Hello and welcome to the Capstead Mortgage Corporation fourth quarter 2020 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today’s presentation, there will be an opportunity to ask questions.

To ask a question, you may press star then one on your touchtone phone. To withdraw your question, please press star then two. Please note today’s event is being recorded. I now would like to turn the conference over to Lindsey Crabbe, Manager of IR. Ms. Crabbe, please go ahead..

Good morning. Thank you for attending Capstead’s fourth quarter earnings conference call. The fourth quarter earnings release was issued yesterday, January 27, 2021 and is posted on our website at www.capstead.com under the Investor Relations tab. The link to this webcast is also in the Investor Relations section of our website.

An archive of this webcast and a replay of the call will be available through April 28, 2021. Details for the replay are included in yesterday’s release.

On the call today are Phil Reinsch, President and Chief Executive Officer; Robert Spears, Executive Vice President and Chief Investment Officer; and Lance Phillips, Senior Vice President and Chief Financial 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.

In addition, certain terms used in this call are non-GAAP financial measures, reconciliations of which are provided in the company’s earnings release and the company tables or schedules, which have been filed on Form 8-K with the SEC and may also be accessed through the company’s website.

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 on this call is current only as of the date of this call, January 28, 2021.

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

Thank you Lindsey, and thanks everyone for your interest in Capstead Mortgage. After I make a few brief remarks, Lance will give a quick recap of the fourth quarter and Robert is going to provide us with some current market color, then we’ll open the call up for questions.

We’re pleased to report another steady quarter with lower borrowing costs offsetting the effects on portfolio yields of continued high mortgage prepayments as Americans continue to take advantage of generational lows in mortgage rates to refinance or purchase a new home.

On a core earnings basis, we have again earned our $0.15 common dividend, producing 8.85% annualized return on common equity. For all of 2020, we earned 9% by this measure. We accomplished these returns with lower leverage and portfolio balances post-pandemic.

The common dividend itself was unchanged for five quarters now and our core earnings met or exceeded the dividend in each of these quarters, despite the market disruption experienced in March. We are the only mortgage REIT that can make that claim.

In fact, looking at peers in the residential mortgage REIT space, on average their dividends currently stand at about 50% of what they were pre-pandemic, and that’s a stark contrast to our steady performance.

Our book value is down $0.04 in the fourth quarter which, together with a $0.15 common dividend, resulted in a three-month economic return of 1.6% or 6.5% on an annualized basis.

Since the pandemic-induced fixed income disruption in March and through year end, book value was up $0.69 which, together with $0.45 in common dividends, resulted in an economic return of about 19% or 25% annualized. Thus far in 2021, book value is little changed, down a penny to $6.75 a share.

Looking forward, we are optimistic that we’ll not see a repeat of the market disruptions experienced in March given the lower leverage levels in the market and the Fed’s bond buying programs; however, mortgage prepayments remain at high levels in no small part due to the Fed’s continued heavy involvement in the markets.

This is having the effect of lowering returns and crowding out private capital, making it harder to reinvest capital made available from portfolio run-offs at attractive levels.

We expect prepays to moderate over time as run-off is replaced with slower paying newer production, with the seasoning of existing holdings, and with lower coupon interest rates on our currently resetting bonds.

Given these market conditions, we’re being judicious in deploying our liquidity, building flexibility to potentially take advantage of opportunities as they unfold in the coming quarters. With that, I’ll turn the call over to Lance and Robert..

Thank you Phil. We reported a GAAP net income of $23.3 million this quarter or $0.19 per diluted common share. Our core earnings were $19.7 million or $0.15 per diluted common share. As a reminder, our core earnings exclude realized and unrealized losses on our portfolio related interest rate swap agreements.

We include a reconciliation of our GAAP to core earnings on Page 9 of our press release. Book value decreased $0.04 per share during the fourth quarter, ending at $6.76 per common share with derivative related increased of $0.10 being offset by $0.14 in portfolio related declines largely due to run-offs.

Portfolio yields averaged 1.55% during the quarter, a decrease of 30 basis points from the 1.85% we reported in the prior quarter.

Yields declined due to lower coupon interest rates on acquisitions and on existing loans that reset to lower current prevailing interest rates, as well as higher yield adjustments for investment premium amortization due to continuing high levels of mortgage prepayments.

Our portfolio-related borrowing costs after adjusting for our hedging activities averaged 0.37% during the fourth quarter, 30 basis points lower than in the prior quarter, leading to approximately a one basis point improvement in our net interest spreads.

As a result of pair outs during the quarter at December 31, the fixed pay rate on our swap book was 0.04%, a decline of 65 basis points from rates in effect on September 30. These lower fixed rates going forward will benefit future earnings.

Robert?.

Thanks Lance. The yield curve steepened significantly during the fourth quarter with 10-year yields increasing 23 basis points while two-year yields declined about a basis point. Longer term, this trend is a positive for ARM valuations and [indiscernible].

There was however short term disruption in new issue RMBS originations due to the transition from LIBOR to SOFR indexes. Many originators quit taking LIBOR applications early in the quarter but didn’t get SOFR product rolled out.

As a result, fourth quarter production was skewed to the downside and was at the lowest level of the year at roughly $1 billion. At the same time, an extremely strong [indiscernible] for new issue ARMs of all shapes and sizes caused spreads to tighten dramatically on the lowest coupon, newest paper that is perceived to be immune from prepays.

Also, secondary selling was very light in the quarter. As a result of these crosscurrents, we’re currently seeing more value in the seasoned ARM space as opposed to new issues. Prepayments remain elevated. We expect this trend to continue for the next several months. As we move into 2021, the yield curve steepening trend has remained intact.

We’re starting to see new SOFR ARMs coming out [indiscernible]. As a matter of fact, we’ve already seen over $200 million of this new SOFR paper in January [indiscernible]. [Indiscernible] spreads are relatively high on this paper, the fact that supply is starting to come out in a more normalized fashion is positive nonetheless.

I would expect the market to become much more normalized as far as production and volume around March. With that, we’ll open the call up for questions..

[Operator instructions] The first question today comes from Steve DeLaney with JMP Securities. .

Hey, good morning everyone.

How are you?.

Morning..

Thanks for the comments and the good release last night.

Robert, you talked about the tightness in the market - a lot of that sounds like just supply and demand, but help us get a sense for as you see the market today, give us a range or an idea of what your minimum ROE hurdle is to invest new cash - it sounds like you’ve kind of stepped back, and that minimum hurdle, how does that change between, say, current reset and fresh paper, longer duration paper?.

Yes, sure. I think--just thinking about it, we have preferred out there at 7.5, and so at a minimum we are not going to invest unless we can get an 8% level of return, so right now we are seeing just in leverage anywhere from 7.25 to 8 times. We’re seeing even 9% returns in some parts of the market, but that’s mainly the seasoned space.

With where new production is trading right now, it’s inside that bogey. I would expect those spreads to normalize, though, as production picks up, but obviously fixed rates have tightened as well. ARMs don’t just trade in a vacuum. The wildcard right now is how long the bank bid lasts.

A lot of times, those guys are in heavy the first quarter and then they back away, so that’s one of the wildcards. But--so the next couple of months, I think new issue paper is going to stay on the tighter side and we’re probably not going to be super active in that space.

We’re optimistic as we move through the year, though, given the slope of the curve, and what we’re seeing already--I mean, some of the larger originators are putting out $25 million, $30 million block-sized bonds out into March and April already, and so we’re very optimistic about that over the coming months, not so much in the first month or two of the year because the trades that we’ve seen so far, new issue [indiscernible] paper is [indiscernible] along with fixed credits.

Right now, it’s not overly compelling. We think that could change over the next few months, so we’re going to probably in the short run stick more to seasoned paper..

Got it, that’s helpful. Thank you. Lance, one for you. Your kind of expanded disclosure these days on fair value swap maturities disclosures, and just looking at your table here for December 31 versus 9/30, you’ve gotten rid of obviously some much higher cost swaps; but also, I think you’ve switched to OIS swaps.

Should I interpret this that when you say you’ve got an averaged fixed rate in any particular quarter, let’s say third quarter of 2022 and it’s only one basis point, is that just your net between what I would normally think of as a fixed pay versus received spread on that swap contract?.

No, that’s actually our average fixed pay..

That’s your average fixed pay?.

For the ones maturing in that period. .

Right, so you’re basically saying you’re paying one basis point?.

Yes, so using that third quarter example, that swap notional amount of $1.2 billion has an average fixed rate of one basis point..

Okay..

[Indiscernible] to follow up on that, those current two-year OIS swaps are at about eight basis points, so that one is [indiscernible] in the money right now..

Okay, thanks. I’m going to do a follow-up with you, Lance, in the next day or two, just to make sure I’m clear on that for modeling purposes. Thanks for the comments, guys. .

Thank you. The next question comes from Jason Stewart with Jones Trading..

Hey, good morning, and congratulations on a great 2020. I think good kudos for a good performance in a tough year. I have a question on the yield adjustment in the fourth quarter.

Lance, if you could quantify it, if possible, and then maybe set expectations for anything that would occur again in the first quarter, if that sort of level set the numbers there. .

On the fourth quarter yield adjustments, it was--do we disclose--? We haven’t been disclosing the breakdown of that, but it’s been pretty consistent in the seven basis point yield adjustment, I want to say over the last second half of the year.

For the first quarter, as a reminder, some of our peers adjust life speeds on a pretty regular basis and then they back it out of core earnings. We traditionally do that on an annual basis and look at life speeds, but there’s no requirement for that, but that’s how we kind of try to look, a little more longer term.

We’ve done that in the past over the last couple of years at least in the first quarter, and I expect that’s what we’re going to look at again this year.

With the higher prepayments, obviously there’s a chance we’d move those speeds up, and if we do, we would certainly disclose the impacts or what others call the catch-up, but what we would just say that life speed adjustment, we would disclose that in the first quarter and break that out for you..

Okay, thanks. Then obviously we’ve seen a little bit of a whipsaw in rates in the first quarter so far.

If you wouldn’t mind just walking us through a little bit of how the portfolio has performed in terms of duration, extension, and I appreciate the comments on new issue, but just in the way that the legacy has traded so far given the short duration nature of it and what we’ve seen happen in rates. I think that would be helpful..

Sure. As Phil mentioned, our book value is down a penny at our last mark, which was as of close of business--marked as of close of business last Friday, and so essentially if you look at the curve, the two to three-year part of the curve is pretty much unchanged.

Given duration of our book, it really hasn’t moved a lot, although spreads on newer issue lower coupon paper have tightened, so we’ve seen some of those prices on the lowest coupon paper we own improve by as much as a quarter of a point. Most of the other paper is--comparable paper out there is fairly flat, and so not a lot of movement so far.

To categorize the ARM market in general, what’s going on right now, most newer ARM paper is trading somewhere between 104.25 and 105.25, and there’s a lot of price compression just like you see in fixed rate, because it’s kind of a speed play right now.

In this environment, just like the fixed rate market, the better performing paper right now is either lower coupon or very seasoned with a really good speed story.

Does that answer your question?.

Yes, that’s super helpful. I just think that with the context in terms of portfolio performance and the moving longer term rates, it’s helpful to stratify the way that the portfolio is performing, so that’s helpful, thank you..

Sure..

Thank you. The next question comes from Jon Evans with SG Capital..

Yes, I was just curious, can you talk a little bit about--I’m sure you’re frustrated by the valuation in your stock, just relative to you guys being the only mortgage REIT that didn’t cut the dividend, etc. You’re trading about 81% of book.

Since you’re bringing down leverage, do you look to potentially start to deploy some of that capital and buy the stock back down here at these levels?.

Yes, that’s a great question. We are trading at a lower multiple than we think we deserve, obviously, and considering that we’re 100% agency book, and we have performed well from a cash flow perspective.

With the leverage coming down a little bit in the fourth quarter, with the supply and demand dynamics that have been in place that Robert described, we’ll see how that plays out; but we would probably run leverage potentially even lower by the end of the first quarter if we don’t see good opportunities to deploy capital, so that gives us a lot of flexibility to look at buybacks or other manoeuvres to use that capital.

We’re certainly open to doing what’s best for our stockholders in that regard..

Okay. Then the other question that I have for you is AGNC on their call, I know your book is different, etc., but they were talking about how they think there’s potentially getting to some kind of burnout on refis and that we’re getting closer to that, etc.

Can you give us any insights into what you see in refis relative to the ARM market?.

Sure. I think over time, most segments of the MBS market start to exhibit burnout, and ARMs are not different in that regard.

I would think that prepayments will remain elevated throughout most of this year and then after that, you get to a point where pretty much everybody out there that could have has refied, and so the dynamics right now over the next six to nine months look like speeds are going to be elevated.

I think after that, you should start to see some burnout exhibited. Also, the difference too in an ARM book versus a fixed rate book, we have [indiscernible] reset securities that are resetting lower in yield.

A fully indexed ARM on this seasoned short reset paper to the borrower now is around 2.5%, and so as those loans reset downward, they will slow down as well. That’s not necessarily burnout, but it’s a nice feature of our portfolio.

The cohorts that remain somewhat fast would probably be no different than if you think about the fixed rates in terms of coupons that we have, three and higher for instance. Those guys are going to remain fast for a while.

But all in all, after we get through the first six to nine months of this year, we think we could see speeds starting to moderate..

Okay, and--yes, go ahead? I’m sorry..

Well just a real quick aside to Robert’s point about our current resetting portfolio, we had a request to increase our disclosure relative to how those bonds will reset in the coming year or so, so we added a sentence to that effect on the last page of the press release. .

Thirty-six percent, right? Thirty-six percent the next six months?.

Yes, there’s 36% there, again on average reset in six months time, but we improved the disclosure to indicate that 22% of that amount will--that reset will occur in the next quarter, and another 33% in the quarter after that, which would be the third quarter, then the remaining 40% over the following six months.

We gave some additional disclosure there..

As investors, though, we should just think about that as positive ramifications, as obviously it’ll reset, the yield will come down, but there won’t be run-off because most likely it’s not going to refi, correct?.

Yes, those folks will have a whole lot incentive to refinance after their coupon resets down.

That part of the portfolio is already paying slower than the bonds Robert was referring to, that have a fixed coupon with years to go, because they already know, or they should know that they’re going to get something out of a coupon reset without having to do anything about it.

It will just happen, so they won’t necessarily refinance in anticipation of a lower coupon on their bonds, but it will certainly be affirmation of that when their mortgage payment goes down..

Got it, and could I--.

[Indiscernible] without getting into the math, [indiscernible] drop in speeds on a seasoned bond may throw up a higher yield at the lower coupon than what it does now, so speeds are very levered in that kind of paper and so all in all, I think the speed decline would more than offset the detriment of the coupon loss..

Got it. Then if I could just ask just a bigger picture, obviously we’ve seen this steepening significantly into the 10s, which eventually should have positive ramifications for your portfolio.

Can you just talk a little bit about what we need to see maybe in fixed rate mortgages before ARMs really start to explode from a production standpoint? You talked about what was going on in LIBOR versus SOFR, and that’s kind of a mechanical issue, but what are we rooting for to happen?.

Well already with the steepness that we’ve seen, originators are out there with, say, 7.1 ARMs at as much as three-eighths of rate difference cheaper than a 30-year fixed, and from what we’re hearing from guys that are in contact with big originators, they’re seeing a big pick-up in ARM production versus the fourth quarter, albeit from a very low level.

That steepness alone is causing an increase. Any steepness from there would only increase supply, liquidity and attractiveness, I think, of the ARM market, so we’re optimistic about supply going forward. In the environment we’re in now, if it steepened further, it only gets better..

Okay. Thank you so much for answering my questions. I really appreciate it, and I hope you buy some of the stock back..

Thank you..

The next question comes from Derek Hewett with Bank of America..

Good morning everyone.

Given those near term headwinds on new issue yields and the portfolio trending modestly lower, and presumably lower leverage if you don’t buy back any stock in the near term, how should we think about the sustainability of the current dividend? Are these headwinds in the near term and things should start to normalize in Q2 and beyond, or what are the expectations around those trends?.

There’s a lot of moving parts, right, and a whole lot of optionality in where we could be from an earnings perspective quarters down the road.

A lot of it can depend on what we were just talking about, how much the yield curve steepens, if any, and if we can buy bonds at decent ROEs, whether we maintain leverage the levels we’re at, if we don’t, what do we do with the capital, do we keep it as dry powder or do we deploy it through buying back our own capital or otherwise.

There’s a lot of unknowns this year. It’s probably more--it’s more uncertain in terms of some of those factors than you might ordinarily have at this stage, so we’re not really prepared to say a whole lot about where that goes. But we will strive to hold onto our dividend level if it looks to be a temporary decline in core earnings.

We don’t want to disrupt our pattern of dividends for something that’s transitory..

Okay, great. Thank you. .

Thank you. Once again, please press star then one if you would like to ask a question. The next question comes from Eric Hagen with BTIG..

Thanks, good morning guys. A follow-up on originators rolling SOFR ARMs.

Can you just shed some light on the product itself, what are the margins and caps and floors being offered to borrowers?.

Sure. So far, most of what’s come out has been in the 7.1 space, and the difference is the old 7.1 LIBOR had margins of--net margins of plus 160 or so. The newer SOFR paper that’s come out has had margins around 212.

It’s theoretically a 1.5 cap structure, if you will, because it resets twice, so it can reset up 5% at the first reset and then 1% every six months after that. If you look at how it’s trading so far, it’s really not trading materially different than what a LIBOR, similar LIBOR ARM would trade at.

It’s basically trading off the coupon with people assuming a margin adjustment of roughly 50-plus basis points over time versus the SOFR index is a fair adjustment. .

Great, that’s really interesting color. Thank you. Hope you guys are well..

Sure, thank you..

Thank you. As that was the last question, I’d like to return the floor to Lindsey Crabbe for any closing comments..

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

Thank you. This concludes the question and answer session as well as the call. Thank you for attending today’s presentation. You may now disconnect your lines..