ARMOUR Residential REIT - Q3 2024

Transcript

Operator (participant)

Good day, and welcome to the ARMOUR Residential REIT's third quarter 2024 earnings conference 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 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 and then two. Please note, this event is being recorded. I would now like to turn the conference over to Scott Ulm, Chief Executive Officer. Please go ahead.

Scott Ulm (CEO)

Thank you, and good morning, and welcome to ARMOUR Residential REIT's third 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 Harper (SVP)

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 risk 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. ARMOUR's Q3 GAAP net income available to common stockholders was $62.9 million or $1.21 per common share. Net interest income was $1.8 million. Distributable earnings available to common stockholders was $52 million or $1 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 continues to waive a portion of their management fees, waiving $1.65 million for Q3, which offsets operating expenses. The waiver continues until further notice.

During Q3, ARMOUR issued 6,413,735 shares of common stock through our At-the-Market Offering program, raising $129.4 million of equity capital at 0.1% diluted to book value, or essentially flat to book value. Since the end of the quarter, we have issued an additional 567,720 shares of common stock, adding $11.1 million of equity capital. 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 $2.3 billion over its history.

Quarter end book value was $20.76 per common share, up from $20.30 at June thirtieth, or up 2.3% for the quarter. As of October eighteenth, our estimate of book value was $19.58 per common share after the accrual of the October preferred C stock dividends and the common stock dividends. I now will return the call back to Scott to discuss ARMOUR's portfolio position and current strategy. Scott?

Scott Ulm (CEO)

Thanks, Gordon. I want to start by sharing our perspective on the current macro environment. In late August, Fed Chair Jerome Powell signaled that after nearly two and a half years of restrictive monetary policy, the risks around inflation and the labor markets are in balance and that interest rates are set to decline. The Federal Reserve committee followed this up with a jumbo 50-basis-point interest rate cut in September, prompting a rapid steepening of the U.S. Treasury yield curve. Quarter over quarter, the 2-year and the 10-year Treasuries rallied by 111 and 62 basis points, respectively, with the twos-ten spread reaching a high of positive 22 basis points, a drastic turnaround from the negative 35 basis points close to the second quarter. Over the last three decades, Fed easing cycles have resulted in curve steepening of 50-300 basis points.

With this in mind, we anticipate that the curve steepening trend has more room to run in the coming quarters. A scenario of Fed easing without the accompanying volatility of a severe economic recession sets up a particularly constructive environment for potential future book value appreciation and earnings growth at ARMOUR. We expect both book value and our earnings to benefit from the return of positive carry in production MBS, declining volatility, and the still historically wide nominal mortgage spreads of nearly 150 basis points versus the average spread of 106 basis points over the last decade. While the U.S. elections could lead to near-term volatility, we expect monetary easing to remain the primary driver for mortgage spreads once the political uncertainty resolves. Overall, we believe we're well positioned to benefit from these favorable market trends over the coming months.

There are also a number of other specific factors that will benefit us into next year and probably beyond. Our strong liquidity and access to financing, particularly through our securities finance affiliate, Buckler, gives us more flexibility to increase leverage to take advantage of this environment. We are keenly aware of the risks and volatility in today's world, but we have the ability to capitalize on this environment when the time is right. We have the demonstrated capability to raise capital at very low cost. In short, despite some volatility, which is not unexpected, this is shaping up to turn into a great environment overall for our business. At this point, I'll turn the discussion over to Sergey.

Sergey Losyev (Managing Director and Head of Portfolio Management)

Thank you, Scott. In the third quarter, our MBS portfolio experienced approximately five basis points of tightening and nominal spreads, and we progressively increased our portfolio size and leverage, taking advantage of pullbacks in the market. As the markets closed on October twenty-first, our portfolio's duration and implied leverage stood at 0.91 years and 8.6 times, respectively. We maintained healthy levels of available liquidity at approximately 50% of total capital, and we continue to closely monitor as well as rigorously stress test our liquidity levels to ensure appropriately reflect market conditions and can support our portfolio growth. In anticipation of a Fed cutting cycle and a more positively sloped yield curve, we steadily increased our duration risk exposure to shorter interest rates, while limiting duration exposure in the longer part of the curve.

We terminated $1.75 billion of notional swaps with a weighted average maturity of 29 months and $1.8 billion of Treasury futures with a weighted average duration of less than 4 years. Terminating the swaps versus receiving their cash flows carries no economic impact, given that the swaps' positive book value is already reflected in their forward pricing. The proactive reduction in our swap position has lowered our ratio of hedges to repo funding to approximately 62%. We expect this recalibrated profile to be economically beneficial for our investors in an environment with a steepening yield curve. While earnings available for distribution related to swap income may be lower in subsequent quarters, over time, we expect EAD to benefit from lower financing costs and therefore increasing carry income as the Fed continues its rate cutting cycle.

We continue to run a diversified hedge book composed of interest rate swaps, Treasury shorts, and futures totaling just over $7.7 billion of notional amount to dampen the volatility of the firm's book value. Our investment portfolio remains very liquid, 100% agency MBS, and is well diversified across 30-year specified pools, ranging from 2.5% to 6.5% coupons. While the largest composition of our holdings is in near par price coupons, we carry strategic exposures to deep discounts and premium coupons totaling 30% and 22% of market value, respectively. This diversification shields the portfolio from prepayment volatility when rates decline. In Q3, constant prepayment rates averaged 7.5 CPR, a slight decrease from 7.7 CPR in Q2 and well below 8.2 CPR so far in October.

It is worth noting that the September's uptick in the mortgage refi index is expected to show up in the prepayment reports later this fall, and we believe this has already been priced into the market. Yet with mortgage rates already backing up to 6.5%, the valuations on premium MBS offer very compelling value as the forward-looking prepayments begin to recede. Additionally, higher mortgage rates and weaker winter seasonals set up low net supply of MBS as yet another favorable near-term driver for spreads. Within the premium coupons, we are focused on specified pools tied with loans to lower credit FICO scores, higher LTV loan characteristics, and states with traditionally lower refi response rates to help mitigate the prepayment risk versus more generic pools and TBA.

In discounts, our analysis shows that some of the more seasoned holdings were a substantial contributor to a gradual increase in the portfolio CPR this year, proving that mortgage prepayments can also work to investors' benefit. We expect this benefit to grow in the future when the housing market begins to recover as interest rates decline. And finally, the repo market remains liquid, albeit some of the funding pressures observed at the end of Q2 have persisted throughout Q3. These pressures are expected to remain throughout the end of the year, with dealers' capacity to intermediate somewhat constrained amid record levels of U.S. Treasury issuance. As Scott had already alluded to earlier, we are funding 40%-60% of our MBS portfolio with our affiliate, Buckler Securities, while spreading out the remaining repo balances across 15-20 other counterparties to provide ARMOUR with the best financing opportunities.

Buckler allows flexibility of overnight funding while seeking out value and market color in term repo markets. Overall, repo funding for agency MBS remains plentiful and competitively priced across the board. Back to you, Scott.

Scott Ulm (CEO)

Thanks, Sergey. I'd also like to mention our preferred stock. We're around where we want to be with preferred as a proportion of our capital structure, so we're less likely to be involved in preferred market. As you know, our preferreds remain fixed once they enter the call period. We're pleased with this feature, given where today's floating levels would be. As we look out over the next few quarters, we believe that our current dividend rate is appropriate. Our dividend outlook is based on the portfolio's future earnings power over the medium term, not the current period earnings. Our primary focus remains on generating total economic return on our portfolio and delivering that value to our shareholders. Thank you for joining today's call and your interest in ARMOUR. We're happy to now answer your questions.

Operator (participant)

Thank you. We will now begin the question and answer session. To ask a question, you may press star and then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the star keys. If at any time your question has been addressed and you would like to withdraw a question, please press star and then two. We will pause momentarily to assemble our roster. The first question we have is from Trevor Cranston of Citizens JMP. Please go ahead.

Trevor Cranston (Director and Senior Equity Research Analyst)

Hey, thanks. Good morning. You know, with the sell-off and rates we've seen here in October, can you give us an update on, you know, what your current duration exposure is, and if you've made any significant changes to either the assets or hedge composition, you know, compared to what you disclosed as of September 30? Thanks.

Desmond Macauley (CIO)

Yes. Hi, Trevor, this is Desmond Macauley. So we did say in our prepared remarks that our duration was point nine. That's actually as of October twenty-first. Overall, we are, as we mentioned, we positioned for a steepener. Most of that duration is in the front end of the curve. In the back end, we have some duration. We look into delta hedge, so we have a program of keeping the back-end duration very close to zero, but, you know, we are point nine one, so we've moved our hedges. We talked about a couple of things we've done so far, but, overall, point nine one duration as of October twenty-first, most of it in the front end of the curve.

Trevor Cranston (Director and Senior Equity Research Analyst)

Okay, and then in terms of leverage, you know, it looks like it's gone up a little bit, since September thirtieth. You know, with the volatility priced into the market, you know, coming up on the election, you know, is the eight point six level kind of what you guys are comfortable running with near term, or how are you thinking about that?

Desmond Macauley (CIO)

Yeah. So as far as our leverage, we see it more as an output. We have ample levels of liquidity, which is typically what we look at. So we're very comfortable with this environment. We think that the Fed easing cycle is going to be the key driver. Of course, we have bouts of volatility, which we think are going to be short-term. Yes, the presidential elections is one, and we wouldn't be looking to add risk into that. But at the same time, in terms of where we are right now with our leverage, we are pretty comfortable.

Trevor Cranston (Director and Senior Equity Research Analyst)

Got it. Okay. Appreciate the comments. Thank you.

Operator (participant)

The next question we have is from Doug Harter of UBS. Please go ahead.

William Huthnance (Founding Partner)

Good morning. This is actually Will Nance on for Doug today. Thanks for the book value update you gave, but given the rate volatility this week, is there any chance we get another update on how book has fared so far this week?

Scott Ulm (CEO)

I don't think we're planning to update the, you know, book value, you know, more frequently than we do. You know, I think, yeah, it's been a volatile week, no question of that. But I don't think we have any plans to, you know, do to go to move to frequent book value updates.

William Huthnance (Founding Partner)

Okay, that makes sense, and then just one more question. Just given the ATM issuance you had in 3Q, can you just update us on how you're thinking about raising capital going forward?

Scott Ulm (CEO)

You know, we, you know, we look at a number of factors on it, you know, and probably the most important is the price that we can raise it at. You know, we attempt to raise capital, you know, very close to and ideally over book value, which we've been able to achieve. Which is not to say that we wouldn't issue at different prices, which goes to the second leg of it, which is looking at investment opportunities and how we view the environment that we'd be putting that capital to work in.

So, you know, we carefully eye that, and, you know, if we see exceptional opportunities in an environment that we like, we may be more aggressive on getting capital. That's the right answer for shareholders. But generally, you know, we remain pretty conservative at the prices that we're willing to issue it and then keep a very close eye on the returns that we can generate with it.

William Huthnance (Founding Partner)

Great. Thanks for taking my questions.

Operator (participant)

The next question we have is from Jason Stewart of Janney Montgomery Scott. Please go ahead.

Jason Stewart (Director and Equity Research Analyst)

Hey, good morning. Thank you. Could you talk a little bit more in detail about where you see current returns in terms of carry, you know, how that relates to the cost of capital, maybe including the cost to operate? But if you could just break it down one more level in terms of carry versus total return and how you're thinking about those two components as you raise and deploy capital.

Desmond Macauley (CIO)

Desmond, why don't you go ahead?

Jason Stewart (Director and Equity Research Analyst)

Yeah, hi, Jason. Hey, Desmond.

Desmond Macauley (CIO)

Sure. Sure, Scott. So production coupon ROEs, you know, 6%, 6.5% coupons are in the high teens. Belly coupons, like fours and four and a halfs, are in the mid to high teens, depending on the specified pools, and lower coupons are trading over a wide range, depending on the pool characteristics. So I think your the second part of your question was in terms of, in terms of, dividend yield? You have to look at the dividend yield plus the preferreds overall. So if our dividend yield is around 15%, you have to adjust that for the preferreds, and then you add a hedging cost to that, and you can kind of get a sense of, what that breakeven is.

But we're very comfortable, as we mentioned, in terms of looking forward. We think that these returns as is are good enough to maintain our dividend, and we also like the environment overall, where we can get some spread tightening, which would include our overall economic return there.

Jason Stewart (Director and Equity Research Analyst)

Okay, that's helpful. Thank you for that. And then a second, just a macro question: you know, in terms of prepayments, I mean, what's your view on the servicing capacity in the industry? You know, there obviously has been a lot of rate fall that's taken some refinancing about. But in general, what's your view on, especially for current production coupons, the near-term outlook for prepays, given the capacity in the servicing industry?

Desmond Macauley (CIO)

Let me start, and Sadek could add more to that. As we mentioned, in our prepared remarks, we did see an uptick in refi activity over the summer, and that should play out to faster speeds over the next month or two. But mortgage rates have already backed up to 6.5%, so looking forward beyond that time period, we can expect prepayments to decline. Now, over time, if you look even further into 2025, as the Fed easing cycle deepens, we think rates overall would come down, and that could lead to faster speeds. We're prepared for that. We maintain a diversified portfolio of both lower coupons and higher coupons. The higher coupons, in terms of their current valuation, has priced in a lot of that prepayment risk already.

Sergey Losyev (Managing Director and Head of Portfolio Management)

Yeah, and just to add to that, you know, it's, it's very hard to define current coupon right now when rates are moving as they are this month. So, longer term, our view is that interest rates are coming down, but it would take mortgage rates, you know, to drop much lower than 5%, given the composition of outstanding mortgage universe. And our portfolio reflects that composition. As we mentioned, we have coupons between two and a half and six and a half coupon in thirty years, so it's really easy to mitigate some of the prepayment concerns just by shifting your exposures along the coupon stack.

Jason Stewart (Director and Equity Research Analyst)

Got it. Okay, that's a good caller. Thank you. Appreciate you taking the questions.

Desmond Macauley (CIO)

Sure.

Operator (participant)

The next question we have is from Matthew Erdner of JonesTrading. Please go ahead.

Matthew Erdner (Director and equity research analyst)

Hey, good morning, guys. Thanks for taking the question. Could you talk a little bit about how you guys are thinking about tail risk outlook? You know, if the ten-year were to run a little bit higher than where it is now, or if it were to contract significantly, and how the recent changes to the hedge portfolio kind of reflect the way that you guys are thinking about it.

Desmond Macauley (CIO)

Yeah. Hi, Matt. So as I mentioned, we are positioned for a steepen. We dynamically hedge our portfolio, particularly that back end. So the back end has run up a lot already. In terms of outlook, well, we do have the elections, and there could be some other volatility there. We do expect, though, that as the Fed easing cycle deepens, that back end rate should come down as well. But in terms of how we're preparing for it, it's about dynamically hedging our duration to meet the profile that we think fits with our macroeconomic views.

Matthew Erdner (Director and equity research analyst)

Got it. That's helpful. Thanks for taking the question.

Desmond Macauley (CIO)

Thank you.

Operator (participant)

Ladies and gentlemen, I would just like to give a reminder. If you would like to ask a question, you may press star and then one. The next question we have is from Christopher Nolan of Ladenburg Thalmann. Please go ahead.

Christopher Nolan (Senior Vice President and Equity Research Analyst)

Hey, guys. Back to the returns question. On the return on equity, given the improved environment that you guys are sort of anticipating, where should we expect equity returns to go?

Desmond Macauley (CIO)

So, Chris, in terms of just looking across, if we think of it as incremental return based on new purchases, I mentioned earlier, we see the higher coupons now in the high teens, so 18%-20% now. Obviously, we do have. We try to maintain a diversified portfolio. Some of the belly coupons in the mid-teens and lower coupons trade over a wide range. We try to maintain a diversified portfolio. We also include, we have those securities as well. So we're looking at overall returns in terms of how it improves our convexity. Sometimes there's a trade-off. Positive convexity securities may have lower ROEs, but we try to balance it to maintain a well-diversified portfolio in terms of what those risks, those returns are, versus the risks that we take.

Sergey Losyev (Managing Director and Head of Portfolio Management)

Yeah, and if I may, really quick, we also apply, you know, of course, total return scenarios to all potential investments. Not running just through the forwards, but using some assumptions we can have on the market, using spreads and rates, given our macro outlook. And given the volatility so far in the month, you know, a lot of these assumptions could start to look more favorable from a total return perspective, in addition to ROE numbers that Desmond quoted.

Christopher Nolan (Senior Vice President and Equity Research Analyst)

... So if I heard Desmond correctly, I heard 18%-20% or so in there?

Desmond Macauley (CIO)

In the higher coupons, yes. 18%-19%.

Christopher Nolan (Senior Vice President and Equity Research Analyst)

Which is pretty much in line with where, you know, forward EPS is for the stock. And so, you know, I hear what you're saying in terms of book value appreciation, stronger earnings, but I'm not hearing it in terms of the details you're providing. It sounds like, you know, equity returns will be pretty much in line with what the market's expecting. Is that a fair summary?

Desmond Macauley (CIO)

Those, as Sergei mentioned, those returns just looks at where current spreads are, right? If you look at our dividend yield, let's say you take that in the mid-teens, and you adjust for operating costs and things like that, the returns as we see today covers that. We think that in a fair easing cycle, you can also see OASs of, for just mortgage credits tightening by 10 to 15 basis points. It most likely post-elections or into next year. That is an additional component of the returns that adds baked into those numbers. That easily gets you into the low twenties for those coupons.

Christopher Nolan (Senior Vice President and Equity Research Analyst)

Okay.

Desmond Macauley (CIO)

Does that help?

Christopher Nolan (Senior Vice President and Equity Research Analyst)

Yes, it does. Thank you. So you're expecting a slightly higher ROE, and that's definitely helpful. Slightly different. Given that you have negative investment spreads, you know, cost of funds relative to investment yields, any handicapping in terms of ideas, in terms of when that could turn positive? Or is that sort of dependent on who wins the presidential election and so forth?

Desmond Macauley (CIO)

It's when you say negative investment spreads, we are currently. I mean, for some coupons, they are already positive, right? It depends. I mean, we do have lower coupons that are, you know, negative carry. As I mentioned, sometimes we look at just the ability to balance our portfolio in terms of the risks, the negative convexity. But there are some securities right now, if you just run them currently to where the repo rate is, they are already positive.

Christopher Nolan (Senior Vice President and Equity Research Analyst)

Okay, I was just looking at the portfolio as a whole.

Scott Ulm (CEO)

A lot of that timing depends on the Fed and where the Fed is going, right? And, you know, forward curve has one view of it. We got dot plots, but I think the direction's pretty clear. You can squint at it and see some timing as that sweeps through the coupon stack, gradually making more and more of it, see some daylight of positive carry.

Christopher Nolan (Senior Vice President and Equity Research Analyst)

Okay. That's it for me. Thank you very much.

Desmond Macauley (CIO)

Thank you.

Operator (participant)

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 (CEO)

Thanks, all. We appreciate your interest. If questions come up, give us a ring. We're around and always happy to talk with you. Have a great day. Thank you.

Operator (participant)

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