American Capital Mortgage Investment (NASDAQ:MTGE)
Q2 2016 Earnings Conference Call
August 02, 2016 11:00 AM ET
Katie Wisecarver - Investor Relations
Gary Kain - Director, CEO, President and CIO
Aaron Pas - SVP, Non-Agency Portfolio Management
Chris Kuehl - SVP, Agency Portfolio Investments
Peter Federico - SVP and Chief Financial Officer
Jeff Erhardt - Senior Vice President, Capital Healthcare Investments
Bose George - KBW
Doug Harter - Credit Suisse
Joel Houck - Wells Fargo
Trevor Cranston - JMP Securities
Good morning, and welcome to the American Capital Mortgage Q2 2016 Shareholder Call. All participants will be in listen-only mode. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.
Thanks, Chad, and thank you all for joining American Capital Mortgage Investment Corp's second quarter 2016 earnings call. Before we begin, I would like to review the Safe Harbor statement.
This conference call and corresponding slide presentation contains statements that to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results may differ materially from those forecasts due to the impact of many factors beyond the control of MTGE.
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 our periodic reports filed with the SEC. Copies of these reports are available on the SEC's website. We disclaim any obligation to update our forward-looking statements unless required by law.
To view the webcast of this presentation, access our website, MTGE.com, and click on the earnings presentation link in the upper right corner. An archive of this presentation will be available on our website, and a telephone recording of this call can be accessed through August 16 by dialing 877-344 (7529) using the conference ID 10087923.
Participating on today's call are Gary Kain, Chief Executive Officer; Aaron Pas, Senior Vice President, Portfolio Management; Peter Federico, Executive Senior Vice President and Chief Financial Officer; Chris Kuehl, Senior Vice President of Agency Mortgage Investments; Don Holley, Senior Vice President and Chief Accounting Officer; Sean Reid, Senior Vice President, Corporate and Business Development; and Jeff Erhardt, Senior Vice President, Capital Healthcare Investments.
With that, I will turn the call over to Gary Kain.
Thanks, Katie, and thanks to all of you for your interest in MTGE. We are really pleased with the performance of the portfolio during the second quarter, as MTGE was able to produce close to an 18% annualized economic return for the quarter, as both our agency and non-agency portfolios performed well.
Our non-agency investment results were especially strong in Q2, a trend that is continued into Q3 as spreads on all fixed income credit products tightened materially from the wides experience in Q1. We believe the positive technical support for U.S. fixed income is likely sustainable against the backdrop of non-existing yields in most global fixed income alternatives and the potential for increased QE from the Bank of England, the European Central bank or the Bank of Japan.
Importantly, we believe the strong performance of our non-agency portfolio is also supported by sustainable fundamentals in the U.S. housing market. With good technicals and solid fundamentals, we remain very optimistic about the intermediate term performance of our credit portfolio.
The agency portfolio also produced attractive returns in the second quarter despite historic lows in both global and U.S. bond yields. As Chris will discuss in a few minutes, we believe the prepayment landscape while no longer benign is very manageable, especially given the composition of our portfolio, which is heavily concentrated in specified pools with favorable prepayment characteristics.
With that, I will quickly review the results for the quarter on Slide 4. MTGE reported net income of $0.85 per share in Q2. Net spread and dollar roll income, excluding catch-up am, our net servicing loss and one-time expenses associated with the American Capital strategic review and sale of our manager was $0.46 per share.
In aggregate, MTGE generated an economic return of 4.4% for the quarter, or 17.8% annualized, which was comprised of our $0.40 dividend and the $0.44 increase in our book value. Consistent with our constructive view of the market, we increased our leverage modestly over the quarter from 4.6x to 4.9x as shown on Slide 5.
Turning to Slide 6, I want to quickly review our capital allocation. The percentage of our capital allocated to agency MBS declined slightly in Q2 to 49%. Our equity assigned to non-agency positions at MSR was little changed at 44% and 5% respectively. As you can see, we added a new sector related to our healthcare and senior living investments this quarter, as we made our first acquisitions in this space. Our equity dedicated to healthcare-related assets totaled only $22 million at the end of Q2.
If we turn to the next slide, I want to highlight why we are optimistic about these investments. We are very fortunate to have a strong team in place with a combined 35 years of experience and an impressive investment track record in the healthcare space. Prior to joining us, the team managed GE Capital’s $2.5 billion healthcare real estate equity portfolio. Second, the sector has the benefit of very strong fundamentals. The U.S. population of seniors in both the 65 plus and 75 plus demographics, are expected to continue their strong growth trajectory, with the population of people over 75 years old projected to double over the next 20 years.
The ageing of our population coupled, with the fact that senior living and skilled nursing facilities constitute a cost-effective combination of housing and care, will likely to continue to drive strong demand for such facilities. These dynamics will serve as a substantial tailwind for the sector for many years to come. In addition to the strong fundamentals, we also like the diversification benefits that these investments provide relative to our core businesses, as well as the attractive absolute returns.
We are expecting mid-teens return from our investments in the sector, with the potential for meaningful upside through the future rent growth and portfolio aggregation strategies.
Lastly, the sector enjoys the substantial benefits of favorable long-term financing from the GSEs and HUD without the risk of margin calls, assets based on market value fluctuations, thereby providing stable leverage. As we look to build-out our portfolio, we are targeting roughly 50-50 mix between equity investments and senior housing and skilled nursing facilities. We will not operate or manage these facilities ourselves, and will instead, lease the facilities to experienced and reputable operators who will be responsible for all the operations of the facilities.
As I mentioned earlier, our investments in this space have been quite small to-date but we do anticipate further growth at a modest and measured pace over the next several years.
With that, let me turn the call over to Aaron to discuss our non-agency investments.
Thanks Gary. Please turn to Slide 8 for a review of the credit markets in our non-agency portfolio. Credit spreads generally performed well in the second quarter, both pre and post-Brexit. There was a brief widening in spreads immediately post-Brexit but these concerns were quickly erased as the focus turned to the potential for increased global monetary easing, was led to a strong close to the quarter in structured products.
After lagging other fixed income structured products in Q1, residential credit spreads performed well in the second quarter as well as through July. A high-yield synthetic index tightened by about 15 basis points in Q2, while CRT generally tightened 50 basis points to 75 basis points and legacy non-agencies tightened approximately 25 basis points.
The size and composition of our non-agency portfolio was largely unchanged over the quarter. We saw the investment grade CRT, which have been a strong performer in the remaining AAA jumbos in our portfolio. We replaced those investments in portfolio pay downs by the adding roughly $80 million of senior bonds, collateralized by non-performing loans.
As Gary mentioned, fundamentals remained intact for both the legacy non-agency investments and loans backing credit risk transfer bonds. Technical factors continue to be favorable for legacy non-agencies. Close to $8 billion was distributed to bondholders under the Countrywide RMBS representation and warranty settlement at the end of the second quarter. This distribution was roughly equivalent to an extra 1.5 months of pay downs, representing a strong technical that should help support legacy spreads at these relatively tight valuations.
In addition, the lack of yield in global fixed income alternatives is also supportive of all spread product in the U.S., and residential credit will benefit from this dynamic as well.
With that, I’ll turn the call over to Chris to discuss the agency portfolio.
Thanks Aaron. Turning to Slide 9, I'll start with a brief review of what happened in the rates market during the quarter. Interest rates were again volatile. 10-year swap rates ending the quarter 26 basis points lower at 1.38% as of June 30. As you can see in the bottom two charts, agency MBS performed well despite prepayment concerns starting to surface again, given the sharp move lowering rates. While prepayment risk is elevated, it is very manageable, and importantly, the technicals for agency MBS continued to be strong given the global fixed income backdrop that Aaron mentioned coupled with a consistent Fed reinvestment bid that will likely be in place through 2017.
Turning to Slide 10, I'd like to review the composition of the agency MBS portfolio. First you'll notice that 96% of our 15-year on balance sheet portfolio is comprised of pools backed by loans with either lower loan balances or loans that were originated through the HARP program. And within our 30-year holdings, 77% of our pools are in the same category.
While the weighting in this category is significant, it's also important to consider the coupon distribution. For example, within the 30-year portfolio, you can see that our higher coupons, which have the largest rate incentive to refinance, also have the highest weighting towards low loan balance and HARP pools. And while we are not yet steering at a repeat of the 2012 refi experience, we are very near historic lows in both Treasury and swap rates and only 25 to 30 basis points away in primary mortgage rates from having a significant refi event.
Against this backdrop, asset selection in proactive portfolio management is critical to generating strong returns across a range of scenarios and will be a key differentiating factor in performance.
I'll now turn the call over to Peter to discuss funding and risk management.
Thanks Chris. I'll begin with our financing summary on Slide 11. The cost of our on balance sheet funding increased slightly to 104 basis points at quarter end, up just 4 basis points from the prior quarter. Slightly higher repo cost for both agency and non-agency collateral led to the increase.
Importantly however, as shown in the table on the bottom of the page, our total cost of funds at quarter-end, which includes the cost of our paid fixed swaps declined to 127 basis points, down 5 basis points from the previous quarter end. Our average cost of funds showed an even more significant decline quarter-over-quarter. Specifically our average cost of funds in the second quarter was 131 basis points, down 8 basis points from the first quarter average. The decrease in cost was driven by lower swap costs. As I mentioned last quarter, we anticipated the decrease as a result of the rebalancing actions that we had already undertaken and the smoothing out of timing differences between the reset on our swaps and the reset on our repo funding.
Turning to Slide 12, I will quickly review our hedging activity during the quarter. Our hedge portfolio balance was unchanged quarter-over-quarter at $2.7 billion. Given the move in swap rates during the quarter, we did however adjust the composition of our hedges for a greater share of paid fixed swaps and reduced maturity profile of our hedge portfolio. In aggregate, our hedge ratio at quarter-end was 70%, up 3% from the previous quarter.
Lastly on Slide 13, we provide a summary of our interest rate risk position. Given the rally in interest rates, the duration of our asset portfolio shortened by about half a year. The rebalancing actions that I mentioned with respect to our hedge portfolio resulted in a more moderate duration change of two-tenths of a year. As a result, our net duration gap at quarter-end was 0.4 years, down from 0.7 years to prior quarter.
With that, I'll turn the call back over to Gary.
Thanks Peter. And at this point, we'd like to open up the call to questions.
Thank you. We will now begin the question-and-answer session. [Operator Instructions]. At this time we will pause momentarily to assemble our roster. The first question comes from Bose George with KBW. Please go ahead.
Hey, good morning. The first question is just on the new healthcare business. You guys noted that the growth is going to be modest. I'm just curious - I mean, it looks like the team that you have is pretty large to scale if that business could be pretty big. So, like what amount of business do they need to see for that team to really sort of scale up to where they want to be?
Look, that's a very good question. And you're right, you want to be meaningful in the industry in order to kind of have access to a good pipeline and so forth, and we are pretty confident that we can do that without having to grow that quickly. I mean, look, realistically I think over a period of two to three years, I think, we could see having equity dedicated to the space be in the neighborhood of 20% to 25% of our equity, so call that $250 million something in that zip code is kind of a target under favorable conditions.
Okay, great. That's helpful. Thanks. And then, just one more on the same subject. What's the unlevered - just the asset yield on this stuff you’re buying?
So, I mean, rent yields, it depends on the product but in skilled nursing, they are going to be in the low like 9% area, and then it's going to be lower in the senior housing, kind of, we’ll call it, 6%, 7%-ish unlevered and senior housing depending on property type and other characteristics.
Okay, great. Thank you.
The next question comes from Doug Harter with Credit Suisse. Please go ahead.
Thanks. Sticking along the lines of the healthcare investments, how do you see - foresee yourselves being able to compete to when properties - when some of the other buyers clearly have a lower cost of capital?
Look, I mean, obviously some of the other healthcare REITs traded significant multiples to book if that's what you're alluding to, but I think what's kind of misunderstood and what's interesting about the space is just how small invest the institutional investors are in this space. So over 80% of senior housing and skilled nursing facilities across the board are held by - are not held in institutionally and are held by smaller, kind of, limited partnerships, individuals, things like that.
So first off, there is a significant amount of opportunity in this space to buy - to invest in properties of varying sizes where you're not necessarily just competing or buying properties from where they are transacting between one institutional investor and another. So we feel confident that we can compete effectively. And I think a competitive advantage for us is the willingness to participate in smaller properties, and I think one advantage is aggregation benefits of doing that because some of the largest investors are going to typically focus on bigger properties. But all of this really does relate to having an experienced team that has the relationships in the business already and knows kind of where to look and has the contracts. It would be very different for us if we were trying to do this without access to a team that knows the space as well as they do.
And then, I guess, how should we think about the mix that you're targeting of, sort of private pay versus sort of government pay and what sort of policy risk you guys are willing to take in these investments?
So what we had said - and very good question - what we had said in the prepared remarks was that the base target, so to speak, is 50-50 between the two. I wouldn't say that that's a firm target for us. I think we have flexibility to move that around based on opportunities.
What I think is a core competitive advantage for us in a sense in this space is the fact that, look, even if we did get to the point where we had 25% of our equity dedicated to this space and if it was 50-50 between the two, let's say the reimbursement - government reimbursement risk, which is obviously a factor that people think about in this space, is a very small percentage of MTGE’s overall equity exposure. So I think it actually positions us very well.
We have talked in the past just in our core business about non-diversifiable refinance risk or non-diversifiable risk. This is clearly a non-diversifiable risk. But as a percentage of our portfolio, it's not going to be a big number. And one thing that's really good about this, we’ll call it non-diversifiable risk, is that you really paid to take it, and we are actually well-positioned to take it because we don't have obviously anything resembling in our core business.
So I think that's a fulsome answer as to why we like the sector and why we are kind of thinking about the mix the way we are.
All right. Thank you, Gary.
The next question is from Joel Houck with Wells Fargo. Please go ahead.
Thank you. If we just assume that given the sector is - everyone is priced below book value, and there is no more capital raises for a few years, how do you fund the growth in healthcare, assuming its runoff from agency and non-agency? Is there one particular book you would look to run-off more, so that kind of investors get a sense for there is going to be more like a kind of quasi-credit healthcare REIT, or is there still going to be significant contribution on the agency side? And I assume [indiscernible] assets.
They are, and that’s important and that's a big benefit. So the short answer is that it will come from both portfolios, we’ll call it the agency and non-agency portfolio. When you think about our non-agency book, you have a combination obviously of CRT for the most part. It's a combination of CRT and legacy non-agencies. And realistically we intend to remain active in the CRT space, but as you know all too well, there are limits to how much you can own in CRT just due to the kind of good REIT income dynamics there. So we don't expect that portfolio to grow that much.
In legacy non-agencies, you're going to likely see that portfolio shrink for obvious reasons. The universe is contracting at a consistent rate and so we are kind of thinking - we view this as somewhat of a key compound and this is a replacement for kind of the legacy non-agency portfolio that’s running off, but I think realistically the agency - the amount of equity dedicated to agencies would probably drop as well. But if I had to rank order them, I would say number one you'd see the decline come from legacy non-agencies than agencies and I wouldn't expect much shrinkage from the CRT book.
Okay, good. That's helpful. And then next question I have, and then I'll jump back in the queue. But in the press release you talk about the annualized net interest rate spreads excludes 18 basis point of catch-up premium amortization expense, but then the second bullet says, excluding 31 basis points to catch-up premium. I'm assuming there is a different time periods that you're referencing to?
Yes, Joel, that was referred to the first quarter. That's 31 basis points of catch-up am in the first quarter and 18 in the second.
Okay, I got you. And so…
Sorry about that confusion.
That’s all right. The projected CPR for agency did that - was it 10.1% as of June, what was it at March?
It was actually unchanged. Our lifetime projection was 10.1% in both quarters and that was really - even though our quarter-over-quarter CPR increased, it was really just due to combination of the composition of our portfolio changes during the quarter. So it was unchanged lifetime at 10.1%.
But on an individual bond basis, they were run faster at the end of the second quarter. So the composition issue is material in that. There were faster prepayment estimates even though it doesn't show up on the portfolio.
And so that's why you get the catch-up premium?
Okay, that helps. All right, thanks guys.
Our next question comes from Trevor Cranston with JMP Securities. Please go ahead.
Hi thanks. Just a couple of more questions on the healthcare investments. First one, are all the expenses that are going to be associated with that in terms of personnel and infrastructure, is that all included in the new line on the income statement called healthcare real estate expense, and is the level that’s in there for the first quarter a good run rate or is that just a partial quarter number?
Hi, Trevor, this is Peter. On the income statement, the healthcare expenses are just expenses related to the transactions that we executed, so debt cost for example or transaction cost which importantly are expensed upfront. The cost of the team would not show up on that line, and that would be part of our compensation expense on the other line item.
Well, actually we are externally managed at MTGE, so essentially the manager is putting the cost of the team and we certainly feel that it's a sector that's worth investing in obviously.
Okay, got it. That's helpful. And second question is, can you disclose if possible who the third-party operators that you're working with at this point are?
A - Jeff Erhardt
This is Jeff Erhardt. So, on the first transaction with senior care centers, its five skilled nursing facilities lease - got in a long-term lease to senior care centers in Texas. The other asset that we acquired was a senior living facility and that is managed by Discovery Senior Living. It’s a southeast manager of facilities,
Perfect. Thank you.
We have now completed the question-and-answer session. I would like to turn the call back over to Gary Kain for any concluding remarks.
I'd like to thank everyone for their participation in MTGE’s Q2 earnings call and we look forward to speaking with you again next quarter. Thank you.
Thank you, sir. The conference is now concluded. An archive of this presentation will be available on MTGE's website and a telephone recording of this call can be accessed through August 16 by dialing 877-344 (7529) using the conference ID 10087923. Thank you for joining today's call. You may now disconnect.
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