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ARMOUR Residential REIT Inc  (NYSE:ARR)
Q3 2018 Earnings Conference Call
Oct. 25, 2018, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the ARMOUR Residential REIT Inc. Third Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded, Thursday, October 25th, 2018.

I would now like to turn the conference over to Jim Mountain, Chief Financial Officer of ARMOUR Residential REIT. Please go ahead, sir.

James Robert Mountain -- Chief Financial Officer

Thank you, operator, and thank you all for joining our call today to discuss ARMOUR's third quarter 2018 results. This morning I am joined by ARMOUR's co-CEOs, Scott Ulm and Jeff Zimmer; and by Mark Gruber, our COO and CIO. By now, everyone has access to ARMOUR's earnings release and Form 10-Q, which can be found on ARMOUR's website www.armourreit.com.

This conference call may contain statements that are not recitations of historical fact, and therefore, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the safe harbor protections provided by the Reform Act. Actual outcomes and results could differ materially from the outcomes and results expressed or implied by the forward-looking statements due to the impact of many factors beyond the control of ARMOUR. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of ARMOUR's periodic reports, which are filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov. All forward-looking statements included in this conference call are made only as of today's date and are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless required to do so by law.

Also, our discussion today may include reference to certain non-GAAP measures. A reconciliation of these measures to most comparable GAAP measure is included in our earnings release, which can also be found on ARMOUR's website. An online replay of this conference call will be available on ARMOUR's website shortly and will continue for one year.

ARMOUR's Q3 GAAP net income was $47.7 million or $1.02 per common share. Core income was $31.2 million or $0.64 per common share, which continues to exceed our dividends paid. Since July 2016, our core earnings have consistently exceeded dividends by more than $30 million in total, which represents about $0.71 per common share outstanding at September 30th.

Based on stockholders' equity at the beginning of quarter three, core income represents a 10.3% return on equity annualized. Core income includes TBA Drop Income and excludes portfolio gains and losses. ARMOUR's quarter-end portfolio consisted of over $7 billion of Agency Securities, $1.3 billion of agency TBA positions $0.9 billion of credit risk and non-agency positions.

Quarter-end book value was $23.49 per common share, down $0.19 for the quarter, due primarily to continued rate increases. Adjusted for dividends, that represents a total economic return of $0.38 per share or up 1.6%. Book value at October 23, 2018, was estimated to be $22.42 per common share outstanding. Now remember that we include updated book value estimates in our update presentations available on our website or on EDGAR.

We paid $0.19 per common share dividend each month during the third quarter of 2018 for a total of $24.2 million or $0.57 per common share. We've announced that October and November common dividends continuing at the rate of $0.19 per share. Those will be paid to shareholders of record as of October 15th and November 15th, and will be payable on October 29th and November 27th, respectively.

Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm, who will discuss ARMOUR's portfolio position and current strategy. Scott?

Scott J. Ulm -- Co-Chief Executive Officer, Co-Vice Chairman, Chief Investment Officer and Head of Risk Management

Thanks, Jim, and good morning. Very low realized volatility, flattening of the government yield curve, and credit spreads grinding tighter, served as a favorable, if unexciting background of fixed income markets for the summer months of the third quarter.

The spreading yields between the 2-year and 10-year treasury notes briefly touched 18 basis points in August, a level not seen in over a decade, and the outright yield on the 10-year treasury note remained in a well-defined range. While the agency mortgage basis reported daily volatility of just 1 basis point versus the 3 basis points average since the year 2000, we did see spreads widen during the quarter in agency MBS.

Spread compression across the U.S. housing credit curve helped non-agency MBS outperform high yield and investment grade corporate credit. Caution signs for stretch valuations have begun to emerge now. Robust economic data threatens to flush out low forward growth and inflation expectations, U.S. home affordability is being challenged by the rapid rise of mortgage rates year-to-date, the continued credit box expansion to a wider range of mortgage borrowers has impacted the credit quality of the collateral in the latest CRT deals, and the Federal Reserve's run-off of its mortgage portfolio challenges our historical perspective on the mortgage basis. By September, shifting perceptions of equity and bond valuations combined with divergence and views on the health of the U.S. economy produced a rebound in volatility, higher yields and subsequently mixed returns for the third quarter.

Running on historically low levels of leverage and duration exposure, ARMOUR's book value declined by 0.8% in the third quarter while producing core income of $0.64 per share versus our dividend of $0.57. Our total economic return for the past quarter was positive 1.6%.

The modest decline in book value was driven primarily by curve flattening and wider spreads in conventional 30-year 4% MBS, which as the production coupon is extremely susceptible to supply and extension concerns. The underperformance was offset by spread tightening in our DUS, Delegated Underwriting and Servicing bonds and CRT, Credit Risk Transfer buckets, which saw another quarter of strong performance.

Owing to the positive convexity, Fannie Mae DUS pools bested agency MBS late in the third quarter when interest rate volatility and extension fears rose. Spreads on Freddie and Fannie CRT mezzanine tranches continued their march tighter through the third quarter, posting another quarter of positive absolute returns resulting in roughly 1.9% total return inclusive of carry.

We remain constructive on the CRT sector, although we view current spreads as quite tight and with limited upside in the near term. A relatively small non-agency legacy portfolio remains a positive contributor to income and had a largely flat price return year-to-date.

Our TBA roll book saw further reduction in the third quarter, declining from $1.8 billion down to $1.2 billion early in the quarter. The combination of attractive relative value in the specified $200,000 max loan balance pools as well as a general weakening trend in dollar roll specialness drove our TBA balance to its lowest amount since the first quarter of 2016. A steady increase in spread between gross and net coupons characterizes a majority of recent mortgage production. This implies faster speeds and worst convexity relative to previous years' cohorts.

Without the Fed's involvement, private investors must absorb worsening supply that's projected to increase further into year-end, potentially resulting in somewhat wider spreads and weaker dollar rolls in production coupons. Despite the current benign prepayment environment, this dynamic bodes well for specified pools, and today, we favor owning better convexity specified pools versus TBAs.

The return of volatility over the last few weeks and spread widening across the Board is a sharply different environment than what we experienced in the summer months. As of October 23rd, our book value is down 4.5%, driven by the spread widening since the end of the month as well as the 10 basis point increase in the 10-year. Current valuations and Agency Securities are clearly more attractive than the past quarter and verging on levels that are quite attractive from an historical perspective.

As of October 23rd, our funded leverage ratio or debt to equity is approximately 6.3 times, slightly higher than the 6.2 ratio observed at the end of the third quarter of 2018. Adding in the leverage effect of unfunded TBA dollar roll positions and forward settling transactions resulted in implied leverage of 7.2 times as of the October 23 close. This gives us some dry powder to add agency assets and more attractive spreads in the future.

While TBA dollar rolls do not trade with the extreme levels of specialness observed over the past decade, we continue to find pockets of opportunity where dollar roll financing is more favorable than the general collateral repo market and expect to maintain our exposure there.

We expect the Federal Reserve to deliver another federal funds rate increase in December this year and three more hikes in 2019. We've taken steps to limit our sensitivity to short-term borrowing costs. As of the end of the quarter, we maintain a hedge book of pay fixed receive floating swaps of $7.1 billion notional. Our agency fixed rate asset repo position is covered 107.8% by swaps. As a result, away from timing issues, our income increases with these Fed increase.

Our net duration is 0.44, an increase from 0.20 on June 30th, but historically, very low for us in our business model. This number does not include any negative duration effects from our repurchased liabilities. Today, our duration stands a touch higher at 0.48 and would increase to 1.45 if rates were to rise by 100 basis points.

Our spread DV01 is $4.98 million, a very slight increase from $4.79 million on June 30th of 2018. Our net interest margin increased by 8 basis points to 164 basis points. Despite our lower risk exposures, based on what we know today, we anticipate the core earnings will cover our dividends during the fourth quarter of 2018.

The average prepayment rate on our agency assets has decreased slightly from 6.7 CPR in the second quarter to 6.1 CPR in the third quarter. Prepayment risk and DUS amortization expense has clearly faded with the increase in treasury rates. It's important to note that a good portion of our agency portfolio is composed of assets with prepayment protection through seasoning, lower loan balances or contractual prepayment lockouts in our DUS paper. As such, the contraction and extension risks of our portfolio are well contained.

Repo financing remains consistent and reasonably priced for our business model. ARMOUR maintains MRAs with 48 counterparties and is currently active with 26 of those for total financing of $7.2 billion at the end of the second quarter.

Most importantly, our affiliate, BUCKLER Securities, which became operational during the early part of the fourth quarter last year, is financing approximately 50% of our entire repo position and 55% of our agency portfolio liabilities. Financing through BUCKLER provides us with greater security of financing, flexibility on terms, attractive rates, and therefore, an overall greater control over our liabilities. Lower haircuts from financing with BUCKLER will free up capital and also reduce our liquidity requirements.

Our investment in credit risk transfer securities was valued at $853.8 million at the end of the third quarter and represented 90% of our credit risk and non-agency portfolio. In the CRT transactions, we take the credit risk of Fannie and Freddie underwriting in return for an uncapped floating rate coupon. The credit quality of our CRT bonds has continued to be reliable due in large part to strong GSE underwriting standards on the 2013 to 2016 vintages that we own. Consequently, we've been rewarded both by the spread tightening that has occurred in this sector since our first investment in 2016 and by the attractive carry. In addition, these securities benefit from increasing credit enhancement over time that can lead to credit rating upgrades.

Currently, 35% of our CRT portfolio has been upgraded to investment grade. Rating upgrades result in better financing terms and possible price appreciation. While we remain very constructive on residential credit, especially among the older CRT reference pools, valuations are high enough to merit some rebalancing in our portfolio, which we will continue to analyze.

At the end of the second quarter, ARMOUR owned $76.2 million of non-agency legacy RMBS. Currently, we see very few opportunities for investment in this asset class. However, our existing holdings from that period continue to perform well as they run-off. Although the jumbo and non-QM market issuance has more than doubled versus 2017, non-agency mortgage issuance remains relatively low. Given the tight credit spreads in the non-agency markets, we currently see better opportunities and agency collateral.

Our focus for the balance of 2018 is managing the reflection of the strong underlying U.S. economy's effect on bond market yields versus potential headwinds from international trade issues and the inevitable maturing of this business cycle. Our hedge book today provides substantial protection against the impact of rate increases on our income and book value. The challenge for our business remains, as always, managing the transitions in the rate environment that will surely occur, but with unknown timing.

Operator, that concludes our prepared remarks, we'll now take any questions.

Questions and Answers:

Operator

(Operator Instructions) And our first question comes from Doug Harter with Credit Suisse. You may proceed with your question.

Douglas Harter -- Credit Suisse -- Analyst

Thanks. Hoping, on the October update, you gave for book value, how much of the decline would you attribute to spread widening versus rate moves?

James Robert Mountain -- Chief Financial Officer

90%, just the vast majority of the spread widening. I mean OAS is another 4, 5 here in the first couple of weeks of the quarter, so anybody that's involved in agency MBS and even CRTs are going to have -- experience lower prices or wider spreads.

Douglas Harter -- Credit Suisse -- Analyst

And I guess, how would you -- I guess, what is your viewpoint kind of look forward for the remainder of this year for -- into next year, kind of your outlook for spreads?

James Robert Mountain -- Chief Financial Officer

So we are currently still a little negative on the mortgage basis. We're still getting the first kind of flow of experience of the Federal Reserve not buying any more. And I think at some point, when analysts were doing their work a year ago when this announcement was made, some people thought mortgages could widen 40 OAS and others said maybe 5 to 10, I think it's going to end up being in the middle there. And we believe we have some widening to go.

On the non-agency side, you actually have seen CRTs widen. This quarter alone, you're on the runs between 20 and 25. Now our investment grade portfolio, which constitutes 35% of our CRT position is only wider by 10, so we benefited from the seasonality factor of that. So we will be pleased to invest some of our dry powder, but I wouldn't expect that unless you see, gosh, another 5 or 10 OAS of widening. Otherwise, we're very pleased with the way we're positioned right now. And at some point, you're going to see buyers say, hey mortgages look really cheap. Then we'll see the universe come in and buy, and we'll be part of that participation and spreads can tighten around the road. Particularly, if you go to a 335, 345 10-year note, mortgages will be prepaying very slowly at that point, OK, their duration extension would have already happened. And if they're wider, they're going to look like a very good investment.

Douglas Harter -- Credit Suisse -- Analyst

I appreciate that color. Thank you.

James Robert Mountain -- Chief Financial Officer

Okay, thank you.

Operator

Our next question comes from Christopher Nolan with Ladenburg Thalmann. You may proceed with your question.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Hi, you mentioned you get a haircut benefit from financing with BUCKLER versus The Street, how much of a benefit is that please?

James Robert Mountain -- Chief Financial Officer

The benefit they show us is between 100 basis points and 200 basis points, 1% and 2%.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Great. And then in the quarter, you bought more 30-year Fannie and Freddie's. Last quarter, you mentioned when you bought those, they were for low FICO scores, mortgages less than $200,000 or so. For the ones that you bought this quarter, how would you characterize those?

James Robert Mountain -- Chief Financial Officer

The vast majority is $200,000 loan max or less of 4 and 4.5s. We weren't able to find as much of the FICO paper this quarter. I don't even know we've actually put any on. The one thing I would point out, Christopher is, this morning I was looking at the publication we put out on the monthly at the end of May, which would have been put out June 15th, at that point, you had $5.8 billion of actual collateral -- agency collateral, fixed rate collateral. This morning, we're $7.04 billion. But the difference being that we reduced by a $0.5 billion, our dollar roll thing and most of that has gone into the collateral that I just discussed. The modestly premium price 4, 4.5s with a very good characteristics in terms of convexity like $200,000 max loan.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Got you. And then my final question, and then I'll get back in the queue, is on the TBA rolls, the lower specialness, I mean, how should we look at -- should we expect TBAs to decline going forward or -- and for leverage to increase, what do you think?

James Robert Mountain -- Chief Financial Officer

For the rest of the year, we're not bullish on TBAs and I suspect that we may take delivery over the next couple of months or sell some of those TBA positions out. When we last spoke, we were quoting some dollar roll positions in Ginnie to 4.5s or Fannie 5s, like 13%, 13.5%. Well, these returns are now down to 10% to maybe 11% max, whereas, I can invest in some of the special securities that I just discussed with you at 11% to 12% in a quarter kind of return. So we are talking an extra 100 basis points or more, which at the end of the day makes your actual leverage to go up, but your implied, inclusive of that still stays the same, because we're just going from dollar rolls to hard collateral.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Sounds good. I'll get back in the queue. Thanks for taking my questions.

Operator

Our next question comes from Trevor Cranston with JMP Securities. You may proceed with your question.

Trevor Cranston -- JMP Securities -- Analyst

All right, thanks. A follow-up on the comments you made earlier about the spread widening you've seen in October. I guess specifically you mentioned that agencies and CRT had widened. I was curious if you're seeing any widening in the DUS market? And how you guys are thinking about DUS versus agencies or CRTs on the margin? Thanks.

James Robert Mountain -- Chief Financial Officer

So we've seen 3 basis points of widening in the DUS market this quarter. We like DUS because of the convexity. And once again, I just quoted looking at the end of May, the June 16th presentation, where our DUS position is up 300 -- just under $300 million since then as well, right? So rates go up, DUS will not extend, they're going to be 9.5 years to 10 years. It's given. If not we get a large prepayment penalty from the borrower. If the market rallies, and you see 285 tender note for a reason (ph) that will shorten up. So we like that position. It's currently 18%. I wouldn't see it going over 20%, but we do like their structure (ph) quite a bit.

Trevor Cranston -- JMP Securities -- Analyst

Got it. Okay that's helpful. And then just a question on the overall portfolio asset yield. In the third quarter, you reported 3.5%, which was up a decent amount from 3.1% the prior quarter. Just wondering, if you could just talk a little bit about what specifically drove the increase in asset yield this quarter? Thanks.

Mark Richard Gruber -- Chief Operating Officer & Chief Investment Officer

Hey, Trevor, it's Mark Gruber. So really just two drivers. We sold about $500 million of lower yielding assets and replaced it with higher yielding, and then prepayment, the amortization expense also declined during the quarter. So those are the two main drivers to asset yield. And there's some little more technical stuff on the TBA side. We were able to take advantage of some interesting dollar roll opportunities into some smaller quantities throughout the quarter.

Trevor Cranston -- JMP Securities -- Analyst

Okay, got it. Thank you.

Operator

(Operator Instructions) Our next question comes from David Walrod from Jones Trading Canada. You may proceed with your question.

David Walrod -- Jones Trading -- Analyst

Good morning. Per your last update, your equity allocation was about two-thirds agency, one-third credit, has that changed much?

James Robert Mountain -- Chief Financial Officer

No. Not at all. The only difference being that some of the TBAs came off, so we went into collateral that we actually carry on the books, but the equity allocation would have been the same. Scott did mention in his comments, Dave, that we are looking very closely at the future value of CRTs. So you could over a period of time see us reallocate modestly from CRTs, which may have maxed out in price and maxed out in potential tightness spread after they've become investment grade into some of the kind of aforementioned (ph) collateral.

Mark Richard Gruber -- Chief Operating Officer & Chief Investment Officer

Hey, David, this is Mark, again. We haven't really bought any asset outside of agencies for a while, now, just FYI. So we haven't found any attractive opportunities in that sector and kind of come in that space over a few times.

James Robert Mountain -- Chief Financial Officer

Yes, more specifically, we haven't bought a CRT for almost two years. And in our portfolio meeting, we check out this dynamic. For the stuff that we bought from the early '13 or '14s, the debt to income ratio is over 45% (ph) or 4%, 5%, 6%. Well, in the last three deals, they're 24%, 26% and 27%. You see in the debt to income in the CRT deals go up quite a bit, OK? Also the sub-660, OK, of the credit scores, 7.6% in the most recent deal that was announced yesterday. The first few deals we had were under 2%, so there's some dynamics going on in the way the agencies are structuring the new CRTs that kind of don't fit us in our model or future vision of where the housing market may go. Now these new deals have a little bit more credit support, but nevertheless, with the characteristics that are being added in, it could create some volatility and how these assets trade spread wise in the future.

David Walrod -- Jones Trading -- Analyst

Okay, that's helpful. And I guess, on a big picture note, you've mentioned multiple times in your press release that you -- when out earning the dividend for nine consecutive quarters, you mentioned in your comments that you expect 4Q to cover the dividend. Can you, I guess, update us on how you're thinking about the dividend, and if -- maybe you're looking at bumping it up?

James Robert Mountain -- Chief Financial Officer

So we -- because we published our Q, we probably just had a Board meeting, and that was a discussion issue as it has been in other Board meetings. Sustainability of a dividend rate is very important to the broad investment base. So to be going up by a $0.01 this quarter or last quarter, we believe our investors want to see stability and our discussions with our investment bankers, and our -- some of our large investors have told us -- given that exact same feedback. So for right now, the dividend will remain the same. The Board did discuss. Perhaps at some point, considering doing a special, which we have a lot of dividends out there that I guess could be paid out as a special dividend, but that has not been announced nor based on any meetings that I've been in, is it live on the table at this moment.

David Walrod -- Jones Trading -- Analyst

Great. Thank you very much. Very helpful.

James Robert Mountain -- Chief Financial Officer

You're welcome.

Operator

(Operator Instructions) We have no further phone questions at this time, sir.

James Robert Mountain -- Chief Financial Officer

Thank you very much for attending our conference call. As we've said before, this executive group is available for investors or research calls at any time. You know our office number. Have a very good day everybody. Thank you.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation, and we ask that you please disconnect your lines.

Duration: 26 minutes

Call participants:

James Robert Mountain -- Chief Financial Officer

Scott J. Ulm -- Co-Chief Executive Officer, Co-Vice Chairman, Chief Investment Officer and Head of Risk Management

Douglas Harter -- Credit Suisse -- Analyst

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Trevor Cranston -- JMP Securities -- Analyst

Mark Richard Gruber -- Chief Operating Officer & Chief Investment Officer

David Walrod -- Jones Trading -- Analyst

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