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Capstead Mortgage Corp  (NYSE:CMO)
Q3 2018 Earnings Conference Call
Oct. 25, 2018, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to the Capstead Mortgage Third Quarter Earnings Conference Call. All participants will be in listen-only mode. (Operator Instructions) After today's presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Lindsey Crabbe, Investor Relations. Please go ahead.

Lindsey Crabbe -- Investor Relations

Good morning. Thank you for attending Capstead's Third Quarter Earnings Conference Call.

The third quarter earnings release was issued yesterday, October 24, 2018 and is posted on our website at www.capstead.com under the Investor Relations tab. The link to this webcast is also in the Investor Relations section of our website, and an archive of the webcast will be available for 90 days. A replay of this call will be available through January 25, 2019. Details of the replay are included in yesterday's release.

With me today are Phil Reinsch, President and CEO; Robert Spears, Executive Vice President and Chief Investment Officer; and Lance Phillips, Senior Vice President and Chief Financial Officer.

Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management. For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are available on our website.

The information contained in this call is current only as of the date of this call, October 25, 2018. The Company assumes no obligation to update any statements, including any forward-looking statements made during the call.

With that, I'll turn the call over to Phil.

Phil Reinsch -- President and Chief Executive Officer

Thank you, Lindsey. After a few brief remarks, Lance will give a quick recap of the quarter, and then we'll open it up for questions.

This summer has proved to be difficult, to say the least, with our third quarter earnings slipping a disappointing $0.05 from our second quarter results to $0.04 per share. Book value also declined this quarter and we posted a negative 2.7% economic return. This in turn brought our year-to-date economic return to a negative 3.6%. We've been buffeted by a combination of relatively high levels of mortgage prepayments and increasing borrowing costs as the Federal Reserve continue to increasing the Fed Funds rate. And the Fed can be expected to continue raising rates going into next year. And we can also expect to see higher hedging cost with the recent narrowing of three-month LIBOR to one month rates, reducing receive-variable swap receipts relative to unhedged borrowing cost.

On a more positive note, we have good news on mortgage prepayments at least the next two quarters, which speed -- with declines in speed expected to decline now that the summer home selling season is over. Other seasonal factors are turning in our favor and with recent increases in prevailing mortgage rate. We can also point the positives on cash yields and portfolio valuation. Cash yields increased considerably this quarter and are expected to continue improving through acquisitions and coupon resets with 51% of our portfolio of agency-guaranteed ARM securities resetting in rate on average in about six months time. My point of reference, this portion of the portfolio had a fully indexed weighted average coupon of 86 basis points, higher than the net WAC at quarter end. In the last page of our press release for further information on coupon resets. Importantly, as these bonds reset higher in rate and continue to season, we anticipate improvements in valuation over time, to the benefit of our book value and future economic returns.

With that, I'll turn the call over to Lance.

Lance Phillips -- Senior Vice President and Chief Financial Officer

Thank you. Phil. We generated earnings of $8.7 million this quarter or $0.04 per diluted common share and paid a $0.11 common dividend. Higher borrowing rates contributed approximately $0.08 per share to the decline in our third quarter earnings with another $0.02 per share of decline as a result of higher mortgage prepayments than we experienced during the second quarter. Partially offsetting the increase in borrowing rates and prepayments was an increase in our cash yields on our portfolio of nearly 14 basis points, contributed an increase of approximately $0.05 per share over the last quarter.

Book value declined by $0.37 ending the quarter at $9.48 per common share. Importantly, $0.07 of our book value decline was actually capital return to our stockholders in the form of dividends in excess of earnings this quarter, and we generated $0.03 in book value accretion from third quarter common stock buybacks. Year-to-date, we earned $0.29 per diluted common share, distributed $0.41 in common dividends and have incurred book value declines of $0.77 per common share.

With that, we will open the call up to questions.

Questions and Answers:

Operator

(Operator Instructions) Our first question comes from Eric Hagen with KBW. Please go ahead.

Eric Hagen -- KBW -- Analyst

Thanks, good morning. So just given the pressure on economic return right now, I guess, one school of thought is to take down your leverage pretty meaningfully in order to at least try to keep book value stable if the recognition is that with higher leverage book value is just at more risk of getting dragged down from prepayments and spread widening, et cetera, and I realize that reducing leverage would really likely take down your earnings. But from a cash flow hedging standpoint, you guys look pretty under hedged in this environment. So I guess the question is whether you guys have actually considered cutting leverage fairly meaningfully in order to at least help preserve book value during this somewhat challenging period. Thanks.

Phil Reinsch -- President and Chief Executive Officer

Well, book value has been a challenge for us, holding book value, but a lot of that driven by -- it's already really incurred with the pricing of our bonds. And we actually see with roll downs and seasoning room for improvement in portfolio valuation to moving forward. So taking our leverage down drastically at this point wouldn't necessarily be a prudent thing to do.

Eric Hagen -- KBW -- Analyst

So is the read-through there that the spread -- I mean, I assume that there's been some fairly meaningful spread widening on especially the current reset bucket as prepayments have accelerated this. Are you sort of implying that spreads have basically widen to their maximum? And that any further increases from the Fed would not really deliver any more spread widening?

Lance Phillips -- Senior Vice President and Chief Financial Officer

Well, Eric, there really hasn't been a dramatic spread widening in the ARM sector. They underperformed fixed rates in the third quarter, but the ARM book pretty much traded off to its implied duration. So there really wasn't any material spread widening. If you looked in our book during the third quarter, for instance, I think our short reset book was down about 430 (ph) seconds and our longer reset book was down close to half a point. So that's really not a material spread widening. And I think what Phil was alluding to earlier, if you look at the natural roll down of an ARM security, we have bonds that are trading for instance with 36 months to roll, call it roughly at par. And those bonds, if they roll down seasoning curve, pickup another half a point for each year, they get closer to the reset. And then once they get through reset, those types of securities are trading with one or three handles. So I think one piece that you may be missing is the roll down potential of ARMs that isn't inherent in the fixed rate mortgage book. And so there's a very high probability unless the Fed goes crazy and move significantly more than what the forwards were anticipating that our prices will be freed up on our bonds over time.

Eric Hagen -- KBW -- Analyst

Okay. Thanks for that. And then one more on leverage. I mean, the counter parties that extend repo financing to you, I mean, do they include as part of your capital, the $100 million -- roughly $100 million in unsecured debt as part of that capital? I know that you guys treat that as long-term investment capital, but do your counterparties view it the same way?

Phil Reinsch -- President and Chief Executive Officer

By and large, yes. There's -- 15 years to run on that are better. And so, there -- our counterparties are asking for more business and are not at least their concern where we're at from a leverage perspective. At least generally speaking.

Eric Hagen -- KBW -- Analyst

Okay. And then one more from me. In the newer issue ARM market, are you guys seeing anything different, I guess, in the borrower profile or the collateral profile that's materially different from the newer issue ARM market during the last Fed tightening cycle? And I guess just if you can give us your outlook for prepayments on those newer issue ARMs maybe into next year, I think that would be helpful. Thanks.

Lance Phillips -- Senior Vice President and Chief Financial Officer

Sure. And obviously, the ARM market is significantly different now than it was during the last Fed tightening cycle, but one trend that has shown up, that's a little troubling recently is newer issued 5/1s, the speed seasoning ramp is -- they're picking up and speed faster than you would expect. And I think a lot of that has to do with that's pretty much the shortest product that's offered out there now, whereas back in the last Fed tightening cycle, lenders offered 1/1s, 3/1s, et cetera. So more hot borrowers, if you will, that we're looking at short-term financing would go to a at 1/1 or 3/1 and that's not really offered right now. So new issue 5/1 speeds have surprised somewhat to the high side. And because of that, we haven't been playing in that space as much as we have in the past. Speeds in general, I think, as Phil alluded to in his commentary, generic ARM speeds from September to October dropped almost 20%. And so we're getting in to see -- and that was a cross product type, season post reset, new issue, Ginnie ARMs. And so it wasn't one particular cohort. So we're getting into seasonally a fairly positive point in time for our ARM book from a prepayment standpoint.

Eric Hagen -- KBW -- Analyst

Okay. Thanks for the comments.

Operator

(Operator Instructions) Our next question comes from Steve Delaney with JMP Securities. Please go ahead.

Steve Delaney -- JMP Securities -- Analyst

Good morning and thank you for taking the question. Robert, your last reply to Eric was my first question and I didn't quite hear exactly how you express the change from September to October. So could you specify what the October factors showed about September speed?

Robert Spears -- Executive Vice President and Chief Investment Officer

The generic ARM cohort speeds were down 18% to 20% from September and that was fairly uniform across all product types. So bonds that were printing, for instance, 30 CPR may have slowed down to 25%, bonds that were printing 22% may have slowed down to 17% or 18%, so it was across all cohorts, but it was close to a 20% decline from the peak levels in September.

Steve Delaney -- JMP Securities -- Analyst

That's great. And then your CPR for the entire third quarter was 25.7%. Can you say sort of as it trending through the quarter, how would September look like compared to the average for the quarter?

Robert Spears -- Executive Vice President and Chief Investment Officer

September was a little faster. It picked up in July, dropped in August and then picked up. September was slightly faster than July. And a lot of that was just day-count driven and other factors like that. And so the -- I think generically ARM speeds actually dropped a little more from September to October on a percentage basis than fixed rate, Steve.

Steve Delaney -- JMP Securities -- Analyst

I know you don't have a crystal ball, but do you -- you won't to take a shot at, you kind of a range for where you might -- you see the trough this winter on speeds?

Robert Spears -- Executive Vice President and Chief Investment Officer

Well, I mean, yes, the front month is down roughly 20%.

Steve Delaney -- JMP Securities -- Analyst

Yes, that's what it sounds like.

Robert Spears -- Executive Vice President and Chief Investment Officer

Yes. If you look at ARM -- fixed rates projection, most guys had a slight pickup in November and then a decline in December. On average the front month speed should be pretty indicative of what's going to happen for the quarter.

Steve Delaney -- JMP Securities -- Analyst

Okay, great. And could you comment on, as far as your spreads, I mean we know what the blended spread was for the quarter, I think it was 26 basis points. When you're reinvesting, OK, and I know you reinvested not a 100% of your repayments this quarter. But could you just theoretically talk about what the spread would look like on a newly invested bond versus the overall portfolio? Obviously, I am assuming there is a difference in the premium relative to UPB on new purchases maybe than it is on the existing book.

Robert Spears -- Executive Vice President and Chief Investment Officer

Yes, I mean, I think it's pretty tight out there right now. But I'd say, you're probably looking at close to 50 basis points, which where we're levered throws off returns in the low 9%.

Steve Delaney -- JMP Securities -- Analyst

Yes. Okay. That's very helpful. And obviously a different picture, because one could argue why -- I remember back when you -- unfortunately I'm old enough to have been with you in 2006, and I remember at one point, it seemed like the reinvestment environment was so unattractive that you just used all of your capital to buyback -- repurchase stock, so comparing 9% opportunity versus buyback that kind of supports at least doing some reinvestment. And then the last question I'll have and I'll let you go, the curve is flattened a lot and maybe we don't know totally about the Fed, there seems to be more mixed signals coming to -- there's certainly mixed signals on what's going to be volatility and maybe some questions about the economic outlook, but is the rationale for hedging new investments, given how flat the curve is and what you're already paying on repo. Is there any real value to put a two-year swap on now, when your existing swap books expire?

Robert Spears -- Executive Vice President and Chief Investment Officer

Well, I think that's a good question. And if you notice, we've led our duration gap drift from about four months to about five and three quarter months. So we have been doing less hedging given the shape of the curve.

Steve Delaney -- JMP Securities -- Analyst

Okay, great. Well, thank you for the comments, guys.

Robert Spears -- Executive Vice President and Chief Investment Officer

Sure.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Lindsey Crabbe for any closing remarks. Please go ahead.

Lindsey Crabbe -- Investor Relations

Thanks again for joining us today. If you have further questions, please give us a call. We look forward to speaking with you next quarter.

Operator

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

Duration: 18 minutes

Call participants:

Lindsey Crabbe -- Investor Relations

Phil Reinsch -- President and Chief Executive Officer

Lance Phillips -- Senior Vice President and Chief Financial Officer

Eric Hagen -- KBW -- Analyst

Steve Delaney -- JMP Securities -- Analyst

Robert Spears -- Executive Vice President and Chief Investment Officer

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