Invesco Mortgage Capital Inc. (NYSE:IVR) Q4 2022 Earnings Call Transcript

Invesco Mortgage Capital Inc. (NYSE:IVR) Q4 2022 Earnings Call Transcript February 22, 2023

Operator: Welcome to Invesco Mortgage Capital Inc.’s Fourth Quarter 2022 Investor Conference Call. All participants will be in a listen-only mode until the question-and-answer session. As a reminder, this call is being recorded. Now, I would like to turn the call over to Matt Seitz in Investor Relations. Mr. Seitz, you may begin the call.

Matt Seitz: 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 two 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?

John Anzalone: Good morning, and welcome to Invesco Mortgage Capital’s fourth quarter earnings call. I’ll give some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss the current portfolio in more detail. Also joining us on the call to participate in the Q&A are our President, Kevin Collins, and our COO, Dave Lyle. Financial conditions began to ease during the fourth quarter, despite a pair of 75 basis point increases to the Fed funds target rate, as investors began to anticipate an end to the FOMC’s tightening cycle. While still at elevated levels, inflation, as seen through the CPI and PPI indices, is well below its recent highs and has begun to ease. Risk markets responded favorably, as equity markets improved, most credit spreads tightened and volatility measures moderated.

After facing the most challenging environment in over a decade during the first three quarters of 2022, mortgage performance rebounded during the fourth quarter and into the first quarter of 2023, with current coupon agencies outperforming treasuries as interest rate volatility came off its recent highs. For the quarter, IVR’s earnings available for distribution remains strong, coming in at $1.46 versus $1.39 last quarter. Our rotation into higher yielding, higher coupon mortgages, in addition to substantial hedging of borrowing costs with interest rate swaps, drove this increase in EAD. Over the coming quarters, we expect EAD to continue to be supported, as our repo hedge ratio remains elevated as forward starting swaps come online. Importantly, these hedges provide benefit for the long term, as the average maturity of our swap book is over 7 years.

ROEs on new investments have also been a positive contributor to EAD, as the wider spreads on new purchases are attractive and we enjoy the benefit of having retained low coupon legacy swaps. While mortgage performance has been positive since the beginning of the fourth quarter, both interest rates and mortgage markets have remained volatile. Book value was largely unchanged in the fourth quarter and combined with our $0.65 dividend resulted in an economic return of approximately 5%. Given strong performance to begin 2023, book value has improved by approximately 4% since year-end through February 17. Our economic leverage remained unchanged during the quarter, finishing at 5.3 times. At quarter end, substantially all of our $4.8 billion investment portfolio was invested in Agency RMBS, and we maintain a sizable balance of unrestricted cash and unencumbered investments totaling $528 million.

While mortgage valuations look attractive given the relatively wide spreads, particularly in higher coupons, our outlook for mortgages remain somewhat cautious. Mortgage performance has been highly correlated with changes in short-dated interest rate volatility, and we expect volatility to remain elevated while the near-term path of Fed funds remains uncertain. Once the Fed’s path becomes clear, mortgages should enjoy significant tailwinds as volatility falls. 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 over the past year. During the fourth quarter, interest rate volatility remained historically elevated as inflation and employment data releases shaped market expectations for the path of monetary policy in 2023. The yield curve continued to invert as yields on US treasuries with maturities one year or less, increased between 75 and 135 basis points, while maturities longer than one year were largely unchanged, reflecting expectations that the current cycle of monetary policy tightening by the Federal Reserve is nearing its conclusion. In addition, expectations for easing in monetary policy has intensified since the end of the third quarter, with substantial cuts in the Fed funds rate priced in for 2024, as indicated in the bottom left chart.

As shown in the lower right-hand chart, US commercial banks further reduced their holdings of agency mortgages during the fourth quarter concurrent with runoff of the Federal Reserve’s balance sheet, resulting in increasing reliance on money manager and foreign investment for the sector. Positively, the organic supply of agency mortgages to the market, continued to decline in the quarter as refinancing activity and housing turnover slowed substantially given the sharp increase in mortgage rates in 2022, largely offsetting the significant decline in demand. Moving on to slide 5, where we provide more detail on the Agency RMBS market. Despite 2022 being an extraordinarily challenging environment for financial markets and Agency RMBS in particular, mortgage performance rebounded during the fourth quarter and has continued its more positive trend this year.

In the upper left-hand chart, we show 30-year current coupon Agency RMBS performance versus US treasuries in 2022, highlighting in the fourth quarter in gray. After underperforming for most of October, Agency RMBS valuations rebounded as interest rate volatility declined from its peak and interest rates fell. The sector performed very well in November, as attractive valuations and limited supply encouraged investor demand, but weakened modestly in December as the decline in interest rate volatility reversed and liquidity decreased into year-end. As shown in the upper right chart, specified pool pay-ups improved modestly during the quarter, as investor demand increased, while implied financing in the dollar roll market for TBA securities continued to deteriorate, as indicated in the lower right chart.

Slide 6 provides detail on our Agency RMBS investments and the changes in the portfolio during the quarter. We continue to rotate lower coupon investments into more attractive higher coupons, expanding our net interest margin and supporting the earnings power of the company. The period end weighted average yield on our Agency RMBS investments improved from 4.65% at the end of the third quarter to 5.26% at the end of the fourth, capturing a significant improvement in available returns given more attractive valuations and higher coupons as the inverted yield curve and elevated front-end interest rate volatility provides higher yields for shorter duration investments. As you can see in the upper left chart, our Agency RMBS holdings are focused primarily on current production coupons and our exposure to policy adjustments in regards to the Federal Reserve’s balance sheet is significantly reduced, given its primarily focused and lower coupons.

In addition, given the continued deterioration in the dollar roll market for TBA securities, we fully exited our TBA position during the quarter and rotated the balance into specified pools. We continue to focus our specified pool allocation on those characteristics, which are expected to perform well in both a premium and discount environment. States such as Texas and Florida, as well as borrowers with low loan balances typically produce faster prepayments when trading at a discount and slower speeds when trading at a premium. During the quarter, we increased allocations to credit stories such as high LTV and low credit score, which should perform well as the economy and home price appreciation slows in 2023. Although we continue to anticipate elevated front-end interest rate volatility as monetary policy evolves, we believe current valuations on production coupon Agency RMBS represent attractive investment opportunities with current ROEs in the mid-teens.

Our remaining credit investments are detailed alongside our Agency CMO allocation on slide 7. Our credit allocation declined during the quarter given the full repayment of our $24 million commercial real-estate loan and further paydowns on our credit securities. Our remaining $46 million of credit securities are high quality with 87% rated single A or higher. Although, we anticipate limited near-term price appreciation, we believe these assets are attractive holdings as they are held on an unlevered basis and provide favorable yields. We have continued to rotate paydowns on our credit investments into lower coupon fixed rate agency interest-only securities, which totaled $85 million and are detailed on the right side of slide 7. These holdings also provide an attractive unlevered yield and benefit from the current slow prepayment environment given minimal housing turnover and limited refinance activity.

Lastly, slide 8 details our funding book at quarter end. Repurchase agreements collateralized by Agency RMBS increased to $4.2 billion given the increase in our specified pool holdings and our weighted average repo cost increased to 4.2%, consistent with changes in short-term funding rates due to tightening monetary policy. Positively, hedges associated with those borrowings increased to $3.5 billion net notional of current pay fixed received floating interest rate swaps, increasing our hedge notional to 81% of borrowings. In order to hedge additional exposures further out the yield curve, we continue to hold $700 million net notional of forward starting interest rate swaps as of year-end. Since year-end, our hedge notional percentage has increased to 90% as $500 million of our forward starters became effective.

Our economic leverage ended the quarter unchanged at 5.3 times debt to equity and since quarter end has moved modestly higher given additional purchases of Agency RMBS specified pools funded via repurchase agreements. To conclude our prepared remarks, 2022 was an extremely challenging year for the Agency RMBS sector. Looking forward, higher interest rates and wider spreads present an attractive environment for investors and the sector should also benefit from a reduction in front-end volatility. While we remain cautious given continued uncertainty regarding monetary policy, we do believe today’s Agency RMBS valuations represent an attractive entry point for those with longer time horizons. 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. Our first question today comes from Doug Harter with Credit Suisse. Your line is open.

Doug Harter: Thanks. I was hoping you could talk about how you’re thinking about the dividend in light of kind of available returns you see versus kind of the EAD that you’re currently generating.

John Anzalone: Yes. Hi Doug, it’s John. Yes, as I mentioned earlier, earnings available for distribution remains well-supported for the reasons I mentioned. Our payout rate is determined by our Board. And when setting the dividend, we look at a number of factors. One of the things we’ll be looking at is how competitive our payout rate is versus peers balanced with the desire to support book value. So, that’s the balance we’ll be looking at. But there’s plenty of time until we need to make that decision by the end of the quarter.

Doug Harter: Great. And I apologize if you said, but I guess obviously, it bounced around. But kind of where do you see kind of incremental returns on new investments today?

Brian Norris: Yes, hey Doug, it’s Brian. ROEs today, we’ve seen some underperformance agency mortgages here in February. So, ROEs are a little bit improved. They’re probably in the mid-teens at this point. I would say at the end of January, it was more low to mid-teens and we’ve seen some improvements since then.

Doug Harter: Great. Thank you.

Operator: Thank you. The next question comes from Trevor Cranston with JMP Securities. Your line is open.

Trevor Cranston: Thanks. Good morning. Can you talk about — I mean looking at the hedge position, it doesn’t look like changed all that much quarter-over-quarter as the portfolio moved up in coupon? Can you guys talk generally about how you guys are thinking about your rate positioning as we stand today? Thanks.

Brian Norris: Yes, hey Trevor, it’s Brian. Typically, we try to eliminate our exposure to both changes in interest rates and changes in the yield curve. So, our swap book is kind of across the yield curve. As John mentioned, the weighted average maturity is over seven years. So, we feel like that fairly closely matches the duration of our securities. So, overall, we think our — we believe our interest rate exposure is relatively muted. I would say we’ve — given the backup in rates that we’ve seen over the last couple of weeks, we’ve moved a little higher, but not — it’s probably half a year to three quarters of a year duration gap.

Trevor Cranston: Okay, got it. And then I was curious about the comment you guys made about adding some IOs to the portfolio. Can you expand a little bit on kind of the value those add to the portfolio and how you see the, sort of, ROE potential on low coupon IO versus potentially just adding more pools?

Brian Norris: Yes. We feel like the agency IO position does help hedge some of the exposures that we have in the specified pool book. Unlevered yields are pretty attractive in the high single digits. We are not levering those securities. So we kind of view the agency IO book similarly to the credit book. We’re allowing it to sit there on an unlevered basis, still earn relatively attractive yields. But again, just kind of hedges some of the exposures that we see in the specified pool book.

Trevor Cranston: Got it. Okay. Appreciate the comment. Thank you.

Operator: Thank you. There are currently no other questions at this time.

John Anzalone: Okay. Well, I appreciate every — we all appreciate everybody dialing in for the call and look forward to you joining us next quarter. Thanks.

Operator: Thank you. That concludes today’s conference, and thank you for participating. You may disconnect.