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Arlington Asset Investment Corp (AI) Q2 2019 Earnings Call Transcript

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Arlington Asset Investment Corp (NYSE: AI)
Q2 2019 Earnings Call
Aug 7, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, ladies and gentlemen. I'd like to welcome everyone to the Arlington Asset Second Quarter 2019 Earnings Call. [Operator Instructions]

It is now my pleasure to turn the conference over to Mr. Ben Strickler, Chief Accounting Officer. Mr. Strickler. You may begin, sir.

Benjamin J. Strickler -- Chief Accounting Officer, Vice President and Controller

Thank you very much and good morning. This is Ben Strickler, Chief Accounting Officer of Arlington Asset. Before we begin this morning's call, I would like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations and any other guidance on present or future periods constitute forward-looking statements that are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances. These forward-looking statements are based on management's belief, assumptions and expectations, which are subject to change, risk and uncertainty as a result of possible events or factors. These and other material risks are described in the company's annual report on Form 10-K and other documents filed by the company with the SEC from time-to-time, which are available from the company and from the SEC and you should read and understand these risks when evaluating any forward-looking statements.

I would now like to turn the call over to Rock Tonkel for his remarks.

J. Rock Tonkel -- President and Chief Executive Officer

Thank you, Ben. Good morning, and welcome to the second quarter of 2019 earnings call for Arlington Asset. Also joining me on the call today or Rich Konzmann, our Chief Financial Officer; and Brian Bowers, our Chief Investment Officer. The combination of a weakening global outlook, ongoing trade tensions and declining inflation expectation have led the Federal Reserve to ease financial conditions by cutting the Federal Funds rate by 25 basis points, ending its balance sheet reduction two months earlier than previously communicated and signaling a more accommodative monetary policy stance going forward. Markets now price more than 100 basis points in Federal Reserve rate cuts in the next 12-months.

In the second quarter, the 10-year US Treasury rate fell 40 basis points end at 2.01% as of June 30th. With the significant decline in interest rate, prepayment expectations for mortgages move meaningfully higher and increased prepayment outlook, patent [Phonetic] interest rate volatility and an inversion of the front end of the interest rate curve for funding led to agency MBS underperforming versus interest rate hedges in the quarter. In particular, both higher coupon agency and generic TBA securities underperformed, lower coupon and specified agency MBS with favorable prepayment characteristics during the second quarter. While agency investment spreads tightened during the month of July, leading through agency MBS, modestly outperforming interest rate hedges, renewed market volatility centered around trade-related concerns in early August has led the 10-year US Treasury to decline below 1.7%.

Turning to our actual results for the quarter, we reported a GAAP net loss of $0.67 per share and core operating income of $0.23 per share. As of June 30th, book value was $7.80 per share, a decline from the last quarter due to agency MBS underperforming versus interest rate hedges. The company's book value was approximately $8.10 per common share as of July 31st, 2019, although agency MBS have widened in early August, as interest rates declined rapidly and flattened [Phonetic]. Recourse leverage measured as the company's repo financing and TBA commitment less cash to total investable capital decreased to 9.1 times as of June 30th, and is modestly higher thus far in the third quarter.

During the second quarter, increased prepayment speed expectations and a continued flat interest rate curve reduced returns on levered agency MBS investments. Given that environment, the company lowered its recourse financing to investable capital leveraged by approximately two times [Phonetic] as of June 30th. The company also shifted more of its agency MBS investment portfolio exposure toward lower coupon securities that carry lower premiums and prepayment risk. As of June 30th, the company's agency MBS investment concentration and higher coupon 4% and 4.5% agency MBS was 73% of its total investment portfolio, a decline from 92% as of the prior quarter end. And since June 30th, the company has continued to further migrate its agency MBS portfolio from higher to lower coupon 3% and 3.5% agency MBS. As of July 31st, the company's agency MBS investment concentration in higher coupon 4% and 4.5% agency MBS, declined further to 57% and is now closer to 50% currently.

Based on current market conditions, we expect that migration process from higher to lower coupon securities to continue during the third quarter. Current available returns in the TBA dollar roll market have declined, particularly for higher coupon securities in response to elevated prepayment expectations. The company decreased its agency investment allocation and TBAs during the second quarter in favor of specified agency MBS with favorable prepayment characteristic. And since June 30th, the company has further reduced its exposure to generic TBA to 8% of the company's total agency portfolio as of July 31st. Given available return opportunities and the measures taken to reduce its overall risk profile, the company lowered its quarterly dividend to $0.225 per common share, which approximated core operating income of $0.23 per share for the quarter.

The decline in core operating income from last quarter was due primarily to higher prepayment speeds as well as lower leverage and unfavorable retail funding rates relative to LIBOR. With lower interest rates during the second quarter, the weighted average CPR of our specified agency MBS was 10.16%, an increase from 7.55% in the prior quarter. As a result of these higher prepayment fees, the weighted average affective asset yield on our agency MBS was 3.21% for the second quarter, a decline from 3.36% in the prior quarter.

The company's weighted average CPR for July was 11.54%, which we expect would result in a weighted average effective asset yield of approximately 3.14% for that period. Given current rate levels, we expect continued elevated prepayment fees, but the transition to additional lower coupon specified pool securities with lower premiums should moderate increases in CPRs going forward.

As a reminder, the company entered into interest rate swap to repay the fixed rate and receives a variable-rate based on three-month LIBOR in order to lock its funding cost for a portion of its repo funding for the length of the swap. Average repo funding rates did not meaningfully change during the second quarter, a sharp contrast to other short-term rates such as three-month LIBOR, which declined significantly.

The company's weighted average repo funding rate was 2.64% during the second quarter a 4 basis point decline from last quarter. Conversely the company's weighted average received rates on its interest rate swap was 2.6% during the second quarter, a 10 basis point decline from the prior year. This unfavorable relationship between the repo funding rates and three-month LOBOR contributed to an increase of 4 basis points in the company's all-in net funding costs during the second quarter. With the recent reduction in Fed fund, current repo funding rates are approximately 2.35% to 2.4% with the potential for further decreases should the Federal Reserve undertake further reductions in short-term rates.

With the increase in expected prepayments, the duration of the company's agency MBS investments declined during the second quarter. Accordingly, the company lowered the duration of its interest rate swaps by decreasing its long-term interest rate hedge positions by $900 million an increase in shorter duration swap by $500 million. The interest rate swap market is priced in expectations from multiple Federal Reserve cuts leading to a significant inversion in the short-end of the interest rate swap curve versus repo funding costs.

For example, as of June 30th, the company's repo funding rate was 2.61%, while two-year swap rates were 1.81%.

The company took advantage of this opportunity by increasing short-term interest rates swap position to effectively lock in much of the anticipated Federal Reserve cuts into its going forward net funding cost. As of July 31st, the company added another $250 million of additional two-year swap and the company retains additional flexibility going forward with swap cost along the curve now centered around 1.55%. Although returns on levered agency MBS today are lower than they were at the start of the year, opportunities for upside potential and forward-looking returns exist in several areas.

First, fort the extended current market expectations for more than 100 basis points of Federal Reserve interest cut materialized, future funding cost and net interest spread would benefit. Second, an increase in net interest spreads from a potential steepening of the interest rates curve from its currently flat stance. Third, potential improvement in repo funding rates relative to LIBOR, which would benefit funding costs. And fourth, a reduced levered posture offers improved balance and flexibility for various interest rate outcome.

In summary, despite a challenging investment environment for mortgages, the company earned a double-digit core operating income, return on equity to shareholders, while also improving its overall risk profile going forward. The company's common stock currently offers an annualized dividend yield of 14.5% based on our last quarterly dividend, which reduced leverage and an overall improved risk profile.

Operator, I'd now like to open the call for questions. Thanks.

Questions and Answers:

Operator

Thank you, sir. Ladies and gentlemen, at this time the floor is opened for questions. [Operator instructions] Our first question comes from Doug Harter with Credit Suisse.

Joshua Hill -- Credit Suisse -- Analyst

Hey, Rock, this is actually Josh, on for Doug. I appreciate the comments on the portfolio construction shifting into lower coupons and away from TBAs. Just looking at the market and where prices are today, given the richness of the spec pool market, how are you thinking about the risk reward trade-off between spec pools and TBAs? And what would you need to see to reverse the trend and start adding more generic TBAs? Thanks.

J. Rock Tonkel -- President and Chief Executive Officer

I guess my first answer Josh is that, other than in the low coupon end of the stack TBA returns continue to be quite low, based on the speed expectations, continuing to be elevated. That's number one. Number two is, given the changes that have occurred in the TBA market versus the protections that one can get in payout on spec pool securities. Today, even with the richness where it is, even with the prices, I'd say where they are. At the margin, we would say that spec pool opportunities outshine the TBA opportunity, and so the new dollar investment would be focused generally in the lower coupon spec pool market.

Joshua Hill -- Credit Suisse -- Analyst

Makes sense. And then around book value, I appreciate the comments around performance in July. We've heard from a few peers that the August volatility is basically wiped out the majority of that outperformance. I'm curious if you guys are seeing a similar dynamic in your portfolio? Thanks.

J. Rock Tonkel -- President and Chief Executive Officer

I would say overall, yes. I think that's a fair characterization. I mean, it's early price. It's still early in the quarter, so we'll see how things evolve with the spreads over the course of the quarter. But I think that's a fair commentary that the change in the market probably offset -- in August have offset, June, maybe a little bit more than that.

Joshua Hill -- Credit Suisse -- Analyst

Great. Thanks for the comments Rock.

Operator

Thank you. [Operator Instructions] Our next question comes from Mikhail Goberman with JMP Securities.

J. Rock Tonkel -- President and Chief Executive Officer

Good morning.

Mikhail Goberman -- JMP Securities -- Analyst

Good morning, guys. Thanks for taking the question. I know the interest rate environment is pretty volatile, but how fast do you guys think prepays would get if the 10-year continues to decline let's say 1.5 [Phonetic], maybe even lower?

J. Rock Tonkel -- President and Chief Executive Officer

Well, keep in mind that as of this morning, we're 15 basis points away from that. So we've already made part of that move. I would say, we would expect them to accelerate from the question I suppose is systemically, is there any capacity constraint on the refinancing flood that might come from ongoing lower rates. But I think while we suspect there may be some constraints, we would expect these to continue to elevate. And as I said in my comments, the shift to lower coupon securities should help to constrain the magnitude of those increases in prepayment fees. So part of the -- there are multiple reasons for the shift in coupon focus to 3s and 3.5 from 4s and 4.5. And one of those benefits is to constrain as best we can to insulate against further increases in CPR. So we expect to continue that process. And we expect to receive a benefit in mitigating some of those increases over time should rates stay here or go lower.

Mikhail Goberman -- JMP Securities -- Analyst

Great, thanks for that. And just quick, how does credit look in-light of the continued rate volatility, is it starting to look more attractive?

J. Rock Tonkel -- President and Chief Executive Officer

Well, certainly funding rates on credit are lower. And structured securities are more attractive from an advanced perspective -- an advanced rate perspective. And cost of funds overall are structured and if one can get comfortable with the credit side, which they don't seem yet to be really meaningful changes in the credit profile and residential credit. Then today, credit is probably more attractive than it has been. Although like other fixed income instruments, investment spreads are tight, but it's more attractive, credit probably more attractive today than it has been given the funding costs decline.

Mikhail Goberman -- JMP Securities -- Analyst

Alright. Thank you very much. And I appreciate.

Operator

Thank you. Mr. Tonkel. You have no further questions at this time, sir.

J. Rock Tonkel -- President and Chief Executive Officer

Okay. Thank you very much. If you have further questions, we are happy to respond offline. Thank you, bye.

Operator

[Operator Closing Remarks]

Duration: 17 minutes

Call participants:

Benjamin J. Strickler -- Chief Accounting Officer, Vice President and Controller

J. Rock Tonkel -- President and Chief Executive Officer

Joshua Hill -- Credit Suisse -- Analyst

Mikhail Goberman -- JMP Securities -- Analyst

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