Anworth Mortgage Asset Corp (NYSE:ANH) Q4 2016 Earnings Conference Call February 16, 2017 5:00 PM ET
Brett Roth - SVP & Portfolio Manager
Joe McAdams - CIO & President
Lloyd McAdams - Chairman & CEO
Douglas Harter - Credit Suisse
Welcome to the Anworth Mortgage Fourth Quarter 2016 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 27A 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 and 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 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 statements as a result of various factors and uncertainties, including, but not limited to, change 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 and the general economy, including the consequences of actions by the U.S. 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 purpose, our ability to maintain an exemption from the Investment Company Act of 1940, as amended, risks associated with our home rental business and the Manager's 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 made.
All forward-looking statements speak only as of the date they are made. New risks and uncertainties arise over time and it's 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 changes 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. Pease go ahead, sir.
Thank you very much. I'm Lloyd McAdams and I welcome you to this call today, where we will discuss our fourth quarter operating results. I will now turn the call over to Joe McAdams, our Chief Investment Officer and President. Also with us today is Brett Roth, Senior Vice President and Chuck Siegel, our Chief Financial Officer. I'll participate in the call later. Thank you very much.
Thanks. This is Joe McAdams. Turning to the fourth quarter results, Anworth generated $12.1 million in core earnings during the quarter or $0.13 per share, a very slight increase over the prior quarter. GAAP earnings were $0.15 per share. But as we typically point out, GAAP earnings only include unrealized changes in market value on some, but not all of our investment portfolio.
Comprehensive income which includes all unrealized mark-to-market adjustments, was a $13 million loss for the quarter. This was the result of our Agency MBS declining in price during the quarter by more than our interest rate hedges increased when interest rates moved sharply higher following the November election.
Market values on our Non-Agency MBS and other residential mortgage credit investments were stable during the quarter. This emphasizes the benefit of our hybrid REIT strategy as opposed to an Agency-only strategy. During a challenging quarter for Agency MBS strategy such as the fourth quarter, the overall decline in book value was lessened by the investments in less interest rate sensitive mortgage credit investments.
These credit investments also provide us an attractive level of income in the portfolio and help support the currently attractive level of core earnings. We will get into more detail later in the remarks, but we made our first investment in a REIT-eligible Agency credit risk transfer securitization during the quarter and are optimistic as to the ability of our residential credit investments to continue to support the overall portfolio earnings as well as provide lessened sensitivity to interest rate movements.
The asset portfolio as a whole at December 31 consisted of 76% Agency MBS and a total of approximately 23% in residential credit investments comprising both Non-Agency MBS as well as securitized residential loans. Looking more closely at the Agency MBS portfolio, total Agency MBS, including the notional value of TBA positions was approximately $4.5 billion. 40% of these Agency MBS were adjustable-rate mortgages or ARMs which are currently resetting to market interest rates.
35% of our Agency MBS are fixed rate MBS, but the vast majority are 15-year maturities so our Agency portfolio continues to have a relatively low interest rate sensitivity with its exposure predominantly on the shorter end of the yield curve. The effect of our ARM holdings can be clearly seen as ARM interest rate coupons increased from 2.75% to 2.90% on the quarter as short term rates moved higher.
Overall, the Agency MBS portfolio had an average coupon of 2.72% and an average cost basis of 102.93%. Premium amortization expense associated with this cost basis decreased from $7.1 million to $5.5 million for the fourth quarter, while the actual prepayment activity in the Agency portfolio decreased 2% to a 22 CPR annualized prepayment rate. Subsequent to quarter-end, driven by the higher interest rates we've seen over the past several months, we could see continued decreases in actual prepayment activity with the most recent month showing a 20% CPR average for the Agency portfolio.
With that, I'll turn the call over to Brett Roth to discuss the residential credit side of our portfolio.
Thanks, Joe. I like to begin with the legacy Non-Agency sector of the portfolio. In general, spreads in this sector continued to tighten during the quarter. The appetite for legacy CU.S.IPs remains robust and both fixed and floating-rate assets continue to be aggressively bid. Since quarter-end, we have continued to see an aggressive bid for these assets and continued tightening of spreads, thus the legacy Non-Agency market, as well as our portfolio have and continue to benefit from spread tightening.
During the quarter, we continued to selectively add positions to our legacy CU.S.IP portfolio specifically within the Alt-A sector of the portfolio. Overall, the portfolio is benefiting from the credit performance of its underlying assets, as well as experiencing strong voluntary prepayment activity. Net-net, the portfolio pay downs outsized reinvestment activities which led to the reduction in the size of the legacy CU.S.IP portfolio.
During the fourth quarter, we added a position in a new sector for the portfolio, Agency Risk Transfer Securities. We anticipate continuing to add assets in this sector of our portfolio, as we believe this asset class will continue to grow and we see it as offering us attractive returns for our portfolio.
Briefly touching on our loans held in securitization trust. We continue to be pleased with the credit performance of the underlying assets in our securitizations. Focusing on the credit tranches, we continue to see spread tightening during the quarter. We believe this is a function of both the performance of our underlying assets and the general tightening experienced in the mortgage credit sector.
Turning to the funding side, we continue to add new counterparties to our mix of lenders. We've been able to aggressively manage our financing and therefore our cost of funds. Thus, our continued active management of funding has been a part of why we've been able to lower our overall leverage. That said, active management has also allowed us to reduce the leverage amount with minimal impact on our levered returns.
Briefly looking forward, we feel that we're in a good position to take advantage of investment opportunities as they arise 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 mortgage credit. Thanks, Joe.
Thanks, Brett. Turning to the next part of the release which is the overall portfolio of financing and leverage, you'll see the total repo borrowings for Agency and Non-Agency were $3.9 billion at year-end which reflected a leverage multiple of 5.6 times total capital, up slightly from 5.5 times at September 30.
If you include the effect of the TBA dollar roll financing which does not involve actual repo borrowings, the Company's effective economic leverage will be increased to 6.5 times at year-end. Including our interest rate swap positions, the repo liabilities had an effective maturity of 488 days or approximately 1.3 years, as of December 31.
The significant rise in interest rates during the quarter lowered our future prepayment expectations on our portfolio which resulted in the lengthening of our estimated or expected duration or interest rates sensitivity to approximately 2.2 years as of year-end.
This left our asset liability gap at slightly less than one year as of year-end which is wider than recent quarters, but still low on an absolute basis. And as we've discussed on the Agency side, that sensitivity is largely focused on the shorter maturity portion of the yield curve.
The interest rate swap positions also effectively hedge our short term borrowings from increases in borrowing rates. The swap balance at December 31 was $1.8 billion down from the prior quarter as a few short maturities swaps matured during the quarter. These swaps currently hedge approximately 45% of our outstanding repo borrowings. Our Eurodollar Future positions effectively hedge another 8% or $300 million of our borrowings.
And so, when you take into account that approximately $1.8 billion of our asset portfolio consist of currently resetting Agency ARM securities which would be the equivalent of 46% of our total repo borrowings. You'll see that effectively all of our short term repo borrowings have some form of protection against rising interest rates, either through the swap or Eurodollar hedges or due to the potential for increasing interest rates on the ARM assets that those repos finance.
Turning to the effective net interest rate spread on the portfolio, it was relatively stable at 1.17% which is what you would expect given the small change in core earnings on the quarter. The Company declared a $0.15 dividend during the fourth quarter which would result in 11.6% dividend yield based on the year-end stock price of $5.17. After declaring this dividend, book value per share decreased approximately 5% on the quarter to $5.95 due to the comprehensive loss on the quarter which was driven by the declines in Agency MBS valuations, as previously discussed.
This resulted in a return on equity to common shareholders of negative 2.4% for the quarter and brought the full year return on equity for common shareholders for 2016 to 5.1%. The price-to-book ratio at year-end stood at 87% which was a substantial improvement from year-end 2015. So as a result, the total return for common shareholders was 34.2% for 2016.
During the quarter, we issued approximately $450,000 worth of Series C preferred stock. Also, with the discount-to-book narrowing significantly during the quarter, we repurchased a relatively small amount of common stock with 80,000 shares repurchased early in the quarter at an average price of $4.78.
With that, I would turn the call over to Lloyd for his remarks. Thank you.
Thank you, Joe and thank you, Brett. As I believe, many of you who have participated regularly in our calls during the past year or so have probably noted after our discussion about the details of the prior quarter's results and insights about the upcoming quarter, I focus my comments on a more longer term view.
In the past, these comments have included such topics as, the benefits of diversifying interest rate risk with credit risk, the type of investor expectations that can result in 10%-plus ROE selling at a discount to book value and the 0% interest rate world of 2016 and the benefits of diversifying our Agency portfolio between adjustable rate mortgages and fixed-rate mortgages.
Today, I will look at where over the long term I see mortgage REITs fitting in the rather broad spectrum of income investing. But first, it is important to acknowledge that we, Anworth, relative to other income providers use a large amount of leverage to invest in callable debt securities as do other mortgage REIT. Using this leverage, we do produce a relatively higher yield along with a high risk which we actively manage with interest rate hedging instruments and diversification strategies. From my perspective, the result is an acceptable risk level and an attractive high yield.
Second item to acknowledge is that, we investors now live in an interest rate world where my bank pays me 0.01% interest on a certificate of deposit; 10-year treasury bonds yield 2.5%; and non-investment grade bond funds typically yield about 5% up to maybe 6%. With mortgage REIT yielding a bit more than 10%-plus today, the investor's question becomes, is the extra yield worth enough to more than offset any extra risk.
For the answer, I look at the past 15 to 20 years; compare the returns of investors in the mortgage REITs that were around during this period and the five-star total rate of return bond mutual funds, most common form of income investing. The result is, mortgage REIT investors have a considerably higher return during this long term period. Mortgage REIT skeptics may say that during this period, mortgage REITs used leverage which makes them more risky than bond funds and on that, as I've said, I will agree. But I will quickly point out that risk management of the mortgage REIT is all about reducing the effects of the inherent risk of leverage.
Thus I believe that it has been the success of mortgage REIT's in fashioning the right combination of higher yield and the level of risk, by using both the asset and liability side of the balance sheet. In so doing have generated top results over this long term period. It is my observation that riskier investments usually follow an expected pattern of outperforming less risky investments until of course, the higher-risk produces losses in the riskier investments which then causes the returns of the two investments to converge, if not invert. And that after this 15-year period, that I've looked at, the returns of even well hedged mortgage REITs are materially above those of the 5-star bond mutual funds, to me, indicates that mortgage REITs may well have an inherent long term advantage with some very important investment pursuit of generating investment income.
I believe that a recognition of this perspective were to become more common, it would benefit the importance of mortgage REITs as a provider of investment income and therefore of course would benefit all mortgage REIT shareholders. With that, I will now turn the call over to our operator, Laura, for any clarifications from the participants or questions that you may have. Thank you very much.
[Operator Instructions]. Our first question comes from Doug Harter of Credit Suisse.
As you look forward, how do you see the portfolio mix between Agency and Non-Agency changing?
Well right now, we've talked about the -- asset-wise, it's about 75-25, but when you take into account the lower level of repo leverage on the Non-Agency portfolio, it's more -- the credit investments are more in 35% to 40% of equity range. We do see attractive opportunities going forward, obviously on residential credit that, as Brett pointed out, we've had good performance from legacy Non-Agency CU.S.IPs.
That asset class is only going to get smaller over time, but both in terms of securitized new production loans, reperforming loans as well as the potential to add through REIT-eligible credit risk transfer securities, we do see a lot of opportunities to maintain and even increase the amount of capital allocated to those residential credit investments given the current level of income they offer.
On the Agency side, we're focused on the shorter end of the yield curve. I think there is the potential for some volatility on the longer end of the curve. So I think in the near term, we would see the potential for maybe a higher equity allocation to residential credit versus Agency at this point.
And, can you help size the potential amortization benefit that you could see in the first half of 2017 given what rates have done?
Sure. When you look at the way we present core earnings. As you're aware Doug, the GAAP premium amortization expense is driven by long term expectations of prepayments and obviously those have come down significantly during the year. So, we had a fairly significant decline in premium amortization expense during the fourth quarter. Some of that is related to changes in these long term expectations as opposed to actual prepayment decreases.
So what we provide in the core income statement is, in effect, the cost of the actual pay downs being reflected. So that did decrease during the quarter, as the actual CPR came down by 2 CPR. So it's about a 10% reduction in the overall amount of prepayment activity. And again, as I mentioned in the comments, so far, quarter-to-date, we've seen another 2% reduction in the CPR rate.
I don't think, we're going to see dramatic decreases in ARM prepayments, if short term interest rates continue to rise. They still are north of 20 CPR on the ARMs and I do think that when you have rising interest rates, you typically continue to see a fairly constant and in some cases, an increase in prepayment activities as interest rates reset.
Given that they're starting at a very low level relative to fixed-rate mortgages and I do think there has been some steepening of the yield curve, I don't think we're going to get to an inverted yield curve anytime soon which would drive substantial ARM prepayments, but I think that should mute the amount of reduction we see in premium amortization on our Agency portfolio.
And this concludes our question-and-answer session. I would like to turn the conference back over to Lloyd McAdams for any closing remarks.
Well, we thank you for participating in our call. We look forward to having this call again in about three months from now, in April -- I'm sorry two months from now in April. So with that, thank you very much for your support. Have a good day.
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.
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