ARMOUR Residential REIT, Inc. (ARR) Earnings Call Transcript & Summary

Good morning, and welcome to ARMOUR Residential REIT Second Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.

Thank you, Drew, and thank you to all of you for joining us on our call this morning to discuss ARMOUR's second quarter 2023 results. With me today are 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 includes forward-looking statements, which are intended to be subject to the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995. The Risk Factors section of ARMOUR's periodic reports filed with the Securities and Exchange Commission describes certain factors beyond ARMOUR's control that could cause actual results to differ materially from those expressed in or implied by these forward-looking statements. Those periodic filings can be found on the SEC's website at www.sec.gov. All of today's forward-looking statements are subject to change without notice. We disclaim any obligation to update them unless required by law. Also, today's discussion refers to certain non-GAAP measures. These measures are reconciled with comparable GAAP measures in our earnings release. An online replay of this conference call will be available on ARMOUR's website shortly and it will continue for one year. ARMOUR's Q2 earnings available to common shareholders was $40 million, which includes $43 million of GAAP net income. We sold the last of our legacy available-for-sale mortgage-backed securities in Q1. Going forward, there will be no mark-to-market items excluded from GAAP net income. We will continue to report total comprehensive income for comparable prior periods as long as they remain relevant. Net interest income was $5.8 million, distributable earnings available to common stockholders was $45.4 million or $0.23 per common share. This non-GAAP measure is defined as net interest income plus TBA drop income adjusted for the net coupon effective interest rate swaps less net operating expenses. Our asset yield of 4.24% less net cost of funds of 2.49% gave us net interest margin of 1.75% for the quarter. ARMOUR Capital Management continues to waive a portion of their management fees. They waived $1.65 million for Q2, which offset operating expenses. This labor will continue until further notice. ARMOUR paid monthly common stock dividends of $0.08 per common share, that's a total of $0.24 per common share for the quarter. We've maintained the $0.08 per share common dividend rate for July and August. As we've discussed on our previous calls, our aim is to pay an attractive dividend that is appropriate in context and stable over the medium term. Taken together with the contractual dividends on preferred stock, farmers made cumulative distributions to stockholders of $2.1 billion over its history. During the second quarter, we issued 15,160,000 shares under our common stock ATM program, raising $77.5 million of capital after fees and expenses. During the second quarter, we also repurchased 425,000 shares of common stock at an average cost of $4.88 per share. That was under our existing standing repurchase authorization. For the first half of the year, our capital activities have been accretive to book value per common share and reducing per share running costs. So far in Q3, we've issued another 21,499,175 common shares, raising net capital of $109.3 million that completes our current ATM program. This brings our common share count to 228,309,234 common shares. Recently, we've approved a new ATM program offering up to 75 million shares through our affiliate BUCKLER and four other agents. Quarter-end book value was $5.38 per common share. Our most recent available book value estimate as of Monday night, July 24 was estimated to be $5.25 per common share. Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm, Scott, if you'd like to discuss in more detail our portfolio position and current strategy. Please go ahead.

Thanks, Jim. Market conditions in the second quarter continue to support our thesis that we are entering into a compelling period for investment in Agency MBS. Spreads remain near historic highs, funding and hedging are widely available. With the Fed nearing the end of the tightening cycle, we believe MBS will offer significant returns through carry, spread tightening or both. Throughout this hiking cycle, U.S. treasuries have had a persistent trend of extreme fluctuations. The 2-year treasury yield surged by 112 basis points from its low 3.78% for the quarter. Simultaneously, the 10-year treasury yield experienced a gain of over 50 basis points, regaining a quarter high of 3.84%. Notably, the spread between these two tenors also made history, closing the week below a negative 100 basis points for the first time since 1981. In response to the portfolio team rebalanced the hedge book to favor a steeper yield curve environment, which we expect will begin later this year. In early May, ARMOUR sold $1.8 billion of the lowest premium specified pools as the looming fight over the debt ceiling greatly increased the likelihood of more volatility in the market. ARMOUR decreased its net portfolio leverage and duration from 8.9x and 1.15x respectively, down to 6.8x and [ 0.87x ] to address this increase in risk. Production coupon MBS underperformed significantly into this event, which presented a good opportunity to buy back exposure to 5.5% and 6% pools shortly after the debt ceiling resolution occurred. The other widely anticipated event was the liquidation of the FDIC portfolio. Net sales of agency mortgage pass-throughs have now surpassed 75% in what has been a remarkably orderly affair. The fear of a major market disruption is faded with demand stronger than initially thought, and we do not expect the remaining liquidation of the FDIC's MBS portfolio to have a material impact on valuations. Despite this, we view the relative valuation of FDIC coupons as too rich versus the opportunities of the coupon stack, where we own over 60% of our mortgage assets. We are maintaining our short position of negative $500 million Fannie, 33% TBAs and have reallocated capital towards Agency CMBS DUS 10, 9.5 pools. These DUS pools are trading at over 100 basis points wide to SOFR swaps, which is almost double the [indiscernible] of lower coupon pools. Coupled this with favorable financing like pools, ARMOUR likes this trade from a total return perspective. Although spreads may remain at these valuations for a while, we see long-term value to positive convexity DUS bonds. Additionally, we've recently allocated over $1.3 billion of recently issued capital in 5% and 5.5%, Ginnie Mae pools. There is 0% risk weighting and wider spreads favor domestic and foreign bank demand in the second half of the year. We feel that the newly proposed banking regulation should provide a greater boost to the Ginnie Mae MBS sector longer term. Our leverage closed the quarter at 7.6x and currently sits at 7.8x as of the 20th of July, a number that reflects attractive valuations and is prudent enough to withstand still elevated and highly unpredictable levels of daily market volatility. Additionally, ARMOUR maintains healthy levels of available liquidity at $714 million which includes cash, unlevered securities and principal and interest receivables as of the 20th of July. Our current portfolio is concentrated in the most liquid low-premium production coupon pools featuring more favorable geographics, LTVs, FICO scores and loan balance characteristics versus generic production cohorts. We continue to favor specified pools over TBAs as we expect no improvement in the deliverable collateral and the implied funding of dollar rolls lag current repo rates. These lower pay-up premium specified stories should perform strongly as demand for Agency MBS remains. Despite seasonal driving up CPRs marginally, these investments reflect historically low prepayment risks and still a significant amount of borrowers are out of the money. ARMOUR's average prepayment rate for all MBS assets in the second quarter of 2023 was 6.3 CPR and still a very low 6 CPR for July. Although mortgage rates have already declined, from the highs of 7.2% in early November of 2022 to 6.8% in mid-July 2023, a substantial refinancing wave will require mortgage rates to fall below 5% in our view. ARMOUR continues to fund just over 50% of its borrowings through our broker-dealer affiliate BUCKLER Securities. Since the debt ceiling resolution, the rebuilding of the Treasury General Account has been orderly and Agency MBS retail funding has been stable. The weighted average haircut on our repo book remained exceptionally low at 2.7% as of the 18th of July. As we've already noted, we set our dividend to be appropriate for the medium term. We will, as always, continue to evaluate the level of the dividend. We're also mindful that this environment can deliver upside prices, surprises that can move our metrics substantially. Thank you very much. And with that, we will open for questions.

[Operator Instructions] The first question comes from Trevor Cranston with JMP Securities.

It looks like you guys -- you mentioned that you added to the portfolio post-debt ceiling in June. It looks like you've continued to add to it to some extent in July. Can you talk about how you guys are approaching leverage overall right now and kind of how high you're willing to go and leverage given the seemingly favorable backdrop for MBS?

Trevor, it's Mark. So we view leverage here as appropriate in that there's still some volatility out there with both rates and spreads. So we feel comfortable where we're at. We think it's appropriate. We do like mortgages a lot, but we do have some dry powder. We think that volatility is going to subside here and rates are basically topped out.

Okay. And can you talk about how you guys are thinking about sort of the supply-demand picture over the rest of the year? And if you think there's any potential catalysts for spread tightening out there, particularly after the FDIC portfolio has cleared the market.

So in -- this is Jeffrey. In Scott's comments, he mentioned specifically our increased exposure to the Ginnie Mae sector. So everyone knows mortgages on a historic basis are achieved the treasuries. There are investors in all sorts of asset classes that are going to be looking at this -- are looking at this and they're going to say, wow, mortgages are really good alternative to corporates or some other assets that they may have, particularly in an environment where you may experience some credit deterioration down the road. Now the reason we increased our exposure to Ginnie's is because the banking rules may positively affect banks' ability to purchase there, but they won't be the only ones. Ginnie's are particularly cheap right now to historically to the Fannie Mae and Freddie Mac counterparties. So catalysts come from buyers from other asset classes. Catalyst for Ginnie specifically comes from banks and other buyers seeing cheap. We have our coupon stack is such that we are not one-on-one affected negatively by the liquidations from the FDIC. And as Mark said earlier, and I think Scott commented, too, we still maintain a short position in one of the coupons that they'll be selling. So we're very comfortable where we are, and we have an optimistic outlook on spreads for the rest of the year.

The next question comes from Matthew Erdner with Jones Trading.

You mentioned getting into CMBS, the DUS pools, what kind of other opportunistic opportunities are you seeing there? And how large are you willing to increase that CMBS position as a percentage of the portfolio?

So as of this morning, I believe, we have $551 million of DUS, which represents 4.5% of the portfolio. We are targeting a number that's larger than that. I think that generally spreads got as wide as $111 million, $112 million to the peak curve. They're $105 million today. We make purchases as low as the $100 million kind of area. We are still selectively looking to buy. Could we take it to 10%, we feasibly could, if they come in quickly, we will stop buying. So we are opportunistically looking to add to the sector. We're going to be very happy down the road that we have that added convexity at really good spreads. Mark, do you want to expand on that?

Yes, just if you look at our history, our DUS position has been, I think, a little north of 20% of the portfolio pre-COVID. We just have to balance the fact that there is no liquid TBA market for DUS. So there is some spread risk there that's a little more magnified than agency pools. So we're just balancing that versus where the spreads are today.

The next question comes from Christopher Nolan with Ladenburg Thalmann.

A follow-up to that question on the CMBS. Are you guys sort of warming up to go back into CRT types securities as the commercial real estate market develops?

We are warming up to continue our exposure to DUS, and we are not warming up to increase our exposure to CRTs.

And on the commercial real estate front, if that turns into a large issue for the commercial banking sector, how do you anticipate that could have impact on residential mortgage-backed securities?