Capstead Mortgage Corporation Announces Fourth Quarter 2016 Results

Capstead Mortgage Corporation (NYSE: CMO) (“Capstead” or the “Company”) today announced financial results for the quarter ended December 31, 2016.

Fourth Quarter 2016 Highlights

• Generated earnings of $17.5 million or $0.14 per diluted common share
• Paid common dividend of $0.23 per common share
• Book value decreased by 1.4% ($0.16) due to changes in unrealized gains and losses on the portfolio and interest rate swaps held for hedging purposes, and by 0.8% ($0.09) due to capital returned to stockholders in the form of dividends in excess of reported earnings, ending the quarter at $10.85 per common share
• Yields on residential mortgage investments increased four basis points to 1.50% while rates on related secured borrowings increased by five basis points to 0.89%
• Total financing spreads decreased one basis point to 0.55% while financing spreads on residential mortgage investments, a non-GAAP financial measure, also decreased one basis point to 0.61%
• Agency-guaranteed residential ARM portfolio and leverage ended the quarter at $13.32 billion and 9.02 times long-term investment capital, respectively

Capstead reported net income of $17.5 million or $0.14 per diluted common share for the quarter ended December 31, 2016. This compares to net income of $16.4 million or $0.13 per diluted common share for the quarter ended September 30, 2016. The Company paid a fourth quarter 2016 dividend of $0.23 per common share on January 20, 2017.

Fourth Quarter Earnings and Related Discussion

Capstead is a self-managed real estate investment trust, or REIT, for federal income tax purposes. The Company earns income from investing in a leveraged portfolio of short-duration residential adjustable-rate mortgage pass-through securities, referred to as ARM securities, issued and guaranteed by government-sponsored enterprises, either Fannie Mae or Freddie Mac, or by an agency of the federal government, Ginnie Mae. This strategy differentiates the Company from its mortgage REIT peers because the ARM loans underlying its investment portfolio reset to more current interest rates within a relatively short period of time. As a result, the Company is positioned to benefit from future recoveries in financing spreads that typically contract during periods of rising interest rates and to experience smaller fluctuations in portfolio values compared to portfolios containing a significant amount of longer-duration ARM or fixed-rate mortgage securities. Duration is a common measure of market price sensitivity to interest rate movements. A shorter duration generally indicates less interest rate risk.

For the quarter ended December 31, 2016, Capstead reported net interest margins of $20.9 million compared to $21.4 million for the quarter ended September 30, 2016. The decrease in net interest margins was largely a result of lower average portfolio balances together with a one basis point decline in financing spreads.

Yields on Capstead’s $13.32 billion residential mortgage investments portfolio averaged four basis points higher at 1.50% during the fourth quarter of 2016, compared to 1.46% reported for the third quarter of 2016. Cash yields (yields on the portfolio before investment premium amortization) increased three basis points to average 2.55% during the fourth quarter, benefiting from mortgage loans underlying the portfolio resetting to higher rates based on higher prevailing six- and 12-month interest rate indices. Yield adjustments for investment premium amortization decreased one basis point to average a negative 1.05% for the fourth quarter as a result of slightly lower mortgage prepayment levels. Mortgage prepayment rates for the fourth quarter averaged an annualized constant prepayment rate, or CPR, of 25.59% compared to 25.80% CPR reported for the third quarter. The following table illustrates the progression of the Company’s portfolio of residential mortgage investments for the quarter and year ended December 31, 2016 (dollars in thousands):

* Residential mortgage investments typically are acquired at a premium to the securities’ unpaid principal balances. Investment premiums are recognized in earnings as portfolio yield adjustments using the interest method over the estimated lives of the related investments.As such, the level of mortgage prepayments impacts how quickly investment premiums are amortized.

Rates on Capstead’s $12.15 billion in secured borrowings, after adjusting for hedging activities, averaged five basis points higher at 0.89% during the fourth quarter of 2016, compared to 0.84% for the third quarter of 2016. The increase is largely attributable to market conditions, most notably the mid-December Federal Reserve action to raise the Federal Funds Rate by 25 basis points. A ten basis point increase in average unhedged secured borrowing rates was partially offset by relatively stable hedging costs, with average hedged borrowing rates increasing two basis points during the quarter. The Company uses primarily two- and three-year term interest rate swap agreements, supplemented with longer-maturity secured borrowings when available at attractive rates and terms, to help mitigate exposure to rising short-term interest rates. Excluding $500 million notional amount of swap agreements that expired January 2, 2017, at year-end the Company held $7.65 billion notional amount of portfolio financing-related swap agreements with contract expirations occurring at various dates through the fourth quarter of 2019 and a weighted average expiration of 14 months.

Operating costs expressed as an annualized percentage of long-term investment capital averaged 0.97% and 0.93% during the fourth quarter of 2016 and the year ended December 31, 2016, respectively (calculated excluding a March adjustment associated with prior year incentive compensation accruals and the effects of separation of service charges associated with the July resignation of the Company’s former chief executive officer). Capstead is a leader in terms of operating cost efficiency among its mortgage REIT peers.

Long-Term Investment Capital, Portfolio Leverage and Book Value per Common Share

Capstead’s long-term investment capital, which consists of common and perpetual preferred stockholders’ equity and $98 million of long-term unsecured borrowings, decreased by $22 million during the fourth quarter of 2016 to $1.35 billion, primarily as a result of declines in portfolio pricing and dividend distributions in excess of earnings, partially offset by swap value improvements. Portfolio leverage (secured borrowings divided by long-term investment capital) decreased to 9.02 to one at December 31, 2016 from 9.09 to one at September 30, 2016 primarily as a result of a decline in portfolio balances. The following table illustrates the progression of the Company’s book value per common share (total stockholders’ equity, less preferred share liquidation preferences, divided by shares of common stock outstanding) as well as changes in book value expressed as percentages of beginning book value for the quarter and year ended December 31, 2016:

Nearly all of Capstead’s residential mortgage investments and all interest rate swap agreements are reflected at fair value on the Company’s balance sheet and related unrealized gains and losses are included in the calculation of book value per common share. The Company’s borrowings, however, are not reflected at fair value on the balance sheet. Fair value is impacted by market conditions, including changes in interest rates, and the availability of financing at reasonable rates and leverage levels, among other factors.

The Company’s investment strategy attempts to mitigate these risks by focusing on investments in agency-guaranteed residential mortgage pass-through securities, which are considered to have little, if any, credit risk and are collateralized by ARM loans with interest rates that reset periodically to more current levels, generally within five years. Because of these characteristics, the fair value of the Company’s portfolio is expected to be less vulnerable to significant pricing declines caused by credit concerns or rising interest rates compared to leveraged portfolios containing a significant amount of non-agency-guaranteed securities or agency-guaranteed securities backed by longer-duration ARM or fixed-rate loans.

Management Remarks

Commenting on current operating and market conditions, Phillip A. Reinsch, President and Chief Executive Officer, said, “Earnings for the fourth quarter were hampered by slower than anticipated declines in mortgage prepayment levels. As a result, portfolio yields did not improve as much as expected. While the 2016 refinancing wave peaked in September, declines in prepayment rates on ARM securities have lagged declines in prepayment rates on fixed-rate mortgage securities during the fourth quarter and in January 2017. However, with the sharp increase in interest rates post-election, opportunities for homeowners to refinance at lower rates have diminished considerably. This is expected to lead to lower mortgage prepayment levels in the coming months, benefiting portfolio yields and earnings.

“Additionally, we expect cash yields to continue increasing in 2017 as coupon interest rates on mortgage loans underlying our portfolio reset to higher rates based on higher prevailing six- and 12-month interest rate indices. Our borrowing costs are also currently benefiting from higher variable rate swap receipts due to higher short-term LIBOR rates relative to our unhedged borrowing rates. However, future actions by the Federal Reserve to increase the level of short-term interest rates will put upward pressure on unhedged borrowing rates and fixed-rate swap payment requirements on new swap agreements. Provided the Federal Reserve does not move to increase short-term interest rates at a considerably faster pace than the financial markets currently anticipate, and longer term interest rates remain benign, we anticipate reporting improved earnings in the coming quarters.

“During the fourth quarter of 2016, longer-term interest rates moved significantly higher, as illustrated by the ten-year Treasury rate increasing 85 basis points to end the year at 2.45%. As a consequence, longer duration mortgage-backed securities lost considerable value. For instance, Fannie Mae 30-year fixed 3.0% mortgage securities declined in price by approximately 4.75% during this period. In contrast, Capstead’s ARM securities portfolio performed relatively well, experiencing a decline in overall portfolio pricing of just 0.49%.

“This translated into a fourth quarter book value decline of only 1.4% due to changes in unrealized gains and losses on the portfolio and interest rate swaps held for hedging purposes. As a result, our fourth quarter economic return (change in book value plus dividends) is expected to significantly outpace the performance of our mortgage REIT peers holding longer duration portfolios that will be reporting in the coming weeks.

“We remain confident in our strategy of cost-effectively managing a leveraged portfolio of agency-guaranteed residential ARM securities that can produce attractive risk-adjusted returns over the long term while reducing, but not eliminating, sensitivity to changes in interest rates.”

Earnings Conference Call Details

An earnings conference call and live audio webcast will be hosted Thursday, January 26, 2017 at 9:00 a.m. ET. The conference call may be accessed by dialing toll free (877) 505-6547 in the U.S., (855) 669-9657 for Canada, or (412) 902-6660 for international callers. A live audio webcast of the conference call can be accessed via the investor relations section of the Company’s website at www.capstead.com and an audio archive of the webcast will be available for approximately 60 days. The audio replay will be available one hour after the end of the conference call through April 26, 2017. The replay can be accessed by dialing toll free (877) 344-7529 in the U.S., (855) 669-9658 for Canada, or (412) 317-0088 for international callers and entering conference number 10099715.

Annual Meeting Record Date

The date for the Company’s annual meeting of stockholders has been set for May 17, 2017. The record date for determining stockholders entitled to notice of and vote at such meeting will be the close of business on March 24, 2017 and the proxy statement and annual report will be mailed to stockholders on or about April 12, 2017.

Statement Concerning Forward-looking Statements

This document contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain the words “believe,” “anticipate,” “expect,” “estimate,” “intend,” “will be,” “will likely continue,” “will likely result,” or words or phrases of similar meaning.

Forward-looking statements are based largely on the expectations of management and are subject to a number of risks and uncertainties including, but not limited to, the following:

• changes in general economic conditions;
• fluctuations in interest rates and levels of mortgage prepayments;
• the effectiveness of risk management strategies;
• the impact of differing levels of leverage employed;
• liquidity of secondary markets and credit markets;
• the availability of financing at reasonable levels and terms to support investing on a leveraged basis;

• the availability of new investment capital;
• the availability of suitable qualifying investments from both an investment return and regulatory perspective;
• changes in market conditions as a result of Federal Reserve monetary policy or federal government fiscal challenges;
• deterioration in credit quality and ratings of existing or future issuances of Fannie Mae, Freddie Mac or Ginnie Mae securities;
• changes in legislation or regulation affecting Fannie Mae, Freddie Mac, Ginnie Mae, the Federal Home Loan Bank system and similar federal government agencies and related guarantees;
• changes in legislation or regulation affecting exemptions for mortgage REITs from regulation under the Investment Company Act of 1940;
• other changes in legislation or regulation affecting the mortgage and banking industries; and
• increases in costs and other general competitive factors.

In addition to the above considerations, actual results and liquidity are affected by other risks and uncertainties which could cause actual results to be significantly different from those expressed or implied by any forward-looking statements included herein. It is not possible to identify all of the risks, uncertainties and other factors that may affect future results. In light of these risks and uncertainties, the forward-looking events and circumstances discussed herein may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements. Forward-looking statements speak only as of the date the statement is made and the Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Accordingly, readers of this document are cautioned not to place undue reliance on any forward-looking statements included herein.

Financing spreads on residential mortgage investments, a non-GAAP financial measure, differs from total financing spreads, an all-inclusive GAAP measure, that is based on all interest-earning assets and all interest-paying liabilities. Management believes that presenting financing spreads on residential mortgage investments provides useful information for evaluating the performance of the Company’s portfolio. The following reconciles these two measures:

After consideration of portfolio financing-related swap positions, Capstead’s residential mortgage investments and related secured borrowings had durations as of December 31, 2016 of approximately 11½ and 8½ months, respectively, for a net duration gap of approximately 3 months. Duration is a measure of market price sensitivity to changes in interest rates. A shorter duration generally indicates less interest rate risk.

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