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Edited Transcript of CMO earnings conference call or presentation 27-Apr-17 1:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 Capstead Mortgage Corp Earnings Call

Dallas May 1, 2017 (Thomson StreetEvents) -- Edited Transcript of Capstead Mortgage Corp earnings conference call or presentation Thursday, April 27, 2017 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Lindsey Crabbe

* Phillip A. Reinsch

Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director

* Robert R. Spears

Capstead Mortgage Corporation - CIO and EVP

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Conference Call Participants

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* Eric Hagen

Keefe, Bruyette, & Woods, Inc., Research Division - Analyst

* Steven Cole Delaney

JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the Capstead First Quarter 2017 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded. I would now like to turn the conference over to Lindsey Crabbe, manager of Investor Relations. Please go ahead.

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Lindsey Crabbe, [2]

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Good morning. Thank you for attending Capstead's first quarter earnings conference call. The first quarter earnings release was issued yesterday, April 26, and is posted on our website at www.capstead.com, under the Investor Relations tab. The link to this Webcast is also in the Investor Relations section of our website and an archive of the Webcast will be available for 90 days. A replay of this call will be available through July 27, 2017. Details for the replay are included in yesterday's release. With me today are Phil Reinsch, President and Chief Executive Officer; and Robert Spears, Executive Vice President and Chief Investment 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 risks 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 of the date of this call, April 27, 2017. 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.

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [3]

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Good morning. Welcome everyone. I know this is a busy morning for earnings calls so I'll keep my comments brief. Then we'll open the call up to questions. The interest rate markets that we navigate continue to be volatile as evidenced by the two 25 basis point increases in the Fed funds rates since December and sharply higher longer-term rates post-election.

More recently, uncertainly -- uncertainty regarding geopolitics and the pace of change in Washington has weighed on longer-term interest rates. Still, U.S. interest rates across the yield curve are significantly higher than they were pre-election. Against this backdrop, we earned $0.20 per common share in the first quarter for an annualized return on common equity of 7.4%. This is up from $0.14 in the fourth quarter. Together with a $0.14 increase in book value this quarter attributed to improved pricing on our agency ARM portfolio and on our swap positions, we produced an annualized economic return of 12.5% for the first quarter. This follows an economic return performance for the fourth quarter that outstripped returns produced by all but 1 of our peers that invest primarily in agency-guaranteed mortgage securities and most of our non-agency residential mortgage REIT peers as well. The primary driver of our improved first quarter results was a 10% sequential decline in quarterly mortgage prepayment levels, which contributed to lower yield adjustments for investment premium amortization. Importantly, higher ARM loan coupon interest rates contributed to higher cash yields, which offset increased borrowing rates during the quarter. This admittedly gradual resetting of cash yields on our portfolio is a key feature of our short-duration ARM investment strategy, which, together with the prudent use of short-tenor interest rate swap agreements can help offset higher borrowing costs over time. As such, and has been -- and as has been borne out in past periods of market instability, we believe we are well positioned to preserve our stockholders' capital while generating attractive risk-adjusted returns over long-term investment horizons. More immediately, mortgage prepayment levels in the coming months and quarters, as well as the pace of future increases in short-term interest rates, remain key to our near-term results. With that, I'll open the call up to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from Steve Delaney with JMP Securities.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [2]

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Phil, could you comment, you got a nice pickup in earnings from the 10% drop in CPR, so it averaged about 23% in the first quarter. I was wondering if you or Robert could comment sort of on sort of how that played out sequentially kind of month to month? And if you'd be willing to comment on what April looked like? It looked to us like the April factors might have turned up about 20% across the board for the agency MBS universe and I'm just curious what you guys saw?

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Robert R. Spears, Capstead Mortgage Corporation - CIO and EVP [3]

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Sure, Steve. First quarter peak speeds in the ARM market were actually the January print and then they trailed down over the course of the quarter and averaged out to just under 23 CPR for us. If you look at ARMs generically, the April prints are out and they are up about approximately 20% from the March print. So it's kind of in line with fixed rate, albeit, at a much higher level than fixed-rate. But the percentages are about the same. They should trail off a little bit in May because day count is lower and then pick back up again in June.

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [4]

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Yes, most of that pickup was day count related.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [5]

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Which pickup, Phil, just so I understand? I know the day count really matters.

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [6]

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Yes, the speed pickup for April was day count related and it's kind of going back the other way for the May print.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [7]

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Got it. But I mean, realistically, given kind of where ARMs are now and where they're resetting, I guess the big issue here, (inaudible), stepping back, is really the flattening of the curve. Isn't it?

In terms of attractiveness of different products. But would it seem reasonable for us to just sort of think that speeds are going to have a kind of a low '20s handle over the next couple of quarters? Does that sound reasonable to you guys?

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [8]

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Well, I mean, if you look at the cohorts out there, what you're seeing is kind of an interesting phenomenon now. For the longest time, longer resets were prepaying faster than short resets. That's flip-flopped now. And so you've got season-short resets that are of kind of printing in mid-20s now. Longer resets, you look at our long reset book, the coupon is 2.70% with a gross mortgage rate of 3 1/4% or so, those are now in the upper teens. So it's kind of flip-flopped. So I don't -- using that, I don't disagree with your thesis.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [9]

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Okay. And Robert, you are having to find about $1 billion a quarter. Are you still able to do that in say 2 to 3-year seasoned kind of paper?

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Robert R. Spears, Capstead Mortgage Corporation - CIO and EVP [10]

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Yes, the first quarter was very interesting. Everything -- spreads tightened dramatically early in the year. The banks weren't buying. There was very little new production. The Street didn't have much inventory and there was very little selling. And it's not uncommon for banks to come in early in the quarter.

Well, as spreads tightened in, then you started to see a pickup in secondary selling, guys taking advantage of tighter spreads, and so shorter resets, for example, tightened early in the year and then started widening out. If you noticed our marks, our shorter resets were actually down in the quarter. And then on top of that, you're starting to see a lot of out-month production mainly as the result of rates going up.

There's more ARM production now and so, for instance, in the out months the bigger Tier 1 originators, for instance, in 5/1s that were selling $10 million to $20 million blocks are now selling $20 million to $35 million blocks.

So ARM production as a percentage of production is up right now. The last number I saw it's about 17% of new production. Now, that's not all going into agency MBS, that includes jumbos and everything else. But net to net, the absolute increase in rates has caused ARM production to go up.

Now, the curve flattening has been a more recent phenomenon and so you could see it dip back down again. But bonds that are coming out now in new production are reflective of when we had about 125 basis points between 2s and 10s and that's come in a little bit now. So a long answer to your question but there's plenty of supply right now between new issue and secondary selling.

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Operator [11]

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(Operator Instructions) The next question comes from Bose George with KBW.

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Eric Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [12]

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It's Eric on for Bose. What is -- what's the -- what's the average loan age now of your current reset ARM portfolio? And do you suspect that, going forward, there will be any difference in the prepaid behavior of super-seasoned post resets versus so called newer cohorts of post reset?

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [13]

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Eric, this is Phil. We don't really break down the average age of the portfolio. We do give some months to roll, months to reset. Average months to reset is about 6 months as it has been for quite some time on our current reset classified loans. All those loans will reset inside of 18 months. And about 20, 22 months for -- or about 40, 41 months for the longer resets and 22 overall for the portfolio.

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Robert R. Spears, Capstead Mortgage Corporation - CIO and EVP [14]

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Yes, and as far as speeds goes, I know you guys look at the different cohorts. And right now, for instance, ARMs that are resetting for the first time that are 5 or 6 years old, seasoned 5/1s, some of those are ramping up to north of 40 CPR.

Very seasoned non-IO product that's 15 years old is still trending around 20 CPR. So there's a huge variance in speeds depending upon the age, whether it's IO, different attributes like that.

So I would just kind of say, generically, short resets are trending in the mid-to upper 20s and depending upon how much of the book is concentrated in newer versus seasoned production it's going to be either lower or higher.

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Eric Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [15]

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Right. Can you share your current thoughts on what the Fed might do next year? How that's factoring into your investment allocations?

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [16]

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I'm sorry, Eric, what does -- what was your question again?

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Eric Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [17]

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What the Fed's going to do next year? How many times are they going to raise next year? What your current expectation is for that?

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [18]

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The curve's calling for a couple of more bumps this year.

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Robert R. Spears, Capstead Mortgage Corporation - CIO and EVP [19]

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(inaudible)

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [20]

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Yes, I think the curve is -- next year, I think the Fed funds futures are calling it, for terminal funds, around 2 1/4%. I think the Feds [dots] implies a terminal funds rate of 3%. It's been pretty transparent, it seems like they're signaling 2 moves this year. Who knows what they are going to do next year. But we really don't try to make a prediction when we're executing our strategy.

We think our strategy works very well in an environment where the Fed's moving gradually and if you some steepness in the curve, if 10s go back out in the high 2s and you get a couple of fed moves, that's not a bad environment for us.

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Eric Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [21]

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Okay. All right, and then one more from me. Can you tell us what the ROE is on the preferred equity that you guys have? I can calculate it pretty easily across the entire portfolio but what are the pre-expense ROEs on the capital used from preferred?

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [22]

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Well, the cost of that capital to us is about 7.75%.

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Eric Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [23]

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What's the ROE, though, on capital used for investments on that?

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Phillip A. Reinsch, Capstead Mortgage Corporation - CEO, President, CFO, Secretary and Director [24]

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Well, at the margin, we're investing close to 10% right now.

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Operator [25]

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This concludes the question-and-answer session. I would like to turn the conference back over to Lindsey Crabbe for any closing remarks.

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Lindsey Crabbe, [26]

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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.

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Operator [27]

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The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.