Capstead Mortgage Corporation Announces Second Quarter 2017 Results

Capstead Mortgage Corporation (NYSE: CMO) (“Capstead” or the “Company”) today announced financial results for the quarter ended June 30, 2017.

Second Quarter 2017 Highlights

• Generated earnings of $17.5 million or $0.14 per diluted common share
• Paid common dividend of $0.21 per common share
• Book value per common share declined $0.26 to $10.72 due to portfolio and swap changes ($0.19) and dividends in excess of earnings ($0.07)
• Since year-end, book value decreased by $0.13, including $0.08 in dividends in excess of earnings, which together with $0.42 in common dividends produce an annualized economic return of 5.3%
• Net interest margins declined by $4.3 million as benefits of portfolio growth and higher cash yields were outstripped by higher mortgage prepayment levels and higher borrowing costs
• Agency-guaranteed residential ARM portfolio and leverage ended the quarter at $13.60 billion and 9.27 times long-term investment capital, respectively
• Operating costs averaged 0.92% of long-term investment capital on an annualized basis

Second Quarter Earnings and Related Discussion

Capstead reported net income of $17.5 million or $0.14 per diluted common share for the quarter ended June 30, 2017. This compares to net income of $22.7 million or $0.20 per diluted common share for the quarter ended March 31, 2017. The Company paid a second quarter 2017 dividend of $0.21 per common share on July 20, 2017.

For the quarter ended June 30, 2017, Capstead reported net interest margins of $20.6 million compared to $24.9 million for the quarter ended March 31, 2017. The decrease in net interest margins was largely attributable to the effects of higher mortgage prepayment levels and higher borrowing costs. Higher borrowing costs were partially offset by higher coupon interest rates on adjustable-rate mortgages underlying the Company’s residential mortgage investments. The Company earns income from investing in a leveraged portfolio of 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. At June 30, 2017, over 50% of the Company’s ARM securities portfolio will reset in rate in less than 18 months, allowing the Company’s cash yields to continue benefiting from higher prevailing interest rates in future quarters.

Portfolio yields averaged 1.66% during the second quarter of 2017, one basis point lower than the 1.67% reported for the first quarter. Cash yields (yields on the portfolio before investment premium amortization) increased six basis points to average 2.66% during the second 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 increased seven basis points to average a negative 1.00% for the second quarter primarily as a result of higher mortgage prepayment levels. Mortgage prepayment rates for the second quarter averaged an annualized constant prepayment rate, or CPR, of 24.69% compared to 22.93% CPR reported for the first quarter.

The following table illustrates the progression of Capstead’s portfolio of residential mortgage investments for the quarter and six months ended June 30, 2017 (dollars in thousands):

Rates on Capstead’s $12.45 billion in secured borrowings, after adjusting for hedging activities, averaged 15 basis points higher at 1.08% during the second quarter of 2017, compared to 0.93% for the first quarter. The increase is largely attributable to higher interest rates primarily resulting from Federal Reserve actions to raise the Federal Funds Rate a total of 75 basis points since December 2016. Average unhedged secured borrowing rates increased 20 basis points during the second quarter, while related hedged borrowing rates increased 12 basis points as older, lower-rate interest rate swap agreements expired and new swaps were entered into at higher current rates. The Company uses 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. The Company held $8.60 billion notional amount of portfolio financing-related swap agreements with contract expirations occurring at various dates through the first quarter of 2020 and a weighted average expiration of 14 months.

Operating costs expressed as an annualized percentage of long-term investment capital averaged 0.92% during the second quarter of 2017. 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 $15 million during the second quarter of 2017 to $1.34 billion as a result of declines in portfolio and swap values and dividend distributions in excess of earnings, partially offset by issuances of Series E preferred stock. Portfolio leverage (secured borrowings divided by long-term investment capital) increased to 9.27 to one at June 30, 2017 from 9.04 to one at March 31, 2017 primarily as a result of an increase in secured borrowings to support a larger portfolio and the decrease in long-term investment capital.

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 six months ended June 30, 2017:

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. Duration is a common measure of market price sensitivity to interest rate movements. A shorter duration generally indicates less interest rate risk.

Management Remarks

Commenting on current operating and market conditions, Phillip A. Reinsch, President and Chief Executive Officer, said, “Second quarter earnings were negatively affected by higher mortgage prepayment levels and higher borrowing costs, while benefiting from higher cash yields and higher average portfolio balances.

“Because average mortgage prepayment levels were higher this quarter by 1.76% CPR (an increase of 7.7%, compared to a decline in the first quarter of 10.4%), we recorded an additional $2.3 million in investment premium amortization. The second quarter increase in prepayments is attributable to a number of factors, including seasonality and a flattening of the yield curve as longer term rates have not increased in tandem with shorter term rates since year-end. This can create refinancing opportunities, particularly for borrowers whose loans have recently reset to higher levels. Given current market conditions, we anticipate quarterly prepayment levels may increase further in the third quarter before declining in the fourth quarter.

“Borrowing and hedging costs were up appreciably in the second quarter as the markets absorbed the effects of three 25 basis point Federal Funds Rate increases since December 2016. During the second quarter average unhedged secured borrowing rates increased 20 basis points over the first quarter to 1.09%, while related hedged borrowing rates increased 12 basis points to average 1.08%. On a combined basis, secured borrowing rates were up 15 basis points. In the current rate environment, older, lower-rate swaps are expiring and new, higher-rate swaps are being entered into in order to provide important balance sheet and future financing spread protection, particularly as it pertains to additions to the longer-to-reset portion of our ARM securities portfolio.

“Importantly, higher borrowing costs were partially offset by a six basis point increase in overall cash yields largely attributable to periodic coupon interest rate resets on mortgage loans underlying the currently-resetting portion of our portfolio. This key feature of our short duration ARM strategy should continue to benefit cash yields in the coming quarters.

“Given our current opportunity for continued increases in cash yields and our prudent hedging posture, we believe that our short duration agency-guaranteed residential ARM portfolio is well positioned to generate attractive risk-adjusted returns over the long term. Key to our near-term success will be mortgage prepayment levels and the pace of future increases in short-term interest rates.”

Earnings Conference Call Details

An earnings conference call and live audio webcast will be hosted Thursday, July 27, 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 October 25, 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 10110571.

About Capstead

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 agency-guaranteed ARM securities. 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.

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 corporate and individual income tax reform, federal government fiscal challenges and Federal Reserve monetary policy, including policy regarding its holdings of Agency and U.S. Treasury Securities;
• 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 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, differ 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:

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