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Capstead Mortgage Corp (NYSE:CMO)
Q4 2020 Earnings Call
Jan 28, 2021, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Hello, and welcome to the Capstead Mortgage Corporation's Fourth Quarter 2020 Earnings Conference Call. [Operator Instructions]

I'd now like to turn the conference over to Lindsey Crabbe, Manager of IR. Ms. Crabbe, please go ahead.

Lindsey Crabbe -- Manager of Investor Relation

Good morning. Thank you for attending Capstead's fourth quarter earnings conference call. The fourth quarter earnings release was issued yesterday, January 27, 2021, 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 28, 2021. Details for the replay are included in yesterday's release. On the call 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 the management. In addition, certain terms used in this call are non-GAAP financial measures, reconciliations of which are provided in the company's earnings release and accompanying tables or schedules, which have been filed on Form 8-K with the SEC and may also be accessed through the company's website. 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 at the date of this call, January 28, 2021. 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.

Phillip A. Reinsch -- President and Chief Executive Officer

Thank you, Lindsey, and thanks, everyone, for your interest in Capstead Mortgage. After I make a few brief remarks, Lance will give a quick recap of the fourth quarter, and Robert is going to provide us with some current market color. Then we'll open the call up to questions. We're pleased to report another steady quarter with lower borrowing costs, offsetting the effects on portfolio yields to continued high mortgage prepayments as Americans continue to take advantage of generational lows in mortgage rates to refinance or purchase a new home. On a core earnings basis, we again earned our $0.15 common dividend, producing an 8.85% annualized return on common equity. For all of 2020, we earned 9% by this measure. We accomplished these returns with lower leverage and portfolio balances post pandemic. Common dividend itself was unchanged for five quarters now.

And our core earnings met or exceeded the dividend in each of these quarters despite the market disruptions experienced in March. We are the only mortgage REIT that can make that claim. In fact, looking at peers in the residential mortgage REIT space, on average, their dividends currently stand at about 50% of what they were pre-pandemic, and that's a stark contrast to our steady performance. Our book value is down $0.04 in the fourth quarter, which together with a $0.15 common dividend, resulted in a three-month economic return of 1.6% or 6.5% on an annualized basis. Since the pandemic induced such income disruption in March, and through year-end, book value was up $0.69, which together with $0.45 in common dividends, resulted in an economic return of about 19% or 25% annualized. Thus far in 2021, book value has little change, down $0.01 to $6.75 a share. Looking forward, we are optimistic that there'll not be a repeat of the market disruptions experienced in March, given the lower leverage levels in the market and the Fed bond-buying programs. However, mortgage prepayments remain at high levels in no small part due to the Fed's continuing heavy involvement in the market. This is having the effect of lowering returns and crowding out private capital, making it harder to reinvest capital made available from portfolio runoff at attractive levels. We expect prepays to moderate over time as runoff is replaced with slower paying newer production with the seasoning of existing holdings and with lower coupon interest rates on our currently resetting bonds. Given these market conditions, we're being judicious in deploying our liquidity, building flexibility to potentially take advantage of opportunities as they unfold in the coming quarters.

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

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

Thank you, Phil. We reported a GAAP net income of $23.3 million this quarter or $0.19 per diluted common share. Our core earnings were $19.7 million or $0.15 per diluted common share. As a reminder, our core earnings exclude realized and unrealized losses on our portfolio-related interest rate swap agreements. We included a reconciliation of our GAAP to core earnings on Page nine of our press release. Book value decreased $0.04 per share during the fourth quarter, ending at $6.76 per common share, with derivative related increases of $0.10 being offset by $0.14 in portfolio related declines, largely due to runoff. Portfolio yields averaged 1.55% during the quarter, a decrease of 30 basis points from the 1.85% we reported in the prior quarter. Yields declined due to lower coupon interest rates on acquisitions and on existing loans that reset to lower current prevailing interest rates, as well as higher yield adjustments for investment premium amortization due to continuing high levels of mortgage prepayments.

Our portfolio related borrowing costs, after adjusting for our hedging activities, averaged 0.37% during the fourth quarter, 30 basis points lower than in the prior quarter, leading to approximately a one basis point improvement in our net interest spreads. As a result of payouts during the quarter at December 31, the fixed pay rate on our swap book was 0.04%, a decline of 65 basis points from rates in effect on September 30. These lower fixed rates going forward will benefit future earnings. Robert?

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Thanks, Lance. The yield curve steepened significantly during the fourth quarter with 10-year yields increasing 23 basis points while future yields declined basis points. Longer term, this trend is a positive for our valuations in ARM supply. There was, however, short-term disruption in new issue ARM MBS originations due to the transition from LIBOR to SOFR indexes. Many originators quit taking LIBOR applications early in the quarter, but didn't get SOFR product rolled out. As a result, fourth quarter production was skewed to the downside, and it was at the lowest level of the year at roughly $1 billion. At the same time, an extremely strong bank bid for new issue ARMS of all shapes and sizes caused spreads to tighten dramatically on the lowest coupon, newest paper that is perceived to be immune from prepays.

Also, secondary selling was very wide in the quarter. As a result of these cross currents, we're currently seeing more value in the season ARM stays as opposed to new issues. Prepayments remain elevated. We expect this trend to continue for the next several months. As we move to 2021, the yield curve trend and has remained intact. We're starting to see new SOFR ARMS coming out and block forward trades. As a matter of fact, we've already seen over $200 million of this new SOFR paper in January alone. And while spreads are relatively tight on this paper, the fact that supply is starting to come out in a more normalized fashion is positive. Nonetheless, I would expect the market to become much more normalized as far as production and volume around March.

And with that, we'll open the call up for questions.

Questions and Answers:

Operator

[Operator Instructions] And the first question today comes from Steve Delaney with JMP Securities.

Steve Delaney -- JMP Securities -- Analyst

Hey, good morning everyone. How are you?

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Good morning.

Steve Delaney -- JMP Securities -- Analyst

Thanks for the comments and the good release last night. The -- Robert, you talked about sort of the tightness in the market, a lot of that sounds like just supply and demand. But help us get a sense for as you see the market today, what would -- what -- give us a range or an idea of what your minimum ROE hurdle is to invest new cash? It sounds like you've kind of stepped back and that minimum hurdle, how does that change between, say, current reset and fresh paper -- longer duration paper?

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Yes, sure. I mean I think just thinking about it, we have preferred ROE at 7.5. And so at a minimum, we are not going to invest unless we can get an 8% levered return. And so right now, we are seeing leverage anywhere from 7.25 to eight times. We are seeing 8% to 9% returns in some parts of the market, but that's mainly the speed of the space. With where new production is trading right now, it's inside of that book. I would expect those spreads to normalize, though, as production picks up. But obviously, fixed rates have tightened as well, so ARMS don't just trade in a vacuum. The long part right now is how long the banks can last. A lot of times, those guys are in heavy the first quarter, and then they back away.

So that's one of the wildcards. But -- so the next couple of months, I think new issue paper's going to stay on the higher side, and we're probably not going to be super active in that space. We're optimistic as we move through the year, though, given the slope of the curve, and what we're seeing already I mean, some of the larger originators are putting out $25 million, $30 million block size bottoms out into March and April already. And so we're very optimistic about that over the coming months. Not so much in the first month or two of the year, because the trades we've seen so far, new issue hybrid papers tightened further, along with fixed rates. I mean so right now, it's not overly compelling. We think that could change over the next few months. So we're going to probably, in the short run, stick more to seasoned paper.

Steve Delaney -- JMP Securities -- Analyst

Got it. That's helpful. And Lance, one for you. Your kind of expanded disclosure these days on fair value swap maturity disclosures. And just looking at your table here for December 31 versus 9/30. You've gotten rid of, obviously, some much higher cost swaps, but also I think you've switched to OIS swaps. Should I interpret this that when you say you've got an average fixed rate in any particular quarter, let's say, third quarter of 2022, and it's only one basis point. Is that just your net between what I would normally think of as a fixed pay versus receive spread on that swap contract?

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

No. That's actually our average fixed pay.

Steve Delaney -- JMP Securities -- Analyst

That's your average fix pay?

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

For the ones maturing in that period.

Steve Delaney -- JMP Securities -- Analyst

Right. So you're basically saying you're paying one basis point?

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

Yes. For that -- you mean that third quarter example, that swap notional amount of $1.2 billion has an average fixed rate of one basis point.

Robert R. Spears -- Executive Vice President and Chief Investment Officer

To follow-up on that. Those -- current two-year OIS swaps are at about eight basis points. And so that one is in the money right now.

Steve Delaney -- JMP Securities -- Analyst

Okay. thanks. I'm going to do a follow-up with you, Lance, in the next day or two, just just to make sure I'm clear on that for modeling purposes. Thanks for the comment guys.

Robert R. Spears -- Executive Vice President and Chief Investment Officer

You bet.

Operator

Thank you. And the next question comes from Jason Stewart with JonesTrading.

Jason Stewart -- JonesTrading -- Analyst

Hi, good morning and congratulations on a great 2020. I think the -- good kudos for a good performance in a tough year. I have a question on the yield adjustment in the fourth quarter. Lance, if you could quantify it, if possible? And then maybe sort of set expectations for anything that would occur again in the first quarter or if that sort of level set the numbers there?

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

So on the fourth quarter yield adjustments, it was -- we disclosed -- we haven't been disclosing the breakdown of that, but it's been pretty consistent in the seven basis-point yield adjustment, I want to say, over the last second half of the year. For the first quarter, as a reminder, some of our peers just like speeds on a pretty regular basis, and then they back it out of core earnings. We traditionally do that on an annual basis. And look at like speed book, there's no requirement for that, but that's how we kind of try to look a little more longer term. We've done that in the past over the last couple of years at least in the first quarter, and I'd expect that's what we're going to look at again this year. With the higher prepayments, obviously, there's a chance we've moved those speeds up and if we do, we would certainly disclose the impact or kind of the -- what others call the catch-up or what we would just say that like speed adjustment, we would disclose that in the first quarter and break that out for you.

Jason Stewart -- JonesTrading -- Analyst

Okay. thanks. And then obviously, we've seen a little bit of whips on rates in the first quarter so far. If you wouldn't mind just walking us through a little bit of how the portfolio has performed in terms of duration and extension. And I appreciate the comments on new issue, but just in the way that the legacy has traded so far given the short duration nature of it and what we've seen happen in rates, I think that would be helpful.

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

Sure. And as Phil mentioned, our book value was down $0.01 in our last March, which was as of close of business -- market close of business last Friday. And so essentially, if you look at the curve, two to three-year part of the curve is pretty much unchanged. And given the duration of our book, it really hasn't moved a lot, although spreads on newer issue, lower coupon paper have tightened. So we've seen some of those prices on the lower coupon paper that we own improve by as much as 0.25 point. Most of the other paper is -- comparable paper out there is fairly flat. And so not a lot of movement so far to characterize the ARM market in general, what's going on right now. Most newer ARM paper's trading somewhere between 104.25 and 105.25. And there's a lot of price compression, just like you see in fixed rate, because it's kind of a speed play right now. So in this environment, just like the fixed rate market, the better performing paper right now is either lower coupon or varied season with a really good speed score. Does that answer your question?

Jason Stewart -- JonesTrading -- Analyst

Yes. That's super helpful. I just think that with the context in terms of portfolio performance and the move in longer term rates, it's helpful to stratify the way that the portfolio is performing. So that's helpful. Thank you.

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Sure.

Operator

Thank you. And the next question comes from John Islands with SG Capital.

John Islands -- SG Capital -- Analyst

Yes. I was just curious, can you talk a little bit about -- I'm sure you're frustrated by the valuation in your stock just relative to -- you guys being the only mortgage REIT that didn't cut the dividend, etc. You're trading about 81% of book. Since you're bringing down leverage, I mean do you look to potentially start to deploy some of that capital and buy the stock back down here at these levels?

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

Yes, that's a great question. We are trading at a lower multiple than we think we deserve, obviously, in considering that we're 100% agency book. And we have performed well from a cash flow perspective. The -- with the leverage coming down a little bit in the fourth quarter with the supply and demand dynamics that have been in place that Robert described, we'll see how that plays out. But we we would probably run down -- run leverage potentially even lower by the end of the first quarter if we don't see good opportunities to deploy capital. So that gives us a lot of flexibility to look at -- to look at buybacks or other maneuvers to use that capital. So we're certainly open to doing what's best for our stockholders in that regard.

John Islands -- SG Capital -- Analyst

Okay. And then the other question that I have for you is, AGMC on their call -- I know your book is different, etc, but they were talking about how they think there's potentially getting to some kind of burnout on refis and that we're getting closer to that, etc. Can you give us any insights on just kind of what you see in refis relative to the ARM market?

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Sure. I mean I think over time, most segments of the MBS market start to exhibit burnout and ARMS are not different in that regard. I would think that prepayments will remain elevated throughout most of this year. And then after that, you hit the point where pretty much everybody out there could have as refi. And so the dynamics right now, though, there's -- over the next six to nine months with like speeds are going to be elevated. And I think after that, you should start to see some burnout exhibited. And also the difference too in ARM book versus the fixed rate book we have, a shorter reset, securities that are resetting lower in deal. A fully indexed ARM on the season short reset paper to the borrower now is around 2.5%. And so if those loans reset downward, they will slow down as well. And that's not necessarily burnout, but it's a nice feature to our portfolio.

The cohorts that are going to remain somewhat fast would probably be no different than if you think about the fixed rates in terms of the coupons that we have three and higher, for instance, those guys are going to remain fast for a while. But all in all, after we get through the first six to nine months of this year, we think we can see speeds start to moderate.

John Islands -- SG Capital -- Analyst

Okay. Yes, go ahead, I'm sorry.

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

Well, just real quick aside to Robert's point about our current resetting portfolio, we had a request to increase our disclosure relative to how those bonds will reset in the coming year or so. So we added a sentence to that effect on the last page of the press release, and it's...

John Islands -- SG Capital -- Analyst

36%, right? 36% in that -- six months.

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

Yes, there's 36% that are going to, on average, reset in six months' time, but we improved the disclosure to indicate that 22% of that amount will -- that reset will occur in the next quarter and another 33% in the second -- in the quarter after that, which would be the third quarter. And then the remaining 40% over the following six months. So we gave some additional disclosure there.

John Islands -- SG Capital -- Analyst

And we -- as investors, though, we should just think about that as positive ramifications as obviously, the reset the yield will come down, but there won't be runoff because most likely, it's not going to refi, correct?

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

Yes. Those folks will have a whole lot less incentive to refinance after their coupons reset down. That core of the portfolio already is paying slower than the bonds Robert was referring to have a fixed coupon with years to go, because they already know or they should know that they're going to get something out of a coupon reset without having to do anything about that. It will just happen. So they won't necessarily refinance in anticipation of a lower coupon on their bonds. But it will certainly be affirmation of that when the mortgage goes down.

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Without getting into the math, for instance, a five CPR drop in speeds on a season bond may throw up a higher yield at the lower coupon than what it does now. So speeds are very levered in that kind of paper. And so all in all, the speed decline would more than offset the detriment of the coupon loss.

John Islands -- SG Capital -- Analyst

Got it. And then if I could just ask you kind of a bigger picture. I mean obviously, we've seen this steepening significantly in two of the 10s, which eventually should have positive ramifications for your portfolio. Can you just talk a little bit about kind of what we need to see maybe in fixed-rate mortgages before ARMS really start to maybe explode from a production standpoint. You talked about what was going on in LIBOR versus SOFR, and that's kind of a mechanical issue. But I guess, if -- what are we rooting for to happen?

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Well, I mean already with the steepness that we've seen, originators are out there with, say, 7/1 ARMS and as much as 3/8th of rate difference, cheaper than a 30-year fixed. And from what we're hearing from guys that are in contact with big originators are seeing a big pickup in ARM production versus the fourth quarter, albeit from a very low level. And so that steepness alone is causing an increase. If any steepness from there would only increase supply liquidity and attractiveness, I think, of the ARM market. So we're optimistic about supply going forward in the environment where now it sees further, and it will get better.

John Islands -- SG Capital -- Analyst

Okay. Thank you for so much for answering my questions. I really appreciate it. And I hope you buy some of the stock back.

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Thank you.

Operator

Thank you. And the next question comes from Derek Hewett with Bank of America.

Derek Hewett -- Bank of America -- Analyst

Good morning, everyone. Kind of given those near-term headwinds on new issue yields and the portfolio trending modestly lower and presumably lower leverage if you don't buy back any stock, at least in the near term. How should we think about the sustainability of the current dividend? Are these near-term -- are these headwinds kind of in the near-term and things start to normalize in kind of Q2 and beyond? Or what are the expectations around those trends?

Robert R. Spears -- Executive Vice President and Chief Investment Officer

There's a lot of moving parts, right, and a whole lot of optionality in where we could be from an earnings perspective quarters down the road. A lot of it's going to depend on what we were just talking about to how much the yield curve steepens, if any. And if we can buy bonds at decent ROEs, whether we maintain leverage at the levels we're at. If we don't, what do we do with the capital, do we keep it as dry powder, do we deploy it through buying back our own capital or otherwise. So there's a lot of unknowns this year. It's probably more -- it's more uncertain in terms of some of those factors than you might ordinarily have at this stage. So we're not really prepared to say a whole lot about where that goes, but we will strive to hold on to our dividend level. If it looks to be a temporary decline in core earnings, we'll -- we don't want to disrupt the -- our pattern of dividends for something that's transitory.

Derek Hewett -- Bank of America -- Analyst

Okay, great. Thank you.

Operator

Thank you. [Operator Instructions] And the next question comes from Eric Hagen with BTIG.

Eric Hagen -- BTIG -- Analyst

Hey, Thanks, good morning guys. A follow-up on originators rolling out SOFR ARMS. Can you just shed some light on the product itself, what are the margins and caps and floors being offered to borrowers?

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Sure. So far, most of what's come out has been in the 7/1 space. And the difference is the old 7/1 LIBOR had margins of net margins of plus one 60 or so. The newer SOFR paper has come out, it's at margins around two 12. It's a theoretically five -- 1/5 cap structure, if you will, could the resets of flight. So it could go -- it can reset up 5% at the first reset and then 1% every six months after that. And so if you kind of look at how it's trading so far, it's really not trading materially different than what a LIBOR -- similar LIBOR ARM would have traded. It's basically trading off the coupon with people assuming the margin of adjustment of roughly 50-plus basis points over time, for the SOFR index is a fair adjustment.

Derek Hewett -- Bank of America -- Analyst

It's really interesting color. Thank you. I hope you guys are well.

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Sure, thank you.

Operator

Thank you. And as that was the last question, I would like to return the floor to Lindsey Crabbe for any closing comments.

Lindsey Crabbe -- Manager of Investor Relation

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

Thank you. This concludes the question-and-answer session and -- as well as the call. Thank you for attending today's presentation. You may now disconnect your lines.

Duration: 29 minutes

Call participants:

Lindsey Crabbe -- Manager of Investor Relation

Phillip A. Reinsch -- President and Chief Executive Officer

Lance J. Phillips -- Senior Vice President, Chief Financial Officer and Secretary

Robert R. Spears -- Executive Vice President and Chief Investment Officer

Steve Delaney -- JMP Securities -- Analyst

Jason Stewart -- JonesTrading -- Analyst

John Islands -- SG Capital -- Analyst

Derek Hewett -- Bank of America -- Analyst

Eric Hagen -- BTIG -- Analyst

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