Image source: The Motley Fool.
Western Asset Mortgage Capital Corp (WMC)
Q3Â 2019 Earnings Call
Nov 6, 2019, 11:00 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Welcome to Western Asset Mortgage Capital Corporation's Third Quarter 2019 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5:00 PM Eastern Standard Time. [Operator Instructions]
Now first, I'd like to turn the call over to Mr. Larry Clark, Investor Relations. Please go ahead, Mr. Clark.
Larry Clark -- Investor Relations
Thank you, Elly. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months ended September 30, 2019.
The company issued its earnings press release yesterday and it's available on the company's website atwww.westernassetmcc.com. In addition, the company has included an accompanying slide presentation that you can refer to during the call. You can access these slides in the Investor Relations section of the website.
With us today from management are Jennifer Murphy, Chief Executive Officer; Lisa Meyer, Chief Financial Officer; and Harris Trifon, Chief Investment Officer.
Before we begin, I'd like to review the safe harbor statement. This conference call will contain statements that 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 protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors, beyond the control of the company.
All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice. 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 the company's reports filed with the SEC. Copies are available on the SEC's website. We disclaim any obligation to update our forward-looking statements. Unless required by law.
With that, I'll turn the call over to Jennifer Murphy. Jennifer?
Jennifer Williams Murphy -- President and Chief Executive Officer
Thank you, Larry. Welcome everyone. I'm pleased to report that we delivered another quarter of solid performance despite a market that continues to exhibit increased rate volatility. We generated GAAP net income of $0.37 per share for the third quarter and core earnings of $0.28 per share for the quarter and $0.91 for the first nine months of the year.
The company's book value increased just under 1% in the quarter despite the volatility in fixed income markets. Our differentiated strategy of holding a diverse portfolio of credit sensitive residential and commercial real estate assets complemented by our investments in mostly Agency CMBS, continued to largely balance our portfolio and mitigate the interest rate risk that impacted a number of other REITs this quarter. This was the main driver of our strong book value performance. The book value increase, together with our dividend, provided our shareholders with an economic return on book value of 3.8% for the quarter and 10.3% for the first nine months of the year.
Our core earnings were down modestly from the second quarter, primarily due to heightened volatility in the repo market, it temporarily impacted our cost of funds. That being said, our quarterly core earnings have been relatively consistent over the last three years, where they've averaged just over $0.33 per share, which averages higher than our quarterly dividend of $0.31 per share over that same time period.
We're comfortable with the earnings power of our portfolio currently and continue to find attractive investment opportunities as Harris is going to talk about. As we've discussed in the past, our dividend decisions in consultation with our Board reflect our long-term view of the earnings power of our portfolio, rather than the level of core earnings in any given quarter. We paid a consistent dividend for 14 quarters and stability in our dividend continues to be an important corporate goal for us.
I'm also pleased to report that in August, we issued an additional $40 million of our 6.75% convertible senior notes due in 2022, allowing us to further invest in attractive assets. We believe this financing is an attractive source of longer-term capital. And we expect the assets we're adding to contribute to the earnings power of our portfolio in coming quarters. In addition, this financing supports our long-term goal of growing the company to achieve increased scale, which we believe will also benefit our shareholders over time.
Our investment team was quite active again during the quarter, selling over $560 million in Agency MBS, and redeploying the capital with the majority going into credit-sensitive investments. This investment activity similar to our past quarters is reflective of our active management approach.
During the quarter, we made a number of investments where we were able to leverage the Western Asset investment platform to gain access to opportunities that we would not have as a stand-alone mortgage REIT. This included investments where we've deployed -- we've developed strategic relationships with residential and commercial mortgage loan originators who understand what we're looking for and are able to provide us with attractive opportunities that meet our disciplined investment criteria.
So in conclusion, we are very pleased with our ongoing strong financial results; we've assembled the diversified portfolio of residential and commercial assets; and we remained focused on our investment and operational execution that better enables us to deliver strong and consistent returns to shareholders. Our performance is a testament really to the efforts of the entire investment team headed by Harris Trifon, our Chief Investment Officer and Sean Johnson, our Deputy Chief Investment Officer. And demonstrates the effectiveness of the strategic initiatives that we've been implementing over the last two years.
With that I'm going to turn the call over to Lisa Meyer. Lisa ?
Lisa Meyer -- Chief Financial Officer and Treasurer
Thank you, Jennifer. This quarter proved to be another challenging quarter with significant interest rate volatility. However, despite the turbulent market environment, our book value increased modestly to $10.60 and we generated an economic return on book value of 3.8%.
A key contributor to our ongoing strong performance is our diversified investment portfolio, which balances mainly Agency CMBS and credit investment, with both residential and commercial loan exposure .
As Jennifer mentioned and Harris will provide more detail, we were again quite active during the third quarter, rotating out of securities that were fully valued into investments that we believe was a better relative value. We continued to shift the mix of our portfolio to more credit investments. Selling $562 million of Agency MBS and reinvesting $327 million of those proceeds into a combination of non-agency CMBS, commercial loans, and residential whole loans.
In the quarter, our portfolio generated net interest income of $19.3 million, inclusive of hedging costs. Our credit-sensitive investments contributed 79% to that total, compared to 73% in the second quarter. Our annualized net interest margin in the quarter was 1.69%, down 45 basis points from the last quarter. The decline was the result of a lower weighted average yield on our portfolio combined with a higher effective cost of funds, inclusive of our net hedging costs.
We generated net income of $19.7 million, or $0.37 per share and core earnings of $15 million, or $0.28 per share. As Jennifer mentioned, our core earnings was down modestly from the second quarter, mainly due to increased volatility in the repo market. Although short-term interest rates declined in the third quarter, we did not experience a parallel decrease in repo rate, resulting in a higher effective cost of funds.
We have proactively staggered our repurchase agreement maturities to mitigate our exposure to the volatility in the market. In the fourth quarter, the repo market has begun to stabilize. So we expect to see less of a negative impact in core earnings. At September 30, we had $2.5 billion in repo borrowings under 20 of 33 master repurchase agreement and $397 million outstanding under our longer-term financing facilities.
We continue to evaluate additional attractive sources of financing. We continue to operate with a significant degree of interest rate protection from our repo -- protection on our repo financing from our interest rate swap positions. At quarter end, we held interest rate swaps with a net notional value of $2.5 billion, covering over 86% of our outstanding variable rate debt. The net duration gap on our Agency portfolio was 0.3 years.
Our leverage ratio was 5.4 times at quarter end, excluding $1.5 billion of non-recourse debt, which was down from 5.6 times at June 30, 2019. As Jennifer mentioned, we issued an additional $40 million of 6.75 convertible senior notes maturing in 2022. Allowing us to further invest in attractive assets. Over time, we expect our adjusted leverage ratio will vary depending on the mix of our Agency and credit-sensitive assets in the portfolio.
With that, I will now turn the call over to Harris Trifon. Harris?
Harris Trifon -- Chief Investment Officer
Thanks, Lisa. The third quarter proved to be another quarter of significant interest rate volatility. To recap, we saw a rally in the rate market early in the quarter, with a partial retracement in September. Prepayment is on Agency mortgages picked up due to an increase in refinance activity, and as previously mentioned, there was significant volatility in the repo market due to a variety of technical factors which caused the Federal Reserve to take measures to stabilize the market.
Our view of the macro environment has not changed materially nor do we anticipate any near-term changes to our broad market views. Interest rates continue to remain low with episodes of increased rate volatility. The US economy continues to grow at a subdued yet steady pace and is modestly outperforming the slower global economy. And inflation remains well below target levels and central banks around the world continue to be accommodative in light of the slower global growth outlook.
Despite the subdued pace of economic growth in the US, consumer balance sheets remain solid and the robust labor market is supporting the housing sector, which continues to show positive improvement. We believe that this backdrop should continue to provide a supportive environment for credit assets. In general, we have seen an increase in compelling investment opportunities across a number of the credit subsectors throughout the course of the year and as a result, we continue to rotate the portfolio into more credit-sensitive assets during the quarter.
Our investments were focused on three main subsectors; commercial real estate whole loans, Non-Agency CMBS and residential whole loans. We invested $130 million into two sizable commercial real estate loans, were the collateral or new luxury retail malls. These investments are very much consistent with our disciplined and selective approach to the space, where we focused on high-quality properties, short duration loans and situations where we generally are able to play significant role in shaping the credit protections and structural terms of the transaction.
We also invested in over $100 million in Non-Agency CMBS during the quarter. We continue to hold a favorable view of commercial real estate fundamentals in the US as demand drivers remain positive and new construction continues to be muted, both factors being supportive of increased rents as well as improved cash flows at the property level.
We continue to find interesting opportunities in the residential whole loan space. The US housing sector continues to exhibit positive fundamentals, a strong household formation, a solid labor market and historically attractive mortgage rates are all contributing to ongoing demand and continued home price appreciation, albeit at a slower pace than the last few years.
Against this backdrop, the supply of new homes remains somewhat constrained due to increased discipline among the public homebuilders as well as tighter lending standards. While we invested $80 million of capital into this asset class during the quarter, a number of transactions that we had planned to complete in the quarter were delayed to the fourth quarter.
We also believe that our Agency MBS holdings, both commercial and residential provide an important balance to our credit sensitive assets and will remain a core component of our portfolio. However, we did sell about a third of our Agency RMBS holdings that we acquired during the second quarter as these securities performed well and in our view, we're fully valued. We rotated a small portion of our Agency CMBS holdings during the quarter as well. These were all security-specific relative value trade as we generally continue to favor Agency CMBS over RMBS.
As we have stated in the past, Agency CMBS will remain a core component of our portfolio due to with attractive risk-adjusted returns as well as its lower sensitivity to interest rate risk due to its built-in prepayment protection, and also because it's more efficient to hedge relative to Agency RMBS.
While Agency CMBS spreads widened modestly during the quarter, where we saw significant volatility and interest rate, it did outperform Agency RMBS, which is more strongly impacted by interest rate volatility and prepayments. Our overall performance in the third quarter, highlighting why we like this sector of the market.
In summary, we are very pleased with the performance of our portfolio during the quarter and we continue to focus on our goal of delivering solid core earnings and preserving book value. Our differentiated approach is built on a barbell investment strategy that pairing Agency CMBS and to a lesser degree RMBS with credit investments, which include both residential and commercial loan exposures. We maintain an active approach to portfolio management, continually seeking the best relative value opportunities within our target universe. We believe this approach is the best way to pursue our objectives while continuing to enhance shareholder value.
With that, we will open the call up to your questions. Operator, please go ahead.
Questions and Answers:
Operator
We will now begin the question-and-answer session. [Operator Instructions]
Our first question comes from Eric Hagen with KBW.
Eric Hagen -- KBW -- Analyst
Hey, thanks guys, good morning. I noticed that you didn't mention the residential bridge loan opportunity in your prepared remarks and the portfolio has gone down a little bit over the last few quarters. And I'm just curious, why you guys might not view that as an attractive opportunity set right now? Just maybe runs a little bit in contrast with some of the commentary we've heard from other REITs. Thanks.
Harris Trifon -- Chief Investment Officer
Thanks for the question, Eric. I would say, it's not that we don't find the investment opportunity attractive, it's just on a relative basis to be compared to the other favored credit assets and subsectors that we've been investing in namely, non-qualifying mortgages residential loans, some of the large transitional commercial loans as well as some of the non-agency securities that we've been active in over the course of the last quarter. It's just simply not as attractive. There is also a number of operational risks and volatility that those types of loans important to the portfolio, and as a result we thought there were better opportunities away from the sector.
Eric Hagen -- KBW -- Analyst
Okay. So it's not necessarily the credit that you just like, it's just the pricing, it sounds like of the loans themselves that might not be as attractive to?
Harris Trifon -- Chief Investment Officer
That's correct. Particularly relative to say, a year ago.
Eric Hagen -- KBW -- Analyst
Sure. Thanks. And then just on the non-QM side, how selective can you be with respect to the loans that you're buying from your origination partners. I mean, I think it's no secret that the prepayment speeds on those loans have been relatively fast. So I'm just curious that as you guys redeploy capital into that segment just how again, just how selective can you be -- are you -- maybe that's, I guess, that's the question? Thanks.
Sean Johnson -- Deputy Chief Investment Officer
Yes. Hey it's Sean. How you doing?
Eric Hagen -- KBW -- Analyst
Great, Sean. How are you?
Sean Johnson -- Deputy Chief Investment Officer
Good. Thanks. Well, the originators that we've been buying from continue to produce a consistent product. And so we continue to see the higher quality stuff coming out of them and we've been able to purchase more of that. It's become a bit more competitive from a price standpoint, but we still are able to buy what we need to buy. We've also been adding some new originators that that are producing loans in the quality sector that we care about.
We've seen tremendous growth in sectors that are sort of outside of our target for credit and rate. And so it feels like the whole market is growing pretty rapidly and demand as well is growing, but we still feel like we're in a good place with our target for the sector.
Eric Hagen -- KBW -- Analyst
Right. How many...
Harris Trifon -- Chief Investment Officer
I would just add more broadly even away from non-QM. The one thing that's critically important to myself and Sean in the rest of the investment team is never to sacrifice our discipline on credit. So if that simply means that we step away from a sector as we were talking about a few moments ago, then we're completely comfortable with that.
Eric Hagen -- KBW -- Analyst
Got it. Yes, that's helpful. That definitely answers the question. How many origination partners are you guys working with on the non-QM side?
Sean Johnson -- Deputy Chief Investment Officer
We have seven active partners and we have a couple more that are coming on board here in the next couple of weeks.
Eric Hagen -- KBW -- Analyst
Okay, super. And then one housekeeping item. Just the transactions that were delayed to the fourth quarter, am I hearing you that the yield will improve because of those transactions in the fourth quarter, or will it stay relatively the same?
Sean Johnson -- Deputy Chief Investment Officer
It will stay relatively the same.
Eric Hagen -- KBW -- Analyst
Okay. Thanks guys for the comments. Appreciate it.
Harris Trifon -- Chief Investment Officer
Thanks for the questions, Eric.
Operator
Our next question comes from Trevor Cranston with JMP Securities.
Trevor Cranston -- JMP Securities -- Analyst
Hey, thanks, good morning. The follow-up question on the non-QM portfolio. It sounds like there is some transactions pending for 4Q. Can you guys talk about how you're currently thinking about the accessing the securitization market again for the loans that you're currently holding outside of securitization? And how you're viewing the profitability of financing via securitization, given how far rates have come down? Thanks.
Harris Trifon -- Chief Investment Officer
Yes, I think, we still view that securitization market for those assets as wide open. So in terms of your question on profitability, our view and the attractiveness of securitization hasn't really changed much over the course of the year. If anything, it become more attractive as a financing option over the course of the year. And in terms of our plan, as Sean mentioned, we are in the process of on-boarding a couple of new originator counterparties. And so we certainly expect to be able to access the securitization market at some point in 2020.
Trevor Cranston -- JMP Securities -- Analyst
Okay, great. Thank you. And then, I understand -- I understood from the prepared comments, you guys made that the core focus of the portfolio continues to be the barbell between Agency CMBS and credit. But you did note that Agency RMBS obviously, underperformed during the third quarter quite a bit. Over the short term, are you guys seeing any opportunities to add to that portion of the portfolio? Or would you still say that, within the Agency sector even given that widening in the RMBS space you continue to favor Agency CMBS near term?
Harris Trifon -- Chief Investment Officer
I think, generally speaking, we still do favor Agency CMBS, because as I mentioned earlier during the prepared comments, there are just structural advantages to that market relative to RMBS. That said, the Agency RMBS market, to your point, has continued to cheapen up and is currently trading at multi-year wise relative to any comparable risk asset and certainly is much more attractive now than it has been in quite some time as a result.
Trevor Cranston -- JMP Securities -- Analyst
Okay, got you. And then last question. I think you guys mentioned that repo had improved somewhat in the fourth quarter. Can you provide any additional color sort of on where you're seeing agency repo rates currently, particularly after the Fed cut we had recently?
Sean Johnson -- Deputy Chief Investment Officer
Yes. Hi, it's Sean. We've -- we saw pre-craziness in September, agency repo trading close to LIBOR and when things got a little weird it wind out to about LIBOR plus 20. Right now, we're back to -- for a three month LIBOR -- three month repo, we're looking at LIBOR, LIBOR plus 2, something in that area. So it's really normalized back to where it was before. The real stresses hit the market.
Trevor Cranston -- JMP Securities -- Analyst
Okay. Great. I appreciate the color. Thank you.
Operator
[Operator Instructions] As we have no further questions, this will conclude our question-and-answer session. I would like to turn the conference back over to Jennifer Murphy for any closing remarks.
Jennifer Williams Murphy -- President and Chief Executive Officer
Thanks, everybody, for joining us and for your questions today, and we'll talk to you soon.
Operator
[Operator Closing Remarks]
Duration: 24 minutes
Call participants:
Larry Clark -- Investor Relations
Jennifer Williams Murphy -- President and Chief Executive Officer
Lisa Meyer -- Chief Financial Officer and Treasurer
Harris Trifon -- Chief Investment Officer
Sean Johnson -- Deputy Chief Investment Officer
Eric Hagen -- KBW -- Analyst
Trevor Cranston -- JMP Securities -- Analyst
