ARMOUR Residential REIT, Inc. (ARR) Q3 2021 Earnings Report, Transcript and Summary

Hello, and welcome to the ARMOUR Residential REIT's Third Quarter 2021 Earnings Conference Call. [Operator Instructions] Please note, today's event is being recorded. I'd now like to turn the conference over to your host today, Jim Mountain. Mr. Mountain, please go ahead.

Thank you, Keith, and thanks to all of you for joining us this morning to discuss ARMOUR's third quarter 2021 results. Today, I'm joined by ARMOUR's co-CEOs, Scott Ulm and Jeff Zimmer; and our CIO, Mark Gruber. 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 these 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 forward-looking statements are included in the Risk Factors section of ARMOUR's periodic reports, which are filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov. All forward-looking statements made in this conference call are made as of today's date only. They are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless we're 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 measures are included in our earnings release, which can be found on ARMOUR's website. An online replay of today's conference call will be available on ARMOUR's website shortly and will continue for 1 year. ARMOUR continues to concentrate its portfolio activity in agency MBS for the foreseeable future. Quarter-end book value was $11.09 per common share, down $0.19 from the end of Q2 2021. This quarter-over-quarter decrease reflects spread widening across our MBS portfolio, which is likely the result of concerns over the increasingly imminent Fed taper and the ultimate direction of several stimulus and debt ceiling bills that continue to consume most of the Congressional calendar. While spread widening negatively impacts the current market value of our existing MBS portfolio, it also often represents improving opportunities for new MBS investments. At September 30, ARMOUR's portfolio consisted of $4.3 billion of agency securities plus TBA positions representing another $4.2 billion. At the close of business this past Tuesday, we estimated book value to be approximately $10.97 per common share. Liquidity, including cash and unencumbered securities, was nearly $900 million, representing almost 78% of our total equity. ARMOUR's Q3 comprehensive income was $13.3 million, which includes $34 million of GAAP net income. Distributable earnings, which excludes gains or losses from security sales and early termination of derivatives as well as market value adjustments but includes TBA drop income, was $24.7 million or $0.25 per common share. You may have noticed that we changed the name of this non-GAAP measure from the prior name we used of core income. We think this better reflects the way we think about this statistic. During the quarter, ARMOUR issued 4,550,825 shares of common stock through our ATM program, raising $49.1 million of capital after fees and expenses. For the first 3 quarters, our capital raising efforts have added about $0.03 to book value per common share. In addition to considering whether these offerings are accretive or dilutive on the margin, we also look at their potential for per share cost savings from spreading administrative costs over a larger share base. ACM, the company's external manager continued to waive a portion of its management fee. That waiver was initiated in the second quarter of 2020. This waiver offset $2.1 million of operating expenses for the third quarter of 2021. For Q4 2021, we expect the management fee waiver to total $2 million. ARMOUR paid dividends of $0.10 per common share for each month in the third quarter for a total of $28.5 million. We've also declared October and November common dividends at that $0.10 rate per share as well as the Preferred C Stock dividends for Q4 2021 at the rate of $0.14583 per share. Now let me turn the call over to co-Chief Executive, Scott Ulm, to further discuss ARMOUR's portfolio position and current strategy. Scott?

Thanks, Jim. Interest rates remained at a stalemate in the third quarter between underwhelming monthly increases in employment and elevated inflation driven by supply chain disruptions and an upswing in pent-up demand. Cognizant of risks that rising prices may prove to be longer than transitory, the FOMC has finally signaled its intention to taper asset purchase amounts down to 0 by mid-2022, with the start date as soon as November 2021. Unfazed by the increasing imminence of the long-anticipated announcement on tapering, bond markets instead focused on the timing and pace of official interest rate hikes likely to follow. As of mid-October, the short-term OIS rates are pricing in approximately 2 rate hikes in 2022, followed by perhaps another 3 rate hikes in 2023. Despite higher expectations for shorter-term borrowing rates, the yield on 10-year treasuries remains below the year-to-date hybrid of 1.75%, muddying the longer outlook for an economic growth recovery. The market seems to be pricing in the looming taper, as seen by the spread widening that happened earlier this year. However, since the second quarter of 2021, option-adjusted spreads on production 30-year mortgages tightened modestly. The wall of cash from the banking community continues to provide a backstop bid to any measurable cheapening from current levels. We see a potential shift in bank demand in 2022. A continuing strong economic recovery could mean opportunity for bank lending portfolios to expand at the expense of their securities portfolios. Nominal premiums on production-specified pools were nearly unchanged in the third quarter, while OAS spreads improved by 3 to 5 basis points. Specified pools have underperformed TBAs in 2021, and we continue to view this sector as rich, supported by demand from outright yield buyers without access to the TBA dollar roll market. The specialness in production dollar rolls is still extraordinarily high. In some instances, TBAs are trading with an implied funding rate of negative 90 basis points, continuing to provide a strong tailwind for earnings. We do expect some of the specialness in funding to start fading slowly as Fed monthly net purchases are set to decline next year. However, the vast majority of worst to deliver bonds remain locked away in the Fed's portfolio, and we foresee strong roll returns persisting beyond the next [indiscernible] months. For now, we continue to allocate approximately 50% of our assets to TBA rolls weighted 60-40 to 15-year and 30-year TBAs. We plan to stay with these proportions until more attractive opportunities in specified pools present themselves. 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. These assets contribute to aggregate prepayment rates that are among the lowest in our peer group and which we believe act as a foundation for stable and predictable earnings ahead. Third quarter prepayments slowed relative to the speeds observed in the past year, providing a tailwind to earnings. ARR's portfolio averaged 12.8 CPR in the third quarter, below the 15.2 CPR from the previous quarter. We expect speeds to remain at similar levels in the fourth quarter. Our implied leverage of 6.7x at the third quarter end, which includes TBAs, is 1.5 to 2 turns below our historical leverage loans. Our lower leverage provides us with dry powder to take advantage of future market opportunities. Despite the Fed's 5 basis point hike to their overnight reverse repurchase rate in the second quarter, funding markets have remained at historic lows to ARMOUR's benefit. Overnight repo rates ranged between 13 and 18 basis points throughout the third quarter with an average of 16 basis points. To remove any potential risks around year-end funding and the debt ceiling increase, we've placed over 90% of our repo maturities out past the year-end. ARMOUR is active with 18 different repo counterparties, and approximately 48% of our principal borrowed is 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'd be delighted to take questions.

[Operator Instructions] And the first question comes from Christopher Nolan with Ladenburg Thalmann.

A couple of quick questions. Jim, was there any nonrecurring expenses or revenue items in the earnings?

I think that the -- from an expense perspective, the answer is no. From a revenue perspective, we did have 1 DUS bond prepaid that had some interest make-whole in that. And I'm looking at Mark and I think that was $2 million?

Yes.

Got you. And then in your comments, did you indicate that the ATM issuance was accretive to book value in the quarter?

Not in the quarter. If you look at the reconciliation in the press release, I think it was $0.01 dilutive for the quarter, and the comment that I made was year-to-date, it's $0.03 accretive.

Great. And then I guess just a general question in terms of the overall market outlook. I mean, I appreciate the color that you guys provided in terms of your macro view. Where do you see long rates going? I mean, they've sort of been moving up and down a bit. And do you have a particular perspective as to what you're expecting for the fourth quarter and into the first quarter on that?

It's Jeffrey. The rise in oil prices recently has caused the curve to flatten a little bit and that's taken some people by surprise. Internally, our year-end target for the 10-year note was 1.75% and we've touched that recently for a cup of coffee. If you have persistent inflation and a lot of it's exhibited itself in energy prices and commodity prices, it's flat or may stay around for a while before you have economic output increase again, with inflation slowing down a little bit. That being said, if the economy continued to perform well, you would expect the 10-year rates to be modestly higher. And the Fed will give us guidance on November 3 in terms of when they're going to do lift-off, which we think would not start until well after they stop taper. So we wouldn't expect lift-off until at least the fourth quarter of 2022. That being said, the way we're hedged, our performance is going to be driven, in the medium term, certainly by what mortgage spreads do. And although everybody in the world expect mortgage spreads to widen a little bit and we do as well, when the Fed winds down, they'll be doing constant reinvestment of their paydowns. And when the Fed gets out of the markets, it brings in other participants who have decided not to participate into the market. And generally, as Scott said in his comments, the Fed's absorbing the worst of the worst of the mortgage deliverable product, okay, and the best stuff's out there for us to buy. And we talked earlier, obviously, about the fact that we're at least 1.5 turns underneath our leverage, which provides a lot of clean air to exceed our dividend rate. So anyway, the short answer is we did expect the 10-year to get up to 1.75% by 10-year. We have achieved that. The bull flattener due to the energy and the concerns around commodity prices, it was a surprise to some but it doesn't affect what we do long term. I hope that's helpful.

Great. It helps, Jeff.

[Operator Instructions] And the next question will come from Mikhail Goberman with JMP Securities.

Wondering how much spread widening you need to see to be able to increase leverage from this point where it is now, and also just a quick question on your outlook for prepay speeds going forward.

Mark, why don't you address our prepay outlook because we have those in our models here for the rest of the quarter?

Yes. For the rest of the quarter, we don't really see really any increase in prepaid speeds. We would assume maybe flat to down just slightly. So for the rest of the -- basically, for the rest of the year.

And so what we're waiting for, and maybe everybody is waiting for this, so we might not have spreads widen so much. Let's see what the Fed says on November 3. It's widely anticipated that they would start to taper, if not toward the end of November, starting in December. And if everybody is expecting that, it'd be hard to believe you're just going to get a big 5 or 10 basis point widener. But you get 5 OAS widener here, we'll start putting a little bit of money to work. And we're not here to pick the wides or what the next perfect opportunity is going to be. We do get paydowns every month. That gives us the ability to take advantage of wideners. If spreads tighten, we'll still have to go ahead and reinvest our paydowns. Does that answer what you're looking for?

Yes, that's helpful.

Thank you. And that does conclude the question session as well as the conference call. Thank you so much for attending today's presentation. You may now disconnect your phone lines.