ARR - NYSE

Good day, and welcome to the ARMOUR Residential REIT First Quarter 2024 Earnings Conference Call. [Operator Instructions] Please note that today's [ event ] is being recorded. I would now like to turn the conference over to Mr. Scott Ulm, CEO, ARMOUR Residential REIT. Please go ahead, sir.

Good morning. I'd like to welcome you to the ARMOUR Residential REIT First Quarter 2024 Conference Call. This morning, I'm pleased to welcome our new CFO, Gordon Harper; as well as our new co-CIOs, Sergey Losyev and Desmond Macauley, to the call. All are experienced members of the ARMOUR team whom we promoted to their new roles in March, and I have tremendous confidence in them all. Gordon has been with us since 2015, and Sergey and Desmond have been on our portfolio management team since 2016 and 2013, respectively. We're all excited to lead the business into this next chapter. Our priorities are unchanged and we are all united on our focus on delivering value to shareholders. I'll now turn the call over to Gordon to run through the financial results. Gordon?

Thank you, Scott. By now everyone has access to ARMOUR's earnings release, which can be found on ARMOUR's website, www.armourreit.com. This conference call includes forward-looking statements which are intended to be subject to the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995. The Risk Factors section of ARMOUR's periodic reports filed with the Securities and Exchange Commission describe certain factors beyond ARMOUR's control that could cause actual results to differ materially from those expressed in or implied by these forward-looking statements. Those periodic filings can be found on the SEC's website at www.sec.gov. All of today's forward-looking statements are subject to change without notice. We disclaim any obligation to update them unless required by law. Also, today's discussion refers to certain non-GAAP measures. These measures are reconciled with comparable GAAP measures in our earnings release. An online replay of this conference call will be available on ARMOUR's website shortly and will continue for 1 year. Now turning to results for the quarter. ARMOUR's Q1 GAAP net income available to common shareholders was $11.5 million or $0.24 per common share. Net interest income was $5.3 million. Expenses included $9 million of nonrecurring professional fees related to the Special Committee internal investigation. Distributable earnings available to common stockholders was $40.4 million or $0.82 per common share. This non-GAAP measure is defined as net interest income plus TBA drop income adjusted for interest income or expense on our interest rate swaps minus net operating expenses. Our capital management continues to waive a portion of their management fees, waiving $1.65 million for Q1, which offsets operating expenses. The waiver continues until further notice. ARMOUR paid monthly common stock dividends of $0.24 per common share per month for a total of $0.72 for the quarter. We aim to pay an attractive dividend that is appropriate in context and stable over the medium term. Taken together with the contractual dividends on the preferred stock, ARMOUR has made cumulative distributions to stockholders of $2.3 billion over its history. Quarter end book value was $22.07 per common share. Our most recent current available estimate of book value is as of Tuesday, April 23 and was $20.48 per common share. I will now turn the call over to Scott Ulm to discuss ARMOUR's portfolio position and current strategy.

Thanks, Gordon. I know you've all seen our disclosure in the K and Q about the events of the spring, and I'd like to address this upfront with some highlights in detail. I, of course, refer you to the K and Q for the company's definitive disclosure and further detail. A variety of issues were raised just prior to our scheduled 10-K filing related to non-GAAP disclosures, the Board's internal review processes, potential conflicts of interest and the external manager. The Board followed best practices and formed a Special Committee of independent directors. The Special Committee engaged outside counsel and a national accounting firm to review all of these issues. The investigation, which was comprehensive, extended through our customary filing schedule and the 12b-25 extension but did conclude in time for the Special Committee, the broader Board and our auditors to review the results and file our 10-K by the March 15 deadline. The Special Committee found that our use of earnings available for distribution and NIM were appropriate. You'll find in our press release a revised presentation of economic interest income makes clear that includes swap payments as a non-GAAP measure. As to the other matters raised, the investigation found no substantiation of any of the matters raised and found that the independent directors of the Board complied with their fiduciary duties. There was a finding that in the course of the investigation, there was an issue with tone at the top that constituted material weakness. The tone set by certain individuals during the investigation was insufficient to create the proper environment for effective internal control over financial. As you've seen, the result of all this was streamlining our management structure to a single CEO and a number of remedial measures, including training on appropriate tone at the top, internal controls reviewing tone at the top and enhance whistleblower reporting. As you know, we had a number of personnel changes, including the removal of our CFO for matters unrelated to the investigation and the resignation of our CIO. We are fortunate to have a deep bench. And as I said at the beginning of the meeting, our CFO, Gordon Harper, he's been with us a long time and spent 25 years prior to joining us at Deloitte. Our co-CIOs both bring extensive experience with our portfolio and deep backgrounds in MBS investment. Now let's talk a bit about the mortgage business. Following the sharp decline in the fourth quarter of 2023, treasury yields reversed path and climbed higher in 2024. Despite the Fed's dovish outlook on inflation at the start of the year with 7 rate cuts penciled in for 2024 and 2025, recent economic data has signaled otherwise and forced bond investors to once again abandon overly optimistic expectation of Fed's rates. Following a trend of hotter-than-expected inflation and labor data releases, the yield on the 10-year treasury climbed above 4.65% by mid-April, totally moved more than 75 basis points from a low of 3.88% reported on the last trading day of 2023. The yield spread between 2-year and 10-year treasuries remain inverted at an average level of negative 34 basis points in the first quarter, posing a challenge for MBS investors and particularly mortgage REITs and banks. We expect a wide-ranging spread environment with elevated volatility to persist until the yield curve reverts to its upward sloping shape. In the first quarter, newly originated MBS traded within roughly 20 basis points of nominal spread range, closing the quarter roughly flat versus the fourth quarter. The 0 volatility OAS on ARMOUR's portfolio tightened by approximately 7 basis points on the heels of a strong performance in March to contribute to a 1.1% total economic return, 4.4% annualized for the first quarter. April's strong inflation print ended the expectations for lower Fed rates in the first half of 2024, causing a sharp widening in mortgage spreads by 10 to 15 basis points and a rise in 10-year treasury yields by 30 basis points. Reflecting the broad sentiment shift on Fed policy staying higher for longer, ARMOUR executed a series of trades aimed at repositioning the portfolio with a view of higher yields and volatility to dominate the second quarter. First, we sold approximately 50% of our 10-year DUS tools and, in turn, purchased higher premium coupon conventional MBS with a shorter duration profile. While DUS spreads continue to exhibit favorable positive convexity, lower spread volatility and diversification benefits compared to our MBS assets, their outperformance in recent quarters allows us to capture 10 to 15 basis points of spread return and reinvest proceeds into cheaper mortgage assets. Second, ARMOUR sold over 40% of our deep discount MBS pools with coupons of 3.5% and lower where faster prepayment speeds have never materialized. We reinvested a portion of these proceeds into higher premium Ginnie Mae TBAs, which stood to benefit from the backup in mortgage rates while still trading at discount to the conventional equivalents. Lastly, ARMOUR sold over 10% of par coupon MBS versus treasury hedges, closing the basis trade that benefited most from the spread rally in March. As the market closed on April 23, the portfolio's implied leverage and duration stood at 6.9x and 0.5x, respectively -- for 5 years, respectively, while maintaining healthy levels of available liquidity. Our book value since the start of the quarter is down 7%. We believe reasons for widening is priced in a more hawkish Fed path and, as a result, mortgages now offer a compelling upside in a scenario where inflation and growth begin to moderate. Our mortgage strategy continues to target a well-diversified portfolio. About half of ARR's mortgage assets are higher coupon MBS, which are experiencing slow prepayments due to historically elevated mortgage rates. Around 40% of our current holdings are in coupons of 5% and lower with specified characteristics favoring faster turnover speeds while priced at a discount. ARMOUR's average prepayment rate for all MBS assets in the first quarter of 2024 was 4.5 CPR and a still low 6.6 CPR for April. The benign prepayment environment continues to favor mortgages that are supported by attractive fundamental and relative valuations. ARMOUR has increased its allocation of funding with BUCKLER Securities to approximately 60% of its borrowings as of quarter end. This reflects BUCKLER's growth as a broker-dealer and ARMOUR's benefit of financing through its affiliate. In the first quarter, repo markets generally priced around SOFR plus mid- to high teens in basis points with a weighted average haircut at under 3%. As our trading activity indicates, we have turned more cautious on mortgage spreads for the remainder of the second quarter. We'll continue to dynamically adjust our risk profile as we continue to analyze the interest rate, new macroeconomic data via political risks and reaction to the evolving environment of market participants in the Fed. Looking further out, we remain constructive on spreads over the longer horizon. We expect that the Fed will eventually start its much anticipated easing cycle later this year, leading banks to increase their share of net MBS purchases on improved net interest margin. We also expect rate volatility to decline as the date of our first Fed cut becomes more certain, attracting more MBS investors, including crossover buyers that may want to increase their allocation to MBS at the expense of tighter corporate spreads. We continue to believe that our dividend level is appropriate for this environment. Thank you for joining today's call. That wraps up our prepared remarks for the first quarter of 2024, and we'd be happy to take any questions.

[Operator Instructions] Today's first question comes from Jason Weaver with Janney Montgomery Scott (sic) [ JonesTrading ].

Actually I'm with JonesTrading. I wanted to ask, Scott, regarding your prepared remarks on BUCKLER, if you were detecting any change in the availability of general repo credit out there given the volatility over the last month.

Yes. Repo's been just fine. It's -- obviously, we monitor that extremely carefully and we are active with a whole bunch of counterparties as well as being sort of on the inside with BUCKLER. But repo has been well behaved.

Okay. Fair enough. And then on the expense side, I was curious how long you plan to continue waiving the management fee as well as if there's any lingering sort of enhanced compliance costs coming from the results of the internal investigation.

So first of all, on the waiver, we expect to continue that. Obviously, it's a function of portfolio dynamics here, but we've had it since COVID and expect to continue. As to enhanced compliance, as I mentioned, the focus on tone at the top is very real and is part of our internal controls now. So that is certainly an area of focus. But other than that, it's -- and some of the other things I mentioned with regard to NIM and its new formulation and economic interest income. We remain in the same place we've always been, which is take great care with this stuff.

The next question comes from Doug Harter with UBS.

Hoping you could talk through a little bit more of the decision to reduce the portfolio size in April as you're kind of balancing kind of the near-term volatility that you might said with kind of the longer-term optimism on current spread levels.

Thanks. I'm going to turn that one over to Sergey.

Yes. Doug, thank you for your question. Yes, so we took a series of trades that we discussed in our earnings script the early Q2. We felt like mortgage markets were pricing in very well in a dovish Fed path. And the high inflation print that we saw early April really kind of triggered a wide portfolio rebalancing to reflect kind of a pushback on future path of the Fed rates. Now we are looking at this as only Q2 event, really quarter-by-quarter. We do still see easing cycle beginning sometime later this year. So we're just kind of seeing this as a grand theme of second quarter's elevated volatility. We have geopolitical risks as well as the strong economic data really kind of moving the market a little bit. So we felt it was prudent to reduce our leverage below 7, target duration of about half a year and then be able to go and deploy the dry powder when we feel the time is right.

I guess just on the leverage, how are you thinking about the right level of leverage over time? And what's kind of the ability appetite to kind of allow leverage to move higher when you have these pockets of volatility?

Yes. So it just kind of goes in line with the previous answer. We have about at least 1x of leverage to deploy currently. But we do still see some residual uncertainty in the market until we confirm with a few more data prints on inflation and labor markets to determine whether this is just a blip or change in the seas. So I think you can see us being aggressively -- buying into the market once we figure out the horizon past the second quarter.

[Operator Instructions] The next question comes from Trevor Cranston with JMP Securities.

A follow-up on a question about the expenses. Just to clarify, are there -- were there -- would you expect to see any more of the sort of onetime expenses coming through in April? Or was that exclusively in the first quarter?

I think we've accrued pretty well for it. But you know how these things go. There's always something that dribbles in. But I don't think it will have anything -- and even if there is some dribbling later on, I don't expect it to be significant.

Okay. Got it. Then given the reduction in the MBS portfolio here in April, can you also maybe comment on any changes you've made to the hedge book, either swaps or treasuries in the early part of April?

Desmond, why don't you go for that one?

That's right, Trevor. In line with some of our asset sales, we've also adjusted our hedge book as well. We've been trying to aim for a 0.5 duration, about half a duration. So our hedge book is -- we dynamically allocate treasuries and swap hedges along those lines. So yes, we've been making adjustments as we do our asset sales, adjusting our hedges as well to keep our duration within a framework that we feel comfortable with given the environment that we are in.

The next question is from Christopher Nolan with Ladenburg Thalmann.

Related to the Special Committee investigation, you mentioned that you hired an outside counsel and an accounting firm. Is this the same accounting firm that does your audit?

No. They were a national accounting firm and not Deloitte.

All right. So is that any reflection on your confidence in Deloitte?

Not at all. With these things, you always hire somebody independent to help and that's best practices. But you just wouldn't use your regular accountant for this sort of work.

Okay. And you repeatedly mentioned tone at the top and then you also mentioned conflict of interest. Is the tone of the top financial related to conflicts of interest or other?

It's other. And this is all found up at the COSO framework, which is the control framework that we used. And the way it works is that tone at the top, which is a broad measure but recognized as a critical part of effective controls, leads into the whole network of financial controls. It's part of that. So that's where that goes. It's pretty clearly laid out in the K and the Q. You see the broader COSO framework and then how this fits in as part of it. But it's unrelated to conflict of interest, on which there are no findings.

There were no findings on the conflict of interest?

Correct.

Okay. And then final question. Given that the Q mentioned you apparently gave all material clean bill of health for the financials, is it fair to say that we're not -- we should not expect a restatement of past results?

That's correct.

At this time, we are showing no further questioners in the queue and this does conclude our question-and-answer session. I would now like to turn the conference back over to Scott Ulm for any closing remarks.

Thanks all. I appreciate your participating in the call. And as always, if you -- something occurs to you later on, give us a ring. We're all here. Thank you.