ARMOUR Residential REIT - Q2 2024

Transcript

Operator (participant)

Good morning, and welcome to the ARMOUR Residential REIT's Second Quarter 2024 Earnings Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's remarks, there will be an opportunity to ask questions. To ask a question, you may press star then one on your touch-tone phone. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to you, Scott Ulm. Please go ahead.

Scott Ulm (Co-CEO)

Thank you, and good morning, and welcome to the ARMOUR Residential REIT second quarter 2024 conference call. This morning, I'm joined by our CFO, Gordon Harper, as well as our co-CIOs, Sergey Losyev and Desmond Macauley. 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 factor 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 discussions refer 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 continue for one year. Turning to results, ARMOUR's Q2 GAAP net loss available to common stockholders was $51.3 million or $1.05 per common share. Net interest income was $7 million. Distributable earnings available to common stockholders was $52.5 million or $1.08 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 and futures contracts minus net operating expenses. ARMOUR Capital Management continued to waive a portion of its management fees, waiving $1.65 million for Q2, which offsets operating expenses. This waiver continues until further notice. ARMOUR paid monthly common stock dividends per share of $0.24 per common share per month for a total of $0.72 for the quarter.

Taken together with the contractual dividends on the preferred stock, ARMOUR has made cumulative distributions to stockholders of approximately $2.3 billion over its history. Quarter-end book value was $20.30 per common share. Our most recent available estimate of book value is as of Monday, July 22nd, which was $20.37 per common share. In July 2024, the voluntary notice of dismissal by the plaintiffs of the previously filed appeal in the Javelin Mortgage Investment Corp. shareholder litigation was processed by the courts. I'll now turn the call back to Scott Ulm to discuss ARMOUR's portfolio position and current strategy.

Scott Ulm (Co-CEO)

Thanks, Gordon. The second quarter marked what could become a turnaround point for the Fed, and its fight on inflation initiated just over 2 years ago. Overcoming months of mixed economic data, May and June consumer prices finally affirmed the disinflationary trend toward the Fed's 2% annual inflation goal. Cooling prices, along with a rising unemployment rate, set the market expectations for the start of an easing cycle to commence at the September 18th FOMC meeting. The market is currently pricing in 2.5 cuts this year and another 4.5 cuts by the end of 2025. While we acknowledge that the trajectory of economic activity has shifted notably, we continue to evaluate each month's data and remain cautious against pricing in too deep of a cutting cycle. We can all recall a bit of overenthusiasm on the path of rate cuts last year.

The yield on a 10-year U.S. Treasury closed the second quarter at 4.4% after reaching 4.7% in early April, and as of July 22nd, it just hits just above 4.2%, the first quarter closing level. Mortgage-backed securities remain range-bound between roughly 135 and 155 basis points in nominal spread the quarter. Despite an overall range-bound environment in the second quarter, interquarter trading remained choppy. MBS nominal spreads finished the second quarter 10 basis points wider, while the SOFR swap rate in the intermediate and longer part of the curve shifted 12-15 basis points above their respective marks at the end of the first quarter. These factors were the driving contributors to our negative 4.8% economic return in the second quarter. As of July 22nd, ARMOUR's book value was $20.37 per share after accounting for July's dividend of $0.24.

Looking ahead, we expect lower rates and eventual normalization of the yield curve to provide exceptionally strong tailwinds to the MBS market, the mortgage REIT sector, and ARMOUR REIT specifically. A full 25 basis point cut in the official overnight rate will flush out the cash sitting in short funds and overnight reverse repo facility into high-quality assets like U.S. MBS. It won't happen overnight, but with every subsequent interest rate cut, this momentum will build and multiply. We expect bank portfolios to follow a similar strategy. Owning mortgages right now is, in many cases, a negative carry versus short-term borrowing rates. Yet we've already seen bank demand flip positive for the first time since 2022. Once the 25 basis point cut is implemented, MBS carry will turn decisively positive and provide an even greater momentum to MBS demand from banks.

We're noting similar strong inflows into MBS mutual funds and ETFs this year and expect them to persist into the cutting cycle as flows into fixed income accelerate. So taking all these factors together, we expect the Fed's actions to have a very profound impact on us and the markets. We believe we could see mortgage spreads move 10-15 basis points tighter into the year-end, but the path there will not be a straight line. So we continue to stay disciplined in the way we approach leverage and putting cash to work. Now I'd like to ask Desmond Macauley to give some more detail on our mortgage strategy and how it has evolved this quarter. Desmond?

Desmond Macauley (Co-Chief Investment Officer)

Thanks, Scott. Our mortgage strategy continues to target a well-diversified portfolio with approximately 10% market value exposures across each of the discount coupons from 3% and up, while maintaining our overweights to 5.5% and 6% coupon MBS for their wide ZV option-adjusted spread and carry. While historically low existing home sales are keeping prepayment speeds in discount coupons very low, their spreads offer a compelling value for an eventual thaw in the housing market and consequently a pickup in turnover speeds thus improving their yield returns. ARMOUR's average prepayment rate on MBS assets in the second quarter of 2024 was 7.7 CPR, increasing from 4.6 CPR in Q1. A large portion of the increase was driven by speeds in discount coupons, where the rate lock effect is expected to dissipate even more as home loan season and mortgage rates turn less expensive.

This benign prepayment environment and near par prices continue to provide a tailwind for MBS. It is worth noting that we are starting to see an uptick in the mortgage refi index, signaling that prepayment speeds should continue to rise gradually into the year-end. However, greater prepayment concerns would require a more significant drop in mortgage rates below 5% and are easily mitigated in higher coupon MBS by moving our exposure towards the middle of the coupon stack. Additionally, we continue to see value in lower premium specified pools tied to Geos, lower FICO, and higher LTV loan characteristics, which will mitigate prepayment risk in the scenario of lower mortgage rates versus the more generic MBS cohorts.

We also maintain around 12% of the portfolio in forward TBA contracts for the attractive dollar roll carry in premium coupon Ginnie MBS and for better market liquidity versus specified pools in lower coupon conventional MBS. ARMOUR continues to fund 50%-60% of its MBS portfolio with Buckler Securities, and the remainder is diversified among 14 other counterparties with a weighted average haircut of just under 3%. The repo markets remain liquid and well-bid. However, we began observing some funding pressures in SOFR rates and repo spreads towards the end of June.

While it's a normal turn of events to see some upward pressure on funding costs into the quarter and year-ends, rates remained 2-3 basis points above running averages into July, indicating that this year's record Treasury issuance is beginning to weigh in on primary dealer balance sheets and their ability to intermediate bonds quickly and efficiently. We see the start of an easing cycle and rising expectations to an end of the quantitative tightening program as two major tailwinds to alleviate some of the pressures in funding spreads for the dealer community. Looking forward, we remain constructive on spreads over the medium to longer horizon as we await the start of an easing cycle to drive the steepness of the yield curve back to historical norms.

A positively sloping curve is much needed to support the inflow of fresh funds into the MBS market, a major tailwind for mortgage REITs. Yet in the near term, we are mindful of the fact that mortgage spreads are trading near this year's tights and a rebound in macroeconomic data from its current trajectory would roll back an aggressive pricing of easy Fed expectations. With the disinflation story already priced in, we turn toward the labor market data in the coming months to indicate the health of economic growth. For now, we have increased our exposure to MBS at 7.7 turns of implied leverage and trimmed our duration risks to 0.1 year as of July 22nd. We have 1-2 turns of leverage to deploy at better risk-reward levels and as we see increased demand from the banking community.

Our earnings available for distribution sufficiently covered our dividend for Q2. We believe our current dividend is appropriate, and we expect earnings to cover the dividend rate into the year-end. Our primary focus remains on generating total economic return on our portfolio to deliver to our shareholders. I'll now turn the call back to Scott.

Scott Ulm (Co-CEO)

Thanks, Desmond. I'd like to comment on capital raising. We've not been active raising capital this year because of an equity valuation that was just too low. Our thinking on raising equity remains as it has been. We will look to raise equity if there are good investment opportunities and we can achieve a fair price, all factors considered, including whether it would lower per share expenses and minimize a negative impact on our stock price. But we'll always look for prices that make sense for our shareholders. At this point, we're less likely to be involved in the preferred market. As you know, our preferred remained fixed once they entered the call period, a feature we're very pleased with given where today's floating levels would be. We look at our dividend over the intermediate term rather than focusing on short-term market fluctuations.

We continue to believe that our dividend is appropriate for today's environment. You can also expect us to continue the fee rebate we've had in place. Thank you for joining today's call. That wraps up our prepared remarks for the second quarter of 2024. We'd be happy to answer any questions. Operator.

Operator (participant)

Thank you. We will now begin the question-and-answer session. To ask a question, you may press star then one on your touch-tone 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'll pause momentarily to assemble our roster. Our first question comes from Doug Harter from UBS. Please go ahead.

Doug Harter (Analyst)

Thanks. Desmond, let's just go into a little bit more about some of the potentially bullish kind of outlook for MBS. It's obviously priced in that the market is going to have cuts. Just how much of that do you think is kind of already reflected in MBS, or does the actual kind of current carry cause more incremental investors? So just trying to get a sense of how MBS markets are already thinking about those cuts.

Sergey Losyev (Co-Chief Investment Officer)

Yeah, good morning, Doug. This is Sergey Losyev. I'll try to answer your question and see if Desmond has any follow-up. But yeah, currently, as Desmond mentioned, our view is very constructive on kind of medium and long-term horizon. Near term, we do see the markets have priced in a lot of easing already. So we feel like the inflation slowdown has been digested by the market. Right now, we're watching the labor markets to give us a sign if more aggressive Fed cuts on the horizon should be in play. But in terms of interest rate markets, we feel like that's very well priced in. In terms of mortgage spreads, we also feel like near term we are trading near year-to-date tights.

But we have very strong conviction that as we start the journey on the Fed easing cycle, that's going to really impact the spreads tighter. Additionally, one other thing maybe is not being talked a lot about yet is the potential and the quantitative tightening program. We feel like the markets could start pricing it in sooner than later as bank reserves could continue to wind down. So a couple of these factors is what we're looking for in terms of really giving the boost. It's going to be a long journey. In terms of banks entering the market in full force, we've already seen it this year finally turning the net demand positive. But the first cut will actually turn their carry positive. So I think that will be a real big boost to the spreads.

As you know, there's a ton of money market funds sitting on sidelines ready to enter fixed income markets as well. So we're looking for signs of the first cut to really change that equation additionally too.

Doug Harter (Analyst)

Appreciate that, Sergey. And then just one other question. On the Treasury hedges you have, what is the duration of those hedges?

Sergey Losyev (Co-Chief Investment Officer)

Yeah, so on the Treasury specific, we have Treasury shorts in the 10-year part of the curve, and we use Treasury futures, and those are kind of barbelled between the 2 and the 10-year part of the curve. As you know, swap spreads are really tightening in here. So we're starting to see as owning swaps more favorable. As you know, we have really big hedge book and interest rate swaps as well.

The duration.

Doug Harter (Analyst)

Great. Appreciate that. Thank you, Sergey.

Operator (participant)

The next question comes from Jason Weaver from JonesTrading. Please go ahead.

Jason Weaver (Analyst)

Hey, good morning. Thanks for taking my question. Can you just briefly discuss how your leverage trended interquarter in Q2 and whether that was greater at the beginning or nearing the end?

Sergey Losyev (Co-Chief Investment Officer)

Good morning. Yeah, thank you for your question. Yeah, our leverage has increased towards the end of the quarter as we saw confirmation in economic data that the Fed is on track to begin cutting rates potentially later this year. So as we saw economic data come in, as we saw FOMC meetings express the fact that we're getting closer to the target for the Fed, we began to increase leverage into the quarter end and currently running 7.7, as Desmond has mentioned.

Jason Weaver (Analyst)

All right. That's down from the 7.8, I guess, just due to a little bit of spread tightening since then.

Sergey Losyev (Co-Chief Investment Officer)

I'm sorry, I was part two here. Could you repeat that, please?

Jason Weaver (Analyst)

No worries. I'll actually move on. And then alongside with Desmond's comments, this is a little bit difficult to ask, but where is the range you see as the real inflection point for prepays on benchmark 30-year mortgages? I'm really asking about the post-2022 vintage paper.

Sergey Losyev (Co-Chief Investment Officer)

Yeah, so on the production coupons, 5.5s and 6s, it would take usually 25-50 basis points of incentive to begin refinancing. As you know, so we're still quite a bit of way there. So I think when we see rates rally towards those levels, we'll reevaluate the coupon positioning. As we mentioned, a few things we're doing right now is kind of adding specified pools that have better convexity and prepay protection versus more generic cohorts. And then the other step would be to migrate lower coupons. Now, our book is very well diversified. We have 10%-8% discount coupons across the stack. So we remain very liquid and tactical across the coupon stack.

Jason Weaver (Analyst)

Got it. All right. Thank you. That's helpful color.

Operator (participant)

The next question comes from Jason Stewart from Janney. Please go ahead.

Jason Stewart (Analyst)

Hey, good morning. Thank you. I wanted to go back to the capital raising question. If we look at your outlook for mortgages and the 1-2 turns of leverage and where the stock's trading, I mean, how likely are you to take leverage up before raising capital, sort of let book value drift higher, or are you more likely to capitalize on where the stock is now in the investment environment, given your view?

Scott Ulm (Co-CEO)

You know, I think we're fortunate we've got some flexibility. We don't, we're not tied to capital raising to manage the portfolio. As Desmond mentioned, we feel we've got some dry powder there that we could take advantage of things. And as we all know, capital raising opportunities come and go. So I think the two are fortunately a little bit disconnected, not ultimately disconnected, but a little bit disconnected within the concept of a turn or a bit more of leverage.

Jason Stewart (Analyst)

Okay. All right. Thank you for that. And then so far in 3Q, obviously, we use pretty stale data from 1Q to project where book value is, but 2037 is a little light. Is there any meaningful moves in July on the portfolio or the hedge side that would be notable?

Scott Ulm (Co-CEO)

I don't know.

Sergey Losyev (Co-Chief Investment Officer)

No, nothing to that.

Scott Ulm (Co-CEO)

Yeah, go ahead.

Sergey Losyev (Co-Chief Investment Officer)

Sorry. Sorry. Yeah, nothing to report as of yet. Our hedge book tactic is very dynamic right now. As you know, our hedge ratio is very close to one if you assume that our TBAs follow the path of refund pools as well. But we continue evaluating every day. But right now, there's no changes to report.

Jason Stewart (Analyst)

Okay. Thanks for that. Last one for me, and I'll jump out. The increase in coupon, increase in CPRs on really discounted coupons, I'm going to call it four and below, would be my likely guess is the most impactful. Is there any way to quantify that increase quarter-to-quarter on net interest spread or earnings?

Sergey Losyev (Co-Chief Investment Officer)

This is a number we'll probably have to come back to you on, but just roughly speaking, yeah, 4.5 and 4s contributed kind of close to 1/3 of the increase quarter-over-quarter in CPRs. And we're starting to see other coupons pick up there as well. But in terms of specific accounting income impact, I don't think we've had that analysis just ready just right now.

Jason Stewart (Analyst)

Yeah. No, it's okay. Thanks for that. And I think conceptually, your expectation would be that most of that move in discounted coupons has happened, and maybe you get some migration in CPRs up in coupon, but I wouldn't expect you to think that 4 and 4.5 have that sequential increase again in 3Q. Is that fair?

Sergey Losyev (Co-Chief Investment Officer)

You know, it's a fair question, but also we're keeping in mind the fact that the housing market is at record lows, right? And the prepayments are near record lows as well. So we feel like there's nothing but upside to a lot of these discount prepays. It's just a matter of timing. And as Desmond mentioned, it's when the housing begins to fall and the turnover activity picks up. That's what we're looking for.

Jason Stewart (Analyst)

Yeah. Yeah, I agree with you. Thanks for taking the questions. I appreciate it, guys.

Operator (participant)

Again, if you have a question, please press star then one. And our next question comes from Christopher Nolan from Ladenburg Thalmann. Please go ahead.

Christopher Nolan (Analyst)

Hey, guys. Gordon, were there any non-recurring items in earnings this quarter?

Gordon Harper (CFO)

No. You recall we had our discussion back in Q1 of the Special Committee costs? But no, nothing this quarter.

Christopher Nolan (Analyst)

Okay. And then also as a follow-up on that topic, just to reconfirm that you don't expect any restatements as a result of the Special Committee activity since the current Q indicates the material weakness continuing into the quarter?

Gordon Harper (CFO)

Correct.

Christopher Nolan (Analyst)

Great. Then I guess the final comments, and I guess it's really for Scott, is given the expectations is for earnings to cover the dividend in the second half of the year. What are the thoughts on the direction of book value given your outlook on the market?

Gordon Harper (CFO)

Well, look, if our outlook comes true and we get demand returning, particularly from the bank sector, and I got to tell you, there's nothing like actually getting cash spread rather than seeing it reflected in the forward curve to motivate buyers. That's real. The other one is a little different. We could see some spread tightening here. You look at the charts over the last 10 years, and we are at elevated levels. It's not to say the last 10 years was normal in any way. We all know that. But certainly, while we might have flirted with a bit of tights for the year, let's just remember how wide 2023 was. So look, we are in the spread. We take spread risk for a living here. We're in the spread business, and tightening spreads would be a very, very strong element for us for book value.

Christopher Nolan (Analyst)

Great. Thanks, guys.

Operator (participant)

There are no more questions in the queue. This concludes our question-and-answer session. I would like to turn the conference back over to Scott Ulm for any closing remarks.

Scott Ulm (Co-CEO)

Great. Thanks all for joining us this morning. As you know, we're always available. Ring the office, and we will be back to you usually within the day, if not faster. Thanks so much for joining.

Operator (participant)

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