Anworth Mortgage Asset Corporation (NYSE:ANH)
Q2 2016 Earnings Conference Call
August 4, 2016 12:00 PM ET
Joseph Lloyd McAdams - President and Chief Executive Officer
Joseph McAdams - Chief Investment Officer, Executive Vice President
Brett Roth - Senior Vice President and Portfolio Manager
Sam Choe - Credit Suisse
Good afternoon, and welcome to the Anworth Mortgage Second Quarter Earnings Conference Call. [Operator Instructions] Before we begin the call, I will make a brief introductory statement.
Statements made on this earnings call may contain forward-looking statements within the meaning of Section 27-A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and we hereby claim the protection of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995 with respect to any such forward-looking statements.
Forward-looking statements are those that predict or describe future events or trends that do not relate solely to historical matters. You can generally identify forward-looking statements as statements containing the words may, will, believe, expect, anticipate, intend, estimate, assume, continue, or other similar terms or variations on those terms or the negative of those terms.
You should not rely on our forward-looking statements because the matters they describe are subject to assumptions, known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control. Statements regarding the following subjects are forward-looking by their nature, our business and investment strategy, market trends and risks, assumptions regarding interest rates, and assumptions regarding prepayment rates on the mortgage loans securing our mortgage-backed securities.
Our actual results may differ materially and adversely from those expressed in any forward-looking statement as a result of various factors and uncertainties including, but not limited to, changes in interest rates, changes in the market value of our mortgage-backed securities, changes in the yield curve, the availability of mortgage-backed securities for purchase, increases in the prepayment rates on the mortgage loans securing our mortgage-backed securities, our ability to use borrowings to finance our assets and, if available, the terms of any financing, risks associated with investing in mortgage-related assets, changes in business conditions in the general economy, including the consequences of actions by the US government and other foreign governments to address the global financial crisis, implementation of or changes in government regulations affecting our business, our ability to maintain our qualification as a Real Estate Investment Trust for federal income tax purposes, our ability to maintain an exemption from the Investment Company Act of 1940 as amended, risks associated with our home rental business, and the managers' ability to manage our growth.
These and other risks, uncertainties and factors, including those discussed under the heading Risk Factors in our Annual Report on Form 10-K and other reports that we file from time to time with the Securities and Exchange Commission, could cause our actual results to differ materially and adversely from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us.
Except as required by law we do not intend to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Except as required by law, we expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements that may be made today or that reflect any change in our expectations or any change in events, conditions, or circumstances based on which any such statements are made.
Thank you. I would now like to introduce Mr. Lloyd McAdams, Chairman and Chief Executive Officer of Anworth. Please go ahead, sir.
Joseph Lloyd McAdams
Thank you very much. I’m Lloyd McAdams and I welcome you to this call today where we will discuss our second quarter operating results. I will now turn the call over to Mr. Joe McAdams, our Chief Investment Officer and President, and I will participate later in the call. Thank you very much.
Thanks, this is Joe. Anworth’s investment portfolio performed well during the second quarter, which saw considerable market volatility driven by uncertainties surrounding the Brexit vote and longer-term yields fell to multi-year lows, largely due to concerns over the Brexit’s potential global economic impact.
Core earnings were $14.4 million, or $0.15 per share on the quarter, while comprehensive income, which includes all of the effects of realized and unrealized gains or losses on the portfolio was $20.3 million or $0.21 per share. As comprehensive income exceeded the $0.15 quarterly dividend declared during the quarter, our book value per share increased by $0.06 on the quarter.
Our investment portfolio continues to be balanced between interest rate sensitive agency MBS investments and credit sensitive non-agency MBS and securitized loans. You can see moving on to the portfolio table that 76% of the portfolio is invested in agency MBS, which includes agency TBA positions and 24% of the portfolio is in non-agency MBS and securitized loans.
Given the lower leverage, we take on average on these positions the corresponding equity allocation to mortgage credit investments is approximately 35% of total capital. The agency MBS portfolio continues to be defensively positioned on the shorter end of the yield curve. We have 43% of our agency MBS portfolio in annually adjusting ARMs, adjustable rate mortgages; we have 28% in hybrid ARMs with an initial interest rate reset of greater than a year before they begin to reset annually; and we have 29% of the portfolio in fixed-rate MBS with the vast majority of those in bonds with 15 years or less until their stated final maturity.
So while we expect short-term interest rates to remain relatively low and stable in the near term the agency MBS portfolio is well positioned to avoid significant price declines should longer-term rates move unexpectedly higher.
The characteristics of the agency MBS portfolio were stable on the quarter with an average coupon of approximately 2.65%. Agency prepayments increased modestly from 17 CPR to 19 CPR on the quarter and with the decline in mortgage rates year-to-date as well as the summer seasonality of prepayments we would expect to see some continued increases in portfolio CPR on the agency MBS over the coming quarters.
On this note I would highlight the increase in premium amortization expense to $16.3 million on the quarter versus $7.4 million in the prior quarter. As many of you may know from how other mortgage REITs report their earnings, significant changes in future prepayment expectations can cause significant quarterly swings in GAAP premium amortization expense relative to the actual prepayment experienced during the quarter. This is largely related to the recognition effect from prior periods of these changes in expectations, which is sometimes referred to as a catch up effect.
With interest rates reaching multiyear lows around quarter end, there were resulting significant increases in long-term prepayment expectations on our agency MBS portfolio, which was the cause of virtually all of this increase in quarterly premium amortization expense. For this reason we have chosen to reflect an additional adjustment to core earnings this quarter and going forward. The details can be found in the table in our release, which reconciles core earnings to GAAP earnings, but basically we have replaced the GAAP premium amortization expense with the pay down expense related to the actual prepayment and pay down activity during the quarter.
In other words, if 5% of the agency MBS portfolio pays down in a given quarter, 5% of the purchase premium of those agency MBS will be reflected as that quarter’s pay down expense. So for the second quarter this expense rose to $7.8 million on the quarter, which is reflected in core earnings. While in most quarters there is likely to be little difference between these two measures and I would note that neither the first quarter of 2016 nor 2015 core earnings would have been materially different had we adopted this adjustment to core earnings previously. We believe that when there are significant changes in the long-term prepayment expectations, higher or lower, this adjustment to core earnings will prove to be a more reflective indictor or our investment portfolio’s current period earnings power, which is what we believe the measure is intended to indicate.
With that bookkeeping aside, I'll turn it to Brett to discuss our non-agency MBS portfolio.
Thanks, Joe. On the non-agency, on the asset side, during the second quarter we continued to selectively add positions to the non-agency portfolio, basically in the Alt-A sector of the portfolio. However, the overall size of the portfolio did shrink due to prepayment activity.
Looking at the market in general in this sector, during the quarter spreads initially tightened and then widened in the aftermath of Brexit. That said net-net for the quarter, spreads ended up a bit tighter. Since quarter end we have continued to see an increased amount of cash being put to work and increased demand for assets in our sector. This has led to a continued and significant tightening of spreads in our sector.
On the funding side, we continued to aggressively manage our financing. We have been able to take advantage of opportunities that have allowed us to lower our leverage with minimal impact to our level of returns. Looking forward, we feel that we are in a good position to take advantage of investment opportunities in the current market. We continue to look to find attractive assets to add to the portfolio across all sectors that we participate in within the non-agency sector.
Turning to the financing of our entire MBS portfolio and leverage measurements, you can see that overall repo borrowings declined to 4.075 billion at quarter-end, and leverage correspondingly decreased to 5.8 times total capital from 6.2 in the prior quarter. When you include the effect of the synthetic financing embedded in an agency TBA position, the effective economic leverage is 6.8 times total capital.
Given the strong price-performance of non-agency MBS in the quarter and the relative stability of our agency MBS investments, we have been comfortable reducing leverage slightly as they provide some cushion so we can go any future buying opportunities providing a chance to potentially increase our leverage somewhat going forward.
The overall repo rate paid on our total borrowings was unchanged from the prior quarter at 83 basis points. The asset liability duration gap was close to zero at the beginning of the quarter and with the decline in interest rates our asset duration shortened to approximately 1.25 years at June 30. Correspondingly were closed out some of our intermediate maturity swap positions and several other of our short-term swaps matured. As a result, our notional swap balance decreased to $2.5 billion, and our average borrowing maturity including the affected swaps decreased from 1.8 years at the beginning of the quarter to 1.5 years at quarter-end. So at quarter-end we were positioned with a small negative asset liability gap.
Looking at our effective net interest rate spread, that was an increase to 124 basis points as core earnings increased quarter-over-quarter. This increase was driven both by the effective higher net yields on assets as well as a reduction in the cost of our liabilities due to a lower average swap balance, even though repo costs alone were unchanged in the quarter.
We declared a $0.15 dividend, maintained from prior quarters. That $0.15 dividend results in an annualized dividend yield of 12.8% based on the quarter-end closing stock price. As discussed previously, we had a $0.06 increase in our book value per share to $6.06. When you take this increase into account along with the $0.15 dividend that was declared that results in a 3.5% return on equity un-annualized to common shareholders for the quarter.
As has been the case for some time now, we do continue to repurchase shares accretively in the open market, and repurchased approximately 870,000 shares during the quarter. These repurchases added a little over million dollars of economic benefit to shareholders and increased book value per share by around $0.01.
With that, I'll turn the call back over to Lloyd for his closing remarks.
Joseph Lloyd McAdams
Thank you very much, Joe and Brett. As most of you know in 2014 we began the program of investing in non-agency mortgage-backed securities to diversify our risk exposure – with the long-term expectation of more stable income asset values.
The objective of this was a reduced level of interest rate risk, while accepting the increased level unemployment risk and house price risk that is associated non-agency mortgage-backed securities. To date I am pleased with the results. We have maintained a steady dividend at $0.15, as Joe mentioned, during the past six quarters. Today when I look at our portfolio and its prospects, I see the three important factors, which I expect can help us maintain this stability.
First, 43% of our agency and TBA agency assets, which is $2.1 billion, are fully indexed agency ARMs, whose interest rates adjust annually. Because of this these ARMs have a more stable income spread to financing cost than do most fixed-rate assets. Secondly, the remaining 57% of the agency and agency TBA securities that is $2.7 billion is [90%] plus covered by our interest rate swap position of $2.5 billion.
The average maturity of these swaps is 2.4 years, which we expect will result in more stability of spreads during this period. However, the remaining average life of the 57% of the portfolio is greater than that of these swaps. So it is correct that if these swaps matured during the next several years in a higher interest rate environment, we will likely be replacing them with higher cost swaps. However, I should add as an offset if a 15% prepayment rate occurs during the next three years, 40% of our portfolio is expected to repay, which gives us the opportunity to reinvest the repayments at higher yielding mortgage backed securities.
The third and last factor, returned from our non-agency portfolio has to date produced returns, which has helped us maintain our income, while reducing the risk of our income from changes in short-term interest rates. At the same time I believe it has added stability to the overall income due to the diversification of risk strategy, which I have just mentioned.
So in summary, while the mortgage backed security market is known for its unanticipated fluctuations, I expect that our increased diversification of risk strategy will help us continue to maintain what in today’s market – capital market, is an above average dividend yield, and that of course is one of our primary objectives.
So with that, I will return the call to Amy for any questions that any of you may have. Thank you very much
[Operator Instructions] Our first question is from Douglas Harter at Credit Suisse.
Hi, actually, this is Sam Choe filling in for Doug. So, I mean, given the premier amortization expense this quarter, I was just kind of curious as to how you saw prepaids trending for the remainder of the year?
Joseph Lloyd McAdams
Sure. This is Joe. We saw prepayments increase month over month. During the second quarter, we had 19 CPR on average. A certain amount of that is the seasonality of higher prepayments in the middle and late summer. But we also would expect given, you know, about a month ago the refi index peaked a little bit. So we would expect some fall through in the late summer and into the fourth quarter of refinancings driven by these lower rates. So, we would expect I think to see higher prepayments on average during the third quarter versus the second, and I guess it is really sort of depending on the strength and follow through of any refinancing from where rates are currently, you know, I would expect them to remain relatively elevated during the fourth quarter.
Got it. So shifting gears, I mean, looking at leverage you guys took that down noticeably, but I mean, I was wondering if you guys have a target leverage in mind going forward?
Joseph Lloyd McAdams
Well, I think our target leverage is a function of two components. I think when we look at the agency portfolio independently or the credit portfolio independently, we have different target levels. I think as our allocation shifts from agency to non-agency as it has done on average over the last several quarters, you would see the – expect to see the leverage come down simply because our non-agency MBS strategy typically involves less leverage.
That said we have gotten involved in some securitizations of loans, where we retained the subordinate pieces and effectively on the balance sheet that shows up as a relatively high leverage transaction because we include a relatively high amount of loans, as well as ABS issue. Although that leverage is non-recourse, so from our perspective a lot safer than repo leverage, so I think given our current mix between credit and agency, our leverage is a little bit lower than our target.
We have had some good performance in the portfolio, particularly on the non-agency side. So I think we would look for some opportunities in the coming quarters when we do see some buying opportunities to potentially move that leverage a little higher.
Got it. All right. That's it from me. Thank you.
Joseph Lloyd McAdams
Thank you Sam.
[Operator Instructions] Seeing no further questions, this concludes the question-and-answer session. I would like to turn the conference back over to Lloyd McAdams for closing remarks.
Joseph Lloyd McAdams
Thank you very much. We appreciate your participating in the call. For those of you who were on the call, we look forward to your participation again with us next quarter, and for those of you who are reading the transcript, if you have questions please let us know, and with that we thank you very much for your participation and for your support in Anworth. Have a good day.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
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