Orchid Island Capital, Inc. (NYSE:ORC) Q2 2023 Earnings Call Transcript

Orchid Island Capital, Inc. (NYSE:ORC) Q2 2023 Earnings Call Transcript July 28, 2023

Operator: Good morning and welcome to the Second Quarter 2023 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, July 28, 2023. At this time, the Company would like to remind 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 risks 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: Thank you Operator. Good morning. Hopefully, everybody had a chance to download our slide deck and I will be going through that over the course of today’s call. As usual I will be following the same format of our on Slide 3 just a table of contents just to give you an outline of the agenda. The first item will just be a quick overview of our results of operations for the quarter, and then I will talk about market developments and what we dealt with over the course of the quarter, and then our financial results before finally describing our current portfolio positioning with respect to the portfolio, the hedges, and so forth, and then say a few words about how we see things going forward. So with that, turning to Slide 4.

Orchid Island generated net income per share of $0.25 per share for the quarter. Net earnings excluding realized and unrealized gains and losses on RMBS and derivative instruments, including interest income on interest rate swaps was $0.34 negative per share. Gain of $0.59 per share from net realized and unrealized gains on RMBS and derivative instruments again including interest income on interest rate swaps. Book value per share at 6.30 was $11.16 versus $11.55 at March 31, 2023. In Q2, 2023, the company declared and subsequently paid $0.48 per share in dividends, and since our initial public offering, the company has declared $65.77 per share in dividends, including the dividend declared in July 2023. Total economic gain of $0.09 per share for the quarter or 0.08% that is an unannualized figure.

Now going to market developments, there were basically four notable developments that occurred during the quarter. The first, which occurred in late May was the debt limit impasse between the administration and Congress, and while that was resolved during that period we did see very negative performance for risk assets generally, but more importantly, mortgage-backed securities in particular, and I’ll just talk about this more in a moment, but it was during that period that most measures of mortgage pricing, in other words, in terms of spread to some comparable duration treasury, reached a cycle high in late May, and that was significant of course and that did trigger some actions on our part, which, again, I’ll get into in a few moments. The second development was the recovery of mortgages in June, obviously, we haven’t recovered all the way back, and we’re close to where we were pre-pandemic, but the mortgage sector had a very good recovery in June.

The third item, which really has gone on for two-plus months now is restricting, if you will, of economic data, both inflation data, strong labor market data, GDP yesterday, and resulting reaction on the part of not just the Fed, but central banks across the globe, which had become very — even more hawkish, and as we saw this week, another hike with the potential, at least potential, maybe not ultimately realized, but even more hikes to come. And then the fourth item, which occurred in the second quarter which were a result of the bank failures in March, with the FDIC taking over those banks, were the options of the assets, well over $100 billion approximately $61 billion of pass through mortgages. This has started on April 18 and it’s still ongoing, although it is going much faster than initially anticipated and it’s also going quite well.

So those are kind of the four major macro developments we dealt with now, just to go through the slides, just to give you some of these things and pictures. Slide 6, this has looked the same, this slide for a year and a half, and what we see, the red line there is where we were at the end of the last quarter, and the lines above it are the most recent ones, the last of which is last Friday, and you can see the curve is the Fed has continued the hike, the front end has moved higher, but the curve has remained very inverted, and that’s meaningful for us and for any levered investor, and I’ll say more about that in a minute, but basically it tells you through hedging and using say for instance, swap insurance, you can lock in very attractive and then interest margin levels using those types of insurance.

So in any event, the curve has continued to steepen, or invert rather, and that’s true in both the Treasury nominal curve and the swap curve. Slide 7, these are just pictures of the 10-year notional and cash, nominal cash, and then the 10-year super swap, and over the course of the quarter rates were drifting higher and in spite of that, as I said mortgages have actually had a decent quarter even with the rise in rates. Moving on to Slide 8, I’ll just focus on the bottom of this page. This is the spread of a current coupon mortgage to the 10-year Treasury. There are many such measures that people look at. You can look at the 510 blend or just to the curve and they’re all pretty much all the same picture and I think if you look at the bottom, this goes back to 2010, and this gives you some very good perspective.

And you can see from say 2013 through the pandemic, the spread was fairly stable. We had a spike in March but more meaningfully if you look to the most recent history last fall in October that spread got as high as $190, but in late May, we reached $200. So as I said, when we had the debt limit in pass, while it didn’t appear to be something that you would consider mortgage market-related, it was during that period that mortgage spreads hit their widest level in cycle high through this current episode. And so that was meaningful and that was something that caused us to take several actions which I’ll describe in a few moments. Moving on to Slide 9, this just shows you the 530 curve. There are many, many other points on the curve you can pick.

Most common would be 2s, 10s, or the spread between Fed funds and 10s. They’re all inverted. In the case of 2s, 10s the cycle high so far is negative 110. We were as high as 105 this week, although this week, in the last two days in particular, that has steepened as in less negative, but still very much inverted. Moving on to Slide 10, this just shows you the size of the Fed balance sheets and bank holdings, and we described the details of what we mean when we refer to bank holdings in the note below. But the takeaway is that you’re seeing a normalization as the Fed likes to refer to it, of their balance sheet. In other words, they expanded their balance sheet in response to developments that occurred in 2020, and they’re now, through quantitative tightening, letting that balance sheet run off or normalize.

And bank balance sheets just follow because, after all, when the Fed is reducing their balance sheet, they’re reducing reserves in the system, and banks tend to mimic what they do both on the way up and down. Now turning to slide 11, this is more mortgage market specific, as you can see in the top left. And remember, these are absolute price change, not necessarily total return versus some benchmark, but just price change with all prices normalized to 100 at the end of the last quarter. And as you can see, all coupons are down in price, which makes sense given the moving rates. But the performance was not uniform and as I mentioned in late May, the spread’s got quite wide and have since recovered somewhat. So you could argue that these price movements are exaggerated to the downside, reflective of that spread widening.

On the bottom left, you can see rolls on the dollar roll market, off any source of income in the levered mortgage space and otherwise and you can see that all of these rolls are essentially non-economic. The only roll that has any positive drop is a six-and-a-half coupon as of this morning. The rest are all negative. And the alternative to TBAs is usually a specified pull market, so if you look in the top right, you get a picture of that. And keep in mind that as I said on April 18 the FDIC liquidation started, so we’ve had substantial selling of mortgages by the FDIC, and almost every bond that they sell is of some form of a specified pull, even if it’s just seasoned. So they all have a pay-up. So you’ve had tremendous supply. The initial reaction to the FDIC liquidations were TBAs widened, as you would expect.

And so the pay-ups initially didn’t look so bad, not just really because the benchmark was lower, but they’ve since stabilized, and as I said, those liquidations are going very well. We’re probably 80-plus percent through, probably be done comfortably before this quarter is over and it’ll be interesting to see how those markets behave once we don’t have $3 billion or $4 billion of supply every week. But again, that market has held up quite well, considering the size of those liquidations. Again, it was over $61 billion of supply just in the patchroom market. Turning to Slide 12, this is a measure of vol, three-month-by-tenure vol. Obviously, mortgages are an asset that is very much impacted by levels of volatility. The short takeaway here as you can see is that vol is normalized or not normalized.

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I guess it’s moderated somewhat since late March or late May. But keep in mind that this level is still over 100, and for reference, during the last decades, up until the pandemic occurred, the average level for that period was about 72. So we’re well above that. So volatility is still elevated, just kind of at a local low, as opposed to a local peak. Turning to Slide 13, as I talked about mortgages earlier, you can see on the left-hand side, these are LIBOR/SOFR OAS levels and as you can see, they’re extremely elevated as of late, and they appeared to peak in late May. And then recover in June, consistent with what I said earlier. Keep in mind that prior to the pandemic, these levels were all negative. And even after the pandemic when the Fed was in the midst of QE, these numbers were negative.

So we moved a long way, and as a result, the mortgage market, while it’s been painful at times of late over the last year and a half, performance-wise, the asset class is very attractive. Turning to Slide 14, these are just returns across our markets and other components of the aggregate index, and even the S&P. And of course, mortgage investors, certainly ones that are focused exclusively on mortgages, a number of investors are invested across multiple asset classes. And so therefore, the returns across these things matter to them, and therefore us, because they are large players in our market. As you can see in the second quarter, the best returns were the riskiest assets, high yield, emerging market, high yield, and the S&P 500. All the other components of the fixed income markets were either very modestly positive in the case of emerging market, investment grade, debt, or negative, but not materially so.

And looking at the year-to-date numbers, again, the riskiest assets have had the best returns. But otherwise, everything’s fairly uniform. The spread between the best and the worst is quite small. The best returns year-to-date are investment grade corporates. And while that’s not been, unfortunately, not mortgages, going forward because of investment grade corporates doing as well, mortgages look fairly attractive versus that asset class. And as a perfect segue to go to the next slide, where we show spread levels across the same large investment grade and sub-investment grade fixed income market. And I’m just going to focus at the top of the page. If you look at the agency, MBS, and corporates, and the reason I’m focusing here is that to the extent money managers are active in the market and they are the largest, most active at the margin player today because the bank, community, and the Fed are largely absent.

So money managers are relevant for us. And so if you look at spread products, in other words, assets that trade was spread to treasuries, the two largest buckets are the agency, mortgage market, and the investment grade corporate market. And so relative attractiveness is important. So just look at a few points or columns in this slide. If you look at the column labeled 2021 year end, you can see that corporates were quite a bit wider than mortgages. If you look a little to the right, you can see that we had a very stressful 2022 and those spreads were much wider, but they converged. If you look to the left, December of 2022, you can see again that those levels, while they’re off the tight or the wide, they tightened, they’re still very much in line with one another.

But if you look at the current level, you can see the mortgages are quite a bit wider. And so that’s not been so good for performance year to date, but going forward, the asset class, the mortgage asset class does look relatively attractive and that should bode well for the sector going forward. And is the reason for that we are very constructive on the market over the balance of 2023 and beyond. Slide 16 just shows you the refinancing picture, so to speak, on the bottom of the page. You can see the percent of the market that’s in the money, which is essentially zero. It’s about 2%, not surprisingly, given where mortgage rates are. But it would call your attention to the top slide on the right. It’s what we call the primary secondary spread of the spread between the newly originated mortgage and a benchmark treasury or swap.

And you can see it’s been volatile of late, but it’s also at fairly high wide levels. And to the extent that the market turns and we see the Fed moving from a tightening bias to an easy bias, that would of course be a beneficial development for the mortgage banking universe because they would be in a position to start doing refinancing, which as you can see has been negligible. And the fact that those spreads are wide, they have ruined the tighten. We’ve said throughout our last few earnings calls that we have a very negative view on current coupon recent originated, recently originated mortgages. And this is just another reason where we would think that convexity could prove to be a real challenge, especially in this case, the ability of this primary secondary spread to tighten and allow mortgage rates available to borrowers to come in and just make that section of the universe that much more refinanceable.

So that’s just an aside, but I just wanted to point that out. Now turning to our financial results on Slide 18, I’m of course going to focus on the left hand side. And this is the same slide we’ve had for several years. And as I’m sure most of you are keenly focused on the left side, the net income excluding realized and unrealized gains and losses, as you can see, that number is a negative $0.34. And we’re paying a $0.48 dividend, so the question in your mind is how can that be the case? And I’m just going to walk you through it. Starting with the net portfolio income of negative $8.7 million, that’s roughly $0.22 negative. And in the expenses of $4.819 million, that’s another $0.12, that gets you to your negative $0.34. However, we use fair value accounting, which means that we do not capture premium amortization or discount accretion in our income figures, but that’s still very much relevant because we do all these securities generally at a discount in the current environment.

The accretion to par of our discount securities was approximately 4.9 million in the current quarter. So that’s a positive $0.12, but much more materially, our hedges. Again, we don’t use hedge accounting, even though we do actively hedge. We use hedge accounting for tax purposes only. But our hedges are very much in the money, and that added about $23.5 million of income or offset to interest expense, which is about $0.59. So when you factor in those two items, that gets you to a positive $0.37, again, versus a $0.48 dividend, so there’s still a shortfall. I will note that during the quarter, we did issue a little under $50 million of equity through our ATM program to increase our leverage by approximately one churn, and we used the proceeds to buy a combination of 30 and 5.5 and 6 securities, and we were able to hedge those positions using interest rate swaps predominantly, and as I mentioned earlier, with the curve inverted, we could lock in basically funding through those hedges such that we had a blended net interest margin on those newly acquired assets of just over 100 basis points.

So that will add about 2.5 to $0.3. So that is going to close that gap some, and I’ll speak more to this in a few moments, but I just want to point out that the gap obviously $0.34 negative were much, much less than that. And we did do this ad here in the very, very late stages of the quarter, so it’s not reflected in these numbers at all. So going forward, all of us equal, we would be at around $0.40 versus the negative 34, even the $0.37 we had this quarter. So that’s just the one thing I want to point out to you, what we’re able to do at the end of the quarter. And then I’ll speak more about our current positioning and how we see things going forward in a moment. Running through the bounds of the slide, Slide 19, this is just a picture of our net interest margin, obviously, with the curve inverted and the fed rise rating rates.

We’re at a local trough and actually a long-term trough in that regard. Slides 20 is more or less the same. Slide 21 is our leverage ratio. I want to speak to this. And we’ve spoken in the past that the blue line represents what we call adjusted leverage. That’s basically just our repo balance divided by our shareholders’ equity. And as you can see, it was 8.6 at the end of this recent quarter, but we also use TBAs, or in our case, hedges of TBAs, so shorts of TBAs to adjust that figure. And late last year and earlier this year, we were short a substantial amount of TBAs, so our economic or at-risk leverage was much lower. And we had said that if we saw the market opportunities as being extremely attractive, which they have been ablating, that we could reduce our TBAs short, in effect increase our leverage, which is what we did in this quarter.

And so by simply just buying back these TBAs shorts and the most recent ad that I mentioned, we were able to take our leverage higher, which we did. And it’s obviously to take advantage of these extremely attractive levels in the mortgage market. And we do have some small, more additional room to do so, but we did take a substantial step this quarter. Moving on to Slide 22, our positioning on the left side is really nothing to say here. It’s basically unchanged with rates as high as they are. There’s not much value in IOs other than carry very little ability to offer a hedge component of their performance. And so as a result, we have a heavy, heavy skew towards pastures. And now I’ll talk about our portfolio characteristics. So on Slide 24, we show our portfolio on the tops of half of the page.

And as has been the case for some time, it’s heavy skew towards fixed rate 30-year mortgages, approximately 97 and almost a half percent. But as you can see, we’ve added five and a half and sixes. All other coupon buckets are basically unchanged from last quarter other than payoff. So the change in the outstanding balance there just reflects paydowns over the course of the quarter. But we did add substantially to the five and a half and six bucket. And we took our weighted average coupon from about 3.56% to 3.83%. So we have taken that higher. And as I said, we may do so more in the future, but I want to table that conversation just for a moment. Otherwise, with respect to the portfolio, there has been no changes in the post-quarter end. So we haven’t done anything in Q3 yet.

Slide 25 shows our speeds. Obviously, in a substantial discount environment, these levels are quite low. If you look at the most recent quarter, which is the bottom left, that’s June. Reasonable speeds, our securities were paying around six CPR in the 3% coupon and a little higher in the three and a half bucket. That may be the cycle high since we’re kind of at the peak seasonal, so turnover and the like. And you get decent yields out of the assets with those speeds, but I would not expect those to change meaningfully in the near term. Going through Slide 26, this is just more of the same. Mortgage rates are very, very high. The orange line there in our turnover or paydowns expressed as a percentage of the outstanding principal balance are quite low.

And you expect that to remain the case until rates turn around and build the other way. Slide 27, this is a picture of our repo bar rings by counterparty. And as you can see, we have quite what I call effective spreading of the exposure across many, many counterparties, diversity. No single counterparties over 8%. And we’ve continued to do that for a number of years and try to avoid concentrations while at the same time maintaining access to more than adequate funding and a large number of counterparties. On the right-hand side, we see our funding cost. One month’s SOFR, which is kind of hard to make out to that’s a light gray line. The red line is basically our cost of funds. And as you can see, it’s risen quite steeply and then continue to rise as we move through 2023, although at a slower rate.

But importantly, if you look at our economic cost of funds, and this is where the impact of our hedges come into play, you can see it’s basically peaked and stabilized. And unless we were to grow the portfolio substantially, that number would be expected to stay there. I’ve spoken at length on prior calls about the dollar amount of hedges that we have that have been closed out, but for federal income tax purposes will still impact our tax of income this year and next and actually years after. And we have substantial gains from those hedges available to offset increased interest expense. And so this number is the ability to stay that way for quite some time. Now, I’ll turn to our hedges. This is an important slide. As we mentioned that in late May, when mortgages got very, very wide and the cycle-wides, and I said that we had taken some steps, I mentioned the fact that we bought some assets.

But the other thing we did was on the hedge side. And what we did was we moved a lot of our hedges from mortgages, TBA shorts, which you see in the bottom left. We were at negative $875 million an hour at minus $350 million. And we moved those to rates, thinking that mortgages could not get meaningfully wider. So we wanted our hedges to be more rate-driven than mortgage-driven. And also we moved more out the curve. And so what we’ve seen over the last couple of months, whenever you get some softer data, like so we had a softer CPI number last month or a non-farm payroll, as is typically the case, the most reactionary point on the curve is the five-year. The five-year point of the curve is typically the most sensitive to changes in the direction of rates.

And we think that eventually, when and if the Fed does pivot and starts to ease, that you’ll see a steepening of the curve, which will be led by the five-year. And so we would not want to be using the five-year as a hedge. We’d much rather use longer-dated treasuries, less of them because they have more duration. But we wanted to move the hedges further out the curve. And so if you look at the top left, for instance, you see in our futures position, our allocation of the five-year Treasury note future was reduced substantially. And when we moved our TBA hedges, we moved them into either 10-year note futures or ultras or swaps. So if you look at the top right side of the page, you can see our swap position went from 1.674 billion to 2.15 billion, approximately a 40% increase.

So we’ve moved our hedges, again, this was in late May, away from mortgages, into rates, and further out the curve. And we think that is a very ideal positioning for an eventual pivot and reversing of the direction of rates. And as, again, given the nature of the curve is inverted as it is, you can lock in very attractive funding, even in this high-fit funds environment, and well north of 100 basis points is available. So it’s not as bad of a market as it appears on the face of it. With respect to post-Q end, we’ve done very little. There was some slight changes to our [swaps and] positions we basically converted one of our forward ball pairs into a forward starting 10-year swap. Again, consistent with what I just described above. And so that’s basically it.

I would just say in summary that our portfolio positioning, as I said, we still have a very low or low coupon bias. We did add opportunistically to some higher coupons. May do so again at the margin in the future if conditions are favorable, although we don’t view those assets as long-term core holdings because we think that they will do very poorly if the market were to turn around and rates were to rally. And we are very comfortable with our current hedge positioning, like the fact that we’ve moved mostly from mortgages to rates and where we are in the curve. And that we have a very constructive view on the market certainly over the long term. We think mortgages have the opportunity to do extremely well over the balance of this year and next.

It may not occur in the very short term, but we have a very constructive long-term view on the sector with our positioning and with our hedges. And with that, I will turn the call over to the operator and I’ll take any questions.

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Q&A Session

Operator: Thank you, Mr. Cauley. [Operator Instructions] We’ll take our first question this morning from Matthew Erdner of JonesTrading.

Matthew Erdner: Good morning, Bob. Could I get your thoughts on the supply demand and spread dynamic after the FDI sales are complete given that the banks are kind of out of that market at this point?

Robert Cauley: Yes. it’s going to be, that’s a hard one to guess. I mean, the market, as I said, it’s gone well. The options have gone well. From what I, we don’t have direct access to the information, but from what we can gather from those that do, it seems that the money manager community, which I kind of alluded to on the call is kind of the critical marginal buyer of mortgages with banks in the Fed on the sidelines and they appear to be a pretty extreme overweight. But that being said, the sector is still attractive on a relative basis versus at least investment-grade corporates if not other sectors. And so I don’t think you get whipsaw tightening, but I don’t know that you probably get some gradual tightening. I just don’t think there’ll be a lot in the near term.

Hunter Haas: Yes, that’s fine. No, I totally agree with that. I think no matter what measure you look at, just nominal spreads like our current coupon to yield to 10-year treasury yield slide, or if we’re looking at on an OAS basis or relative to other spread products, mortgages are obviously still wide. I think that’s, once some of this uncertainty around the FDIC goes away, as it has gone away over the last month or so that we would expect to see a gradual tightening. But I think to your point banks have yet to reemerge and become players. And so I don’t think we’re going to see anything dramatic. But we still really like mortgages here. We don’t think they’ve had the opportunity to perform, particularly on a spread duration basis. And so that’s why we’ve kept our focus on lower coupon and longer duration assets that can benefit from spreads grinding tighter over time.

Matthew Erdner: Thank you. That’s helpful. And then sorry if I missed this, but did you provide a book value update quarter-to-date?

Robert Cauley: No, we did not. I’m sorry. It is very close to unchanged. As of Wednesday, we were probably slightly positive. Yesterday, we had a widening, especially in the afternoons. We gave back some probably took us to slightly negative on the quarter. And before I came in here, it looked like we were green. So I would say plus or minus 1% is where we’ve been for about the last week.

Matthew Erdner: Awesome. Thank you.

Robert Cauley: Yes.

Operator: Thank you. We go next now to Mikhail Goberman at JMP Securities.

Mikhail Goberman: Hey, good morning, guys. Hope everybody’s well. Just wanted to get quick thoughts on how you guys see the specified pool market going forward versus the TPA in roles?

Robert Cauley: Well, it’s certainly been under duress, so to speak, as I said, with the FDIC liquidations, everything that’s being auctioned is essentially a specified pool. And in addition to that, we’ve had, well, they’re smaller than we’ve seen in the past, but we still are seeing cash window lists from Fannie and Freddie. So insane amounts of supply and levels of held in. And also all that occurring while rates are very, very high. So I think it all bodes well. We don’t have the technical squeeze that we had when the Fed was doing QE to keep the TBA market hot. And that’s probably not coming back. So we’re kind of left with the specified pool market again. Those went into the indices last year. And so all the money managers out there that run against the index have to own them.

And I think that’s bode well. That’s definitely been a benefit during this most recent period without bank participation. So I would say that given the weather quite a storm, I would say I’m reasonably optimistic. I don’t think you’re going to see a material move, but I just don’t think that it’s going to be more of a slow, gradual positive performance, I guess, I would say.

Hunter Haas: Yes, I agree with that. And I think that, you know, there’s a large bifurcation in the specified pool market between some of the lower coupon universe that was produced over the course of the last 10 years or so that has been popping up on these liquidations and the more recently produced current coupon assets. I don’t have a high degree of confidence that what’s been produced in the last year and a half or so is in the specified pool form is going to be particularly great in terms of convexity protection both in a rally or a sell-off. And the other side of that coin is the older stuff is, I think very attractive from a convexity viewpoint. There’s not a lot of pay up in that universe because it’s such a discount, huge upside into a big rally and not a meaningful amount of extension into a continued sell-off or inflation scare or something. And I think that those comments, can be seen in our positioning as well.

Robert Cauley: Yes, I would just add to that is they’re easier to hedge. We talked about the ability to use the inversion of the curve to lock in longer-term funding. But when you’re earning something, owning something of an $86 or $84 price, it really can’t extend a lot, so you can use longer-term or treasuries to hedge. But also, with respect to the more recent production current coupon, if you look at the collateral that’s being produced, the gross whacks are extremely high. Now, they’re running 95 to 105 basis points over the net coupon. So, if you’re buying a 6, it’s a low 7 or a very high 6 gross whack. I mentioned primary, secondary spreads are very wide, and they may be for a while, but if the market ever turns and goes the other way and the mortgage banker industry has to re-engage, there’s a lot of low-hanging fruit out there to go after.

And that stuff is going to exhibit poor convexity, because in a rally it’s not going to tighten material, because speech is going to be fast as they move into a bigger, premium position. And they’re just going to really inhibit their upside, especially relative to, as Hunter just mentioned, the lower coupons, which have very favorable convexity. So, you know, it’s somewhat painful in this environment to continue to have such a bias, and we have mitigated that some. But we just think, net, net long-term, that that’s where you want to be. And it’s obviously always a challenge to try to time the market. You know, you can’t just say, well, I’ll just sell out of all those high coupon mortgages when the market turns. You don’t get an email the day before it happens and say, I’ll sell out.

It’s kind of hard to do.

Mikhail Goberman: Kind of with that in mind, I’m just thinking about leverage and seeing your, eight turns right now, kind of in between the historical range of 6 and 10. If you guys see, the opportunities that you hope to see going forward, how you can ratchet that leverage up a bit. Could we potentially see a sort of drift towards a 9 and 10 range if we get a good amount of spread tightening?

Robert Cauley: Yes, you can. 10, maybe not, but, we’ve been in the mid 9s before. We could do that. And we have two ways of getting there. The one big step we already took which is where we got rid of a lot of the TBA shorts when mortgages got to very wide levels. And then we, raised some equity, but also added to our balance sheet just through purchases. So yes, we could go higher. I mean, it’s, I don’t think it’s meaningfully higher, but we could. And, you know, we’re at a wide level now. So I mean, this arguably is the time to do that. So, yeah, we could go a little wider, but I don’t think meaningfully or higher leverage, I should say.

Mikhail Goberman: All right. Thanks a lot, guys. Appreciate it.

Robert Cauley: Yes.

Operator: [Operator Instructions] We go next now to Christopher Nolan at Ladenburg Thalmann.

Christopher Nolan: Hey, guys. Bob, on your comment, you mentioned $0.40 per quarter going forward. Was that including the discount accretion and the hedge income that you were discussing?

Robert Cauley: Yes. So, basically, I kind of walk you through from the negative $0.34 added back accretion. I think it was $0.12 added back to hedge, which was [0.59]. So, that got you to [0.37]. And that was for that quarter. I mean, obviously, this quarter is not necessarily going to be a mere image of that. And with the additional assets we added, that got you to about [0.40]. So, there’s still a slight gap there, at least for gap purposes, no pun intended. As I said, for hedge purposes or for tax purposes, we have a lot of legacy hedges that were closed years ago that still covered this period. And just to kind of refresh your mind how that works, say you entered into a 10-year swap today and you designated that as a hedge for tax purposes.

And a year from now, you close out that position and let’s say that the open interest at the time you close it out was $10 million. For GAAP purposes, you would have recorded that $10 million mark-to-market gain, and that would be the end of it. For tax purposes, that $10 million is applied to the balance of the hedge period, that period being the day you close it to the end of the maturity day of that swap. So, if I closed out a 10-year swap one year from today, I would apply that $10 million as an offset to interest income for the period beginning one year from today and ending 10 years from today. So, we have a lot of those hedges that have been closed, and we had open interest, positive open interest in those hedge positions. And so, they’re available to offset interest expense in the periods of those hedge periods.

So, I don’t have the numbers in front of me. I think we provided them at year end, but those numbers are in the low hundreds of millions of dollars for the balance of all of those hedges. And so, they apply so much per year for the next few years. So from a tax perspective, it’s a lot different. From GAAP, it’s just whatever you’re realizing in that particular period. There’s no application of that position over any future period. It’s all captured in the current period. And so, we’re showing approximately a $0.40 positive net interest margin for this second quarter only, but for tax, it’s a lot different.

Robert Cauley: I think you can think about it a little bit, too, but if you look at our hedge positions, all of those, we have a book of $1 billion worth of T-Note futures shorts on. And that’s been a consistent part of our portfolio mix forever. But the thing about those instruments is they don’t play out quite like a swap does. I mean, we have swaps that we put on sort of at those cycle lows as well that are around 100 basis points pay-fix and we’re receiving so far well into the fives now. So if you think about the dynamics that took place that made those swaps go into money by so much where we’re realizing that positive income value as the life of the swap plays out, we’ve had those same types of gains in those T-Note futures as well.

But the nature of the beast is that you don’t have an income component to those where you’re paying a fixed rate and receiving float. So, you’re just rolling them and every time you roll them, you have a capital gain that you tuck away that you’re going to use to offset your interest expense for tax purposes over the life of the underlying instrument, which is a five-year note or a 10-year or something like that. So, for tax, it’s a little easier to get your head around where, you know, how those different types of hedge instruments, mimic one another for offsetting interest expense for federal income tax purposes.

Christopher Nolan: So, given all of that, where do we stand with the dividend? Should we view, the dividend sustainability to be somewhat detached from core EPS or GAAP EPS?

Robert Cauley: Yes, I mean, we haven’t said anything. I don’t want you to read any too much, but yes, I mean, we know that that can never change. Our dividend has certainly changed in the past, but given, where we are at the moment in terms of that, our positioning in the portfolio, as we mentioned, we’re kind of comfortable with this lower coupon bias. We may add at the margin some higher coupon securities to close that gap some time, see an opportunity to do so, but we think that the modest shortcoming in that regard is offset by the much greater price appreciation potential of those assets versus the higher coupon securities, which offer greater current income, but in our minds, much lower long-term total return opportunities.

So if you look over the next year, total return, the lower coupon securities may give you a little less income, but we think they offer much higher price, potential price return, and therefore, higher total rate of return over that horizon. I think we think about it also, bounces around as sentiment for what the Fed’s going to do next, bounces around. I mean, it wasn’t all that many weeks ago when we had cuts baked into this year, and the third and the fourth quarter, maybe not the third quarter, but definitely the fourth quarter, and so and now the market’s kind of taking the view that we’re going to have more of a soft landing, I think and maybe rates can stay higher for longer. So, the point of all of that is just in terms of the dividend, we definitely don’t want to put our shareholders through any unnecessary pain.

So if there’s if we’re looking at Fed cuts in the next, 6 to 12 months, then under-earning dividend is not as much of a problem for us, versus a time, if it’s going to be, if we think it’s going to be higher for, a long period of time, and we’ll perpetually be under-earning. So I think there’s a little bit of latitude for us in terms of the way that we think about cuts. It doesn’t always have to be, we can pull forward some of the Fed expectations and kind of continue to think that way.

Christopher Nolan: All right. Thanks for the word. That’s it for me.

Robert Cauley: All right, Chris.

Operator: Thank you. [Operator Instructions] And Mr. Cauley, it appears we have no further questions this morning. I’d like to turn the conference back to you, sir, for any closing comments.

Robert Cauley: Thank you, operator, and thank everybody for taking the time to listen in. To the extent another question comes to mind later that you didn’t have a chance to ask today, feel free to call our office, or if you happen to listen to the replay and you have questions, we’ll be glad to take any and all questions. The number of the office is 772-231-1400. I’ll look forward to your questions. And if not, we look forward to talking to you at the end of the next quarter. Thank you, everybody.

Operator: Thank you, Mr. Cauley. Ladies and gentlemen, that will conclude the Orchid Island Capital Second Quarter Earnings Conference. I’d like to thank you all so much for joining us and wish you all a great day. Goodbye.