Orchid Island Capital, Inc. (NYSE:ORC) Q3 2023 Earnings Call Transcript

Orchid Island Capital, Inc. (NYSE:ORC) Q3 2023 Earnings Call Transcript October 27, 2023

Operator: Good morning and welcome to the Third Quarter 2023 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, October 27, 2023. 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. The 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. I would now 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, and good morning, and thank you for joining us today. Hopefully, everybody has had a chance to download our deck. You probably will notice there’s some substantial changes made to the deck. Hopefully, you find it more useful. I think we presented the information in a better format that we’ve been doing up until now. And with that, I will begin the outline of our talk today. We’ll follow the same pattern and go over our financial results for the quarter, talk briefly about our market developments and how those shape our results and how they form our outlook going forward and then get into a discussion of the portfolio and our hedging positions and so forth. So with that, turning to Slide 5.

Here are the high-level numbers for the third quarter. Net income for the quarter was a loss of $1.68 versus income of $0.25 last year. Book value, given the moves in the market, it was a very rough quarter for mortgage investors. As you can see, our book value was down just over 20% from $11.16 to $892. Unfortunately, October has been equally is intense, and our books down about 14 – a little over 14% through yesterday. So obviously, especially since September 1, it’s been a very challenging mortgage market environment. Total return for the quarter was a very unsatisfactory negative 15.77%, and we paid dividends again of $0.48, same as the last quarter. The average MBS portfolio did increase over the course of the quarter. We did use our ATM, we raised about $80 million and added to the portfolio.

But given what’s happened since quarter end with the significant move in rates and volatility in mortgage spreads, we have sold assets to maintain our leverage and liquidity positions at acceptable level and the portfolio is about $3.65 billion as of yesterday. That’s down 18% from the average of Q3. But as I said, that’s the average, that’s not the 930 number. The economic leverage ratio did increase during the quarter. As a result, the selloff in the declining book value, not terribly so from $8.1 million to $8.5 million but since then, the steps we’ve taken this month so far, we’ve actually lowered our economic leverage ratio to about 7.4%. So it’s down quite a bit. Our speeds, given that the portfolio is heavily skewed towards discounts, we do have a lot of seasoning, especially in our lower coupon security.

So the speeds are fairly acceptable 6%. And with the deep dollar price of the securities we own, that’s allowing us to increase a fair amount of discount, and that helps with our earnings. Liquidity is right around the low end of our range, then that was driven by the events of late September into early October. Currently, it’s in that same range around the high 30%, maybe 40%, but we are working to bring that up. The next page just shows you our summary balance sheet income statement. I’ll leave that for you to Hass. I’m not going to spend any time talking about it. The next slide is something we’ve been talking about more frequently lately. This is kind of where we show you kind of our proxy for disposable income. We don’t use that term. We use fair value accounting, which makes it challenging for us to present those types of numbers.

But what we do here as we’ve done in the past is we show you our interest income and repo interest expense. But then we also show you the dollar amount of discount accretion and then also the effective hedges that were in place during the quarter. And as you can see, there’s substantial numbers there. Finally, be backed on our expenses, as you can see the earnings for the last four quarters. And on the bottom of the page, we just present that per share. And as you can see, we’re running around $0.10 a little more below the dividend. We were doing so because we were believing the market would turn sooner rather than later, and we did not want to make wholesale changes to the portfolio, but that has not proven to be the case and we’ve had to make some changes.

Although you also know we lowered the dividend this quarter. So now it’s $0.12, which means we have a $0.36 run rate, which means we should probably have earnings right in line with the dividend. Going now to market developments, Page 10, you can see a very meaningful change in the top left and top right. For the last 1.5 years, all we’ve seen in the movement of curve via the swaps curve or the nominal curve is movement higher in the front end. It just kept getting higher and higher in the long end given that the curve was inverted, always had the downward sloping look and was moving up slowly. Well, that’s changed dramatically in the third quarter. As you can see, the front end of the curve is pretty much anchored. And I think most market participants expect it to remain that way, maybe go up slightly more if there’s one more hike that’s pretty much it.

What we’re seeing now is moving on the long end of the curve, kind of it’s a steepening in the sense that it’s a less inverted but it is a meaningful move and 100 basis points plus just from late July to where we are now. Another proxy for that is one on the bottom of the page is just a three month treasury bill versus the 10-year note. Again, you can see a significant move of late. Turning now to mortgages. There’s two pictures here. The first one is the spread to the 10-year. And as you can see, that spread is very wide, very close to the widest levels we’ve seen since the financial crisis. And when you take into consideration the fact that, as I mentioned, long-term rates have been up materially of late. And the spread, again, this is the current coupon, but it’s a proxy for the mortgage universe.

That spread has been widening also, which gives you an idea what that the yield on mortgages are going up much faster and even treasuries those resolved. If you look at the bottom left, you can see this is a normalized price change of several coupons so basically just starting at 100 for each coupon on June 30 and showing you what that coupon has done since the end of the second quarter. And obviously, those are very big negative numbers. It’s been a very challenging market for mortgage investors to say the least. Another thing that’s been a challenge for us has been volatility. As you know, mortgages are very much impacted by volatility because we’re going to your long in the mortgage or shorting mall. And if it’s going up, then it’s hurting you, and that’s what we see.

These are two different measures of volatility. They paint the same picture, three month by 10-year normal and then swaption implied vol from the MOVE Index at elevated levels and continue to remain there as we speak. One last page on the market. If you look at the top right, this is the primary secondary spread. And the mortgage originator community is trying to maintain their ability to generate mortgages. And so that’s why you’re going to see a slight downward trend in that spread. So as rates go up, they’re trying to accept less margin in order to get rates to borrowers that they can live with. They only have so much capacity to do that because originators typically will sell all their origination. And to the extent that the prices at which they can sell their production are going down, that limits how much that they can cut the primary secondary spread.

So I would not expect to see that come down much more. Otherwise, with respect to this page, as you all know, with rates as high as they are and third year mortgage rates approaching 8% refinancing activity is at an extremely low level. And in fact, we’re approaching the late year, early 2024 period, which will be the seasonal slowdown. So speeds will do anything that will go down from here. Moving on to the portfolio on Slide 15. These are just the highlights for the quarter. As I mentioned, we raised about $80 million in our ATM. We bought a 30-year 6 and 6.5 coupon securities to increase the income of the portfolio in light of the higher rates for longer in the apparent case so we’re going to be higher for longer. The effect of those was to raise our average coupon from 3.83% to 4.05%.

And the realized yield increased even more from 3.81% to 4.51%. That was impacted somewhat by speeds being a little higher, helped with increased accretion of discount. And then with respect to our economic interest spread, this is just where we apply our swaps. The GAAP spread, and you can see it increased slightly from 128 basis points to 133 basis points. Slide 16 shows me pictures what I just was referencing, if you look at the right-hand side of this page. You can see at the end of last year, we had a very, very low coupon bias, and we had no exposure to higher coupons. But given the fact that rates are as high as they are and apparently going to stay here for a while, our goal now is to try to even out the distribution across the stack.

Just to give you, for instance, in September when rates started to move high, we saw the lowest coupons really suffer presumably, a lot of money managers who run against the index. We’re reducing over-weights and the lower coupons make up, a significant portion of the index. And so that’s selling caused lower coupons to suffer. In October, it’s been more the belly coupon. So 3.5, 4, 4.5, 5 that have suffered. So, the takeaway for us is that we need to have greater diversification across the coupons that we own, and that’s what we’re in the process of doing. I mentioned that we have sold some assets since quarter end. If you look at the far left, you see our holdings as of 9/30, we reduced our exposure to the 3% coupon by about 40%. So it’s down to about $1.2 billion.

A businessperson examining financial graphs and charts of the company’s portfolio, while surrounded by residential mortgage loan documents.

That will have the effect of raising our average coupon and our yield somewhat. But we still expect to maintain a bias there, because as I’ll say in a few moments. Our outlook – is we still think eventually there will be a softening of the economy in the [WAC AGE] pivot. And we think that those securities are the best securities we can own to maximize our potential outcome in that scenario. Now going to Slide 17. This is where we talked about hedging. Obviously, in this environment, this has been critical with borrowing costs rising and interest rates selling off. Our hedge positions exceed our repo liability. I’ll get to that point in a moment. What I want to show you here, is the effect of the hedges we have in place. And you can see in this chart on the right, that blue line is our economic interest expense, in other words, just our economic expense adjusted for the effective hedges, and its well below our actual funding cost or one month SOFR.

It did go up slightly this quarter from 2.53% to 3.18%. But given – unless we get more heights, we expected, that’s pretty much where it should plateau and that gives us fairly comfortable NIM. And obviously, the hedges and the strategy is very critical in that regard. The next slide just lays out all of the hedge positions we have in place. On the bottom, we have a table with the notional amount and the duration of each. We have interest rate swaps, futures options and rate derivatives, which are sometimes floors or caps or other types of structured derivative bets that are designed to give us protection in the event of certain outcomes, say, for instance, the curve stays flatter for longer those type kind of thing. And then we also short TBAs. And we show you the duration of that.

All told, all of these hedges, the notional balance is about 115% of our repo funding liabilities. All of these hedges work in two ways, they are both asset hedges and funding hedges. TBAs more on the asset side. Swaps are very much both, because it does cap your floating rate cost, to the extent of the notional balance of those swaps. But they also work as an asset hedge at least, as long as the points on the curve that are moving higher are the same tenders or swaps. In our swaps, we do have a large allocation to longer maturity swaps. So that’s been very beneficial and is going to be critical going forward. Slide 19, we just lay out all of the different positions. I’m just going to make a couple of points. The top left, you can see that the treasury futures went down and swaps went up, just more effective hedge in this environment.

It is more capital intensive to own swaps versus futures, but we can lock in pretty low funding. And as much as rates have sold off as of late in the last few months, we put a lot of these on prior to a meaningful move. So, some of our longer-dated swaps, you can see the pay fixed rates are only 2.84% on our swaps with a maturity of greater than five years. So our blended rate is only 2.46% very effective. And fortunately, we were able to get all those on, and we expect we will have to maintain those for some time. The next slide is kind of new. We haven’t done anything like this before. And – I need to explain to you what you’re looking at. So basically, what we have here for all of the 30-year fixed rate conventional mortgages, starting with a 3% coupon up to 6.5%.

And we took the price as of 9/30, we use Citibank’s yield book to run the metrics on a generic coupon of each one. So you can see for each one, you see the OAS, effective duration and convexity. But as you can see, convexity, which is very important for mortgage investors, because that kind of drives how you do when rates are moving, and we’ve had a lot of that lately. The lower coupons have by far the best convexity. If you look at how those securities perform in these different scenarios, again, these are just generic yield book scenarios, a 50 basis point higher lower shock and then a bull steepener and a bear flattener. There’s no question that the Fed may hike some more and the inflation data could stay stronger for a little longer, and we may get a bit more of a bare flattener.

But we think, if that happens more likely not that just increases, the chance of you also we get the bull steepener, when the Fed does succeed in breaking the economy. And you can see on the returns of these coupons, the lower coupons definitely stand out with the best return potential. And since we still have a bias towards that outcome, although a little less than we did a few months ago, we still view that as more likely than not outcome. And that explains why we’ll probably maintain an overweight to those coupons. On the far right column, we just show the allocation as of 9/30 that, as I mentioned it has changed slightly, when we report fourth quarter, those numbers will look somewhat different. Slide 21 just shows you our interest rate sensitivity of the portfolio.

I’m not going to say much about this. This should be pretty self-explanatory. Slide 22, our speeds. And what we’ve included in the slide here for each coupon that we own is the wallet of those securities. And you can see – the deepest discounts that we own the 3s, the 3.5s have very high wallet as a result, they’ve prepaid fairly well. In fact, for the third quarter, our 3 is paid at 6 CPR and our 3.5 at 6.3%. Those aren’t very high speeds, but when you consider the dollar price of these securities in the case of 3s, sometimes they’ve been under $8, the $8 level. That means a lot in terms of discount accretion. So that has been a very beneficial fab for us. And really – that kind of it. The next slide is just kind of a wrap on what we’ve experienced and what we’re going through.

Obviously, the market is very challenging. We expect it to be challenging going forward. So our focus now is to just diversify the portfolio across coupons try to avoid excessive concentration in any point on the curve. We’re going to maintain our hedge levels as high as we have in the recent past just, because of where our funding costs are. We’re going to keep our leverage ratio at the low end of the range. I mentioned it’s down from 8.5% to 7.4%. And we’re going to have to keep our liquidity as high as we can just to get through the balance of this episode. We don’t really know when this period will end, but we know these are the steps that we take, they are going to give us a high, high level of confidence that we’re going to get through this period.

Okay. And at the same time, allow us to be positioned in such a way that we can do very well when the market turns. Assuming we do get the outcome we foresee. If we don’t, the portfolio positioning is at a point now where we’re covering the dividend, we think, and we can get along just fine here. But we think if we do get the outcome of a bear a bull steepener that we could be poised to do quite well. So that’s a rundown of our positioning in our portfolio and all the market developments. And with that, operator, I will turn the call over to questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Your first question is from Matthew Erdner of JonesTrading. Please go ahead. Your line is open.

Matthew Erdner: Hi. Good morning. Thanks for taking the question. So you mentioned the diversification – within the coupon stack. Are you looking to kind of spread out evenly across coupons? Or are you going to favor the belly more so than current production? Obviously, the reduction in the 3% is coming, but what part of the curve are you really looking to diversify into?

Robert Cauley: We’ll still have a slight down in coupon bias just won’t be as pronounced just, because we just – we like the characteristics of those assets. The convexity, the return potential in the event we do get a bull steep, which we may not. The problem with the higher coupons, they do well in times like this, at least most of the time, and they carry well, but they have a lot of risk, a lot of extension potential and a meaningful selloff. And in a rally, they will not perform well. And one thing that we did really well on, but if you look at new production, current coupon mortgages, the gross [indiscernible] typically 95 to 105 basis points above the coupon. So Fannie 7 has a gross WAC of 795.8 and loan balances are very high. And what that means and what predicts is when we do get a rally, if we do get a rally that those are going to be prepaying very, very fast. Hunter, do you want to throw in a few extra words on that?

Hunter Haas: Sure. I think that the – there will be a little bit of a focus on higher coupons, maybe not as extreme as 7s, but just like we did a continuation of what we did in the third quarter, 6s and 6.5 are quite attractive from a carry perspective. They fit that part of our portfolio where we’re in a higher for longer environment, but not necessarily higher rates and higher for longer. There’s some extension risk on the upper coupons. But if we are kind of topping out somewhere in the, say, 5% to 6% ballpark for 10-year rates. I think that those higher coupons can do quite well. They have a lot of current carry. So that’s the portion of our portfolio, it’s going to carry a little bit better, but not necessarily do well on the wings, big rally or big selloff.

Matthew Erdner: Got you. That’s helpful. And then from a technical perspective, it seems like when money managers went overweight, they’ve kind of sold off in the recent months. So what do you think will tighten spreads from here? And who do you think is going to be the purchasers of this MBS?

Robert Cauley: Well, that’s the million dollar question. The reason that mortgages have done so poorly is that you really have no sponsorship from any large investor base. Obviously, the Fed is long gone. Banks are not. Money managers are very overweight and maybe having redemptions. And that’s really what keeps mortgages from tightening anytime soon. That just isn’t. You really probably need the curve to uninverted banks to come in in a meaningful way or something like that because it’s just not out there. And that’s why we expect that we’ll probably be positioned the way we are for some time because it can get some tightening, but I don’t see a meaningful tightening with the market the way it is. It’s going to – something is going to have to change. It probably is going to be the shape of the curve.

Hunter Haas: Yes. It was very disappointing third quarter. We were – we leaned into the basis a little bit towards the end of the second quarter when spreads were sort of at their wides during the second quarter in the wake of the regional bank crisis. Those lists went off so incredibly well and so much faster than we expected. There was definitely a more positive farmer tone. But as you alluded to, the money managers quickly got overweight. And quantitative tightening continued. And as rates just grinded higher, there was really that lack of marginal buyer. So optimistic, I guess, that you’ve seen some signs of life from the banking sector. I don’t think they’re quite ready to come in, in full force. But there was a couple of reports out in the last couple of weeks about banks being able to unload some of their lower coupon assets and supplement their income with some better earning potential in higher coupon mortgage space.

So it’s not anywhere near them becoming the marginal buyer, but it’s certainly starting to see some signs of life. So it will probably be grind for the next couple of quarters and will be volatile. But we’re also having those days when we see just the slightest glimmer of hope in mortgage spread space really brings in an influx of participants. And so the basis is incredibly volatile, but on those days when it’s green and it’s very green. So that’s been a little bit of a welcome change over the past four to five weeks that we’ve really just seen show up in the last handful of days.

Matthew Erdner: That’s helpful. Thanks for the color guys.

Robert Cauley: All right. You’re welcome.

Operator: Your next question is from Chris Nolan of Ladenburg Thalman. Please go ahead. Your line is open.

Christopher Nolan: Hi guys. Bob, have you guys received any margin calls on your repo funding this quarter?

Robert Cauley: This morning? We get them every day. I mean we – margin call activity is very robust. We get calls both on the hedges and on the assets every day. We’ve internalized that. We used to outsource that to AVM. We hired Pat Doyle from AVM, and we brought in our own systems. And so now we can manage that whole process entirely on our own. And yes, I mean the margin call activity keeps Pat busy several hours a day in and out. So absolutely.

Christopher Nolan: Thank you. And then also a follow-up. What sort of flexibility do you have on the dividend? Because I know you need to distribute so now taxable income. But given all the moving pieces here, what sort of flexibility do you think you might see on how you reinvest the dividend you used to do that.

Robert Cauley: We brought it down into kind of line with what we were earning. We were under earning over distributing, thinking that the market was going to turn and we didn’t want to take the steps to reposition the portfolio. But we had to adjust some and we did. But that 12% seems fairly well reasonable. I mean the big picture view on the dividend, trust, we’ve spent hours discussing this. The market does tend to punish you if you change it too often, and they also punish you if you over distribute too much and the tax laws keep you from under-distributing. So – and we track our taxable earnings. We have a pretty good sense generally as we go throughout the year where we are in terms of overdistribution. There is some latitude, but it’s not boundless.

Christopher Nolan: Great. Thank you.

Operator: Your next question is from Mikhail Goberman of JMP Securities. Please go ahead. Your line is open.

Mikhail Goberman: Hi, guys. Good morning. I hope everybody’s known well. Could you guys give an update on where book value stands right now? And also, I believe you mentioned economic leverage is down to 7.4% now from 8.5%, is that right?

Hunter Haas: Yes. Yes, it is. And [Gob], I did mention it’s – we’re down about a little over 14% through yesterday.

Mikhail Goberman: Okay. Thank you. Sorry if I missed that. And all my other questions were kind of touched on by the other two questioners. So good luck going forward, guys. Thank you.

Hunter Haas: Thank you.

Robert Cauley: Thank you.

Mikhail Goberman: Thanks.

Operator: There are no further questions at this time. I will now turn the call over to Robert Cauley for closing remarks.

Robert Cauley: Thank you, operator, and thank you for taking the time listening to the call. If you have any further questions that come to mind after the call is over, feel free to call us or if you listen to the replay. Have a question, you can always reach us in the office. The number is 772-231-1400. Otherwise, we look forward to speaking with you at the end of the fourth quarter. Thank you, everybody.

Operator: This concludes today’s conference call. Thank you for your participation. You may now disconnect.