Lloyd McAdams - Chairman of the Board, Chief Executive Officer Joe McAdams - President, Director, Chief Investment Officer Brett Roth - Senior Vice President, Portfolio Manager.

Douglas Harter - Credit Suisse Steve Delaney - JMP Securities.

Good afternoon and welcome to the Anworth Mortgage second quarter earnings conference call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note, this event is being recorded.

Before we begin the call, I will make a brief introductory statement. Statements made on this earnings call may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended.

And we hereby claim the protection of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to any such forward-looking statements. Forward-looking statements are those that predict or describe future events or trends and that do not relate solely to historical matters.

You can generally identify forward-looking statements as statements containing the words may, will, believe, expect, anticipate, intend, estimate, assume, continue or other similar terms or variations on those terms or the negative of those terms.

You should not rely on our forward-looking statements because the matters they describe are subject to assumptions, known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control.

Statements regarding the following subjects are forward-looking by their nature, our business and investment strategy, market trends and risks, assumptions regarding interest rates and assumptions regarding prepayment rates on the mortgage loans securing our mortgage-backed securities.

Our actual results may differ materially and adversely from those expressed in any forward-looking statements as a result of various factors and uncertainties, including, but not limited to, changes in interest rates, changes in the market value of our mortgage-backed securities, changes in the yield curve, the availability of mortgage-backed securities for purchase, increases in the prepayment rates on the mortgage loans securing our mortgage-backed securities, our ability to use borrowings to finance our assets and, if available, the terms of any financing risks associated with investing in mortgage-related assets, changes in business conditions and the general economy, including the consequences of actions by the U.S.

government and other foreign governments to address the global financial crisis, implementation of or changes in government regulations affecting our business, our ability to maintain our qualification as a real estate investment trust for federal income tax purposes, our ability to maintain an exemption from the Investment Company Act of 1940, as amended, risks associated with our home rental business and the manager's ability to manage our growth.

These and other risks, uncertainties and factors, including those discussed under the heading Risk Factors in our Annual Report on Form 10-K and other reports that we file from time to time with the Securities and Exchange Commission, could cause our actual results to differ materially and adversely from those projected in any forward-looking statements we make.

All forward-looking statements speak only as of the date they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us.

Except as required by law, we do not intend to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Except as required by law, we expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements that may be made today or that reflect any change in our expectations or any changes in events, conditions or circumstances based on which any such statements are made. Thank you.

I would now like to introduce Mr. Lloyd McAdams, Chairman and Chief Executive Officer of Anworth. Please go ahead, sir..

Thank you very much. I am Lloyd McAdams and I welcome you to this call today where we will discuss our second quarter operating results. I will now turn the call over to Joe McAdams, our Chief Investment Officer and President. Also with us today is Brett Roth, Senior Vice President and Chuck Siegel, our Chief Financial Officer.

I will participate in the call later. Thank you very much..

Thanks. This is Joe McAdams. Turning first to the company's earnings for the second quarter. Core earnings were $12.1 million or $0.13 per common share. This was a decline from $0.15 during the first quarter.

This $0.02 decline was largely driven by an increased rate of prepayment and early repayment on both our agency and non-agency MBS during the quarter.

While this portfolio runoff was ultimately reinvested and total assets increased by quarter-end, lower average assets during the quarter as well as the higher prepayment related expense on agency MBS resulted in a decline in quarterly interest income. GAAP income for the quarter was $0.08 per common share, or approximately $8 million.

And comprehensive income, which includes all realized and unrealized gains or losses on our portfolio of assets and related hedged liabilities, was $14.6 million for the quarter. Looking at our asset portfolio. Total assets increased to $6.1 billion from $5.9 billion the prior quarter-end.

Our allocation to agency MBS increased to 77% from 74%, while non-agency mortgage-backed security holdings decreased from 13% to 11.3% at June 30. Within the agency MBS portfolio, new purchases were focused on fixed-rate mortgage backed securities. 15-year MBS holdings increased from 19% to 21%. 15-year TBAs increased from 14% to 16%.

And longer maturity fixed-rate MBS increased from 3% up to 10% of total agency assets. I would note that all of the quarter's purchases of longer maturity MBS were 20-year mortgage-backed securities as opposed to a 30-year maturities.

So our fixed-rate portfolio as a whole continues to have a significantly shorter maturity and therefore interest rate price risk than the mortgage-backed security market as a whole.

ARMs, adjustable-rate mortgages, decreased on the quarter, due primarily to prepayments, down to 53% of the portfolio with 31% of the portfolio being ARMs with their next interest rate rest in the coming 12 months.

As can be seen in the table in our earnings release showing coupon rates on our agency MBS holdings, the average coupon on these ARMs continues to increase as interest rates reset to current levels. The ARM coupon now stands at 3.25%, up from 3.11% last quarter.

The addition of higher-yielding fixed-rate MBS also helped increase the overall portfolio interest rate with the average coupon of the agency MBS increasing from 2.84% to 2.94% at June 30.

The average cost of our agency MBS increased to 102.87% from 102.7% the quarter before, resulting in $108 million of unamortized premium related to our agency MBS purchases. The premium amortization expense for the quarter was $8.8 million. The prepayment rate increased on our agency MBS from 19% CPR in the first quarter to 22% CPR this quarter.

This increase was driven primarily by the ARM and hybrid ARM MBS whose prepayment rate increased from 22% to 26% CPR. The increase in overall portfolio CPR is partly attributable to typical seasonal effects, which result in higher prepayment due to home sales in the late spring and summer months.

ARM prepayments have largely been focused in securities whose interest rate is increasing upwards for the first time. This so called rate shock effect has been seen this year as more ARM borrowers are now seeing the affect of the rise in one-year LIBOR that took place during 2016.

It should be noted that the FED rate increases of 2017 have been priced into one-year LIBOR. And if anything, future expectations for additional increases have been decreasing in somewhat. So the one-year LIBOR rate has been fairly stable so far in 2017 which should limit these rate shock-effects going forward.

With that, I would like to turn the call over to Brett Roth to discuss our mortgage credit investments..

Thanks Joe. Over the course of the second quarter, generally spreads in the legacy non-agency sector continued to tighten. The bulk of that tightening occurred during the month of June.

That said, toward the end of June, post June 25, when Wells announced their holding back of reserves for legal fees on called deals, the market paused at it digested this information. Since then, the market has analyzed the situation and returned to its previous liquidity with the appetite for legacy CUSIPs remaining robust.

To that point, since quarter-end, we have continued to see an aggressive bid for these assets and continued tightening of spreads for both fixed and floating rate assets. The technical of the continuing decline of legacy CUSIPs continues to and will continue to support tighter spreads in this sector.

Thus, the legacy non-agency market as well as our portfolio have and continue to benefit from spread tightening. During the quarter, we continued to selectively add positions to our legacy CUSIP portfolio, mainly within the Alt-A sector of the portfolio, but also within the securitized NPL sector.

Overall, the portfolio was benefiting from credit performance and its underlying assets as well as experiencing strong voluntary prepayment activity. Additionally, we experienced a significant increase of part calls of loans we purchased at discounts. Net net, during this last quarter, the non-agency portfolio shrank.

We will continue to look to selectively add assets at levels that make sense for us. Further, we are continuing to expand the asset types we are involved in within the credit space, including further CRT transactions. Briefly, touching on our loans held in securitization trust.

We continue to be pleased with the credit performance of the underlying assets in our securitizations. Focusing on the credit tranches, we continued to see spread tightening during the quarter. We believe this is a function of both the performance of our underlying assets and the general tightening experience in the mortgage credit sector.

On the funding side, we continue to add new counter parties to our mix of lenders and to prudently manage our financing book and therefore our costs of funds. This activity has allowed us to help offset some of the costs of the rise in interest rate. Thus we are working to, at a minimum, maintain that spreads of our assets.

Looking forward, we feel that we are at a good position to take advantage of investment opportunities as they arise in the current market. We continue to look to find attractive assets to add to the portfolio across all sectors that we participate in within mortgage credit. Thanks Joe..

Well, thanks Brett. Turning to the portfolio financing and leverage. Repo rates increased on the quarter to 1.36% on average with a hedged rate taking into account interest rate swaps now at 1.57%. The balance of our repo borrowings increased in line with the larger asset portfolio with borrowings at quarter-end at $3.5 billion.

Due to some additional preferred capital being raised during the quarter, overall leverage was unchanged at 5.3 times total capital. Our TBA agency positions increased quarter-over-quarter. So the total effective leverage, which includes the economic leverage embedded in our TBA positions, increased from 6.2 to 6.4 times total capital.

Interest rate swap balances increased as well on the quarter with a notional balance of $1.8 billion. The average maturity of the swaps increased from 2.8 years to 3.1 years to offset the increased interest rate sensitivity due to our increasing allocation to fixed-rate MBS.

Our gross and net asset duration is still relatively low with the portfolio duration of approximately 2.25 years and hedge liabilities with 524 days or 1.4 years to maturity, resulting in a duration gap of less than one year. Our effective net interest spread decreased on the quarter from 135 basis points to 122 basis points.

Asset yields were largely unchanged as the coupon increases we saw in agency ARMs was largely offset by higher prepayment expense on the quarter and average costs to fund rose by 13 basis point during the quarter. We declared a $0.15 dividend relative to the second quarter, resulting in a yield of 10% based on the June 30 closing price of $6.01.

Book value decreased by $0.05 per share to $6.04 per common share. The combination of this $0.15 dividend and $0.05 decline in book value resulted in a total economic return to common shareholders of 1.6% for the second quarter bringing the total economic return for the first six months of 2017 to 6.6%.

Finally in stock transactions, we raised $22.1 million of Series C preferred stock with a 7.625% interest rate being the total of issue size of the Series C to almost $40 million. With that, I would like to turn the call back over to Lloyd for his comments..

Thank you very much, Joe and Brett. Before we answer any questions you may have, I will briefly discuss a few topics. First in our dividend reinvestment plan, we have reinstated the 2% discount to shareholders who reinvest their dividends.

More detailed information about this is available for all our stockholders on our website or that of our transfer agent, American Stock Transfer. Next, three years ago, we first discussed our plans to integrate mortgage credit as a strategic component of our portfolio.

Our primary goal in this effort was to and is to diversify the risk that we accept as we operate our business. In most stages of the residential mortgage ownership cycle, the environment is quite placid. During these quiet times, the benefits of risk diversification are usually not that visible.

However during periods of stress in the residential mortgage ownership cycle, adequate risk diversification is often critical to long-term success. As mortgage credit now being a significant part of our assets, we will continue to identify additional ways to enhance mortgage credit diversification qualities.

As always, enhance the returns from this portion of our portfolio. This is important to us, because an important benefit of risk diversification is improving the long-term stability of quarterly income, which for companies whose emphasis is on distributions to shareholders is clearly an important benefit to all shareholders.

Final topic is the recent returns earned by shareholders. During the three years ending June 30, shareholders without the benefit of reinvesting their dividends, earned 52.3% or 15.1% compounded annually which, to be blunt, is higher than nearly all mortgage REITs during this three-year period.

For those of you who have supported Anworth during this period by being a shareholder, I say on behalf of all of our employees, I thank you. I also hope that you are just as pleased as I am as a shareholder, with these results and our prospects for ongoing success.

With that, I will turn the call over to Kate so that we can answer the questions that you might have..

[Operator Instructions]. The first question is from Douglas Harter of Credit Suisse. Please go ahead..

Thanks.

Just wonder if you could talk about how attractive you see incremental returns in the context of, if you could, would you look to raise additional capital, either preferred or common, if the stock cooperated?.

Sure. Hi Doug. This is Joe. We have, during the quarter, added to both our agency portfolio as well as additional mortgage credit investments, largely to replace, as Brett talked about, the ones that were being called or prepaying early.

In both cases, we saw on the agency side, what we feel are attractive incremental spreads of 110 to 120 basis points, when we looked, as we have been adding exposure in the fixed rate side of the portfolio.

And while Brett has obviously discussed its spreads have come in, which has been very good for our holdings of non-agency legacy CUSIPs, there is still attractive leveraged ROE potential in that sector, especially as we look to expand the range of investments we make.

So I would say on the margin, at this point, with the spread is available in mortgage credit as well as the more attractive spreads that have become available in the fixed rate agency MBS space and I think we are likely to continue as we move into a process of the Fed beginning to unwind its fixed rate agency MBS holdings.

I think we have accretive potential on really both sides of the portfolio. So if the opportunity would present itself, I think it would be a positive to look to grow the portfolio in the current market environment..

And then can you talk about how you view the risk-reward of taking extra duration risk today? How you are thinking about the right amount of that duration to hedge?.

Sure. We have been fairly constant over the past several quarters with where we stand with our net duration. The interest rate sensitivity is, the correlation is much stronger and direct on the agency portfolio, even though we did see rates increase in the last six months.

On the non-agency side, spread tightening offset a good deal of that, if not all of that. So most of our direct interest rate sensitivity lies on the agency side. The overall interest rate gap is less than a year and again as we have tried to point out really that year is positioned on a fairly short part of the yield curve.

So our exposure to interest rates would be more about significant moves in the shorter or belly part of the yield curve as opposed to the 10-year rate or the 30-year mortgage rate. So we have been comfortable with that exposure. We haven't really thought about extending it much from here.

As you know, volatility has been very low in the marketplace and agency mortgage spreads have stayed relatively constant, which is a positive. But I think we are comfortable with the gap we have.

I do think if we are going have to a change in the overall risk profile of the portfolio I do think, given the current portfolio structure and interest rate gap, we might see a higher level of overall portfolio leverage as we move forward. As we mentioned in the comments, we did see some decline in the assets into a quarter due to the prepayments.

We did get those repayments reinvested and deployed some of the additional preferred capital we raised during the quarter. But the net effect of that was still unchanged leverage.

To see maybe half a turn or maybe a little less of an increase in overall portfolio leverage is something that I think on the different measures or metrics of risk that we might look to increase moving forward, I think that's where it's probably going to come first..

Great. Thank you..

Thanks Doug..

The next question is from Steve Delaney of JMP Securities. Please go ahead..

Thanks. I appreciate you taking my questions. Lloyd and Joe and Brett, nice to be on with you. Anworth has always favored shorter duration MBS along with your friends down in Dallas, at Capstead. But these prepays have certainly been problematic with the curve flattening, hybrids underperforming and especially the short ARMs.

So you are 41%, I guess at the end of June. Just curious if, as you look at that and look at sort of the risk-rewards of hybrids for lower duration but also the higher CPR, are you inclined to maintain that 40-some percent? Or would you expect to see that decline over the next few quarters? Thank you..

Well, thanks Steve. This is Joe.

Yes..

So the first thing, just when you think about Anworth relative to other agency REITs, that we are in a position now that even though the majority of our assets are agency MBS, when you think about capital deployed in the relative leverage, our overall equity allocation is in 60/40, maybe two-thirds, one-third, it between deploying capital to our agency portfolio and deploying capital to mortgage credit.

So within the roughly two-thirds of the capital that we have deployed to agency MBS, you are correct, we do have 31% of that portfolio in these shorter resetting ARMs. I do think that allocation will continue to decrease due to prepayments. We have always thought that ARMs in having short duration is a real positive for our strategy.

It does reduce the potential for book value volatility. But the period where ARMs perform the best relative to other investments is when rates are rising in general or especially when the yield curve is steepening.

When you have a flat yield curve environment or a potential for flatter yield curve environment going forward, it's where ARMs typically underperforms..

Right..

Compared to the rest of the mortgage backed securities market due to the fact that they have got greater refinancing incentives than the rest of the market does and there is not a particular expectation going forward of significant interest rate increases.

So I think we are in that sort of environment where we would probably expect to be at a position where we are deemphasizing the allocation to ARMs sort of due to where we are in interest rate cycle. And during the second quarter, we did not acquire certainly any shorter reset ARMs. We do from, time to time, buy some new longer reset hybrid ARMs.

But most of our allocation has been focused on shorter fixed rates..

Right. And as you pointed out, Joe, that's the shorter ARMs that had the 26% CPR in the quarter. You offer up a 3.25% coupon. That's obviously the MBS coupon. But I would think that the underlying mortgages are probably in the 3.75% to 4% range.

Would you agree with that, when you add the servicing fee and the G fee?.

Right. If you think about them being tied to one-year LIBOR and having a spread of, let's call it, 2.25% over that. You have got a rate that is still not necessarily economic to refinance into a longer hybrid or a 15-year or a 30-year mortgage. But it's closer than it is typically, right.

And so it's not just the short reset ARMs, it's the ARMs that are moving into that upward reset.

We have a number of short reset ARMs that have been resetting for three, four or five years and they have not seen the level of increase, largely because I think those borrowers have gotten to see their rates come down over time and now see them going up a little bit and it hard to pull the trigger to refinance..

Yes. Makes perfect sense. Thanks. And Brett, one for you. I am just curious, we hear this constant theme that things are so tight, spreads are so tight, it's just hard to find anything in the credit world. I am curious if you have spend any time, it looks like all your work so far has mostly been on the residential side.

I am just curious whether you spend any time looking at the CMBS market? And whether it's multifamily or general CMBS? And if you see any possible opportunities there for Anworth?.

To-date, I have not explored opportunities in that marketplace for us. I have really been focused on the residential side. I think that we are always looking for opportunities and making sure that when we enter into any transactions, we are going in fully aware of what we are doing. So we are always looking for opportunities..

Okay. Well, thank you for the comments. I appreciate it..

[Operator Instructions]. There are no additional questions at this time. This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Lloyd McAdams for closing remarks..

Well, thank you very much for joining us everyone and we appreciate your questions and comments and we look forward to having the occasion to listening to you again, whether it's live or on the Internet or listening to it on the website. We look forward to talking with you again after the third quarter. Thank you very much..

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