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Edited Transcript of AI earnings conference call or presentation 7-Aug-19 1:00pm GMT

Q2 2019 Arlington Asset Investment Corp Earnings Call

Arlington Aug 10, 2019 (Thomson StreetEvents) -- Edited Transcript of Arlington Asset Investment Corp earnings conference call or presentation Wednesday, August 7, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Benjamin J. Strickler

Arlington Asset Investment Corp. - Controller, CAO & VP

* J. Rock Tonkel

Arlington Asset Investment Corp. - President, CEO & Director

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Conference Call Participants

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* Joshua Hill Bolton

Crédit Suisse AG, Research Division - Research Analyst

* Mikhail Goberman

JMP Securities LLC, Research Division - VP & Research Analyst

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Presentation

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Operator [1]

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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.

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Benjamin J. Strickler, Arlington Asset Investment Corp. - Controller, CAO & VP [2]

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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 beliefs, 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.

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J. Rock Tonkel, Arlington Asset Investment Corp. - President, CEO & Director [3]

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Thank you, Ben. Good morning, and welcome to the second quarter 2019 earnings call for Arlington Asset. Also joining me on the call today are 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 2 months earlier than previously communicated, and signaling a more accommodative monetary policy stance going forward.

Market is now priced more than 100 basis points in Federal Reserve rate cuts in the next 12 months.

In the second quarter, the 10-year U.S. treasury rate fell 40 basis points to end at 2.01% as of June 30. With the significant decline in interest rate, prepayment expectations for mortgages moved meaningfully higher and increased prepayment outlook, tightened interest rate volatility and an inversion of the front end of the interest rate curve to 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 to agency MBS modestly outperforming interest rate hedges, renewed market volatility centered around trade-related concerns in early August has led the 10-year U.S. Treasury rate 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 30, 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 31, 2019, although agency MBS have widened in early August, as interest rates declined rapidly and the curve flattened. Recourse leverage measured as the company's repo financing and TBA commitments less cash to total investable capital decreased to 9.1x as of June 30 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 leverage by approximately 2x as of June 30. The company also shifted more of its agency MBS investment portfolio exposure towards lower coupon securities that carry lower premiums and prepayment risk. As of June 30, the company's agency MBS investment concentration in 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 30, the company has continued to further migrate its agency MBS portfolio from higher to lower coupon 3% and 3.5% agency MBS.

As of June 31 -- excuse me, July 31, 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 has declined, particularly for higher coupon securities in response to elevated prepayment expectations. The company decreased its agency investment allocation in TBAs during the second quarter in favor of specified agency MBS with favorable prepayment characteristics, and since June 30, the company has further reduced its exposure to generic TBA to 8% of the company's total agency portfolio as of July 31. 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 repo funding rate 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 speeds, the weighted average effective 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 speeds, 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 enters into interest rate swap for which it pays a fixed rate and receives a variable-rate based on 3-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 3-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 rate on its interest rate swap was 2.6% during the second quarter, a 10 basis point decline from the prior. This unfavorable relationship between repo funding rates and 3-month LIBOR continued -- excuse me, contributed to an increase of 4 basis points in the company's all-in net funding cost during the second quarter. With the recent reduction in Fed fund, current repo funding rate 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 swap by decreasing its long-term interest rate hedge position 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 curve. For example, as of June 30, the company's repo funding rate was 2.61%, while 2-year swap rates were 1.81%. The company took advantage of this opportunity by increasing short-term interest rate swap position to effectively lock in much of the anticipated Federal Reserve cuts into its going forward net funding cost. As of July 31, the company added another $250 million of additional 2-year swaps, and the company retains additional flexibility. Going forward, with swap costs 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, to 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 rate 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.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Doug Harter with Crédit Suisse.

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Joshua Hill Bolton, Crédit Suisse AG, Research Division - Research Analyst [2]

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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 tradeoff between spec pools and TBAs? And what would you need to see to reverse the trend and start adding more generic TBAs?

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J. Rock Tonkel, Arlington Asset Investment Corp. - President, CEO & Director [3]

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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 expectation continuing to be elevated. That's #1. Number 2 is given the changes that have occurred in the TBA market versus the protections that one can get in pay up on spec pools 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.

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Joshua Hill Bolton, Crédit Suisse AG, Research Division - Research Analyst [4]

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Makes sense. And then, around book value, 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?

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J. Rock Tonkel, Arlington Asset Investment Corp. - President, CEO & Director [5]

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

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Operator [6]

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(Operator Instructions) Our next question comes from Mikhail Goberman with JMP Securities.

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Mikhail Goberman, JMP Securities LLC, Research Division - VP & Research Analyst [7]

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I know the interest rate environment is pretty volatile, but how fast you guys think rebate -- prepays would get if the 10-year continues to decline to say 1.5, maybe even lower?

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J. Rock Tonkel, Arlington Asset Investment Corp. - President, CEO & Director [8]

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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 some. The question I suppose is systemically, is there any capacity constraint on the refinancing flood that might come from ongoing lower rate, but I think while we expect or may be some constraints, we would expect speeds to continue to elevate. And as I said in my comments, the shift to lower coupon securities should help to constrain the magnitude and the -- of those increases in prepayment speed. So part of the -- there are multiple reasons for the shift in coupon focused to 3s and 3.5 from 4s and 4.5 and one of those benefits is the constraint as best we can to inflate against further increases in CPR. So we expect to continue that process. And we expect to get to receive a benefit in mitigating some of those increases over time should rates stay here or go lower.

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Mikhail Goberman, JMP Securities LLC, Research Division - VP & Research Analyst [9]

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

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J. Rock Tonkel, Arlington Asset Investment Corp. - President, CEO & Director [10]

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Well, certainly, funding rates on credit are lower and structured securities are more attractive from an advance perspective -- an advance rate perspective. And cost of funds overall are structured and if 1 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, investments spreads are tight, but it's more attractive, credit is probably more attractive today than it has been given the funding costs decline.

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Operator [11]

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

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J. Rock Tonkel, Arlington Asset Investment Corp. - President, CEO & Director [12]

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Okay. Thank you very much. If you have further questions, we're happy to respond offline. Thank you. Bye.

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Operator [13]

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Thank you. Ladies and gentlemen, that concludes the Arlington Asset Second Quarter 2019 Earnings Call. You may now disconnect, and have a wonderful morning.