Capstead Mortgage (CMO) Q4 2019 Earnings Call Transcript

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Capstead Mortgage (CMO)
Q4 2019 Earnings Call
Jan 30, 2020, 9:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning. Welcome to Capstead fourth-quarter 2019 earnings conference call. [Operator instructions]. Please note that this event is being recorded.

I would now like to turn the conference over to Lindsey Crabbe, director of IR. Please go ahead.

Lindsey Crabbe -- Director of Investor Relations

Good morning. Thank you for attending Capstead's fourth-quarter earnings conference call. The fourth-quarter earnings release was issued yesterday, January 29th, 2020 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.

An archive of this webcast and a replay of this call will be available through April 29, 2020. Details of the replay are included in yesterday's release. With me today are Phil Reinsch, president and chief executive officer; 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 January 30, 2020. The company assumes no obligation to update any statements, including any forward-looking statements made during this call. With that I will 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 recap of the quarter and then we'll open the call up for questions. Fourth-quarter earnings benefited from lower borrowing rates due in large part to a total of 75 basis points in Fed cuts last summer and fall. We also took advantage of lower prevailing interest rates to further reduce our swap cost by replacing higher rate swaps with new swaps with lower fixed rates.

Additionally returns on deploying our capital in the agency guaranteed ARMs securities continue to look attractive. This earnings improvement came despite rate pressures and short-term funding market that contributed to elevated repo borrowing rates relative to Fed funds and other short-term rates. Note I referenced rate pressures, not availability. We continue to find repo to be readily available through our network of lending counterparties.

And even as repo rates remain elevated relative to Fed funds from a historical perspective, post quarter end, we're seeing repo rates 30 to 35 basis points lower than the average rates incurred last quarter. With the caveat that we still expect some degree of upward pressure on rates each quarter and going forward absent regulatory or other release that reduces disincentives for major banks to fully participate in the short-term funding markets. Given these dynamics we anticipate further significant improvement in our borrowing cost going forward in the environment where the Federal reserve may be on the sideline for most if not all of 2020. These lower borrowing costs together with attractively priced portfolio acquisitions was served to offset lower portfolio yields as mortgages underlying the current reset component of our portfolio reset the lower rate and mortgage prepayment levels remained somewhat elevated.

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

Lance Phillips -- Senior Vice President and Chief Financial Officer

Thank you Phil. We reported a GAAP net income of $32.7 million this quarter or $0.29 per diluted common share. Our core earnings were $19.1 million or $0.15 per diluted common share. The difference between our GAAP and our core earnings this quarter primarily relates to market-to-market activity in our interest rate swap agreements, which are included in our GAAP results and excluded from core earnings.

We include a reconciliation of these differences on Page 9 of our press release. Portfolio yields averaged 2.67% during the quarter a decrease of 9 basis points from the 2.76% we reported in the prior quarter. Yields declined primarily due to lower cash yields as a portion of our ARM portfolio reset to lower prevailing interest rates. Our portfolio-related borrowing costs after adjusting for our hedging activities averaged 1.97% during the fourth quarter 34 basis points lower than in the prior quarter leading to a 25-basis-points improvement in net interest spread.

The benefit of lower unhedged repo rates and lower fixed rates on our swap book were partially offset by the continued decline in three-month LIBOR, which negatively impacted the received leg of these derivatives. At December 31, the fixed pay rate on our swap book was 1.77% a decline of 27 basis points from the rates in effect on September 30. This helps illustrate how repositioning our swap book will benefit future earnings. Book value increased $0.02 per share during the fourth quarter ending at $8.62 per common share, reflecting a $0.19 increase in value associated with our hedging activities, offset by an $0.18 decrease in portfolio-related unrealized gains.

With that we will open the call up to questions.

Questions & Answers:

Operator

[Operator instructions] Our first question is from Eric Hagen from KBW. Please go ahead.

Eric Hagen -- KBW -- Analyst

Good morning. What was the portion of the dividend paid in 2019 that was characterized as a return of capital? For 2018 roughly a third of your dividend was a return of capital. And I know the reason for capital return varies among REITs. But can you just remind us what drives that return of capital for Capstead?

Phil Reinsch -- President and Chief Executive Officer

I think 2019 was pretty unusual and that we put a lot of realized losses rather than unrealized loss in value of our swap book. By repositioning the book, we created taxable losses, which pretty much covered up all the dividend distributions we had last year such that we've reported to the broker-dealer community and everywhere else, we need to -- that none of our distributions last year are taxable.

Eric Hagen -- KBW -- Analyst

None of them are. OK interesting. OK great. Maybe I could follow-up with you guys after the call.

Phil Reinsch -- President and Chief Executive Officer

Sure.

Eric Hagen -- KBW -- Analyst

And just kind of understand the taxable impact there. It would be great to hear your outlook with regard to what the transition to SOFR from LIBOR means for the agency hybrid ARM market? And just what a transition like that could do to the prepayment speeds in the market and the net supply as well? And a segue to that question would really just be how you guys are thinking more generally about just remaining a pure-play strategy and agency ARMs right now? Thanks.

Phil Reinsch -- President and Chief Executive Officer

So regarding the SOFR transition, the ARCC came out with a concept release just last week that indicated -- asking for comment on a solution to consumer products that -- such as farm loans to handle the transition and their approach makes lot of sense. They're going to publish a series of indices based on tenor whether it's overnight, one month, three months, six months, 12 months like LIBOR would report. And they're going to add a spread adjustment based on historical relationships. It has come out with a life-minded approach.

So we actually are pretty encouraged about that solution. We think it makes a ton of sense for everybody involved. And their goal is to not disrupt the markets in any way and treat everyone fairly. So they have a lot of support from all participants and that looks to be where the answer is headed for consumer products like ARM loans relative to prepays, I don't know, Robert, do you have any opinion on that? I don't see any real impact?

Robert Spears -- Executive Vice President and Chief Investment Officer

No. I mean if they do what they're saying right now, I mean the mortgage servicer would just pick up whatever the new index is and it should be adjusted, looking at regression analysis to make up for that differential between LIBOR and SOFR. So if that is the case and the adjustment is fair and accurate, there really won't be any difference in the underlying mortgage rate to the consumer. So I wouldn't think it would affect prepayments at all, if they do what they said in the release last week.

Eric Hagen -- KBW -- Analyst

OK. How about the second part of my question? Just a segue, just how you guys are thinking about remaining a pure-play strategy and agency hybrid ARMs as we open up to a new year here?

Phil Reinsch -- President and Chief Executive Officer

Sure. So we're for a short duration play. And if that means we branch out beyond just adjustable rate mortgage -- agency guaranteed adjustable rate mortgage rate securities that could happen. We're already buying more seven ones than we used to and the season ten ones.

So that's a natural extension, and if we're able to succeed in growing a larger capital base prior to ARM supply starting to pick up with a steeper curve at some point, then we would look to potentially add some other short-duration strategies to our existing strategy.

Eric Hagen -- KBW -- Analyst

OK. Thank you very much.

Phil Reinsch -- President and Chief Executive Officer

You bet.

Operator

[Operator instructions] Our next question is from Steve Delaney from JMP Securities. Please go ahead.

Steve Delaney -- JMP Securities -- Analyst

Hey good morning everyone. Thanks for taking the questions. So I'd like to -- obviously, you guys have been very proactive in managing your swap book. And it looks like there's probably still some benefit.

I wanted to run a comment by on your 2020 expiration. So we're seeing 1.2 billion over the course of 2020. We get an average pay rate of about 2% there. It's about 60 basis points I guess above where swaps are today.

So we're getting about a blended. If we roll all those off, and let's just say, you replaced them at 140 over the course of the year, we're seeing about a 10 basis point additional benefit to your overall financing costs. I was just curious if that seems like -- not asking specifically but is that a ballpark that you would think as far as incremental benefit to your financing cost from the 2020 expirations?

Phil Reinsch -- President and Chief Executive Officer

Yeah. So just to be clear, you're talking about 2020 expirations and not the benefit we have standing on January 1st of having lowered our rates to 177 down.

Steve Delaney -- JMP Securities -- Analyst

Yes, 177 is where you were at December 31, right?

Phil Reinsch -- President and Chief Executive Officer

Right. Yeah. Yeah.

Steve Delaney -- JMP Securities -- Analyst

Exactly.

Phil Reinsch -- President and Chief Executive Officer

Yeah which is a very nice rate relative to where we're repo-ing right now.

Steve Delaney -- JMP Securities -- Analyst

Sure.

Phil Reinsch -- President and Chief Executive Officer

Yeah. So I haven't done specifically the math on that. But that sounds like the right perspective to take.

Steve Delaney -- JMP Securities -- Analyst

It wasn't any calculus, Phil. I don't do well with higher math but I'm seeing 60 basis points difference between the -- if you look at the 2020 expirations, they're about 2% and the current market is 40. So that's 60 basis points and they represent about 16% of the total swap book. So I guess like a higher amount.

Phil Reinsch -- President and Chief Executive Officer

We've got like $1.2 billion expiring and it looks like roughly 2%. So yes doing that math, I think that's pretty much spot on.

Steve Delaney -- JMP Securities -- Analyst

All right. And Robert, the -- it's -- I guess, even belly of curve is a flat. I mean, you've been -- you guys have been doing three years I think on your new. But given where we are in rates and -- would you be tempted to maybe push some of your new swaps out to five years, just to kind of lock in these unexpectedly low rates or at least in my mind unexpectedly low?

Robert Spears -- Executive Vice President and Chief Investment Officer

Yeah. We've actually been doing more two years lately. The only thing is, given what we're buying in this type of environment, putting a lot of five-year swaps on for us, we really don't have that type of duration in our book. As the market continues to rally, we can get upside down pretty quickly because the upside of price on the ARM is not going to be enough to compensate for that additional term risk on the swaps.

And so I'm not saying we wouldn't put any on, but in all likelihood, what the -- bulk of what we're doing is going to be closer to two-year tenors because it just matches the duration of our book better.

Steve Delaney -- JMP Securities -- Analyst

No that makes sense. It's got to be balanced on...

Robert Spears -- Executive Vice President and Chief Investment Officer

Last year, for instance, and there were points in time where that trade looked great and it's potentially, but then if you look at what happened by the end of the year, we had a 100 basis point rally and ARM spread wide than 30 basis points. So they basically improved almost a point less in price than you would expect that we would have gotten crossed last year having done that. So we could do a little bit of it, but I would look for us to do a lot of it.

Steve Delaney -- JMP Securities -- Analyst

OK. That's helpful. Just an outlook on how you see the market. It sounds like you see current investment opportunities.

It sounds like you see those as pretty attractive?

Robert Spears -- Executive Vice President and Chief Investment Officer

Yes. I mean I think ARMs in the fourth quarter may be tightened versus swaps 5 basis points or so. But I still think right now, we're kind of looking at 10% to 10.5% levered returns semi nine times leverage. So we still view that as very attractive.

And on a performance basis, once again, fixed rates knocked it out of the park in the fourth quarter like where the ARMs did. But so far, year-to-date, that's starting to reverse a little bit because I think fixed rates are probably 10 wider and ARMs are pretty close to flat versus their swap hedge. So they're making up a little bit on the underperformance in the first quarter so far.

Steve Delaney -- JMP Securities -- Analyst

One quick thing just to close out. Obviously we understand your change in your premium amortization. And we're trying to -- I think, we put a new model out, and trying to learn as we go a little bit, and I think we were reasonably close here in the fourth quarter, but you're still running, and this is like 3Q, 4Q when rates were higher, certainly in the fourth quarter, but you're still up in the high 20s, almost 30. How many more -- if rates stay where they are and you continue to print upper 20s, we're calculating that your $18.5 million of amortization in the fourth quarter represents about a lifetime assumption of about 23%.

I'm not asking you to comment on that. But if that's even close in CPRs 29% to 30%, how frequently will you evaluate that lifetime assumption?

Lance Phillips -- Senior Vice President and Chief Financial Officer

Yeah. So Steve, this is Lance.

Phil Reinsch -- President and Chief Executive Officer

Hi Lance.

Lance Phillips -- Senior Vice President and Chief Financial Officer

We do monitor the lifetime speeds continuously, and we'll update it as warranted, like we did last year. I would tell you, I think we all feel like we're at the higher end of the range, but not -- unfortunately not surprised by the current higher speeds. So other than kind of monitoring what's happened, we don't have a set schedule when we'll change as much as if something on our overall expectations change going forward.

Steve Delaney -- JMP Securities -- Analyst

OK. So I mean I think what you're saying to us Lance is none of us know where rates will be in six months. But if -- as an analyst, if I think that we are in for prolonged low rates, then I might -- I certainly might want to take a more conservative approach on premium amortization. And so -- and I think that conservatism from an analyst standpoint is never a bad thing.

Thank you guys for the comments this morning. Appreciate it.

Lance Phillips -- Senior Vice President and Chief Financial Officer

You bet.

Operator

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

Lindsey Crabbe -- Director of 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

[Operator signoff]

Duration: 22 minutes

Call participants:

Lindsey Crabbe -- Director of Investor Relations

Phil Reinsch -- President and Chief Executive Officer

Lance Phillips -- Senior Vice President and Chief Financial Officer

Eric Hagen -- KBW -- Analyst

Robert Spears -- Executive Vice President and Chief Investment Officer

Steve Delaney -- JMP Securities -- Analyst

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