ARMOUR Residential REIT, Inc. (ARR) Q1 2018 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the ARMOUR Residential REIT Incorporated Fiscal First Quarter 2018 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, April 26, 2018. Now I'd like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead, sir.

Thank you, Tommy, and thank you all for joining our call to discuss ARMOUR's first quarter 2018 results. 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 www.armourreit.com. This conference call may contain statements that are not recitations of historical fact, and therefore, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such 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 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 to do by law. Also, our discussion today may include reference 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 first quarter GAAP net income was $44.7 million, or $0.96 per common share. Core earnings were $32 million or $0.66 per common share, which comfortably exceeded our dividends paid. Based on stockholders' equity at the beginning of the year, core earnings represent a 9.7% ROE annualized. Differences between GAAP and core income are mostly due to the treatment of TBA drop income and unrealized gains on our interest rate contracts. We paid dividends of $0.19 per common share for the first quarter of 2018 for a total of $24.1 million or $0.57 per common share for the quarter. We've announced April and May common dividends of $0.19 per share to shareholders of record on April 13, 2018 and May 15, 2018 payable on April 27 and May 30 respectively. Quarter-end book value was $24.61 per common share, down $2.01 for the quarter, due primarily to rate increases and a lesser extent to the spread widening. Adjusted for dividend that represents a total economic return of a negative $1.44 or a negative 5.4%. As a reminder, we include updated estimates of book value per share in company updates available on our website. Book value at April 24, 2018 was estimated to be around $23.69 per common share outstanding. ARMOUR's quarter-end portfolio consisted of over $6.2 billion of agency securities, plus another $4.3 billion of agency TBA positions. Our credit risk and non-agency positions totaled $1 billion at March 31. In addition, we added $700 million approximately of U.S. treasury securities as of March 31. Now let me turn the call over to co-Chief Executive Officer, Scott Ulm and Jeff Zimmer to discuss in more detail ARMOUR's portfolio position and current strategy.

Thanks, Jim. Beginning of 2018 saw a sharp reversal from 2017, a year marked by low volatility and strong returns across fixed income products. The volatility in the stocks -- stock and bond markets as measured by the VICs [ph] and move into seasons rebounded sharply, while the yields on tenure treasuries reached their highest levels since January 2014. With such a turbulent backdrop, the agency MBS Index posted negative 1.2% returns, it's worse first quarter total return performance over the past 20 years. Because of higher durations, 30 year MBS underperformed the 15 year sector while lower coupons fared worse than higher coupons. Similarly Agency CMBS index posted a negative 1.2% total return, while outperforming a 7 to 10 year U.S treasury benchmark return of negative 1.9%. Despite such unfavorable market term our credit risk transfer bonds or CRTs issued by Freddie and Fannie returned to positive 1.1% to 1.4% in the first quarter. It seems unlikely as we study the credit worthiness of our CRT portfolio, that we should experience any meaningful degradation of quality given strong U.S. housing fundamentals. A relatively small non-agency legacy portfolio remained positive and contributed to results with an average of 1% of total return for the first quarter. As of April 24, our funded leverage ratio or debt to equity is approximately 6.1%, a somewhat higher number from the 5.8 ratio observed at the end of 2017. During a period where rates increased in the first quarter we added five year and seven year treasury notes, at what we believe were good risk adjusted yields versus lower coupon mortgages at the time. Additionally we faced no mortgage basis risk or widening on those treasuries. Adding in the leverage of fact of unfunded TBA dollar roll positions results implied leverage of 8.3 as of April 24. While TBA dollar rolls do not have the extreme levels of specialness observed prior to the beginning of the Fed Taper program, most TBA coupons continue to imply lower financing rates than those obtained through the general collateral repo market. This funding advantage existed long before the QE program and we expect it to remain an important component of our agency MBS strategy. We expect the Federal Reserve to announce three more federal funds rate increases in 2018 and we have taken steps to limit our sensitivity to these hikes and heighten market volatility. As of March 31, 2018 we maintain a hedge book of pay fixed received floating swaps of $6.8 billion no show. Our agency fixed rate asset repo position is covered 110.8% by swaps. Our net duration is 0.54, a decrease from 0.80 on December 31, 2017. This number does not include any negative duration effects from our repurchase liabilities. Our spread DVL1 is $4.87 million a decrease from $5.35 million on December 31, 2017. Despite lower risk exposures, we anticipate that core earnings will cover our dividends during the second quarter of 2018. The average prepayment rates on our agency assets has decreased for the third consecutive quarter to 6.3 CPR. This rate is our lowest quarterly rates since the second quarter of 2014 and the 6.9 CPR level for April ranged well below the 2017 average of 7.3. Prepayment risk has clearly faded with the increase in treasury rates. It is important to note that a good portion of our agency portfolio excluding TBAs is composed of assets with prepayment protection through seasoning lower loan balances or contractual prepayment lockups in our DUS paper. As such as rates go up the average life of these assets do not extend like typical MBS. Repo financing remains consistent and reasonably priced for our business model. ARMOUR maintains MRAs with 46 counterparties and is currently active with 27 of those for total financing of $6.85 billion at the end of the first 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 portfolio liabilities. Financing through BUCKLER provides us a greater security of financing, the flexibility on terms, attractive rates and therefore an overall greater control over our liabilities. Lower haircuts from financing with BUCKLER also reduced our liquidity requirements. Our investment in credit risks transfer securities was valued at $866.7 million at the end of the first quarter and represented 89.5% of our credit risk in non-agency portfolio. The performance of this sector has been exceptional since ARMOUR began investing in the first quarter of 2016. We have been rewarded both by the spread tightening that has occurred in the sector and by the attractive carry. Our weighted average CRT coupon as of the end of the first quarter was 6.37% with a weighted average discount margin of 4.5%. In the CRT transactions we take the credit risk of recent Fannie and Freddie underwriting and return from an uncapped floating rate coupon. The combination of strong mortgage underwriting standards of the GSCs and increasing housing prices have provided a robust underpinning to the credit quality of the CRT box. In addition, these securities benefit from increasing credit enhancement overtime, that can lead to credit rating upgrades and we expect several securities in our portfolio are potential candidates for future upgrades. These upgrade results in prices appreciation and better financing terms. While our value and gains above par will amortize overtime the affect is remarkable [ph], about 1% of our CRT book value over the next two years, and is likely to be further reduce by lower prepayments and the higher rate environment. While gross portfolio allocations will show a much larger quantum of agencies on our balance sheet we believe the clearest way to think about capital allocation is equity committed to financing haircuts in these sectors. Our allocation to credit assets as a percent of all haircuts and repo at the end of the first quarter was approximately 43%. Equity that's not tied up in financing haircuts is our liquidity and that liquidity is available to support any partner for OREO. At the end of the first quarter, ARMOUR owned $84 million of non-agency legacy RMBS. At the moment we see very few opportunities for investment and in to 2008 and prior non-agency and MBS assets class. However, 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. Our principal concerned for the balance of 2018 is the turbulent geopolitical background. If this becomes more prevalent, strong economic growth expectations will be hampered and stock market and bond volatility will increase. In the midst of the current plain hiking cycle, such developments raise the risk of a flatter or even an inverted yield curve and higher risk premiums. At this point, we believe those factors to be somewhat transient and we expect strong economic growth expectations to reemerge to the forefront of investment guidance for the markets. We've positioned the portfolio and our hedging needs to reflect these potential hurdles ahead, while still allowing us to return an attractive risk adjusted return. Operator, that concludes our prepared remarks. We'll now take the questions.

Thank you very much. [Operator Instructions] And we get our first question on the line from Douglas Harter with Credit Suisse. Please go ahead.

Good morning guys. This is actually Josh Bolton on for Doug. Just one question on leverage, with the increase you guys saw in the quarter, how are you thinking about current leverage? Are you comfortable running in the eights or should we expect some repositioning in from unlining to moderate leverage back down? Thanks.

Hey, Josh, good morning it's Jeff. So leverage is where we want it to be and we are quite comfortable with it right there. When the book value does go down as it did in the first quarter, you will get a natural obviously increase in leverage. But at a 3% ten year note there are interesting opportunities to my assets. I would not expect this to have any meaningful increase in leverage from here. But within the half a turn you can see at the end of the quarter either way. In none of the terms of investment opportunities, as I just noted the dollar rose low to mid-teens right now, specified premium balanced assets are low to mid-teens. If you look at about a 7.5 times leverage it starts like a one duration. So those are the kind of returns you are getting, our leverage is a little higher than that.

Great, make sense. And then just one quick one on funding cost, can you remind us the cost benefit you guys get for funding through BUCKLER rather than street repo?

So I talk about that in the last two earnings calls, that we had targeted initially in the five to seven balance sheet range. The competition in the repo market as you may be aware, has actually limited our direct savings from BUCKLER. But this is a really good thing for ARMOUR REIT. You might be aware that there has been a backlog of companies trying to get approved by up and running -- by CD [ph] and as we were approved last fall, so were six to seven other companies have come through. So they are all trying to get balances on -- into their new corporate enterprises. So the aggressiveness in the repo market has benefited ARMOUR considerably. I would note that down the road as that kind of -- that market stabilizes and that group isn't quite as aggressive, that you'll actually be able to identify some larger direct savings from BUCKLER but on the balance we are very pleased with BUCKLER's performance.

Great, thanks for the color, Jeff.

You bet. Have a great day.

Thank you very much. [Operator Instructions] And our next question on the line of Christopher Nolan from Ladenburg Thalmann & Company. Please go ahead.

Hi, thanks for taking my questions. You mentioned on the call that Buckler is handling roughly 50% of liabilities if I heard correctly. How much hard can we expect that to go?

I would say right now we’re exactly where we want to be and that’s what we targeted originally. So the only reason you would see that change a little bit, if for example, we sold some actually hard assets that we have repoed out and go into some dollar rolls. We won’t necessarily just BUCKLER or one of our other repo counterparties would just let that roll off. But within a given range of where it is right now we would expect to see it at least over the next couple of quarters.

Great and Jeff, just a follow up on the prior question. If I understood you correctly you’re expecting 5 to 7 basis points of funding advantage, which you did mention earlier calls that you are coming in a little bit lower than that, is that correct?

Yeah, we are but it’s a really good thing because the reason that we are is because the competition in the repo market has made pricing so much better than it had been prior to these new six or seven companies getting accepted by the FICC. So just to be clear the business model is for those that have outside clients. BUCKLER currently, the vast, vast majority of what it does is for ARMOUR REIT. The business model is you need to build up your book and typically if you maintain fair pricing you don’t see people move their repo from you very much. So these companies are all out trying to build up $5 billion to $10 billion books and so they’ve been very aggressive in pricing. So it’s benefited ARMOUR REIT considerably.

Great, thank you for the clarification. Also in the TBAs, if $4.3 billion from TBAs which is roughly 50% or so of your balance sheet asset, how high can we expect the TBA volumes to go given the size of your balance sheet, or is that not the right way to look at it?

Absolutely. I have TBAs that down currently on March 31 as 24.9% of our portfolio. And that’s kind of where we’ve been targeting. Are you referencing some numbers that I'm not familiar or we just don’t know?

Just looking at the total assets in the balance sheet, the $8.4 billion?

I'm looking at the March 31.

Jeff, let me answer. Hey it’s Mark Gruber. What you’re seeing on the balance sheet because of the TBAs are classified as derivatives, any forward sales don’t get put on the balance sheet. So the net position is actually I think $2.3 billion as at the end of the quarter, but you net out some forward sales that happened in April.

Okay, so $2.3 billion is really the correct number, not 4.3 in this respect?

I think it’s 2.3. I have to go check when you net it, but I think there’s another disclosure in the MD&A that has been there.

You don’t have to. I'm just trying to get a clarification. So roughly you guys are up -- the TBAs are roughly 25% or so of total balance sheet assets which is normally the limit I would think?

There is no limit but we’re targeting that or less right now, I wouldn’t anticipate us seeing that go much higher. The opportunities [technical difficulty] the pricing is very-very good and we had anticipated after the move of the Fed from being so involved in the last seven years that those opportunities wouldn’t exist on indeed they are. So we’ve been utilizing them and when you see a reduction, if you do see it in our dollar position it’ll mean just because of the opportunities aren't there.

Got you, my final question is from the comments that you’re talking about in terms of the outlook for 2018, should we infer from that you’re sort of anticipating a steeper yield curve or should I get a clarification in terms of how you think the interest rate environment will evolve and how are you trying to position balance sheet from that?

Our corporate position right now is that we’re going to see more of a flat there, but it might be at slightly higher rates than we are right here because if the Fed indeed does increase two more times, or three times, very hard to see a steepening unless you see the ten year get up to 3.70 or 3.74 and we personally don’t expect the ten year not to -- our next target range would be 3 to 3.25, we will just move from here. So expect a little bit more of a flattening there. However we’re 48 basis points as when I last looked to two and tens and we’re still making opportunities and the total of 13% range for specified pools in dollars also thus far the flattening has not hurt our business model.

Great, thank you. I’ll get back in the queue. Thank you.

Thank you very much. Actually Mr. Mountain we have no further questions on the line. I’ll turn it back to you.

Well thank you, Tommy, and again thank you all for joining the ARMOUR's first quarter 2018 conference call. As always if you have questions coming up in the intervening period, give us a call at the office. We'll try and get back to you as quickly as possible. And until next time, have a great day.

Thank you very much. And ladies and gentlemen this concludes the conference call for today. We thank you for your participation, ask you to disconnect your lines. Have a good day everyone.