Orchid Island Capital - Q2 2024

Transcript

Operator (participant)

Hello, good morning, and welcome to the second quarter 2024 earnings conference call of Orchid Island Capital. This call is being recorded today, July 26th, 2024. At this time, the company would like to remind the listeners that statements made during today's conference call relating to matters that are not historical facts are forward-looking statements subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good faith, belief with respect to future events, and are subject to risk and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements. Important factors that could cause such differences are described in the company's filings with the Securities and Exchange Commission, including the company's most recent annual report on Form 10-K.

The company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions, or changes in other factors affecting forward-looking statements. Now, I would like to turn the conference over to the company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead, sir.

Robert Cauley (Chairman and CEO)

Thank you, operator, and good morning. Hopefully, everybody's had a chance to download our slide deck. As usual, I'll be using that for the presentation today. Turning over now just to slide three, just kind of the agenda as usual. We'll go through our financial results, then we'll talk about market developments and how those impacted our results and how we see things going forward. And then we'll dive deeper into the portfolio, our hedging and funding positions, and then a few comments on our outlook for the market and for the portfolio going forward. On slide five, for the quarter, Orchid generated a net loss of $0.09 per share versus an income of $0.38 in the last quarter. Book value declined approximately 5.9% from $9.12-$8.58.

Book value as of last Friday, I know that most of our peers have mentioned that, is down about 0.9%, so a little under 1%. That has to do primarily with just our hedges, which I'll get into later in the presentation. Total return for the quarter was slightly under -2%, and we declared and paid $0.36 in dividends. The portfolio, the average portfolio grew quite substantially from a little under $3.9 billion to $4.2 billion. We have been raising capital in the ATM. The portfolio, as we stand today, is about $5.1 billion, and repo is about $4.9 billion. Leverage ratio was 7.1 at the end of the quarter, unchanged primarily from the beginning of the quarter. Today, it's a little higher in the mid-sevens. Speeds on the portfolio did increase slightly.

That's probably due to rates being a little lower and seasoning, especially in the discount side of the portfolio. Liquidity remains strong, up slightly, and represents a little under 50% of equity. Slide seven just presents our financials. I won't spend time going through these. Those are just for your review, the income statement and balance sheet as of the end of the second quarter. Slide eight, as we all know, all of our peers published something they referred to as earnings available for distribution. This is commonly compared to the dividend. We don't publish such a number. This is kind of our proxy. This number is what we call our kind of our economic income. It's all derived from GAAP financials. So we are taking all of these numbers from our GAAP numbers. You know, dividend is based on taxable income, not GAAP. So there are some differences.

I just want to walk you through just this presentation and kind of highlight where there could be differences between GAAP-derived numbers and tax. So for instance, you know, just walking down the income statement, the interest income number is slightly different for tax, but I think this is a good proxy. There are minor differences in the calculation of interest income on pass-through portfolios and derivatives, but this number should be reasonable. The amortization of discounted premium, that number is the GAAP number here. That can deviate quite a bit from the taxable number. The main reason is simply the fact that we do this based on changes or paydowns from the market and how that impacted the market value at the beginning of the quarter, whereas for taxes from purchase date. And then with repo funding, of course, that's pretty much identical.

Then the hedges, we show the impact of the benefit of the hedges that we have in place, which is quite substantial. There is a slight difference between GAAP and tax in that with tax, you have to take into effect hedge positions that are actually closed to the extent they cover the affected period or the current period. So for instance, if you entered into a 10-year swap two years ago and closed it one year ago, the open equity at the time of closing would still impact your interest income for tax purposes over the remaining eight years of that swap. So that can be slightly different than expenses are basically the same. So we're showing this number, this economic income or adjusted income of $0.50. It is a proxy for what our taxable income.

I just want to make sure you understand that they're not necessarily exactly the same. As you can see, it's been fairly stable for the last three quarters. That's all I'll say for that for now. Moving on to the market developments, just kind of go through these four slides. The first on slide 10, this is basically just a nutshell of what's happened in the economy. If you look back to the end of the first quarter, the inflation and economic data had been quite strong. In fact, we were talking about the rates being higher for longer, even the potential that the Fed would have to hike again. Second quarter, that all changed. All the mainstream, all the main key data, inflation, jobs, ISM for April, May, and June were considerably softer.

Especially the inflation data is back consistent with what we saw late last year, which is inflation trending down towards the Fed's 2% target. Now the market views the Fed is likely to be on path to cutting rates later this year. Then just kind of fast forward to where we are now in July. The big change has been the change in the slope of the curve as the market gets closer to pricing in or pricing eases closer. So now, for instance, 2s10s is a proxy for the shape of the curve. In late June, that was at-50 basis points. Earlier this week, it got as low as -13. So a big move. It's really hard to discern from these charts if you're looking at the difference between the green and the blue line.

But the two-year point on the swap curve has moved over 35 basis points. So a big move. The curve is much deeper. In our view, going forward is that that will continue. And it's easy to have a fair amount of conviction in that because there's really two forces that could drive that. On the one hand, obviously, if the Fed eases, you can get the front end of the curve moving down. It's currently anchored. But also on the longer end of the curve, to the extent that we're going to continue to run, for instance, large deficits, there's somewhere in the $5-$8 trillion of debt that has to be rolled over by the government in the next year and a half.

Depending on the outcome of the election, say, for instance, if Trump were to win, he has talked at length about imposing more tariffs, which could be inflationary. So there's a lot of reasons to think that the long end of the curve may not rally as much as the front end. In fact, it could even go higher. So for these reasons, it's easy to gain a fair amount of conviction and a steepener. And that's kind of how we expect the market to unfold. That being said, to the extent that it doesn't, we are positioned to do quite well even with that outcome. Moving on to the mortgage market, this chart on the top I like to talk about. This is just the spread of the 10-year Treasury going back very far. It's a good perspective.

As you can see, we are still at a fairly elevated level. On this chart, we show as the most current reading of 141 basis points spread to the 10-year. Today, that's closer to 135-136. Although that being said, the current coupon mortgage has a duration that's much, much shorter than a 10-year. So a more appropriate benchmark for today would probably be the 5-year. And that spreads a little under 150. And it hasn't moved as much of late. So it's not tightened as much. So mortgages are still attractive. And we expect going forward that there's room for tightening. The market expects that to the extent we do see Fed easing, we're likely to see the banks become more involved. They have been modestly involved to date.

But if they were to become more meaningfully so, that could be the impetus or the catalyst for some more tightening. I don't know that we're going to go back to the levels we saw pre-pandemic, but it could certainly drive us fairly tighter. And again, that's the kind of market's conventional thinking is that the banks would become more involved if we do get easing. Outside of that, money manager inflows have been substantial. I saw some data published by Nomura yesterday that showed something like $7 billion or $8 billion weekly average to date this year, which is pretty strong. And to the extent that those money managers continue to be overweight mortgages, those are pretty substantial inflows. So they've been supportive.

And then of late, as we know, that REITs have been raising capital, and those are kind of on the margin support of the market as well. Looking at the bottom left of the page, you can see the performance of select coupons of mortgages. And you can see early in the second quarter, quite weak performance. April was a rough month. We were still looking at data from March. It was very strong. The market was expecting the Fed to keep rates high for an extended period of time. So mortgages were looking less appealing. And we had a nice recovery into the end of the quarter. Gave up most of that in the last week, which really ended up hurting the returns for the entire quarter. Only to turn around in July and kind of rebound, although of late, the last week or so, that's turned around again.

We're probably close to unchanged if you look back at a 3/31 reference point. The next slide, we talk about volatility. Volatility is obviously a very big driver of mortgage performance. And as this chart on the top shows, if you go back to October of 2023, when we were at very high levels, rates and volatility, we've had a nice long rally since. Although of late, that is starting to pick up. And in particular this week, especially realized volatility has been quite high. And this is just something that we always have to keep an eye on because it is a very big driver of mortgage performance. So for now, we're at relatively low levels looking back just a year or so, but starting to go the other way. Slide 13 is kind of our proxy for the housing market and refinancing.

As you can see, as we all know, it's been the same story for quite some time. Mortgage rates are high. That's the red line in the top left. The blue line is the refinancing index, which is basically zero. But just speaking more generally about the housing market, affordability is very, very low, near record lows. So that impacts a lot of things like turnover, rates again near the high level. Prices are high, which these two combined drive affordability. Now what we're starting to see are inventory levels build. I know this week, for instance, new home sales were released. The inventory of new homes is over nine months' supply, which is typically associated with recession levels. I'm not saying that we're going to get a recession, but those levels have moved a lot.

In fact, I think the absolute level of new homes and inventory is similar to the levels we saw before the financial crisis. So the housing market is definitely weak. There's no question of that. Slide 14 is something I introduced last period. It's just kind of an interesting look at GDP and the money supply. I'm not really going to talk about it, but it paints an interesting picture. You can see that growth has been above long-term trend now for some time since the pandemic. And whether it's causal or not, the money supply would appear to be behind that. And that's kind of associated with the significant deficits that we've been seeing since the pandemic. That's about all I have to say for that. Now I'll turn to the portfolio. On Slide 16, as I said, our outlook for rates is for the curve to steepen.

As I said, there are 2 potential drivers of that. You could have the Fed lower short-term rates and/or longer-term rates could stay the same and/or go higher if inflation and/or deficits continue to stay high. So with that in mind, that's kind of the backdrop of how we view the world going forward. Now, in terms of what we did, well, the big driver was we had a lot of money to put to work. We used the ATM quite exclusively in the second quarter. We raised about $100 million. And actually, in July, through the first third of the month or so, we raised another $55 million. So quite a bit of capital in relation to our size. As a result, we've been deploying that into the portfolio and basically almost exclusively or exclusively in higher coupons.

As a result, our weighted average coupon went from 4.38 at the end of the first quarter to 4.72 at the end of the second, which is a pretty substantial move. But it's even higher now. It's at 4.88. So a 50 basis point increase off of where we were at the end of March. Realized yields are higher. I don't have the current number, but it would be higher than what we report here for the end of Q2. And then also, our net interest spread for the quarter went from 2.47-2.64 with the additions of the higher coupons and our slight changes to our hedging strategy, which I'll get into in a moment. There's room for that to expand slightly more.

I will just point out, if you look back at our portfolio historically, say going back a year or so, especially in relation to our peers, we probably had one of the lowest weighted average coupons in the portfolio. As we employ our barbell strategy and add higher coupons, that's been coming up quite a bit. So we were, in terms of performance for the quarter, our net interest income for June, even though we were negative for the quarter, was actually slightly positive. I don't have any Q2 figures yet for you, but that's clearly the trend. With respect to the portfolio itself, as you can see on slide 17, these charts just are bar graphs of our portfolio. If you look at the right, that's where we were at the end of last year.

As you can see, moving to the left, the current positions at 6/30, we have, as I said, been adding to the higher coupons. Just to give you some updates of what we've done since quarter end, 6/30/2024, our allocation to sixes now is just under $1 billion. So that's grown quite a bit. Six and a half, we're now over $800 million. And sevens are almost $400 million. So that's almost $600 million of adds and all on those higher coupons. And the reason we prefer this barbell strategy is we think it does well in either rate environment. So for instance, if we were to have a rally on the long end in particular, our lower coupons would do quite well. And to the extent the rates, long end rates in particular, stay higher, these higher coupon securities generate lots of income.

Absent a substantial increase in longer-term rates, don't have much extension risk. The belly of the coupon stack has more often than not been quite rich of late. That's another reason why we find these securities to be attractive. Turning to our slide 18 in our funding, well, the Fed hasn't done anything. So not surprisingly, our average repo rate for the quarter was unchanged. Although that being said, with the market starting to price in eases, we have extended our average maturity. And we've continued to do that into July. So we can get some benefit of some slightly lower, not meaningfully small, but slightly lower rates further out. With respect to our economic cost of funds, it did improve a fair amount from 2.56-2.41. And that has a lot to do with changes in the strategy of how we're hedging.

We've been using a lot more swaps versus Treasuries or futures. We've been moving those swaps up the curve. So slightly maybe lower notional balance, but with more DV01 further up the curve. With the curve very, very flat, in effect, our borrowing rate, hedged borrowing rate's gone down slightly. That's what's caused the NIM to improve. Now turning to our hedged positions, as I mentioned, we've been moving the swaps out, moving two swaps and using longer tenor swaps in almost all 10, seven, and 10-year. The reason we're doing that is just that we think the greatest potential pain or risk to the portfolio would be a long end sell-off, which would typically be accompanied by an increase in vol.

Therefore, by using seven and 10-year swaps, especially when we're hedging new purchases, which are lower or higher coupon, lower duration, if those mortgages were to extend, they're extending towards the long end of their extending their duration. That's moving close to our hedges. We would dynamically hedge and potentially add to those positions. But it really, I think, is the most sound way to protect the portfolio because that, as I said, I think that would be the greatest source of pain, would be a significant sell-off in the long end. Also, just more of the statistics on Slide 19. We do cover 84% of our funding liabilities with our hedges, excluding TBAs. Swaps are now up to 72% of that. And our weighted average paid fixed rate is 2.71%.

If you look at the bottom of that page, you can see our swaps are now a little over $3.1 billion. Corresponding number at the end of Q2 was $2.53 billion. So a significant move. The futures, those were $842 million. Now it's $521 million. So we've been, in addition to adding to our hedges, we've been moving some of them from futures to swaps and moving the swaps further up the curve. TBA shorts are essentially unchanged. Same with the swaptions. That's really just one position. Now, if you look at slide 20, we provide a little more detail on our hedges. I just want to say a few comments. In particular, on the top right, our swaps. As you can see, if you compare where we were at the end of the first quarter versus now, the short and maturity swaps are the same.

So we've been adding to the longer tenor swaps, as I mentioned. With respect to the performance of the portfolio through last Friday, it really was just driven by the fact that we do have a fair number of swaps in the five, six, seven year part of the curve. And that's where the market's really rallied. And so the reason that we're down slightly is just because of that, the rally in the swap positions that shot the mark to market to a slightly negative position. Now, that being said, I don't know that we're going to change that. I think we expect the curve to steepen. We do expect the Fed will ultimately ease. But current pricing is for quite a few eases by the end of the cycle, 200 basis points or so. And I don't think we're ready to take the over on that.

I don't think we'll see the economy about to roll into the recession. So I wouldn't be surprised if we actually realize less than that. So the fact there's no real reason in our minds to unwind any of those hedges because we think the market's maybe a little ahead of itself. Also, with respect to the swaps, I want to point out that none of our swaps mature before March of 2026. 85% of our swaps are in place through or mature in February of 2029 or longer. And 65% in May of 2030 or longer. So these hedge positions are going to be in place for quite a while. The one swap that does mature in March of 2026 represents less than 10% of our notional balance. So our hedges are here. We're not going to have them roll off.

We don't have to refinance those, so to speak, anytime soon. And then secondly, with respect to our balance sheet, as you know, we have no preferred. We have no floating rate preferred. So our balance sheet in that regard is very clean. And we don't have that risk to our net interest margin posed by either a floating rate preferred or swaps that have to be refinanced in the near term. Slide 21 just gives you a look at the portfolio. I would point your attention to the column entitled Effective Duration. And you can see across the various coupons, those numbers. And in the bottom or the far right is just our allocation. So basically, if you look at the Effective Duration column starting from the top down to the bottom, that's basically the curve where we're positioned along the curve.

So the shortest part of the curve, which would be 1.27 year, our current allocation at the end of June was 7%. Those are higher. But basically, this just gives you a sense of how we've positioned the portfolio across the curve. Granted, these are static numbers. If rates were to move materially, these duration numbers can change. But as you can see on the far right column, how we're positioned. And just note in the bottom right, the allocations to those higher coupons have gone up. Slide 22 just kind of gives you a sensitivity of our net duration gap or the sensitivity of the portfolio. As you can see, we do a little better in a backup. And that's just because we've added longer tenor swaps primarily. Finally, Slide 23, our speed experience.

The one thing that we benefited from of late, as I mentioned earlier, is that most of our deep discounts, say, bonds with 95 handles or below, 4s and 4.5s and so forth. So they're quite seasoned. And as a result, our speeds, if you look in the very far right column, they're not bad for deep discount bonds. So that's been beneficial for us. And with respect to our newer higher coupons, they've been maintained at just basically moderate speeds. We haven't had any issues there. So that's pretty much it. Now, just kind of turning to our outlook. As I mentioned earlier, lots changed since the end of the first quarter. We were looking at higher for longer, maybe the Fed hiking. The data changed pretty abruptly. And now the market really thinks that we're on the verge of a easing cycle. We've been here before.

We've certainly, if you go back to December of last year, we thought we were on the verge of a big easing cycle. It didn't turn out to be the case. We are mindful of that. But that being said, to the extent we do get an easing cycle, there's obvious benefits to that as our funding costs decline and our position in the portfolio, which I think is well suited for that outcome. But all that being said, if nothing happens and the data turns around again and we don't get any tightening or easing, rather, we just have a status quo.

The portfolio is very well positioned. The income and net of our hedges is very attractive. We think that our hedges are such that we can maintain pretty stable book value throughout. We're very comfortable positioning the way we are. That's it. Operator, I will now turn the call over to questions.

Operator (participant)

All right. Thank you. The floor is now open for questions. If you would like to ask a question, please press star followed by the number one on your telephone keypad. That number again is star followed by the number one. All right. Our first question comes from the line of Jason Weaver from JonesTrading. Please go ahead.

Jason Weaver (Managing Director and Equity Research Analyst)

Hi. Good morning. Appreciate that market commentary. It's very helpful. I was wondering, can you comment on the pace of deployment over the quarter of the ATM issuance and if that represents any sort of meaningful cash drag? Or were you able to get that invested relatively simultaneously?

Robert Cauley (Chairman and CEO)

I'll give you my first comments and turn over to Hunter. We did wait a little bit in June. We raised a lot of money in the ATM in June. And with the market, especially the mortgage market, underperformance late in the month, we did wait. So we didn't deploy most of that until July. So that would cause slight drag for the first month because we just have less income on more shares. But we then did deploy it. We're, I would say, fully deployed. Take that, Hunter.

Hunter Haas (CFO)

Yes. We're fully deployed at this point, although our numbers in June and July would not reflect being fully invested. So the first, with this most recent slug of capital that we've raised, the money will be fully put to work starting in the month of August. So we'll get full, sort of full month's worth of interest accruals on all those. We raised some capital in the beginning of May, put that money to work relatively quickly, and then also did some more fundraising in the later part of May and early June. We really waited until towards the end of the quarter to put that money to work. I think it was a wise decision as that last week of June spreads really backed up quite a bit. So we put some money to work in late June and early July at pretty attractive levels.

Jason Weaver (Managing Director and Equity Research Analyst)

Got it. Thank you. And then just on the macro front, as far as the book looks today, where do you think benchmark mortgage rates or spreads, for that matter, have to come in for you to begin to get really concerned about your convexity exposure?

Robert Cauley (Chairman and CEO)

Where do spreads have to come in?

Jason Weaver (Managing Director and Equity Research Analyst)

Sorry. Where do rates have to move before you start worrying about accelerated prepayment exposure?

Robert Cauley (Chairman and CEO)

Oh. I would say right now, the current coupon's about 558 or 560. We have a lot of 6s and 6.5s. I think you guys mentioned a little under $400 million of 7s. So the 6s and 6.5s are not significant premiums. And we also have a lot of those are New Yorks. They're all specs, a mixture of low pay-up and some higher pay-up bonds. They would have to be quite a rally, I think, for those to become meaningfully in the money and become a concern.

Exact number, you're probably looking at, I don't know, 25 basis points or more. And the other thing is that mortgage spreads, primary and secondary spreads, I didn't mention that on the thing that they were called earlier, but they've been kind of sticky to the high side. So I don't know that we would necessarily see them keep up with rates basis point for basis point.

Hunter Haas (CFO)

Yeah. The strategy has been, especially in the 6.5 and seven, even more so as you go up in rate, has been to stay sort of close to TBA. So we're trying not to recognize that convexity risk. And we monitor our hedge ratios as they change from day to day on that front. So we're trying to stay on top of the convexity into a rally. We did mention that our barbell strategy, the other side of that is we have a lot of really high-quality specified pools that are lower coupon. And so because they're so far out of the money, at this point, their payoffs aren't all that high. But we would expect those payoffs to accelerate at an increasing rate if we were to have a really big rally.

So on the opposite side, the high coupon portfolio, because it's relatively low pay-up, if we were to have that big sell-off, I think as Bob alluded to in his comments, we would expect those assets to do quite well. And we've really seen that as we've bounced around the rate range. If we have a big sell-off, we'll see 6.5 and seven TBAs do relatively well. Lackluster performance down lower in coupon. That market's a lot more technical, less predictable as rates rise and fall. But the production coupons tend to do well into a sell-off and tighten up. So we like the way we're positioned for that reason.

Jason Weaver (Managing Director and Equity Research Analyst)

Got it. Well, thank you for that color. Very, very helpful.

Robert Cauley (Chairman and CEO)

Yep. Thank you.

Operator (participant)

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

Jason Stewart (Director and Equity Research Analyst)

Hey. Good morning. Thank you. Hey, Bob. Let me start with the current cash ROE of the portfolio and what you're seeing in terms of incremental capital deployment on current cash ROEs.

Robert Cauley (Chairman and CEO)

Well, we've seen we were at 150 for quite a while. Now we're getting closer to 200 over, especially as we've been using more of the longer dated swaps. I don't think we published the numbers, but yields on the new acquisitions that Hunter just alluded to were in the very, very high 5s on average. And using a combination of 7 and 10 year swaps, they're in, depending on when we put them in, either the low 4s or even high 3s. So I don't know if we're 200 over, but they're quite high. And with 7x leverage, 7.5, that's pretty decent ROEs. And I don't think that's being very aggressive with respect to leverage. So they're very, very attractive. I think the one thing we do think about is what's going to be the big driver if you're going to get the big tightening.

We haven't seen that yet, obviously. I don't know that we're going to see it in the immediate term unless you really start to see the banks come in. I would just add just a comment. One thing we've seen, since you don't have the Fed doing QE, you don't have banks buying, is the mortgage market has become very relative value-driven. No coupon outperforms for more than a day or so. If the belly outperforms today, then you know it's going to underperform tomorrow kind of thing. So performance has been very volatile in that regard on a just rich-cheap basis. But that being said, we've been able to generate very decent yields with this kind of stationary market. Taking advantage of the funding or hedging strategy, we got very attractive ROEs. Yeah. Yeah.

Depending on the point in time where we, as alluded to earlier, some of the early May settles were done at slightly tighter spreads from both an OAS and yield perspective. But yeah, it's 180-200 over positive cash flow versus funding today's repo funding levels just in terms of carry. And then, one of the benefits of hedging these a little bit farther out the curve is if and when we do get those Fed cuts, we have immediate room for NIM expansion on sort of the unhedged portion of the assets. So yeah.

Jason Stewart (Director and Equity Research Analyst)

Yeah. So yeah, no, it does. Thanks for that. So it's like mid- to high teens and all cash carry with room for improvement is sort of the bottom line there, right?

Robert Cauley (Chairman and CEO)

Yeah. Yep.

Jason Stewart (Director and Equity Research Analyst)

Okay. Then just a technical question on the payouts. When you look at hedging sort of that spread duration of the payout, does that change your hedging strategy at all? Just given, I mean, we've seen some pretty aggressive refi programs out there. It seems like a lot of the mortgage market is going to be very quick to refi some of the new production. I mean, just maybe talk a little bit about how you're looking at that spread duration and hedging that risk on the payouts?

Robert Cauley (Chairman and CEO)

Well, we've seen that be very painful in the past. I mean, as we all know, there's been some gut-wrenching episodes early in 2023 where those pay-ups can move a lot and you experience that spread duration. What we've done is basically just basically stick to more low pay-up stuff. As I did mention, we own some New Yorks, but those are in sixes. So the pay-ups aren't that high. Generally, it's been higher loan balance or FICO or Texas or Florida or LTV. So try to avoid that as much as we can. We have not been buying low loan balance sevens, for instance. Yeah. And those pay-ups are a little bit different than the traditional pay-up stories where you might say like a low loan balance or something where you're really paying up for this superior convexity.

A lot of times the payout that is embedded in some of those less expensive stories is really kind of a months to break even sort of play, right? So are they going to go outperform generic TBA deliverable type collateral by a handful of ticks per month? And the market kind of works out what the break even is for that. They do have, in all cases, better than cheapest to deliver convexity or S curves. But a lot of times what you're really paying for is just a month to break even type of approach. And it's been a good strategy. They do carry a little bit better than worse to deliver. We don't expect them to defy gravity into a huge rally. That's why we're focused on the lower payouts. And they have relatively low negative convexity.

We think in a volatile market, they can do well. That's also part of the barbell strategy because we still have a lot of threes. If we do get a lot, we don't expect a huge rally on the long end. If we do, they're going to do very, very well even in spite of the fact that some of these higher coupons may not do as well. They're fully extended at this point. They have very low convexity for the opposite reason. Yeah.

Jason Stewart (Director and Equity Research Analyst)

Yeah. Yeah. Absolutely. Okay. That's helpful on that. Last question for me. On slide 8, Hunter, maybe this one's for you. If I look at the 2Q24 numbers, say $29.5 million of gains on funding hedges attributed to the current period, how much of that is coming from closed swaps? And really what I'm trying to get at is none. None of it is.

Hunter Haas (CFO)

None. These are all from currently existing hedges.

Jason Stewart (Director and Equity Research Analyst)

Okay. When we look at these numbers relative to the dividend and book value, there's a mark-to-market impact, obviously, that's been realized into book. It's going to change as rates move around. Some of this is going to come out of book value. It will be a return of capital and a dividend.

Hunter Haas (CFO)

Right.

Jason Stewart (Director and Equity Research Analyst)

Okay. Okay. I got it. I'm thinking about it the right way. Okay. Thanks a lot.

Hunter Haas (CFO)

Yep.

Operator (participant)

Our next question comes from Eric Hagan from BTIG. Please go ahead.

Eric Hagen (Managing Director)

Hey, thanks. Good morning. Hope you guys are well.

Hunter Haas (CFO)

Hey, Eric.

Eric Hagen (Managing Director)

How are we thinking about the range for your leverage right now? Can you remind us kind of the historic range that it's been and what you think might get you to take it up to kind of the higher end of the range versus raising more capital? Thank you, guys.

Robert Cauley (Chairman and CEO)

Yep. The range I think is 7-8. But the range maybe a little less than 7. We're about 7.5 now. We were right around 7 or 7.1 at the end of the last two quarters. I would say at the moment, I don't see a reason to take it meaningfully higher. I would say [we'd] be quite comfortable at 7.5. Yeah. I think that this fall could be very volatile. We're not really in a position where we're thinking about hiding and taking cover. But we're also, I think there's a lot of black swans flying around right now. So we're content to sit at this level for the time being.

Eric Hagen (Managing Director)

Yep. All right. That's helpful. So how are we also thinking about repo rates in light of higher volatility? I think you guys mentioned a lot of government debt coming to the market pretty soon. Should we expect repo rates?

Robert Cauley (Chairman and CEO)

Well, yeah. You tend to see that. I was just reading this morning about, and we have our in-house repo traders been in the industry for 30 years. We spent a lot of time talking about this. So if you look at SOFR today, I think it said it's 34. It's above Fed funds. I don't want to get over my skis, but my understanding is that SOFR is set on the; it's the average of weighted average of Triparty Repo, GC Repo, and then I don't even remember what the third component is. But what we've been seeing is that the banks, the Wall Street firms have been using sponsored repo more for balance sheet constraint reasons. As a result, the blended rate has been driven higher. So less Triparty, more sponsored repo, which is at a higher rate. And so you're seeing that drift higher.

It's actually quite a bit higher now than the RRP, which is why the RRP usage has been coming down. Money markets are moving funds into there. But that's been higher. I don't know that that's not a function of deficits. That's just funding levels and QT and things like that. Our focus on the deficits and things like that is more of a long-end story with so much debt to be refinanced over the balance of the next two years. Obviously, at much higher rates, we think that's going to pressure longer-term rates. And that's why, in spite of the fact we're playing for a steepener, we think it's going to be more front-end driven than long-end. And then depending on the outcome of the election, as I mentioned, Trump talks a lot about sanctions and the like, and he's not known as a deficit hawk.

So I don't think you're going to see inflation come roaring back down to the low ones. So all those things are going to keep pressure on long-end, I think. Yeah. In spite of all the volatility in the bills markets and everything that's rolling off there and the index rates bouncing around, and there's a lot of noise there, repo rates have been remarkably stable. And we're now finally just starting to roll into that period where if we're taking longer-term, putting on some longer-term repos, so 2, 3 months, we're going to, every day that passes, start incorporating more of that September rate cut that's baked into the market. So spreads may widen out a little bit, but I think we'll see the nominal level of repo rates come down.

Eric Hagen (Managing Director)

Good perspective. I appreciate you guys very much.

Robert Cauley (Chairman and CEO)

Yep. Thanks, Eric.

Operator (participant)

Our next question comes from Mikhail Goberman from Citizens. Please go ahead.

Mikhail Goberman (Equity Research Analyst)

Hey, good morning, guys. Hope everybody's doing well. If I could just jump in with a question, if you could flesh out perhaps a little bit further your ideas about book value and the swap portfolio. Given we're going to probably get some Fed loosening here in the next couple of months and quarters, are you guys thinking about book value stability or book value growth in a lower-rate environment?

Robert Cauley (Chairman and CEO)

Stability versus growth. I don't know that we have that ironclad outlook. I think, as I said, I think you're going to see the curve steepen on the front end. So obviously, the swaps are going to suffer there. But if you look on the asset side, especially with our large allocation to threes, I think a lot of that can be offset. So I guess without thinking out too much, it would be stability, but there is certainly room for growth. That would be more mortgage tightening. Like I said, we're trading depending on your benchmark between 135 and 150 off. If we do get a meaningful easing cycle, which I don't think it's going to be that meaningful, but if we do and the banks come back in and they're more of a buyer of the space, you can get spreads tightened 10 or 15.

That's probably where the book value would come from. Yeah. I'd add that we have, from a tax perspective, we had a little bit of an over-distribution earlier in the year. So as the NIM expands, we have some latitude to think about preserving a little bit of book. That's in the very short term, just really kind of through the end of this year. And then 2025, we'll be more tax-driven in terms of whether or not we can distribute or retain some excess profit.

Mikhail Goberman (Equity Research Analyst)

Got it. Thank you, guys. Good luck going forward.

Robert Cauley (Chairman and CEO)

Thanks, Mikhail.

Operator (participant)

Our next question comes from the line of Christopher Nolan from Ladenburg Thalmann. Please go ahead.

Christopher Nolan (SVP)

Hey, guys.

Robert Cauley (Chairman and CEO)

Hey, Chris.

Christopher Nolan (SVP)

Bob, your comments on the banks staying out of the MBS market. Is this any sort of anything related to the fallout from the Silicon Valley Bank etc. seizure where suddenly the Feds are?

Robert Cauley (Chairman and CEO)

That was more of a last year's story, maybe earlier this year. No, it's not present. They're just not in a big way. The conventional wisdom is that they're waiting for the Fed to ease. And once they do, that they'll become meaningful buyers. And that was what I was trying to get at earlier in the comment. And the one question I was answering is that we had QE back in the day. The Fed was just an indiscriminate buyer. And banks were buying too because the Fed was pumping reserves into the system. So even though people didn't talk about it at the time, if you looked at bank holdings and mortgages, they were going up in lockstep with Fed holdings. So you had these two huge buyers of the space. They're pretty much both gone. I mean, the banks buy some, as I just said.

So you don't really have this huge indiscriminate buyer. So now money managers buy, but they're very much relative value-driven. So they'll buy mortgages if they think they're cheap versus, say, corporates or versus treasuries, whatever. But so mortgage trading now is all relative value-driven. So nothing stays rich for long or cheap for long. And so you haven't seen mortgages gap wider or tighter much. There's no real potential for that. But that could change if we get banks back in. So we'll see. But the regional banks, I think, were the biggest culprits when it came to the underwater held-to-maturity accounts. The Wells Fargos and JPMorgans in the world, I don't think, are in that position as much, or at least not at all. Yeah. They still have legacy portfolio issues to work off.

The accounting classifications that they use limit how much they can sell at a loss and redeploy at wider spreads. So it's just going to be a matter of time. Or, in the case of, there have been some large bank portfolio movements, and those have been sort of one-off in nature. They've related to selling some profitable arm of the business and then using the gains from that to offset selling lower coupon mortgages at a loss and then redeploying into higher coupons. So Fed cuts will definitely accelerate the amount of time that they're sort of in the penalty box from having to work off those losses before they can redeploy into more profitable strategies. So I think they'll be present at an increasing rate, but I don't really expect a monumental shift anytime soon.

Christopher Nolan (SVP)

Okay. And then turning to capital management, what was the average share issuance price for the ATM in the quarter?

Robert Cauley (Chairman and CEO)

I don't have that in front of me. It did vary quite a bit. I would say in the second quarter, we were probably around 97% of book on average where we were selling. Book was moving around, obviously. That number's higher. We weren't selling for long in July, but it was at a much higher percentage of book. But I think the last sales we did were even in the 860s gross. But the stock has since fallen back. So it's really we traded in quite a range, probably 825-875 throughout the second quarter. And the selling price tracked book. So it's, like I said, it was kind of 97% of book gross, maybe 97.5%. And so it just depended on the day where those prices were. I don't have that in front of me, unfortunately.

Christopher Nolan (SVP)

Yeah. So given that you're raising equity capital, which is dilutive to book value, how much of the swing in book value this quarter and the second quarter was due to these capital raises?

Robert Cauley (Chairman and CEO)

It was about $0.09. Here's how you get to that number. We had GAAP earnings of -$0.09, and we paid dividends of $0.36. So if you don't issue any shares, the change in your book value is just going to be earnings less the dividend, right? So -$0.09, -$0.36 gets you to -$0.45. But we did issue shares, and book was down $0.54. So that difference, that delta is $0.09 that was attributable to share issuance.

Christopher Nolan (SVP)

Final question. Given that, should we expect further book value dilution from the capital raises you've done quarter to date?

Robert Cauley (Chairman and CEO)

Well, we did those at much higher percentages of book. My rough estimate is about $0.01, quarter to date. And that's because I said the last sales we did were almost at book, essentially at book. And so there's very little dilution in those.

Christopher Nolan (SVP)

Great.

Robert Cauley (Chairman and CEO)

Maybe worth noting also that something that makes this a little bit tough to get your hands around, your mind around, is that some of the, as I alluded to earlier, some of the capital that we raised, we did so when book was higher and then put the money to work when book was lower. So not to confuse the matter too much, but we did save some capital and put it to work when spreads were sort of at their quarterly wides, so.

Christopher Nolan (SVP)

Okay. Thanks, Hunter. Okay. Thanks, guys.

Robert Cauley (Chairman and CEO)

All right, Chris. Thank you.

Operator (participant)

As a reminder, if you would like to ask a question, please press star and the number one. Our next question comes from the line of Jim Fowler from Kingsbarn Capital. Please go ahead.

Jim Fowler (CEO and Chief Investment Officer)

Hello, Bob and Hunter. Good morning.

Robert Cauley (Chairman and CEO)

Hey, Jim.

Jim Fowler (CEO and Chief Investment Officer)

Hey, guys. Thanks for taking the question. I just wanted to ask a bit, refer to a couple of tables, one in the press release, one in the deck. Tie a few together, see if I'm looking at this properly, and then ask a question. So I've noted that the last two quarters had strong economic income relative to the dividend distribution. A few notes on page 8, and which you also provided detail on, the largest contributor of that has been the hedges in the current period, of which about 60% is related to the net swap benefit. And those swaps, you have a very unusual position of not having any maturities until 2026, and then they're much longer.

So when I look at the economic income for the quarter of $29 million, and I look at that as a return on the average capital allocation of the quarter of $405 million from the press release, I get an economic income return on average invested economic capital of about 28% for the quarter. And as you articulated earlier, I think the marginal cash ROE is in the 19%-19.5% range, levered 7.5x. So if all of that seems reasonable to you and is accurate, I guess the question that I have or the observation I'm making is that this is now a convergence situation where how long will it take for the portfolio economic return of 28% on average invested capital to converge onto the marginal investment return on cash ROE of approximately 19%?

That would seem to be a very long convergence cycle unless a significant amount of capital was being raised and invested at that margin, that marginal cash ROE. That would cause that economic return to converge more rapidly. And here we are in the second quarter, not into July, raising lots of capital. I think share issuance in the quarter was up quarter-over-quarter about 22%. So I'm wondering how you think about that vis-à-vis the relationship of economic income versus the current distribution. And if that economic income on the margin begins to climb closer to distribution, the distribution rate because of capital raises, does that obviate any opportunity to adjust the dividend upward and could potentially pressure the dividend?

Robert Cauley (Chairman and CEO)

Let me take a crack at that. So the convergence, if we were to get an easing cycle.

Jim Fowler (CEO and Chief Investment Officer)

Well, let's not talk about easing at this point. I'm just talking about marginal capital raised, invested at 19% when you have a balance sheet and a hedge structure right now that's now it's obviously above market, mostly driven by the swap benefit. But I don't want to introduce anything with the Fed at this point. I'm just looking at static balance sheet and the raising of capital on the market at a cash ROE that is diluted to the economic ROE.

Robert Cauley (Chairman and CEO)

So if I'm following you correctly, so you're saying it's diluted because the legacy ROE is higher than the marginal ROE, right?

Jim Fowler (CEO and Chief Investment Officer)

Absolutely right. Yes.

Robert Cauley (Chairman and CEO)

Right. And the rationale for doing so is that if you look at it purely from the perspective of a NIM, in your framework, it doesn't make sense. But the way that we would look at it is not just from the perspective of NIM, but the valuation of the assets. So we think that the NIM that you allude to, the 19.5%, that is, if you think of total return as the sum of price appreciation and income, that's purely income, right? So that's assuming no price delta. And the rationale for us in doing so is the expectation that there's the potential for fairly meaningful price return because we're putting the money to work at assets that we view as historically cheap. That may not come.

So let's say that mortgages don't tighten at all for the next two years, in which case you're right. As we raise capital, we will continuously dilute the return, the NIM. That being said, there is potential for price return, and that would cause the marginal return to be higher. I guess that would be our justification for continuing to do so. We view ourselves as putting money towards, and that's really the reason, getting back to the last question, why would you issue stock slightly below book? And that's why is that you think that you have the potential to generate capital or price returns that will more than offset any potential dilution from issuing stock.

Just to add, I think there's one oversimplification here, and that's that these gains and losses attributable to the swaps, for example, as you alluded to. The swaps have already been marked to market. So the mark-to-market on the swaps that are in the money is going to go from whatever it is now to zero over the life of that swap, right? So it's going to accrete or it's going to amortize back out of book value. That's, I think, one of the missing pieces to the 28% number is just on a total return basis.

Jim Fowler (CEO and Chief Investment Officer)

Right. They're going to accrete to zero. The market value impact will accrete to zero as they approach maturity.

Robert Cauley (Chairman and CEO)

Right. And that's why I was going to bring up the Fed, not because I'm making a call on the Fed, but if the Fed were to ease, to Hunter's point, the value of those swaps would decrease, right? Right? Because there's what the Fed does and what the market's pricing of the Fed to do. If you look at the curve, the swap curve, where's the 10-year swap yield? Well, it's a hell of a lot lower than Fed funds. The 10-year point on the swap curve is 4%. So the market expects 6 eases on average over the next 10 years. So just the fact that the Fed eases may not do anything.

But potentially, if you do get more eases than expected, those swaps start to lose value, but your return on marginal equity goes up because, as Hunter alluded to earlier, the NIM on the unhedged position grows. So in that sense.

Jim Fowler (CEO and Chief Investment Officer)

I look at that as being a geographic change on your economic income schedule. I mean, NIM will increase and the swap benefit will decrease, and the net benefits, bottom line, should approximate no change. Yeah.

Robert Cauley (Chairman and CEO)

That's right.

Jim Fowler (CEO and Chief Investment Officer)

I was just looking, yeah, I was just looking at this and saying I was looking at the first quarter number where it was such a strong performance. The economic income was such a strong performance relative to the distribution. And then in the second quarter, it was even slightly better, thinking that that was indicative of the opportunity to address the distribution. But then with the capital being raised, it's going to be, it's going to cause, on the margin, that delta to decline in the third quarter and in the fourth quarter. So I just wanted to see what your view on that thinking was, but I appreciate the insight. Thank you very much.

Robert Cauley (Chairman and CEO)

Yeah. I think you might have heard that. But just one more point on that, and that's that the legacy portfolio is largely a lower-yielding portfolio. And so what we've actually seen is if we think about marking our portfolio and our hedges to market every day, really, as far as that goes, but every quarter, our mix of assets, once marked to market, doesn't fall out of line with that 180-200 basis point economic return that gets us to that sort of high teens type of number. And so as we have added higher coupon production coupons, those have come at a slightly wider NIM than the legacy portfolio.

And so if we just think about moving from one quarter where we were marked both on an asset and hedge basis to the next quarter, the recent capital raises have actually increased our blended income earning capacity of the portfolio. All right, Operator, next question. Hello? Operator, are you there? All righty. I seem to have lost the operator, and I'm assuming that we don't have any more questions. Okay. I'm told that the operator's still on. We just can't seem to hear them. In any event, we appreciate your time.

Thank you for joining us today. To the extent that any other questions come up, and because of these apparent technical difficulties we were unable to ask, please reach out to us at the office. The number is 772-231-1400.Or if, for instance, you don't get a chance to listen to the call live and listen to the rebroadcast, if you have any questions, you can use that same number to call us. Otherwise, we look forward to speaking to you at the end of the third quarter. Thank you.