ARMOUR Residential REIT - Q1 2024

Transcript

Operator (participant)

Good day, and welcome to the ARMOUR Residential REIT first quarter 2024 earnings conference call. Today, all participants will be in a listen-only mode. Should you need assistance during today's call, please signal for a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on your telephone keypad. To withdraw your question, please press star, then two. Please note that today's call is being recorded. I would now like to turn the conference over to Mr. Scott Ulm, CEO, ARMOUR Residential REIT. Please go ahead, sir.

Scott Ulm (CEO)

Good morning. I'd like to welcome you to the ARMOUR Residential REIT first quarter 2024 conference call. This morning, I'm pleased to welcome our new CFO, Gordon Harper, as well as our new co-CIOs, Sergey Losyev and Desmond Macaulay, to the call. All are experienced members of the ARMOUR team, whom we promoted to their new roles in March, and I have tremendous confidence in them all. Gordon has been with us since 2015, and Sergey and Desmond have been on our portfolio management team since 2016 and 2013, respectively. We're all excited to lead the business into this next chapter. Our priorities are unchanged, and we are all united on our focus on delivering value to shareholders. I'll now turn the call over to Gordon to run through the financial results. Gordon?

Gordon Harper (CFO)

Thank you, Scott. 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, describe 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 will continue for one year. Now, turning to results for the quarter. ARMOUR's Q1 GAAP net income available to common shareholders was $11.5 million, or 24 cents per common share. Net interest income was $5.3 million. Expenses included $9 million of non-recurring professional fees related to the special committee internal investigation. Distributable earnings available to common stockholders was $40.4 million, or 82 cents per common share. This non-GAAP measure is defined as net interest income plus TBA drop income, adjusted for interest, income, or expense on our interest rate swaps minus net operating expenses. ARMOUR Capital Management continues to waive a portion of their management fees, waiving $1.65 million for Q1, which offsets operating expenses. The waiver continues until further notice.

ARMOUR paid monthly common stock dividends of $0.24 per common share per month, for a total of $0.72 for the quarter. We aim to pay an attractive dividend that is appropriate in context and stable over the medium term. Taken together with the contractual dividends on the preferred stock, ARMOUR has made cumulative distributions to stockholders of $2.3 billion over its history. Quarter-end book value was $22.07 per common share. Our most recent current available estimate of book value is as of Tuesday, April 23, and was $20.48 per common share. I will now turn the call over to Scott Ulm to discuss ARMOUR's portfolio position and current strategy.

Scott Ulm (CEO)

Thanks, Gordon. I know you've all seen our disclosure in the K&Q about the events of this spring, and I'd like to address this upfront with some highlights and detail. I, of course, refer you to the K&Q for the company's definitive disclosure and further detail. A variety of issues were raised just prior to our Schedule 10-K filing related to non-GAAP disclosures, the board's internal review processes, potential conflicts of interest, and the external manager. The board followed best practices and formed a special committee of independent directors. The special committee engaged outside counsel and a national accounting firm to review all of these issues.

The investigation, which was comprehensive, extended through our customary filing schedule and the 12b-25 extension, but did conclude in time for the special committee, the broader board, and our auditors to review the results and file our 10-K by the March fifteenth deadline. The special committee found that our use of earnings available for distribution and NIM were appropriate. You'll find in our press release a revised presentation of economic interest income, which makes clear that includes swap payments as a non-GAAP measure. As to the other matters raised, the investigation found no substantiation of any of the matters raised and found that the independent directors of the board complied with their fiduciary duties. There was a finding that in the course of the investigation, there was an issue with Tone at the Top that constituted Material Weakness.

The tone set by certain individuals during the investigation was insufficient to create the proper environment for effective internal control over financial reporting. As you've seen, the result of all this was streamlining our management structure to a single CEO and a number of remedial measures, including training on appropriate tone at the top, internal controls, reviewing tone at the top, and enhanced whistleblower reporting. As you know, we had a number of personnel changes, including the removal of our CFO for matters unrelated to the investigation and the resignation of our CIO. We're fortunate to have a deep bench, and as I said at the beginning of the meeting, our CFO, Gordon Harper, has been with us a long time and spent 25 years prior to joining us at Deloitte. Our co-CIOs both bring extensive experience with our portfolio and deep backgrounds in MBS investment.

Now let's talk a bit about the mortgage business. Following the sharp decline in the fourth quarter of 2023, treasury yields reversed their path and climbed higher in 2024. Despite the Fed's dovish outlook on inflation to start the year with seven rate cuts penciled in for 2024 and 2025, recent economic data has signaled otherwise and forced bond investors to once again abandon overly optimistic expectation of Fed's rates. Following a trend of hotter than expected inflation and labor data releases, the yield on the 10-year treasury climbed above 4.65% by mid-April, totally moved more than 75 basis points from its low of 3.88%, recorded on the last trading day of 2023.

The yield spread between two-year and ten-year treasuries remained inverted at an average level of negative 34 basis points in the first quarter, posing a challenge for MBS investors and particularly mortgage REITs and banks. We expect a wide-ranging spread environment with elevated volatility to persist until the yield curve reverts to its upward sloping shape. In the first quarter, newly originated MBS traded within roughly 20 basis points of nominal spread range, closing the quarter roughly flat versus the fourth quarter. The zero volatility OAS on ARMOUR's portfolio tightened by approximately 7 basis points on the heels of a strong performance in March to contribute to a 1.1% total economic return, 4.4% annualized for the first quarter.

April's strong inflation print ended the expectations for lower Fed rates in the first half of 2024, causing a sharp widening in mortgage spreads by 10-15 basis points and a rise in 10-year Treasury yields by 30 basis points. Reflecting the broad sentiment shift on Fed policy staying higher for longer, ARMOUR executed a series of trades aimed at repositioning the portfolio with a view of higher yields and volatility to dominate the second quarter. First, we sold approximately 50% of our 10-year DUS pools and in turn purchased higher premium coupon conventional MBS with a shorter duration profile. While DUS spreads continue to exhibit favorable positive convexity, lower spread volatility, and diversification benefits compared to our MBS assets, their outperformance in recent quarters has allowed us to capture 10-15 basis points of spread return and reinvest proceeds into cheaper mortgage assets.

Second, ARMOUR sold over 40% of our deep discount MBS pools with coupons of 3.5% and lower, where faster prepayment speeds have never materialized. We reinvested a portion of these proceeds into higher premium Ginnie Mae TBAs, which stood to benefit from the backup in mortgage rates while still trading at discount to their, the conventional equivalents. Lastly, ARMOUR sold over 10% of par coupon MBS versus treasury hedges, closing the basis trade that benefited most from the spread rally in March. As the market closed on April twenty-third, the portfolio's implied leverage and duration sit at 6.9 times and 0.5 times, respectively, 0.5 years, respectively, while maintaining healthy levels of available liquidity. Our book value since the start of the quarter is down 7%.

We believe recent spread widening is priced in a more hawkish Fed path, and as a result, mortgages now offer a compelling upside in a scenario where inflation and growth begin to moderate. Our mortgage strategy continues to target a well-diversified portfolio. About half of ARR's mortgage assets are higher coupon MBS, which are experiencing slow prepayments due to historically elevated mortgage rates. Around 40% of our current holdings are in coupons of 5% and lower, with specified characteristics favoring faster turnover speeds while priced at a discount. ARMOUR's average prepayment rate for all MBS assets in the first quarter of 2024 was 4.5 CPR and a still low 6.6 CPR for April. The benign prepayment environment continues to favor mortgages that are supported by attractive, fundamental, and relevant valuations.

ARMOUR has increased its allocation to funding with Buckler Securities to approximately 60% of its borrowings as of quarter-end. This reflects Buckler's growth as a broker-dealer and ARMOUR's benefit of financing through its affiliate. In the first quarter, repo markets generally priced around SOFR plus mid- to high-teens in basis points with a weighted average haircut at under 3%. As our trading activity indicates, we've turned more cautious on mortgage spreads for the remainder of the second quarter. We'll continue to dynamically adjust our risk profile as we continue to analyze the interest rate, new macroeconomic data, geopolitical risks, and reaction to the evolving environment by market participants and the Fed. Looking further out, we remain constructive on spreads over the longer horizon.

We expect that the Fed will eventually start its much-anticipated easing cycle later this year, leading banks to increase their share of net MBS purchases on improved net interest margin. We also expect rate volatility to decline as the date of a first Fed cut becomes more certain, attracting more MBS investors, including crossover buyers, that may want to increase their allocation to MBS at the expense of tighter corporate spreads. We continue to believe that our dividend level is appropriate for this environment. Thank you for joining today's call. That wraps, or that wraps up our prepared remarks for the first quarter of 2024, and we'd be happy to take any questions.

Operator (participant)

Thank you. We will now begin the question-and-answer session. As a reminder, to ask a question, you may press star then one on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then two. At this time, we will pause momentarily to assemble our rosters. Today's first question comes from Jason Weaver with JonesTrading. Please go ahead.

Jason Weaver (Analyst)

Hi, good morning. Actually, I'm with JonesTrading. I wanted to ask Scott, regarding your prepared remarks, on Buckler, if you were detecting any change in the availability of general repo credit out there, given the volatility over the last month?

Scott Ulm (CEO)

You know, repo's been just fine. You know, it's, you know, obviously, we monitor that extremely carefully, and we are, you know, active with a whole bunch of counterparties, as well as being sort of on the inside with Buckler. But repo's been well-behaved.

Jason Weaver (Analyst)

Okay, fair enough. And then on the expense side, I was curious how long you plan to continue waiving the management fee, as well as if there's any lingering sort of enhanced compliance costs coming from the results of the internal investigation.

Scott Ulm (CEO)

So first of all, on the waiver, we expect to continue that. Obviously, it's a function of, you know, of portfolio dynamics here, but we've had it since COVID and expect to continue. You know, as to enhanced compliance, you know, as I mentioned, the focus on tone at the top is very real and is part of our internal controls now. So, you know, that is certainly an area of focus.

But other than that, you know, it's and some of the other things I mentioned with regard to to NIM and its new formulation in economic interest income, you know, the we remain in the same place we've always been, which is take great care with this stuff.

Jason Weaver (Analyst)

All right. Thanks for that. I appreciate you taking the question.

Operator (participant)

The next question comes from Doug Harter with UBS. Please proceed.

Doug Harter (Analyst)

Thanks, good morning. Hoping you could talk through a little bit more of the decision to reduce the portfolio size, in April, as you're kind of balancing kind of the near-term volatility that you might said with kind of the longer-term optimism, you know, on current spread levels.

Scott Ulm (CEO)

Thanks, Doug. I'm gonna turn that one over to Sergey.

Sergey Losyev (co-CIO)

Hey, yeah. Good morning, Doug. Thank you for your question. Yeah, so we took a series of trades that we discussed in our earnings script, the early Q2. We felt like mortgage markets were pricing in very well in dovish Fed path. And the high inflation print that we saw early April really kind of triggered a wide portfolio rebalancing to reflect kind of a pushback on the future path of the Fed rates. Now, we are looking at this as only Q2 event, really quarter by quarter. We do still see easing cycle beginning at some time later this year. So, we're just kind of seeing this as a grand theme of second quarter as elevated volatility.

We have geopolitical risks, as well as the strong economic data really kind of moving the markets here a little bit. So we felt it was prudent to reduce our leverage below seven, target duration of about a half a year, and then, you know, be able to go and deploy the dry powder when we feel the time is right.

Doug Harter (Analyst)

I guess, just on the leverage, how are you thinking about the right level of leverage over time? And what's kind of the ability, appetite to kind of allow leverage to move higher when you have these pockets of volatility?

Sergey Losyev (co-CIO)

Yeah. So, you know, it just kind of goes in line with the previous answer. We have about, at least a turn of leverage to deploy, currently. But we do still see some residual uncertainty in the market until we confirm with a few more data prints on inflation and labor markets to determine whether this is just a blip or a change in the, change in the seas. So, I think you can see us being aggressively buying into the market once we figure out, you know, the horizon past the second quarter.

Doug Harter (Analyst)

All right. Thank you.

Operator (participant)

As a reminder, if you do have a question, please press star then one on your telephone keypad. The next question comes from Trevor Cranston with JMP Securities. Please proceed.

Trevor Cranston (Analyst)

Hey, thanks. A follow-up on a question about the expenses. Just, just to clarify, are there, were there, would you expect to see any more of the sort of one-time expenses coming through in April, or was that exclusively in the first quarter?

Scott Ulm (CEO)

I think we've accrued pretty well for it, but, you know, you know how these things go. There's always something that dribbles in, but I don't think it will have anything... Even if there is some dribbling later on, I don't expect it to be significant.

Trevor Cranston (Analyst)

Okay, got it. Then, you know, given the, you know, the reduction in the MBS portfolio here in April, can you also maybe comment on any changes you've made to the hedge book, either with swaps or treasuries, in the early part of April?

Scott Ulm (CEO)

... Desmond, why don't you jump on that one?

Desmond Macauley (co-CIO)

Yes. Hi, Trevor. In line with some of our asset sales, we've also adjusted our hedge book as well. We've been trying to aim for 0.5 duration, about half the duration. So our hedge book is we dynamically allocate treasuries and swap hedges along those lines. So yes, we've been making adjustments as we do our asset sales, adjusting our hedges as well, to keep our duration within a framework that we feel comfortable with, given the environment that we're in.

Scott Ulm (CEO)

Okay, got it. That's helpful. Thank you.

Operator (participant)

The next question comes from Christopher Nolan with Ladenburg Thalmann. Please proceed.

Christopher Nolan (Analyst)

Hi. Thanks. Related to the special committee investigation, you mentioned that you hired outside counsel and an accounting firm. Is this the same accounting firm that does your audit?

Scott Ulm (CEO)

No. They were a national accounting firm and not Deloitte.

Christopher Nolan (Analyst)

All right. Is that any reflection on your confidence in Deloitte?

Scott Ulm (CEO)

Not at all. These things, you always hire somebody independent to help, and, you know, that's best practices. But, you know, you just wouldn't use your regular account for this sort of work.

Christopher Nolan (Analyst)

Okay. And you repeatedly mentioned Tone at the Top, and then you also mentioned conflict of interest. Is the Tone at the Top financial related to conflicts of interest or other?

Scott Ulm (CEO)

It's other. And, you know, this is, this is all, you know, bound up at the, the COSO framework, which is a, you know, control, framework that, that we use. You know, and, and, the way it works is that, you know, Tone at the Top, which, you know, is a, you know, which is a broad measure, but, you know, and, and but recognized as a critical part of, of, effective, effective controls, you know, leads into the, the, whole network of financial controls. It's part of that. So that's, you know, that's where that goes. It's pretty clearly laid out in the, in, the K and the Q. You know, you see the broader COSO framework and then how this fits in as part of it.

But it's unrelated to conflict of interest, though.

Christopher Nolan (Analyst)

Gotcha.

Scott Ulm (CEO)

On which there were no findings.

Christopher Nolan (Analyst)

There were no findings on the conflict of interest?

Scott Ulm (CEO)

Correct.

Christopher Nolan (Analyst)

Okay. And then final question: Given that the Q mentioned apparently gave all material, you know, clean bill of health for the financials, is it fair to say that we're not—we should not expect a restatement of past results?

Scott Ulm (CEO)

That's correct.

Christopher Nolan (Analyst)

Okay, that's it for me. Thank you.

Operator (participant)

At this time, we are showing no further questioners in the queue, and this does conclude our question-and-answer session. I would now like to turn the conference back over to Scott Ulm for any closing remarks.

Scott Ulm (CEO)

Thanks, all. Appreciate you participating in the call, and as always, if something occurs to you later on, give us a ring. We're all here. Thank you.

Operator (participant)

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