Orchid Island Capital, Inc.

Hello, good morning, and welcome to the second quarter 2024 earnings conference call of Orchid Island Capital. This call is being recorded today, July 26th of 2024. 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 Security 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 risk 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 a 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 Colley. Please go ahead, sir.

Thank you, operator, and good morning. Hopefully everybody's had a chance to download our slide deck. As usual, I'll be using that for the presentation today. Turning over now just to slide three, just kind of the agenda as usual. We'll go through our financial results, and we'll talk about market developments and how those impacted our results and how we see things going forward. And then we'll dive deeper into the portfolio hedging and funding positions and then a few comments on our outlook for the market and for the portfolio going forward. So on slide five, for the quarter, ORCA generated a net loss of $0.09 per share versus an income of $0.38 in the last quarter. Book value declined approximately 5.9% from $9.12 to $8.58. Book value as of last Friday, I know that most of our peers have mentioned that, is down about 0.9%, so a little under 1%. That has to do primarily with just our hedges, which I'll get into later in the presentation. Total return for the quarter was slightly under negative 2%. and we declared and paid $0.36 in dividends. The portfolio, the average portfolio grew quite substantially from a little under $3.9 billion to $4.2. We have been raising capital in the ATM. The portfolio as we stand today is about $5.1 billion, and repo is about $4.9 billion. Leverage ratio was 7.1 at the end of the quarter unchanged, primarily from the beginning of the quarter. Today, it's a little higher in the mid-7s. Speeds on the portfolio did increase slightly. That's probably due to rates being a little lower and seasoning on the, especially the discount side of the portfolio. Liquidity remains strong, up slightly, and represents a little under 50% of equity. Slide 7 just presents our financials. I won't spend time going through these. Those are just for your review. The income statement and balance sheet as at the end of the second quarter. Slide eight. As we all know, all of our peers publish something they refer to as earnings available for distribution. This is commonly compared to the dividend. We don't publish such a number. This is kind of our proxy. This number is what we call our economic income. It's all derived from GAAP financials. We are taking all of these numbers from our GAAP numbers. You know, the dividend is based on taxable income, not GAAP. So there are some differences. I just want to walk you through just this presentation and kind of highlight where there could be differences between GAAP-derived numbers and tax. So for instance, you know, just walking down the income statement, the interest income number is slightly different for tax, but I think this is a good proxy. There are minor differences in the calculation of interest income on pass-through portfolios and derivatives, but this number should be reasonable. The amortization of discounted premium, that number is the gap number here. That can deviate quite a bit from the taxable number. The main reason is simply the fact that we do this based on changes or paydowns from how that impacted the market value at the beginning of the quarter, whereas for taxes from purchase date And then with rebill funding, of course, that's pretty much identical. And then the hedges, we show the impact of the benefit of the hedges that we have in place, which is quite substantial. There is a slight difference between GAAP and tax in that with tax, you have to take into effect hedge positions that are actually closed to the extent they cover the current period. So, for instance, if you entered into a 10-year swap two years ago and closed it one year ago, the open equity at the time of closing would still impact your interest income for tax purposes over the remaining eight years of that swap. So that can be slightly different and expenses are basically the same. So we're showing this number, this economic income or adjusted income of 50 cents. It is a proxy for what our taxable income, I just want to make sure you understand that they're not necessarily exactly the same. And as you can see, it's been fairly stable for the last three quarters. So that's all I'll say for that for now. Moving on to the market developments, just kind of go through these four slides. The first on slide 10, this is basically just a nutshell what's happened in the economy. If you look back to the end of the first quarter, the inflation and economic data had been quite strong. In fact, we were talking about, you know, rates being higher for longer, even the potential that the Fed had would have to hike again. Second quarter, that all changed. All of the mainstream, all the main key data, inflation, jobs, ISM for April, May, and June were considered to be softer. And especially the inflation data is back consistent with what we saw late last year, which is inflation trending down towards the Fed's 2% target. And now the market views the Fed is likely to be on path to cutting rates later this year. And then just kind of fast forward to where we are now in July. And the big change has been the change in the slope of the curve as the market gets closer to pricing in or pricing eases closer. So now, for instance, 2.10 is a proxy for the shape of the curve. In late June, that was at minus 50 basis points. Earlier this week, it got as low as minus 13. So a big move. It's really hard to discern from these charts if you're looking at the difference between the green and the blue line. But the two-year point on the swap curve has moved over 35 basis points. So a big move. The curve is much deeper. And our view going forward is that that will continue. And it's easy to have a fair amount of conviction in that because there's really two forces that could drive that. On the one hand, obviously, if the Fed eases, you can get the front end of the curve moving down. It's currently anchored. But also on the longer end of the curve, to the extent that we're going to continue to run, for instance, large deficits. There's somewhere in the $5 to $8 trillion of debt that has to be rolled over by the government in the next year and a half. And depending on the outcome of the election, say, for instance, if Trump were to win, he has talked at length about imposing more tariffs, which could be inflationary. So there's a lot of reasons to think that the long end of the curve may not rally as much as the front end. In fact, it could even go higher. So for these reasons, it's easy to gain a fair amount of conviction and a steepener, and that's kind of how we expect the market to unfold. That being said, to the extent that it doesn't, we are positioned to do quite well even with that outcome. Moving on to the mortgage market, this chart on the top I like to talk about. This is just a spread of the 10-year treasury going back very far. It's a good perspective. As you can see, we are still at a fairly elevated level. On this chart, we show as the most current reading of 141 basis points spread to the 10-year. Today, that's closer to the 135, 136. All of that being said, the current coupon mortgage has a duration that's much, much shorter than 10 years. So a more appropriate benchmark for today would probably be the five-year, and that spreads a little under 150. and it hasn't moved as much of late, so it's not tightened as much. So mortgages are still attractive, and we expect going forward that there's room for tightening. The market expects that to the extent we do see Fed easing, we're likely to see the banks become more involved. They have been modestly involved to date, but if they were to become more meaningfully so, that that could be the impetus or the catalyst for some more tightening. I don't know that we're going to go back to the levels we saw pre-pandemic, but it could certainly drive us fairly tighter And again, that's the kind of market's conventional thinking is that the banks would become more involved if we do get easing. Outside of that, money manager inflows have been substantial. I saw some data published by Nomura yesterday that showed something like $7 or $8 billion weekly average to date this year, which is pretty strong. And to the extent that those money managers continue to be overweight mortgages, those are pretty substantial inflows. So they've been supportive. And then of late, We know that REITs have been raising capital and those are kind of on the margin support of the market as well. Looking at the bottom left of the page, you can see the performance of select coupons of mortgages. And you can see early in the second quarter, quite weak performance. April was a rough month. We were still looking at data from March. It was very strong. The market was expecting the Fed to keep rates high for an extended period of time. So mortgages were looking less appealing. And we had a nice recovery into the end of the quarter. Gave up most of that in the last week. which really ended up hurting the returns for the entire quarter, only to turn around in July and kind of rebound, although of late the last week or so, that's turned around again. We're probably close to unchanged if you look back at a 331 reference point. On the next slide, we talked about volatility. Volatility is obviously a very big driver of mortgage performance, and as this chart on the top shows, If you go back to October of 2023, when we were at very high levels, rates and volatility, we've had a nice long rally since, although a light that is starting to pick up. And in particular this week, especially realized volatility has been quite high. And this is just something that we always have to keep an eye on because it is a very big driver of mortgage performance. So for now, we're relatively low levels looking back just a year or so, but starting to go the other way. Slide 13 is kind of our proxy for the housing market and refinancing. And as you can see, as we all know, it's been the same story for quite some time. Mortgage rates are high. That's the red line in the top left. And the blue line is the refinancing index, which is basically zero. But just speaking more generally about the housing market, affordability is very, very low, near record lows. So that impacts a lot of things like turnover. Rates, again, near the high level. Prices are high, which these two combined drive affordability. And now what we're starting to see are inventory levels build. I know this week, for instance, new home sales were released. The inventory of new homes is over nine months supply, which is typically associated with recession levels. I'm not saying that we're going to get a recession, but those levels have moved a lot. In fact, I think the absolute level of new homes and inventory is similar to the levels we saw before the financial crisis. So the housing market is definitely weak. There's no question of that. Slide 14 is something I introduced last period. It's just kind of an interesting look at GDP and the money supply. I'm not really going to talk about it, but it paints an interesting picture. You can see that growth has been above long-term trend now for some time since the pandemic. whether it's causational or not, the money supply would appear to be behind that, and that's kind of associated with the significant deficits that we've been seeing since the pandemic. That's about all I have to say for that. Now I'll turn to the portfolio. On slide 16, as I said, our outlook for rates is for the curve to steepen. As I said, there's two potential drivers of that. You could have the Fed lower short-term rates, and or longer-term rates could stay the same and or go higher if inflation and or deficits continue to stay high. So with that in mind, that's kind of the backdrop of how we view the world going forward. Now in terms of what we did, well, the big driver was we had a lot of money to put to work. We used the ATM quite exclusively in the second quarter. We raised about $100 million. And actually in July through the first, you know, third of the month or so, we raised another $55 million. So quite a bit of capital in relation to our size. As a result, we've been deploying that into the portfolio and basically almost exclusively or exclusively in higher coupons. As a result, our weighted average coupon went from 4.38 at the end of the first quarter to 4.72 at the end of the second, which is a pretty substantial move. but it's even higher now. It's at 4.88, so a 50 basis point increase off of where we were at the end of March. Realized yields are higher. I don't have the current number, but it would be higher than what we report here for the end of June 2. And then also our net interest spread for the quarter went from 2.47 to 2.64 with the additions of the higher coupons in our slight changes to our hedging strategy, which I'll get into in a moment. There's room for that to expand slightly more. And I will just point out, if you look back at our portfolio historically, say going back a year or so, especially in relation to our peers, we probably had one of the lowest weighted average coupons in the portfolio. And as we employ our barbell strategy and add higher coupons, that's been coming up quite a bit. And so we were, in terms of performance for the quarter, Our net interest income for June, even though we were negative for the quarter, was actually slightly positive. I don't have any Q2 figures yet for you, but that's clearly the trend. With respect to the portfolio itself, as you can see on slide 17, these charts just are bar graphs of our portfolio. If you look at the right, that's where we were at the end of last year. And as you can see, moving to the left, the current positions at 630, we have, as I said, been adding to the higher coupons. Just to give you some updates of what we've done since quarter end, 6-30-24, our allocation to sixes now is just under a billion dollars. So that's grown quite a bit. Six and a half were now over 800 million, and sevens are almost 400 million. So that's almost $600 million of ads, and all of that is higher coupons. The reason we prefer this barbell strategy is we think it does well in either rate environment. So, for instance, if we were to have a rally on the long end in particular, our lower coupons would do quite well. And to the extent the rates, long end rates in particular, stay higher, these higher coupon securities generate lots of income. And absent an extantial increase in longer-term rates, don't have much extension risk. The belly of the coupon stack is, more often than not been quite rich of late that's another reason why we find these securities to be attractive turning to our slide 18 in our funding well the fed hasn't done anything so not surprisingly our average repo rate for the quarter was unchanged all that being said uh with the market starting to price in eases uh we have extended our average uh maturity and we've continued to do that into july so we can get some benefit of some slightly lower, not meaningfully small, but slightly lower rates further out. With respect to our economic cost of funds, it did improve a fair amount from 2.56 to 2.41. And that has a lot to do with changes in the strategy of how we're hedging. We've been using a lot more swaps versus treasuries or futures. and we've been moving those swaps up the curve, so slightly maybe lower notional balance, but with more DV01 further up the curve, and with the curve very, very flat, in effect, our borrowing rate, hedge borrowing rate's gone down slightly, and that's what's caused the NIM to improve. Now turning to our hedge positions, as I mentioned, we've been moving the swaps out moving two swaps and using longer tenor swaps almost all ten, seven and ten year. And the reason we're doing that is just we think the greatest potential pain or risk to the portfolio would be a long-end sell-off, which would typically be accompanied by an increase in vol. And so therefore, by using seven and ten year swaps, especially when we're hedging new purchases, which are higher coupon, lower duration, if those mortgages were to extend, they're extending towards the long end of, you know, they're extending their duration, absolutely close to our hedges, we would dynamically hedge and potentially add to those positions. But it really, I think, is the most sound way to protect the portfolio because that, as I said, I think that would be the greatest source of pain would be a significant sell-off in the long end. Also, just more statistics on slide 19, we do cover 84% of our funding liabilities with our hedges, excluding TBAs. Swaps are now up to 72% of that. And our weighted average paid fixed rate is 2.71. If you look at the bottom of that page, you can see our swaps are now a little over 3.1 billion. Corresponding number at the end of Q2 was 2.53. So a significant move. The futures, those were 842 million. Now it's 521. So we've been, in addition to adding to our hedges, we've been moving some of them from futures to swaps. and moving the swaps further out the curve. TBA shortage essentially unchanged, and same with the swaptions. That's really just one position. Now, if you look at slide 20 and find a little more detail on our hedges, and I just want to say a few comments. In particular, on the top right are swaps. As you can see, if you compare where we were at the end of the first quarter versus now, the shorter maturity swaps are the same. So we've been adding to the longer tenant swaps, as I mentioned. With respect to the performance of the portfolio through last Friday, it really was just driven by the fact that we do have a fair number of swaps in that five, six, seven-year part of the curve. And that's where the markets really rallied. And so it's the reason that we're down slightly is just because of that, the rally in the swap positions that shot the Mark-to-market to a slightly negative position. Now, that being said, I don't know that we're going to change that. I think we expect the curve to steep, and we do expect the Fed will ultimately ease, but current pricing is for quite a few eases by the end of the cycle, 200 basis points or so. I don't think we're ready to take the over on that. I don't think we see the economy is about to roll in the recession. I wouldn't be surprised if we actually realized less than that. So the fact there's no real reason in our minds to unwind any of those hedges because we think the market's maybe a little ahead of itself. Also, with respect to the swaps, I want to point out that none of our swaps mature before March of 2026. 85% of our swaps are in place through or mature in Feb of 29 or longer. and 65% in May of 2030 or longer. So these hedge positions are going to be in place for quite a while. The one slot that does mature in March of 26 represents less than 10% of our notional balance. So our hedges are here. We're not going to have them rule off. We don't have to refinance those, so to speak, anytime soon. And then secondly, with respect to our balance sheet, as you know, we have no preferred, we have no floating rate preferred. So Our balance sheet in that regard is very clean and we don't have that risk to our net interest margin posed by either a floating rate preferred or swaps that have to be refinanced in the near term. Slide 21 just gives you a look at the portfolio. I would point your attention to the column entitled Effective Duration. And you can see across the various coupons those numbers. And in the bottom or the far right is just our allocation. If you look at the effective duration column, starting from the top down to the bottom, that's basically the curve, where we're positioned along the curve. So the shortest part of the curve, which would be 1.27 year, our current allocation at the end of June was 7%. Those are higher, but basically this just gives you a sense of how we've positioned the portfolio across the curve. Granted, these are static numbers. If rates were to move materially, these duration numbers can change. But as you can see on the far right column, how we're positioned, and just note in the bottom right, the allocations to those higher coupons have gone up. Slide 22 just kind of gives you a sensitivity of our net duration gap or the sensitivity of the portfolio. As you can see, we do a little better in a backup, and that's just because we've added longer tenor swaps, primarily. Finally, slide 23, our speed experience is The one thing that we benefited from of late, as I mentioned earlier, is that most of our deep discounts, say bonds with 95 handles or below, fours, four and a half and so forth, so quite seasoned. And as a result, our speeds, if you look in the very far right column, they're not bad for deep discount bonds. So that's been beneficial for us. And with respect to our newer higher coupons, they've been maintain just basically moderate speeds we haven't had any issues there that's pretty much it now just kind of turning to our outlook as I mentioned earlier you know lots changed since the end of the first quarter we were looking at higher for longer maybe the Fed hiking the data changed pretty abruptly and now the market really thinks that we're on the verge of a easing cycle We've been here before. We certainly, if you go back to December of last year, we thought we were on the verge of a big easing cycle and it didn't turn out to be the case. So we are mindful of that. But that being said, to the extent we do get an easing cycle, there's obvious benefits to that as our funding costs decline and our position in the portfolio, which I think is well suited for that outcome. But all that being said, if nothing happens and the data turns around again and We don't get any tightening or easing, rather. We just have a status quo. The portfolio is very well positioned. The income and net of our hedges is very attractive, and we think that our hedges are such that we can maintain pretty stable book value throughout. So we're very comfortable positioning the way we are. And that's it. Operator, I will now turn the call over to questions.

All right. Thank you. The floor is now open for questions. If you would like to ask a question, please press star followed by the number one on your telephone keypad. That number again is star followed by the number one. All right, our first question comes from the line of Jason Lieber from Jones Trading. Please go ahead.