ARMOUR Residential REIT, Inc.

Greetings, everyone, and welcome to the Armour Residential REIT Inc. Third Quarter 2020 Earnings Call. During today's presentation, all participant lines will remain in a listen-only mode. Afterwards, we will conduct a question and answer session with instructions to follow. If at any time during today's briefing you need to reach an operator, please press star zero on your telephone. Please note as well, today's conference is being recorded Thursday, October 22nd, 2020. It is now with pleasure that I turn today's presentation over to Mr. Jim Mountain, Chief Financial Officer. Please go ahead, sir.

Thank you, Bridget, and thank you all for joining our call to discuss ARMR's third quarter 2020 results. This morning, as usual, I am joined by Armour's co-CEOs, Scott Ulm and Jeff Zimmer, and by our CIO, Mark Gruber. By now, everyone has access to Armour's earnings release and Form 10-Q, which can be found on Armour's website, www.armourrete.com. This conference call may contain statements that are not mere recitations of historical fact and, therefore, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the safe harbor protections provided by the Reform Act. Actual outcomes and results could differ materially from the outcomes and results expressed or implied by the forward-looking statements due to the impact of many factors beyond the control of armor. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of Armour's periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov. All forward-looking statements included in this conference call are made only as of today's date and are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless we're required to do so by law. Also, our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to our most comparable GAAP measure is included in our earnings release, which can be found on Armour's website. An online replay of this conference call will be available on our website shortly and will continue for one year. Quarter end book value for Armour was $11.74 per common share, up 63 cents from Q2 2020. Armour's Q3 comprehensive income was $61.9 million, or 91 cents per common share, and that includes $58.4 million worth of GAAP net income. Core income, on the other hand, was $25.4 million, or 35 cents per common share. Core income includes TVA drop income and excludes market value adjustments. A complete definition and reconciliation showing how we compute core income is included in yesterday's press release. Core income for the quarter represents an annualized return on equity of 12.6% based on per share book value at the beginning of the quarter. Armour's portfolio consists exclusively of agency MBS totaling over $5.5 billion. Since the beginning of Q2, we have continued to designate any agency MBS purchased as trading securities, and the fair value changes for these investments are reported in net income. Commencing with the second quarter of 2020 and continuing until further notice, the company's external manager is waiving 40% of its management fee. This waiver offset $2.95 million of operating expenses in the quarter. Armour paid dividends of 10 cents per common share for each month in the third quarter. We've also declared October and November common dividends continuing at that rate of 10 cents per common share. And the Series C preferred stock dividends for Q4 2020 at their contractual rate of .14583 dollars per share. Now let me turn the call over to our Co-Chief Executive Officer, Scott Ulm, to discuss Armour's portfolio position in further detail and give us an insight on our current strategy.

Thanks, Jim. The quarter of 2020 saw a return to calmer conditions across the mortgage market and dramatically improved sentiment. The Federal Reserve flooded the market with funding in agency and treasury markets, and their outright purchases helped drive the bond market's recovery and stabilization. We completed the previously announced strategic transition of our investment portfolio to solely agency mortgage-backed securities issued or guaranteed by U.S. government-sponsored enterprises, treasury securities, and cash. With Armour's common equity closing at $9.43 yesterday, a 20% discount to the third quarter ending book value, the current yield on the common is 12.7%. Our core income for common share of 35 cents, was 16.7% higher than the $0.30 in dividends we paid in the quarter. The Federal Reserve's large footprint in the agency MBS market continued to be a major factor in MBS performance during the third quarter, driving OAS tighter, volatility lower, and greatly improving liquidity. The Fed purchased about $330 billion of agency MBS throughout the third quarter, absorbing almost the entirety of new net agency MBS supply. Falling treasury yields and tightening mortgage spreads drove primary mortgage rates to all-time lows during the quarter. Armour continued its strategy of focusing its investments on prepaid protected, lower coupon mortgage passers to protect its MBS portfolio from the expected refinance wave triggered by these ultra-low rates. In addition to stable income, these specified stories delivered considerable results in book value appreciation for the quarter. As of September 30th, Armour held 94% of its MBS portfolio in securities with favorable prepayment protection characteristics. These include 58% in bonds with loan balances less than or equal to $225,000, 22% in agency CMBS with lockouts and prepayment penalties, 11% in bonds with loan-to-value ratios greater than 95%, FICO scores less than 700, and or seasoning of greater than 24 months. and 4% in bonds with 100% of the loans in states that have additional taxes on refinancing and cash-out transactions, such as Texas, Florida, and New York. We saw a strong dollar roll performance in the production coupons where the Fed's purchases matched new supply throughout the quarter. We expect dollar rolls to continue to yield double-digit returns over the medium-term horizon. Armour's duration as of the end of the third quarter was 0.86%. We're comfortable with the portfolio's interest rate risk in both up and down rate scenarios. Our portfolio's convexity profile is significantly more favorable than that of newly issued MBS. We manage our net duration gap within a tight range dictated by our team's outlook on the rates mark. It should be noted the significant portion of the portfolio's duration is in the key rate buckets inside of 3.5 years, where we expect yields to be pegged close to zero for the foreseeable future. Our exposure to the long end of the curve is considerably less than our overall duration. While our third quarter ending debt to equity was approximately five times, we maintained our all-in leverage, which includes the implied leverage of dollar rolls, between 7.5 and eight times throughout the quarter. This provides us with ample dry powder should new investment opportunities arise. We expect this leverage range to persist at least through the fall, absent some attractive opportunities arising. The repo market continues its benign course with financing costs that are at all-time lows with little to no term premium for longer-dated repo. Ample year-end funding, as we see it today, reinforces that. Our broker-dealer affiliate, Buckler Securities, continues to provide us with attractive terms and, perhaps more importantly, reliable financing. Our earnings outlook remains constructive despite the rich reinvestment market in cash securities with attractive convexity characteristics. As noted, the high returns available in the TBA market are very attractive, but will remain a distinctly smaller portion of our portfolio than specified pool cash securities. Based on these investment opportunities, we believe that our core earnings will cover our dividend in the fourth quarter. While third quarter 2020 marked a bright spot in a bleak year, Armour continues to monitor and plan for what's ahead. The Fed's statements suggest a strong commitment to lower rates in the medium term and continued support for the mortgage-backed securities market. Over the longer term, the timeline and future sizing for the Fed's QE program remains in question, as does the shorter-term uncertainty surrounding next month's elections. Pre-payment speeds have stabilized but remain elevated as lenders continue to streamline their technology and grow staff to capture the refinancing business. We believe our portfolio is balanced considering these uncertainties. It's an excellent convexity profile right amount of exposure to QE buying, and enough dry powder to take advantage of opportunities ahead. Operator, we'll now take any questions.

Thank you very much. As a reminder to register questions or comments, please press 1-4 on your telephone. Our first question comes from the line of Douglas Harder of Credit Suisse. Please proceed with your question.

Hey, guys. This is Josh Bolton on for Doug. Good morning. Appreciate the comments, Scott, about leverage. From the fourth quarter update you gave, it looks like leverage was up a little bit from the end of the third quarter. Is that intentional or is that, you know, just the result of book value moving around? And I guess how are you thinking about target leverage going forwards and specifically what would you have to see to take that level either up or down? Thanks.

Jeff Zimmer here. So, our leverage is exactly where we want it to be. We recently settled some forward purchases, which had the leverage slightly tick up. Book value today is actually almost unchanged since the end of the quarter. So, the leverage has not changed because of book value moving around. And matter of fact, the number we published yesterday is actually up a little bit since then. The opportunities in the marketplace And we talk about this in our morning meetings, so this is kind of important. So they're bifurcated right now, right? Zero volatility OAS on Fannie 2s is like 65. Zero volatility OAS on Fannie 3s where the Fed is not buying anything are up to 93. So when Scott in his comments talked about keeping powder dry for buying opportunities, you start seeing some on-the-run stuff or TBA, non-TBA stuff where the payoffs come off a little bit, perhaps in a steepener, you could see that leverage pop up from 8 to 8.5 to 8.75, but only because we see good opportunities. Otherwise, our target leverage will stay in the range that it is right now. And as you could see from the monthly company update that we published last night, we continue, as Scott also said in his comments, with the barbell strategy, meaning we're We bought a lot of specs at low pay-ups in early, mid-April. A number of those are up two times or even more from what we paid for them. And we offset that with about 27% of our portfolio in the TBA market, whereas he also said we're seeing returns in mid-teens to even low 20s. So I hope that addresses your question.

Yes. Thanks, Jeff, for those comments. And I guess my second question is, Last quarter you talked on the call about the percentage of repos through Buckler securities longer term getting closer to 50% down from what it is. Just curious if that's still a goal or if there's any update. I know it's running higher than that today, but any comments you can give about the Buckler broker deal? Thanks.

Yeah, Josh, you know, Buckler – We're running a little above the proportion we did over the last few years, mostly because there's a little unutilized capital at Buckler, and we wanted to make sure it was working. I would expect that percentage may drift down a bit, but I think it's still at a reasonable amount. Basically, determined to keep a balance of being able to utilize the advantages we get from Buckler while at the same time staying active with the you know, 17 other counterparties that we're operating with. You know, our execution at Buckler is on the screws with what we're seeing elsewhere, and we get better terms, you know, principally in haircut and, you know, the ability to access some different types of financing there. So, you know, that's a little higher than we have been for the last few years. You know, it's there just because, you know, Buckler has had some capital that we want to make sure we're using.

Awesome. Thanks for the comments, guys.

Our next question comes from the line of Trevor Cranston of JMP Securities. Please proceed with your question.

Hey, thanks. Good morning. You had mentioned a couple times the return opportunity that's available within the TBA market being quite attractive. Can you say where you're seeing returns in specified pools compared to TBAs? And, you know, also as part of that, can you maybe talk about, you know, how much larger you'd be willing to take the TBA position as a percentage of the overall portfolio going forward? Thanks.

Hey, Trevor, glad to have you dial in. So we can see returns as low as 4% in some of the specified pools. That's how high these prices have gone. which we haven't purchased anything like that. But there are returns also in low double digits, so just exceeding 10% to 11.5%. Now, that would imply an eight times leverage and a duration between 0.5 and where we are right now. You increase that leverage to where others in the sector have done, which would be 9% to 9.5%. Those numbers go up proportionally from there. And so what we were discussing earlier, just to repeat on the leverage, we get spreads to widen or pay-ups to come down. We will use the opportunity to go ahead and make some additional investments in the space, but that is not the case today. So we'll keep that target, leverage where it is right now, and let opportunities go. And I said we could be up to 8.5 to 8.75, but only if great opportunities arise. As Scott said in his comments, as it is right now, we estimate that our core income is will equal or exceed the dividends for the fourth quarter. Okay. Gotcha. That's helpful.

And then on the multifamily portion of the portfolio, you know, spreads have obviously recovered pretty well in that sector. You know, in light of that recovery, how are you guys thinking about that part of the book? Is it something that you still see value in holding as sort of a prepaid diversification or, you know, given that spreads have recovered so much, is it something you'd, you know, potentially look to partially sell and reallocate to the agency RMBS market?

So if you go look at monthly updates, you know, month by month, you can see the positions come down a little bit. It's currently on the information we published last night, 1.19%. billion and you know we did sell some over the last 60 days to take advantage of really tight spreads but if you refer to page four on that publication you can see that the weighted average net coupon is 369 and the estimated effective duration is seven which means that you know most of those are going to have a maturity north of seven and a half to up to like nine years from now great convexity paper earning a lot for our shareholders So we would very selectively be selling in that asset class in the near future. It has no extension risk. Market rallies, they'll go up in price. It's paying our shareholders a large dividend. They finance equally to specified in TBA market. And once again, there is just an insatiable demand for banks for that asset class, and I don't see that going away. So the answer is we probably won't sell a lot, but occasionally we see opportunities to sell. And I would also note, one of the reasons we sold, we wanted to make sure we cleaned ourselves out of any potential assets in that asset class that might be subject to forbearance or bankruptcy or some of the negative factors that have occurred since COVID. We believe we've done a really good job of that so far, and so that protects the premium in that asset class. Okay, got it. Appreciate the comments.

Thank you. Thanks for calling in.

And again, as a reminder to register questions or comments, please press 1-4 on your telephone. Our next question comes from the line of Christopher Nolan of Leidenberg, Salmon, and Co. Please proceed with your question.

Hey, guys. Good quarter. Given the EPS guidance to cover the dividend in the fourth quarter, It seems like your core ROE is going to be at the higher end of your guidance, which was high single digit to low double digits, at least in the fourth quarter. I guess my question is, should the core ROE guidance be low double digits to mid double digits going forward, or are you going to keep it the way it is?

So if you have the publication that I just referred to a minute ago that we put out last night, if you go to page six, the monthly portfolio CPR, you can see that the October CPR was up 11% over the average of Q3. Now, we expect CPRs for our portfolio to remain relatively flat over the next two months, November and December, from that up 11% level. As a result of higher prepays, you would expect the core earnings to be off modestly from what they were in Q3. That doesn't mean they will be, but our expectations to be a little lower, but yet to cover certainly our dividend. So the change in earnings based on the reinvestment opportunity is really two different things to look at. With the great convexity and the low amount of actual dollar prepays that we have that month, each month our exposure to reinvestment risk is quite limited, well under $100 million a month. So is that helpful in your analysis?

Yeah, no, very, and good point you made. On a different topic, any thoughts on buybacks given where your stock is trading?

So we are always looking at buybacks. As we discussed on the last two earnings calls, There are times where you really need to protect your capital, and that benefits shareholders greatly. And then there are times when, hey, we're trading at a really cheap level, and it's a creative to book value to go ahead and buy. We haven't executed that second step yet, but it's clearly out there if we want to and need to. We're still watching capital. Let's get through the election. Let's see if any buying opportunities happen. For example, you get OASs to widen out here, and you get a steepener in the curve. we might be earning so much more money taking leverage up from, you know, eight to eight and a half or eight and three quarters that might benefit shareholders more than doing a buyback. But, however, those are the things that we look at every day. And, obviously, we just had our board meeting, you know, in order to go ahead and publish our queue. And these are things that are discussed at all levels of the corporation. So I hope that addresses your question.

Great. Thanks, Jeff.

And there don't appear to be any further questions in the queue. As a final reminder to register questions, please press 1-4. And there are no further questions at this time. I'll now turn the call back to you. Please continue.

Thank you for your help, Bridget. And to all our friends in the analyst community, thank you for joining us this morning. We very much appreciate your time and interest in Armour. And as always, You know where we live, so if there are any questions that come up between these calls, feel free to reach out. Give us a call, send us an email, and we'll try and get back to you before the sun sets if we can. And until next time, stay safe.

And that does conclude today's presentation. We do thank you for your participation and ask that you please disconnect your lines. Have a great rest of the day, everyone.