Invesco Mortgage Capital Inc. (NYSE:IVR) Q1 2024 Earnings Call Transcript May 9, 2024
Invesco Mortgage Capital Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Welcome to Invesco Mortgage Capital Incorporated’s First Quarter 2024 Investor Conference call. All participants will be in a listen-only mode until the question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded. Now I would like to turn the call over to Greg Seals, an Investor Relations. Mr. Seals, you may begin.
Greg Seals: Thanks, operator. Thank you, operator, and to all of you joining us on Invesco Mortgage Capital’s quarterly earnings call. In addition to today’s press release, we have provided a presentation that covers the topics we plan to address today. The press release and presentation are available on our website, invescomortagecapital.com. This information can be found by going to the Investor Relations section of the website. Our presentation today will include forward-looking statements and certain non-GAAP financial measures. Please review the disclosures on Slide 2 of the presentation regarding these statements and measures as well as the appendix for the appropriate reconciliations to GAAP. Finally, Invesco Mortgage Capital is not responsible for and does not edit nor guarantee the accuracy of our earnings teleconference transcripts provided by third parties.
The only authorized webcasts are located on our website. Again, welcome and thank you for joining us today. I’ll now turn the call over to John Anzalone.
John Anzalone: All right. Well, good morning and welcome to Invesco Mortgage Capital’s first quarter earnings call. I’ll provide some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss our portfolio in more detail. Also joining us on the call this morning are our President, Kevin Collins, our CFO, Lee Phegley, and our COO, Dave Lyle. The first quarter was characterized by sharply higher interest rates across the yield curve as persistent inflation and strong economic data led to a repricing of the market’s expectations of future monetary policy. These expectations, as reflected in the federal funds futures market, adjusted from projecting over six cuts in the Federal Reserve’s benchmark rate during the balance of 2024 to less than two cuts today.
Despite the sharp increase in interest rates, interest rate volatility fell as market expectations for monetary policy converged with official projections by the FOMC. In addition, organic mortgage supply remained at very low levels while demand from money managers, commercial banks, and overseas investors broadly outpaced expectations. Against this backdrop, higher coupon agency mortgages outperformed treasuries given the decline in interest rate volatility and improvement in supply and demand dynamics in the quarter. These factors led to a positive economic return of 4.8% for the quarter, consisting of an eight-tenths of a percent increase in our book value combined with a $0.40 common stock dividend. Our debt-to-equity ratio ended the quarter at 5.6 times, down modestly from 5.7 as of year-end.
At the end of the quarter, 94% of our $5 billion investment portfolio was invested in agency mortgages, 5% invested in Agency CMBS with the balance in credit assets. Our liquidity position remained strong as we maintained a sizable balance of unrestricted cash and unencumbered investments totaling $451 million at quarter end. We began to build an allocation to Agency CMBS during the quarter. We believe this position will benefit the portfolio in a number of ways, most notably by providing stable cash flows with minimal prepayment risk, attractive returns, and favorable funding. During the quarter, Agency CMBS spreads tightened as new issuance volumes remained relatively low, funding improved, and higher yields drove investor demand for fixed-rate bonds.
Earnings available for distribution was supported by attractive interest income on our target assets, favorable funding, and low-cost pay-fix swaps. For the quarter, EAD per common share was $0.86, down from $0.95 last quarter, primarily due to adjustments to our hedge portfolio that’s still comfortably above our $0.40 dividend. The trends of higher inflation readings combined with positive economic growth have continued into the second quarter. Interest rates have continued to move higher as expectations of the timing and magnitude of rate cuts adjust. This has led to an increase in interest rate volatility and has put pressure on mortgage valuations. To that end, as of May 3rd, our book value was down approximately 2.5%. Given the increase in market volatility we have seen since quarter end, we remain cautious on the near-term outlook for the agency mortgage sector.
Our recent allocation to fixed-rate Agency CMBS reduces our exposure to near-term interest rate volatility while providing attractive returns with favorable funding. Over the longer term, however, the potential normalization of monetary policy and a steeper yield curve should be supportive of agency mortgages. We believe agency mortgage investors stand to benefit from attractive valuations, favorable funding, and robust liquidity as the macro environment evolves. I’ll stop here, and Brian will go through the portfolio.
Brian Norris: Thanks, John, and good morning to everyone listening to the call. I’ll begin on Slide 4, which provides an overview of the interest rate and agency mortgage markets since the beginning of last year. As shown on the chart in the upper left, U.S. Treasury yields increased across the yield curve largely in parallel fashion during the first quarter. Yields on maturities from two years to 30 years rose between 25 and 40 basis points, given a pause in the disinflationary trend in the U.S. amidst resilient economic growth. The chart on the bottom left details pricing in the Fed Funds futures market over the past year. At the end of the first quarter, market pricing reflected expectations for just three 25 basis point cuts in the target rate in 2024, after beginning the year pricing at more than six.
Since the end of the first quarter, this has declined to less than two cuts in 2024, as first quarter inflation data remained elevated. Given the Fed’s dot spots indicate two to three cuts this year, the market has moved from pricing in more accommodation than the Fed’s projections to largely being in line, leading to a decline in interest rate volatility despite the increase in interest rates. The decline in interest rate volatility combined with the increase in interest rates provided a supportive backdrop for higher coupon agency mortgages. While runoff of the Federal Reserve’s holdings of agency mortgages continues to increase net supply to the market, domestic bank holdings of Agency MBS also increased, supporting the supply and demand dynamics of the sector.
Slide 5 provides more detail on the agency mortgage market. In the upper left chart, we show 30-year current coupon performance versus U.S. Treasuries over the past 12 months, highlighting the first quarter in gray. Despite underperformance to start the quarter, production coupon agency mortgage valuations rebounded in March as interest rate volatility declined. Ultimately, higher production coupons modestly outperformed treasuries during the quarter, with nominal spreads relatively unchanged. Specified pool pay-ups were largely unchanged during the quarter as well, as illustrated in the chart on the top right. Lastly, as shown in the lower right chart, the dollar roll market for TBA securities remained unattractive as implied financing rates continued to exceed short-term funding.
Slide 6 details our agency mortgage investments and summarizes investment portfolio changes during the quarter. Our Agency RMBS portfolio decreased by 6% quarter-over-quarter, given a modest rotation into Agency CMBS through a combination of sales and paydowns during the quarter. We remain focused on more attractively priced higher coupons, which benefit from a decline in interest rate volatility and are largely insulated from direct exposure to assets held by commercial banks and on the Federal Reserve’s balance sheet. In addition, we remain exclusively invested in specified pools, where funding remains more attractive than what is available in the dollar roll market for TBA securities. We focused our specified pool allocation on prepayment characteristics that are expected to perform well in both premium and discount environments, and modestly improved the quality of our specified pool holdings by increasing our allocation to lower loan balance stories.
Although we anticipate interest rate volatility to remain moderately elevated in the near term, we believe current valuations on production coupon Agency RMBS largely price in this risk and represent attractive investment opportunities with current gross ROEs in the mid-to-high teens. Slide 7 provides detail on our Agency CMBS purchases as well as an overview of the benefits of the sector. We purchased $264 million in the first quarter, which represents approximately 5% of our investment portfolio. We believe Agency CMBS provides numerous benefits to the portfolio, primarily through its prepayment protection and bullet-like maturities, which reduces our sensitivity to interest rate volatility. Gross ROEs on new purchases were in the low double digits in the first quarter, but given strong performance in the sector so far in the second quarter, that has declined to the high single digits.
Financing has been robust, as we have been able to finance our purchases with numerous counterparties at attractive funding levels. We will continue to monitor the sector for opportunities to increase our allocation as they become available, recognizing the overall benefits to the portfolio as the sector diversifies risks associated with an Agency RMBS portfolio. Our Agency CMO allocation is detailed alongside our remaining credit investments on Slide 8. Our allocation to both agency interest-only and credit securities remains largely unchanged, with $75 million allocated to Agency IO and $18 million allocated to credit at quarter end. Although we anticipate limited near-term price appreciation in these investments, we believe they provide attractive yields for unlevered holdings, with returns in the high single digits.
Slide 9 details our funding and hedge book at quarter end. Repurchase agreements collateralized by Agency MBS declined modestly from $4.5 billion to $4.4 billion, while our net notional pay-fixed interest rate swaps increased from $4.1 billion to $4.3 billion, as the ratio of our hedges to borrowings increased to 97% from 91% last quarter. We continue to maintain a high hedge ratio, as monetary policy remains restrictive. The increase in interest rates led to further repositioning of the hedge book, as the interest rate sensitivity of our assets increased, warranting a similar increase in the weighted average maturity of our interest rate swap hedges. Reflecting this change, the weighted average maturity of our hedges increased from 6.6 years at the end of 2023 to 7.2 years, resulting in a modest increase in the weighted average coupon on our pay-fixed swaps, negatively impacting earnings available for distribution.
Positively, we retained much of the benefit of our low cost pay-fixed swaps, with an attractive weighted average coupon on our hedge portfolio of 1.17%. Leverage ended the quarter at 5.6 times debt-to-equity, down from 5.7 times at the end of December, given the modest improvement in book value. Slide 10 provides further detail on our asset yields and funding costs. Interest rates on our repurchase agreements were largely unchanged at 5.5% at quarter end, and yields on our Agency RMBS portfolio increased modestly to 5.4%, while the pay rate on our interest rate swaps increased from 1.1% to 1.17%. Overall, our effective interest rate margin declined, but remained very attractive at just over 4% highlighting the benefit of our remaining legacy swap portfolio.
To conclude our prepared remarks, we continue to believe IVR is well-positioned to navigate future mortgage market volatility and selectively capitalize on historically attractive agency RMBS spreads, which provide a supportive backdrop for long-term investment. Our recent allocation to Agency CMBS mitigates our exposure to further bouts of heightened interest rate volatility, such as what was experienced in April of this year, while our remaining agency mortgage holdings should benefit from a potential normalization of the yield curve, interest rate volatility, and agency mortgage valuations. Further, our liquidity position remains robust and provides more than adequate cushion for further stresses in the market, while also providing ample resources to deploy into our target assets as the investment environment improves.
Thank you for your continued support for Invesco Mortgage Capital, and now we will open the line for Q&A.
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Q&A Session
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Operator: Thank you. We will now begin our question and answer session. [Operator Instructions] Our first question comes from Jason Weaver with Jones Trading. Your line is open. Jason, your line is open. You may need to unmute yourself. Our next question will come from Trevor Cranston with Citizens JMP. Your line is open.
Trevor Cranston: Hi. Thanks. On the new allocation to Agency CNBS, looking at the spread tightening that’s happened in that asset class over the last several months, would you look to be continuing to add that to the portfolio where spread sits today or is that something where you’d like to see spreads widen out further before increasing the allocation further there? Thanks.
Brian Norris: Sure, Trevor. Hi, it’s Brian. Yes. Like I said, spread tightened really throughout the first quarter and through April as well to where ROEs are kind of in the high single digits at this point. So we certainly slowed down our purchase activity at this point. It continues to be a relative value play between the two sectors. Right now, we think Agency RMBS is a little bit more attractive. So certainly there are benefits to the Agency CNBS portfolio to our overall portfolio, but at this point we think that spreads have gotten pretty snug here, so we’ve slowed down.
Trevor Cranston: Okay. Makes sense. Thank you.
Operator: Thank you. [Operator Instructions] Our next question comes from Eric Hagen with BTIG. Your line is open.
Eric Hagen: Hi, thanks. Good morning. Hope you guys are well. Can you share any perspectives on the supply of prepay protected specified pools in the higher coupons and how active you guys have been there? And then just kind of separately, we’re talking about the higher coupon product in your portfolio just in general, but how much prepayment variability do you maybe see like developing within the coupon stack at different levels of interest rates? Thank you, guys.
Brian Norris: Yes, sure. Hi, Eric, it’s Brian. Yes, I mean, I think at our size, the supply of specified pools is certainly not prohibitive. I wouldn’t necessarily say we’ve been active. We haven’t really been increasing the size of the portfolio given where volatility is and I guess has a tendency to increase leverage at these levels. So, we’re pretty pleased with the allocation that we have currently split between the various stories that you see in the presentation there. So, I wouldn’t say that we’ve been too active and like I said, we were mostly in the first quarter re-investing pay downs into the Agency’s CNBS allocation so there hasn’t been any additional purchases there. As far as variability of prepayments, I think we’ve been hesitant, obviously, to add significantly higher coupons, six and a half and sevens.
Those prepayments have been fairly well contained at this point just given what we’ve seen in rates. But, our overall belief is that, the Fed will be at some point cutting rates, rates should be moving lower and that those very high coupons could come under some pressure in that scenario. So, we’re pretty comfortable continuing to own kind of four through six at this point.
Eric Hagen: Okay, great. That’s helpful. I mean, when you set the dividend and you see the yield and the stock kind of trading near the highest in the sector right now, I mean, how do you think the stock could trade at higher levels of leverage from here? I mean, do you feel like there’s support for the dividend if the Fed leaves rates higher for longer and you need to maybe raise your leverage at some point?
John Anzalone: Yes, I think, it’s mostly about interest rate ball for us. I think, we certainly have the capacity to add to leverage if we deem that if we’re comfortable doing so. But at this level, at the current dividend, we feel pretty comfortable with where we are, so we don’t feel to need to — we need to increase leverage.
Eric Hagen: Okay. Thank you, guys.
Operator: Thank you. [Operator Instructions] One moment, please. And at this time, we have no further questions.
Greg Seals: Okay, well, thank you, everybody, for joining us. And we look forward to meeting again next quarter. Thanks.
Operator: Thank you. That concludes today’s conference. Thank you for participating. You may disconnect at this time.
