ARMOUR Residential REIT, Inc. (NYSE:ARR) Q4 2022 Earnings Call Transcript

ARMOUR Residential REIT, Inc. (NYSE:ARR) Q4 2022 Earnings Call Transcript February 16, 2023

Operator: Good morning, and welcome to ARMOUR Residential REIT’s Fourth Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. Please note, this event is being recorded. I’d now like to turn the conference over to ARMOUR’s Chief Financial Officer, Jim Mountain. Please go ahead.

James Robert Mountain: Thank you, Anthony, and thank you all for joining our call to discuss ARMOUR’s fourth quarter 2022 results. This morning, I’m joined by ARMOUR’s Co-CEOs, Scott Ulm and Jeff Zimmer; and Mark Gruber, our CIO. 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 protections provided by the Private Securities Litigation Reform Act of 1995. The Risk Factors section of ARMOUR’s public reports filed with the Securities and Exchange Commission described certain factors beyond ARMOUR’s control that could cause actual results to differ materially from those expressed 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 there for one year. ARMOUR’s Q4 comprehensive income available to common stockholders was $39.5 million. That includes $39.4 million of GAAP net income. Net interest income was $11.6 million and net interest margin for the quarter improved 38 basis points to 2.59%. Distributable earnings available to common stockholders was $38.8 million, or $0.27 per common share.

This non-GAAP measure is defined as net interest income plus TBA Drop Income adjusted for the net coupon effect of our interest rate swaps minus net operating expenses. ARMOUR paid monthly common dividends of $0.10 per common share during the quarter and has paid dividends at that rate since January and has announced dividends at that rate for January 2023 and February 2023. Yesterday, we announced an adjustment to our dividend rate to $0.08 per common share monthly. As we have discussed in our previous calls, our aim is to pay an attractive dividend that is appropriate in context and stable over the medium-term. We keep a keen eye on economic conditions and the ARMOUR Board believes that this dividend rate achieves those objectives. With this dividend declaration, lifetime cumulative common and preferred dividends are approaching $2.1 billion.

During the fourth quarter, we purchased 449,700 shares of our common stock at an average cost of $5.01 per share under our standing repurchase authorization. On the sales side, our common stock ATM program has been very successful. During the fourth quarter, we issued 30,721,405 shares, raising $174.2 million of capital after fees and expenses. That represents an average net landed price of $5.67 per share. So far in Q1 2023, we’ve issued approximately 29,863,000 shares, raising net capital of $181.3 million. This represents an average price of $6.07 per share. This brings our common share count to 192,774,581 shares, representing a common share market capitalization of over $1.1 billion based on last night’s closing market prices. In addition to providing capital to take advantage of appealing current investment opportunities, share issuances build a larger base over which to spread our mostly fixed running costs.

Our book value at quarter-end was $5.78 per common share. Our most current available estimate of book value is as of Monday night, February 13. We estimate that our book value was $6.04 per share after providing for the February dividends. We finalized our tax projections for calendar 2022, and as expected, all common stock dividends and Series C preferred dividends were treated for federal income tax purposes as a return of capital and are not currently taxable. This is comparable to 2021’s tax results. Looking forward to 2023, we expect that Series C preferred stock dividends will likely be treated as fully taxable ordinary income to those shareholders. We also expect common dividends for 2023 will likely be treated at least partially as taxable ordinary income.

Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm, to discuss ARMOUR’s portfolio position and current strategy in more detail. Scott?

Scott Ulm: Thanks, Jim. While 2022 marked an all-time worst year for total returns on U.S. Treasuries and agency mortgages since their inclusion in fixed income indices, several trends beginning in the fourth quarter and extending into the new year give us optimism that 2023 will see a very constructive environment for MBS and our investment strategy. MBS volatility, which was exceptionally high in 2022, is declining. While the Fed seems by no means to be at the end of rate increases, the size is moderate and we should eventually see a more stable rate environment. We also expect the economic and rate environment to continue to moderate supply and mortgages. Most importantly, the unprecedented decline in bond prices generated incredible values as measured by zero volatility adjusted MBS spreads, reaching just shy of 150 basis points.

Spread levels have not observed since the great financial crisis of 2008/2009. While spreads have tightened driving our book value gain, we continue to see an attractive investment environment. Responding to new investment opportunities, ARMOUR purchased over $3 billion of MBS pools and TBA positions in the fourth quarter of 2022, split $2.2 billion in MBS and $800 million at TBA. ARMOUR continued to grow in its portfolio in 2023 with the addition of $5.9 billion of MBS divided $4.9 billion of MBS and $1 billion of TBA. As of February 13, ARMOUR’s portfolio size is over $12.3 billion. ARMOUR supported the new purchases through our ATM or share issuance program raising over $345 million in capital since the third quarter of 2022. MBS assets we purchased are concentrated in the most liquid, low premium bank service production coupon MBS pools.

We believe these pools will benefit the most as volatility eases from its recent highs and reverts to historical norms. These investments also reflect historically the loan prepayment rates since the MBA refinance index has fallen to its lowest level since the 1990s. ARMOUR’s average prepayment rate for all MBS assets to the fourth quarter of 2022 was 4.3 CPR and just 3.7 CPR so far in 2023. Although mortgage rates have already declined from the recent highs of 7.2% in early November 2022 to 6.3% in mid-February 2023, a substantial refinance wave would require mortgage rates well below the 4.5% to provide approximately 20% of existing borrowers with enough incentive to prepay early. ARMOUR maintains very healthy levels of available liquidity.

Our total leverage closed the year at 6.8x and currently sits at 8x, providing us with room to increase our investment portfolio size as future opportunities come along. ARMOUR continues to fund just over 50% of borrowings to a broker dealer affiliate, BUCKLER Securities. Despite the overall increase in market volatility, agency repo funding remained on a strong footing throughout the quarter with spreads ranging 10 to 20 basis points above the SOFR benchmark. The weighted average haircut on our repo book remained exceptionally low at 3.6% of year’s average numbers. We see leveraged and hedge returns in the current market in the low to mid-teens. For prospective investments as well as the current book, a substantial amount of yield is provided by hedges.

Nonetheless, we’ve always viewed our investment book is holistically comprised of MBS and related hedging. As we’ve always noted, we set our dividend to be appropriate for the medium-term. Earnings available for distribution have moderated, and we feel it is appropriate to reduce our dividend by $0.02 to $0.08 per month. We will, as always, continue to evaluate the level of the dividend. We are also mindful that this environment could deliver upside for surprises as well they could move our metrics substantial. Now open the line to questions.

Q&A Session

Operator: We will now begin the question-and-answer session. Our first question will come from Doug Harter with Credit Suisse. You may now go ahead.

Doug Harter: Thanks a lot. I was hoping you could talk about where you see available returns on incremental investments and just help put the new dividend in the context of those returns rather than an EAD perspective.

Jeffrey Zimmer: Good morning, Doug. This is Jeff here.

Doug Harter: Good morning.

Jeffrey Zimmer: Thanks for calling in. Available returns are in the 14% to 16% area. Some of that’s supported by €“ these are new marginal investments, of course. They’re supported by swaps. They’re still positive. You’ve been on a swap. You’re actually getting paid. So looking back two years ago, you paid on a swap and it maybe detrimental to your earnings capabilities. Well, now, the swaps that we have and the swaps we put on are incremental to the earnings and that’s a benefit shareholders. So we pay that out. $6 a share, you got about a 16% payout right now. We think that’s appropriate based on the book that we have and where we’ve been able to invest. I guess Scott stated a 150 basis points, just a nominal spread is almost as good as it gets.

And I think in October, we might spiked out to 175, 180 for a very short period of time. But these are the best investment opportunities that we’ve seen in a long time and we’re making the investments with our new capital and paying that benefit out to shareholders.

Doug Harter: Okay. And then just on expenses, you talked about one of the rationales for using the ATM being to kind of spread the expense base. I guess if I look at the operating expense as a percentage of equity, it’s actually been going up over the course of the year, since the management fee is

Jeffrey Zimmer: Doug, are you there? Yes, Doug, we lost you. Let me try and jump in and look. Did we get you back, Doug?

Operator: His line is on silent.

Jeffrey Zimmer: Why don’t you go ahead, Jim?

James Robert Mountain: Hopefully, listening or will pick up the answer on replay, Doug. Sort of the way we look at expense and the ATM, when we look at the sort of the dollar difference between net landed proceeds and recent book value that we actually use to guide the ATM program for the full-year that dollar difference that we disclosed in the 10-K is about $9.5 million if you divide that by ending share count at the end of the year of about 163 million shares, you get $0.06 a share, or the $6 ending share price, that’s kind of 1 percentage. But if you look at running costs for 2021 divided by ending shares that’s $0.37 a share ending the running cost for 2022 divided by ending share of $0.23 a share. So $0.14 per share pickup. If it cost you $0.06 a share to pick up $0.14 annually, that’s a payback of €“ seems to us less than six months, good deal.

Jeffrey Zimmer: So Doug, thank you for calling in. If you’d like to call back, I’m sure the operator can put you in. Otherwise, operator, if there’s another question available, we’re here to answer. Thank you.

Operator: Okay. Our next question will come from Trevor Cranston with JMP Securities. You may now go ahead.

Trevor Cranston: Hey, thanks. Good morning. Looking at the portfolio over the last few months, as you guys have added MBS and moved up in coupons, it looks like the hedge positions haven’t changed all that much. So I guess there’s two questions. First, can you say what the treasury hedges that you show in the slide deck? Could you detail what those are? And can you more generally just talk about how you guys are approaching hedging rate risk as you make incremental investments here? Thanks.

Jeffrey Zimmer: Sure. Mark, why don’t you get into that, please. Chief Investment Officer, Mark Gruber.

Mark Richard Gruber: Thanks, Jeff. So Trevor, so the first answer is the treasuries are going to be a mix of futures and cash treasuries and it’s going to be across the curve. So . So it’s just a mix of that. And yes, as we’ve added assets, we have moved up in coupon. So the duration of the asset side has shortened, but €“ and we didn’t add a lot of hedges also because we took our duration up a little bit. We were a little more comfortable as rates were higher. Did not add hedges and extend the portfolio duration just a little bit. So that’s what’s going on there.

Trevor Cranston: Okay. Got it. That makes sense. And then in terms of leverage, obviously, the portfolio has been growing and it looks like leverage is up to around 8x or so currently. Is that kind of where you guys are targeting for the near-term or could we expect some additional portfolio growth over the next month or so? Thanks.

Jeffrey Zimmer: Historically, Trevor €“ go ahead, Mark, either way.

Mark Richard Gruber: I was going to say, we were targeting somewhere between eight and nine. So we have a little bit of dry powder. Historically, we’ve been closer to nine. So you’ll probably see it drift up a little bit from here, but not much from where we are today.

Trevor Cranston: Got it. Okay. Thank you.

Operator: Our next question will come from Matthew Howlett with B. Riley. You may now go ahead.

Matthew Howlett: Hey, guys. Good morning. Thanks for taking my question. On the topic of leverage, I mean, obviously, you’ve had great success to access from the equity capital markets. When I look at the preferred market here, there has been some recent activity in this space. Look at your Series C is trading at I mean, on a 7% coupon. What’s the outlook? Your common equity basis increased to the extent that you do have room to do another preferred series. What sort of €“ if you looked at that market, is it open? Would you look at it here in 2023?

Jeffrey Zimmer: Hey. Good morning, Matt. Jeff Zimmer here. So if you look at our preferred last night, I believe it closed at 22.5, okay? So it’s a current strip yield of something like 7.78, okay? The reason that we issued a fixed, fixed and we are the only company whose primary issuance over the last three years have been fixed, fixed because we did not want to subject our balance sheet and our income statement in the future to the possibility of rates going up and rates are higher. And the most recent issuance by other firms in our broader space have been at higher coupons and the existing issues that they have outstanding that were fixed for five years and go to floating will mean their coupons are going to go to 9% and 10%.

So in the environment that we have today, we’re able to raise common equity right around par, right around book value as Jim Mountain stated. And we think that’s a better way to run the company right now. We can access mortgages with some of the widest spreads they’ve been in a decade. We access capital around book value and the cost go down. You would not see us in the near future going back to the preferred market. It’s just too expensive right now. I hope that answers your question.

Matthew Howlett: No, it does. And it’s €“ look, I certainly acknowledge that you don’t have those five years switching to floating. So that was a good move on your part. And it certainly looks the balance sheet has room. But if you choose to wait for the market to come back that would make sense. And then Jeff, just on the macro question, it looks like the Fed €“ I’d love to hear your thoughts and it looks like markets thinking 25 in March, 25 in June, and then pausing, love to hear if you think the next move after that would be a cut. And then on the Fed, obviously, the balance sheet, I think Powell said it’ll take a couple of years to shrink the MBS. Just your thoughts on the impact on MBS spreads. Would they €“ you think that they’ll €“ that should start selling? Or it €“ what could surprise us, I guess?

Jeffrey Zimmer: So I’ll address that, and I’ll €“ then I’ll see if Mark or Scott want to improve. We do expect an increase at the next two meetings of 25 basis points. Our firm does not anticipate the Fed cutting rates in 2023. If they cut, it would be in 2024. The economic numbers that are coming out are just showing that the employment picture is very strong and that’s not going to go away. It’s going to take some time. They may internally have to change their target from 2% to, like, 3% to 4% without announcing it. And to ease off the pedal a little bit. But on the other hand, we did see an announcement yesterday that already we’re seeing commercial credit defaults are not without saying company’s names. There were two defaults just announced for office buildings in New York and LA.

So even though you have a very strong employment situation as you see credit defaults and we’re sure the Federal Reserve expects these credit defaults, you’ll see that will spread to the employment sector just takes a while. So that’s where we are now. Now we also believe mortgages, as I said, number of times on today’s call, are historically very well priced and attractive. We would expect in the near future for mortgage spreads to stay where they are or even perhaps tighten a little bit. We are not nervous about the Fed selling mortgages down the road. As a matter of fact, most of what they would have to sell, they’re not in our portfolio, frankly. We’ve got a mid to higher coupon matrix right now that Mark and his team have put together and if I just don’t own that stuff.

So they want to go ahead and sell their two and two and a halves, which are areas that others maybe invested in, that’s fine. But there’s no other supply other than them and there’s no originations in that sector. So we’re always going to be aware of it. And we’re acutely aware, I guess, is to say, of the possibility of them selling, but it shouldn’t have an awful direct effect. Now look at €“ when the tide goes out, all shifts go down, okay? And we understand that, but we will not have a direct impact on the assets we own from them selling the coupons in our portfolio. So does that answer your question?

Matthew Howlett: No, absolutely. And it’s always good to hear your insight on that. And I guess the last topic, the CPRs, I mean, I think you said 4.7, well, these are the lowest numbers I’ve seen in my career. And look at €“ and I asked a question in the last call about convexing. It looks like you’re buying stuff close to par now here. I mean, just you think you said €“ any sense on €“ if there’ll be a pickup in CPRs, I mean, what you’re looking at when you put on your new asset these higher coupons? Thanks a lot.

Jeffrey Zimmer: I’m going to hand that over to Mark because he and his team spent a lot of time working on that. Mark?

Mark Richard Gruber: Yes. We would expect in our portfolio of CPRs pick up a little bit as we’re adding newer bonds. So they’re going to start at zero and they’re going to slowly ramp up. And it really just going to depend on rates. If rates decline, your mortgage rates decline, we’ll see a pickup. But we don’t see anything systemic where we go back to 15, 20 CPR right now.

Matthew Howlett: And the premium you’re adding, is it just sort of minimal in terms of what you’re putting on that what you’re booking?

Jeffrey Zimmer: Scott, go ahead.

Scott Ulm: It’s minimal. The pay ups in general, like we said earlier, are usually single digits, maybe half a point. But when you look at 5.5 or 6 coupons, it’s 2 points or so.

Matthew Howlett: Got it. Thanks a lot. Appreciate it.

Jeffrey Zimmer: Thanks for calling in.

Operator: Our next question comes from Christopher Nolan with Ladenburg Thalmann. Thalmann, you may now go ahead.

Christopher Nolan: Hey, guys. I think I’ll try to take up from the €“ I think the line of questioning Doug Harter was pursuing. On the dividend, I’m hearing mixed signals from the standpoint that you’re saying that the environment is good, and you’re going to get low to mid-teen returns and then we’re cutting the dividend. And I guess my question really centers, is the dividend cutting just expectations of a dramatically growing share count going forward? Or can you give some clarification on that, please?

Jeffrey Zimmer: Sure. In all cases, when we increase our share count, it’s to benefit existing shareholders and not just new shareholders. So as I said before, we look at it very holistically. Repo rates have gone from 25 basis points to 4.5 and 4.7 right now. So as those repo rates go up and the tenure remains inverted to those rates, it’s generally going to put a stress on your earnings rate. So whether we had raised zero or $300 million, we would be cutting the dividend right now. So please look at that as the holistic approach and a separate things. I hope that’s helpful.

Christopher Nolan: Yes, it’s helpful. It’s just €“ I thought I heard your comments where €“ you’re going to have low to mid-teen equity returns, which is pretty consistent with what you’ve been seeing recent quarters. I might have misheard it, but just trying to get a clarification.

Jeffrey Zimmer: The returns available in the 14% to 16% range and we’re currently paying approximately 16%. But what I also said and I wanted to be crystal clear on that. We have a very large swap book that was put on at very low rates. And that still covers about 65% of our repo book. So that is a real big driver and benefit that we’re passing along to shareholders in terms of earnings. So that’s a trailing aspect and some of that has quite a ways to go.

Christopher Nolan: Okay. Thank you.

Jeffrey Zimmer: Thanks very much.

Operator: It appears there are no further questions. This concludes our question-and-answer session. I would like to turn the conference back over to Jim Mountain for any closing remarks.

James Robert Mountain: Well, we’d like to thank you all for joining us this morning for the attention that you give to our firm and our stock and our shareholders, and look forward to speaking again in April until then.

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