Good morning, and welcome to the Capstead Mortgage Corporation First Quarter 2021 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Lindsey Crabbe, Director IR. Please go ahead.
CMO Capstead Mortgage
Good morning. Thank you for attending Capstead's first quarter earnings conference call.
The first quarter earnings release was issued yesterday, April 28th, 2021, and is posted on our website at www.capstead.com under the IR 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 this call will be available through July 28th, 2021. Detail for the replay are included in yesterday's release.
On the call with me 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 accompanying 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 in this call is current only at the date of this call, April 29th, 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 some brief remarks, Lance will give a quick recap of the first quarter and Robert is going to provide us with some market color, then we will open the call up for questions.
Our core earnings were $0.13 per share for the first quarter of 2021, returning 7.7% on common equity capital, which includes the effect of adjusting prepayment speed estimates that Lance will describe further in a moment. Including these adjustments, this breaks our string of five quarters going back to the fourth quarter of 2019 and throughout the pandemic, where our core earnings met or exceeded our $0.15 quarterly dividend with average returns on equity of towards 9%.
While down modestly quarter-over-quarter, mortgage prepayment rates remained at high levels as homeowners took advantage of historically low mortgage rates available late last year to refinance their mortgages. We now see prepayment rates cresting in April as most mortgage refinancings with 2019 loan locks were closed by the end of March. Recall, April portfolio runoff reflects March loan closings. And with fixed mortgage rate increases of towards 50 basis points during the first quarter, the refi indices are soft shortly indicating fall in prepayment rates in the coming months and quarters.
Of course, should the yield curve steepen further and mortgage rates resume trending higher, prepayment rates should recede faster. We do not replace all of our portfolio runoff in the first quarter or in the fourth quarter, for that matter. This was primarily due to the transition of ARM production to SOFR from LIBOR indices and strong demand for agency-guaranteed MBS in general, including agency ARMs. This was due in large part to buying programs at the Federal Reserve and the commercial banking sector, seeking to deploy ever-increasing bank reserves. This crowding out of private capital has had the effect of lowering returns, what we view as unacceptable levels in many instances and making it harder to reinvest capital may available from portfolio runoff at attractive levels. All that said, we have ample amounts of dry powder and continue to pick our spot, having already made more portfolio acquisitions current quarter-to-date than we did in the entire first quarter.
Looking forward, we remain committed to generating attractive risk-adjusted returns and we will be judicious in deploying our liquidity, building flexibility to potentially take advantage of opportunities as they unfold in the coming quarters. With that, I will turn the call over to Lance and Robert.
Thank you, Phil. We reported a GAAP net income of $18.9 million this quarter or $0.15 per diluted common share.
Our core earnings were $17.4 million or $0.13 per diluted common share.
As a reminder, our core earnings exclude realized and unrealized losses on our portfolio-related interest rate swap agreement. We include a reconciliation of GAAP and core earnings on page eight of our press release. Book value decreased $0.10 per share or 1.4% during the first quarter, ending at $6.66 per common share, with derivative-related increases in value of $0.17 being offset by $0.22 in portfolio related declines, largely due to runoff and $0.05 in declines related to capital activity. Portfolio yields average 1.38% during the quarter, a decrease of 17 basis points from the 1.55% we reported in the prior quarter. Portfolio yields were negatively impacted by $2.3 million in -- by $2.3 million in additional premium amortization, approximately 12 basis points as we made adjustments to our lifetime prepayment fees in line with current and expected future market conditions. We do not anticipate making any further life speed adjustments this year, but all we will monitor and adjust as conditions require. Yields also declined due to lower coupon interest rates on existing loans that reset the lower current prevailing interest rates. From a volume perspective, as Phil mentioned, we do not fully replace runoff in the first quarter, resulting in our average portfolio balance being down approximately $500 million from the previous quarter.
Our portfolio related borrowing cost after adjusting for our hedging activity averaged 0.2% during the first quarter, 17 basis points lower than in the prior quarter, resulting in consistent net interest spreads from the fourth quarter. The average fixed pay rate on our swap book was only six basis points at March 31st, an increase of two basis points from rate in effect on December 31st.
Now, I will turn it over to Robert.
Thank you, Lance. The recent trend of a steepened yield curve remain a factor in the first quarter, with 10-year yield increasing 82 basis points to 1.74%, while two-year yields only increased four basis points to 0.16%. Longer term, this trend is extremely positive for ARM valuations in ARM supply. In the short-term, however, the LIBOR to SOFR transition and record low fixed-rate mortgage rates at year-end caused new issue ARM supply to plummet to an all-time low of $360 million in quarter one.
In addition to this $360 million new issue paper, there was also $560 million of season secondary sale. It should be noted that the new issue supply is picking up dramatically in the second quarter. In April alone, over $1.25 billion of new issue agency ARMs were sold in front-month and forward settle transaction. Many originators are now actively pushing ARM products due to the relative attractiveness of an adjustable rate mortgage versus the fixed rate mortgage. There is still a very strong bank bid for front-month new issue paper, which is keeping spreads on this cohort at extremely tight levels.
As a result of this, we currently see more value in season paper as well as forward settle new issue transaction. Current repo rates are extremely attractive in a 10 to 12 basis point area from one month term repo.
Looking ahead, we're very encouraged by the recent pick up in ARM supply, the dynamics of the steeper yield curve and how that can translate into attractive risk-adjusted returns going forward. With that, we'll open the call up for questions.
We will now begin the question-and-answer session. [Operator Instruction] Your first question comes from Steve DeLaney from JMP Securities. Please go ahead.
Hey good morning everyone and thanks for that introductory summary.
I think, that must have -- that was probably the most comprehensive of layout at the quarter that I can recall who we had -- we had Phil, we had Lance and Robert, so appreciate the overview. Kind of took -- you kind of answered about all my questions there right with that, but we will find something to talk about. Phil, if you can, you mentioned that the relationship, a pickup in second quarter purchases versus all of first quarter, are you willing to quantify that for us? And could you describe type of securities that you are currently buying? Is it the -- is it new production or seasoned? Maybe you could just give us a little flavor for what the second quarter investment is look like? Thank you.
Well, we only bought about $400 million in the first quarter versus almost $900 million of runoff. And we're well ahead of that $400 million at this stage. I hate to throw a number out there, because people might want to try that annualize or quarter on quarterly basis and that's probably really not fair to either of us.
So, I'm not going to do that, but I'll let Robert speak to what he is seeing and what he is actually buying.
Yes, so Steve, we continue to buy season securities. There were a couple of -- it was late in March, which settled in April, where we read -- we take up some bonds there. We still don't see, as I mentioned in the commentary, much value in front-month new issue paper.
You have a handful of names, so those in that sector very rich, but the good thing is production amped up so much that we're speaking stuff in the back months, 36 week time that to us is much more compelling than new issue in the front month. That's mainly because some of these buyers that are driving spreads are only buying for immediate settle.
So, we're seeing a lot more to choose from than we have over the last three to six months.
Yes. And do you see better -- I mean, I know, it would be a probably fairly minimal difference, but you actually see slightly lower prices when you're buying three months out, I assume you would versus aggressive banking.
Yes, both on absolute dollar price, but also on the spread basis or OAS basis or any way you want to look at it. Obviously, you don't get--
You are buying cheaper.
50 days, but from a -- the accretion from going 60 to 90 days out versus the front month is pretty compelling right now.
Okay, got it. And then, Lance -- the dip, the $0.02 dip, which is -- and as Phil pointed out, you covered -- been covering the dividend pretty steadily and so that was the first observation.
You kind of say, well, okay, so something changed in this quarter and it sound like to me that it's pretty much you're the life speed. I didn't know whether it was a question -- a combination of being slightly underinvested as Phil said not covering runoff for two straight quarters or really the $0.02 drop may just be accounted for by the adjustment you made to the life speed, knocked 12 basis points off the yield. Can you just help -- the $0.02 drop, would you attribute it to the life speed change or more to the being underinvested or a combination?
Yes, I mean, this quarter, certainly the $2.3 million could translate to the $0.02 drop in earnings.
I think, the underinvested obviously didn't help this quarter earnings, but I would attribute the $0.02 directly to the $2.3 million of additional amortization.
Okay, great. Thanks for the comments guys.
Your next question comes from Jason Stewart from Jones Trading. Please go ahead.
Thanks. Good morning.
As we think about the portfolio growing again in 2Q, can you talk a little bit about how you're going to adjust or take the hedge portfolio up, leave it as it is or just sort of that interplay and how you're thinking about it?
I think from a duration gap standpoint, we'll keep that fairly constant. We're a little over three months' right now. I wouldn't look for that to drift materially. Obviously, the newer issue paper that's out there is lower coupon and has a little more duration risk than sort of the rest of our portfolio.
So, we need to be mindful of that, as we acquire those type of securities. They obviously offer the most prepayment protection, but they also have the longest duration.
So, we will hedge those accordingly and in aggregate, we look for a duration gap to remain fairly flat around three months.
Okay, great. That's helpful. And then I would -- I'm going to put a word out there, temporary difference between core earnings and the dividend as we migrate through this period. I guess could you talk about whether you think it is temporary that we stay down at this $0.13 level? I mean, just look at the yield curve today its steeper; I imagine that is going to be a factor for the way the rest of 2Q plays out.
Just the temporary nature of the drop in leverage, the additional amortization and how you think about that when setting the dividend policy?
So, the -- this is Phil.
So, obviously, you could look at the adjusted to lifetime speed since we don't hear Capstead routinely adjust speeds every quarter.
You can kind of look at that as kind of a one-off. It doesn't meet the technical definition of a one-time non-recurring thing, but it certainly doesn't happen that often. And on the other hand, we have a lower -- a smaller portfolio and that's going to affect our quarterly results until we can build it back up and that's going to be dependent upon finding decent reinvestment opportunities. And with this Fed buying and bank buying, that's tougher to do, that's why we're here.
So, we are picking up a little ground on that this quarter. We don't mean to imply that we'll be able to grow the portfolio in the second quarter, but we should at least be able to stem the loss of that through portfolio outstanding that we've experienced more recently.
So, yes, you're going to have to look at that average portfolio outstanding to gauge what our near-term results are until such time, as we can get our leverage back up to a better level. And from a dividend perspective, we'll look at that, so the Board looks at that. We look at little longer term, little more medium term look to our earnings and incentive dividend policy accordingly. We like the fact that we're able to earn and pay a $0.15 dividend in the last -- for five quarters until this quarter, where we still declared $0.15, but didn't quite get there mostly due to that speed adjustment, but we have to be realistic about it as well.
Okay. Thanks for taking the question. Appreciate it.
Thank you. This concludes our question-and-answer session. I would now like to turn the conference back over to Lindsey Crabbe for any closing remarks.
Thank you for joining us today.
If you have any further questions, please give us a call. We look forward to speaking with you next quarter.
Thank you. That does conclude our conference for today. Thank you for participating.
You may now disconnect.