© 2024 Alpha Spread Limited. All Rights Reserved.
www.alphaspread.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on www.alphaspread.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. In no event shall Alpha Spread Limited be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on www.alphaspread.com, or relating to the use of, or inability to use, www.alphaspread.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance.
You don't have any saved screeners yet
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning. I’d like to welcome everyone to the Arlington Asset third quarter 2018 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 questions. If you would like to ask a question, please press the star key followed by the one key on your touchtone phone. If you would like to remove yourself from the questioning queue, please press star, two.
I would now like to turn the conference over to Rich Konzmann. Mr. Konzmann, you may begin.
Thank you very much, and 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, 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 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 when evaluating any forward-looking statement.
I would now like to turn the call over to Rock Tonkel for his remarks.
Thank you, Rich. Good morning and welcome to the third quarter 2018 earnings call for Arlington Asset. Also joining me on the call today are Eric Billings, our Executive Chairman, and Brian Bowers, our Chief Investment Officer.
Before discussing the specifics of Arlington’s results for the quarter, I would like to begin by providing some overall market commentary. The Federal Reserve raised the target federal funds rate by 25 basis points in September, its third rate hike this year, while also affirming its commitment to its balance sheet normalization policy and further gradual increases in the target federal funds rate. The 10-year U.S. Treasury rate rose 20 basis points to end the quarter at 3.06% while the Treasury rate curve continued to flatten as the spread between two-year and 10-year U.S. Treasury rate narrowed nine basis points to 24 basis points, with the short end outpacing the long end of the curve.
During the third quarter, continued reduced Federal Reserve support for agency MBS and rate volatility led to agency MBS spread widening, resulting in the pricing of agency MBS modestly underperforming interest rate hedges. In general, lower coupon fixed rate agency MBS and related hedges outperformed higher coupon hedged fixed rate MBS during the quarter, and to start the fourth quarter we have seen ongoing rate volatility with the 10-year U.S. Treasury rate rising 11 basis points. While widening agency MBS spreads may impact book values, levered returns should increase going forward, leading to higher spread earnings on new and reinvested capital.
Turning to the actual results for the quarter, we reported a GAAP net loss of $0.19 per share, which includes a $0.33 per share deferred tax provision resulting in pre-tax income of $0.14 per share. Non-GAAP core operating income was in line with our expectations at $0.47 per share for the quarter, which is in excess of our quarterly dividend of $0.375 per common share. Core operating income compared to the prior quarter was impacted primarily by modestly lower average investment volumes and the favorable funding dynamic of repo [indiscernible] with interest rate swaps the industry experienced in the second quarter, reverting more towards the mean in the third quarter.
If the company were to elect REIT status, its book value would equal its tangible book value. Tangible book value, defined as equity excluding our net deferred tax asset or liability, was $11.06 per common share as of September 30. Our annualized total economic return, which includes the change in tangible book plus our quarterly dividend, was 2.3% for the quarter.
The weighted average CPR for our agency MBS during the quarter was 10.66%, a slight increase from 10.31 in the prior quarter. The weighted average effective asset yield on our agency MBS was 3.11% for the third quarter compared to 3% last period. The 11 basis point increase in the effective asset yield was driven primarily by new purchases at higher current investment yields as a result of portfolio repositioning and reinvestment of monthly pay down. The company’s prepayment speeds declined during to start the fourth quarter with the weighted average CPR for October at 7.92%, which we expect would result in a weighted average effective asset yield of approximately 3.3% for the month.
As of quarter end, the company’s agency MBS portfolio totaled $5.2 billion, consisting of $4.4 billion of specified agency MBS and $0.8 billion of net long TBA agency securities. With the decline in the available TBA dollar roll advantage relative to specified agency MBS funded with repo, the company reduced its concentration in net long TBA agency securities, which represented 15% of the total investment portfolio as of September 30 compared to 22% in the prior quarter. The company has continued to reduce that component somewhat subsequent to quarter end in favor of specified agency MBS with a favorable spread impact.
During the third quarter, the company modestly lowered its overall recourse leverage to investable capital primarily through the reduction in its TBA position. The resulting lower average investment portfolio volumes contributed to an approximate $0.08 per share decline in core operating income compared to the prior quarter. During the quarter, the company increased its allocation to 5% coupon 30-year agency MBS while lowering its exposure to 4% 30-year securities to take advantage of expected higher risk-adjusted returns in a rising rate environment.
The company carries a substantial interest rate hedge position that serves two primary purposes: first, our hedges mitigate the impact of rising interest rates on the value of our fixed rate agency MBS portfolio; second, our interest rate swap position converts a substantial portion of our repo funding from a variable to a fixed rate for the life of the interest rate swap. During the third quarter, the company extended the duration of its interest rate swap portfolio by replacing $600 million of notional amount of swaps with a weighted average maturity of 8.1 years with $750 million of notional amount in new swaps with an average maturity of 12.7 years. As of September 30, the notional amount of our interest rate swaps was 85% of our outstanding repo funding balance.
The total notional amount of all our interest rate hedges, consisting of interest rate swaps and U.S. Treasury futures, was 86% of our repo funding and TBA purchase commitments as of September 30, an increase from 82% at last quarter end. Importantly, we extended the duration of our interest rate hedges during the third quarter, resulting in our duration gap moving from neutral net zero years last quarter to a negative 0.2 as of September 30, resulting in stronger protection against rising long term rates.
As we stated in our last earnings call, we expected that the favorable funding dynamic of repo funding hedged with interest rate swaps that we experienced last quarter would begin to normalize in the second half of the year. In general, our repo funding rates are based on one-month LIBOR plus or minus the spread. Under the company’s interest rate swaps, it receives three-month LIBOR on the received lag of its interest rate swaps, which are reset every three months based on the respective reset date of each swap. To the extent that three-month LIBOR increases at a faster pace than repo funding rates, the company’s net funding rate declines. The favorable funding dynamic that benefited earnings in the second quarter, which was driven by three-month LIBOR rising faster than one-month LIBOR and a historically narrow spread between repo funding rates and one-month LIBOR, reverted more towards the mean in the third quarter. The impact of this progression towards a more normalized funding dynamic this quarter along with the increase in funding costs on our unhedged repo funding contributed approximately $0.02 per share to the decline in core operating income from last quarter.
As a C-corp, the company continues to utilize its tax loss carry-forwards that allow it to shield all of its income from taxes. Based on its current investment and hedge portfolio, the company expects that it will utilize its NOL carry-forwards as a C-corp by mid-2019, although changes to the composition and the size of the portfolio and actual higher or lower than expected future taxable income could change that estimate. The company also expects to utilize its remaining federal AMT credit carry-forwards as a C-corp in the latter half of 2019, although the company could ultimately still claim a cash refund on any remaining AMT credit carry-forwards not utilized as a C-corp.
With an expectation that we will fully utilize our NOL carry-forwards during 2019, the company is currently evaluating possible long term tax structures, including potentially electing to be taxed as a REIT effective as of early January 1, 2019. If the company were to elect REIT status, it would not anticipate significant modifications, if any, to its investment portfolio or operations to qualify as a REIT; however, its financial statements would no longer reflect the net deferred tax liability as currently presented, resulting in the company’s reported book value being equivalent to its current presentation of tangible book value. As a result, it would be important for investors that currently use book value as a financial metric for the company to also focus on our current presentation of tangible book value of $11.06 per share.
In summary, despite a flattening yield curve over the past year, Arlington continues to provide attractive mid-teens returns on capital to our shareholders. This past quarter, we increased our hedge position and meaningfully extended its duration to provide more capital protection against increases in long term rates. We believe Arlington represents an attractive investment opportunity and is poised to benefit when the market eventually transitions to a steeper yield curve and wider net interest spread opportunities that occur during that period.
Operator, I’d now like to open the call for questions.
[Operator instructions]
The first question will come from Doug Harter with Credit Suisse. Please go ahead with your question.
Thanks. Rock, if you could just talk about the magnitude of spread widening you’ve seen so far in October, how that would translate into a book value move and your ability to purchase--take up leverage to participate in that spread widening.
I think we would characterize the widening so far this quarter, Doug, to be maybe a little more than 5 and less than 10 basis points. My guess--you know, it’s early in the quarter so it’s hard to say exactly where that shakes out over time, but as we sit here today, it might be in the neighborhood of equivalent to the mark in the third quarter, something in that neighborhood. It might be a little less, a little more, but maybe that’s a benchmark for five to 10 basis points widener across the stack, and it’s pretty evenly displaced across the stack.
Great, and then your appetite and willingness to kind of add assets into that widening that we’ve seen so far?
Well, you saw that we were lighter in balance going into the end of the quarter, and that leaves us some room to take advantage of those wider spreads with new investments at those better spread opportunities and higher ROEs.
Great, thank you, Rock.
Thank you for the question. Again, if you would like to ask a question, please dial star, one to enter the queue. The next question will come from Trevor Cranston with JMP Securities. Please go ahead.
Hi, thanks. A question on the potential conversion to a REIT structure. I understand that it won’t necessarily have any meaningful impact on the composition of the portfolio, but I guess looking at the current dividend level, it was only about 80% of your core earnings rate. I was wondering if you could comment on whether or not you believe a potential change in structure would have any impact on how you guys think about the dividend relative to your core earnings level, if you can comment on that, thanks.
As you’ve heard us describe in prior conversations, Trevor, we think about the dividend level in relation to the underlying economic earnings of the company, and we’ve talked in the past about the reasons why that is somewhat different from core, a bit lower than core but also undisclosable because of GAAP. But essentially, there’s really nothing about a potential REIT conversion that would impact economic earnings of the business, so we don’t think of that as material at all in our assessment of the future economic earnings capability of the business nor dividend levels.
Yes Trevor, this is Rich, just to add onto that. As you know, REIT requirements require you to distribute out your taxable income, your ordinary taxable income, and based upon our current dividend levels and what we’re generating in that taxable income category for ordinary income, we don’t foresee any kind of change in our dividend as a result of the required minimum distribution requirements as a REIT.
Got it. Okay, that’s helpful.
I’d also add, Trevor, that to some extent--to the extent that we carry NOLs into that initial period as a REIT, it does allow us to potentially retail capital even as a REIT.
Got it, okay. Thank you for that. Second question on leverage, in the past you guys have talked a little bit about your plan to reduce leverage a bit over time in sort of a measured way, but leverage didn’t really change much in the third quarter, and in response to Doug’s question it sort of sounded like you guys felt like there could be an opportunity to add to the portfolio here. Can you just give us an update on your thoughts around leverage in sort of the near to intermediate term? Thanks.
Sure. Well, the way we look at the leverage calculation, which is based on investable capital of the firm, we assess that as something more like at least half a turn of reduction in leverage. You also are familiar with the things we’ve said in the past about folks shouldn’t be surprise if they see that occur through sort of tranquil, relatively tranquil periods in the market because we’d want to invest in periods when you get volatility and widening, and that’s part of what I was trying to communicate in response to Doug’s question, which is to the extent we’ve now had a little bit of widening in the third quarter but also a little bit here in the beginning of the fourth quarter, then that’s the period in time when we’d expect to reinvest. So as I said earlier, we came into the end of the quarter down about a little over half a turn on leverage the way we look at it, and that gives us some room to add new assets at higher spreads today.
Got it, okay.
And we have been in the process of undertaking that, as you might imagine.
Right, got it. You mentioned, I think, that you continue to reduce the relative size of the TBA position a bit in the fourth quarter. Can you comment on any other portfolio changes or changes to the hedge book you might have made in October? Thanks.
I don’t think there’s anything material, other than we’ve tried to take advantage of a bit of this widening from the asset side, and obviously if we’re investing on the asset side then we may be making modest adjustments attached to that on the hedge side, but I wouldn’t describe it as anything material thus far.
Thank you.
Thank you for the question. Again, if you have a question, please dial star, one at this time. The next question will come from David Walrod with JonesTrading.
Good morning everyone. A couple of questions. It’s been pretty thorough so far, but in your slide deck, you talk about the opportunity to invest in other assets classes. Is that something you guys are actively pursuing, or are you just throwing it out there that you always have that opportunity?
Well, we always have that flexibility. We are looking from time to time more seriously at certain things, and right now we’re actually looking more closely at a potential opportunity, but there’s nothing there that’s advanced to the stage yet where we are in a position to talk about it. But we do evaluate potentially accretive opportunities and we’re looking at some right now that might run a little bit complementary to the agency opportunity.
Having said that, particularly with a bit wider spreads here, we find the investment opportunity in the agency side right here to be even more compelling than it was a couple months ago.
Okay. Given what you just commented about current opportunities being compelling, have you--what are your thoughts on a share buyback given where the stock is trading?
Well, when we see the stock at these levels, obviously it’s among the first things that we’re thinking about. We’ve got an authorization that’s almost 2 million shares. Obviously we think the stock is attractive because you saw that some of the executives purchased stock recently, so I would say that, and every day it’s a question of analyzing the opportunities and the ROEs associated with not shrinking the capital and adding wider spread assets against the permanent effect of the buyback of the capital. We evaluate that every day, it’s one of the first things we’re looking at when the stock is down here, and we have the firepower to take advantage of it if we decide to act on it.
Okay, thank you very much.
Thank you. The next question will come from Christopher Nolan with Ladenburg Thalmann. Please go ahead.
Hey guys, I apologize - I joined the call late. In case you did not ask it, was the equity raise in the quarter neutral to book value per share?
I’d say, Chris, it was probably in the immediate short term slightly dilutive, but accretive, materially accretive certainly over time. Remember to the extent we’re adding that capital, we’re leveraging the G&A structure, and that’s unique because we’re internal and we have the ability to do that. If we were external, it would not be the same, but because we’re internal and we get to leverage the structure, that allows us to be accretive on an earnings perspective, and obviously when we’re doing that, we’re layering in long term assets with long term hedges, so we’re creating a stream of net spread income that is pure accretion and lasts for many, many years. It’s a long term accretion from an earnings perspective, although it may in the very short term be modestly dilutive to the book value.
Got it, okay. Thanks Rock.
Mr. Tonkel, there are no more questions at this time.
Great, well thank you very much. If you have further questions, we’re happy to answer them offline, and thank you for your time, everyone.
Thank you. Ladies and gentlemen, this concludes today’s event. You may now disconnect your lines. Have a great day.