Lindsey Crabbe - IR Andy Jacobs - CEO Phil Reinsch - CFO Robert Spears - Chief Investment Officer.

Steve DeLaney - JMP Securities Joel Houck - Wells Fargo Mike Widner - KBW.

Good morning, and welcome to the Capstead Mortgage Second Quarter 2015 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Lindsey Crabbe. Please go ahead..

Andy Jacobs, President and Chief Executive Officer; Phil Reinsch, Executive Vice President and Chief Financial Officer; and Robert Spears, Executive Vice President and Chief Investment Officer.

Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management.

For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are available on our website. The information contained in this call is current only as of the date of this call, July 30, 2015.

The company assumes no obligation to update any statements, including any forward-looking statements made during the call. With that, I'll turn the call over to Andy..

Good morning and welcome to our second quarter 2015 earnings call. The first six month of 2015 has been volatile period from net asset prospective. 10-year Treasury began the year 2.17 and during the first quarter the 10-year had a trading range of 60 basis points, trading between 1.64 and 2.24 ending the quarter 1.92.

For that the 25 basis points decline during the first quarter. And the second quarters the 10-year Treasury rate had a 63 basis point trading range from 1.84 to 2.47 and it end of the quarter at 2.35 are up 43 basis points from the beginning of the quarter.

I guess somewhat good news is that in the current quarter we only have a 25 basis points trading range from 2.19 to 2.46 and I guess when we walk in here the 10-year rate was standing right in middle of that range at 2.30, so it's been quite a volatile year.

There continues to be a significant amount of uncertainty regarding the timing of lift off for the first movement in the Fed funds rate, yesterday the Fed announced that they will take into an account a wide range of information before they begin to raise their target rate are as using -- the way they’re used to saying it, the timing will be data dependent, but the market expectation for lift off currently remains kind of in the September period for the Fed meeting.

We’ve heard that before I guess, for several years we heard the timing. This rate volatility and continued uncertainty has been particularly challenging for investors trying to manage a portfolio of fixed rate mortgage security.

So far this year ARM securities have outperformed fixed rate security due to the steeper yield curve and the hedging volatile associated with a longer cash flows embedded in fixed rate MBS.

Because of our focus on short duration mortgage security, we have not yet to reposition our investment portfolio or adjust our hedging strategy or position to deal with this rapidly changing interest rate environment. All in all, our book value during the quarter decline $0.17 or 1.4% and we closed the quarter at $12.30.

The majority of this decline was attributable to the payment of the second quarter dividend and excess of earnings which totaled $0.9. Remainder of the decline, our 0.6% was attributable to portfolio pricing levels.

For the year -- for the full year so far our book values have decline a total of $0.22, but after you consider the $0.31 common dividend that we paid in each of the first and second quarter. Our analyzed economic return has been 6.4%.

This relative stability in our book value and reasonable economic return in the first half of the year during a period of high interest rate volatile speaks to the resiliency inherent in our investment strategy. Now just briefly on second quarter operating result.

Net income totaled $25 million or $0.22 per common share and when paid a common dividend of $0.31. Our net interest margin related to our investment portfolio decline at 30.2 million from 39.4 million in the first quarter with financing spread lower by 27 basis points. Most of which was attributable to higher mortgage prepayment.

Mortgage prepayment increased to 22 CPR from 16.7 CPR in the previous quarter and as I said on previous call each percentage point change in CPR quarter-over-quarter is worth upwards to $1.5 million in quarterly premium amortization, so this 5.3 increase in CPR during second quarter represented substantially all of the $8 million increase in premium amortization which is reflected on page nine in our press release.

So the rule of thumb was again valid. Borrowing rates including hedging cost averaged 52 basis points during the second quarter, three basis points higher than the previous quarter, and this was largely due to greater use of higher rate longer maturity repo.

The duration of our investment portfolio remains one of the lowest in the industry at 11 months and after considering the eight month duration on related borrowing the net duration on our investment portfolio was three months. Regarding our portfolio we maintained the size of our investment portfolio to a little over $14 billion.

As a result of the decline in book value our portfolio leverage increased slightly to 8.76:1. Overall we're very comfortable with this level of leverage especially considering the short duration character of our investment portfolio. And just a couple kind of remarks before I open it for questions.

Future level of prepayments will continue to be key to our portfolio yield in coming quarter and as we stated yesterday mortgage prepayments are expected to begin receding during the third quarter during the current level of interest rates. And with that, I'll open it up for questions..

We will now begin the question and answer session, [Operator Instructions]. Question from Steve DeLaney from JMP Securities, please go ahead..

So Andy, I guess the quarter, a little surprising obviously just in terms of the bottom line number and the magnitude of the CPR growth. And I guess this is just sort of a -- it's a case study almost and the good and the bad, if you will, in terms of an ARM concentrated strategy.

I mean, it appears you guys will probably have the best book value performance in the second quarter among the agency REITs, but probably the largest sequential earnings decline. So I guess my -- where I would start is -- you've seen this before, this volatility in ARM prepays.

At any point does this cause you to think about the ARM strategy on a longer-term basis? Or do you like the risk that you're living with in terms of maybe more volatile prepays?.

Well I think that at this point prepayments are as we said are the key.

This quarter as you identified prepayments were -- really were much higher than what we thought they would be, ARM securities have the tendency to lag what changes you see in the fixed rate universe and so you know this is not totally unexpected that the second quarter was as high as it was, but with where we're headed and where interest rates are we truly expect to see, during the latter half of this year that this increase in prepayments will subside, probably substantially.

You know a lot of that depends of course on the direction of the yield curve whether it steepens or flattens from here, but yes, this quarter was a challenge.

That said you know our discipline is to stay in the short duration side of the market, with what we see in front of us which is arguably the Fed beginning their lift offer, beginning with the tightening this is the exact type of portfolio that you want to own into today’s environment and we're very comfortable with that.

So again we'll just -- we will maintain our discipline, this is just one of those challenging times but it's not to where we change the direction what we’re doing with our portfolio..

Yes Steve, I'd like to add something too, if you look at ARM this year, you look at our portfolio, fourth quarter last year they prepared it a little over 17.5 CPR. Our book actually dropped in the first quarter to 16.65 and then went up to 21.98 in the second quarter, at the same time frame, the fixed rates went up from 13 CPR to 15 CPR to 19.4 CPR.

So on a percentage basis fixed rate passthroughs actually went up more.

It's just because as Andy mentioned the lag effect it seems like we have like a two to three month lag and so fixed rate started to slow down a little bit and ARM stayed a little hot and there were several reasons for that, I mean we rallied into the second quarter against most of volatility in our prepayments or in the ARM universe are in longer resets particular the 5/1 cohorts [ph] and those guide -- some of those guide, when we hit in 1.65 to 1.75 and a 30 year no cost refinance was a -- call it three and three quarters, you had some ARM with fixed rate financing.

Then as fixed rates went up, they weren't refinancing in to fixed, but originators were often times slower to move their ARM rates up and so because of that then you see some ARM-to-ARM refinancing.

But most of the prepayment volatility in our sector is in longer resets, not the season short resets and also there's some commentary, when the FHA lowered their MIP from 1.35 to 0.85 that was basically like a 50 basis point rally in our Ginnie ARM portfolio and we've got some longer reset Ginnie ARMs that those fees kicked up just like getting Ginnie Mae fixed rates.

So those were kind of the driving reasons. If it wasn't totally surprising, but as we know, we have to align the books, and ARMs speeds generically picked up another 1 CPR or so, but they should start declining in August as we now have a 30-year no cost up [indiscernible] and the seasonal start tapering off.

So, we should see a fairly precipitous decline in later part of the year.

That's great color, Robert, and very helpful. Could you specifically give us your CPR prints for the trend for June and July, that would be helpful..

We don't have the disclosure on July.

You don't?.

You saw a generally, you saw ARMs in general move from about 21 CPR in June to 23 in July..

Okay.

And that's just general market color, not your portfolio is what you're saying, so?.

That's right, yes. And our portfolio -- it moves kind of in unison with the ARM universe, but not to the same degree. Just because the composition of our book as you know is shifted more towards season shore reset and [indiscernible] and whereas now the outstanding aggregate ARM universe is more weighted towards I think the 5/1 and 7/1 [ph] cohorts. .

That's helpful.

So what I'm taking that you're not seeing is say, post reset guys that are living there, living with a very low coupon, you're not necessarily seeing consumer behavior, people saying, hey, I've got to get out of this floater because the Fed is going to tighten, you're seeing more of the pre-reset ARMs or where you're seeing the pressure..

Or the pre-reset ARMs that are resetting for the first time, those are kind of hot buckets and then newer issued Ginnie ARMs but it's obvious from the pricing that you're seeing in the very season post reset market that you're not seeing that those prices really stopping and because of the stability of the speed and the stability in the cash flow.

So, it's mostly our newer production bucket..

Steve, I'd just add a finishing comment on this is that, we have to -- pre payments and the volatility that we have been seeing and we'll see the remainder of this year, hopefully less, we have to live with that there is not anything we can to control with that is.

What I think is key and again you can't lose sight of is the portfolio valuation of our investment portfolio, the declines that we’ve seen this year have been very minimal compared to our cohort for the longer duration investors in this market. So our -- value has hung in there very well this year.

And I mean that's -- yes, we have more interest rate volatility with the amortizations we saw in the second quarter but I think over the long run, you're going to see more preservation of capital as a result of that and we're very comfortable with that strategy..

Yes, no question, that's your key point to differentiation in terms of your strategy. Thanks for the comments..

And our next question comes from Joel Houck from Wells Fargo. Please go ahead..

Just to explore the prepay in the portfolio. So I heard you correctly, you're saying that the shorter -- there really wasn't a spike in prepayments in a shorter reset, it all occurred in the longer reset.

Is that -- did I hear that correctly?.

I'm just saying generically if you look at the ARM market, very seasoned, short reset ARMs you're not seeing a spike in prepays and those are consistently hanging around kind of the low teens there. And so the -- yes, there is not been a spike in prepayments and very season ARM securities..

That would -- if you just kind of do the math in your portfolio, that would mean that the CPRs on a longer day to resets are much higher than low 20 where the overall --?.

I think if you just look at the cohorts that are out there, and it's published data, not specifically our portfolio, but you're seeing newer issue 5/1 or season 5/1, those type of securities are trending in the -- it's not unusual to see mid to high 20s prints on that..

Okay..

That's what we're seeing and I just want to make sure [indiscernible]..

Joe, we're losing you. We can't hear you. .

Can you hear me now?.

That's better..

I was just saying there is a lot of sensitivity around these -- particularly given the rate volatility we saw in the first quarter, I guess I'm a little surprised there, I mean, seeing at least generically in the market some recovery in prepay speed into July.

You're saying you expect to see in August pretty much your numbers on generic [indiscernible], I guess it’s a little surprising that kind of given how tame rates have been now for the last one month or two months that we would see that. I guess the --..

If you remember 10-year hit rallied again down around 1.85 in early April. And so fixed rate speeds picked up slightly too in July and so you had that last little rally, and so you’re not going be in an environment where the 10-year was substantially more than 2% until you start seeing the August prepay data -- the August numbers.

But we had rallied that of 2% in early April if you remember..

Yes, that's a good point.

And how much of a burn out effect is there with your borrowers? In other words, even if rates don't -- long rates, I'm talking, rise materially, shouldn't -- I guess that give you the confidence that the speeds are coming down in the second half of the year?.

Yes. I mean, if you look at our gross lag on our portfolio it's run 3.15 and so 30 year fixed rate once again is in the [4.25 to 4.38 series][ph]. So that's not really a viable option. But what’s happen, you still have 5/1 rates in 3.38 the 3.5 area.

And so if you have, let's just say, for example, a one-year-old 5/1 than at the guy has a 3.75 rate, his got good credit.

He could re-finance, so I think which we are seeing now are some of those 5/1’s that are one-two years old and it may be concerned about rate rising and either taking get slight improvement in their rate or they can lock in the same rate and extend their term.

That make sense?.

Okay, I know that make sense..

That's why the Mortgage Services originators are focusing now, because the players in --..

Yes, really there is not -- the difference not there is still little in the ARM market. I don't think it’s really driven by originators, its more borrowers and it’s not like originators are making consolidated affords to go after ARM's because there is just not as much outstanding volume and there are used to be.

So I think it's more borrower related and then they go through [indiscernible] go after the low hanging fruit first, which are your fixed rates that are in the money and then they will after ARM's that they have originated within the last couple of years and so -- and then you once again throw gas on the fired, FHA lowered the MIP premium and so those one became immediately re-financeable.

So that’s kind of where we are right now, that’s why I thinking a lot of times we’ll see a lag in ARM's speed versus fixed rate..

Okay, and the last one I have is, obviously there's a lot of retail ownership in your name, you guys have been through this before, as Steve pointed out.

How should people think about the dividend as prepays kind of come back in the second half and presumably the earnings power improves for the company? This is a pretty big delta in the second quarter..

Granted it was a larger delta than we anticipated during the second quarter.

We were looking into -- that section is for future dividends and run rate of where we think we’re going to be over the longer term, come September even likely we were facing Fed rate increase, there is a whole lot to consider as to the dividend on a quarterly basis and our board of directors.

We take that all into consideration prior to the announcement of the dividend. So I’ll used the Feds where it will be data dependent, but what's the expectation and what for the Fed and the yield’s curve. All that's a factor and we will have to see, we’ll leave it up to our board to make the decision as to where we go from here..

Okay.

But all rate increase is generally positive for core earnings, for Capstead, which is unique in this space?.

Just we sure anticipate that yes..

And this a remainder [Operator Instruction] Our next question comes from Mike Widner from KBW. Please go ahead..

Let me change the subject from prepays for a minute and talk about the hedge book. You guys added -- you added some swaps in the quarter. I know some are running off but, all in the active pay kind of total notional amount went up. And it's higher now than it has been over the past couple of years.

How do you think about that level and you get a -- I think between this quarter and next quarter, like 1.6 billion running off, how should we think about the overall swaps balance and what you're trying to do there?.

I mean I think you look it in terms of our duration gap and in this type of environment our duration gap drifted out a little bit, but a lot that was around me.

I think we will stay and see over the three month duration gap area, while in this environment and so if you kind of backend into the map on swaps, we will be continuing to actively hedge our longer reset book in particular and I wouldn't look for our percentage of longer term either repo or swaps to come down anytime soon..

And Mike we did add some longer days repo as well during the quarter, we’re at about 2.5 billion on that..

Okay. That makes sense. And let me go back then to I think what I heard Joel just asking you kind of answer that -- when it comes to Fed tightening, conventional wisdom is that net interest spreads kind of across the group go down, and it sounded like your response to this question is that may very well be different from Capstead.

I just want to make sure I'm hearing you kind of right there as you think that -- that would be the case, just perhaps you are not as -- you might not see net interest spread compression as the Fed tightens?.

No I don't think, I don't think we said that. I think everybody is going to see, if the curve flattens everybody's going to see some compression and speed, I mean compression spreads, but ours will recover more quickly.

But obviously unless you got 100% of your liabilities hedged and we do have the lag effect of our short resets going up to some degree you're going to have some spread compression.

Although that could be offset some by slowing speeds, things like that, but I think it's very hard as the Fed moves and you're in a flatter yield curve environment to not have some spread compression..

Yes, and add to that I mean the resiliency of our book value even in that sort of environment that we will -- our portfolio will adjust higher which will have some delayed improvement in our net interest spreads as the underlined mortgage coupons adjust to higher level over their reset period but don't fall lock set with the Fed rate increases, those have a 6 to 12 month lag as to when the underlying loans will adjust.

That has a very beneficial value -- relative to market value of the portfolio, it gives you greater stability much more so than the average fixed rate, fixed income security. So we're very comfortable with that side of it. Yes, spread compression will likely happen in that world but book value will be, will hold in reasonably well..

I think if you look at everybody it's obviously the big concerns are flatter inverted curve and there's, some people assume that since we're at the shorter end of the curve we're going to be disproportionately hurt and I don't think that's the case because I mean if you look at fixed rate passthrough for the most part, let's just peg that to the 5-year Treasury.

Even if the two year goes up to, call it 2% which is kind of where people are saying I don't think the 5-year is going to stay at 1.65 and so if the 5-year goes up 50 basis points and you're fairly flat between two’s and five’s you're still going to lose more in value on a fixed rate MBF portfolio than you are on ARM portfolio.

And past rate cycles where we've gone up ARM spreads cannot widened as much during the initial tightening phase as fixed rate passes are, so I don't think you can just isolate the part of the curve, we're all going to say, we're going to be disproportionately hurt because I don't think that's going to be the case..

Well, so on the first part thank you for the color because I was scratching my head a little bit when I heard something different. But yeah, I know everything you said makes sense.

And just in the latter part, I mean I certainly hear it from investors that, worry about the current reset ARMs and the valuations on those, are they still going to trade 107 if the Fed at 100 basis points or are they going to trade back to 103, and I -- that will be, I think a very interesting question. .

Well it is I mean and if you look at past cycles ARMs have outperformed fixed rate passthroughs in a rising rate environment from most, I mean if the 5-year goes up 50 basis points in theory on a 15 year security, you're going to lose over 2 points in value, if spreads don't widen at all.

Given the duration of our portfolio it's just over a year even if short rates went up a 125 basis points you're still going to do better than a fixed rate pass through, unless ARMs widen significantly more than fixed rate passthroughs and that hadn't been the case in the last tightening cycles we've been in and we've been three or four with similar types of portfolio..

No, I mean, I hear you and the math is -- kind of the math in some sense but I think we've talked about this before.

But the argument that we hear against that is that there's something different about the Fed being at zero and in fact the scarcity value of anything with yields and inside of a year duration puts current reset ARMs at sort of an artificially inflated duration now and when if you get into an environment where you actually have a lot of other options for a short duration paper treasuries or otherwise that have positive yield as opposed to zero yield that -- the scarcity value of current reset ARMs which were inherently callable bonds could move down disproportionately, that looks like spread widening perhaps but --..

Obviously and that's going to be a function of speed and you have to determine what your view is on the slope for the curve, but if short rates go up then ARMs are in the low fours and fixed rates are in the high fours you're going to have some refinancing.

But at the same time then we have our, our book now is prepaying quickly, that those guys are going to be out of the money and so you have to look at both pieces of the portfolio and so the guys that are refinancing now will have less and less incentive and so at that point you're just talking about very seasoned current resets and the valuation is going to be driven by speed as much as anything..

No, I mean think that's all fair and I wish I had perfect crystal ball because there's money to be made somewhere -- somebody's wrong about this argument and somebody is not, and I don't I'm frankly pretty agnostic because I can see both sides of it.

And instead of rambling forever on this topic, let me just go back to the portfolio composition for one second, on the current reset bucket -- I'm sorry, on the longer to reset bucket, how would you generally characterized that? Is that like relatively new 5/1s versus little more season 7/1s.

I mean, I know that the average amount to reset -- I think you listed as 40 something. .

Yes, it's a combination of season 7/1, we have some newer -- for the most part, we haven't been buying anything longer than 60 months to reset.

Now that could be a new issue 5/1 and could be a season 7/1, but I -- the bulk of it is a season 5/1 and 7/1, there is no a ton of new issue paper in there and as you look at the Ginnie Mae portfolio, longer resets, its -- same thing holds true..

Okay, so I'm -- I mean basically 3/1s are non-existent and not near obviously [indiscernible] and probably not a lot on the 10/1 side either so basically --. .

Yes, it's mostly season 7/1 and season 5/1..

Okay, alright. Well, thank you. I appreciate the color as always guys and my congratulations on at least that and positive economic returns this quarter, which is so far unique in the group..

Here ladies and gentlemen, this will conclude our question-and-answer session. I would like to turn the conference back over to Lindsey Crabbe for any closing remarks. .

Thanks again for joining us today. If we have any further questions please feel free to give us a call. We look forward to speaking with you in next quarter..

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect your line..