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Edited Transcript of AI earnings conference call or presentation 2-May-19 1:00pm GMT

Q1 2019 Arlington Asset Investment Corp Earnings Call

Arlington Jul 9, 2019 (Thomson StreetEvents) -- Edited Transcript of Arlington Asset Investment Corp earnings conference call or presentation Thursday, May 2, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* J. Rock Tonkel

Arlington Asset Investment Corp. - President, CEO & Director

* Richard E. Konzmann

Arlington Asset Investment Corp. - Executive VP, Treasurer & CFO

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Conference Call Participants

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* Christopher Whitbread Patrick Nolan

Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research

* Trevor John Cranston

JMP Securities LLC, Research Division - Director and Senior Research Analyst

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Presentation

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Operator [1]

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Good morning. I'd like to welcome everyone to the Arlington Asset First Quarter 2019 Earnings Call. (Operator Instructions) I would now like to turn the conference over to Rich Konzmann. Mr. Konzmann, you may begin.

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Richard E. Konzmann, Arlington Asset Investment Corp. - Executive VP, Treasurer & CFO [2]

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Thank you very much, and good morning. This is Rich Konzmann, Chief Financial 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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Good morning, everyone. Before I provide my remarks on our results for the quarter, I'd like to take a moment to pay our deep respects to Dave Walrod, who unexpectedly passed away last month. Dave was a recognized leader in our industry, as a sell-side analyst with Jones Trading and prior to that with Ladenburg Thalmann. Dave was a good person. And a friend of both the firm and our team members and he will be sorely missed. Thank you.

After a challenging fourth quarter and improved investor risk sentiment and lower volatility led to a rebound across financial markets during the first quarter. In response to lower global growth and inflation expectations, the Federal Reserve adopted a more neutral monetary policy stance, by signaling that it does not anticipate further rate increases this year and announcing that it would end its balance sheet reduction initiative by this September. Although these actions and other factors led to lower interest rate volatility, interest rates continue to rally that began last quarter with the 10-year U.S. treasury falling 28 basis points during the first quarter ending at 241. Today, the U.S. Treasury 10-year rate is at 2.52%. With lower interest rate volatility, the spread between the market yield of an agency MBS and benchmark interest rates tightened modestly during the first quarter.

Retracing some of the meaningful widening experienced last quarter. Leading to the pricing of agency, MBS outperforming interest rate hedges. In particular, values of agency MBS backed by specified pools of loans with favorable prepayment characteristics, performed very well during the first quarter as the decline in mortgage rates increased forward prepayment speed expectations in anticipation of higher refinancing volumes.

Turning to our actual results for the quarter, we reported GAAP net income of $0.52 per share and core operating income of $0.32 per share. Core operating income compared to the prior quarter was impacted by the timing of investing the capital raised during the quarter and lower average leverage. As we highlighted during our Fourth Quarter Earnings Call, we expected that the reduction in the company's leverage at the end of 2018 would enhance portfolio resiliency and reduce book value volatility going forward, however, it would also have a moderating impact on earnings.

During the first quarter, our weighted average leverage was approximately 1.5x less than last quarter, which accounted for a majority of the decline in core operating income during the first quarter. As of March 31, the company's recourse leverage measured as the company's repo financing and TBA commitment less cash, the total investable capital was 11x.

During the first quarter of the tightening of agency MBS spreads relative to benchmark interest rates led to gains on our agency MBS investments exceeding the losses on our interest rate hedge positions. With pay up premiums on our specified agency MBS increasing approximately 2/3 of a point during the first quarter.

Overall, the net gain on our agency MBS investment and interest rate hedge portfolio increased book value by 2.6% during the quarter. Our book value ended March 31 at $8.70 per share, relatively unchanged from last quarter as the net gains from our investment and hedge portfolio were offset by dilution from our capital raises and other factors. During the first quarter, the company successfully raised $78 million in common and preferred equity capital. The company was able to deploy the capital in favorable investment environment at attractive returns while improving the company's operating leverage by lowering its ratio of G&A expenses to investable capital by approximately 70 basis points and also improving liquidity of the common stock.

While the capital raises resulted in a onetime dilution to book value per share this quarter, the company expects to recover the dilution through accretive earnings in approximately 6 quarters from just the improved G&A leverage alone and not factoring in the potential earnings accretion from investing the capital at attractive spreads. As of quarter end, the company's total agency MBS portfolio totaled $5.1 billion with 82% of the investment portfolio allocated to specified agency MBS and 18% allocated to TBA agency securities. During the first quarter, the company decreased its position in 4.5 coupon agency MBS somewhat while increasing its exposure to 4% coupon securities, in order to take advantage of the pricing performance of 4.5 specified agency MBS during the quarter and to reduce the company's premium to par risk and higher coupon bonds going forward.

The weighted average CPR for our specified agency MBS during the quarter was 7.55%, a decrease from 8.25% in the prior quarter. The weighted average effective asset yield on our agency MBS was 3.36% for the first quarter compared to 3.30% in the prior quarter. The improvement in the effective asset yield was driven by lower prepayment speeds and new purchases at higher current investment yields as a result of portfolio repositioning and reinvestment of monthly pay downs.

The company's prepayment speeds to start the second quarter were quite contained with the weighted average CPR for April at 8.18%, which we expect would result in a weighted average effective asset yield of approximately 3.35% for that period. The company's weighted average repo-funding rate was 2.68% during the first quarter, a 25 basis point increase from last quarter, consistent with the 25 basis point increase in the Federal Funds rate in December. Funding markets tightened in March resulting in a weighted average repo-funding rate rising to 2.73% as of March 31.

In addition, the favorable funding dynamics of repo-funding hedge with interest rates swaps that the industry experienced for much of 2018 began to return to more normalized levels in the first quarter as the spread of repo-funding rates over 1 month LIBOR widened and the spread between 1-month LIBOR and 3-month LIBOR narrowed. Since quarter end, repo-funding rates have improved with the company's weighted average repo-funding rate at 2.62% as of April 30 and 11 basis point improvement since quarter end. During the first quarter, the company migrated the net duration gap of the company's agency MBS and interest rate hedge portfolio to a negative 0.2 years as of March 31.

Although, returns on levered agency MBS today are lower than they were to start the first quarter, they continue to offer an attractive investment opportunity relative to other alternatives with several positive factors offering potential upside for the company going forward: First, market participants are currently pricing in a Fed rate cut in the next 12 months. And without opining on whether that will or will not occur, certainly if it did occur, that would benefit our future funding costs and net interest spreads; second, repo-funding availability for our agency MBS continues to be strong and growing; third, our recent capital raises had improved our return on equity profile by lowering our G&A to investable capital ratio by approximately 70 basis points and we feel opportunities exist for some additional cost expense reductions going forward; fourth, the Fed shift to a more neutral monetary policy and resulting lower rate volatility environment may produce a more stable return profile for agency MBS.

In summary, Arlington produced solid results for the first quarter with an annualized economic return of 16.8% while also raising $78 million of capital that we expect to be accretive to earnings going forward. The company looks forward to continuing to deliver an attractive risk-adjusted return to its shareholders. 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) We will now go to our first question, Trevor Cranston with JMP Securities.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [2]

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First, a question on the prepay speeds, which you commented on, you said where they've started out the second quarter. Could you maybe provide some additional color around sort of how you expect those to develop over the remainder of the quarter and into the summer, given the rate that we've had?

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

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Well, I guess, I'd say, Trevor that market expectations for speed progression really throughout the coupon stack have been increased and our April experience suggests that possibly the expectations may be a little severe relative to how reality will unwind. I think we would expect there to be normal seasonality effects and that would have an elevating effect on speeds through the latter part of the spring and the summer as it typically does from year-to-year. On top of that, we may expect some increase from the level of rates, that wouldn't surprise us. But I'm not sure, we would expect the speeds to elevate, maybe to the degree that the market expectations are pricing so I would expect some increase in speeds. We've run models as high as 10, 11 through the meaty parts of the seasonality curve. We'll see if those develop. I -- those may -- that may be reality, it could be higher than that, it won't surprise me if they're maybe not quite as severe as the market expects.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [4]

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Got you. Okay, that's helpful. And then on the duration gap, you mentioned that it's down to around negative 0.2 years right now. So pretty close to neutral. I was curious how you guys are thinking about that and how you're managing against the potential risk for spreads to widen in a rate rally scenario, how that plays into -- how you're positioning the duration gap right now?

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

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Well, you can see from the materials, the shift in net duration position quarter-over-quarter and I'd say we're pretty close to neutral. I think we look at the higher coupon book that we have is providing some level of protection in the uprate move. So we feel like that gives us a little bit more room to be more balanced, maybe than we had been before. In respect of exactly that dynamic, which is a downrate widener and I think, the combination of bringing that hedge, relative hedge and duration ratio closer to neutral combined with the lower leverage should mitigate our book volatility reaction to that to a widener -- a downrate widener should it occur. I would also say that the benefit, the other benefit of somewhat reduced leverage is an increased flexibility from liquidity, excess liquidity position, which would give one the benefit of being able to add bonds potentially into that widener and get the ongoing accretion effect, the benefit of a downrate widener. So we feel like a -- we feel like a multiple fence. We're in a better position although, of course, we're not immune to a widener in whatever direction it should occur.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [6]

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Great. Okay. And then last question. When you think about the dynamics that are going sort of forward into the second quarter from where we were in the first quarter in terms of your prepaid speeds and the spread versus LIBOR and repo costs, where core earnings were in the first quarter. Can you maybe comment as much as you can on how you guys are thinking about the dividend level going forwards?

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J. Rock Tonkel, Arlington Asset Investment Corp. - President, CEO & Director [7]

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Sure. I mean -- you, everyone understands that there are number of variables in play in that conversation. I would say broadly that the flatter -- flattening curve over time has made levered MBS return somewhat more challenging and the less favorable funding equation for now versus 2018 probably costs a couple of hundred basis points of ROE. But the more dovish global central bank environment has obviously reduced volatility and we think created a more friendly environment for levered MBS. Therefore, more stable and resilient/higher quality earnings profile over time. And so overall even with some spread pressures from those sources, this environment provides, we think, very attractive agency MBS returns for the industry. Particularly, at this stage of a cycle for the industry to be generating double-digit ROEs and paying dividends above that is, we think, pretty appealing relative to other asset classes. As net interest spreads are moderated in recent periods from the curve flattening, the erosion of the favorable funding conditions. And somewhat less benefit from leverage and so in response to that, we've moderated the leverage gradually, whereas the industries added leverage.

And from here, we've said people shouldn't be surprised if they see some gradual, gentle, over time, nonlinear decline in leverage. We feel like that will be always dependent on market conditions and from here, given these conditions that's probably moderate. If any move, it's probably moderate from here. The key variables, look I think they're pretty straightforward, how the speeds develop seasonally interacts with current rate levels. The curve has steepened somewhat from the lows, does that continue or does it reverse? Obviously, if it -- it could give us a boost if we get some steepening there.

And does the funding dynamic sort of reverse from being quite favorable in '18 to really not favorable at all, slightly negative, right? Sort of in the first quarter/right now to more normalized with a bit of a benefit there, which might be worth 5 or 10 basis points. On balance, it seems to us that the overall returns are higher quality. The clarity of those returns has increased because of the Federal -- the Fed and central bank environment. In lowering that volatility it gives a better outlook for earnings we think and having said that, that lowers return profiles from the mid-teens to really the lower double-digits low-teens with potential upside to us from the steeper curve if it occurs, Funding conditions more normalizing up 5 to 10 basis points benefit somewhere in there if they normalize. And speed expectations proving maybe not to be quite as severe as markets expect.

And so those are the factors that may improve that, sort of reverse the pressure on earnings and improve that profile, but in the interim I think, we feel like we've migrated from a mid-teens to a sort of low-teens double-digit ROE and that seems like a -- with more clarity, it seems like a very appealing, very attractive opportunity to us looked at over time and looked at in relation to other asset classes.

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Operator [8]

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(Operator Instructions) Our next question comes from Christopher Nolan with Ladenburg Thalmann.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [9]

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Rock, as a follow-up on the dividend, what is your outlook for leverage ratios? Going to the second quarter and the third quarter.

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

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Well, I think, Chris, you could probably hear in my comment in response to Trevor's question that we've migrated down in leverage, gently. And in respect of somewhat less benefit from leveraging as the curve is flattening funding conditions are reversed. We now find ourselves the circumstance where the industries started elevating at the same time. And we look at it, and we feel like with the overall Fed environment and the volatility environment and what we think is a very reasonable and attractive outlook for agency MBS returns. Although there are some -- have been and continue to be some spread pressures, we feel it is very attractive.

I think that we feel like we -- we're comfortable in that, low double-digits, low-teens environment. From a -- from an earnings perspective, looking forward for the foreseeable future and that's migrated downward, but it's got some potential upside to it from those factors. So I think leverage implicit in that is probably we've said over time don't be surprised if it declines gradually, that has occurred. There may be somewhat more of that, but I would expect if that, if that impact would be moderate from here, not dramatic low -- dramatically lower leverage. But if at all, it would be lower and it would be determined by factors on the ground at the time, how do these factors that I've referenced develop.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [11]

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And as a follow-up, just doing a quick math on the new shares and the dividend, I estimate that they're going to require roughly, I don't know, $9 million in dividend costs, assuming $6 million shares, million in shares and I'm just trying to figure out what sort investment spread or what sort of leverage assumptions you guys are doing in terms of going forward, that would justify being able to support the current dividend? Because right now, given the 11x leverage, the 120 bps in terms of economic investment spread, I'm not seeing that incremental earnings are covering the dividend, but maybe I'm doing the numbers wrong. Just trying to get your perspective on that.

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

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Well, I think I tried to get out those points in response to Trevor's question and your first question, but look, those are factors. These are all factors that we're evaluating all the time. Every quarter, we evaluate the dividend with the board and we set the dividend based on that process, that's an ongoing process naturally. I think the ingredients that inform that process are as I've discussed in response to these questions. Although, there can be others that pop up in market conditions that are certainly relevant to consider as well, but the primary factors are the ones I've just enumerated here and those are factors we'll be evaluating over the rest of the quarter. I think I've shared with you what I can share, which is that we feel like -- leverage is moderated, it's migrated downward. From here, changes in leverage would probably be moderate if any and spreads have compressed some from these factors I've talked about. Higher speed expectations and a change in the funding environment. The rest of it will be determining over the course of the quarter as everybody else will as they look to their dividends quarter-by-quarter-by-quarter.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [13]

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Okay. And by the way, thanks for the comments on Dave Walrod. He's a good guy.

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J. Rock Tonkel, Arlington Asset Investment Corp. - President, CEO & Director [14]

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He was a good friend to all of us.

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Operator [15]

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And Mr. Tonkel, there are no further questions at this time.

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J. Rock Tonkel, Arlington Asset Investment Corp. - President, CEO & Director [16]

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Right. Thank you. If you have anything further, we're happy to talk offline. Otherwise, we'll look forward to talking to you next quarter. Thank you.

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Operator [17]

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Thank you, and thank you all for your attention. This concludes today's conference. All participants may now disconnect.