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Capstead Mortgage Corp  (NYSE:CMO)
Q4 2018 Earnings Conference Call
Jan. 31, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day and welcome to the Capstead Mortgage Corporation Fourth Quarter 2018 Earnings Conference Call. Today's conference is being recorded. After today's presentation, there will be an opportunity to ask questions. (Operator Instructions). I'd now like to turn the conference over to Ms Lindsey Crabbe, please go ahead ma'am.

Lindsey Crabbe -- Investor Relations

Good morning. Thank you for attending Capstead's fourth quarter earnings conference call. The fourth quarter earnings release was issued yesterday, January 30, 2019 and is posted on our website at www.capstead.com under the Investor Relations tab. A link to this webcast is also in the Investor Relations section of our website.

An archive of this webcast and the replay of the call will be available through April 24, 2019. Details for 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 the date of this call January 31, 2019. The company assumes no obligation to update any statements including any forward-looking statements made during this call.

With that, I'll turn it over to Phil.

Phillip A. Reinsch -- President and Chief Executive Officer

Thank you Lindsey. After a few brief remarks, Lance will give a quick recap of the quarter and then we'll open the call up to questions. This past quarter, and all of 2018 for that matter was challenging on a number of fronts, for companies like Capstead that invested in levered portfolios of residential mortgage assets. With ARM mortgage prepayment speeds down somewhat from speeds reported in 2017, they still remain a concern for us given that longer-term interest rates have receded from recent highs in October and November. And with 5.25 basis point hikes in the Fed Funds rate since December 2017, our financing spreads contracted in 2018 due to higher borrowing costs even as coupon interest rates ARM mortgages underlying are currently resetting ARM securities continue to increase.

In this environment, our stock price has not fared well, has been particularly weak the last six months. In response, we redeployed a portion of our capital made available from portfolio run off in the stock buybacks, generating $0.29 per share in book value accretion for the year. We believe that effectively buying into our existing portfolio at roughly $0.77 on $1 has made good sense and illustrates our commitment to increasing stockholder value. Future buyback decisions will hinge on market conditions, including consideration of improved return profiles on new acquisitions being realized thus far in 2019.

And now that the Federal Reserve is signaling that they may be on the sidelines for a while, we have an opportunity to play catch-up in 2019 in terms of further increases in cash yields through both coupon resets and new acquisitions. This natural resetting of yields, is that the core of our strategy of investing in agency guaranteed ARM securities. Because ARM loans can reset the market and agency MBS carry a little or no credit risk, our book value is relatively resilient in the face of changing interest rates or deteriorating housing credit conditions brought on by a weakening economy. The benefits of this are best seen by looking beyond our current earnings and dividend yield and focusing on total economic returns, changes in book value as well as dividends. This way, the risk of loss of capital due to interest rate and credit risk is fully considered.

Consider that during a very difficult fourth quarter we had a modest 0.9% decline in book value and economic return of a nearly flat, minus 0.1%. And for all of 2018, our economic return was a minus 3.6%. While not indicative of what we expect to earn over the course of an interest rate cycle, we are confident our fourth quarter performance would have exceeded that of all but a few residential mortgage REITs. And for the full year, we expect our economic return will be better in several of the credit focused residential mortgage REITs even as credit conditions have remained benign in a growing economy and better than all, or nearly all agency focused residential mortgage REITs.

I will close with the settlement that expressed in our press release that we believe Capstead said represents a reasonably compelling opportunity for investors seeking risk adjusted levered returns with the comparably higher degree of safety from interest rate and credit risk.

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

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

Thank you, Phil. We generated earnings of $9 million this quarter or $0.05 per diluted common share and paid an $0.08 common dividend. Our cash yields on our portfolio improved 14 basis points, contributed an increase of approximately $0.05 per share over the third quarter. A largely seasonal decline in mortgage prepayments added 12 basis points to yields through reduced premium amortization compared to our last quarter, contributing the additional $0.04 to our earnings. Unfortunately, 25 basis points and higher borrowing rates, primarily due to Federal Reserve rate hikes reduced earnings by approximately $0.08 per share and largely offset our higher yields. Book value declined $0.09 per share during the fourth quarter, ending the year at $9.39 per common share, which was largely offset by the $0.08 common dividend introducing in the basically flat economic return Phil discussed earlier.

Breaking down our book value decline for the quarter, lower swap gains of $0.37 and dividends in excess earnings were $0.03, while higher portfolio values added $0.17 and common stock repurchases during the fourth quarter added $0.14. Year-to-date, we earned $0.34 per diluted common share distributed $0.49 in common dividends and have incurred book value declines of $0.86 per common share. The details of which are in the press release.

With that, we will open the call up to questions.

Questions and Answers:

Operator

(Operator Instructions) We'll go first to Eric Hagen with KBW.

Eric Hagen -- KBW -- Analyst

Okay, thanks. Good morning. First on the hedging. It looks like you guys have a wall of maturities that are approaching over the next few quarters. So how should we think about the trade-off between hedging your duration gap with the leverage in the portfolio. Against the backdrop of what's likely to be a more dovish Fed policy and just the lower likelihood of your, of your repo repricing higher in the future. Thanks.

Phillip A. Reinsch -- President and Chief Executive Officer

Yeah, sure, Eric. If you look at what we did in the second half of last year, we let our duration gap run longer. I think the 9:30 reported duration gap just under six months. We actually let it get longer than that. So we don't just replace losses, they roll off. We didn't put any swap trade on until the market started to rallying in December. And so I think we've done swaps roughly of 284 three year swap rate those hit as high as 320 in October. So we got longer during the second half of the year. And that helped to contribute to our book value not declining as much, because we essentially didn't hedge some purchases in the second half of the year. So once again that worked out pretty well for us. Since then, right now, for instance, three year swaps are around 260, so we could synthetically fund the book cheaper via the swap market than repaying on spot repo, which is closer to 265.

So we are looking at that and there is a chance that we will decrease our duration gap even more just because of the funding dynamics of what we can swap out our funding costs for right now. So it's not just -- we don't just replace swaps as they run off, we look at where rates are at a given point in time and if it makes sense, we'll wait and shortened our duration gap. At this point with the rally, and basically the forward markets are pricing in the Fedies (ph), we will probably take advantage of that and layer more swaps then at these levels. At the same time our spreads widened in the fourth quarter, not to the degree of fixed rate, but they are very compelling from a reinvestment standpoint, right now. So between those two things. What we're doing in the first quarter, well, probably was materially different than what we did in the fourth quarter.

Eric Hagen -- KBW -- Analyst

Great. Great. As a follow-up to that, can you just provide the unlevered yields on new purchases in the quarter and just kind of (multiple speakers)

Phillip A. Reinsch -- President and Chief Executive Officer

Right now we're looking at our returns on a hedge basis of around 11% given our leverage, which as compelling as they've been in a long time.

Eric Hagen -- KBW -- Analyst

Okay, great, thanks. My next question is just kind of around liquidity in the agency ARM market more generally. The share buybacks were obviously very nice to see. I mean, there were strong support for book value in the quarter. But presumably you guys would like to regrow the portfolio, again, if the investment opportunities became more attractive than the market allowed you to do that. I guess one concern to doing that would just be the weaker liquidity in the agency ARM market. I mean it continues to pay down pretty rapidly. So maybe you can just share your thoughts on how you manage the leverage in the portfolio and your expectations for what Capstead looks like in the future just by staying invested in this market? Thanks.

Phillip A. Reinsch -- President and Chief Executive Officer

I mean, if you're talking about supply, supply is down but there is ample liquidity in the agency ARM market. I wouldn't use the term that there is a lack of liquidity in the ARM market. I mean their supply was down in the fourth quarter around 3 billion, but you always have secondary selling, you've got outstanding MBS issuance of around just under 150 billion. But there is also a lot more ARM product in bank portfolios that could potentially come out. So yes, supply is low, but liquidity, there is not a lack of liquid -- there is not a lack of liquidity in the ARM market.

Eric Hagen -- KBW -- Analyst

Okay.

Phillip A. Reinsch -- President and Chief Executive Officer

And we have not had a problem replacing runoff when we chose to do so at compelling returns.

Eric Hagen -- KBW -- Analyst

Okay. Thanks for -- thanks for the questions or the answers. Thank you.

Operator

(Operator Instruction). We'll go next to Steve DeLaney with JMP Securities.

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Good morning, everyone. Echo Eric's comment, we applaud the buyback activity and congrats on the your industry base book value performance in the quarter in a challenging market. Want to ask about the buyback, we noted at the end of the third quarter that there was 55 million authorized and with what you did in this quarter, it looks like it's -- it would have been down to about 11 million or 12 million at the end of the year. Now your stock today is 725 so lower than the 747 average, should we assume that the Board is looking at that authorization and likely to increase that if the stock stays down at this level.

Phillip A. Reinsch -- President and Chief Executive Officer

Yeah. Board can increase the authorization at any time. So there is, there is about 12 million left on our, on the original authorization. But I wouldn't concerned -- be too concerned about that. We are going to be disciplined though with better return profile on new acquisitions that (multiple speakers)

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Understood.

Phillip A. Reinsch -- President and Chief Executive Officer

Use for that capital, so.

Steven C. DeLaney -- JMP Securities LLC -- Analyst

So it doesn't sound like there's any -- there's no targeted level, you're just going to take Roberts going to take the pulse of the ARM market and what's available, the returns on investment and you're going to balance that out sort of on a -- on the run basis is -- that's pretty much what I'm hearing.

Robert R. Spears -- Director of Residential Mortgage Investments

Absolutely.

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Okay.

Robert R. Spears -- Director of Residential Mortgage Investments

And there are, there are some pretty significant earnings black periods in this -- in that part.

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Understood.

Robert R. Spears -- Director of Residential Mortgage Investments

Where you can see where you're going with earnings per year(ph)?

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Yeah. Robert you mentioned the spot rate. And frankly, I was hoping that, we were a little bit lower than that to 265 -- seems like we've got one month LIBOR just settled at 250 Fed funds just under 240, and based on yesterday's comments, and I think it all pretty much decided, but might just be flat on Fed funds for this year. Do you think -- is there any like continued pressure on repo or do you think 15 basis points over one month LIBOR is sort of where repo will settle over most of this year.

Robert R. Spears -- Director of Residential Mortgage Investments

Actually, We're seeing a drift down a little bit already, I mean we're seeing now kind of 263 areas, but I would think a lot of technical factors at the end of the year -- end of the year that commented about --

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Yes.

Robert R. Spears -- Director of Residential Mortgage Investments

Into the first quarter and I think you'll see some of that, because for instance, the last couple of years, for the most part, if you use one month LIBOR as a proxy, we've been recalling like LIBOR plus and (inaudible) So all things being equal if you would have projected this six months ago, you would have expected of the repo of around 255 right now. So I would think given what the Fed's doing and they're talk about their balance sheet activity, potentially buying stuff at the shorter end of the curve and keeping reserves in the system, I would think repo rate should address that.

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Okay. And just looking at your spread, you were 207 on your hedge cost of funds, and I know you've got some swaps, but it almost feels like we can now sort of see what a cap maybe -- might be nine to 12 months out as repo rolls up, because the 207 obviously doesn't reflect the December -- doesn't reflect much of the December hike. But it would seem like we now sort of have a cap, do we not? An assuming the Fed is on hold, it seems like we kind of have a -- there's not that much more pressure to to see on your, on your cost of funds over the next, say, three to six months.

Robert R. Spears -- Director of Residential Mortgage Investments

That's fair. I mean, and once again, if you look at where two to three year swaps are and if you take the (inaudible) into account, you could predict that repo cheaper than spot rate. So yeah, I mean I think repo -- and it's kind of going to be a good proxy for our funding costs over the next several month (multiple speakers)

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Yeah.

Robert R. Spears -- Director of Residential Mortgage Investments

For value creation.

Steven C. DeLaney -- JMP Securities LLC -- Analyst

And so the flip side of that -- and this is my last question, I am sorry to ramble on here. But now that we can. For the first time in a couple of years, we could, we can look at funds and borrowing costs and say -- OK, we can see these settling in 250, 260 whatever. Now my attention turns to your short book and your WACC and you're fully indexed WACC. And I'm looking in your press release, you give us this data every quarter which is greatly appreciated, but 380 current net WACC and a fully indexed WACC of 450. So that's 70 basis points if I'm reading that that's getting premium amortization now, but just in terms of cash yield that 70 basis points of potentially higher cash returns. And obviously those resets are inside of a year, as I understand it based on how you describe your 52%. Can you just, focusing on that 70 basis point of potential upside, give us a feel for how that's likely to come through into the portfolio over the next two to three quarters.

Robert R. Spears -- Director of Residential Mortgage Investments

Sure. I think if you just try to interpolate and assume the 12 of it resets every month of that short book. And then that longer resets will not go up in coupon other than through repurchases, you should get an extra 10 to 12 basis points in coupon per quarter. And as they've just -- obviously you said our book has a lot of upside on coupon side. And then you look at where the next part of I think where you were bond on prepays where our ARMs is fully indexed. One thing right now in aggregate our Fannie, Freddie book fully indexed you'd be looking at like I call it 5 and 8 coupon, our Ginnie is 4 and three-quarters. So let's just call it 5% fully indexed versus a no-cost rebuy of around 4 and three-quarters it was more 7-8 for this rally.

So if some incentive, there but conversely, it's not any more incentives than they had last year and what we saw actually our speeds went down last year from 2017 with a flatter curve at higher rates. And so you starting to see some burn out. And then also what we experienced in last time cycle, which was so long time, obviously but once the Fed stops moving and have that headline risk about rates going up, a lot of these ARM borrowers loans refinance into a fixed rate at sustained level because they're not getting the notification that their payments going up again. And they may start thinking that rates are going to come down. So if you start to see even with the flatter curve, once the indexes stop going up, you don't have as much prepayment delays and you starting to get some burnout. I mean again (inaudible) So one-year LIBOR hit 315 in October, it's 297 now and a similar decline in one year CMB fee that you could conceivably see some guys that reset last fall. The next time they would be coming down.

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Could have come down.

Robert R. Spears -- Director of Residential Mortgage Investments

And they were flattening for some time.

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Yeah. Great.

Phillip A. Reinsch -- President and Chief Executive Officer

So the big jumps in the portfolio are out right now. And so we are more positive on prepaid this year than we would have been last year.

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Okay. Really appreciate the comments, guys. Thank you.

Operator

(Operator Instructions) With no further questions in queue, I'd like to turn it back to you Ms. Crabbe for additional or closing remarks.

Lindsey Crabbe -- 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

Ladies and gentlemen, this does conclude today's conference. We thank you for your participation, you may now disconnect

Duration: 21 minutes

Call participants:

Lindsey Crabbe -- Investor Relations

Phillip A. Reinsch -- President and Chief Executive Officer

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

Eric Hagen -- KBW -- Analyst

Steven C. DeLaney -- JMP Securities LLC -- Analyst

Robert R. Spears -- Director of Residential Mortgage Investments

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