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Edited Transcript of CMO earnings conference call or presentation 31-Jan-19 2:00pm GMT

Q4 2018 Capstead Mortgage Corp Earnings Call

Dallas Feb 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Capstead Mortgage Corp earnings conference call or presentation Thursday, January 31, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Lance J. Phillips

Capstead Mortgage Corporation - Senior VP, CFO & Secretary

* Lindsey Crabbe

Capstead Mortgage Corporation - Manager, IR

* Phillip A. Reinsch

Capstead Mortgage Corporation - President, CEO & Director

* Robert R. Spears

Capstead Mortgage Corporation - Executive VP & CIO

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Conference Call Participants

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* Eric J. 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 day, and welcome to the Capstead Mortgage Corporation Fourth Quarter 2018 Earnings Conference Call. Today's conference is being recorded. (Operator Instructions)

I'd now like to turn the conference over to Mr. Lindsey Crabbe. Please go ahead, ma'am.

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Lindsey Crabbe, Capstead Mortgage Corporation - Manager, IR [2]

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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. The link to this webcast is also in the Investor Relations section of our website. An archive of this webcast and a replay of this 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 of 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.

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [3]

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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 number of fronts for companies like Capstead that invest in levered portfolios of residential mortgage assets. With ARM pre -- 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 seen in October and November. And with 5 -- 25-basis point hikes in the Fed funds rates since December 2017, our financing spreads contracted in 2018 due to higher borrowing cost, even as coupon interest rates on mortgages underlying our currently resetting ARM securities continue to increase.

In this environment, our stock price has not fared well, has been particularly weak the last 6 months. In response, we redeployed a portion of our capital made available from portfolio runoff 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, roughly $0.77 on the dollar 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 at the core of our strategy of investing in agency-guaranteed ARM securities because ARM loans can reset the market rates 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 an 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 will 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'll close with the sentiment I expressed in our press release that we believe Capstead represents a recently compelling opportunity for investors seeking risk-adjusted levered returns with a comparably higher degree of safety from interest rate and credit risk.

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

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Lance J. Phillips, Capstead Mortgage Corporation - Senior VP, CFO & Secretary [4]

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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 an additional $0.04 to our earnings.

Unfortunately, 25 basis points and higher borrowing rates, primarily due to Federal Reserve rate hike, 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 and producing the basically flat economic return, Phil discussed earlier.

Breaking down our book value, it declined for the quarter, lower swap gains of $0.37 and dividends in excess of 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.

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Questions and Answers

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Operator [1]

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

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [2]

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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 a lower likelihood of your repo repricing higher in the future?

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [3]

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Yes. 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, on 9/30, we reported duration gap just under 6 months. We actually let it get longer than that. So we don't just replace swaps as they roll off. We didn't put any swap trades on until the market started routing in December. And so I think, we put on swaps that had roughly a 2.84% 3-year swap rate, both hit as high as 3.20% in October. So we got longer during the second half of the year. 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, 3-year swaps are around 2.60%, so we could synthetically fund the book cheaper via the swap market than we're paying on swap repo, which is closer to 2.65%. 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 dynamic of what we can swap out our funding costs more 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 lengthen or shorten our duration gap. At this point, with the rally and the Fed basically, the forward markets are pricing in the Fed ease, we will probably take advantage of that and layer more swaps then at these levels. But 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 2 things, what we're doing in the first quarter will probably look materially different than what we did in the fourth quarter.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [4]

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Great. Great. As a follow-up to that, can you just provide the unlevered yield on new purchases in the quarter? And just kind of where you stand with...

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [5]

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

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [6]

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Okay, great. My next question is just kind of around liquidity in the agency ARM market more generally. You know the share buybacks were obviously very nice to see. I mean, they 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, and 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?

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [7]

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Well, 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 as 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 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 one, but liquidity -- there is not a lack of liquidity -- there is not a lack of liquidity in the ARM market. And we are not having a problem replacing runoff when we chose to do so at compelling returns.

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Operator [8]

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(Operator Instructions) We'll go next to 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 [9]

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Echo Eric's comment, we applaud the buyback activity and congrats on the -- your industry-best book value performance in the quarter in a challenging market. I want to ask about the buyback. We noted at the end of the third quarter that there was $55 million authorized and with which you did in this quarter. It looks like it would have been down to about $11 million or $12 million at the end of the year. Now your stock today is $7.25, so lower than the $7.47 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?

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [10]

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Yes, the board can increase the authorization at any time. So there is about $12 million left on our -- on the original authorization, but I wouldn't concern -- be too concerned about that. We are going to be disciplined though with better return profile on new acquisitions that's used for that capital so.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [11]

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So it doesn't sound like there's any -- there's no targeted level where you're just going to take -- Rob, is 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.

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [12]

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Absolutely. And there are some pretty significant earnings blackout periods in an industry of ours where you can see where you're going with earnings pretty easily.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [13]

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Yes. Robert, you mentioned the spot rate. And frankly, I was hoping that we were a little bit lower than that 2.65%. Seems like we've got 1-month LIBOR just settled at 2.50%, Fed funds just under 2.40%. And based on yesterday's comments, and I think we all pretty much decided 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 1-month LIBOR is sort of where repo will settle over most of this year?

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Robert R. Spears, Capstead Mortgage Corporation - Executive VP & CIO [14]

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Actually, Steve, we're seeing a drift down a little bit our rally. I mean, we're seeing now kind of 2.63% areas, but yet I would think a lot of technical factors at the end of the year to kind of go into the first quarter. And I think you will see some of that abate because, for instance, the last couple of years for the most part, if you use 1 month LIBOR as a proxy, we've been repoing like LIBOR-plus $0.05. And so, all things being equal, if you were to project it, 6 months ago, you would have expected us to be repoing around 2.55% right now. So I would think, given what the Fed is doing and their talk about -- their balance sheet activity and potentially buying stuff, et cetera, shorter end of the curve and keeping reserves in the system, I would think repo rate should drift down.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [15]

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Okay. And I'm just looking at your spread, you were 2.07% on your hedge costs to funds and I know you've got some swaps, but it almost feels like we can now sort of see what a cap may be -- might be 9 to 12 months out as repo rolls up, because the 2.07% 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 on -- assuming the Fed is on hold? It seems like we kind of have a -- there's not that much more pressure to see on your cost of funds over the next say 3 to 6 months?

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Robert R. Spears, Capstead Mortgage Corporation - Executive VP & CIO [16]

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That's fair. I mean, once again, if you look at where 2 to 3-year swaps are and if you take the refi then into account, you could synthetically repo cheaper than spot rates. So yes, I mean, I think repo and -- it's kind of going to be a good proxy for our funding costs over the next several months as far as for Fed increases.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [17]

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And so the flip side of that, this is my last question, I'm sorry to ramble on here. But now that we can -- for the first time in a couple of years, we can look at funds and borrowing costs and say, okay, we could see these settling in 2.50%, 2.60%, whatever. Now my intention turns to your short book and your WAC and your fully indexed WAC. And I'm looking in your press release, you gave us this data every quarter, which is greatly appreciated. But at 3.80% current net WAC and a fully indexed WAC of 4.50%. So I mean, that's a -- that's 70 basis points. As I'm reading that, that's forgetting 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 sort of -- 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 2 to 3 quarters.

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Robert R. Spears, Capstead Mortgage Corporation - Executive VP & CIO [18]

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Sure. I mean, I think if you just kind of interpolate and assume that 12 of it resets every month of that short book, and that impacting our longer resets won't go up in coupon other than through new purchases, you should get an extra 10 to 12 basis points in coupon per quarter. And as they adjust that obviously so our book has a lot of upside on the coupon side. And then you look at where the next part of, I think, where your going are prepays, when our ARMs sit fully indexed. One thing right now in aggregate, in our Fannie/Freddie book fully indexed, you'd be looking at like I call it a 5 1/8% coupon or Ginnie's 4 3/4%, so we just call it 5% fully indexed versus a no-cost refi of around 4 3/4% of what's 4 7/8% for this rally. So we will get some incentive there, but conversely, it's not any more incentive than they had last year. What we saw -- actually our speeds went down last year from 2017 with a flatter curve and higher rate. And so you start to see some burnout. And then also what we experienced in the last tightened cycle, which was a long time ago, obviously, but once the Fed stops moving and you don't have that headline risk about rates going up, a lot of these on borrowers won't refinance into a fixed rate that's the same level because they're not getting a notification that their payment is going up again. And they may start thinking that rates are going to come down, so you start to see even with a flatter curve, once the indexes stop going up, you don't have as much prepayment noise and you start to get some burnout. I mean, a good example like, so when your LIBOR hit 3.15% in October, it's 2.97% now and a similar decline in 1-year CMT. So you could conceivably see some guys that reset up last fall that next time it will be resetting down than they were at 5 1/8%. So the big jumps in the portfolio are out right now. And so we were more positive on prepays this year than we would have been last year.

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Operator [19]

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

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Lindsey Crabbe, Capstead Mortgage Corporation - Manager, IR [20]

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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 [21]

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