Q3 2023 Cherry Hill Mortgage Investment Corp Earnings Call
Participants
Garrett Edson; IR; ICR
Jay Lown; President & CEO; Cherry Hill Mortgage Investment Corporation
Julian Evans; Chief Investment Officer; Cherry Hill Mortgage Investment Corporation
Michael Hutchby; CFO; Cherry Hill Mortgage Investment Corporation
Mikhail Goberman; Analyst; Citizens JMP Securities, LLC
Matt Howlett; Analyst; B. Riley Securities, Inc.
Presentation
Operator
Good day, and thank you for standing by, and welcome to the Cherry Hill Mortgage Investment Corporation third-quarter 2023 earnings call. (Operator Instructions) Please be advised that today's conference is being recorded.
I would now like to hand the conference over to your speaker today, Garrett Edson with Investor Relations. Please go ahead.
Garrett Edson
We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's third-quarter 2023 conference call. In addition to this call, we have filed a press release that was distributed earlier this afternoon and posted to the Investor Relations section of our website at www.chmireit.com.
On today's call, management's prepared remarks and answers to your questions may contain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ from those discussed today. Examples of forward-looking statements include those related to interest income, financial guidance, IRRs, future expected cash flows as well as prepayment and recapture rates, delinquencies and non-GAAP financial measures such as earnings available for distribution or EAD, and comprehensive income.
Forward-looking statements represent management's current estimates and Cherry Hill assumes no obligation to update any forward-looking statements in the future. We encourage listeners to review the more detailed discussions related to these forward-looking statements contained in the company's filings with the SEC and the definitions contained in the financial presentations available on the company's website.
Today's conference call is hosted by Jay Lown, President and CEO; Julian Evans, the Chief Investment Officer; and Michael Hutchby, Chief Financial Officer. Now I will turn the call over to Jay.
Jay Lown
Thanks, Garrett, and welcome to our third-quarter 2023 earnings call. While the third quarter initially seemed as if we were headed to a soft landing and an end of the REIT hike cycle, hotter-than-expected inflation and an overheated economy led to a significant rise in the 10-year treasury to nearly 4.6% as it became clear that higher for longer was likely going to persist for some time. Along with the rise in the 10-year, Agency mortgage spreads widened considerably during the quarter.
While Agency REITs have been feeling the pain of the spread widening for the past few months, given our capital structure, we proactively positioned our portfolio to mitigate the spread widening by hedging out a portion of our basis risk in our RMBS portfolio with TBAs. We believe this positioning, along with our portfolio of MSRs, worked to our shareholders' advantage in the quarter as we successfully preserved the vast majority of our shareholder equity. We have maintained this positioning through October given the elevated volatility as markets digested macroeconomic data globally and reacted to the events in the Middle East.
The 10-year crossed the 5% threshold at one point in October, and mortgage spreads have widened further, as others have noted. In these volatile and turbulent times, we believe that it remains prudent to minimize our exposure to mortgage basis risk and the potential for any additional widening, such as what we have seen impacting much of the REIT space over the past few months. As a result, we believe we remain positioned well to take advantage of select RMBS opportunities that offer attractive risk-adjusted returns and that the overall strategy of pairing MSR with Agency RMBS remains the proper strategy for the current environment.
For the third quarter, we generated a GAAP net gain applicable to common stockholders of $0.49 per diluted share, and we generated earnings available for distribution or EAD, a non-GAAP financial measure, of [$4.4 million] or $0.16 per share, which exceeded our quarterly distribution. As we've noted before, EAD is only one of several factors considered in setting our dividend policy. Additionally, factors such as the existing market environment and portfolio return potential, our level of taxable income, including hedge gain impacts, and the degree of certainty regarding forward investment return economics all contribute to determining what we believe is the appropriate dividend level.
Book value per common share finished at $4.99 as of September 30, down 3.9% from June 30. On an NAV basis, which includes preferred stock in the calculation, we were down 1.9% relative to June 30. As we've previously noted, our existing mix of common to preferred equity amplifies the impacts of changes in our total equity or common book value. Creating a more stable equity profile is in our shareholders' best interest and remains a top priority for us.
During the third quarter, we remained firm on our MSR portfolio as we believe Agency RMBS continues to present a better return profile in the current environment. Prepayment speeds on our MSR portfolio remain low and thus the pace of reinvestment required to maintain the allocation of capital to the asset class is low.
Recapture rates on MSR remain minimal given the higher interest rate levels. Our portfolio of MSRs weighted average note rate of approximately 3.5% provides us with plenty of room to weather potential rate cuts down the road before impacting our prepay speeds in a meaningful manner.
At the end of the quarter, financial leverage again stayed consistent at 4.4 times as we opportunistically deployed additional capital during the quarter, while remaining prudently levered as the volatile market dynamics persist. We ended the quarter with $45 million of unrestricted cash on the balance sheet, maintaining a solid liquidity profile.
Looking ahead, we maintain a concerted focus on risk management to reduce our exposure to mortgage spreads in the near term, which we believe is the prudent approach in the current environment. We will continue to selectively deploy capital into additional agency MBS, which currently presents a strong risk-adjusted return profile while awaiting signs of market stabilization and lessening volatility. Our priority remains to protect book value, and we remain mindful of our liquidity and leverage profile.
With that, I'll turn the call over to Julian, who will cover more details regarding our investment portfolio and its performance over the third quarter.
Julian Evans
Thank you, Jay. The third quarter commenced with expectations that the Fed rate hiking cycle was nearing completion. However, persistent inflation, hotter US economy than expected, and hawkish Fed commentary led not only to unexpected 25 basis point rate hike increase in September but also the renewed sentiment that higher for longer would be for much longer than investors initially expected.
Those factors coupled with continued increased treasury issuance because of a rising budget deficit put additional pressure on interest rates. These things led to the 10-year spiking during the quarter and also led to significant mortgage spread widening. The poor sentiment has extended into October along with major geopolitical turmoil injecting additional volatility into the market.
During the quarter, we positioned our portfolio to minimize current spread widening and the potential for additional spread widening by hedging our RMBS portfolio with TBAs. In the near term, that decision has paid off for our portfolio. In October, we believe our investment strategy of hedging our risk and reducing our exposure to mortgages remains in our best interest until there's a clear picture of stabilization.
At quarter end, our MSR portfolio had a UPB of $20.3 billion and a market value of approximately $266 million. The MSR-related net assets represented approximately 45% of our equity capital and approximately 31% of our investable assets excluding cash at quarter-end. Meanwhile, RMBS portfolio accounted for approximately 41% of our equity capital. As a percentage of investable assets, the RMBS portfolio represented approximately 69% excluding cash at quarter end.
During the quarter, prepayment speeds for our RMBS and MSR portfolios did not shift a great deal from the prior quarter given the continued elevated rate environment. Our MSR portfolio's net CPR averaged approximately 5.6% for the third quarter, modestly down from 6.2% at CPR in the previous quarter. The portfolio's recapture rate remained consistent but low at approximately 1% as the incentive to refinance continues to be minimal. Moving forward, we continue to expect low recapture rates and a stable net CPR for the foreseeable future given the current levels of interest and mortgage rates.
The RMBS portfolio's prepayment speeds remain low as expected, driven by the combination of new asset purchases as well as the fact that the current higher mortgage rate environment is compressing CPRs for the existing portfolio. As of today, the majority of the mortgage universe remains out of the money in terms of refinancing, we would expect prepayments to remain at low levels if interest rates remain at these levels or move higher.
For the quarter, the RMBS portfolio's weighted average three-month CPR moved slightly higher to approximately 4.4% compared to approximately 4.2% in the second quarter. As of September 30, the RMBS portfolio, inclusive of TBAs, stood at approximately $583 million compared to $602 million at the previous quarter end.
Quarter-over-quarter, we shifted the composition of our portfolio as we moved up in coupon, taking advantage of higher yielding assets. As we position the portfolio in higher coupon mortgages, we also continue to maintain TBA hedges in the portfolio, especially in lower coupon mortgages.
For the third quarter, our RMBS net interest spread was 3.6%. The decrease from the prior quarter was driven by higher repo and larger net interest expense, which were partially offset by higher asset yields resulting from new purchases as well as a change in the portfolio's coupon composition. At quarter end, the portfolio's financial leverage remained at approximately 4.4 times, and the 30-year securities position continue to represent 100% of the RMBS portfolio.
Looking forward, we remain mindful of the ongoing challenging environment and continue to expect to minimize our exposure to mortgage spreads in the near term until there are clear signs of stabilization.
I will now turn the call over to Mike for a third-quarter financial discussion.
Michael Hutchby
Thank you, Julian. Our GAAP net income applicable to common stockholders for the third quarter was $13.1 million or $0.49 per weighted average diluted share outstanding during the quarter while comprehensive loss attributable to common stockholders, which includes the mark-to-market of our available for sale RMBS, was $1.1 million or $0.04 per weighted average diluted share. Our earnings available for distribution attributable to common stockholders was $4.4 million or $0.16 per share. Our book value per common share as of September 30 was $4.99 compared to a book value of $5.19 as of June 30.
We use a variety of derivative instruments to mitigate the effects of increases in interest rates on a portion of our future repurchase borrowings. At the end of the third quarter, we held interest rate swaps, TBAs and treasury futures, all of which had a combined notional of approximately $791 million. You can see more details with respect to our hedging strategy in our 10-Q as well as in our third-quarter presentation. For GAAP purposes, we've not elected to apply hedge accounting for our interest rate derivatives, and as a result, we record the change in estimated fair value as a component of the net gain or loss on interest rate derivatives.
Our operating expenses were $3.4 million for the quarter. On September 14, our Board of Directors declared a dividend of $0.15 per common share for the third quarter of 2023, which was paid in cash on October 31, 2023. We also declared a dividend of $0.5125 per share on our 8.2% Series A cumulative redeemable preferred stock and a dividend of $0.515625 on our 8.25% Series B fixed-to-floating cumulative redeemable preferred stock, both of which were paid on October 16, 2023.
At this time, we will open up the call for questions. Operator?
Question and Answer Session
Operator
(Operator Instructions)
Mikhail Goberman, JMP Securities.
Mikhail Goberman
Hey, good evening, gentlemen. Congrats on the very, very strong quarter book value preservation and stability in the EAD.
I guess the question I have right off the top of my head is perhaps if you guys could flesh out the trade-off between MSRs and agency MBS going forward, if we were to get a pretty strong bond rally -- assuming a good bond rally for the next couple of months into the end of the year, how do you guys see that trade-off in terms of capital allocation? Thanks.
Julian Evans
Hi, Mikhail. It's Julian. Currently, we find RMBS to be more attractive than MSR. We have been adding additional dollars into RMBS. We've just chosen to hedge those additional dollars with buying a spec pool and hedging it with TBA on the side -- so kind of just taking out some of the duration curve.
As for the extended bond rally, I think it all depends on why we are rallying, because we obviously know that the mortgage basis spread is on the wider side. But if we're rallying in these markets because there's some geopolitical turmoil or there's a flight to quality, I wouldn't expect mortgage spreads to really tighten in that type of market. If anything, volatility probably picks up, and that will offset any on spread gains that you might be seeing in RMBS.
If we're rallying because there's stabilization by the Fed, which we've seen over the last couple of days and volatility has come down, which is typical after a Fed meeting, we would expect the basis to outperform. I don't think that our gains would be as much as our competitors because of the way we're currently hedging the portfolio. But we also have the opportunity to remove some of those hedges and thus would increase our overall leverage in the portfolio and have some additional gains via that.
Jay Lown
So I'll add one thing and a lot of what I'm going to say is revolving around financing costs. So on top of the yields, the financing cost for each asset class matters as well. So we think about the levered return on each of the assets as it relates to the risk return profile. So one of the things that has obviously creeped up is the cost to finance the MSR.
And so when we think about the MSR, one of the things that factored into it is the cost to lever it and sale. As Julian pointed out, at least sitting here today, RMBS has over the last few months -- sort of six months or so have been a better return profile.
Mikhail Goberman
Got it. Thank you, guys. Appreciate that. And if I may potentially get an update on book value one month into the quarter?
Michael Hutchby
Sure. We see our October 31 book value per share down approximately 5% from quarter end, and that is prior to any fourth-quarter common dividend accrual has not yet been approved by the Board.
Mikhail Goberman
Great. Thank you for that. And good luck going forward, guys.
Jay Lown
Thanks.
Michael Hutchby
Thank you.
Operator
(Operator Instructions) Matt Howlett, B. Riley.
Matt Howlett
Hey, guys. Thanks for taking my question. A remarkable quarter, really. The hedging really paid off and it shows.
My question is on you covering -- you covered the dividend. You've got the hedges in place. Seems like the prudent thing to do. Is -- you're in as well bill for distribution. Is that going to be a function primarily? If so, where do you want to take leverage? How much risk you want to -- if you want to kind of take some hedges off like you said, what's going to drive that EAD or the core income kind of going forward from here? Seems like you got the -- it's de-risked as possible, the portfolio.
Julian Evans
Hi, Matt. It's Julian. So in terms of -- let's say we want to increase some additional EAD, we've obviously said that we can take off some hedges and obviously increase our leverage. I think we've also tried to shift the portfolio around in terms of moving to higher-yielding assets into the portfolio. We did have a -- each quarter, I would say, as rates have risen here, you almost hit them playing a little bit of catch up with your repo cost having -- moving higher and your assets kind of on the lower end. And we constantly try to make some adjustments for that in the portfolio.
So I think those are kind of some of the primary drivers that we have. We're changing around the composition of the portfolio as we assess the REIT market and volatility as well as the Fed -- and in addition to that, we do have the option of pulling off some of our leverage components at this time.
Matt Howlett
How much do you -- Julian, how much are you willing to move up coupon? I mean, what was the risk-reward of -- you hear some guys that want to do -- the belly of the curve, some want to be higher in the curve. Where do you guys stand right now to where you want to be?
Julian Evans
Yeah, it's interesting from that perspective. Look, I think long term -- and let's say -- I would define maybe a year from now -- six months to a year from now, I think if the economy is slowing down and the Fed is truly on hold and rates are moving lower, I do think that you want to have lower coupons in your portfolio via --maybe it's a combination of 3.5s and 4s in the portfolio.
If we remain at some of these higher levels, obviously the higher coupons yield you a little bit more in the portfolio but you're also, in the back of your mind, kind of concerned about prepayment speeds. Up until the last couple of days -- if you take the last 36 hours, 6.5s were trading at a discount. They're now trading slightly above par -- call it at par at 20.
I think that's not a bad place to say that the high of the coupons that I'm willing to kind of take on. Because I do believe at some point in time, this market will become refinanceable for some of the higher coupons, let's say, 7 and 7.5. I think there the servicers have teed up those borrowers that at some point when rates move to an attractive level, even if it's 25 to 50 basis points advantage, they will be refinancing them.
We've tried to stay around in terms of when we're adding additional securities in this portfolio at a slight discount, call it $98 price, $96 price up to par. So lately, we haven't purchased anything that's been above par, but you feel like you're getting a pretty decent amount of coupon income from a long-term perspective.
Matt Howlett
Makes total sense. I think the same way you guys -- you are thinking. I think the portfolio is very well-positioned.
A last question, I guess, just on -- like you say, you're seeing more relative value in the RMBS. Is there a catalyst for the basis to tighten? On the money man -- and what will drive it? Would you care? Would you rather just have these widespreads and just say, listen, we want to reinvest in this or you want to take advantage of your book -- the materially higher book value you would experience if the basis does tighten on MBS?
And just, Jay, you've been through a lot of cycles that. You can in a lot of ways make a lot of money here the next cycle. How do you feel? Is it going to be just the MBS basis tightens or is it going to be the sensitive part of the curve starts to go down; you guys can take leverage up? Just want to hear how you see the next year playing out.
Jay Lown
Sure, Matt. It's a topic of regular debate here and to your point, cycles matter. And if you pay attention to only the periods where the Fed was a major participant in the space and kept spreads tight, then you might have a view that spreads are materially wide relative to historical levels. But once you introduce history going back further than the financial crisis in 2008, you see a slightly different picture, which suggests that maybe they're slightly wide relative to historic levels.
So I think what we're trying to do here is, over time get a better picture of what spreads normalize, would look like in an environment where the Fed is not an active participant in the space, and how tight those spreads should get relative to the relative value in the space. And because, quite honestly, we don't have the perfect answer to that, we have chosen to one, hedge a fair amount of that out with TBA to protect ourselves from the volatility in the space today; and two, the cost to hedge with TBAs today is not prohibited. So we have decided to take that approach as well.
Should any of those catalysts change, although we have a more definitive view on the direction of rates and the level of volatility, I would expect us to make changes to our hedge strategy. Did that help?
Matt Howlett
Look, the quarter you put up here, no one's -- it's just terrific what you're able to do in light of all of the volatility, and that's really good. It seems like you guys are very conservatively positioned, and you'll rotate at the portfolio as you see opportunities. So that said, let's look forward to hopefully the next leg in the cycle and that you guys are having great returns for shareholders. So I really appreciate Jay and the team.
Operator
And I'm showing no further questions at this time. I would like to turn the conference back to Jay for closing remarks.
Jay Lown
Thank you, everyone, for joining us on our third-quarter conference call. We look forward to updating you on our quarter earnings call next year. Have a good evening.
Operator
This concludes today's conference call. Thank you for participating. You may now disconnect.
