Invesco Mortgage Capital Inc. (NYSE:IVR) Q3 2024 Earnings Call Transcript

Invesco Mortgage Capital Inc. (NYSE:IVR) Q3 2024 Earnings Call Transcript November 6, 2024

Operator: Welcome to the Invesco Mortgage Capital’s Third Quarter 2024 Earnings Call. All participants will be a in a listen-only mode until the question-and-answer session. [Operator Instructions] Also as a reminder, this 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: Thanks 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, 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 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 IVR’s CEO, John Anzalone.

John Anzalone: All right, thanks Greg. Good morning and welcome to Invesco Mortgage Capital’s third 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 for Q&A is our President, Kevin Collins; our COO, Dave Lyle; and our recently appointed Interim CFO, Mark Gregson, so welcome Mark. During the quarter, interest rates dropped sharply across the curve as investors reacted to cooling inflation and the potential for slower economic activity signaled by a weakening labor market. These factors also led to a repricing of the market’s expectations of future monetary policy.

Following the FOMC’s initial 50 basis point reduction in its benchmark rate in September, the federal funds futures market reflected an expectation that the target rate would be reduced by an additional 50 to 75 basis points during the balance of 2024, with another 100 to 125 basis points worth of cuts priced into 2025. Against this backdrop, Agency Mortgages outperformed treasuries during the third quarter. Moderating industry volatility and the steepening of the yield curve spurred demand for Agency Mortgages, with lower coupons performing better than higher coupons as a sharp decline in interest rates mitigated demand for coupons trading at a premium to par. Overall prepayment speeds remained at very low levels given limited housing activity and elevated mortgage rates, but speeds increased notably on higher coupons in September as the decline in mortgage rates over the summer led to a surge in refinancings in more recent originations.

Given the decline in mortgage rates and upward pressure on prepayments, premiums on higher coupon specified pool collateral increased modestly, while implied volatility via the dollar roll market or implied financing via the dollar roll market for TBA investments remained relatively unattractive throughout the quarter. Agency CMBS risk premiums moved modestly wider, increasing the relative value versus Agency Mortgages. The positive environment for mortgages contributed to a 1.1% increase in book value per common share to $9.37. Combined with our $0.40 common stock dividend, this resulted in an economic return of 5.4% for the quarter. As we enter the fourth quarter, uncertainty around the U.S. elections and the future path of monetary policy has caused a sharp increase in both treasury yields and interest rate volatility, which has put heavy pressure on mortgage valuations.

As of last night, our estimated book value is down approximately 5.8% since 9.30. Our debt-to-equity ratio ended the second quarter at 6.1 times, up from 5.6 times as of June 30, while our economic debt-to-equity ratio increased from 5.9 times to 6.1 times quarter-over-quarter. As of the end of the quarter, our $5.9 billion investment portfolio primarily consisted of $5.2 billion of Agency Mortgages and $0.7 billion of Agency CMBS, and we continue to maintain a sizable balance of unrestricted cash and unencumbered investments totaling $520 million. For the quarter, earnings available for distribution for common share was $0.68 compared to $0.86 in the second quarter. This decrease primarily reflects reduction in our effective net interest income related to changes in the size and composition of our hedging portfolio.

Yesterday we announced our intention to redeem our Series B preferred shares on December 27, which will help optimize our capital structure and reduce our dividend obligations going forward. Looking ahead, the recent disinflationary trend in economic data suggests that the Federal Reserve can continue to ease monetary policy in the coming months as the need for restrictive monetary policy declines. This easing, combined with the end of the U.S. election cycle should lead to a steeper yield curve and lower interest rate volatility, creating a favorable environment for Agency Mortgage investments. However, if the disinflationary trend reverses the labor market and economic growth improved, expectations for monetary policy could shift posing a near-term risk.

Additionally, short-term funding pressures into yearend could impact demand for the sector. Despite these near-term risks, we are constructive on the sector as Agency Mortgage performance stands to benefit from normalization of monetary policy given attractive valuations and supportive supply and demand technicals. We also remain constructive on Agency CMBS as we expect a gradual increase in new issuance to be met with adequate investor demand as the sector offers value relative to other fixed income investments given its attractive prepayment protection and return profiles. Now I’ll turn the call over to Brian to 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. As shown on the chart in the upper left, U.S. treasury yields declined across the yield curve during the third quarter as two-year yields were 111 basis points lower while 10-year and 30-year yields declined 61 and 44 basis points respectively. The chart on the bottom left provides fed funds futures market pricing since year end. Due to ongoing disinflation and a weakening labor market Investors priced in two more 25 basis point cuts in the fed funds rate for 2024 and 2025 by the end of the third quarter compared to the end of the second quarter. By the end of October, investor expectations moderated due to a stronger than expected September employment report, raising concerns that monetary policy may remain tighter for longer.

Elevated monetary policy uncertainty and the strength of the economy has caused interest rate volatility to rise sharply leading to Agency Mortgage underperformance in October. The chart in the upper right reflects changes in short-term funding rates since year end. During the third quarter funding rates declined in line with expectations from near-term monetary policy easing, while repo rates exhibited substantial volatility at quarter end given heavy U.S. treasury supply and increased demand for repo. Positively, the repo market normalized in October, although spreads have remained modestly wider given concerns regarding future treasury supply, election and monetary policy uncertainty, and the risk of renewed funding pressures into year end.

Lastly, the bottom right chart details Agency Mortgage holdings by the Federal Reserve and U.S. Banks. Runoff of the Fed’s balance sheet continues with Agency Mortgages declining by approximately $15 billion to $20 billion per month, while U.S. banks added modestly to their balance sheets. We expect bank demand for HCMBS to rise as monetary policy eases and the finalization of the Basel 3 guidelines, likely by late 2024 or early 2025, provides banks with greater regulatory clarity. 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 since year end, highlighting the third quarter in grey. Current coupons outperformed during the quarter as interest rate volatility declined and the yield curve steepened, improving investor demand.

Since the end of the quarter however, increased interest rate volatility and a bear flattening yield curve led to sharp underperformance in the sector. Nominal spreads on current coupons returned to year-to-date wides and remained historically attractive as ongoing interest rate volatility is limiting demand. Specified pool payouts improved in the third quarter due to the decline in mortgage rates, but have partially reversed as the abrupt increase in interest rates has led to less demand for prepayment protection. Lastly, as shown in the lower right chart, the dollar roll market for TBA securities became relatively unattractive again with implied funding rates higher than silver for most coupons. We continue to prefer specified pools over TBA given their more predictable prepayment behavior and favorable funding yield levels.

Slide 6 details our Agency RMBS investments and summarizes investment portfolio changes during the quarter. Our Agency RMBS portfolio increased 12% quarter-over-quarter as we invested proceeds from ATM issuance into higher coupons. We continue to rotate a portion of our lower coupons into Agency CMBS as the relative value improved given tighter spreads and discount Agency RMBS. Overall, we remain focused in higher coupon Agency RMBS, which should see greater 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. We focused 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 given more predictable prepayments.

In addition, during the quarter we rotated our $200 million notional TBA position into higher coupon specified pools as implied funding levels in the dollar roll market deteriorate. Although we anticipate interest rate volatility to remain moderately elevated in the near-term, we believe current valuations on Production Coupon Agency RBS 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 portfolio. We purchased $214 million in the third quarter bringing our exposure to approximately 12% of our total investment portfolio. We believe Agency CMBS offers many benefits mainly through its prepayment protection and fixed maturities which reduced our sensitivity to interest rate volatility.

Gross ROEs on our new purchases were in the low double digits ROEs and we have been disciplined on adding exposure only when the relative value between Agency CMBS and Agency RMBS accurately reflects their different risks. Financing capacity has been robust as we have been able to finance our purchases with multiple counterparties at attractive levels. We will continue to monitor the sector for opportunities to increase our allocation as they become available, recognizing the overall benefits of 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 $73 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 HCMBS increased from $4.3 billion to $5.2 billion, reflecting the increase in our equity base and assets and our notional pay fixed interest rate swaps increased as well from $3.9 billion to $4.3 billion. Given the smaller increase in our hedge notional, the ratio of our hedge notional to borrowings decreased quarter-over-quarter to 83% from 92% as we increased our position in longer duration treasury futures. In addition, the sharp decline in interest rates led to further repositioning of the swap book as the interest rate sensitivity of our assets decreased, warranting a similar decrease in the weighted average maturity of our hedges.

Reflecting this change, the weighted average maturity of our swaps declined from 7.5 years at the end of the second quarter to 5.4 years, resulting in an increase in the weighted average coupon on our pay fixed swaps from 1.22% to 1.37%. Economic leverage ended the quarter at 6.1 times debt to total equity up from 5.9 times at the end of June, while our debt to common equity declined from nearly 9.5 times to 9.1 times at quarter end. The increase in our total equity leverage and decline in common equity leverage highlights the positive impact of our improving capital structure. Subsequent to quarter end we announced our intention to call our Series B preferred equity in late December, which will further improve our capital structure as we enter 2025.

To conclude our prepared remarks, despite strong results in the third quarter, financial markets have been quite volatile in recent weeks as investors become increasingly concerned about the outcome of the election and its impact on near-term fiscal policy while also continuing to debate the path and magnitude of monetary policy easing. The sharp decline in interest rates reversed notably in October, increasing interest rate volatility and negatively impacting Agency RMBS valuations. We believe IVR is well positioned to navigate current mortgage market volatility given our moderate leverage and robust liquidity as well as our increased allocation to Agency CMBS. We continue to selectively capitalize on historically attractive Agency RMBS spreads and believe the sector is poised to perform well as the currently volatile election cycle passes.

Our liquidity position provides substantial cushion for further potential market stress, while also providing capital to deploy into our target assets as the investment environment improves. In addition, we believe further easing of monetary policy will lead to a steeper yield curve and decline in interest rate volatility, both of which provide a supportive backdrop for Agency Mortgages as they improve demand from commercial banks, overseas investors, money managers and REITs. Thank you for your continued support for Invesco Mortgage Capital and now we will open the line for Q&A.

Q&A Session

Operator: [Operator Instructions] Looks like our first question comes from Jason Weaver with JonesTrading. You may ask your question.

Jason Weaver: Hi, good morning. Thanks for taking my question. I want to bridge to your comments about the addition of the Agency CMBS. I appreciate the fact that that might dampen book value volatility, but does that change your approach to how you set leverage targets there? That is, could you support higher leverage forward?

Brian Norris: Hey, Jason, it’s Brian. Yes, thanks for the question. Yes, I think, to the extent that our exposure to rate volume declines that that would allow us to increase leverage. I think clearly, the month of October has been pretty challenging, but that puts us in a pretty good position where spreads are attractive and you know, as that volatility declines, it gives us more room to be able to add in the future.

John Anzalone: Yes, I’ll point out all this, John. The Agency CMBS has basically the same borrowing costs and haircuts as Agency Mortgages. So that doesn’t impact leverage from that perspective either.

Jason Weaver: Got it. Thank you, that’s helpful. And then I was curious about any sort of perspective change in positioning quarter to date. Not that you’ve raised quite a bit on your ATM in the third quarter.

Brian Norris: Yes, quarter to date, nothing too significant changes wise. I think, like I said, October was pretty volatile, and we came into it with a strong liquidity position and, moderate leverage. And so, our ability to kind of withstand that volatility allowed us to. Do not have to make significant changes since quarter end.

Jason Weaver: Okay, that’s helpful. Thank you.

Operator: [Operator Instructions] Our next question comes from Trevor Cranston with Citizens JMP. You may ask your question.

Trevor Cranston: Hey, thanks. You guys have historically mostly used swaps for hedging purposes, and those have kind of underperformed relative to using treasury hedges over the last several months. I was just curious if you guys have any kind of general thoughts about swaps versus treasuries, why swap spreads have become so negative and if there’s any sort of change in your thinking in terms of using either as hedge instruments going forward. Thanks.

Brian Norris: Yes. Hey, Trevor, it’s Brian. Yes, we certainly started in the third quarter to using treasury features more prominently. You’re right. I mean, swap spreads have been moving tighter for quite a while now. And I think the move from LIBOR to SOFR kind of removed the credit component of swap spreads and it’s mostly more just about treasury supply at this point. And, the expectation is that treasury supply has been robust and it’s likely to continue to be robust. So we’re a bit concerned that swap spreads won’t be mean reverting. And so this tightening that we’ve seen could be relatively persistent. And so our idea is to increase our exposure or a hedge book in treasury futures that will help mitigate our exposure to swap spreads.

Trevor Cranston: Okay, got it. That’s helpful. Thank you.

Operator: Thank you. Our next question comes from Jason Stewart with Janney. Your line is open. You may ask your question.

Jason Stewart: Hi. Thanks. Good morning. Just a quick clarification on the down 5.8 through 11.5, is that including a dividend accrual?

Brian Norris: Correct? Yes. Yes, that includes. I’m sorry. Well, it excludes the impact of the dividend.

Jason Stewart: Excludes the dividend. Okay.

Brian Norris: Yes.

Jason Stewart: And then, obviously some big moves this morning with 10 sort of approaching 450. I was just wondering what your macro take was on. On where you think tens as a benchmark for mortgages are headed in terms of the news we got overnight and maybe how that coincides with your view of rate fall.

John Anzalone: Yes, certainly pretty fresh moves so far this morning. I think the move in treasury rates was largely expected based on the outcome of the election. And so that’s not a surprise from that perspective. I think actually implied volume has come down. So that’s been a positive for Agency Mortgages, at least here initially. I haven’t looked in the last 30 minutes or so. Clearly there have been on the day after the election some pretty big swings in markets historically. But I do think that it’s a question of, implied volatility versus realized volatility. I think, like I said, I think implied has come down now that we’re kind of past this event. So that’s a positive, as far as, where treasury yields kind of end up.

That’s a tough question. I think, the expectation is kind of in that, 4.5 to call it four, three quarters range here in the near-term. So we could continue to see some pressure higher. But, the steeper curve and lower implied volume should both be relatively positive, particularly for higher coupon Agency Mortgages.

Jason Stewart: Yes. Okay, that’s helpful color. And then on the short end of the curve, I mean, the forward has taken out, about one rate cut so far. Is your, is the house view or your view and sort of the way you construct the portfolio, take forwards at their word or do you feel like, when you look at underlying inflation trends that the Fed might be, off-sides on some of these moves and we’ll see more forwards come out. And I guess net, net to that is, how important is 350 versus a 4% Fed funds rate if the curve remains steep to the strategy and the structure of the portfolio?

John Anzalone: Yes, like I think to your point, the overall level may be less important as opposed to the steepness of the curve and what it means for volatility going forward. Clearly, we prefer a steeper curve and lower fall. Yes, our house view has been in that five to six cut range between now and the end of 2025. So, I think based on last night, again, I think that probably moves to the lower end of that range. But, I think clearly there’s been a lot of talk about tariffs and tax cuts. And so we’ll have to just kind of see how that plays out here over the near-term before we kind of settle in on a specific number.

Jason Stewart: Okay, thanks for the caller.

Operator: Thank you. Our next question comes from Eric Hagen with BTIG. Your line is Open. You may ask your question.

Eric Hagen: Hey, thanks. Good morning. Maybe a couple follow-ups here. I mean, does retiring the preferred stock change the way that you think about your overall debt to equity leverage and does the range for your leverage that you might explore change because of that at different spread levels?

John Anzalone: Yes, I think our overall debt to the common, it doesn’t change our view on that, but the total debt to equity will move higher as the capital structure kind of normalizes.

Eric Hagen: Okay. Is there a target range for your leverage that you envision running with over the near-term?

John Anzalone: Yes, that’s a common. We’ve been pretty comfortable around that nine area. I think, we’ll continue to kind of monitor how the market evolves here over the near-term. But, I think nine has generally been a pretty kind of conservative/moderate comfortable level where it gives us a lot of liquidity and, it allows us to maybe take that up a notch higher if we see that ball come down.

Eric Hagen: Yes. Okay, another follow-up on the kind of spread conversation. I mean, do you basically see more risk that spreads would widen at this point in a rate rally or a sell off? And as the yield curve steepens, I mean, how much appetite do you have to maybe extend your duration gap? I mean are there any constraints that you see to extending your duration gap?

John Anzalone: As far as duration goes, we intend to keep that pretty close to zero. Mortgages have been trading pretty long versus rates over, well, really since the curve has been inverted. And so, what that means is, they tend to outperform as rates rally and underperform as rates sell off. You know, and I think at least in the near-term, we don’t expect that to change too dramatically. But it, like I said, it is dependent upon, where implied volatility kind of moves from here. So, sorry, I’m trying to remember what the first question was.

Eric Hagen: No, I think you got it. I mean, it was just, gauging the sensitivity to spreads in a rally or a sell off. Thanks for the comments. I appreciate it.

John Anzalone: All right. Yep, sure.

Operator: Thank you again. [Operator Instructions] Our next question comes from Doug Harter with UBS. You may ask your question. Your line is open.

Doug Harter: Thanks. Wondering if you could just touch on how you’re thinking about the dividend and especially kind of in light of the, kind of the more challenging start to 4Q.

John Anzalone: Yes. Hey, Doug, it’s John. Yes, so as always, our Board recommends the dividend or determines a dividend based on recommendations. So, that said, what we’re generally looking at is, where available ROEs on our target assets are. I mean, that’s the biggest driver of where, set dividend policy. So, we’ll kind of see where that goes. I mean, we have a month and a half until we have to make that decision. So lot can happen between now and then, we balance that with. You want to stay competitive within the space and in line with investor expectations. So it’s kind of the things we look at. So, yes, I mean, that’s kind of where we’re at right now. It’s a little early for that, though.

Doug Harter: Understood. I get that the markets are moving around fair bit, but appreciate that answer, John.

Operator: Thank you. And at this time, I’m showing no further questions.

John Anzalone: Okay. Well, thanks, everybody, for joining us, and we look forward to speaking to you next time. Thanks.

Operator: Thank you. That does conclude today’s conference. We thank you for your participation. At this time, you may disconnect your lines.