Arlington Asset Investment Corp. (NYSE:AAIC) Q3 2022 Earnings Conference Call November 15, 2022 10:00 AM ET
Rock Tonkel - President, Chief Executive Officer
Rich Konzmann - Chief Financial Officer
John Murray - Portfolio Manager
Conference Call Participants
Doug Harter - Credit Suisse
Matthew Erdner - JonesTrading
Christopher Nolan - Ladenburg Thalmann
Good morning! I'd like to welcome everyone to the Arlington Asset, Third Quarter 2022 Earnings Conference Call. Please be aware that each of your lines is in a listen-only mode. [Operator Instructions].
I’d now like to now turn the conference over to Mr. Richard Konzmann. Mr. Konzmann, you may begin.
Good morning. This is Rich Konzmann, Chief Financial Officer of Arlington Asset. Before we begin this morning's call, I would like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations, and any other guidance on present or future periods constitute forward-looking statements that are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances.
These forward-looking statements are based on management's beliefs, assumptions and expectations, which are subject to change, risk, uncertainty as a result of possible events or factors. These and other material risks are described in the company's Annual Report on Form 10-K and other documents filed by the company with the SEC from time-to-time, which are available from the company and from the SEC, and you should read and understand these risks when evaluating any forward-looking statements.
I would now like to turn the call over to Rock Tonkel for his remarks.
Thank you, Rich. Good morning, and welcome to the third quarter of 2022 earnings call for Arlington Asset. Also joining us on the call today is John Murray, our Portfolio Manager.
Through yet another quarter of challenging financial markets, Arlington’s primary focus of preserving capital in the current market environment once again proved to be beneficial for shareholders during the third quarter, generating a 2.4% economic return, its fifth consecutive quarter of a positive economic return.
Going forward, Arlington’s low leverage and diversified investment strategy continues to be well suited for various market conditions and positioned to generate strong returns for shareholders over time. Overall, we are pleased with the results achieved during the quarter and year-to-date; an economic return of 2.4% during the quarter and economic return of 8% over the last 12 months. We completed the initial sale of a portion of the company's SFR portfolio for net cash proceeds of $42 million in the third quarter, harvesting a $14 million gain.
We entered into an agreement to sell the company's remaining SFR portfolio for expected net cash proceeds of $29 million in the fourth quarter. If that is consummated, the overall strategy will generate a 28% overall annualized return over the last 15 months. 25% annualized total return on the company's MSR strategy during the third quarter while lowering the leverage to 0.2x.
We migrated credit investments upward towards high quality assets with 64% of credit investments in AAA rated assets that achieved a total 18% annualized total return during the third quarter, and we repurchase shares of capital stock that accreted $0.07 per share during the third quarter and $0.27 per share year-to-date to book value.
During 2022, Federal Reserve policy and economic developments have driven valuations and liquidity down and return opportunities on new investments higher.
In general, available return opportunities in certain asset classes have nearly doubled in expected return profile over the course of the year. While we have selectively taken advantage of these higher return opportunities over the course of the year, capital preservation and shareholder value creation have been the company's priorities. In line with that focus, this quarter we reduced leverage and harvested gains, capital and liquidity, and extended our overall patient approach to portfolio management.
The company's low coupon MSR portfolio again produced strong results during the third quarter in both current interest yields of 16% and through further multiple expansion, resulting in a 25% total annualized return. Since we acquired our first MSR investment less than two years ago, strong current cash yields along with asset appreciation have resulted in an annualized total return of 47% while employing modest leverage.
As of quarter end, the company's MSR investments had $190 million of underlying mortgage servicing rights, valued at a multiple of 5.5x with a leverage of only 0.2x. Importantly, with a weighted average coupon of 3.14% in the underlying mortgage servicing rights, the company's MSR investments are well positioned to mitigate declines in value if interest rates should fall.
The significant appreciation and value of the company's MSR investment portfolio has contributed to it becoming the company's largest investment allocation at 41% of capital at quarter end. During the third quarter, the company successfully closed on its previously announced sale of 371 of its SFR properties for a sale price of $130 million, and net cash proceeds of $42 million after pay down of the secured credit facility.
Sale resulted in a net-GAAP gain of $14 million that contributed $0.47 per share to book value during the third quarter. The company is also pleased to announce that it signed a purchase and sales agreement on November 11 to sell its remaining SFR investment portfolio of 251 properties, including the assumption of its secured credit facility for a gross sales price of $87.3 million, which would result in net cash proceeds of approximately $29 million and a slight positive impact to book value.
The sale transaction is expected to close in the fourth quarter and is contingent upon receiving lender consent and other closing conditions. Assuming the second sale transaction is ultimately consummated, it would represent the culmination of investment strategy that we expect would result in a total annualized return of approximately 28% over the investment horizon that's been just over one.
Given the uncertain near to intermediate term outlook for housing, we felt that crystallizing and locking in the 28% return from our SFR strategy was prudent for shareholders. As of September 30 the company's investable capital allocation to its credit investment strategy increased to 20%. The company elevated the overall credit quality of its credit investments with 64% in floating rate AAA rated senior commercial mortgage securities as of quarter end with remaining maturities under five years and that have attractive double digit levered returns.
As of quarter end, 11% of the company's credit portfolio consists of a high performing interest only investment in low LTV non-QM residential mortgages, for which the return is principally predicated on rates instead of credit, and the average coupon of the underlying mortgages is approximately 400 basis points out of the money. Overall, the company's credit investments continue to produce strong returns, delivering an 18% annualized total return during the third quarter.
Also during the third quarter, continued interest rate volatility led to significant widening of agency MBS spreads, resulting in underperformance in values of agency MBS relative to interest rate hedges. Although wider spreads led to increased potential carry returns, the company does not expect to materially increase its investment allocation toward levered Agency MBS in the near term as the risk to capital remains in excess of the current hedge carry return. As of September 30, the company's investable capital allocation to Agency MBS was 14%.
Turning to the results for the quarter, the company reported book value of $6.45 per share as of September, a 2.4% increase from the prior quarter end. The company continued to operate with overall low leverage and significant financial flexibility, with its overall at-risk leverage ratio standing at 1.2 to 1 as of September 30.
For the third quarter, the company reported GAAP net income of $0.10 per share and earnings available for distribution of $0.11 per share, an increase of $0.06 per share from last quarter. We believe there is greater value in Arlington’s business than the public markets recognize, and the company continues to be an active buyer of the company's common stock.
During the third quarter, the company repurchased capital stock that accreted $0.07 per share to book value, including repurchasing nearly 2% of its outstanding shares of common stock. Subsequent to quarter end the company has repurchased an additional 1% of its common stock that accreted an additional $0.03 per share to book value, and since reinstituting its current common stock repurchase program in 2020, the company has repurchased 26% of its outstanding shares. Notably, the company has a substantial remaining authorization of 10.2 million shares or in excess of $32 million of current market capitalization from its board, to repurchase shares of its common stock.
The company has been able to produce solid economic returns during a period of challenging market conditions, including an 8% return over the last four quarters. As our investor presentation illustrates compared to our peers, in the FTSE NAREIT Mortgage Home Financing Index, the company had significantly outperformed our peers in total economic return in both recent quarters and the last 12 months, while also experiencing the lowest volatility of quarterly economic returns over the last year.
During this period, the company is focused on preserving capital and creating economic shareholder value, principally through a combination of low leverage, prudent high return asset selection and a strong emphasis on share repurchases. As we approach year end, we believe that market volatility around fed tightening and the period of elevated interest rates, maybe somewhat more prolonged than the most recent market actions imply.
Having monetized $42 million from our third quarter SFR sale and another expected $29 million from our pending fourth quarter SFR sale for a total of $71 million, Arlington is an attractive investment platform in a strong and flexible position with low leverage, high return assets, sound overall credit quality and substantial liquidity available from our current balance sheet configuration.
We have worked hard to successfully position Arlington to both preserve capital and grow book value per share through recent market turmoil. In the current economic environment, we now intend to use Arlington’s strong position to capitalize on new opportunities as they may arise and continue to create and harvest substantial value embedded in Arlington for its shareholders.
Operator, I would now like to open the call for questions.
Yes, sir. Thank you. [Operator Instructions]. We’ll go ahead and take our first question from Doug Harter with Credit Suisse.
Thanks Rock. As you mentioned, you have a large remaining authorization, you know just a high percentage of your outstanding float. How do you balance, you know continuing the value you see in the stock versus kind of declining liquidity in the stock and kind of the negative scale of impacts of continuing to shrink the business.
Well, I think Doug that the approach we've taken over the last two years has proved itself out in the results. That approach has been predicated on a combination of investing in high return, high risk adjusted return opportunities that we see, at the same time buying significant amounts of the shares of the company. Over that two and a half year period we bought about 10 million shares I believe, and at the same time we've made some successful investments, high return investments in certain categories that have worked to add to capital aggregation as well.
So I think that approach has worked well, and I think that formula we would expect to continue that. Again, keeping a prudent eye on markets today with a focus on capital preservation and as we said, seeking alternatives to create and harvest value for the shareholders opportunities in that regard.
Thank you, Rock. And then I guess talking about the MSR portfolio that has you know – I guess how are you thinking about that at current levels, obviously current nice attractive yield. You've already received a lot of attractive appreciation in it. Would you be willing sellers of it? Do you want to continue to accumulate? Kind of what are your thoughts around the MSR portfolio?
As we've said in the past Doug, I think that portfolio has grown in value substantially and even at the same time as our purchases have been modest through this year. So we have incrementally added to that portfolio, but most of the growth in that capital allocation has come from appreciation in the asset. And so as we sit here today, we're not really aggregating additional MSRs in the present market and at the margin, as I think we've said in the past you know, folks shouldn't be surprised if they see us wheel that portfolio down to some degree over time.
So I think we probably are at our peak for capital allocation to that absent further appreciation which might take it up or incremental sales which might take it down, and that's a process that we're examining all the time as you can imagine for the best use of capital. And as we sit here today, clearly this asset still has very high performance associated with it. It certainly is appreciated and so there is a different element of price risk to it today than there than there was over at various points over the last two years.
But as we sit here today, with an asset that generates double digit unlevered returns and can be moved up with incrementally small leverage, that's a pretty attractive asset. So you know, and today at these valuations given the coupons in the asset, there's less duration risk to the asset as we sit at these valuations and keep in mind, there's no credit risk, right. These are strong underlying assets that sit below these servicing rights.
So overall we think it's a pretty powerful asset opportunity, and if we feel like there are sufficiently attractive bids for components of it, then we would look to push that capital allocation down somewhat, but we don't anticipate it moving up except to the extent there's further appreciation.
Great! Thank you.
Our next question comes from Jason Stewart with JonesTrading.
Hey guys! This is Matthew on for Jason this morning. Congrats on a good quarter! So following up on the MSR, what's your view of the directionality of it from here? We're near natural housing turnover lows, so CPRs are bottoming, so if rates kind of stabilize in this level, what are your views on the multiple going forward?
Well, I guess that depends in part Matt on overall risk markets and risk parameters, right. So you know the prepayment profile is pretty steady, and remember these are almost 400 basis points out of the money. So you'd expect them to continue to be pretty steady from a prepayment perspective and pretty protected and therefore the cash flows to be quite high on the one hand.
On the other hand, the discount rate may move around based on movements in risk markets. So to the extent we see a rally in risk markets and ongoing strength in general risk markets, then you know we wouldn't be surprised to see that discount rate come down and the multiple come up at the same time. And the inverse is true as well, to the extent that there's a significant risk off type move, then it's possible that the discount rates could move up somewhat and the multiple move down somewhat.
We have seen that at one or two points over the course of the last – the latter part of this year. We have seen movements up in discount rate, so that's been part of the normal course and even as the discount rate is moved up, obviously you can see the valuation has moved up. So from here, I would say that the valuations depend more on the discount rate movement and overall risk parameters in the broader markets.
Yeah, thank you. And then did you guys provide an updated book value number quarter-to-date.
I’d say we are about flat, best estimate is approximately flat.
Great, thank you. And then any other updated thoughts on dividend for share repurchases.
Maybe possibly a little bit up, flat to a little bit up. Say that again Matt?
Do you have any updated thoughts on dividend for share purchases?
No change in view there. At this level, at $0.50 on the dollar, the stock continues to be very interactive and so you know we – as we said we have been consistent buyers of it. So at this stage I don't think there's a – not a meaningful change in our view.
Awesome! Thank you guys.
Our next question comes from Christopher Nolan with Ladenburg Thalmann.
Hey Rock! Hey Rich!
Hey! Your comments Rock in terms of in the second half sale of the SFR portfolio, that you're also part of the packages your financing facility. Should we read into that, you're sort of walking away from the SFR portfolio for the moment, SFR?
Yes, for now that’s the case, yes.
Okay, great. And then the decline in the at risk leverage.
We feel – by the way, we still feel that the overall long term housing dynamic is positive. Just as I said in the script, that the near to intermediate term outlook suggested to us, the uncertainty around that near to intermediate term outlook suggested to us that locking in a 28% overall return was the right thing to do for shareholders.
Okay. And then so as we move forward into 2023, how do you see the portfolio composition? Is the SFR – excuse me, will the mortgage servicing rights go up or credit investments go up. I mean, you sort of indicate that you're not really interested in the RMBS portfolio growing.
Well, that'll depend, right. I think that depends on where opportunities – how we see opportunities unfold here over the next few months. I think we've seen since – as I said in the script, we've seen return opportunities in certain asset classes nearly double in the last - throughout the course of this year from the combination of upward movements and absolute rates and the significant widening and investment spreads.
So that's left a broader field of opportunities within the credit spectrum that could fit in our warehouse. Why? Because the very high credit quality opportunities with shorter duration have evolved to a point where they can be attractive opportunities, attractive enough opportunities to be compelling.
So I think for now, assuming that the MSR portfolio is not moving around substantially, which I spoke to that earlier, then the opportunities that we see in front of us are generally liquid products with returns in the low to mid double digits pretty consistently.
Now, I would say that I think our overall view is that while there's been a significant movement and adjustment in publicly traded risk markets, in our view there's still a significant reckoning in the private markets in adapting – and assets and companies adapting to a higher cost of capital and we expect that through the course of ’23 going into’23 and through the course of ’23, that may create opportunities that are very attractive for investors in our space and those we will be keeping an eye on.
It's a little early, yet for some of those to take advantage of and as I said, in the meantime we will remain in a capital preservation mode first, and stay with the formula that's derived as value for shareholders over the last year, year and a half, two years, which is keeping leverage modest, keeping liquidity high, reserving capital, staying in high credit quality assets and seeking to drive double digit returns on capital in intelligent investments, and at the same time seeking to use where we can our repurchase authorization, which has obviously been an important emphasis for us now for a good long while.
Final question, and talking about the repurchases, any thoughts about just putting in a token dividend, just so you guys can broaden the potential universe of funds that might invest in you?
A - Rock Tonkel
Well, we're always serving the landscape and we're evaluating that question constantly for the best use of capital, new investments, repurchasing shares, dividend, and obviously you've seen – we've seen the incremental increase in the earnings power of the company and so the company at least in the fourth quarter – in the third quarter had an earnings profile shift up to a degree, which is some more supportive of improving aggregating capital or other uses, repurchasing shares, etc.
So we wrestle with that. We feel like we're in a good position to wrestle that question and for now I don't have anything new to say on that topic, but I think it's a good question and we will wrestle with that again in the fourth quarter and beyond.
Okay, thank you. That was a nice quarter Rock.
And Mr. Tonkel, there are no further questions at this time.
Okay, thank you very much. I appreciate it. If you have any follow-up, please reach out.
Thank you ladies and gentlemen, that does conclude today's program. You may disconnect at any time.