Robert Cauley - Chairman & CEO Hunter Haas - CFO.

David Walrod - Jones Trading Steve DeLaney - JMP Securities.

Welcome to the Fourth Quarter 2016 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, February 17, 2017.

At this time the Company would like to remind their listeners that statements made during today's conference call relating to matters that are not historical facts are forward-looking statements subject to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995.

Listeners are cautioned that such forward-looking statements are based on information currently available and the management's good faith, belief with respect to future events are subject to risk and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements.

Important factors that could cause such differences are described in the Company's filings with the Securities and Exchange Commission including the Company's most recent annual report on Form 10-K.

The Company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements. Now I would like to turn the conference over to the Company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead, sir. .

Thank you, operator and good morning everyone. Since we last spoke at the end of the third quarter of 2016, the markets and the economic outlook have shifted by approximately 180 degrees.

The outlook for the economy, interest rates and the Federal Reserve or Fed, all changed in the fourth quarter 2016 as Donald Trump unexpectedly won the presidential election. The Republican Party retained both houses of Congress which also surprised the market.

The markets reacted strongly to these developments and interest rates moved significantly higher. In what is commonly referred to as a risk on trade, Treasury securities declined in price while other assets that carry more risks -- equity, commodities, municipal bonds, et cetera, all increased.

The market expects expansionary fiscal policy such as tax cuts and reform, infrastructure spending, less regulation and a very pro-business administration going forward.

As a result, the market expects the Fed to follow a more aggressive policy in removing a combination from the economy, as many of the expected policy proposals should be both expansionary and inflationary.

Comments by the Fed Chair at the conclusion of their December meeting, a meeting at which they increased the Fed's funds target rate by 25 basis points, were taken as quite hawkish by the market. The summary of economic projections or SEP, implied the Fed expected three Fed funds rate increases in 2017.

The incoming economic data in the last part of the fourth quarter and into the first six weeks of the first quarter 2017, has contributed to the positive tone to the risk asset market.

Readings from the job market indicate the economy is at or near full employment, broad measures of growth, namely GDP, appear to be running at or slightly above 2% on average over the last three quarters and inflation appears to be rising.

Certain measures of inflation, namely the headline and core CPI data releases from the Bureau of Labor Statistics -- while not the Fed's preferred measure -- are up 2% on a year over year basis and appear to be accelerating.

Retail sales were reported this Wednesday and were also quite strong, with both headline and various subcomponents up at least 4% on a year over year basis. With this backdrop, it was not surprising that the Fed Chairwoman was quite upbeat on her assessment of the economy when testifying before Congress this week.

Market participants increased the likelihood of another rate increase next month, as evidenced by the Fed fund futures market. The market is currently pricing at approximately a 40% chance of another hike next month. These developments adversely impacted the MBS market, especially so after the Fed rate hike on December 14.

Up until that point, our portfolio of generally higher coupon fixed-rate 30-year securities had performed reasonably well, especially given the rather high exposure to specified.

However, our pass-through MBS portfolio generally widened its spread to comparable duration Treasuries during the second leg of the market sell off in the fixed income market that occurred after the rate hike. The rate hike was the event that really triggered convexity related to selling in the MBS market.

By the end of that week, we observed brief periods where U.S. Treasury prices were up on the day, while MBS prices were down several ticks. However, the sell-off was also beneficial to our interest-only securities and prepayment expectations going forward, albeit not enough to offset the widening in our pass-through MBS portfolio entirely.

Returns for the quarter were primarily driven by the increase in rates triggered by the election results. Our pass-through portfolio generated return on average invested capital of negative 16.9% for the quarter on in an un-annualized basis, while the structured securities portfolio generated return of 8.4% for the quarter.

The resulting return for the combined portfolios was a negative 5.9%. As followers of Orchid Island Capital and our investment strategy know, we rely on our structured portfolio to mitigate the effect of rate increases, such as what occurred in the fourth quarter. For the fourth quarter, our IO positions had a 21.8% return, just as we anticipated.

However, our inverse IOs had a negative return of approximately 2.9%. We have slightly more capital allocated to the inverse IO portfolio.

As you may recall from our discussion at the end of the third quarter of 2016, we took steps to lessen our exposure to hard premium-specified polls at the time by selling many of these polls to various dealers, who then structured the collateral with agency CMO deals and we took back the inverse IO off of the deal.

Owing to the slow speeds and long duration of these cash flows, the inverse IOs we bought had significant exposure to future rate increases and the forward curve. This caused these securities to underperform in the sell-off during the quarter.

However, while this is less than an optimal outcome, the trades we executed were still beneficial since the high premium [indiscernible] we sold had significantly more duration, especially those that were explicitly levered by a repo funding. The Company's book value decreased from $11.21 at September 30, 2016 to $10.10 at December 31, 2016.

Our leverage ratio, excluding unsettled security purchases and sales, increased from 7.8 to 1 at September 30, 2016 to 8.4 to 1 at December 31, 2016. Over the course of the fourth quarter, we also issued shares under our aftermarket program which led to increases in the size of the portfolio of approximately $500 million.

While rates have increased into the end of the year, prepayment speeds did not slow materially until January which were reported in early February. For the fourth quarter of 2016, our pass-through portfolio prepaid at 9.7 CPR, versus 8.9 CPR in the third quarter.

Our structured securities portfolio prepaid at 18.4 CPR in the fourth quarter, versus 7.9 CPR in the third quarter. Both portfolios slowed materially in January of 2017 as the pass-through portfolio prepaid at 6.2 CPR, while the structured portfolio prepaid at 12.6 CPR.

Portfolio positioning remains concentrated in higher coupon, fixed-rate securities, with various forms of call protection. Exposure to increasing rates is mitigated by interest-only and inverse interest-only securities, coupled with various forms of funding hedges.

Short positions in Eurodollar futures, Treasury futures, paid fixed interest rate swaps and short position in TBAs and annuities. Pay up premiums for call-protected securities have decreased since the November cycle just prior to the election, but seem to have stabilized for now.

As mentioned, to address the exposure to a more dramatic increase in rates and likely erosion of these premiums, we continue to sell securities with some of the highest forms of call protection to the dealer community, for purposes of structuring them into agency CMO structures, whereby we took back an inverse IO position, thereby allowing us to maintain the favorable prepayment protection while removing the exposure to high premiums.

This activity was the primary reason that capital allocation continues to shift from pass-throughs to structured securities in the fourth quarter. The allocation to pass-through securities declined further, from 58.9% at September 30, 2016, to 54.2% at December 31, 2016. The allocation to pass-throughs was 62.1% at June 30, 2016.

The allocation to structured securities increased by the same amount, from 41.1% September 30, 2016, to 45.8% at December 31, 2016. As we move into the first quarter of 2017, the market is still waiting to see what the Trump administration will actually deliver for the economy and markets.

As developments unfold over the course of the year and beyond, the markets will react as these developments are either consistent with or counter to, current market expectations. At this point there is no way of predicting this outcome.

In the meantime, the combination of higher rates and slower prepayments fees should be supportive of the earnings power of the Company's portfolio. That being said, the incoming economic data continues to run strong and there is no mistaking the pronounced shift in the tone of the remarks emanating from the Fed, especially the Chairwoman.

To date, market pricing of future rate hikes is lowered in the Fed rhetoric and their SEP thoughts would warrant. We will be increasing our funding hedges slightly as we think the market is offering cheap protection from higher rates, versus our view on the economy and fed rate hikes in the future.

Going forward, the exposure to the higher forms of call protection is likely to continue to decrease, absent a reversal of the upward trend in rates. We may continue to reduce such exposure by the structuring options described previously.

Otherwise the portfolio will rely on lower forms of call protection when redeploying pay-downs or investing new capital when and if available. Operator, that concludes my prepared remarks and we can now turn the call over to questions. .

[Operator Instructions]. Our first question comes from David Walrod from Jones Trading. .

Good morning.

Bob, could you talk about the environment -- towards the end of your comments as far as where you're putting new capital? Are you still going to be favoring the structured portfolio? How are you viewing new capital deployment?.

Twofold. We're still not going to have a very focused concentration of portfolio and higher-coupon fixed-rate securities, although we're buying lower forms of call protection. As I mentioned, we had taken on a lot of the inverse IOs with restructuring option and I will let Hunter's speak to this in a minute.

But we're probably going to take some of that off and look to replace some of that with IOs. But I will turn it over to Hunter. .

Sure. Dave, basically, the securities that we created are fully extended now, so we took back a lot of inverse IOs off of the higher, more expensive forms of call protection, really in the third quarter I guess and in the beginning of the fourth -- early -- pre-election in the fourth quarter. Those securities are now paying at turnover-like speeds.

They do not have as much upside related to the IO component of the inverse IO and so have gotten a lot longer. They are also trading very well right now. They have tightened up considerably since the election.

So we look to move out of some of that stuff and into more IOs and inverse IOs that have more room to slow down and can actually benefit from rising rates on the long end of the curve. .

And then, you also mentioned that your prepaids have come down in January.

What is your outlook for the first quarter and going into the year on prepaids? Do you think that trend will continue?.

Yes, I would expect, at least for the near term. And we have been down this path to some extent before, where we've had a sell-off and the markets and ourselves kind of get convinced it is going to stay like this for a while, only to be surprised. I do think it is different this time.

I think the underlying economic data is pretty strong and I think there is a sense that inflation, whether you look at the preferred measure of the Fed which is PCE or CPI -- they may not be the same level but they are moving the same direction. All of the other economic data seems strong and who knows what we get from the Trump administration.

But to the extent we get much of anything, it is more fuel on the fire. I think rates probably are, safe to say, stay here for a while which would imply slower speeds. We still are in the middle of the seasonal slowdown, so if you move into spring you're still going to see some pickup associated with people moving.

The underlying fundamentals for the consumer, clean balance sheet, income rising, job opportunities are plentiful, it is not hard for people to be able to move or trade up in-house, you will still see some of that. I do not think and I would be surprised if we saw, over the next three to six months, a return to where we were in the third quarter.

Hunter, you want to add to that?.

Sure. There are three primary things that are going to be very beneficial to our earnings in the next several months. One of which, as you know, asset prices are considerably lower, so there is less premium to amortize. And, as you know, we focus on a high-premium portfolio, high-coupon securities combined with IOs and inverse IOs.

The absolute level of bond prices is lower. Speeds are going to continue to be much slower, as Bob alluded to, so that brings amortization expense way down. But then the third element that is going to be helpful to us is that there is more of the types of securities that we like to own being produced now.

So there was really not very much by way of the high-coupon securities that we like to buy in the second half of the year, post-election. We have already seen a considerable uptick. The coupons we like to buy are becoming more of the production -- closer to the production coupon.

So we actually have choices and do not have to settle for high pay-up securities if we want to acquire, say a Fannie 4.5%. We have sort of our pick of the litter now. So that will help out our ability to turn over the portfolio from month to month which is something that we like to do to help keep speeds slower. .

Our next question comes from Steve DeLaney from JMP Securities. .

Just from questions from clients, there seems to be a little bit of confusion this morning about what the GAAP $0.72 loss really means with respect to the dividend. So we have been trying to help people out.

I realize your accounting is complex and that probably contributes to the reason why you and your accountants decided not to go -- for the Company not to provide a core, but we I think have the license to do that where we sit.

If I were to add back the $38 million that you identified for realized and unrealized losses on securities and on derivatives, would you consider that a logical starting point to adjust your GAAP net income to arrive at something that we might call core?.

Yes, it is. It's the first step -- we go back and forth on this a lot, Steve. The fair value option which we've elected does offer a lot of complexities and it really prevents us from publishing a core number. You obviously can do so, but whenever you report a core earnings, you have to do a reconciliation from GAAP numbers.

The biggest stumbling block for us is that, because we use the fair value option and we do not use available for sale, we have no explicit amortization premium. It just shows up in the mark to market, if you will. So on the press release we put this number in there called Premium Loss Due To Pay-Downs. That is a non-GAAP measure.

If we were to try to publish a core number and do a GAAP to a non-GAAP reconciliation, we have to use that number but it is non-GAAP. So its really not something we can get to. Our accountants and lawyers are just not comfortable. But, as you say, we have had this happen before where we have large mark-to-market gains and losses.

The headline number gets really distorted, either up or downside. We put in a second bullet point hoping to mitigate that, but based on what I see on the screens today, it does not seem like it has worked too well. .

Yes. It was just a process. On the other hand, for core, we generally for our companies will add back non-cash stock comp. I am curious if your $9.1 million of expenses does have a component that is stock comp. .

It does. I think it is only a couple hundred thousand dollars for the year. Not a material number. .

Okay. Great. The one final thing I would like to touch on is leverage, 8.4 times.

How does this compare to the highest levels that you have been at historically? And I am curious whether you have an internal limit that you and the Board have set for the maximum leverage?.

We have no explicit range. I think we have been as high as the high 8s, probably bringing that down as Hunter said. We're probably looking to continue to move away from pass-through towards structure. They're not levered, so they tend to bring it down.

We have not -- we don't set a specific target, it is more a byproduct of the capital allocation and how our profile looks when we stress the portfolio, what we think is prudent. It still appears to be on the high side, but one of the things about the portfolio, that number is a product of a pretty arbitrary calculation.

When you look at the first half of 2016, when the market was rallying, we had a negative duration. Our book value went down over that six-month period. It is just the nature of the portfolio.

We have such a high concentration of high-coupon fixed rates and I really have to see a meaningful move in the market, like we had in the fourth quarter, to get the portfolio to show a lot of positive duration. So it is a little more art than science in that regard.

But we do run stresses all the time and that really drives the level that we're comfortable with and so far, so good. .

Steve, two things I would add are, one we felt it was important for us not to de-lever going into the -- in the wake of the big sell-off that we saw. Part of that uptick in leverage was associated with the fact that we did not want to sell our portfolio in the weakness and de-lever at that point in time.

We think we can pick better spots and so far it has turned out to be a wise decision. We're going to de-lever now, it is a much more conducive environment to do it than it was at the end of December when mortgages -- there was a very weak bid for mortgages at that point in time. Selling was a challenge at that point in time.

We made the strategic decision to leave the balance sheet a little bit higher than where we would typically like for it to be and that is showing up in the numbers.

The other thing is, we have started to put on some trades, over the last six months or so, where long, lower pay-up specified pools that are brand new and we're taking a little extra balance sheet -- we're adding to the balance sheet with those trades, but we do not really feel like they are upticking the risk of the portfolio.

We may say 100 million new issued Fannie 4.5%s that we expect to carry at 7% or 8%, 6% a month for the first few months and hedge those with an equal number of TBA shorts. So the risk in the portfolio is only to the extent of the pay up on the security and we can clip a few cents here or there by doing these types of trades.

The balance sheet will look bigger, but in my mod view, the additional risk to the portfolio is not materially larger than it was at with lower levels of leverage. .

Steve, I would add one final point to that. As I mentioned in my prepared remarks, through the ATM we did issue more stock and increased the size of the portfolio by about $500 million. Almost all of that was put to work in early December. We felt very fortunate that in the midst of a meaningful sell-off, that we had some capital to put to work.

And we were able to acquire some bonds at significantly lower dollar prices than where we were buying them in the third quarter. That was another reason we felt a little more comfortable taking the leverage up, because we were buying these bonds, one, at pretty cheap attractive levels, but two, after already a pretty meaningful mark-up.

As I mentioned, after the Fed increase and the tone of the Chairwoman's remarks was so hawkish, the market really did react violently. That is where [indiscernible] book value decline occurred, but we still bought a lot of nice assets at attractive prices. The market, you know, is more or less traded sideways since.

We're still waiting to see what comes next out of Washington. We were very comfortable with that trade. .

[Operator Instructions]. I am showing no further questions. I would now like to turn the call back to Mr. Robert Cauley for any further remarks. .

Thank you, Operator and again thank everybody for their time. We will be in the office all day to the extent anybody has follow-up questions or doesn't get a chance to listen to the live call and wants to respond after hearing the replay. Our number in the office here is 772-231-1400. Look forward to hearing from you.

Otherwise we will hear from you at the end of the first quarter. Thank you. .

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone have a great day..