ARMOUR Residential REIT, Inc. (ARR) Q2 2021 Earnings Report, Transcript and Summary

Good day, and welcome to the ARMOUR Residential REIT Second Quarter 2021 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jim Mountain, CFO. Please go ahead.

Thank you, Sarah. And thank you all for joining our call to discuss ARMOUR's second quarter 2021 results. This morning, I'm joined by ARMOUR's Co-CEOs Scott Ulm and Jeff Zimmer; Mark Gruber, our CIO is also with us this morning. By now, everyone has access to ARMOUR's earnings release, 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 Factors section of ARMOUR's periodic reports filed with the Securities and Exchange Commission. Copies are available at the SEC's website, 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 we are required to do so by law. Also, our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to our most comparable GAAP measure is included in our earnings release, which can also 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 continues to concentrate its portfolio activity in Agency MBS for the foreseeable future. Quarter-end book value was $11.28 per common share. The quarter-over-quarter decrease reflects spread widening across our MBS portfolio, likely as a result of taper discussions and the markets synthesis of this Fed talk about future reductions in agency mortgage purchases. That trend has continued through the close of business this past Wednesday, when we estimated book value to be approximately $10.77 per common share. While spread widening negatively impacts the current market values of our existing MBS portfolio, it also reflects increasing current asset yields and improving opportunities for new MBS investments. ARMOUR continues to enjoy widespread access to repurchase financing, funding our MBS portfolio under attractive terms and pricing, both through its affiliate BUCKLER Securities and through our numerous other active lending counterparties. ARMOUR's portfolio consists exclusively of Agency MBS valued at approximately $4.4 billion plus to be announced positions representing another $3.8 billion of securities. ARMOUR's Q2 comprehensive loss was $61.3 million, which includes $69.2 million of GAAP net losses. Core income, which excludes gains and losses from securities sales and early termination of derivatives as well as market value in adjustments, but does include TBA drop income, was $18.9 million or $0.21 per common share. During Q2, we issued 13,290,759 shares of common stock through our at-the-money programs raising $159.3 million of capital after fees and expenses. That represents an average price of $11.99 per share, which was accretive to book value and exceeded the volume weighted average price of our share trading for Q2. ARMOUR Capital Management, the company's external manager continued to waive a portion of its contractual management fees, which waiver was initiated in the second quarter of 2020. In Q2, the waiver offset $2.1 million of operating expenses. The waiver will remain at that level until further notice by ACM. ARMOUR paid dividends of $0.10 per common share for each month in the second quarter for a total of $26.2 million. We've also declared the July and August common dividends at the rate of $0.10 per share, as well as the stated Series C preferred stock dividends through Q3 2021. The company's remote work environment protocol has allowed us to keep operations fully functional while we worked remotely. All of ACM’s eligible employees are fully vaccinated and we've begun a phased plan to return to working from the company's offices. We expect that to be completed in September of 2021. Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm, to discuss ARMOUR's portfolio position and current strategy. Scott?

Thanks, Jim. Crossroads hit financial markets in July, while COVID seemed to be in retreat in the second quarter, rapidly increasing infections driven by the spread of the delta variant in July sparked concerns about renewed business restrictions. In the opposite direction, the pace of the global economic reopening kept on an upswing with an abundance of liquidity from fiscal and monetary policies. A strong rebound in growth created outsized imbalances between demand and supply of labor and materials, pushing producer and consumer prices above historic averages. Dismissive increases in prices is largely transitory, the Fed has pointed to the low level of labor participation and the existing slack in labor markets is the main reasons to keep its monetary policy accommodative for the foreseeable future. Despite these assurances to the market, the U.S. treasury yield curve flattened significantly, signaling greater uncertainty around the strength of economic growth once monetary accommodation is removed. The outright yields on the ten-year treasury decreased from 1.74% to 1.47% during the second quarter, and dropped as low as 1.19% in July and even lower intraday. Similarly, the yield spreads between the twos, tens and fives, thirties on the treasury curve flattened considerably by approximately 36 basis points and 28 basis points, respectively, in the second quarter. In the mortgage market, the option-adjusted spreads on Fannie 2s widened significantly from their historic types observed in the first quarter. As of June 30, the OAS’ on 30-year Fannie 2s and Fannie 2.5s widened by 14 basis points and 17 basis points, respectively, since the end of the first quarter. For the month of July, we've seen a widening of an additional 3 basis points and 4 basis points in those coupons, respectively. While this widening has impacted book value, it has significantly improved reinvestment opportunities. Spreads are no longer deeply negative, and we foresee a slow but steady normalization in spreads towards historical averages prior to the end of this latest round of QE. Continuing improvement in reinvestment opportunities is an extremely positive development for our business model after a year plus of continued tightening. Nominal outright pay-ups on specified pools rebounded from their lows in the second quarter. The TBA dollar roll specialness is still quite high as deliverable bonds remain locked away in the Fed's portfolio. We continue to allocate nearly 50% of our assets to dollar rolls in 15-year and 30-year TBA markets. The other half of our assets have favorable prepayment protection characteristics, composed primarily of prepayment penalties and DUS and lower loan balances in MBS pools. Second quarter prepayments slowed relative to the prior two quarters, providing a tailwind to earnings. ARR's portfolio averaged 15.3 CPR in the second quarter, below the 17.4 CPR from the previous quarter. We expect spreads to remain – speeds to remain at similar levels in the third quarter. ARMOUR used the past quarter to position this portfolio ahead of the potential changes in monetary policies, with all eyes on the Jackson Hole Symposium in August and the FOMC meeting later in September. Our debt-to-equity ratio of 3.5 times and our implied leverage of 7.2 times, which includes TBAs is 1.5 times to 2 times below our historical leverage levels. Our lower leverage provides us with ample dry powder to take advantage of future market opportunities. Average term and overnight REPO rates ranged between 10 and 14 basis points throughout the second quarter. Despite the Fed's five basis point hike to their overnight reverse repo rate, funding markets continued to stick to their historic lows and are projected to remain dormant into the year-end. ARMOUR is active with 18 different repo counterparties, and approximately 58% of our principal is borrowed with our broker-dealer affiliate, BUCKLER Securities. As I've noted before, we set our dividend policy based on the medium-term outlook on our business. We continue to see our dividend level as appropriate. With that, we would like to take any questions.

Thank you. We will now begin the question-and-answer session. [Operator Instructions] First question comes from Doug Harter with Credit Suisse. Please go ahead.

Thanks. You guys mentioned in your prepared remarks that the returns on new investments are improving. Can you just quantify that where you see incremental investment returns today and just if you could put that in context of where that was three months ago.

Sure Doug, it’s Jeff. Good morning. So, returns on specified pools have improved by 200 to 450 basis points depending on the coupon. There are specified pools now that have double-digit returns. And that's – the way we look at that is we run a generic eight times leverage, 50% hedged, but to a 0.5 duration, sousing all that criteria we're seeing low double digits on some TBAs, that's an asset that might be 10.5% or 11% return, now was 6% perhaps six to nine weeks ago. So that's kind of moves you see in there. The dollar rolls at one point got crazy, you're getting returns of 20%, 22%, and they're now in the 12% to 16% depending on the coupon, and we expect over time that you would see those dollar rolls returns probably go down as the Fed quits buying, but that's a little bit about waiting for [indiscernible]. That will happen, but probably not in this quarter. Now in terms of marginal cash then, you could actually invest equal or better to your dividend rate, if that's what you're asking.

Got it. And then just on that comment you just made about eventually expecting dollar rolls to kind of normalize. I guess just how do you think about portfolio construction and kind of how to think about the trade-off of owning pools versus TBAs in that – with that as a backdrop?

Yes. So right now, we're approximately 50/50 TBAs and specified, and we would anticipate over time that as the Fed moves out of the TBA market, that also specified prices or returns would improve as well. So, at that period of time, we would morph from some of our dollar roll positions into our specifieds, but let's go back even two years ago, we were 20%, 22%-dollar rolls. So, there are and will be always opportunities in the dollar roll market. Now, it's not just the Fed that buys in the front month Doug that helps that out. While the mortgage banker activity is very heavy, they're oftentimes hedging 60, 90, even 120 days out. So, that puts pressure on one, two, three months out of prices. So – and that's what creates the opportunity with the Fed buying in the front month, just exacerbates that makes it even better. So, we anticipate exposure to dollar rolls, but wouldn't be surprised if we talked a year from now and it's 20% to 25% of portfolio.

Great. Appreciate it.

Well, thanks very much for calling in.

Our next question comes from Trevor Cranston with JMP Securities. Please go ahead.

Thanks. To follow-up on the questions about the new investment opportunities, where you guys see things today, do you consider the reinvestment opportunity attractive enough that you would start taking your leverage back up towards your more historical average levels or do you guys want to continue to hold on to some dry powder anticipating that new investment returns could get even more attractive than where they are at currently? Thanks.

Trevor, good morning, it’s Jeff again. We're going to be very slow about increasing our leverage. So, I'm looking at a chart right now. If I go to the last couple of days of April, LIBOR OAS' on Fannie 2.5s were negative 23. Everybody's model is a little different. Okay. I look at them today, they are about 5. Historically, they should be 20 wider than that. Now, we weren't trading Fannie 2.5s 10 years ago either. So, we have to look at what the current coupon is, and a number of your broker-dealer brethrens can provide those kinds of charts for you. I look at Fannie 3s and at that same date in April, they were negative 2 to 5 OAS LIBOR, and I got them about 34 and they could probably widen another 15. So, we're not going to be able to catch the wides, and I anticipate and I think our group anticipates that a lot of the Fed tapering probably just came into the marketplace over the next six weeks. So don't expect to see our leverage go up immediately, but we are studying very closely the reinvestment opportunities as they are now equivalent to what we're paying out in dividends with a number of other coupons. And if we widen further, you'll see us start putting some money to work on. As Scott said in his comments, we’re 1.5 turns to 2 turns lower than our historic leverage numbers. And if we go back up there, that core income is going to be at your dividend rate or perhaps even exceed it.

Got it. Okay. That's helpful. And then looking at the portfolio composition now versus last quarter, it looks like the asset durations are a little bit shorter. And the swap book increased somewhat. Could you just comment on sort of where your duration positioning is at and how that's evolved over the last few months as interest rates come back down? Thanks.

We've targeted over the last two to three years, maintaining a duration of the whole business of about 0.5, but what happens when you see moves in the marketplace like we've seen that duration increases, so what you're seeing from our portfolio is the rally in the 10-year as Scott said, down intraday down to 113 [ph] at one point. Those mortgage prices are quick going up, and they hit a wall, but your hedges don't, right? So, we believe it's temporary, and that duration goes back down, we believe that that will equalize, as the market kind of gets back to what we think is normal, perhaps slightly higher rates and a slightly steeper curve. And that duration, which is now closer to zero would work its way back to 0.4 to 0.5 area. So, the only reason you're seeing those assets get shorter durations is the rally in the marketplace except for the DUS [ph]. The DUS are kind of locked out and they've maintained their duration quality. Now, on the hedge side, I'd say the following. We don't anticipate at this point changing our hedging profile or the way we run our hedge book. I would note that our average pay rate is 68 basis points right now. If you were to put out 10-year OAS this morning, it is about 109. We do have 600 million of real short hedges rolling off within the next 10 months, and we will not replace those. But should we put any new assets on, we will hedge them, assuming 8 or 8.5 times leverage to where we get to a 0.5 duration. That's our target right now. Is that helpful?

Yes, very helpful. Appreciate the comment. Thank you, guys.

Well, thanks for calling in.

[Operator Instructions] Our next question comes from Christopher Nolan with Ladenburg Thalmann. Please go ahead.

Hey, guys Jeff, in recent quarters, you articulated that you were changing the investment strategy to protect book value at the cost of EPS. Given the change in the interest rate environment since then, is there any update to the strategy that you can articulate for us?

No, it's exactly the same despite the book value decrease, if we maintain our historic leverage, you would have seen decreases of similar to what some of the other firms announced, which were 300 to 400 basis points, worse than ours unfortunately. So, we maintain the lower than historic leverage to protect ourselves. And what we saw is a too tight and OAS environment. And turns out we were right. But we can't sell all our mortgages, we're in the business of providing income for our shareholders. So, as they say in that one movie, this is the business that we've chosen. So, we will remain mortgage investors, we are just not investing as much as we normally would in order to protect book value as much as we can, what equalizing and balancing that with the fact that we need to produce a dividend for our investors.

Got it. And then I guess, in Scott prepared comments; he indicated he's seeing an improved investment environment. Could we start seeing guys reenter the non-agency space at all?

You won't see that, no.

Okay. And final question is, what is your outlook for prepayments going forward? I know they're up a little bit in July, but any…

We actually expect them to be level for the next couple months? Now, we are getting a refi burnout here. We've been at very low rates. Ever since 2008, we've been at low rates. And now we've been at low rates, obviously, since April of last year, even lower rates. Our models have shown that's equal to what the Wall Street dealers estimate, for example, August they estimate down 4%, we're going to, we're running them at zero, so no change. They're estimating September, unchanged from August, and we're going to maybe make them up a couple percent, because we usually are very conservative in our estimates. And we haven't estimated yet for October or November. It's too early.

Great. Okay. That's it for me. Thank you.

Thank you very much for calling in.

This concludes our question-and-answer session. I would like to turn the conference back over to Jim Mountain for any closing remarks.

Well, I'd like to thank everyone for joining us this morning. And as always, if there are questions or inquiries in the intervening period between now and when we gather again in another three months, feel free to give us a call at the office or send us a note. Well, as I said earlier, we're still working somewhat remotely through September. So, an e-mail and we'll get right back to you. And speaking of between now and September, August usually is a slightly slower month on the finance business. So, I hope everyone has an opportunity to unplug and recharge for a little while before we get back full speed in September, so until then, stay well.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.