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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning. I like to welcome everyone to the Arlington Asset First Quarter 2020 Earnings Call. Please be aware that each of your lines is in a listen-only mode. After the company’s remarks, we will open the floor for question. [Operator Instructions].
I would now like to turn the conference over to Richard Konzmann. Mr. Konzmann, you may begin.
Good morning. This is Rich Konzmann, Chief Financial Officer of Arlington Asset.
Before we begin this morning's call, I would like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations, and any other guidance on present or future periods constitute forward-looking statements that are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances.
These forward-looking statements are based on management's beliefs, assumptions and expectations, which are subject to change, risk and uncertainty as a result of possible events or future factors. These and other material risks are described in the company's Annual Report on Form 10-K and other documents filed by the company with the SEC from time to time, which are available from the company and from the SEC and you should read and understand these risks in evaluating any forward-looking statements.
I would now like to turn the call over to Rock Tonkel for his remarks.
Thank you, Rich. Good morning and welcome to the first quarter 2020 earnings call for Arlington Asset. Also joining me on the call today is Brian Bowers, our Chief Investment Officer.
During the quarter, the global health crisis caused by the COVID-19 pandemic rapidly led to an unprecedented forced shutdown of large portions of the global economy. The uncertainty surrounding the magnitude and length of the economic impact of the pandemic quickly led to extreme market volatility and dislocations in the financial markets resulting in significant spread widening on most fixed income assets, interest rate volatility, a sharp sell-off in equities, substantial liquidity strains, and significantly less price transparency of financial assets.
During that period, agency mortgage spreads widened significantly until actions by the Federal Reserve to aggressively resume purchases of Treasury securities and agency MBS improved the liquidity and functioning of the financial markets and led to a tightening of agency mortgage spreads by the end of March. Severe dislocations in the market for non-agency MBS also led to substantial declines in the market prices of non-agency MBS during the quarter.
Repo funding for high quality assets such as agency MBS continued to function at relatively normal levels, however, the repo funding markets for more credit-sensitive assets, such as non-agency MBS were strained characterized by limited availability as well as increased pricing and haircuts.
Repo margin calls along with fund redemptions led to selling pressure in mortgage investments contributing to the decline in pricing during the quarter. In the latter part of February, as it began to be apparent that financial conditions were deteriorating, the company proactively shifted its focus to delevering and increasing liquidity, and the company continued this approach of prioritizing liquidity through the end of the quarter.
Notwithstanding aggressive Federal Reserve monetary actions and policies as well as record fiscal stimulus, market conditions continue to be constrained in certain sectors and rapidly evolving across many sectors. As a result, the company has maintained a relatively cautious stance, which prioritizes preservation and protection of the company's balance sheet through low leverage and substantial liquidity. Through this volatile period, the company continued to meet all of its margin requirements in the ordinary course while maintaining its strong relationships with all counterparties.
The company reported book value of $5.28 per share as of March 31. Core operating income for the first quarter was $0.17 per share, a decline of a $0.01 per share from last quarter. As of March 31, the company's investable capital was allocated to 85% to agency MBS and 15% to mortgage credit investments. Book value since the end of the quarter has improved by approximately 2%.
In order to maximize its liquidity, the company did not declare a dividend on its common stock during the quarter. Company's fourth quarter common stock dividend declared back on December 13 and paid on February 3 of this year will be applied to the company's REIT distribution requirements for 2020. This prior quarter dividend along with its tax loss carryforwards provides the company with a great deal of flexibility in managing its REIT distribution requirements this year. The company will evaluate future common and preferred stock dividends based upon multiple factors, including overall economic and market conditions, return opportunities on investments, company's ongoing liquidity needs, and REIT distribution requirements.
Although the financial markets have improved since the lows experienced in March through aggressive Federal Reserve monetary policies as well as record fiscal stimulus, market conditions continue to be constrained and rapidly evolving in many sectors. The company has continued to maintain a stance, which prioritizes preservation and protection of the balance sheet through low leverage and liquidity. Accordingly, the company is taking a patient and selective approach to redeploying its capital or increasing leverage in the current environment.
Steadier funding conditions and lower repo funding costs, as a result of recent Federal Reserve interest rate cuts have provided support to agency MBS, however, after substantial widening in the mortgage bases and precipitous drops in specified pool pay ups during the lead up to the peak of market deterioration in mid-to-late March, prices and pay-ups since that time have elevated significantly due to substantial Federal Reserve purchases of agency MBS and its ongoing support for agency MBS funding markets.
With the Federal Reserve as the marginal and non-economic buyer, agency MBS valuations have become relatively expensive, while at the same time there continues to be great uncertainty in the path of prepayments, although they are expected to remain elevated. This has had the effect of compressing available yields below 1.5% and toward 1% or lower for some coupons, shortening agency mortgage durations further and creating the potential for material extension risk, as well as price pressure to the extent Federal Reserve support subsides. Notwithstanding the credit protection and liquidity associated with agency MBS with available levered returns on a new dollar invested generally in the single digits with appropriate leverage, we remain relatively cautious on levered agency MBS exposure.
The company's current non-agency investments are reasonably balanced between residential and commercial credit with about two-thirds currently dedicated to residential collateral, 85% liquid CUSIP collateral, 85% discounted or deeply discounted bond, 70% senior first pay, leverage at 0.3x through long-term repo only with expected overall returns in the low teens and representing approximately 25% of capital currently. These characteristics reflect what we are targeting.
The recent dislocations in financial markets have laid the foundation for opportunities in mortgage related and other credit assets with attractive returns with no work or low-to-modest leverage. For a range of residential and commercial loans and non-agency MBS, available unlevered returns currently range from the low-to-single digits for the most liquid and most senior assets, and high-single to low-double digits for other senior credits and collateral types depending on liquidity, seniority, leveragability, funding costs, and return volatility under stress scenarios.
The company is actively identifying and evaluated various investment opportunities like these through both proprietary and non-proprietary channels with existing and new partners. As of today, we are currently well-positioned to take advantage of these opportunities with our overall low leverage, substantial liquidity, zero non-agency MBS repo, and only one piece of long-term repo on a senior mortgage loan with very strong collateral and credit characteristics which has received no margin calls. We also have the benefit of our historical experience investing in assets that generate unlevered returns in the high teens through prior stressed economic cycles.
Based on current conditions, we are executing a plan which focuses on investments that provide acceptable returns on capital while retaining sufficient liquidity to both sustain substantial ongoing financial flexibility through various market conditions and benefit from the optionality to capture opportunities from situations that may arise over time, but that may not yet be clearly visible during these earlier phases of this economic shock.
While the current stage of massive monetary and fiscal stimulus supporting markets may make some of these opportunities somewhat more challenging to access, we are having success identifying, evaluating and investing in them. We've capitalized on the benefit of our financial flexibility during the second quarter to make attractive investments with these characteristics and as conditions permit, we expect to continue that over the course of coming months.
In April, the company made new unlevered investments and discounted mortgage and related credit assets with attractive characteristics totaling $44 million. However, we expect second quarter earnings to reflect a period of underinvestment as the company selectively capitalizes on these attractive available opportunities over time which may not fully be reflected in the earnings power of the company immediately.
A key investment objective is the realization of double digit overall returns on investments while retaining a low to modest overall leverage profile as well as substantial liquidity in order to sustain financial flexibility and to capture attractive returns with potential platform upside created by ongoing dislocations as the COVID-19 related economic shock revealed its full impact over time.
In summary, with a flexible financial and liquidity profile characterized by low leverage, the company is well-positioned to take advantage of attractive investment opportunities that have been created from the current economic environment that should enable the company to deliver attractive risk adjusted returns to shareholders over time.
Operator, I would now like to open the call for questions.
Thank you. At this time, we will open the floor for questions. [Operator Instructions]. Our first question comes from Doug Harter with Credit Suisse.
Yes. [Technical difficulty] could talk about your thought process around buyback or returning capital to shareholders given the significant discount to book versus kind of buying new assets?
Well, as you'd expect, Doug, that is something we certainly spend a lot of time looking at and thinking about. Naturally, it’s the first thing that we contemplate as we think about our larger mission. I think one of the key ingredients in that process and for us is naturally the importance of liquidity in providing opportunity to absorb whatever additional challenges may come from these market circumstances as they develop in an uncertain path over time as well as to provide the flexibility to take advantage of opportunities in the securities on our own balance sheet as well as longer-term opportunities that may create quite exceptional returns over time for shareholders that are available in markets and may become available in markets including, as I said, potentially platform-type opportunities that we are seeing and in discussions about right now.
Great. And then if you can just give us a little more detail about the senior [ph] commercial loan that has leverage? What are the details behind the loan and just any extra color there would be great?
I would say it's a -- it benefits from a sort of ideal location, number one. Number two, it's a specialized and very sensitive critical operation-type piece of -- set of real estate assets that support a critical function operation, and the detail is in the 10-Q as well. But I would say, overall, it's exhibited ideal behavior, reasonably ideal or ideal behavior as one might expect through this type of period of time of volatile economic circumstances. And I think that's a combination that's due to a combination of its critical function as well as the credit quality built into the loan itself, the collateral, the liquidity, the coverage ratios, and those sorts of things. And I think that all flows through to the bottom line in the form of no margin calls on that asset. And again, it is financed with very long-term repo, so there's not a financing risk there.
Thank you. Our next question comes from Trevor Cranston with JMP Securities.
I guess, so when you guys were discussing the new investment opportunities and the capital you’ve deployed in April, I think you characterized them as discounted unlevered investments. Can you provide any additional color there in terms of what you guys are looking at and buying, whether it’s loans or securities, and kind of what the types of collateral you're looking at?
I would say a combination. We're seeking return circumstances that reflect what I described in terms of credit and collateral protection, liquidity in most cases not necessarily every case, but in most cases and where there's not absolute liquidity those are naturally adjusted for in return expectations. The predominant focus has been in the residential spectrum, and we are -- and we continue to see very interesting opportunities there.
We are seeing front pay securitizations in RPL and other similar type assets that have cash carry in mid-to-high-single digits, discounted in nature and carry total returns that are above that in the most senior part of the cash flow stack, and then we see others that are maybe either a little less liquid or have a couple of other variables to them that we see generating opportunities for return in the double digits, low-to-mid double digits, and then we're also seeing some other opportunities that carry higher returns than that, which may have a platform aspect to them over time.
And so, those sort of break it down. Again, I think the characteristics that we illustrated in the script speak pretty well to the kinds of emphasis we're providing in our process of identifying and evaluating new opportunities, a combination but residential primarily, senior primarily, liquid primarily although not exclusively and very robust from a credit perspective with attractive returns that on balance are going to be in the low-to-mid double digits.
Okay. Got it. That's helpful.
Taken together.
Sure. And you mentioned that some of the new investments you're looking at, they were through existing and potentially new partners. Is this stuff you've done so far, is that -- are those direct purchases by you guys or are there some structure with another investment partner in what you've been buying?
Today, it's more of the former. Although as we speak, we're engaged on a number of situations that are -- that look more like the latter that also can provide opportunities we think with returns up sort of in the higher end of the spectrum that I illustrated before.
Got it. Okay. And when you described the investment environment, it sounded like you're obviously much more positive on the credit side as opposed to the agency side. Do you have any thoughts as we progress over the next two three quarters, how much of your capital you might be willing to shift into credit investments and away from agencies?
Well, that depends on how markets adjust and adapt to this economic shock as it develops over time. I think -- I illustrated our thoughts on the agency side. If that were to change materially, well, then that would suggest we should reconsider it. I would say we're always sort of adjusting to where those markets are and expected returns associated with a new dollar invested of capital in each side, the non-agency and the agency. So -- and there may be more than one way to play the agency opportunity. So, we're investigating other alternatives to be involved in the agency resi space and even other agency spaces.
And I think we'll continue to emphasize those over time as long as the agency, direct agency, MBS returns with what we would be comfortable in a leverage profile are yielding what we think to be single digits somewhere whether it's mid-to-high or to high-single-digits appropriately levered in our view then we'll be focusing on these other characters -- these other assets, which on an unlevered basis can certainly compete or exceed the -- not the agency opportunity on a risk adjusted basis over time.
Keeping in mind again the emphasis there on the non-agency side, the credit side, would be short duration, very strong credit collateral protection, currents in the solidly single digits, mid-to-high, maybe even low-double digits cash yields and total returns higher than that on unlevered basis loss adjusted. So that competes pretty well with agency as we speak here. And as I said, there may be opportunities related to the agency space that also allow for those kinds of opportunities on an unlevered basis or low -- very -- or very low leverage basis.
For now, we continue to book -- for now, we're focused on those. And to the extent markets shift in those types of opportunities and non-agency become more expensive and drive the returns down, well then we can look back to agency if that has become also less expensive in the near to intermediate term. I don't think any of us necessarily expect the agency support from the Fed to be immediately removed. But to the extent that that or other effects cause a reduction in agency prices that's material enough to widen those spreads and give us a chance to reenter with a new dollar at better returns, well, we always have our eye on that.
Thank you. Our next question comes from Christopher Nolan with Ladenburg Thalmann.
Hey, Rock. Excuse me if you mentioned this earlier, but what are you targeting in leverage ratio going forward with the new strategy?
Well, I think that relates directly to the question that I just answered. I think it will depend on how circumstances and markets evolve over time. And to the extent that the emphasis, given market conditions remains on the non-agency side with the approximate parameters that I described in here and in my answers and in the script, then I would expect that our leverage would continue to be on the low side and sort of reasonably in-line with what we have and what I've disclosed -- what we've disclosed in our script and in my comments to the extent that the investing environment shifts over time and suggest that a new dollar may get a better risk adjusted return in agency, to the extent agency conditions that change over time, well then the leverage would naturally be increasing associate with that. So it's -- I wouldn't say we have a specific target. I think I try to illustrate in the script and in my comments the objectives for our investments on the credit side, which would be low leverage across -- generally across the board, low-to-no leverage across the board.
Okay. Great. And then –
In that space.
And then in terms of liquidity, how much you're looking to cash keep on the balance sheet going forward given everything going on?
Well, as a general matter you can probably divine from my comments that we are emphasizing maintaining substantial liquidity. And we think there is an opportunity to create these kinds of attractive returns, provide an attractive overall return to the shareholders and yet still keep a very significant liquidity pool available for absorbing market shocks should this economic pathway prove more turbulent over the next six to 12 months than it has been already. So we would provide a meaningful protection layer against those kinds of ongoing or more severe shocks in markets and at the same time that liquidity can provide positive optionality for us to take advantage of dislocations as they occur along that economic recovery pathway or decline pathway. And I would say that we would hope that that would include a platform opportunity along the way or one or more along the way that we can take advantage of with the substantial liquidity pool that we expect to keep in addition to making these attractive investments with the characteristics we have described.
Great. Final question. I guess it's for Rich. Are these new real estate assets they're going to be carried on the balance sheet at fair value or cost? And are you going to break down the cost or fair value for each property?
Well, we don't have any real estate self on our balance sheet. We're talking about if we have a mortgage loans and our investments in mortgage-backed securities, so everything has been -- we've elected a fair value option for all of our investments. So everything is carried on our balance sheet at fair value.
Thank you. [Operator Instructions]. Our next question comes from Jason Stewart with JonesTrading.
Hi. Good morning. Thank you. On the agency portfolios, spec tabs are back to, you call it, mid-February. When you think about that versus TBAs, could you just describe a little bit more about your thought process given your comments on prepays and what would cause you to shift added spec pools?
Well, I'm not sure there's a lot right now that would cause us to shift out of the limited spec pool position that we have, Jason. The role has experienced a lot of movement and it is subject to pretty significant forces that can emerge in short periods of time. And we all -- I think we all fully understand that the underlying quality of that pool continues to probably deteriorate over time given the circumstances from a speed and predictability perspective. So I think we would probably emphasize -- continue to emphasize the spec pool side just simply from a predictability perspective and that we would sort of adjust for pay-up risks through adjustments -- movements along the coupon stack, but also adjustments in the size of that portfolio and capital allocation to it or away from it at a given time based on how expensive we view the basis to be, and the pay-ups to be.
So I'd just say keep that in mind. We might use just the overall scale of capital dedicated to it and moderate that up or down to adjust for that, the relative expansiveness of the basis and the pay-ups, and that would cause us to be potentially holding excess liquidity or moving capital to the other side of the book and I just expect they have so the basis get cheaper, we would come back to -- we may come back to the agency.
Okay. That makes sense. Then on the credit side, you talk about total return. If you could just link the two components of the total return cost discount accretion and cash carry to the way you think about the strategy, capital allocation and the dividend, that would be helpful. Thanks.
Jason, we just missed the first part of that. Could you just repeat that? Pardon us.
Sure. So when you think about the allocation of credit, I think probably two components cash, carry and discount accretion, if you could just relate the two of those if you weigh capital allocated to that strategy, and as you think about the dividends, that would be helpful.
Well, I think we sort of spoke to it in a way in the script, right? We see on the types of investments that we're primarily targeting, we're seeing cash on cash yields in the mid to high single digits to start with, some certainly in the double digits. So I'd say on balance presently we see a cash on cash yield that would be in the high single digits with expected returns in the low to maybe mid-double digits in total and I think we're comfortable -- that we're comfortable that over time as this capital is fully utilized put to work into those kinds of investments then we'll be able to certainly comfortably manage a dividend over time that would be acceptable, appealing to shareholders and provide for some potential upside above that as well through the non-cash component of the earnings or from upside potential from a platform or otherwise.
So I think to frame it maybe 75%, 80% of the expected return in that book is going to come from cash yield, cash -- current cash yield and the rest from either an accretion of the discount toward the loss adjusted par or spread compression if that occurs in a shorter time period. And keep in mind most of these are very short duration. So that accretion period to the extent it exists is abbreviated.
Thank you. There are no additional questions at the time.
Okay. Thank you very much. And we'll be available to for further questions or conversation if you'd like. Thank you very much.
Thank you, ladies and gentlemen. This concludes today's presentation. You may now disconnect.