ARMOUR Residential REIT Inc (ARR) Q1 2021 Earnings Call Transcript

Image source: The Motley Fool.

ARMOUR Residential REIT Inc (ARR 2.99%)
Q1 2021 Earnings Call
Apr 22, 2021, 8:30 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Greetings, and welcome to the ARMOUR Residential REIT, Inc. First Quarter 2021 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded, Thursday, April 22, 2021.

I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.

James Robert Mountain -- Chief Financial Officer, Treasurer and Secretary

Thank you, Kelly, and thank you all for joining our call to discuss ARMOUR's first quarter 2021 results. This morning, I'm joined as usual by ARMOUR's Co-Chief Executive Officers, Scott Ulm and Jeff Zimmer; and by our Chief Information Officer, Mark Gruber. By now, everyone has access to ARMOUR's earnings release, which can be found on ARMOUR's website, www.armourreit.com. This conference call may contain statements that are not mere 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 protection 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 impacts 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 filed with the Securities and Exchange Commission. Copies of these reports 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 we are required to do so by law. Also, our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to our most comparable GAAP measures is included in our earnings release, which can 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 continues to concentrate its portfolio activities in Agency MBS for the foreseeable future. Quarter end book value was $12.40 per common share, up $0.08 from Q4 2020. As of the close of business this past Monday, we estimated book value to be approximately at $12.15 per common share. ARMOUR's portfolio consisted exclusively of specified agency mortgage-backed securities valued at approximately $4.3 billion. Plus Agency TBA positions, representing another $3.6 billion in underlying securities. ARMOUR's Q1 GAAP comprehensive income was $29.1 million, which includes $71.3 million of GAAP net income and represents an annualized return on equity of 12%. Let me make a brief comment on prepayment accounting and core income.

We recognize the amortization expense of prepayments as they occur. Given the recent ramp-up in prepayments, we estimate that using the forecast method for this quarter, amortization would have been $0.06 to $0.07 lower per share or about 29% of core income. We paid dividends of $0.10 per common share for each month in the first quarter for a total of $20.1 million. We've also declared the April and May common dividends at the rate of $0.10 per common share. Series C preferred stock dividend for each month in Q2 and continuing is at the contractual rate of $14.583 per share. ARMOUR's common and Series C preferred stock ATM programs were active in Q1 and through Friday, April 9. They raised approximately $107.7 million in total capital. Common stock represented about 2/3 of that total and preferred stock represented the remaining 1/3. We saw no discernible effect on share prices and dilution to common stockholders was negligible, a shade over $0.04 per common share for the entire program. That equates on a per share expense basis to savings that will occur over about 16 months.

Our current projections for 2021 show that 100% of both common and preferred dividends will likely be treated as tax basis adjustments rather than current taxable income, when it gets distributed to our shareholders. That's due to the tax shield provided by the amortization of hedging costs that were previously deferred for tax purposes. This is consistent with the results for 2020. ACM, the company's external manager, continued to waive a portion of its management fee, which was initiated in the second quarter of 2020. This waiver offset $2.4 million of operating expenses for Q1 2021. On April 20, 2021, the company's external manager notified ARMOUR that it intended to adjust this fee waiver to the rate of $2.1 million for the second quarter of 2021 and continue with the rate of $700,000 per month thereafter until further notice.

The annual meeting of ARMOUR Residential REIT is scheduled for Thursday, May 13, at 8:00 a.m. Eastern Time. By now, all shareholders of record of ARMOUR common stock should have received their notice and access cards in the mail. If not, they should contact their broker. Full proxy statement and annual report are available electronically at proxyvote.com or on the SEC website. Stockholders of record may also request paper copies by following the instructions on their notice and access card. The annual meeting will be webcast on www.cstproxy.com/armourreit/2021, and it will be virtual only again this year. That link is also on the notice and access cards. We encourage all ARMOUR common stockholders to log in to proxyvote.com and register their votes in advance. I've already voted my ARR shares, and the process is painless. Shareholders who wish to vote their shares during the annual meeting will need to obtain a legal proxy in advance, however.

Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm, so that Scott, you can discuss ARMOUR's portfolio position and current strategy.

Scott J. Ulm -- Co-Chief Executive Officer, Co-Vice Chairman and Chief Risk Officer

Thanks, Jim. The first quarter of 2021 --

[Technical Issues] Thank you. Apologies, we were disconnected. Scott Ulm, Co-Chief Executive Officer of ARMOUR REIT continuing with my remarks. The first quarter of 2021 delivered the first raise of optimism in a nearly year-long fight against the pandemic and its impact on the economy. The positive sentiment was fueled by the largest fiscal stimulus in U.S. history of $1.9 trillion and rapid distribution of effective vaccines. The financial markets saw this as a potent fix to reinflate and reopen the economy ahead of the expected time lines. Higher projections for inflation and treasury issuance have quickly repriced the yield on the 10-year treasury higher by 82 basis points to touch as high as 1.75%. While the yield spread between 2s and 10s, treasuries expanded by 78 basis points.

Despite a rise in treasury yields at a quicker pace than in 2013, mortgage spreads avoided a repeat of the 2013 taper tantrum. Due in large part to the Federal Reserve's unwavering commitment to keep the Mortgage Purchase Program going well into the economic recovery cycle. Over the course of the first quarter, the option adjusted spreads on 30-year Fannie 2% TBAs have tightened by eight basis points, while zero-volatility OAS tightened as much as 19 basis points for this cohort. Despite sharply lower treasury bond prices, ARR delivered a positive 3.1% or 12.4% annualized economic return in the first quarter, illustrating strong risk controls around the portfolio's duration and convexity. ARMOUR was active in managing its hedge book and exposure in production coupons in a very dynamic market.

Over the course of 2021, ARMOUR's implied leverage declined from 7.6 times at the end of the fourth quarter to 6.9 times as it sits today. This took place through capital raises through our ATM program and sales of assets with either rich valuations or less favorable prepayment profiles. Our lower leverage provides us with ample dry powder to take advantage of market opportunities ahead. We will continue to be very selective in the prices we will accept for the risks on offer in the current market. ARMOUR's duration as of year-end was 0.62 and is currently 0.30 with a negative duration exposure to the 10-year-plus part of the yield curve. We like this duration profile, which matches our long-term bias for higher interest rates in the second half of 2021.

First quarter prepayments remained elevated as originators were slow to increase mortgage rates in order to protect their market share. ARR's portfolio averaged 17.4 CPR in the first quarter, slightly above 17.3 CPR from the previous quarter. Note that both are at still significantly below speeds on more generic MBS cohorts, and we expect prepayment pressures to subside in the second quarter, a potential tailwind to earnings.

While we've allocated approximately 45% of our portfolio to dollar rolls in 15-year and 30-year TBAs, 97% of the remaining portfolio are assets with favorable prepayment protection characteristics, including prepayment penalties, lower loan balances and seasoning. Nominal specified pay-ups have declined by nearly 50% quarter-over-quarter, but still performed well on a duration adjusted basis. TBA roll specialness was also notably weaker in the first quarter as origination supply remained robust, while investor demand cooled relative to the fourth quarter. Today, we're again observing an increase in roll specialness as higher mortgage rates reduced the available supply that we delivered into the Fed portfolio.

Although current MBS QE purchases are clearly favorable to the supply demand balance near term, markets are continuously challenging the timing of the Fed's eventual exit from MBS, something that we see as a key driver to book value performance this year. As we've noted before, we set our dividend policy based on the medium-term outlook on our business. We continue to see our dividend level as appropriate. So in summary, we are just not comfortable putting our shareholders extensively into very high-priced securities. Vista grades return, increases risk and threatens book value. Long term, this business makes a lot of money. But we clearly have a distortion of the market from the Fed. Delighted they are there, but we need to be a bit cautious.

With that, we would be delighted to take questions.

Questions and Answers:

Operator

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

Doug Harter -- Credit Suisse -- Analyst

Thanks. I was hoping you could give a little more context to the amortization expense comment you gave. I think you said it was kind of around the $0.06 drag this quarter versus kind of model prepay speeds. How would that compare to the prior quarter?

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

Well prepayment -- Hi, Doug, it's Jeff. Prepayments were up, as you could see from the monthly company update that we put out last night, as much as 25% over a year ago. The exact difference in amortization, I actually don't believe we've released those numbers yet, so I need to be careful about releasing non-public information. So I'll have Jim double check on that and we'll get back to you, and if indeed, we haven't, we'll go ahead and we'll release that where everybody could see that. But prepayments are up 25%, and that's the biggest drag on earnings -- or two things: Higher prepayments, which is greater amortization, as Jim said in his comments, and I think everybody knows, we don't do modeling or forecasting and then do catch ups, the catch-ups run through book value and actually, in some cases, make current core earnings, a non-GAAP measure appear to be higher than perhaps they are. We take amortization as it occurs. So as prepayments have ramped up here, we are getting a larger hit to core earnings even though if you kind of look at the returns over the quarter, the comprehensive income was quite substantial and honorable.

The other thing that I think you need to be aware of in addition to that, are what's around the corner and expectations. Most of The Street, and we have seven firms here on our chart, expect May prepayments to be down by 18% and expect June prepayments to be further down another 11%. If interest rates, which have rallied a little bit, do stay here, then of course, you'll see a little catch up and maybe they'll increase as we get into the late summer. Now the other element is, as Scott Ulm said in his comments, is our leverage is in the high 6s now. We target 8.5, so almost two full turns. I can tell you, we had two full turns of TBA 2s right now and you're going to have $0.15 a quarter to income. So a little bit of reinvestment can add a lot of income. That being said, also to Scott's point, OASs are negative here. And I'm looking at a chart left to right, it's just negative 20-some OASs on 2s and 2.5s. We're not going to do heavy reinvestment at these kind of levels. We're going to be patient. However, as Scott also indicated, highly likely that we maintain our dividend structure as it is now. We look at dividends in the medium-term, way out, not just on a month-to-month basis based on our perspective on reinvestment and occurrences of prepayments.

Doug Harter -- Credit Suisse -- Analyst

Just to drill down on the prepay, I guess industrywide prepays were down in the first quarter relative to the fourth quarter. Can you just talk about kind of what pieces of your portfolio and what kind of drove you to have higher sequential prepays in the first quarter?

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

Our prepayments are well under our peer group prepayments. Our prepayment rate for the last month was in the high to mid 18 CPR level. You compare that to the peer groups that are going to be at least 10 CPR higher. Our individual securities that prepaid represented our higher coupons, our positions in four and 4.5s. We own those positions at very low prices, but they continue to have some higher prepayment levels, but we're going to maintain those securities in our portfolio. I would also note to be exact, the CPR in Q1 was 17.4, not 18.

Doug Harter -- Credit Suisse -- Analyst

Great. Thank you.

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

Thank you very much.

Operator

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

Trevor Cranston -- JMP Securities -- Analyst

Hi, thanks. I was wondering if you could elaborate maybe on sort of the thought process behind the dividend level. I know you said it's sort of based on your medium-term view. But is the way to think about that sort of -- that's where you guys see your earnings level if you were at your target leverage as opposed to running a lower risk, lower leverage strategy in the near term? Or are there other things at play there as well?

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

That's right. That's exactly correct. And as a matter of fact, we could probably earn a little bit more than our dividend rate if we were fully invested, as I just indicated. Investing long-term on core incomes that have -- for core income with assets that have negative 20 OAS is going to lead to some book value dilution at some point. We're going to be very cautious and I expect for the remainder of this quarter, there will be great opportunities to reenter, and we have lots of dry powder.

Trevor Cranston -- JMP Securities -- Analyst

Okay. Got it. That makes sense. And then in terms of your rate positioning, you mentioned, I think, in the prepared remarks that you had some overall positive duration, but negative duration further out the curve. Can you kind of comment on how that's changed as rates go up? And if you guys see any value in sort of adding some additional optional protection into the portfolio as well to protect against large moves in the 10-year?

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

So the DV01, we don't release our DV01s, but as Scott said, the whole duration pattern is a 0.28 duration as of this morning, was slightly negative in the 10-year, and that will defend us against a steepening that has occurred and we, as a firm, expect more steepening. We feel that the Fed will keep the short end of the curve, see overnight funding rates low, don't see an increase for as many -- potentially as much as another two years. And as economy expands and banks have opportunities to provide credit in other areas, you'll see higher 10-year rates, and so we're positioned for that.

At some point, the Fed will also reduce their buying of mortgages, and that is a hopeful period where we can do some more reinvestment. Mark and his team have only reinvested paydowns, I think, once, one full round of the last three months. So not only underinvested in paydowns to maintain, but underinvested, of course, in our full leverage target. By the way, you saw yesterday that Canada announced that they're starting to reduce the amount of purchases that they're going to make. And many people's comments on that is, at some point, we'll be next. I think the expectation is that if the Fed wants to maintain the same level of purchases, they would reduce in the mortgages and put it in the treasuries.

Trevor Cranston -- JMP Securities -- Analyst

Okay. To follow-up on that comment about reinvesting paydowns. I guess with OASs negative here, would you guys continue to let leverage drift lower if valuations remain this tight or even potentially get tighter? Or are you at a level where you'd like to keep leverage kind of where it was at at the end of the quarter?

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

I don't think leverage at all it will get much lower. Maybe you could see debt-to-equity get a little bit lower if we put more money into TBAs. I mean you can do TBA 2.5s right now, May, June rolls at 17% unchanged. TBA 2s are 11.5%. Even 15 year, 1.5s are 11.5%. So there's areas to put money there. But when we look at the risks associated with that and the potential spread widening of negative 20 OAS investment opportunities today, we're just being cautious. So we will do some reinvestment, we'll do some reinvestment in specifieds. And I would note the pay-ups for specifieds, interestingly enough, have come off quite a bit from their highs, some stuff that was like 80, 90 ticks over, it's 60 ticks over now. But interestingly enough, the OASs have come in. So pay-ups over TBAs have come down, but the OASs are more negative. And the dynamics of that, Mark, maybe you want to speak to that element because we talk about that in our investment meetings.

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

Sure. I mean, it's just -- the fact is that as rates decline, I mean the option cost to hedge out the mortgage portfolio has gone up. So even though you see a little bit of maybe some nominal spread widening, the option adjusted spread has just continued to decline. And so that's the reason why we continue to not reinvest a lot of our paydowns back in the mortgage product because we're seeing negative OASs, we're seeing single-digit kind of yields, mid-single-digit yields on spec pools, and TBAs, like Jeff said, have some specialness and are interesting, but they have a lot of convexity and risk in different spots. So the investment opportunities when we look out on the outlook are not super attractive to reinvest all of our paydowns.

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

These opportunities come at you very quickly. The difference between the investment opportunities on May 10, 2013 and July 10, 2013 were like six points difference. These things come at you. We're trying to set ourselves up. So if the marketplace provides an opportunity for a larger reinvestment, we can ramp up our leverage very quickly 2 times. Otherwise, we will continue to reinvest. We do want to maintain a dividend, and we have the power to create earnings.

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

Okay. Appreciate your comments. Thank you.

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

Thank you.

Operator

[Operator Instructions] Our next question comes from Christopher Nolan with Ladenburg Thalmann. You may proceed with your question.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Hey guys. The lower waiver, is that indicative of more confidence in the earnings momentum outlook for 2021?

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

It's actually probably more reflective of the capital raise and the way that our fee changes with capital raises. By the way, to Jim's point on that, that entire raise of the equity and the preferred combined was a total $0.04 diluted paid at underwriting fee between 1% and 1.5%. Versus peer groups paying underwriting fees of 4.75% to 5.75%. So sometimes, you raise capital, not that you necessarily need it at the moment, but because it benefits shareholders so greatly to raise capital at a very cheap level. And so that's the way we look at that.

Scott J. Ulm -- Co-Chief Executive Officer, Co-Vice Chairman and Chief Risk Officer

Well, and Jeff, you also didn't mention absolute zero effect on market trading price through the ATM program that we've seen, whereas in addition to underwriting discount, we often can see some negative overhang on market trading from block offerings, which we did not have here.

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

I'm sorry, Christopher, you're about to also ask a second -- follow-up question.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

No, Jeff, I was just -- is that $0.04 to book value?

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

Yes. All in. So what is that? 0.03%?

Scott J. Ulm -- Co-Chief Executive Officer, Co-Vice Chairman and Chief Risk Officer

Yes, paid back fairly rapidly through expense savings on a larger capital base.

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

Yes.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Going forward, you guys generated a 12% core ROE in the quarter. I mean, is that the type of momentum that we should see? Or should we see it improve given your comments?

Scott J. Ulm -- Co-Chief Executive Officer, Co-Vice Chairman and Chief Risk Officer

That was economic return. So that's a combination of dividends paid and change in book value. So the change in book value, have trouble predicting that. The dividend, I can probably give you a little more confidence on.

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

So -- but yes, you can earn that in today's market, as I just said, we got right now and do dollar rolls in 2s and 2.5, 30 years and 1.5, 15 years and combined, hedge that out and earn 12%, you can do it. It's just those securities at negative 20 OAS have risk. So I think the profile you might see in the future is as the Fed reduces their purchases of mortgages and OASs, get back to some prior investment levels, you might see us own less TBA or have less TBAs on our balance sheet and more securities that we'd be funding in the repo market on our balance sheet. Now I think that might be the difference you see in the future, but the business model will still and should still produce those kind of returns.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Great. Thanks for the color, Jeff.

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

You're welcome.

Operator

Mr. Mountain, we have no further phone questions at this time. I will now turn the call back over to you. Please continue with your presentation or your closing remarks.

James Robert Mountain -- Chief Financial Officer, Treasurer and Secretary

Thank you, Kelly, and thank you, everyone, for joining us. We look forward to speaking again next quarter. And in the meantime, if anything comes up, if you have questions or comments. Give us a call at the office, and we did enjoy the conversation. Until next time, keep safe.

Operator

[Operator Closing Remarks]

Duration: 28 minutes

Call participants:

James Robert Mountain -- Chief Financial Officer, Treasurer and Secretary

Scott J. Ulm -- Co-Chief Executive Officer, Co-Vice Chairman and Chief Risk Officer

Jeffrey J. Zimmer -- Co-Chief Executive Officer, Co-Vice Chairman and President

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

Doug Harter -- Credit Suisse -- Analyst

Trevor Cranston -- JMP Securities -- Analyst

Christopher Nolan -- Ladenburg Thalmann -- Analyst

More ARR analysis

All earnings call transcripts