Invesco Mortgage Capital Inc (IVR) Q1 2023 Earnings Call Transcript

Invesco Mortgage Capital Inc (NYSE:IVR) Q1 2023 Earnings Call dated May. 10, 2023.

Corporate Participants:

Greg Seals — Investor Relations

John M Anzalone — Chief Executive Office

Brian Norris — Chief Investment Officer,

Analysts:

Douglas Harter — Credit Suisse. — Analyst

Trevor Cranston — JMP Securities LLC — Analyst

Matthew Earner — Jones Trading. — Analyst

Presentation:

Operator

Welcome to Invesco Mortgage Capital Inc’s First Quarter 2023 Investor Conference Call.

[Operator Instructions]

Now, I would like to turn the call over to Greg Seals at Investor Relations, Mr. Seals you may begin the call.

Greg Seals — Investor Relations

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 earnings teleconference transcripts provided by third-parties. The only authorized webcast are the version on our website. Again, welcome and thank you for joining us today. I’ll now turn the call over to John Anzalone. John?

John M Anzalone — Chief Executive Office

All right, good morning and welcome to Invesco Mortgage Capital’s first-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 speak in the Q&A are our President, Kevin Collins; our CFO, Lee Fegley and our COO, Dave Lyle.

As we entered 2023, agency mortgages continued the strong performance we saw during the fourth-quarter of 2022, as interest-rate volatility eased in anticipation of the end of the Fed’s tightening cycle. However, favorable market conditions quickly deteriorated as several regional banks failed and concerns around the health of the banking system grew. These concerns impacted mortgage valuations as interest-rate volatility spiked and investors became concerned about the potential liquidation of mortgage assets seized by regulators. Swift actions by both the Federal Reserve and the FDIC were effective in reducing fears of further contagion and mortgage spreads ended the quarter only modestly wider.

Since quarter-end, regional banking troubles reignited and mortgage spreads continue to be pressured as volatility remains heightened. Despite heightened marketing volatility, IVR’s earnings available for distribution remains strong, increasing to $1.50 per share versus $1.46 last quarter. Our focus on higher-yielding, higher coupon mortgages in combination with the hedging strategy benefiting from low-cost pay-fixed swaps drove the increase in EAD. Over the coming quarters, we expect EAD to remain well-supported, as our repo hedge ratio remains elevated and forward-starting swaps come online.

Importantly, this hedging provides benefit for the long-term, as the weighted-average maturity of our pay-fixed swap portfolio including the forward-starting swaps is over seven years. ROEs on new investments have also been a positive contributor to EAD as wider spreads on new purchases are attractive and we enjoy the benefit of having retained growth coupon legacy swaps.

Given the underperformance of mortgages, our book-value ended the quarter at $12.61, down 1.4% from last quarter. Combining the change in book-value with our $0.40 dividend produced an economic return of 1.7% for the quarter. With continued pressure on mortgage spreads, our book-value has fallen by approximately 3% since quarter-end, through last Friday, May 5th.

Our economic leverage increased modestly during the quarter, moving from 5.3 times to 5.8 times. At quarter-end, substantially all more $5.4 billion investment portfolio is invested in agency RMBS, we retained a sizable balance of unrestricted cash and unencumbered investments totaling $464 million. During the quarter, we reduced our dividend from $0.65 to [Technical issue] Importantly, this dividend reduction was not in response to downward pressure on EAD, as EAD has increased in the past few quarters. Rather, reducing the dividend enables us to retain excess earnings to enhance book-value and improve our capital structure while continuing to pay a competitive dividend. This also allows us to further invest capital into what we see is an increasingly positive environment for the agency mortgage market. The widespread is currently available on agency mortgages and the potential for reduced bank demand should continue to provide good opportunities to invest new capital.

Finally, we expect that the conclusion of the Fed’s tightening cycle will bring about a reduction in volatility, providing a tailwind for agency mortgages.

So I’ll stop here and Brian can go through the portfolio.

Brian Norris — Chief Investment Officer,

Thanks, John, and good morning to everyone listening on the call. I’ll begin on Slides 4 and 5, which provide an overview of the interest-rate in agency mortgage markets over the past year. After a strong start for Fixed Income in January, interest-rate volatility moved higher in February, as the pace of disinflation slowed. During the first-half of March, volatility did spike — spikes shortly higher given the turmoil in the banking sector before declining into quarter-end as measures were taken by the FDIC, treasury and Federal Reserve to mitigate further distress for banks.

Yields on US Treasury ended the quarter roughly 40 basis-points lower and maturities from 2 to 10 years. Meanwhile, short-term rates rose in-line with further increases in the expected Fed funds rate, as the market pushed out the anticipated timing of a pause and monetary policy tightening.

As shown in the lower-right chart, US commercial banks further reduced our holdings of agency MBS during the quarter. Concurrent with the runoff of the Federal Reserve balance sheet, resulting in an 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, largely offsetting the decline in demand.

Slide 5 provides more detail on the Agency RMBS market, in the upper-left chart, we showed 30-year current coupon agency RMBS performance versus US treasuries over the past 12 months, highlighted in the first-quarter in gray. Exceptional performance in January was offset by underperformance in February and March, with the sector ending the quarter modestly weaker. As shown in the lower-left chart, nominal spreads remain attractive for current coupon MBS, as uncertainty regarding monetary policy, further stress in the banking sector and asset liquidations weigh on valuations.

As indicated in the upper-right char,t specified pool pay-ups into the quarter largely unchanged, while implied financing in the dollar roll market for TBA securities remained unattractive, as shown in the lower-right chart.

Slide 6 provides detail on our Agency RMBS investments and the changes in the portfolio during the first-quarter. We increased leverage during the quarter from 5.3 times debt-to-equity to 5.8 times, reflecting a modestly more positive outlook on this sector, with valuations at attractive levels and tightening of monetary policy nearing an end. In addition, we further diversified our coupon allocation, investing proceeds from our ATM activity during the quarter into 30-year 4% specified pools, decreasing our sensitivity to interest-rate volatility, given purchase prices well below par. We are largely insulated from direct exposure to asset liquidations from the FDIC as a substantial portion of their holdings are and lower coupon 30-year and 15-year collateral, while we remain in higher coupon 30-year.

In addition, we have no exposure to the deterioration in the dollar roll market for TBA securities as we were invested exclusively in specified pools at quarter-end. We continue to focus our specified pool allocation on pools that are expected to perform well in a premium and discount environment. Although we anticipate elevated interest-rate volatility to persist, as the fixed-income market continues to reflect the uncertainty in the banking sector, we believe current valuations on production coupon agency RMBS largely price uncertainty and represent attractive investment opportunities with current ROEs on production coupons in the mid-teens.

Our remaining credit investments are detailed alongside our Agency CMO allocation on Slide 7. Our credit allocation was largely unchanged during the quarter at $45 million and remains high-quality with a 87% rated 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.

Our allocation to Agency Interest Only Securities detailed on the right of Slide 7 remain unchanged as well, totaling $81 million at quarter-end. These holdings also providing 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 $4.8 billion, given the increase in our specified pool holdings and our weighted-average repo costs increased to 4.9%, consistent with changes in short-term funding rates due to tightening monetary policy. Positively, we also increased the hedges associated with those borrowings to $4.5 billion net notional of current-pay fixed received floating interest-rate swaps, increasing our heads notional to 93% of borrowings and largely mitigating the impact of higher borrowing rates on the earnings power of the company.

And in order to hedge additional exposures further out the yield curve, at quarter-end, we held $200 million debt notional of forward-starting interest-rate swaps. Our economic leverage ended the quarter modestly higher at 5.8 times debt-to-equity versus 5.3 times at year end, reflecting our positive outlook on Agency RMBS, given historically attractive valuations and a likely end to the monetary policy tightening cycle.

To conclude our prepared remarks, the first-quarter of 2023 was another challenging period for the Agency RMBS sector, as uncertainty regarding monetary policy and its impact on the banking sector kept volatility elevated. However, our relatively modest leverage combined with a bias for higher coupons that remain at attractive valuations and are largely insulated from bank liquidations, along with a notably higher percentage of our funding costs hedged, leaves us well-positioned for the current environment.

Further, earnings are well-supported and our liquidity position is robust. While we anticipate potential near-term volatility, we believe current valuations provide a supportive backdrop for long-term investment. Thank you for your continued support for Invesco Mortgage Capital and now we will open the line for Q&A.

Questions and Answers:

Operator

Thank you. We will now begin the question-and-answer session.

[Operator Instructions]

Our first question comes from Douglas Harter from Credit Suisse.

Douglas Harter — Credit Suisse. — Analyst

Thanks and good morning. Hoping you could talk about how you kind of see your current leverage and what capacity you would have to, if any, to take advantage of kind of current wide spreads?

Brian Norris — Chief Investment Officer,

Yes, hey, Doug, it’s Brian, good morning. I think we view current leverage kind of in the midpoint of where are we would see our range. We certainly have capacity to add. We’re somewhat hesitant to do that at this point, just given continued elevated volatility, but as that volatility — still volatility declines, we believe given current valuations that it would be attractive to do so.

Douglas Harter — Credit Suisse. — Analyst

And just on that, being attractive to do so, do you view that it’s kind of a longer term attractive carry or do you see kind of meaningful potential further basis to tighten.

Brian Norris — Chief Investment Officer,

Yeah, that’s a good question. I think given what’s going on with banks lately, the question is, how involved they’ll be with the sector on a longer-term basis, we do believe they’ll be somewhat involved, maybe not as much as they had been in the last couple of years and certainly the liquidations from the FDIC over the next, call it seven to nine months, will likely keep spreads relatively attractive over that time period.

So I think, we’re probably not in an environment where spreads will go back to where they were, call it, pre COVID. But they will — they should tighten modestly from here over the long-term period.

Douglas Harter — Credit Suisse. — Analyst

Great. I appreciate it. Thank you.

Operator

Our next question comes from Trevor Cranston from JMP Securities.

Trevor Cranston — JMP Securities LLC — Analyst

Thanks. Can you talk a little bit more about how you — how you guys are thinking about Agency MBS performing going-forward as bank sales continue to hit the market and if you think any other– any further underperformance from here would likely be concentrated in the coupons that are being sold there or if you think there could be some sort of sympathy widening in the higher coupons as well? Thanks.

Brian Norris — Chief Investment Officer,

Yes, hey, Trevor, it’s Brian. Good morning. You know, we do think that there will likely be continued kind of near-term volatility as liquidations work their way through the system. The lower coupons have held in relatively well this month. But we do think as we’re only three weeks into the liquidations and we still have another 7 to 9 months of selling. So over that time period, we do think that spread volatility will remain somewhat elevated, which is why we’re keeping our leverage kind of in the mid — mid-point of our typical range. So as those liquidation start to work their way through the environment, we think that it would probably make sense to take advantage of relatively attractive valuations at this point. To move to leverage [Indecipherable] higher.

Trevor Cranston — JMP Securities LLC — Analyst

Got it, okay. I appreciate the comments. Thank you.

Brian Norris — Chief Investment Officer,

Our next question comes from Matthew Earner from Jones Trading. Hey, guys. Matthew on for Jason this morning. Thanks for taking the question.

John M Anzalone — Chief Executive Office

How are you valuing deploying capital in new investments versus share repurchases, and then in addition to the share repurchases, could you talk about the preferred a little bit? Yes, thanks. This is John. Yes. I think the decision between their new purchases and share buybacks, and for new purchases like, I think Brian mentioned on the call, we’re seeing solid mid-teens ROEs on new purchases. And depending on, obviously, our book-value and as mortgage valuations have been quite volatile, has been bouncing around quite a bit, so. I think if we hit a time when our valuations are low enough enough, we will certainly look at buying back common, but given where we’re seeing ROEs right now, we’re not quite there yet. And you would find that comment would further make our common to preferred ratio out of line. So there’s that hurdle also. As far as preferreds go, I mean, we are certainly looking at — we were aware of it. The preferred market in general, I mean is another sort of secondary victim of the regional banking crisis, given that whole sector is mostly made up of financials and most mortgage REIT preferred got swept up in that also recently. So certainly, I think it — where we are seeing them trading now, they’ve become much more attractive to try to go back and buy some. I mean, the challenge there always is just a limited trading volume that we see on a daily basis, but certainly, we’re going to make — make every effort to try to repurchase preferred when we can.

Matthew Earner — Jones Trading. — Analyst

Thank you.

Operator

I’m showing no further questions at this time.

Greg Seals — Investor Relations

Okay, well thanks everybody for joining us and we look-forward to meeting again in about three months for our second quarter call. Thanks.

Operator

[Operator Closing Remarks]