ARMOUR Residential REIT, Inc. (ARR) Q2 2017 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the ARMOUR Residential REIT Incorporated Second Quarter 2017 Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded, Thursday, July 27, 2017. I would now like to turn the conference over to Jim Mountain, Chief Financial Officer of ARMOUR Residential REIT. Please go ahead.

Thank you, operator, and thank you all for joining ARMOUR’s second quarter 2017 earnings call. This morning, I’m joined by ARMOUR’s co-CEOs, Scott Ulm and Jeff Zimmer; and our Chief Operating Officer, Mark Gruber. By now, everyone has access to ARMOUR’s earnings release and Form 10-Q, which can be found on ARMOUR’s website. This conference call may contain statements that are not recitations of historical fact and therefore, constitute forward-looking statements within the meaning of Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to Safe Harbor protection 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 Factor section of ARMOUR’s periodic reports filed with the Securities and Exchange Commission. Copies 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 by law. Also, our discussions today may include reference to certain non-GAAP measures. A reconciliation of these measures to the most comparable GAAP measures 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 Q2 GAAP net income was $29.7 million, or $0.70 per common share. Core earnings were $29.4 million, or $0.69 per common share. That represents an annualized return on equity of 10.3% based on book value at the beginning of the quarter. Differences between GAAP and core income are mostly due to the treatment of our TBA dropped income and unrealized gains on our interest rate contract. ARMOUR does not use hedge counting for GAAP reporting, and fluctuations in the fair value of our open interest rate swaps is a dominant factor in GAAP income, while the inversely-related mark-to-market on our Agency Securities flows directly into shareholder’s equity. We paid dividends of $0.19 per common share during each month for Q2. That’s a total of $21 million, or $0.57 per common share. Today, we also paid common dividends of $0.19 per share for July, and we’ve announced August common dividends of $0.19 per share for shareholders of record on August 15, 2017, which will be payable on August 28, 2017. As previously announced, on June 30, we completed an offering of 4.5 million shares of ARMOUR common stock, priced to ARMOUR at $25.96 per share. The offering delivered net proceeds of $116.7 million after expenses and lifted ARMOUR’s common equity market capitalization over the $1 billion mark. At June 30, 2017, ARMOUR’s book value was $26.40 per common share, up 3% for the quarter. The net dilutive effect of Q2 share issuance was $0.06 per common share. Now to put that number in context, the average daily change in book value due to movements in interest rates and mortgage spreads for 2017 to-date has been $0.10. For the resulting 12% increase in the common share base reduces per share administrative costs, so we expect to earn this dilution back in about eight months. As a reminder, we will include updated estimates of book value per share in our monthly company updates available on our website, www.armourreit.com. ARMOUR’s quarter-end portfolio consisted of over $6.9 billion of Agency Securities plus another $2.4 billion of agency TBA positions. Our non-agency positions totaled $1 billion at June 30, with a substantial majority being the credit risk transfer securities that have continued their strong performance in Q2. Our mortgage-backed securities portfolio was financed with approximately $6.3 billion of borrowings under repurchase agreements. Our lending counterparties continue to compete vigorously for our borrowing business. ARMOUR’s interest rate hedge positions were $5.2 billion of notional coverage at the end of June. Now, let me turn the call over to our Co-Chief Executive Officers, Scott Ulm and Jeff Zimmer to discuss ARMOUR’s portfolio position and current strategy. Scott?

Thanks, Jim. Good morning. In addition to the customary SEC filings, we also continue to provide a company update, which is furnished to the SEC and available on EDGAR, as well as our website, www.armourreit.com. The company update contains a considerable amount of information about our portfolio, our hedge book and our repo financing book. These company updates along with the comments we made during our last earnings call provide our shareholders and analysts with substantial information on the state of the company. Thus, the quarterly financial report that we filed last night should contain very few surprises for any of our listeners today. ARMOUR realized total shareholder return of 12.6% and total economic return of 5.3% for the second quarter of 2017, or 21.1% annually. Additionally, core income exceeded dividends declared and paid for the fourth quarter in a row. Our book value increased by 3% during the quarter. Second quarter earnings benefited from slower prepays and a benefit from penalty payments on DUS prepayments. DUS prepayment penalty added approximately $1.1 million, or $0.03 to earnings this quarter. In the future, we cannot count on these positive effects to earnings. As of July 25, our book value was $26.50, up 0.4% in Q3 versus Q2. The prepayment rate on our agency assets declined during the quarter from 8 CPR in the first quarter to 7 CPR in the second quarter. Our portfolio paid 7.5 CPR in July. Please note that a good portion of our agency portfolio, excluding TBAs is composed of assets with prepayment protection through lower loan balances or contractual prepayment lockouts. Our notional swap position increased from $4.2 billion at the end of Q1 to $5.2 billion at the end of Q2. Repo financing remains consistent and reasonably priced for our business plan. ARMOUR maintains MRAs with 44 counterparties and is currently active with 26 of those for total financing of $6.3 billion at the end of Q2. We carefully analyze opportunities for longer-term financing and will add this to our book when it looks attractive. In addition, we anticipate that our affiliate, BUCKLER Securities, will become operational during the third quarter. Financing through BUCKLER is expected to provide us greater security of financing, as well as contribute to a lower cost of funds. On June 30, we completed a 4.5 million common share offering in block trade format. Our decision to issue equity was driven by attractive spreads available in agency assets, as well as increasing operational efficiency. The proceeds are completely invested as expected or somewhat better, given the rate back up immediately after the offering. We estimate that this transaction will add approximately $0.085 per share to earnings over the next year. The agency portfolio is comprised of six major components, not including the TBA dollar rolls. As of June 30, 47.8% of our agency portfolio was comprised of 25 and 30-year maturity fixed rates, currently maturing between 241 and 360 months, 32% of which have a $175,000 loan balance or less. 23.4% of our agency portfolio was comprised of 15-year final maturity pass-throughs with a weighted average seasoning of 62 months. 34.7% of those 15-year pass-throughs have loan balances less than or equal to $175,000. 23.2% of our agency portfolio was comprised of Fannie Mae Multifamily bonds or DUS, which stands for Delegated Underwriting and Servicing bonds. The DUS bonds we purchased are generally locked out from prepayments for the first 9.5 years of their 10-year expected maturity. Any prepayment penalties received due to early payoffs can enhance the yield on the bonds. At the end of Q2, our DUS bonds had a weighted average maturity at the end of the lockout period of 6.5 years. The bullet like maturity of these assets means, they roll down the curve over time, much like a corporate bond or treasury note, providing great potential to trade tighter, particularly as they approach benchmark areas like the 5-year treasury note. In addition, these bonds are subject to an early redemption penalty. These call payments provided us with approximately $1.1 million of additional revenue in the quarter. It is not possible to predict whether we will receive additional payments in future periods. 2.6% of our agency portfolio was comprised of 20-year fixed-rate assets, maturing between 181 months and 240 months with a weighted average seasoning of 153 months. Our 10-year final maturity or shorter agency assets represent 1.6% of our portfolio. Our $74.2 million ARM position, 1.1% of our agency assets has a weighted average reset of 11 months. $28.6 million of our agency portfolio are interest-only securities. These act as interest rate hedges and can have positive carry. At the end of Q2, we had dollar rolls with a net notional value of $2.1 billion. We continue to see certain TBA dollar rolls at very attractive levels versus owning and financing bonds. We actively monitor the attractiveness of risks and return in dollar rolls and may increase or decrease this position depending on market conditions. We believe that our current investments in non-agency assets will provide attractive and stable returns going forward, enable us to operate at a lower leverage multiple and reduce the risks associated with swaps. Our equity allocation to non-agencies is approximately 47%. As a bright-line statistic, we define that equity allocation as a percentage of our equity tied up in haircuts from repo, while gross portfolio allocations will show a much larger quantum of agencies on our balance sheet. We think the purest way to think about capital allocation is equity committed to financing haircuts in each sector. Equity that is not tied up in financing haircuts is our liquidity, and that liquidity is available to support any part of the portfolio. Over a year ago, we began accumulating non-agency assets with a focus on credit risk transfer or CRT Securities, a position which was valued at $868.8 million at quarter-end. We’ve been rewarded both by the spread tightening that has occurred in this sector over the last year and by the attractive carry. Our weighted average CRT coupon as of the end of the first quarter was 5.7% with a weighted average margin of 4.5%. In the CRT transactions, we take the credit risk of recent Fannie and Freddie underwriting in return for uncapped floating rate coupon. We continue to believe that housing trends and strong mortgage underwriting will give a robust underpinning to the credit quality of the CRT bonds. In addition, these securities benefit from increasing credit enhancement over time that can lead to credit rating upgrades. One of our securities has been upgraded to investment grade, and we feel several other securities and portfolio will be candidates for upgrade in the year ahead. As of June 30, ARMOUR owned $17.2 million of non-agency NPL, RPL securities or non-performing and reperforming securities. This position has declined since last quarter as some of our season deals were called. We’ve not added any of this asset class to our portfolio in the last three quarters, as spreads tightened in the sector to a level that could not provide the company with a levered yield available in other investment opportunities. At the end of Q2, ARMOUR owned $93.2 million of non-agency legacy MBS. Today, we see very few opportunities for investment in the 2008 and prior non-agency MBS asset class. Our existing assets from that period continue to perform well as they run off. Like many market participants, we continue to hope for a revival in the jumbo securitization market. While we have owned more significant amounts in the past, our new issue jumbo MBS exposure is only $19 million. The third quarter has started well for us. We continue to face the same principle issues: rates, spreads and prepayments. In addition, we have the continuing discussion on when and how the Fed may change policy on reinvestment or sale of its MBS portfolio. We anticipate that the Fed will likely begin to taper its reinvestment this fall. While more than that MBS supply without the Fed suggests higher spreads, we also note that spreads remain relatively wide from a multiyear perspective. More widening in MBS is always possible, but investment-grade and high-yield spreads are quite tight. While there has been much discussion about the Fed halting reinvestment in its MBS portfolio and even potentially beginning to dispose of assets, we see a variety of constraints there to suggest the Fed will take the utmost care to avoid market disruption. We expect another Fed hike this year, most likely in December. Prepayments will likely move up a bit this quarter, but should remain within expectations and constrained by our prepayment protected assets on the agency side. We see the U.S. economy is continuing to make progress, but with headwinds from domestic challenges with productivity and weak economies abroad. The Trump administration’s policies hold the potential for both positive and negative effects on our operations. We feel that the pace of change is likely to be moderate. We have positioned the portfolio and our hedging to reflect this assessment of heightened risk while still allowing us to earn our dividend, which we feel is sustainable based on current investment opportunities and funding rates. Operator, that concludes our prepared remarks. We’ll now take any questions.

Thank you. [Operator Instructions] Our first question comes from the line of Douglas Harter with Credit Suisse. Please go ahead.

Thanks. Can you talk about your outlook for volatility and the cost – how you view the cost of – the cost-benefit of reducing risk today?

Hey, Doug, it’s Jeff. So if you look at the history of our leverage, our leverage, as reported as of June 30, is the lowest it’s ever been. In conjunction with, as Scott mentioned, 30-year OAS spreads are why they have been in the last four or five years going back to beginning of QE3 in September 2012. So functionally having modestly lower leverage than, at least, that we’ve ever had and maybe versus the peer group and as well as noticing that the primary investment opportunity being in dollar rolls with OAS that are historically very wide, despite what the Fed may do with tapering put us in a position to be defending against increased volatility. Now, I would also say that volatility can expose itself in other areas. For example, the funding rates could add volatility to earnings, but not necessarily volatility to the book value. And in response to that, the fact that we seem to be very close to opening up BUCKLER Securities will help us in our funding.

On BUCKLER Securities, can you talk about what might be the funding benefit there? And how big that needs to get to to offset the cost of running that?

Sure. So depending on the net relationship between FICC funding and the funding that we might otherwise get from our normal set of counterparties, you could see 5 to 7 basis points in our business planning model. We anticipate anything above $3 billion of funding, based on our business model would start dropping right down to the bottom line.

Thank you.

Thank you.

[Operator Instructions] Our next question comes from the line of Trevor Cranston with JMP Securities. Please go ahead.

Hi, thanks. I just wanted to follow-up on the comment you just made, Jeff, about thinking about potential for volatility to increase in the future and defending against that. Given how low the level of and pride volatility is in the interest rate market today, how are you guys thinking about that in terms of your hedge positions and potentially, using some optional hedges in addition to the just regular swaps you have in place now? Thanks.

So with the addition to the CRT position, which started 17 months ago or so, that does not need hedging. We really have to only focus on the non-agency side of our balance sheet, which is a percentage of our equity allocations greatly reduced in over 16 to 18 months ago after the purchase of JMI. So we have in the past used the different derivatives to give us optionalities, swaptions or forward starting swaps. Our current analysis, despite what we’ve heard some others say is that, the necessity of the expense related to that derivative exceeds their usefulness for our purposes right now.

Got it. Okay, that’s helpful. Thank you.

You’re welcome.

And there are no further questions on the phone lines at this time.

Well, thank you, everybody, for joining us. Please, as we’ve always said at the end of our earnings calls, all four of us are available at the office. So please call with any questions. We’re very pleased to have had another good quarter and look forward to talking to you in three months. Have a good day.

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.