Orchid Island Capital, Inc. (NYSE:ORC)
Q2 2016 Earnings Conference Call
July 28, 2016 10:00 AM ET
Robert Cauley - Chairman and Chief Executive Officer
George Hunter Haas - Chief Financial Officer
David Walrod - Ladenburg
Christopher Testa - National Securities
Good morning, and welcome to the Second Quarter 2016 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, July 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 the 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 and good morning. The second quarter of 2016 was in many respects a continuation of what we saw in the first quarter, albeit with a few twists and turns as the market reacted to the events that unfolded.
At the conclusion of the Federal Reserve Open Market Committee meeting in late April, the committee released a statement that was perceived to be dovish by the market. The committee was seen to be backing away from earlier calls for two to three rate increases in 2016 and more concerned with market turmoil and events abroad.
However, the market reaction was apparently stronger than the committee expected. The committee once again reversed their tone in May, and several governors and committee members returned to their data dependent focus in their public comments, appeared to try to talk the market back into expecting further policy normalization.
This seemed to make sense as the incoming economic data improved and events overseas moderated. Just as this market was starting to price in a meaningful probability of a rate hike in June, the May non-farm payroll data was released in early June. The lone stalwart of the expansion, job growth, appeared to slow dramatically.
The market was taken by surprise by the magnitude of the slowdown in job creation. Once again the market reversed course, and the futures market priced out most policy adjustments for the balance of the year.
Later in the month the Federal Reserve conducted their scheduled meeting, and at the press conference Chair Yellen stressed the committee would be even more patient in normalizing rates and needed to see more data on the employment front to determine if the June report was the start of a new trend or an aberration.
The chair also cited the pending referendum in the United Kingdom or U.K., the following week regarding the potential exit of the U.K. from the European Union referred to as Brexit, as another reason for patience.
The following week the market was stunned when voters in the U.K. voted in favor of the referendum and opted to leave the EU, although the process could take up to two years.
The initial market reaction was violent, and the futures market priced in a small probability of an easing in monetary policy by the Fed in the months ahead. The second quarter ended with rates, particularly longer term rates, at or near all-time lows. In fact, in July Germany issued 10-year bond with a negative yield for the first time.
These events made for a volatile market as expectations for the path of the economy, Federal Reserve monetary policy and the status of the EU changed violently and often over the course of the second quarter. The impact of these events in the second quarter on the mortgage market was to push spreads wider and heighten prepayment fears.
Mortgages have tightened since the end of the second quarter although they still traded at slightly wider levels than those seen before the Brexit vote.
Importantly for us, primary mortgage rates did not react meaningfully to the sharp rally in rates as originators appear to be unable or unwilling to lower rates available to borrowers as much as the move in benchmark rates would suggest.
The events of the second quarter had a negative impact on our book value per share, although far less than the first quarter. The book value declined by approximately 1.4% during the quarter. Our portfolio remains biased towards higher coupon, fixed rate securities with various forms of prepayment protection and interest only and inverse only securities. Our funding hedges are positioned primarily on the belly of the curve and, to a lesser extent, the ten year part of the curve.
Returns for the portfolio for the second quarter was 3.6% with the rallying rates, pass-through securities, especially premiums for call protected securities increased. Return for the pass-through portfolio net of hedges was a positive 10.6% on average invested capital.
Most of the appreciation occurred as a result of the increase in premiums on call protected securities as the underlying TBA prices did not appreciate much given the extreme level of rates achieved late in the quarter. In fact, premiums on call protected securities are in their early June cycle reached levels last seen in the first quarter of 2013 before the taper tantrum.
The structured securities portfolio generated a return of negative 7.1% as IOs were materially impacted by the rallying generated a negative 12.1% return while inverse side IOs generated a slight positive return of 0.4% as the impact of lower LIBOR rates expected in the future offset the heightened speed expectations resolving from lower long-term rates.
Prepayment speeds increased over the course of the past several months as the market has rallied. However, our portfolio’s reaction has been muted so far. For the quarter prepayment speeds on our pass-through portfolio increased from 5.5 CPR in the first quarter to 8.4 CPR in the second. For July the figure was 8.8 CPR. This compares with 13.8 CPR in the second quarter of 2015, the last time the rates market rallied strongly.
Our structured securities prepaid at 15.9 CPR in the second quarter and 17.4 CPR in July versus 17.9 CPR for the entire second quarter of 2015. We expect prepayment speeds to remain somewhat elevated over the next two months given interest rate levels and the time of year, and then moderate as we move into the fall.
While the rallying rates during the quarter, was in subsequent rise in prepayment rates, we shifted the capital allocation of the portfolio slightly. We increased the allocation to pass-through from 58.8% at March 31, 2016 to 62.1% at June 30, 2016. We added better forms of prepayment protection to guard against increased speeds expected over the near term.
The increase in the allocation of capital of the pass-through is result in our leverage increasing from 7.7521 at the end of the first quarter to approximately 8.521 at June 30, 2016, excluding a small amount of unsold securities as of quarter end.
Since the quarter end, we have moved the allocation to pass-through down somewhat and added some IOs securities that were available at attractive prices.
As we enter the third quarter of 2016, U.S. economy appears to be rebounding from the slowdown in the first quarter. To date, Brexit does not appear to be having the true impact on growth in the United States as feared. Well, it may be too early to tell, the Brexit vote does not appear to be having any true impact on growth in the European Union as well.
In the U.S. the job market appears quite healthy as job growth continues above the rate needs to absorb new workers and renew workforce. Wage growth appears to be accelerating and the economy maybe near full employment albeit with a lower participation rate and has been the norm in the past perhaps the result of [indiscernible] leaving the workforce as they retire.
The housing market appears robust and manufacturing while still suffering the effects of a strong dollar and weak energy prices as at least stabilize. In sum, U.S. economy seemed likely to maintain growth at or near 2% annually over the near to medium term. While conditions outside the U.S. namely Europe, Japan, China and many other areas are clearly operating below the terms of low, the impact of this sub contract does not appear to be having a meaningful impact on growth in the U.S.
Growth in these areas, are likely to remain below trend over the near to medium term as well. The net effect of these developments is likely to be a continuation of what we have seen year-to-date, namely low sovereign rates across the globe, generally low levels of inflation, continued step by Central Banks to stimulate growth and inflation with the exception of U.S. and occasional episodes of financial market turmoil.
Such an outcome will likely very slower move of a combination by the Federal Reserve under next two years, as to that expected acceleration and inflation.
We expect the slope of the U.S. Treasury curves to remain flat by historical standards. We also expect demand for agency MBS both from private and public institutions, in other words Central Banks to remain robust given the incremental yield offered by the securities over sovereign debt instruments and the low credit risk.
Finally, we expect prepayments on such securities will not accelerate materially owing to the already compressed margins at mortgage originators and the fact most borrowers have already had numerous opportunities to refinance.
As for the positioning of the portfolio going forward, the portfolio will continue to have a higher concentration of pass-throughs in spite of the IOs added this quarter end. The higher premium focus of the portfolio both from high coupon pass-throughs and IOs and inverse IOs securities has resulted in negative empirical duration, in other words these rates rally the value of the portfolio net of hedges has actually declined.
To some extent this is driven by our hedge positions rolling down the curve as forward rates are not realized. However, the higher quality prepayment protection securities we have added should move our empirical duration closer towards zero. We believe the global reach for yield is likely to suppress long-term rates over the near term and will mitigate the risk to prepayment protection premiums.
We may reduce our exposure to the very highest quality payout security somewhat but we’ll likely retain some part of higher quality protection securities. Our goal is to maintain a high coupon focus with prepayment protection of paying that at reasonable cost with the IO and hedge positions offering protection from an unanticipated sell-off in rates.
Operator that concludes my prepared remarks. We’ll now open the call up to the questions.
And our first question comes from David Walrod of Ladenburg. Your line is open.
Good morning, Dave.
George Hunter Haas
First question, just given all the volatility in the global economy. Can you talk about repo and the cost of repo and the availability? Is there any dislocation in that market?
I would say we have not seen a pull-back in the availability. One interesting development which you may be aware of is, with respect to LIBOR, and this is really driven by events outside of our market, it’s more the money market funds. We have seen LIBOR start to spike up particularly three months. But funding costs have not followed suite, they’ve been un-impacted by that move although that that does impact the cash flows on our swaps.
But generally I would say repo especially for an all-agency focus like ours, remains readily available. Hunter, do you have anything to add to that?
George Hunter Haas
No. Repo has been, at least for us and some of this may have to do with our size, I don’t know what’s the firms, they’ve had issues or not but we’ve not seen any pressure to reduce our balances with any counter parties.
Great. And then, it looks like you sold some stock through the ATM in the second quarter and again some here in the third quarter. Can I guess you talk a little bit about how quickly you like to grow your capital base?
Well, when and if the market presents the opportunity we would. There are certain disadvantages of being a company of our size. People refer to obtaining critical mass I’m not sure exactly what that means. I’m guessing its somewhere north of $0.5 billion if not $1 billion. There is, economies to scale there. Our cost structure is mostly fixed. So, as a percentage of our operating or of our income it tends to be high. So, we would like to grow that again, the price of the stock has to be there.
One way of looking at the stock that we sold late in the second quarter is to look at those sales in the context of the shares we bought back last year. We were buying shares back in the high $8.80, $8.90 and we sold these shares couple of dollars above that almost. So that was very, on net very accretive to us to do so.
But going forward, there is certainly a reason to do so but the market will depict when and if we can do so.
George Hunter Haas
I would just add on that last point that Bob made that, it’s important for us to be able to react in buying our shares back when we see things that happened like we saw last summer, a big dislocation huge discount to book value. And so for us, being the size that we are, it’s important if we can do some of these ATM sales really close to book value to give ourselves the flexibility to have that arrow in our quiver so to speak when the market - when we feel like the market is dislocating from the fundamental value of the assets we own.
Yes, I mean, just to put a final point on that is, given the size of the company which is not that big and we don’t have kind of unlimited capacity to buy back shares to the extent that the market suffers another disruption like the companies that are billions of dollars in size. So, it’s kind of nice to have some ammo if you will available in the form of shares and capital to be able to do so when and if that opportunity presents itself.
Final question from me is, as you noted quarter ended just less than a week after the Brexit referendum. Can you talk about how your hedges have performed so far as there has been a little more - I guess a little less volatility in the marketplace since then?
Yes, they’ve obviously come back quite meaningfully. So and probably are likely to continue to do so assuming the data continues to cooperate on, the data has I guess you could say that data has been somewhat volatile. There was a period where it looked quite weak in the first quarter but now it’s come back to look fairly robust.
The two big drivers in the U.S. are employment data and housing data and to a lesser extent I guess retail sales. They’ve all been strong. And to the extent that that continues and inflation keeps trending back towards the committee’s goal of 2%, you’re likely to see the market continue to price in at least the odds of maybe one hike, I don’t know if you get much beyond that. I think that happen to be hedges come back.
One thing about the second quarter was more of a long-end of the curve rally. So the TY futures that we showed were impacted, the very front end of the curve was impacted less. And frankly that gets to another point which has to deal with the primary and the secondary spread in mortgage rates.
One of the reasons you’re seeing originators not lower the rates is simply the fact that you had a flattening of the curve. Their funding costs have not really moved yet but rates that they could receive on their loans have potentially come down so that’s why they’re unwilling to compress that spread much further. And that kind of helps us.
Because it is, the Fed expectations, there was a brief period where the market expected them maybe to ease but that’s practically quite quickly now, there is about 50% probability of a hike by the end of the year. And to the extent that data continues to cooperate that will stay the case.
So, the hedges, they’re not going to meaningfully increase from here but they should stay where they are until the increase over time.
Pre-Brexit we were really in-line to have a pretty nice quarter. And mortgages widened versus treasuries and swap rates and our euro/dollars, hedge instruments, the underlying rates of the hedge instruments and the market in general I think, in terms of equities as well as rates have really come back pretty strongly since the end of the quarter.
And our book is certainly participated in that. So, we’ve recovered a little bit of our book values up a little bit as we sit today. But obviously on any given day, it’s been incredible volatile for the last 6 or 9 months. And so, things can change very quickly as we saw at the end of the second quarter.
George Hunter Haas
One final point there also is this nuance with LIBOR, three months LIBOR, and this in fact, any one of our peers or anybody frankly who uses swaps is short the market and your hedging, you pay fixed to see floating, but the floating rate keeps creeping up, the net GAAP is increased materially by over 10 basis points just since mid-July, mid-June.
So, that another aspect of our hedging cost if you will, it’s not so much a mark-to-market item per say as it is just actual cash flow. So that’s moved on favor as well. We think that will probably persist through the date in which the regulatory reform takes place which is October 14, I believe.
Okay. Thanks very much.
And our next question is coming from Christopher Testa of National Securities. Your line is open Christopher.
Hi Bob, hi Hunter, how are you?
Very good Chris. How are you?
George Hunter Haas
I’m doing well. I’m just wondering could you just say what the core EPS number was for this quarter.
$0.32. And so how much of the - roughly $11.6 million of derivative losses were unrealized?
The majority of them were unrealized. It will show up in the realized lines just because that’s the way the derivative accounting works. It always flows through as a realized loss. I don’t have the split in front of me but the majority of those positions are still in place.
George Hunter Haas
We only really rolled the TY futures from June to September. So even the ones that were covered are hedge if you will are still sort of in place. And then the June euro/dollar futures, that’s the only activity that we have as those contracts were expiring. Everything else in the hedge book was relatively unchanged.
And we did a lot of changes in the first quarter. That’s when we moved a lot, closed out euro/dollar positions and put on swaps.
Right, okay. And just with the portfolio comp position and the balance sheet levered, so you guys now have about 62% of the capital allocated to pass-throughs. But the balance sheet leverage is 8.5 times debt to equity. And you’re talking about potentially adding some pass-throughs going forward. So, how should we think about you, potentially allocating more the pass-throughs but where the balance sheet leverage is now? Should we expect you guys to opportunistically reduce the leverage?
I don’t think it’s going to change materially from where we were. Like I said in my prepared remarks, we had lowered it slightly just by buying a few IOs, to move the little capital back into the IO side. But that’s probably going to be where it stays in the low 60s. We’ve been operating in the high-50s for a long time. There was a brief we did early last year, we were higher than that.
But I would expect it to stay around that range. And the reason is, kind of I tried to alluded to in my prepared remarks, we’re fairly comfortable that the long-end is going to stay here for the near-to-medium term kind of like the balance of the year probably. And I don’t see a lot of threats of extension, meaningful extension which we would get kind of like you had in ‘13. That course could change but for now it doesn’t appear to be the case.
In fact, tonight the Japanese Central Bank is going to, as a policy meeting they announced - they tentatively announced the other day, substantial stimulus package. So central banks across the globe outside of U.S. are definitely adding to stimulus. So it’s really hard to imagine, I mean, there is going to be more negative rates next week than there are this week. So it’s kind of hard to imagine that that’s going to change.
And the yield growth as people look at negative German tenure yields versus where we are it is so attractive. That kind of mitigates our concern with owning pass-throughs in higher pay-ups, back in ‘13 we would never have done.
Right, I agree. It seems like the flow of funds in the world is going to keep MBS prices pretty high here.
Yes. One other point about the leverage and I don’t want to misrepresent this in any way.
We put on a trade where we are taking advantage of weakness in the loan market for higher coupon CBAs. So, there have been times and we’ve done this in the past in little bit smaller sizes. But we’re currently short Fanny 4s [ph] in August and we consider that a little bit of a hedge I guess. But it’s more of a parent trade with specified pools that we think go into earn carrier that’s brighter than the drop from say July to August.
And we put those trades on I believe the drop was like two takes or two plus filling into the, going into the old data in July. And so, it’s just sort of neurons where we feel like we could old Fanny 4s or even 4.5s and have a real higher leverage. But a trade that has no bases risk effectively, right.
So, the leverage is higher, I don’t want to, that’s what I said, I don’t want to misrepresent. It’s certainly on the balance sheet it’s higher asset balances and higher repo balances because we’re funding those obviously in the repo market. But this is just sort of a one-off opportunity that we saw. There are some bonds out there that we really liked. And we know we’re going to carry more than what was being offered in the drop and so, it’s just a way to add a little bit of incremental income.
Got it, that’s very helpful. Thank you. And just touching on the repurchase agreements again, I know David asked the question about it. Just with the, I know the cost have remained relatively constant across repurchases. But is there an expectation that potentially with more QE coming around the world and it seems that the Fed is really not going aggressively hide the way people have thought.
Is there a potential here that these kinds of drift back down in a quarter or two with people kind of hamper their expectations of further said hikes?
I mean that’s kind of an economic high. I don’t see that. I think that the data, I think inflation for instance is going to be trending very close to 2% this calendar year. Baseline, inflation is an arbitrary thing it’s a 12-month look-back. And so you’ve got what we call a baseline effect. And so, late 2015 you’re reporting as oil is dropping and so forth, that data rolls off by the end of the year, the look-back is going to point to something around 2%.
And you’re also starting to see signs of wage inflation. There is, a number of measures that you can look to but they’re all pointing in the same direction. So, ideally the Fed granted they are extremely dovish but they could actually ease, you would have to have meaningful negative events abroad I think in order to get them to do that. And they can only do 25 basis points, I mean, maybe they got negative.
I don’t see that. And nor do I see any evidence that negative rates meaningfully help economic growth. I think that’s kind of an example that monetary policies reach these limits. Those tend to be on the short-end, 90 days and end, and a lot of that has to do with our hedge position and the fact that going our farther out the curve is, obviously increases the expense and not quite convinced the way then if that’s going to go.
So, we have seen as volatility comes off, we’ve seen repo levels ease a little bit and we’re still able to fund out two or three months in kind of 70-basis point range, and mid-60s for one month. So, that was as high as kind of 70 basis points for one month and 75 basis points or so for two or three, didn’t kind of the height of the Brexit crisis. And it’s come off pretty quickly. But I wouldn’t expect it to go too much further than that.
Okay. And with you guys expecting elevated prepayment speeds over the next couple of months, is this going to be - is this going to negatively impact results like data on the core basis this quarter you’re expecting it to impact you so far as to fall short of the dividend again on a core basis? Or should we expect it to be milder this quarter?
Well, I would say that we very much expect speeds in the market to be faster. We took some steps versus the portfolio and we added very high quality prepayment protection and our new securities. So we do not expect those assets to prepay fast per say.
So, it’s more of the market, even then I mean, I would - depending who you ask, it’s either going to be next month or the month after. But there is not that much of the market that’s refinance-able, but a lot of the street research is however the fact that. If you look at the whack of the mortgage universe say in early 2015 versus then prevailing rates, the GAAP was over 100 basis points, now it’s much less than that.
So, like in our speeds and we went from 5.5 to 8.5 CPR that’s in percentage terms big but not very big in absolute terms. So, couple that with the fact that we’ve added a lot of the loan amounts and the higher quality stories we do not expect those too much at all on the speeds.
George Hunter Haas
Chris, this is an environment where this concept of core income combined with our accounting policies which is the fair value option, it’s a little tricky because when we have prepayments, they all run through - the premium loss associated with them runs through income immediately. And so just it’s - it comes right off the top of our interest income.
Whereas an available for sale type of account, it’s going to have a yield approach in which there is already sort of some level of prepayments baked into the way they calculate their either sort of normal income.
And when speed expectations change to the extent that that affects their forward-looking yield, then it does, lot of times that works its way through their core income in its retrospective adjustments that they make.
And so, my only point is just, it’s tough to kind of comparing apples and oranges if we use the same brush for both accounting practices. Both are right, it’s just - it’s a little bit different to, and difficult to compare.
Because like I said would we have prepayments, it immediately comes out of income and then to the extent that after the little spike is over, our income quickly falls right back up whereas if to the extent that cost basis has increased or prepayment assumptions increased in the available for sale world that’s going to have a long-lasting effect on income on a go-forward basis.
And other point, most of our peers do as you know, use the available for sale and the retrospective method of accounting. Most of them, they do these retrospective adjustments and they have this catch-up amortization, it typically backs that out of core earnings. We don’t have the ability to do any such things. So, as Hunter said it all falls to the income statement in the current period.
Any non-zero prepay speed, it comes right out of our income whereas in a yield approach, there is some base level of prepayments which is used to determine the yield which is used to determine income or core income. So it’s a little bit of a strange comparison.
Right, no, I understand, well, that’s absolutely fair. And just with the pay-ups being at extremely high level, higher than they’ve been in the past several years you guys had mentioned. And you had also mentioned possibly selling some of the highest quality ones. Are you looking to recycle those into cheaper call protection or IOs at this point?
Call protection is just not the quite extreme high levels, there are other ones - I don’t want to get into the details. But you can get very good quality prepay protection. I think the highest quality, are actually low loan balance, that’s 85,000 and less. And those hit low 130,000s in the July cycle. So, we might even book some profits there and there are some other very strong forms, it’s not that high.
George Hunter Haas
I think the levels that we saw in the July origination cycle sort of caught everyone off guard. They were exceptionally high. And so, when we mentioned that, it’s just because one, the need for that is type of call protection is coming off and the levels are still relatively high, they’re not as high as they were in the July cycle obviously, because rates are higher here.
But we try to just, try to time our sales such that we get the benefit of the slower prepays in the months in which prepays are going to be elevated and then if we time it right, then we get out while the pay actually is still relatively high. And we don’t necessarily need that type of protection going into the fall and winter months.
Great. That’s all from me. Thanks for taking my questions guys.
[Operator Instructions]. And I’m showing no further questions from the phone lines. I’d now like to turn the call back over to management for closing remarks.
Thanks Tonya. Again, everybody we appreciate your time and listening into the call today. To the extent you catch the replay or a question comes to mind after the call, please feel free to call us in the office, we’ll be here all day. Our number is 772-231-1400. Otherwise, look forward to talking to you next quarter. Thank you.
Ladies and gentlemen, this concludes today’s conference. Thank you for your participation. And have a wonderful day.
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