Invesco Mortgage Capital Inc. (NYSE:IVR) Q4 2023 Earnings Call Transcript

Invesco Mortgage Capital Inc. (NYSE:IVR) Q4 2023 Earnings Call Transcript February 23, 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 Inc. Fourth Quarter 2023 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 the call.

Greg Seals: 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, 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 the 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 or guarantee the accuracy of our earnings teleconference transcripts provided by third-parties.

The only authorized webcast 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 will give some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss the portfolio in more detail. Also joining us on the call are President, Kevin Collins; and our COO, Dave Lyle. As we enter the fourth quarter, interest rate volatility accelerated as changes in investor expectations for the supply of U.S. treasuries and the path of monetary policy led to substantial adjustments to both the level of interest rates and the shape of the yield curve. The heightened volatility drove notable underperformance in agency mortgages as investors reduced exposure to the asset class. During this period, we sought to maintain appropriate levels of cash number assets, reducing risk by decreasing leverage as volatility increased.

The market sentiment improved, bolstered by incoming data supporting a soft landing narrative and market expectations for a quicker pace of interest rate cuts by the Federal Reserve, we return to our target range. Despite the volatility we experienced during the quarter, our book value per common share ending the quarter at $10, representing an increase of 0.7% from September 30th. When combined with our $0.40 common stock dividend, this produced an economic return of 4.7% for the quarter. Our debt-to-equity ratio ended the quarter at 5.7 times, down from 6.4 as of September 30th. As of the end of the quarter, nearly all of our $5.1 billion investment portfolio was invested in agency mortgages, and we maintained a sizable balance of unrestricted cash and unnumbered investments totaling $422 million.

Earnings available for distribution for the period benefited from attractive interest rate — interest income on our target assets, favorable funding and low-cost pay-fixed swaps. For the quarter, EAD per common share was $0.95 compared to $1.51 for the third quarter, reflecting declines in interest income on investments and interest rate swaps in connection with our reduction in leverage and adjustments to our swap portfolio. Over the first six weeks of 2024, mortgage valuations have been challenged with lower coupons underperforming higher coupons. As of February 16th, our book value per common share is down moderately estimated to be between $9.50 and $9.88. As we entered 2024, both the FOMC and the Federal Fund futures market forecast the next policy move by the FOMC will be a rate cut, although they have had different expectations regarding the timing and quantity of these cuts.

While evolving expectations around the timing of changes in monetary policy may bring challenges in the coming months, we believe that a potential reduction in interest rate volatility combined with compelling valuations and favorable funding conditions will support an attractive investment environment for agency mortgages in 2024. I’ll stop here, 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 rates to the agency mortgage markets since the beginning of last year. As shown on the chart in the upper left, U.S. treasury yields fell sharply across the yield curve in a parallel fashion during the fourth quarter. Yields on maturities from two years to 30 years declined between 65 and 80 basis points, and the disinflationary trend and economic data persisted, while estimates of future treasury funding needs declined. By the end of the fourth quarter, pricing in the Fed Funds futures market reflected expectations for a 25 basis point cut in the target rate in the first quarter of 2024 and nearly seven cuts in total by the end of January 2025.

Despite further runoff of the Federal Reserve’s balance sheet during the quarter, the decline in interest rate volatility and expectations for the easing of monetary policy, led to an improvement in domestic bank holdings of agency mortgages for the first time in nearly two years. 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 course of 2023, highlighting the fourth quarter in gray. Despite notable underperformance to start the quarter, production coupon agency mortgages, mortgage valuations rebounded into year-end as interest rates and interest rate volatility declined. Ultimately, current coupons outperformed treasuries during the quarter with nominal spreads tightening approximately 30 basis points.

In addition, specified pool payoffs improved as interest rates fell as illustrated in the chart on the top right. As shown in the lower right chart, the dollar roll market for TBA securities remained unattractive as more recent issuance with higher loan balances have a worse prepayment profile, and the lack of consistent bank demand has negatively impacted technicals. Slide 6 provides detail on our agency mortgage investments and summarizes changes during the quarter. Our portfolio decreased by 7% quarter-over-quarter as the sharp increase in interest rate volatility in October warranted a reduction in risk. We net sold approximately $1.7 billion of specified pools in October across our coupon holdings to reduce the risk of further declines in book value before adding nearly $1.2 billion of exposure, predominantly in 30% or 6% specified pools in November and December as interest rate volatility declined.

We remain focused and more attractively priced higher coupons, which 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, which means we have no exposure to the deterioration 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 the 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 mortgages largely priced in this risk, represent attractive investment opportunities with current gross ROEs in the mid to high teens.

Our Agency CMO allocation is detailed alongside our remaining credit investments on Slide 7. Our allocation to agency interest-only securities remain largely unchanged, totaling $75 million at quarter end. The modest decline from $78 million at the end of the third quarter to $75 million this quarter primarily due to paydowns and a modest decline in the weighted average dollar price, given the rally in interest rates during the quarter. Our credit allocation declined during the quarter to $19 million as a result of paydowns. Our credit investments remain high quality with 68% rated AA or higher. Although, we anticipate limited near-term price depreciation in our credit and Agency IO investments, we believe these assets provide attractive yields for unlevered holdings.

Slide 8 details our funding and hedge book at quarter end. Repurchase agreements collateralized by HC RMBS declined by — from $5 billion to $4.5 billion, and our net notional of pay-fixed interest rate swaps declined from $5 billion to $4.1 billion, both commensurately with our reduction in specified pool holdings during the quarter. We continue to reposition the hedge book, unwinding our remaining received fixed interest rate swaps and a portion of our legacy pay-fix swaps as the reduction in leverage during October warranted a proportionate decline in hedges. As we added specified pool exposure back to the portfolio in November and December, we also added new pay-fixed swaps to hedge the additional borrowings. We ended the quarter with a hedge ratio of 91%.

These changes resulted in a modest increase in the weighted average coupon on our pay-fixed swaps, which negatively impacted earnings available for distribution. Positively, we retain much of the benefit of our low-cost pay-fixed swaps with an attractive weighted average coupon on our hedging portfolio of 1.1%, and weighted average maturity at 6.6 years. Leverage ended the quarter with 5.5 — 5.7 times debt-to-equity, down from 6.4 times at the end of September, given the net sales in specified pools and modest improvement in book value. Slide 9 provides further detail on our asset yield and funding cost. Interest rate on our repurchase agreement increased modestly from 5.4% to 5.5% at quarter end, largely offset by a similar increase in the receive rate on our interest rate swaps.

Yield on our HC RMBS portfolio increased approximately 20 basis points to 5.3%, while the pay rate on our interest rate swaps increased 30 basis points to 1.1%. Overall, our expected interest rate margin remains very attractive at just over 5%, which includes the benefit of our remaining legacy swap portfolio. To conclude our prepared remarks, the fourth quarter of 2023 began another very challenging quarter for Agency RMBS investors, as uncertainty regarding the path of monetary policy led to another sharp increase in interest rate volatility. Valuations rebounded, however, as the disinflationary trend persisted despite the notable strength in the economy, resulting in a pivot for expectations of monetary policy from further tightening, potential easing in the first half of 2024.

Despite significant tightening of spreads in the asset class in the fourth quarter, we believe the Agency RMBS valuations remain attractive for long-term investors, given our expectations for the potential reduction in interest rate volatility over the course of 2024 as easing monetary policy likely results and a steeper yield curve. Our preference for higher coupon specified pool should perform well in that environment. Further, our liquidity position remains robust. As a result, we believe IVR is well-positioned to navigate future mortgage market volatility and selectively capitalize on historically wide Agency RMBS spreads, which provides the supportive back drop for long term investment. Thank you for your continued support for Invesco Mortgage Capital and now we will open the line for Q&A.

Operator: Thank you. We will now begin our question-and-answer session. [Operator Instructions] Our first question comes from Trevor Cranston with JMP Securities. Your line is open.

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Q&A Session

Trevor Cranston: Hey, thanks. Good morning. A question on the hedging side. It looks like the net swap portfolio declined by more than the MBS portfolio did in the quarter. I guess can you elaborate a little bit on if you guys have made any changes just to sort of your net duration exposure along any part of the yield curve, given the shifting outlook for what the Fed is going to be doing going forward? And just generally how you’re approaching hedging across the yield curve right now? Thanks.

Brian Norris: Yes. Hey good morning, Trevor, it’s Brian. Yes, we haven’t really made any significant changes to our yield curve exposures. We’re positioned slightly for a steeper curve, given our expectations for Fed policy in 2024. The sharp rally that we saw in interest rates during the fourth quarter did shorten our mortgage investments. So, you saw the shortening in our hedges as well. But really, the changes that we made to the swap portfolio were pretty consistent across the curve. So, there weren’t any significant changes. As far as our duration gap goes, we’re still just modestly positive, but very slight.

Trevor Cranston: Okay, got it. Appreciate the color. Thank you.

Operator: Thank you. Our next question comes from Jason Weaver with Jones Trading. Your line is open.

Jason Weaver: Hi guys. Thanks for taking my question. I have sort of a two-parter here. I’ve seen over the last three, four quarters, you’ve been migrating higher in the coupon stack. Obviously, that’s in response to the available ROE in the market. But what do you think of the convexity profile here given your remarks on the timing of monetary easing? I assume you’re still migrating up to quarter-to-date.

Brian Norris: Yes. Hey Jason, it’s Brian. Good morning. Good to hear from you. Yes, we have moved slightly up in coupon. Obviously, we did buy some 6s in the fourth quarter that do have a slightly worse convexity profile. But just given our expectations for interest rate volatility, we don’t exactly mind taking a little bit of additional convexity risk from that perspective. And given our continued holdings in 4s to 5.5s that are still at decent discounts, we certainly have a fair amount of protection from that perspective as well.

Jason Weaver: And on that subject, to the new coupon — new high coupons in the 6s, are — what is the typical type of specified pool those guys are in?

Brian Norris: Yes, it’s pretty consistent with the rest of our portfolio, leaning a little bit heavier into loan balance, but also higher loan balance, call them, $225,000, $250,000, but also a fair amount in the lower pay-up stories like LTV and FICO and geo stories.

Jason Weaver: Got it. All right. That’s helpful. And finally, I see cash right now at around $77 million. I know you have some unencumbered as well for enhanced liquidity, but does that imply you’re inclined to raise leverage going forward?

Brian Norris: I wouldn’t necessarily say we’re inclined to raise leverage. We do have the ability to do that if we — if the market — if volatility declines and we see improvement and valuations. But I wouldn’t say we’re necessarily inclined to do that in the near-term. I think we still — certainly, there’s still some uncertainty about the timing of Fed policy, and we would expect there continue to be some great ball around that until that kind of comes to fruition. So, at the moment, I think we’re pretty comfortable with where we are. But we do have the ability to increase leverage if conditions warrant that.

Jason Weaver: All right. Thank you for that color and congrats, guys.

Brian Norris: Thank you.

Operator: Thank you. Our next question comes from Doug Harter with UBS. Your line is open.

Doug Harter: Thanks. I was hoping to get your thoughts around the dividend if you look at it relative to common book value, it kind of screens higher, but if you look at it relative to total equity factoring in the preferred, it seems kind of more in line. Just curious as to how you’re thinking about the dividend?

John Anzalone: Yes. Hey Doug, it’s John. Yes, I mean, as always, the dividend is churned by the Board. So, that’s — but I think given where EAD — even though, it’s trended lower with the adjustments in the swap book, EAD supports the level of dividend pretty comfortably at this point. So, we do look if we — if we’re — if the level of dividend is really an outlier versus peers, that’s one consideration we think about. The other consideration is really where we see cash flows and where we see EAD. We’re forecasting that over the next several quarters. So, from that perspective, it’s been well-supported. So I think as long as things stay relatively around here. I don’t see any catalysts to change this. But then again, it’s pretty early settled. And that’s what I said.

Doug Harter: Thanks John. And then around the capital structure, I guess, how are you thinking about kind of plan to kind of bring the preferred equity percentage down? And then sort of along those lines, how do you think about — do you think about leverage as more leverage to come on or leverage to total equity?

John Anzalone: We look at it both ways in terms of leverage, how we think about it. Leverage to common equity is probably the way we think about risk more often or — so that’s how we think about it. And as far as capital structure, we’ve been buying back preferreds in the open market, it’s been a very slow process just given the amount of activity in those issues out there. I think we have two preferreds out there. Our Series B is callable at the end of this year. So, we’ll have a decision to make come fourth quarter. And we’re looking — we’ll be starting — are starting to look at options around, whether we call that or not and how we kind of handle that coming event. So — but we do continue to attempt to buy preferreds and then when the market is willing — when market conditions are appropriate, we are also looking to raise money through the ATM, which would also help balance the capital structure.