I appreciate that, that’s good color. And just with the IOs, I know you made a decent purchase this quarter give the volatility in IOs. How cheap would they have to get again for you to take up the capital allocation even more towards IO, is that the right way to look at that?
George Hunter Haas
Yeah, it was tough and we did want to allocate, you know we took a couple of steps on the negative duration side of the portfolio and hedge book frankly in the first quarter along was adding some IOs. We’ve added another one recently. It’s been not them after really change the landscape as far as the allocation of derivative - two derivatives, some of that is a function of income, some of that is just not wanting to get more short here, right. So I mean we obviously - the portfolio was positioned with some negative duration profile in the first quarter and so we have to be mindful of that.
And that’s debases for all of our capital allocation decisions as we start with the profile that we are comfortable within various range of break shocks and try to anticipate how the portfolio would perform in rising and following rates. And I think we just had enough negative duration at this point. Or if you want add anything at that part?
No, I mean we got - we actually have pretty cheap bond this week and we you know replaced runoff. But you know kind of just go back what I said before you know the pass through portfolio is so focused on high coupon premiums which generally going to be very sensitive to prepayment concerns as you would expect. And of course IOs as well, so it’s just like how much of that exposure do you want, I mean you know and IOs levered play on speeds, we’ve already had an awful lot of exposure there just like you know I said, its overkill at some point.
Right. And just a housekeeping item, what was the quarter EPS number this quarter?
George Hunter Haas
We didn’t publish it, but it was about $0.53, which is if you recall from our Analyst Day last year, you basically take the net interest income on the income statement, you back out the expenses and then the number we call premium loss due to pay down which I think was around 300 million. And then use to weighted average share outstanding which of course was pretty stable, see it come in around $0.53.
Got it, yeah, I just wanted to check that number. Okay, great, thanks for taking my questions guys.
George Hunter Haas
Thank you. [Operator Instructions] And I am not showing any further questions at this time. I would like to hand program back to Robert Cauley for any closing comments.
Thank you, operator. Everybody we appreciate your time and questions. If anybody has any follow-on questions, we are available all day. You can always reach us in the office. The number is 772-231-1400. Otherwise, we’ll speak with you next quarter. Thank you.
Thank you, ladies and gentlemen for your participation in today’s conference. This does conclude the program. You may now disconnect. Good day.
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