U.S. Markets close in 2 mins

Edited Transcript of IVR earnings conference call or presentation 8-Aug-19 1:00pm GMT

Q2 2019 Invesco Mortgage Capital Inc Earnings Call

ATLANTA Sep 3, 2019 (Thomson StreetEvents) -- Edited Transcript of Invesco Mortgage Capital Inc earnings conference call or presentation Thursday, August 8, 2019 at 1:00:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Brandon Burke

Invesco Mortgage Capital Inc. - Director of IR

* Brian P. Norris

Invesco Mortgage Capital Inc. - CIO

* David Lyle

Invesco Mortgage Capital Inc. - COO

* John M. Anzalone

Invesco Mortgage Capital Inc. - CEO

================================================================================

Conference Call Participants

================================================================================

* Douglas Michael Harter

Crédit Suisse AG, Research Division - Director

* Eric J. Hagen

Keefe, Bruyette, & Woods, Inc., Research Division - Analyst

* Trevor John Cranston

JMP Securities LLC, Research Division - Director and Senior Research Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Welcome to Invesco Mortgage Capital's Second Quarter 2019 Investor Conference Call. (Operator Instructions) As a reminder, this call is being recorded.

Now I'll turn the call over to Brandon Burke in Investor Relations. Mr. Burke, you may begin the call.

--------------------------------------------------------------------------------

Brandon Burke, Invesco Mortgage Capital Inc. - Director of IR [2]

--------------------------------------------------------------------------------

Thank you, and welcome to Invesco Mortgage Capital Second Quarter 2019 Earnings Call. The management team and I are delighted you've joined us, and we look forward to sharing with you our prepared remarks and conducting a question-and-answer session. Joining today are John Anzalone, our Chief Executive Officer; Kevin Collins, our President; Lee Phegley, our Chief Financial Officer; Dave Lyle, our Chief Operating Officer; and Brian Norris, our Chief Investment Officer.

As a reminder, statements made in this conference call and the related presentation may include forward-looking statements, which reflect management's expectations about future events and our overall plans and performance. These forward-looking statements are made as of today and are not guarantees. They involve risks, uncertainties and assumptions, and there could be no assurance that actual results will not differ materially from our expectations.

For a discussion of these risks and uncertainties, please see the risks described in our most recent annual report on Form 10-K and subsequent filings with the SEC. Invesco makes no obligation to update any forward-looking statements. We may not also discuss non-GAAP financial measures during today's call. Reconciliations of these non-GAAP financial measures may be found at the end of our earnings presentation.

To view the slide presentation today, you may access our website at invescomortgagecapital.com and click on the Q2 2019 Earnings Presentation link under Investor Relations. Again, welcome, and thank you for joining us today.

I'll now turn the call over to our CEO, John Anzalone.

--------------------------------------------------------------------------------

John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [3]

--------------------------------------------------------------------------------

Good morning, and thank you for joining us on IVR's second quarter earnings call. This quarter commemorates the 10th year anniversary of IVR's initial public offering. Investors in IVR's common stock have achieved an annualized total return of 11.4% since our inception on June 25, 2009, and I'd like to take this opportunity to thank everyone who supported us over the past decade.

I'm pleased to announce core earnings for the second quarter of $0.46, despite an increase in financial market volatility, characterized by sharply lower rates, elevated prepayment fears and wider spreads in the agency mortgage market. Our book value was stable, ending the quarter at $16.21. Combined with our $0.45 dividend, this produced an economic return for the quarter of 2.3%. This brings our year-to-date economic return to a robust 12%.

Before Brian goes into details of the portfolio, I want to take a few minutes to discuss how, through active management, we produced results that have not only allowed us to recently increase our dividend but to consistently outearn that dividend while keeping book value volatility mitigated. There are 3 things that I believe, have been critical to our success. The first is the recent repositioning of our assets. We purposefully rotated into assets with greater prepayment protection. And going forward, we believe managing convexity risk is going to be the greatest challenge facing our space. While we have always focused on buying specified pool collateral, over the past several quarters, we've rotated out of areas of the agency market where prepayment protection is less readily available, namely 15-year in hybrid collateral and into prepaid protected 30-year specified pools. At the same time, we reduced our overall exposure to the agency mortgage sector and allocated a significant portion of our capital to Agency CMBS when ROEs on those bonds are very attractive. Agency CMBS bonds have minimal prepayment risk while exhibiting less spread volatility compared to private-label paper.

While these active moves have not eliminated prepayment risk entirely, our exposure has been greatly reduced. The breadth and depth of capabilities and resources available at Invesco allow us to take advantage of the flexibility inherently available in the hybrid mortgage REIT model.

The second thing I would point out is our seasoned credit book. While we have been selecting -- while we've been selective in adding to our credit book, we still have 45% of our equity capital dedicated to residential and commercial credit. Brian will go into more detail on this in a minute, but the majority of our credit positions were issued prior to 2015, which means they have been the beneficiary of years of property price appreciation and have shorter durations. The property price appreciation has had the effect of strengthening our credit enhancement and the shorter duration has helped insulate our portfolio against the impact of interest rate and credit spread movements, making them an attractive investment for this environment.

Additionally, like Agency CMBS, non-Agency CMBS benefits from notable prepayment protection, which provides a nice way to lock in a rate -- a rate hedged net interest margin that doesn't constantly force you to reinvest into a lower absolute yield environment.

The third thing I'd like to point out is our strong risk management discipline. Active risk management is an area that often gets overlooked in this space, but is absolutely critical when markets become volatile. The book value and earnings stability that we've been able to achieve would not be possible without our strong culture of risk management. Despite the downdraft in rates, our book value has remained relatively stable. We've avoided mismatches between our assets and liabilities and key rates across the interest rate curve, including the front end. In particular, the spread between 1-month and 3-month LIBOR has collapsed over the past several quarters, with that relationship inverting as the market anticipates more cuts in the fed funds rate.

We are well hedged in this part of the curve and have thus experienced no net interest margin compression due to these changes. I'll finish by saying that all of this would have been nearly impossible to achieve without the Invesco platform behind us. While only a few of us speak on these calls, we have a large, extremely talented team of experienced portfolio managers, traders, credit analysts and risk managers behind us. And our investors gain access to all these expertise while paying one of the smallest expense ratios in the space.

Thanks, and I'll hand the call over to Brian to discuss the portfolio.

--------------------------------------------------------------------------------

Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [4]

--------------------------------------------------------------------------------

Thanks, John, and good morning to everyone on the call. I'll start on Slide 6, where I'd like to highlight the advantages of our actively managed hybrid strategy and providing book value stability. While our equity and asset allocations to agency and credit assets remained relatively stable, we continue to rotate out of Agency RMBS and into Agency CMBS, given its attractive prepayment characteristics and funding levels. Our Agency CMBS position grew to 13% total assets during the second quarter, up from 9% in the first quarter, with an offsetting decline in Agency RMBS assets. This rotation within agency assets allowed us to keep leverage largely unchanged while maintaining core earnings above our dividend. The increase in Agency CMBS over the past year, accompanied by the rotation out of less prepay-protected 15-year and hybrid Agency RMBS collateral and into 30-year specified pools, increased our total allocation to assets with prepay protection to 86% of the total portfolio, up from 62% in the second quarter of 2018, which should provide additional book value protection and a more predictable core earnings stream despite the recent sharp move lower in rates.

In addition to the portfolio rotation within our agency assets, the continued strong performance and seasoning of our credit assets also supports book value stability, as embedded property price appreciation improves credit quality and shortening duration dampens spread volatility. Lastly, we were also active in managing our hedge book during the quarter, making adjustments across the swap curve to lock in lower fixed rates while also responding to movements and the durations of our assets as interest rates rallied.

Moving on to Slide 7. The pie chart in the upper left-hand corner of the slide displays the composition of our Agency RMBS assets. Our total Agency RMBS book declined by approximately $640 million during the quarter through a combination of paydowns and sales as capital was deployed into Agency CMBS, but the composition within our Agency RMBS book remained relatively unchanged. Generic Agency RMBS spreads widened during the quarter and particularly in May, as sharply lower interest rates and higher volatility weighed on valuations. Underperformance in this sector was largely offset by our allocation to prepayment protected specified pools as payouts on our holdings appreciated by approximately 2/3 of 1 point. Specified pool pay-ups have risen sharply since the beginning of the year, and we expect them to be well supported at these levels as lower interest rates and a worsening environment for TBA increased demand for prepay protected assets.

Turning to Slide 8. You can see in the lower left-hand table that our allocation to Agency CMBS has grown to nearly $3 billion. We purchased $819 million of Agency CMBS during the quarter, predominantly in the Fannie Mae DUS program. Spreads tightened modestly during the quarter, and we anticipate continuing to add to our position in the sector, given attractive spreads, repo funding and prepayment characteristics, which provides strong risk-adjusted returns and serves as a nice complement to our Agency RMBS book.

Moving on to commercial credit on Slide 9. Our CMBS portfolio consists of a combination of well-seasoned A and BBB bonds financed via repo and AAA and AA bonds financed at the Federal Home Loan Bank. Our holdings continue to perform very well from a credit fundamentals perspective and strong demand during the quarter led to tighter spreads and modest book value gains. In addition, we were able to add $120 million of recently issued non-Agency CMBS during the quarter with ROEs in the low to mid-teens as accretive opportunities remain available.

Slide 10 highlights the credit quality of our commercial portfolio. Fundamentals in commercial real estate remain supportive of our assets, particularly given the seasoned nature of our portfolio as property price appreciation since issuance reduces embedded leverage in our holdings. The chart on the left shows the seasoning of our CMBS assets, indicating roughly 70% of our holdings were originated 5 or more years ago, while the chart on the right highlights the strong credit performance of our holdings, with $684 million benefiting from rating agency upgrade since purchase. Positively, spreads on seasoned subordinate bonds continue to benefit from increased investor demand due to rating agency upgrades, contracting spread duration, embedded property price appreciation, and in some cases, deleveraging from loan paydowns.

Slide 11 covers our residential credit portfolio. This portfolio remains well diversified as indicated in the pie chart in the upper left. Spread tightening across most of our assets was partially offset by widening in our seasoned GSE CRT securities as the sharp move lower in rates led to faster prepayments in bonds that have experienced significant price appreciation since issuance. However, credit fundamentals remain supportive here as healthy borrower balance sheets, combined with lower mortgage rates and improving wage growth are helping to offset declining affordability due to the rise in home prices. Given the strong fundamental and technical backdrop of the sector, fewer opportunities are available to add accretive assets in the residential credit, although we were able to add $26 million in recent issued GSE CRT during the quarter.

Slide 12 provides some detail around the credit quality of our residential credit portfolio. 66% of our CRT investments have been upgraded by at least one rating agency since issuance, as shown on the chart on the left. The upgrades are a result of significant underlying home price appreciation and low default rates. The chart on the right reflects the vintage distribution of our investments, where approximately 2/3 of our assets were issued prior to 2015 and benefit from the strong recovery in the housing market.

Lastly, Slide 13 summarizes our financing and hedging. At quarter-end, we had $17 billion of repo outstanding with 31 counter-parties and $1.65 billion of secured financing through the Federal Home Loan bank. We have seen improved financing spreads for our credit assets, offsetting modestly wider financing spreads on Agency RMBS while the reduction in LIBOR improves funding across our target assets. To reduce the risk associated with changes in repo funding cost, we held $12.5 billion notional of interest rate swaps, which fell modestly quarter-over-quarter as we took advantage of lower swap rates during the quarter by locking in longer-dated hedges, requiring less swap notional. We continue to avoid exposure to the basis between 1-month LIBOR and 3-month LIBOR by focusing primarily on 1-month LIBOR swaps, which better matches changes in our financing costs, protecting them and reducing the volatility of our core earnings.

In closing, we believe we are well positioned for the current environment. Given our efforts over the last year to increase the percentage of investments with prepayment protection characteristics, our credit portfolio should continue to benefit from notable asset seasoning, supportive -- and supportive real estate fundamentals and our hybrid structure as well as the broader Invesco platform gives us the needed flexibility to continue to find attractive reinvestment opportunities.

That ends my prepared remarks. Now we'll open the line for Q&A.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Our first question comes from Doug Harter with Crédit Suisse.

--------------------------------------------------------------------------------

Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [2]

--------------------------------------------------------------------------------

Obviously, as you guys mentioned, prepays or spec pools have done well and pay-ups are now relatively high. Just wondering how you see kind of the trade-off today between kind of those high pay-ups and kind of higher prepays and more generic collateral.

--------------------------------------------------------------------------------

Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [3]

--------------------------------------------------------------------------------

Yes. Thanks, Doug. This is Brian. Yes, we've certainly seen an increase in pay-ups. And like I said, I think given the current environment, we expect those pay-ups to persist at these levels. The benefit of specified pools is certainly kind of the lack of negative convexity that you see in them. So you see a much steadier duration profile on the bonds and a longer duration, so that helps protect your NIM. We're currently seeing net interest margin of about 75 to 100 basis points on specified pools, whereas in generic collateral, that net interest margin is more around 50 basis points. So that's a pretty significant difference in ROE that we're seeing between those 2.

--------------------------------------------------------------------------------

Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [4]

--------------------------------------------------------------------------------

And then, I guess, if you could just talk about, I guess, how you're thinking about protecting book value just from those spec pool pay-ups, if we were to kind of get a surprise increase in rates similar to kind of, say, the experience of the taper tantrum in 2013 and kind of what lessons might have been learned from there, if we were to see kind of spec pool prices come down sharply?

--------------------------------------------------------------------------------

Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [5]

--------------------------------------------------------------------------------

Right. A couple of things there. We do focus on lower pay-up to the extent that we can lower pay-up story. So we're talking kind of low FICO, high LTV, high loan balance bond. So we're avoiding the extremely high pay-ups that we're seeing in the market right now. And then secondarily, just the reduction overall in our portfolio to Agency RMBS kind of insulates the entire portfolio. We've seen our percentage of total assets to the Agency RMBS sector shrink from about 70% to 60% over the last year. So we think that's going to help insulate us from any changes in pay-ups.

--------------------------------------------------------------------------------

Operator [6]

--------------------------------------------------------------------------------

The next question comes from Eric Hagen with KBW.

--------------------------------------------------------------------------------

Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [7]

--------------------------------------------------------------------------------

I'll kind of tag along to some of the questions Doug was just asking and maybe go into the CMBS sector too. So as you guys think about the relative value between deploying new capital into Agency RMBS versus CMBS, how are you guys thinking about that? Because it seems like the more favorable prepaid profile that you guys talked about for CMBS would imply much stronger relative value, considering the environment we're in. I'm just trying to understand how you think about that? And I guess what I'm really trying to ask is, what prevents you from being much more aggressive in rotating out of RMBS and into CMBS?

--------------------------------------------------------------------------------

Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [8]

--------------------------------------------------------------------------------

Yes. Thanks, Eric. I'll take this one again. Certainly, you're on the right path there. We -- I've been reinvesting most of our pay-downs into Agency CMBS. We continue to like that story. There's less supply there. So that makes it a little more difficult to be too aggressive. We can't necessarily rotate large percentages of our portfolio just given that we would likely tighten the market on it. So as long as the ROEs are relatively close to each other between Agency CMBS and RMBS, we will definitely lean towards the Agency CMBS side. But again, just given more limited supply there, it does dampen our ability to transition significantly.

--------------------------------------------------------------------------------

Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [9]

--------------------------------------------------------------------------------

Got it. That certainly makes sense. Can you just give us a snapshot of where levered ROEs on Agency RMBS and CMBS stand today relative to earlier in the year, call it, mid-February-ish when you guys raised capital?

--------------------------------------------------------------------------------

Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [10]

--------------------------------------------------------------------------------

Yes. Mid-February, we were talking probably mid-teens, say, 14% to 16% ROEs and now we're kind of low double digits. So like I said earlier on specified pools, we're seeing NIMs in the 75 to 100 basis point range. So that would imply low double digits into maybe 13% area.

--------------------------------------------------------------------------------

Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [11]

--------------------------------------------------------------------------------

Okay. And quarter-to-date, how has 1-month repo changed? Were you guys rolling the 1-month repo on the agency side?

--------------------------------------------------------------------------------

Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [12]

--------------------------------------------------------------------------------

Yes, on agency, it's coming quite a bit, mainly due to LIBOR. And like I said, spreads have widened a little bit, on our financing spreads that is. But we are seeing a pretty significant pickup in our -- or I'm sorry, more attractive financing levels, given the pressure on LIBOR.

--------------------------------------------------------------------------------

Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [13]

--------------------------------------------------------------------------------

Have rates dropped to the full 25% at the fed cut? Or has it been something less than that?

--------------------------------------------------------------------------------

Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [14]

--------------------------------------------------------------------------------

Yes, we're getting pretty close. I want to say we're around 2.30, low 2.30s on agency repo right now. So we were certainly in the 2.50, 2.60 area not too long ago.

--------------------------------------------------------------------------------

Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [15]

--------------------------------------------------------------------------------

Got it. That's helpful color. And then on the non-Agency RMBS, how should we think about prepays there, just call it, over the near term? And what that does to the overall kind of return in the strategy, just given that you hold those bonds at a discount?

--------------------------------------------------------------------------------

David Lyle, Invesco Mortgage Capital Inc. - COO [16]

--------------------------------------------------------------------------------

Yes, this is Dave Lyle. I'll take that one. We have seen them tick up a bit as rates have rallied and that shouldn't be a surprise. There is still some rate incentive in that collateral despite the seasoning. Although I will say we saw when rates were very low in that -- in those same pools in 2016. We saw a greater increase in prepays. And given that those borrowers have seen low rate levels before. It may not be as sensitive this time around. But at the same time, we have additional home price appreciation, so there could be better borrower equity position that will make up for some of that. So I would -- short answer is, I would not expect prepays to run as high as they did in 2016. But at the same time, we have and we'll continue to see them run a little bit higher, which is positive for yields on that part of the book, given that book values are at a discount [RMBS] bonds.

--------------------------------------------------------------------------------

Operator [17]

--------------------------------------------------------------------------------

(Operator Instructions) Our next question comes from Trevor Cranston with JMP Securities.

--------------------------------------------------------------------------------

Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [18]

--------------------------------------------------------------------------------

Follow-up on Eric's last question about prepays and the, I guess, resi credit book. More specifically on the CRT portfolio, I was wondering if you guys could talk about what kind of premium your CRT portfolio currently trades at? And what impact do you think you could see on that book from faster prepay speeds?

--------------------------------------------------------------------------------

David Lyle, Invesco Mortgage Capital Inc. - COO [19]

--------------------------------------------------------------------------------

Yes, sure. That's a good point. I should clarify my last answer related to the legacy book. So it is a distinctly different story for CRT. I don't want to quote our exact premium on our seasoned CRT, but generally, 2014, 2016 type M2s and M3s have a premium anywhere from, call it, 6 to 12 points over par, and there is some prepayment sensitivity there. So the fact that the weighted average lives will shorten as collateral speeds increase means that you have to amortize that premium over a shorter period of time and that's not helpful for spreads. So we have seen some drag on our seasoned CRT book just in terms of spread widening and valuation performance. And we highlighted that in our presentation and prepared comments as one of the areas of our book where we did suffer a little bit of valuation decline. But overall, we continue to like those bonds. We had a very good entry point, given that we built that book several years ago, and it's kind of a portfolio that can be recreated today at the spread levels that we've put it on despite the widening of spreads that we've seen. So the ROEs being generated by that book continue to be accretive and beneficial for the portfolio despite some of the spread widening caused by faster prepays.

--------------------------------------------------------------------------------

Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [20]

--------------------------------------------------------------------------------

Got it. Okay. And then on the hedge portfolio, you guys talked about -- a bit about the benefits of dynamically hedging as rates have come down a lot. Looking at Slide 13, it doesn't look like there was any big changes in the notional swap position anyways. Can you talk a little bit in more detail about what the changes to the hedge book were and maybe also comment on kind of where you're earning the duration gap currently?

--------------------------------------------------------------------------------

Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [21]

--------------------------------------------------------------------------------

Sure. Yes, this is Brian. Yes, most of the changes -- so we did extend out our maturities a little bit. So -- and we also were able to take off some swaps and our treasury features, just as kind of the durations on our Agency RMBS assets were shortening, we were able to take some swaps off. And also, like I said, kind of lock in those lower rates in longer duration, so extended that out a little bit. So it was a little bit of -- we don't have our treasury future exposure kind of on there, but we did take some of those off as well.

--------------------------------------------------------------------------------

John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [22]

--------------------------------------------------------------------------------

Yes. I would add that our current positioning in terms of equity duration, empirically, we're running pretty close to 0 duration right now, give or take a year or 2, given how volatile rate environment is, but it's been remarkably stable.

--------------------------------------------------------------------------------

Operator [23]

--------------------------------------------------------------------------------

At this time, I'm showing no further questions. I'll turn the call over to John Anzalone.

--------------------------------------------------------------------------------

John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [24]

--------------------------------------------------------------------------------

Okay. Well, I'd like to thank everyone for joining us on the call this morning. I'd also like to thank everyone who's helped make IVR successful over the past decade, and we look forward to joining you all next quarter. Thanks.

--------------------------------------------------------------------------------

Operator [25]

--------------------------------------------------------------------------------

And this does conclude today's call. We thank you for your participation. At this time, you may disconnect your lines.