ARMOUR Residential REIT, Inc. (NYSE:ARR) Q2 2018 Earnings Conference Call July 26, 2018 10:00 AM ET
Scott Ulm - Co-CEO, Co-Vice Chairman & Chief Risk Officer
James Mountain - CFO, Treasurer & Secretary
Mark Gruber - COO & CIO
Christopher Nolan - Ladenburg Thalmann & Co.
Joshua Bolton - Crédit Suisse
Trevor Cranston - JMP Securities
David Walrod - JonesTrading Institutional Services
Ladies and gentlemen, thank you for standing by. Welcome to the ARMOUR Residential REIT, Inc. Second Quarter 2018 Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded, Thursday, July 26, 2018.
I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.
Thank you, operator, and thank you all for joining us this morning to discuss ARMOUR's second quarter 2018 results. I'm joined by ARMOUR's co-CEOs, Scott Ulm and Jeff Zimmer; and by Mark Gruber, our Chief Operating Officer and Chief Investment Officer. By now, everyone has access to ARMOUR's earnings release and Form 10-Q, which can be found on ARMOUR's website, www.armourreit.com.
This conference call may contain statements that are not mere recitations of historical fact, and therefore, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such as forward-looking statements are intended to be subject to the safe harbor protections provided by the Reform Act.
Actual outcomes and results could differ materially from the outcomes and results expressed or implied by the forward-looking statements due to the impact of many factors beyond the control of ARMOUR. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of ARMOUR's periodic reports filed with the Securities and Exchange Commission. Copies of those reports are available on the SEC's website at www.sec.gov. All forward-looking statements included in this conference call are made only as of today's date and are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless required to do so by law. Also, our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to the most comparable GAAP measure is included in our earnings release, which can be found on ARMOUR's website. An online replay of this conference call will be available on ARMOUR's website shortly and will continue for one year.
ARMOUR's second quarter GAAP net income was $13.6 million or $0.22 per common share. Core income was $31.3 million or $0.65 per common share, which comparably exceeded our dividends paid. Based on stockholders' equity at the beginning of the quarter, core income represents a 10.1% return on equity on an annualized basis. Core income includes TBA Drop Income and excludes gains and losses on our portfolio.
ARMOUR's quarter-end portfolio consisted of over $6.3 billion of Agency Securities plus another $2.1 billion of TBA positions. Our credit risk and non-agency positions totaled $1 billion at June 30.
As we discussed on our last call, our book value declined $0.92 in the first three weeks of April, continuing the trend from first quarter. Over the last 90 days, however, our book value has been relatively stable, exhibiting a more normal volatility with no discernible trend. Book value as of last Monday night, July 24, 2018, was $23.74 per common share outstanding, up $0.06 from the quarter-end figure. Remember that we include updated book value estimates, and our update presentation's available on our website or on EDGAR.
We pay dividends of $0.19 per common share for the -- for each month of the second quarter, totaling $24.1 million or $0.57 per common share for the quarter-end total. We've announced July and August common dividends of $0.19 per share to shareholders of record on July 16, 2018, and August 15, 2018, which will be payable on July 27, 2018, and August 28, 2018, respectively.
Now let me turn the call over to our co-Chief Executive Officer, Scott Ulm, to discuss ARMOUR's portfolio position and current strategy in more depth. Scott?
Thanks, Jim. Good morning. In the second quarter of 2018, broad market volatility continued to dissent from its first quarter highs though remained elevated relative to last year. Steady supply of bonds from overseas and percolating U.S. economic growth pushed yields on the 10-year treasury bonds up to 3.11%, a new high since the second quarter of 2011. Still new challenges emerged in the shape of a global trade wars as rather trade negotiations and regulatory tariffs threatened the still fragile economic recovery. Longer-term growth prospects repriced lower while monetary policy remained on a rising rate trajectory. This dynamic is pushing spreads between the yields on 10-year and two-year treasury bonds to decade lows and perhaps an aversion precursor to past economic recessions.
While overall economic trends remain strongly positive, we note persistent issues with productivity and demographics that work to restrain growth. We expect the shape of the yield curve to continue to flatten and the overall level of interest rates to gradually rise.
Despite lower volatility, the bond markets total in excess returns were mixed in the second quarter contributing to ARMOUR's book value decline of approximately 3.8% in the second quarter. Additionally, during that time, the 10-year treasury rate increased by 12 basis points. The five-year treasury rate increased by 18 basis points, and the two-year treasury increased by an even larger 26 basis points. ARMOUR maintains a positive duration exposure to interest rates across the curve. So higher yield's responsible for the bulk of ARMOUR's book value decline.
Coming off week first quarter performances, spreads on U.S. agency mortgages outperformed high-grade corporate credit and the agency CMBS sectors. The U.S. MBS index total and excess returns for the second quarter were a positive 24 basis points and a positive 15 basis points, respectively. By contrast, the second quarter's total in excess returns in the agency CMBS sector were negative 12 basis points and negative 8 basis points, offsetting some of the gains from agency MBS spread tightening in ARMOUR's portfolio.
Despite the higher treasury yields, conventional 30-year MBS delivered positive unhedged returns of 19 basis points inclusive of carry. This return is 11 basis points greater than comparable duration treasuries. By contrast, 15 and 20 years lagged 30-year passers and were another source of drag on book value.
Turning more positive on the basis in the second quarter, we swapped out of our treasury positions and a significant portion of our older MBS bonds into new origination, $200,000 maximum loan size, higher coupon, 30-year MBS passers. This rebalance constitute close to 20% turnover of our total assets.
Additionally, we've allocated a significant portion of our dollar roles to higher coupon Ginnie Mae 2 program securities, which have traded a substantial discount to conventional mortgages and have since outperformed them on a more favorable prepayment outlook.
Credit risk transfer bonds, or CRTs, issued by Freddie and Fannie posted another quarter of positive absolute returns of roughly 90 basis points for mezzanine tranches, perhaps inclusive of the carry. Spreads were slightly wider during the second quarter. Due to the ongoing strong U.S. housing fundamentals and the bonds' floating rate coupon, we remain constructive on the sector although we view current spreads as full and with limited upside in the near term. Our relatively small non-agency legacy portfolio remains a positive contributor to the income and had a largely flat price return year-to-date.
The combination of portfolio changes, better financing on CRTs and a significant portion of our swap book moving to net receivers drove the 21 basis point increase of our net interest margin to 1.73%. This is the widest we have enjoyed since the first quarter of 2014.
As of July 24, our funded leverage ratio or debt to equity is approximately 5.6x, just 1/4 turn higher versus the 5.5 ratio observed at the end of the first quarter.
Adding in the leverage effect of unfunded TBA dollar role positions and forward settling transactions resulted an implied leverage of 7.3x as of July 24. While TBA dollar roles did not currently have the extreme levels of specialness observed prior to the beginning of the Fed taper program, we continue to find pockets of opportunities where dollar role financing is much more favorable than the general repo market. We do expect the Fed's reinvestment caps to surpass the MBS pay-downs later this year, implying much lower specialness in production coupons.
We expect the Federal Reserve to announce two more federal funds rate increases in 2018, and we've taken steps to limit our sensitivity to these hikes and heightened market volatility. As of June 30, 2018, we maintained a hedged book of pay fixed received floating swaps of $6.8 billion notional. Our agency fixed-rate asset repo position is covered 116.1% by swaps. Our net duration is 0.2, a decrease from 0.55 on March 31. Although today, it is just about 0.5. This number does not include any negative duration effects from our repurchased liabilities.
Our spread DV01 is $4.79 million, a very slight decrease from $4.87 million on March 31. Despite our lower risk exposures, we anticipate the core earnings will cover our dividends during the third quarter of 2018. The average prepayment rate on our agency assets increased slightly from 6.3 CPR in the first quarter to 6.7 CPR in the second quarter. This rate remains below the 2017 average of 7.3 CPR.
Prepayment risk and -- plus amortization expense is clearly faded with the increase in treasury rates. It is important to note that a good portion of our agency portfolio is composed of assets with prepayment protection through seasoning, lower loan balances or contractual prepayment lockouts in our DUS paper. As such, the contraction and extension risks of our portfolio are well contained.
Repo financing remains consistent and reasonably priced for our business model. ARMOUR maintains MRAs with 47 counterparties and is currently active with 26 of those for total financing of $6.25 billion at the end of the second quarter. Most importantly, our affiliate, BUCKLER Securities, which became operational during the early part of the fourth quarter 2017, is financing approximately 50% of our entire repo position and 55% of our agency portfolio liabilities. Financing through BUCKLER provides us with greater security of financing, flexibility on terms, attractive rates, and therefore, an overall greater control over our liabilities. Lower haircuts from financing with BUCKLER will free up capital and also reduce our liquidity requirements.
Our investment in credit risk transfer securities was valued at $859.6 million at the end of the second quarter and represented 89.7% of our credit risk and non-agency portfolio. In the CRT transactions, we take the credit risk of recent Fannie and Freddie underwriting and return for an uncapped floating rate coupon. The credit quality of our CRT bonds continued to be reliable due in large part to strong GSE underwriting standards on the 2013 to 2016 synergies that we own. Consequently, we've been rewarded both by the spread tightening that has occurred in this sector since our first investment in 2016 and by the attractive carry. In addition, these securities benefit from increasing credit enhancement over time that can lead to credit rating upgrades. Currently, almost 40% of our CRT portfolio has been upgraded to investment grade. Rating upgrades result in better financing terms and possible price appreciation.
While grows portfolio allocations will show a much larger quantum of agencies on our balance sheet, we believe the purest way to think about capital allocation is equity committed to financing haircuts in each sector. Our allocation to credit assets, as a percent of all haircuts in repo at the end of the second quarter, was approximately 40%. Equity that's not tied up in financing haircuts is our liquidity, and that liquidity is available to support any part of the portfolio.
At the end of the second quarter, ARMOUR owned $80.5 million of non-agency legacy RMBS. Currently, we see very few opportunities for investment in this asset class. However, our existing holdings from that period continue to perform well as a runoff. Like many market participants, we continue to hope for revival in the jumbo securitization market.
Our principal concern for the balance of 2018 is weighing growth expectations triggered by the recent rise in trade barriers. While wages, consumer and housing pay that remain on an upward trajectory, we're seeing forward implied rates, giving signs of economic distress ahead. An inverted yield curve environment doesn't bode well for any financial institution, and they serve as a precursor for economic recessions in the past. Having said that, we do believe that this year's strong economic backdrop that projected supply of treasury will arise in longer maturity rates by the years end. We do expect our asset base combined with repo hedge coverage to benefit from this dynamic.
Operator, that concludes our prepared remarks. We'll now take any questions.
[Operator Instructions]. The first question is from the line of Douglas Harter with Crédit Suisse.
This is actually Joshua for Doug. One question on the higher asset yields in the quarter. Anything specific to call out there other than the portfolio turnover? I know you talked a little bit about it, but I was just curious anything specific to call out there. And then are you expecting the higher net interest margin to be sustainable in the back half of the year?
So the lower loan balance, the 200k max loan balance premium securities that we purchased, will have some reliability over the next few quarters in terms of slow prepayments. So very little amortization schedule on those. And we definitely would expect that, what Scott said, about 20% of the portfolio -- or part of that is 20% of portfolio to maintain a similar name over the next quarter or two, yes.
I'd also add in the move to net receiver on our swaps, clearly driven by the rate environment that is likely to persist as well.
Both on [indiscernible], exactly.
Our next question is from the line of David Walrod with Jones Trading.
Just wanted to get your prepays a little bit. They were pretty much in line in the second quarter. Can you give us an update so far in the third quarter and your outlook for the rest of the year?
So, well, look [indiscernible] rates without mortgage applications are slightly down quarter-over-quarter and mortgage rates are up. And what you're seeing is basically housing turnover numbers in our portfolio, very little amount of that is actually prepayments due to refinancing. So we would expect our prepayment rates into the third quarter to maintain similar levels from what we've seen in the last few quarters with no increases.
Great. And then in regards to the various asset classes, in terms of the runoff, where are you seeing the best return opportunities? Is it in the agencies, non-agencies?
So there's two areas, and Scott touched on them in his prepared remarks a moment ago where we're seeing. So there are premium, new originated assets, 4%, 4.5% coupons that are double-digit returns. And the way we look at our book is when we're doing analysis. Right now is we look hedge to a 0.5 duration with maximum leverage to 7.5. So that's how kind of we're doing our analysis. So using that is a box that you live in. We're seeing opportunities in the 200k, 175k, lower FICO, 4 and 4.5s, for sure. On dollar roles, Scott mentioned the -- some of the Ginnie Mae 2 premium dollar roles, 11 plus percent and actually some of the Fannie premiums are as well. So we have places to put money and to do reinvestments. Understanding with these low prepayments right now, we're not even reinvesting $50 million a month.
[Operator Instructions]. The next question is from the line of Trevor Cranston with JMP Securities.
Question, you guys mentioned a couple of times that you're finding opportunities in the Ginnie 2 dollar roles specifically. Can you elaborate a little bit on why you're finding those more attractive versus conventionals and also maybe comment on how the role financing is for those securities relative to the conventional market?
Sure, Mark will give you a little overview on that.
Sure. So Trevor, a few months ago, we had looked into some Ginnie 2s, mainly some higher coupon like 4.5s. And if you are following in the news with some of the VA, FHA kind of -- with the originators, we thought there was an opportunity there to see that discount to conventionals kind of collapse. And so -- we were small enough still that we can hit these different opportunities because of these -- the markets are not super liquid. And so you can't go in there and buy a billion of these bonds. You have to be able to -- you can only go in there and find $100 million or $200 million at a time. So it's just one of those opportunities we saw. We did enough research on, and then we took a shot at it and it worked out for us. So we're really happy with that trade.
And the dollar roles, Trevor, still continues. I think I mentioned it when David was on here, it was north of 11% on Ginnie 2 for dollar roles is the way look at it using our duration boxes 0.5 and no more than 7.5 leverage. And if you look in some higher coupons, 30 or Fannie's, you can get even some higher returns like 5%. But when you get into on the runs, they're single-digit returns, if not low single-digit returns.
The next question is from the line of Christopher Nolan with Ladenburg Thalmann & Co.
On the CRT, you mentioned that they're moving into investment grade so the funding costs are going down. And given their floating rate, the yields are going up. What's the NIM on if you have it for that portfolio second quarter versus fourth quarter?
I don't know, Christopher, that we actually released the exact NIM, but let me have Mark respond to you on maybe different financing rates for the BBB or BBB- and above your investment grade versus not. And then if -- Jim, I believe that we have released some of that information, if you could comment further on those NIMs.
Yes. So the difference between investment grade and noninvestment grade on the CRTs is going to be between 20 and 30 basis points. And if you think about where we first started investing these a while ago, LIBOR plus 175 is probably where the majority of our stuff financed when they were non-investment grade. And now it's going to be whenever -- investment grade, it's probably the spread has come in 100 basis points from there. But it also really depends upon what class and tranche and what deal you're looking at. But in general, CRT financing has come in a lot since we first started this investment.
Unidentified Company Representative
Yes. And Jeff, to your point, we have traditionally not broken out in this level of detail of financing details between agency and non-agency. We provide financing details about the overall liability portfolio. So doing specific close NIM calculations on a sector-by-sector basis would be new ground for us that we're not going to do on the fly on a call.
Sure. But I'll just repeat what Mark said. When we first started buying them like LIBOR plus 175 financing for new issues, well, new issues are now one -- LIBOR plus 125 and your investment grades are like 75 over LIBOR. So that gives you an idea of where the return patterns if it continue to increase for our investment in that sector.
And I guess as a follow-up to an earlier question on NIM, you indicated that the NIM was sustainable in the second half of the year due to the change in your swap position, I guess, to net receivable and also the agency portfolio. Am I correct? Or I mean, does it mean that CRT portfolio is really going to be supporting the NIM?
Well, actually, since we have 116% of our repos swapped out and you are going to likely see our Feds run rate increase in September and December, so we're net receivers right now. And so in fact, 16% net receiver if you look at the rest of it is equal, right? So that should actually increase. The CRTs will go up in terms of their coupon with the resets and the Federal funds rate, but their financing over LIBOR will increase as well. However, we borrow far less on those than we own. We have a number of those in the box. So it should be an additive. You're completely correct. Now because our prepayments are so low, as I indicated today, we're lower at -- we're $50 million or less in reinvestment each month. So if the mortgage rates go higher, we don't have a lot to reinvest. I will say, however, our leverage is still relatively low. While we don't anticipate a substantial increase of leverage at this point, at some point in mortgages, you don't look very, very attractive. You could see us increase our leverage to take advantage of those opportunities.
And then final question. Given how the CRTs have performed so well, would you consider selling these or invest?
So we've discussed in the last earnings call and or the previous one to that the following, that the CRTs are really locked out. And with the slower prepayments, the lockouts continued to be pretty formidable. So if they all prepay today, we would lose the premium that we've gain because of their increase in value. So why we expect almost no losses in that sector, at least no losses to us, because the lockouts continued to extend its lower prepayments. We're likely to hold vast majority of those for a few years out because our amortization expense is very, very low there right now.
And there are no further questions at this time. I will now turn the call back to you. Please continue with your presentation or closing remarks.
This is Jeff, and Scott, Jim and Mark, thanking everybody for dialing in and listening to us today. By the way, the stock market's reacting. It looks like there are few people out there that are very happy to see our results. As always, for any analysts, you're welcome to call the office and we'll get back to you as soon as we can to address any questions you have. Thank you very much, and have an enjoyable rest of the summer.
Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.