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Edited Transcript of ORC earnings conference call or presentation 28-Apr-17 2:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 Orchid Island Capital Inc Earnings Call

Florida Apr 30, 2017 (Thomson StreetEvents) -- Edited Transcript of Orchid Island Capital Inc earnings conference call or presentation Friday, April 28, 2017 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Robert Cauley

Orchid Island Capital, Inc. - Chairman, President & CEO

* Hunter Haas

Orchid Island Capital, Inc. - CFO, CIO & Director

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Conference Call Participants

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* Mickey Schleien

Ladenburg Thalmann - Analyst

* David Walrod

JonesTrading - Analyst

* Andre Zerona

Say Capital - Analyst

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Presentation

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Operator [1]

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Good morning and welcome to the first-quarter 2017 earnings conference call for Orchid Island Capital. This call is being recorded today April 28, 2017.

At this time the Company would like to remind the listeners that statements made during today's conference call relating to matters that are not historical facts are forward-looking statements subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good faith belief with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements.

Important factors that could cause such differences are described in the Company's filings with the Securities and Exchange Commission, including the Company's most recent annual report on Form 10-K. The Company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements.

Now I would like to turn the conference over to the Company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead, sir.

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [2]

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Thank you, operator. Good morning, and welcome to the first-quarter earnings call for Orchid Island Capital. With me today is Hunter Haas, our Chief Investment Officer and Chief Financial Officer.

Today we will depart from our normal practice and incorporate a slide deck presentation into our call. I hope you have had a chance to download the slide deck from the Investor Relations section of our website. If not please do so now if you can as we have provided some helpful graphs and tables that will facilitate today's discussion.

Before going over the slides I would like to go over the events that unfolded over the course of the quarter and their impact on Orchid. As the year 2017 unfolded risk markets, and particularly the equity markets, were buoyed by optimism stemming from developments in Washington generated by the incoming Trump administration.

The president elect made every effort to let the world and the markets know that a Trump administration was going to be very pro-business and pursue an aggressive legislative agenda that encompassed healthcare reform, tax reform, infrastructure projects and regulatory relief.

As various cabinet nominations were announced, most of which were from the business world and the new president continuously met with leaders of most major industries, the equity and risk markets continued to rally, setting all-time new highs in the case of the Dow Industrials and S&P 500 in early March. Optimism was so high that when the Federal Reserve raised the Feds fund rate by 25 basis points at their March meeting the markets reacted calmly.

Various members of the Federal Open Market Committee and Fed governors have increasingly discussed the reduction of the Fed's balance sheet as the next phase of the removal of monetary accommodations in addition to increasing the Fed Fund Rate of course. Members of the Fed have indicated that the reduction of the Fed's balance sheet would be accomplished by tapering the reinvestment of the pay downs they receive on its MBS holdings and maturities of treasury and agency debt holdings.

The market, particularly the MBS market, is keenly focused on the timing and extent of a reduction of Fed purchases. The prospect of the largest source of demand for agency MBS reducing its purchases has caused agency MBS assets to cheapen to comparable duration treasuries.

As for MBS performance, prepayment speeds moderated during the quarter with a combination of the typical seasonal slowdown coupled with substantially higher mortgage rates versus levels prior to the election. Prepayment speeds prepare -- appear to have hit a trough in February based on the report released in March before picking up again slightly in March based on the report released in April.

Now to the slides. First on slide 5 we provide a brief overview of our results for the quarter of -- first quarter of 2017. And I would like to remind investors that the information provided on this slide was disclosed on April 12 when we declared our April dividend.

As a practice going forward for the first quarter of every month we will continue to provide our preliminary results for the past quarter in addition to the dividend for the current month. And of course that dividend will be declared in full knowledge of the results of the prior quarter.

So first off we had earnings per share of $0.07 per quarter. This included $0.63 of losses per share from net realized and unrealized gains and losses on MBS and derivative instruments. Absent these unrealized and realized gains and losses we had earnings per share of $0.70 for the quarter. Book value per share was $9.75 at March 31, 2017, a decrease of $0.35 or 3.5% from $10.10 at December 31, 2006. Dividends of $0.42 were declared for the quarter. In sum, the combination of a $0.35 decline in book value and $0.42 in dividend resulted in an economic return of $0.07 for the quarter which is 0.7% unannualized or 2.8% annualized.

Now I will review the balance of the slide deck. The slide deck has three basic sections and I will follow the deck in sequential order. The first section covers developments in the markets during the quarter; specifically I will focus on the rates and MBS markets.

On slide 7 we provide a picture of the 10-year treasury and the 10-year swap yield for the quarter. These are a primary focus for MBS investors. As you can see both cases, they were relatively stable for the quarter. In the case of the 10-year treasury, it ended the quarter at 5.7 basis points below the 12-31 level and the 10-year swap rate was 4.74 basis points higher reflecting some slight widening of swap spreads.

There are a few notable events that occurred during the quarter as you can see and March 10-year yields and 10-year swap rates increased. As we are all aware, the Fed did raise rates in the middle of March. And as is the case the market -- the Fed is very cognizant of disrupting the market. And so to the extent the Fed used that the market is not anticipating a rate hike they can, and in this case did, through their rhetoric and public pronouncements, try to talk the market up in anticipation of a Fed hike. In fact we did get one, as we know, and the market started to price in a more aggressive Fed.

Shortly thereafter the Trump administration's proposal for Affordable Care Act replacement was not voted on, it more or less failed and the market started to rally at the end of the quarter. That continued into April, was added by geopolitical events, first the missile strike and Syria, secondly the rhetoric between the Trump administration and North Korea. And then finally really the economic data for March was almost uniformly weak.

And as we found out this morning GDP for the first quarter was sub 1% at 0.7%. The market really hasn't reacted too strongly to that data because we have seen now for several years that the first quarter can and often is very weak. But it is not necessarily a good barometer of what to expect going forward.

Of course we don't know that for sure this year, but that market seems to be anticipating the fact that this was somewhat of an aberration possibly caused by seasonal adjustment issues or the like. And the rest of the economic data, the underlying data with respect to the consumer and the housing market seems to be quite strong in any event.

Slides 8 and 9 just give you a picture of the change in the treasury curve and the swap curve for the year -- or the quarter, I am sorry. And as you can see, both cases are relatively stable, modest flattening in the case of the treasury curve, the very front end of the curve moved up, kind of pivoted around the five-year point of the curve. So 10-year and beyond rates were down very slightly.

In the case of the swap curve they are all up again in somewhat of a flattening, most of the movement is on the front end. And again, this ends on March 31 so it doesn't really pick up what happened post end of the quarter when the market started to remove pricing for Fed hikes which it kind of occurred mid-March with the strong language from the Fed.

Slide 10, here we are going to talk a little bit more about the mortgage market. I'm going to focus here on 30-year fixed rate coupons, specifically higher coupons which make up the bulk of our holdings. As you can see relatively stable for the quarter but it is important to note a couple of things.

One, say for instance the 10-year treasury which I mentioned finished slightly down in yield. Both 4's and 4.5's, which we have pictured here, were down in price. And as you can see, 4.5's were down more in price than 4's. So clearly throughout that quarter up in coupon underperformed.

Also we added 5's in the quarter so they also underperformed. And we attribute most of this widening to an initial reaction by the market to the rhetoric out of the Fed. As I mentioned, they started to talk about a tapering of their MBS reinvestments. As for now it looks like that is probably going to occur late 2017, early 2018 and will probably be gradual.

But of course the market will be very keenly focused on any change to that timing or the extent of the tapering. So it will be very much a primary driver of MBS performance for the balance of the year. Of course to the extent that there is material widening that represents a very opportune buying opportunity. So there is a silver lining for sure there.

The next slide, on page 11 we show payups on certain specified pools, these are an important component of our portfolio. What we try to show you here on slide 11 and 12 are the payups for what we would call the two extremes in the TBA deliverable universe. So 85k, which is probably the premier call protected security, 85k is the lowest loan balance of available.

On the second page we show you New, which is kind of -- basically you are just buying a brand-new mortgage, so the lowest form of pay up protection. And we provided three plus years of history here so you kind of get a perspective of how things change. I just want to point out a couple of things going back to 2013 at the time of our IPO.

One, you can see that 85k, 4's were a very, very high payup. And you also note that there were no 4.5's there, that is simply because they weren't being produced. You could buy a lot of 2.5's at that time. But of course the world changed after the taper tantrum. And also you can see in 2016 these payups got quite high, nearly as high as they were in 2013. Of course then we have the Trump administration win the surprise election, those values change.

But I do want to point out that if you look at the first quarter of 2017 they are relatively stable, at least most if not all -- and certainly not all. In some cases they were stable, in some cases they were not. In the case of 85K relatively stable, at least for 4.5's. But if you turn to slide 12 you can see in the case of the New that they continued to leak lower. And that of course also was reflected in our mark-to-market because we do well in securities. So did lead to a second layer of widening if you will.

Now I would like to discuss our results for the quarter in a little more detail, so if you would please turn to slide 14. And we think this is a very important slide. And the reason we provided this slide the way we have is the following. Basically what you see here is in the case of the third column the numbers that will appear on our 10-Q, which we will file in the near future, this is basically the results of the quarter.

But what we have tried to do here is to disaggregate basically our results into two general categories. The column that's marked Realized and Unrealized Losses, this basically just reflects mark-to-market on everything we own, so pass-throughs, IOs, inverse IOs, Eurodollar futures, all of our hedges. And these are of course subject to whatever happens in the course of a quarter. So these numbers can be quite volatile up or down.

The next column is basically net income absent that and it basically shows you the things that tend to be more stable. So in that case of the realized and unrealized gains and losses, these can and are often quite volatile from quarter to quarter. And the left-hand column basically shows you the net interest income from the portfolio less the expenses we incur. And these tend to be more stable.

And the reason we did this is the following: we use what is known as the fair value method of accounting which, as I just said, means that we take everything into earnings in every given quarter, everything that changes in, value, and this does and can -- can and does introduce an element of volatility to our earnings.

That being said, without question the far right column is the GAAP results that we report and those are the most important results. But we are just trying to show you that we do have this component of our income that is driven by mark-to-market events which can and are volatile.

And so in this case we had, as you see on the table at the bottom, GAAP net income of $2.449 million, which is about $0.074 per share. But the mark-to-market gains on losses were almost $0.63 a share. Excluding those realized and unrealized gains and losses we had earnings of $0.701 per share for the quarter.

Going down starting with interest income, $32 million, that is a 29% increase over the fourth quarter of 2016. It is a result of a slightly larger portfolio and, as I will discuss in a few moments, some changes to the composition of the portfolio whereby we raised our weighted average coupon.

Interest expense was up 35% to $6.7 million, that reflects both the Fed hike in December and of course anticipation of another hike in March. So LIBOR and funding levels increased. Net interest income as a result is up 27%. Expenses were relatively flat for the quarter, down 3% in the aggregate, and the mark-to-market gains and losses across all assets and hedges $20.7 million or $0.627 per share. That is versus losses of $38 million in the fourth quarter when we had the initial reaction to the Trump administration surprise win.

So we will continue to show this slide. We think it is helpful to investors to recognize that there are very volatile components to our earnings. And we are just trying to desegregate them to make it easier for you to see that. But we also recognize with the far right-hand column is our cp results and those are of course the most paramount.

Turning now to slide 15. We present this slide in our press release every quarter. This is basically a roll forward of the portfolio and it shows you what happened over the course of the quarter. I want to point out a few things.

First, in the column labeled Pass-Throughs you can see under securities purchased and securities sold that we did some meaningful reposition of the portfolio. So it was in an effort to get the average coupon higher, the age of the portfolio down. And we also were able to do this with a lower average purchase price across the portfolio. And Hunter and I will discuss that in a little more detail in a few moments.

Also want to point out the premium loss due to pay downs, which is our proxy for premium amortization, was $4.65 million, that is down materially from $6.87 million in Q4.

With respect to interest only securities, we added approximately $43.5 million. Most of these IOs are off of jumbo collateral. In other words, very negatively convex collateral which has a lot of extension potential in an up rate scenario and that is exactly why we add it, to protect against the more meaningful sell off.

With respect to the inverse IOs you see that we had sales of a little over $38 million. This is a story that started in the fall of 2016 when payups, as I mentioned earlier, had gotten very, very high. We had taken steps to sell some of that collateral to the Street where it was structured into an inverse IO which we took back. Then with the meaningful sell off as a result of the Trump administration surprise win, these bonds extended quite a bit and they had a lot of exposure to the very front end of the curve and we look to reduce that exposure over the course of the first quarter of this year.

Now turning to slide 16, not a lot to say here other than I want to point about the fact that as you see our allocation of capital is closer now to 50/50. It was 54.2% pass-throughs at the end of the year, now it is 52.4%. And just as a reminder, a comparison, at the end of the first quarter of 2016 it was 59/41.

So, basically reflects a change in allocation to reflect the fact that the structured portfolio is generating a little more return. And we -- as I mentioned, we wanted to add to the IO positions to increase our protection against up rate scenarios.

Page 17 shows the returns by sector. I would like to point out one simple fact; as you can see, there are realized and unrealized losses across all asset classes. In the case of the IOs and inverse IOs it just reflects the fact there was a slight rally in the market. But in the case of pass-throughs it was widening. But in spite of that we had positive returns on all sectors for the quarter. So we are very pleased with that. It does reflect that the earnings power in this case can outweigh even a very volatile quarter.

Turning to slide 19, this is the composition of our portfolio. I did want to make another comment with respect to leverage, our leverage was up slightly from [8.4% to 1%] at the end of the year to [9.2%]. Of course those numbers do not reflect the TBA shorts that we have in place which, in our minds, reduce our economic leverage by several hundred million dollars.

The reason we feel comfortable with the leverage slightly higher is, one, we made some changes to the TBA shorts; they have a longer duration so that we get a greater up rate protection. As I mentioned, we added the IOs back by jumbo collaterals which also give us up rate protection. And we have made some changes to our Eurodollar swap positions which I will get to in a moment.

I do want to point out though, as we mentioned, we did a lot of trading for the quarter. The weighted average purchase price of the portfolio dropped from $108.64 to $108.26. Current price of this quarter versus the last quarter is relatively stable, but we did raise the weighted average coupons from 4.19% to 4.31%. So the trading was done such that we could lower our average purchase price and increase our average coupon, which is very positive for us going forward.

Slide 20 just list our various repo counterparties, there is not much to say about it, it is very self evident.

Page 21 lists all our hedge positions. We show our Eurodollars. We took these positions up during the first quarter; we now are basically at $1 billion across all contracts with the exception of the first and last. We do list in the far right column our open equity.

So for instance the $1.364 million shown there in the bottom right, if the world never changed from 3-31 that would be taken into taxable income -- interest expense rather, over these contract periods. And then the treasury futures short, that is $3.1 million. And again, if the world never changed that would be taken in taxable interest expense basically over the next 10 years.

Finally, on slide 22 we show you our TBA short positions. We went from basically $100 million of 3%'s and $100 million of 4%'s at the end of the year to $150 million of 3%'s, $297 million at 4.5%'s. Since then we have moved the TBA shorts into all 3%'s, we have $250 million there.

And then with respect to our swaps, we did increase our swap position slightly from $700 million to $800 million. And as you can see on the second to last column, the market value, these are in the money as we speak, so to speak. The order of swaps, the $600 million of shorter swaps are quite in the money and the newer swaps with a paid fixed rate of 2.14% are slightly out of the money.

I want to take a second and discuss some trading activity, Hunter. By the way, this is the last slide; it just shows you our hedge position laid out over the curve.

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Hunter Haas, Orchid Island Capital, Inc. - CFO, CIO & Director [3]

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Sure, the primary theme in the first quarter, and really even extending into April, has been to continue to shorten the duration of the portfolio. We have done so through, as Bob just mentioned, adding the hedge positions, adding to the swap position, adding longer TBA shorts vis-a-vis the Fannie 3 shorts that we have in place.

And continuing and up in coupon shift out of lower coupon 15 years, 20 years and even 30-year 4's into 4.5's which were the -- really the performance of the 4.5 was the primary culprit of our unrealized and realized mark-to-market losses in the period. The coupon widened considerably versus treasuries. Using Wall Street had ratios on the 10-year we spotted that the coupon underperformed by roughly 0.5 point, maybe a little bit more than that depending on who's hedge ratios you used.

So we have continued to sort of lag in as that coupon has gotten cheaper. As Bob mentioned, the first quarter was big for reducing our exposure to inversed IOs. We had a unique opportunity -- similar really to what we saw in the third and fourth quarter of 2016 when payups were very high; in the early part of the first quarter we saw, at least on a spread basis, very tight levels for certain call protected inverse IOs.

I think there was some concern that we had gone too far and might rally back a little bit in the wake of the Trump euphoria that we saw in the fourth quarter. Whatever the reason was we were able to, at least on a spread basis, sell those inverse IOs at what have basically been year-to-date [tights] for loan balance and other call protected types of inverse IO securities off of the coupons we like to own which are primarily 4%'s and 4.5%'s.

As Bob alluded to, throughout the period we shifted that capital allocation into fixed IOs which have large negative durations. Again, we are bolstering our position for continuing to be prepared for rate increases. So as we lagged into those positions through the quarter we continued to rally and have actually rallied a little bit in the second -- the beginning of the second quarter here through April.

So that was a little bit of weight to our results as we were sort of lagging into negative duration positions as the market rallied. So it worked against us a little bit in the period but we like where the portfolio is now. It is significantly shorter. If we do get a pop-up in rates or an inflation scare of some sort or just realization of any of the things on the Trump agenda that are important items I think we can see higher rates.

We are starting to see inflation pick up. While the economists that Bob and I follow are sort of uniformly in the camp that we are going to see higher inflation this year. And I think that it will pay to be prepared for if and when that happens. I don't know if you want to add anything to that, Bob?

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [4]

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No, I would say the portfolio has been for quite some time now kind of bias to an uprate scenario. We continued on a lot of securities that have risk or exposure to prepays, whether it is high coupon premiums or the IOs and inverse IOs. When we have periods like we did mid to late 2016 prior to the election you have a big rally, that amortization puts downward pressure on our earnings.

But we do view the underlying economy as quite strong. The market very much is focused on Trump and his ability to execute on his legislative agenda. Right now it looks like it is maybe a struggle. And of course the first-quarter data was weak, and so the market just kind of sees that as reinforcing this kind of negative bias.

But I think if you look at the underlying economy it is still quite strong, whether it is the housing market in the case of say for instance home price appreciation running in the mid-single-digits very strongly, new home sales, existing home sales are still increasing. The labor market is still strong. The Fed has mentioned in many occasions that they view say 50,000 to 100,000 as the number of jobs that need to be added every quarter to absorb new entrants to the workforce. We have been running above that for some time.

Various measures of unemployment continue to either be flat at a low level or trend down. And the consumer spending as a result is -- there is some volatility. Certainly what we saw today when it was only up 3/10 for the quarter. But it has been running and the high 2%'s, the low 3% for a number of quarters.

So all the underpinnings of the economy appear to be strong. I suspect there are some issues with the GDP data that tends to have some seasonal adjustment factors whatever the case may be. It doesn't seem to be consistent with the rest of the data. So we are positioned for uprates and we see the economy being supportive of that position.

As Hunter mentioned, inflation -- the price component today was 2.3%. We think it will continue to trend above the Fed's 2% -- and through the Fed's 2% target. And I think the Fed will continue to raise rates probably more aggressively than the Fed -- or the market is pricing. So that is kind of it. Operator, I think we are ready to take some questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions). Mickey Schleien, Ladenburg.

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Mickey Schleien, Ladenburg Thalmann - Analyst [2]

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First off, your prepared remarks were very good. And I appreciate you taking the time to explain the backdrop for your investment thesis. Just wanted to ask you about the balance of the year.

There is certainly a lot of uncertainty about how and when the Fed will start shrinking its balance sheet and the potential impact on spreads. So I am curious to understand how that uncertainty is affecting the cadence of your capital deployment?

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [3]

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Thank you. Good question. As I said, I think the key is the market has formed an expectation of how they think this will play out. And that is that it will start probably late this year, early next and it will be a wind down of the reinvestment at a gradual pace. What is critical I think is whether or not they stick to that. To the extent they accelerate that or they change that then I think you will see more widening.

For now it has been modest; we did see some widening, we may see some more, but it has not been shocking, it is nothing like the taper tantrum in 2013. And that I think that is probably key. The Fed is very cognizant of what happened then and they want -- it appears they want to avoid having that happen again. Ben Bernanke wrote in an op-ed and he talked about the need for a gradual pace and I think that made sense. I think the various state governors that have spoken and Board members have echoed that.

So really, we do anticipate there may be some slight widening over the balance of the year into next. But as long as the rhetoric stays consistent I think it will be very easy to live with, for lack of a better word, and also represent some slightly improved investment opportunities.

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Mickey Schleien, Ladenburg Thalmann - Analyst [4]

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So, Bob, given what you just said, it doesn't sound like you are going to take a wait and see attitude and retain dry powder. It sounds more like a steady as she goes investment pace unless you see something to change your fundamental view. Would you agree with that?

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [5]

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Yes, I would. That is a fair assessment.

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Mickey Schleien, Ladenburg Thalmann - Analyst [6]

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Okay. That is it for me. I appreciate your time this morning, thanks.

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Operator [7]

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(Operator Instructions). David Walrod, JonesTrading.

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David Walrod, JonesTrading - Analyst [8]

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Just a little more on the Fed. Can you kind of walk us through your outlook for the pace of rate increases and how you've positioned the portfolio?

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [9]

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Well, the positioning of the portfolio, as I said, is very much biased towards stable to high rates. I think the Fed is going to go in June. The current Fed funds futures is pricing 70% depending on the second you happen to look at the screen. And I think you will probably get at least one more hike after that.

Everything in the economy seems to be sound and strong. And inflation appears to be increasing. So I think they are going to continue to go through their process of normalization. I think the market is a little overly focused on what Trump is able to achieve, the timing of the year doesn't help. First quarter this year was weak, it has been for several years. We will see what happens going forward.

But the fundamentals in our minds tell us that this first quarter is not going to be repeated. This is not indicative of what the underlying strength of the economy is. So I think you continue to see if the Fed goes in June and once more that is three hikes this year. And you will probably get more next year. I think what will determine what happens in 2018 is going to be the extent to which inflation gets above 2%. If it does in a meaningful way then you will definitely probably see three hikes in 2018.

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Hunter Haas, Orchid Island Capital, Inc. - CFO, CIO & Director [10]

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David, this is Hunter. If you happen to have the slide deck in front of you and can go to page 23, you can see that with respect to how we are prepared for coming Fed hikes, we have a very large hedge position skewed towards the first three or four years of -- for the next three or four years. And the vast majority of that is comprised of -- or I guess about over two-thirds of that is comprised of short Eurodollar positions and pay fix swaps.

So to the extent that the Fed goes more than anticipated or even just follows really the path of forward rates, as you can see on -- there is a dotted line that shows what the term structure looks like at the moment. Those hedges will continue to go in the money and help offset our interest expenses in coming quarters.

We do have a little more of a skew towards the long end of the curve than we have traditionally in the hedge book. This is accomplished through shortening TY note futures and also being short at the moment some longer duration mortgage TBAs.

So, those two positions in conjunction with our skew back towards being more long IO than inverse IO in our structure book definitely puts us in a position where if there is a surprise to the upside in inflation we are prepared for it. But for the next one, two, three, four years we do have a considerable amount of protection on the front end of the curve as well.

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David Walrod, JonesTrading - Analyst [11]

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Great, that is very helpful. And then my other question is just in regards to prepays. Can you give us your thoughts on how they are going to trend in the coming quarters?

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [12]

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That is always a tough one because, while we feel fairly comfortable with our view on the Fed, the long end can be driven by a number of other factors. I suspect it is going to be much more time than last year. We have the French election coming up and that seems to be the last hurdle for the ECB to get over in terms of the risk to the economy -- the markets in Europe.

Yesterday, I thought [Droege] was fairly bearish and the underlying data in Europe continues to be fairly sound or evidence of recovery. And that has been -- so to the extent that Europe continues to recover and we start looking towards a tapering of ECB purchases, I think that is important. Because what drove rates on the long end down in the US for a long time was the relative yield difference between European sovereigns and treasuries.

And so between the Fed buying treasuries and investors buying them because they were such high yields relative to what was available in Europe, they really were suppressed and couldn't really respond in a meaningful way to economic data. To the extent that source of demand is removed both in the case of the Fed and investors overseas because of the yield gap between European and US spreads are lower, that would imply that the long rates could go higher. And of course to the extent they do that is going to keep speeds lower.

So, we view those developments will be positive. Obviously event risk, geopolitical risk, escalation of what is going on with respect to North Korea would cause a flight to quality and lower rates. Let's hope we don't see that for a number of reasons. But the backdrop I think is favorable for rates to stay here or creep higher.

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Hunter Haas, Orchid Island Capital, Inc. - CFO, CIO & Director [13]

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Yes. I would just add to just -- more locally I guess, our earnings were really impacted by the speeds we saw in the fourth quarter and we are going to witness a -- and have, a market -- a mortgage market that has considerably slower speeds than what we saw. Those even creep really into January.

So, absent that negative influence and sort of fully being into the plus 2% 10-year treasury to even [2.30%, 2.40%], as we have witnessed over the course of this year so far, that is a dramatically different rate environment and a dramatically different speed environment.

And I think you can see that starting to show up in our numbers like our premium loss due to amortization, which is sort of an important theme I guess with respect to the earnings power of our portfolio, because it didn't look all that great in the fourth quarter when we were seeing a lot of pressure on our amortization or our income via amortization. And that headwind has really come off pretty strongly in the first few months of the year, in particular in February and March.

And so, we may see a slight uptick as rates bounce around or as we go into the -- sort of the seasonally high turnover portion of the year, which is summertime when people move. But we think that our earnings power is much more in line with our dividend pay rate now than it was at the end of the fourth quarter.

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David Walrod, JonesTrading - Analyst [14]

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Okay, great. Thanks a lot, guys.

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Operator [15]

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[Andre Zerona], [Say Capital].

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Andre Zerona, Say Capital - Analyst [16]

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A quick question just going back to some boring accounting and mark-to-market fair value thing. I guess the other way that sort of flows through is through the balance sheet. And that seems like it has ticked up leverage quite a bit where we are close to 9 times now.

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [17]

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Right.

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Andre Zerona, Say Capital - Analyst [18]

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How -- what leverage are you comfortable taking on to maintain the dividend?

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [19]

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Well that -- thanks for that question and thanks for asking a question generally. We are definitely at the higher end of the range in the low 9's. Our leverages probably range from the mid to low 6's at the extreme low to this low to mid 9's.

As I mentioned, the reason we do feel a little comfortable as we made a few changes to the composition of the portfolio. One, as Hunter mentioned, we changed the composition of our TBA shorts from a mix of low and high coupons to exclusively lower coupons. So, in this case it is Fannie 3's long duration hedge.

We have also added to our Eurodollar and swap hedges. And then we have also added these IOs that we talked about which have what we call extension potential in other words. These are IOs backed by collateral that is typically paid very, very fast. It is jumbo collateral. So when these borrowers are in the money they tend to prepay very, very fast. And when they are out of the money they prepay very slow, very binary if you will.

And so, with the backup -- or any backup in rates those prepayment speeds can drop precipitously and those IOs perform extremely well. So we basically enhanced, if you will, the hedges to allow us to get more comfortable with that leverage level.

To the extent that we do get, for instance, a meaningful sell off and those hedges work, at some point we say, look, we view going forward maybe the balance is more -- risk is a little more balanced and we don't need as much uprate protection in which case we could take some of that off. But we definitely -- we're cognizant of the points you just raised and we did take these steps in advance of allowing the leverage to creep higher.

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Hunter Haas, Orchid Island Capital, Inc. - CFO, CIO & Director [20]

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Just sort of ballpark numbers the way we think about it is we are -- Bob I think mentioned earlier in the call that we were short roughly 250 million Fannie 3's in the TBA [form]. We feel like this takes off a little bit more than one turn of leverage without adding a lot of risk.

So the trades that we are putting on that go against these shorts, and there is a little bit of curve exposure in that we are buying some higher coupon stuff and we are shorting the Fannie 3's. But we are buying very low payup bonds that we expect to carry well for a few months versus those trades.

So it is really just a little bit of an earnings boost that we put on in this trade. And to the extent that we get a selloff it helps us with our hedges and it also helps with current carry.

But I think we put in our last dividend press release what we called an effective leverage ratio where we sort of backed out the effect of TBA shorts from the balance of the portfolio or the balance of our liabilities I should say. So that is just something to be cognizant of, I am not saying that it is not added risk, but it is a much different form of risk.

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Andre Zerona, Say Capital - Analyst [21]

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Got it. So the headline number is a little bit higher than you would like, but there are some things in there that you think count against leverage but don't flow through the financials?

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Hunter Haas, Orchid Island Capital, Inc. - CFO, CIO & Director [22]

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Correct.

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [23]

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Yes.

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Hunter Haas, Orchid Island Capital, Inc. - CFO, CIO & Director [24]

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TBA shorts don't reduce the liability balance.

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [25]

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Right.

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Andre Zerona, Say Capital - Analyst [26]

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Right, right, right. Great, thank you.

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Operator [27]

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Thank you. And that concludes our Q&A session for today. I would like to turn the call back over to Robert Cauley for any further remarks.

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Robert Cauley, Orchid Island Capital, Inc. - Chairman, President & CEO [28]

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Thank you, operator. To the extent anybody comes up with a question after the call that they didn't think of now, please give us a call. Or to the extent you capture the call on a recorded version versus live, feel free to call us. Our number here at the office is 772-231-1400. We will be available and very willing to take any and all questions. Other than that we look forward to talking to you next quarter. Thank you.

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Operator [29]

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Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone have a great day.