Invesco Mortgage Capital Inc. (NYSE:IVR) Q2 2024 Earnings Call Transcript

Invesco Mortgage Capital Inc. (NYSE:IVR) Q2 2024 Earnings Call Transcript August 9, 2024

Operator: Good morning and thank you for standing by. Welcome to the Invesco Mortgage Capital second quarter 2024 earnings call. All participants will be a in a listen-only mode until the question and answer session. At that time, to ask a question, press star followed by the one on your telephone. As a reminder, today’s call is being recorded. Now I would like to turn the call over to Greg Seals, Investor Relations. Mr. Seals, you may begin.

Greg Seals : Thank you Operator, and thanks 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, invescomortgagecapital.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, 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 IVR’s CEO, John Anzalone. John?

John Anzalone: All right, good morning and welcome to Invesco Mortgage Capital’s second 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, and our CFO, Lee Phegley. The second quarter was characterized by elevated interest rate volatility as uncertainty regarding near term monetary policy persisted. After initially rising by 50 basis points in April, the yields on the 10-year treasury reversed course and rallied during May and June to end the quarter only 14 basis points higher. The sharp reversal was driven by data showing slowing inflation and increased confidence in a soft economic landing.

As market expectations for interest rate cuts changed throughout the quarter, agency mortgage generally under-performed compared to treasury hedges. This under-performance was primarily in higher coupons, which were more affected by volatility and seasonal increases in supply. These factors led to a negative economic return of 4.1% for the quarter, consisting of an 8% decline in book value combined with our $0.40 common stock dividend. Our debt to equity ratio ended the quarter at 5.9 times, up from the 5.6 times at the end of March. As of the end of the quarter, our $5 billion investment portfolio primarily consisted of $4.6 billion of agency RMBS, including agency TBA, and $400 million of agency CMBS, and we continue to maintain a sizeable balance of unrestricted cash and unencumbered investments totaling $446 million.

Earnings available for distribution was supported by attractive interest income on our target assets and favorable funding of low cost pay-fixed swaps. For the quarter, EAD per common share was $0.86, unchanged from last quarter and still comfortably above our $0.40 dividend. Entering the third quarter, the decline in interest rates that began in May accelerated due to weaker than expected employment data, raising concerns about economic growth. Since the end of June, the 10-year treasury yield declined by over 50 basis points and the two-year treasury yield fell by 85 basis points. This shift also caused the market to expect four to five cuts by year-end, according to Fed [indiscernible]. Despite these sharp declines in interest rates and continued elevated volatility, agency mortgage performance has been modestly positive to start the quarter with lower coupons in particular benefiting from lower rates and a steeper yield curve.

This has resulted in our book value remaining approximately unchanged since quarter end as of yesterday’s close. Given our expectations for a steeper yield curve and an eventual decline interest rate volatility, our outlook for agency mortgages is positive. In particular, we believe investors in agency mortgages stand to benefit from attractive valuations, favorable funding and strong liquidity as market conditions improve. I’ll stop here, and Brian will go through the portfolio.

Brian Norris: All right, 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. As shown on the chart in the upper left, U.S. treasury yields increased across the yield curve largely in a modest bear steepener during the second quarter. Yields on maturities from two to 30 years rose between 13 and 22 basis points as investors priced in greater potential for looser fiscal policy. This change has more than reversed since quarter end, as reflected by the purple line which represents the yield curve as of Wednesday, August 7. Recent employment data was softer than expected, increasing fears that monetary policy had been kept too tight for too long, leading to a sharp bold steepening in the yield curve since quarter end.

The chart on the bottom left details pricing in the Fed fund’s futures market since year end. By the end of the second quarter, the market expected two 25 basis point cuts in 2024, consistent with the Fed’s median dot plot and down from over six expected cuts at the beginning of the year. Since the end of the quarter, however, recent weakened employment data has led to more than four cuts anticipated in 2024. The increased uncertainty about monetary policy and the economy has caused interest rate volatility to rise sharply, leading to modest under-performance in agency mortgages. The chart in the upper right reflects the recent sharp decline in three-month SOFR, highlighting the volatility in short term interest rates. Positively, our repo market counterparties have begun to price these cuts into their longer term rates, offering more attractive financing for agency RMBS and CMBS.

Lastly, the bottom right chart details the agency RMBS holdings by the Federal Reserve and U.S. banks. Run-off of the Fed’s balance sheet continues with agency RMBS declining by $15 billion to $20 billion per month, while U.S. banks have added modestly to their balance sheets. We expect bank demand to rise as monetary policy eases, creating a more attractive investment environment with a steeper yield curve and less interest rate volatility. Additionally, the finalization of Basel-III guidelines, likely by late 2024 or early 2025, should give banks more regulatory clarity and confidence, boosting demand in 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 second quarter in grey.

Current coupons modestly under-performed during the quarter as interest rate volatility spiked, both in April and late June. Since the end of the quarter, strong performance in July has been offset by increased interest rate volatility and a general risk-off tone in early August due to weaker than expected August employment report. Although nominal spreads on higher coupons are now narrower than in the second half of 2023, they are still historically attractive as ongoing interest rate volatility is limiting demand. Specified pool pay-ups fell in the second quarter due to rising interest rates, but have partially recovered as the abrupt decline in rates has led to more demand for prepayment protection. Lastly, as shown in the lower right chart, the dollar roll market for certain TBA securities improved dramatically in the second quarter as heavy demand for higher coupon Ginnie collateral from CMO desks led to a significant imbalance in the supply-demand technicals in those coupons.

This imbalance has since normalized, however, and the dollar roll market for most 30-year TBA securities is once again largely unattractive relative to repo financing on specified pools. Slide 6 details our agency RMBS investments and summarizes the investment portfolio changes during the quarter. We continued to rotate a portion of our lower coupon specified pools into agency CMBS at the beginning of the quarter; however, continued outperformance in agency CMBS limited the amount of the rotation as contracting premiums throughout the quarter made the sector less attractive relative to agency RMBS. We remain focused in higher coupons, which should benefit from decline in interest rate volatility and are largely insulated from direct exposure to assets held by both commercial banks and on the Federal Reserve’s balance sheet.

We focus our specified pool allocation on prepayment characteristics that are expected to perform well in both premium and discount environments, with our largest concentration in lower loan balance collateral, giving more predictable prepayments. In addition, during the quarter we added $200 million notional in higher coupon Ginnie TBA to benefit from the very attractive levels and the dollar roll market. Although we anticipate industry volatility to remain moderately elevated in the near term, we believe current valuations on production coupon agency RMBS largely reflect 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 $120 million in the second quarter, bringing our exposure to approximately 7% to 8% of our total 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 at the beginning of the second quarter, but given the strong performance in the sector, that declined to the high single digits. Financing capacity 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 remained 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 RMBS and agency CMBS declined modestly from $4.4 billion to $4.3 billion, and our notional pay-fixed interest rate swaps decreased as well from $4.3 billion to $3.9 billion, as the ratio of our hedges to borrowings decreased to 92% from 97% last quarter.

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 7.2 years at the end of the first quarter to 7.5 years, resulting in a modest increase in the weighted average coupon on our pay-fixed swaps from 1.17% to 1.22%. Economic leverage ended the quarter at 5.9 times debt to equity, up from 5.6 times at the end of March, mostly reflecting the decline in book value. Slide 10 provides further detail on our asset yields and funding costs. Interest rates on our repurchase agreements and swap receive rates were largely unchanged at quarter end, while yields on our agency RMBS portfolio increased five basis points to 5.4%, consistent with the five basis point increase in our swap pay rate.

To conclude our prepared remarks, despite a near consensus that easing in monetary policy will begin in the third quarter, financial markets remain quite volatile as investors debate the probability of a recession and magnitude and timing of near-term policy easing. The recent sharp decline in interest rates has provided a supportive backdrop for lower coupon agency mortgages since quarter end, while higher coupons have modestly lagged given the spike in interest rate volatility. We believe IVR is well positioned to navigate future mortgage market volatility and selectively capitalize on historically attractive agency RMBS spreads, given our balance of discount and higher coupon agency mortgages and agency CMBS. In addition, we believe the easing of monetary policy will eventually lead to further declines in interest rate volatility and a steeper yield curve, both of which provide a supportive backdrop for agency mortgages.

Lastly, our liquidity position remains robust and provides cushion for further potential stresses in the market, while also providing capital 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.

Q&A Session

Operator: Thank you. [Operator instructions] Our first question comes from Jason Weaver with JonesTrading. Your line is open.

Jason Weaver : Hey, good morning. Thanks for taking my question. Brian, I appreciate your comments around leverage, and I understand it was book value-related, the change in the quarter; but can you comment on your comfort zone going forward? It seems like with the comments around easier monetary policy leading to tighter spreads, it might be appropriate to get more aggressive at some point in the near future.

Brian Norris: Yes, hey Jason, good morning as well. Thanks. Right now, we would consider our leverage to kind of be in the middle of our range. You’re right – if we start to see a decline in interest rate volatility and a steeper yield curve, that would potentially warrant an increase in leverage, but as of right now, we’re still in a pretty volatile environment, so I think remaining somewhat in the middle of that range is prudent.

Jason Weaver: Got it, that makes sense. Just one clarification – you made the comments on agency CMBS. Is that not likely to become a much–a growing portion of your portfolio going forward?

Brian Norris: We certainly like the benefits that it brings to the portfolio. Like I said, spreads got a little too tight for it to make sense later in the second quarter, but if we were to see some compression between agency CMBS and agency RMBS, it’s likely that we would look to increase the allocation there.

Jason Weaver: Got it, thank you for that.

Operator: Thank you. The next question comes from Doug Harter with UBS. Your line is open. Okay, moving onto our next question – Jason Stewart with Janney. Your line is open.

Jason Stewart: Hey, good morning. Thanks. Can you give us an update on where taxable income stands relative to the dividend, and how you see that evolving going forward?

Brian Norris: Hey Jason, it’s Brian. Taxable income is a challenging one. I think that’s going to be in our Q. I think the thing that we look at certainly is EAD, which is comfortably above the dividend, and taxable income typically gets driven by derivatives pricing, so that tends to be a little more volatile depending on what rates are doing during the quarter, so it makes it a little bit more challenging to use that as a guide.

Jason Stewart: Okay. Maybe generally, and I’m looking it up right now, could you give us–like, are we in a position of being over-distributed or under-distributed, just generically, kind of mid-year?

Brian Norris: Relative to our taxable income, is that the question?

Jason Stewart: Correct, yes.

Lee Phegley: Hey Brian, do you want me to address that?

Brian Norris: Sure.

Lee Phegley: Okay. We have operating loss carry-forwards that allow us to sustain the delta between taxable income, right now being in excess of the disclosure of the–or in excess of the dividend that we’re paying, if that’s the question in terms of is tax going to drive a need to increase the dividend. We have flexibility there based on our operating loss carry-forward.

Jason Stewart: Okay, that’s helpful. Then you guys addressed where, I think, marginal economic returns were in the mid to high teens on a gross basis. Where do you see them on the existing book today, and what do you think the best path forward given your view of the basis and the macro environment? Is it raising capital to deploy at incremental returns? You know, how does that look relative to the existing book, taking the benefit of swaps into account? How do you think about those two factors going forward?

Brian Norris: Hey Jason. I think the current book has been mostly added at wider spreads than where we are now, so I would say the yields on those, or the ROEs are in the high teens to 20 area, because we’ve seen over the last couple of years more attractive environments on a spread basis than we currently see right now. Sorry, what was the second part of the question?

Jason Stewart: I guess how do you see–you know, the benefit of the swaps today and the current economic returns on the book, how do you balance that versus raising capital to invest at marginal economic returns, again taking into account–

Brian Norris: Yes, given our–sorry, Jason. Yes, given our current capital structure, it’s not optimal. Raising capital and deploying in new assets becomes quite accretive given where spreads are right now, so that we view as a relatively attractive option for us.

Jason Stewart: Okay, all right. I’m jump out and let Doug get back in here. Thanks.

Operator: As another quick reminder, if you’d like to ask a question, please press star followed by one. Showing no further questions, but we’ll allow one moment. Okay, I’m showing no further questions at this time.

John Anzalone: All right, well thank you everybody for joining us, and we look forward to next quarter’s call. Thanks.

Operator: Thank you, and that concludes today’s conference. You may all disconnect at this time.