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Edited Transcript of IVR earnings conference call or presentation 8-Nov-18 2:00pm GMT

Q3 2018 Invesco Mortgage Capital Inc Earnings Call

ATLANTA Nov 8, 2018 (Thomson StreetEvents) -- Edited Transcript of Invesco Mortgage Capital Inc earnings conference call or presentation Thursday, November 8, 2018 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brandon Burk

Invesco Mortgage Capital Inc. - Director of IR

* Brian P. Norris

Invesco Mortgage Capital Inc. - Interim CIO

* David Lyle

Invesco Mortgage Capital Inc. - COO

* John M. Anzalone

Invesco Mortgage Capital Inc. - CEO

* Kevin M. Collins

Invesco Mortgage Capital Inc. - President

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Conference Call Participants

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* Eric J. Hagen

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

* Joshua Hill Bolton

Crédit Suisse AG, Research Division - Research Analyst

* Steven Cole Delaney

JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst

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Presentation

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Operator [1]

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Welcome to Invesco Mortgage Capital Inc. Third Quarter 2018 Investor Conference Call. (Operator Instructions) As a reminder, this call is being recorded.

Now I would like to turn the call over to Brandon Burk in Investor Relations. Mr. Burk, you may begin the call.

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

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Thank you, and good morning, everyone. Again, we welcome you to the Invesco Mortgage Capital Third Quarter 2018 Earnings Call. Management team and I are delighted you've joined us as we look forward to sharing with you our prepared remarks during the next several minutes before we conclude with a question-and-answer session.

Joining today are John Anzalone, our Chief Executive Officer; Kevin Collins, our President; Lee Phegley, our Chief Financial Officer; David Lyle, our Chief Operating Officer; and Brian Norris, our interim Chief Investment Officer.

Before we begin, I'll provide the customary forward-looking statement disclosure. This presentation and comments made in the associated conference call may include statements and information that constitute forward-looking statements within the meaning of the U.S. Securities Laws as defined in the Private Securities Litigation Reform Act of 1995, and such statements are intended to be covered by the safe harbor provided by the same. Forward-looking statements include our views on the risk positioning of our portfolio; domestic and global market conditions, including the residential and commercial real estate market; the market of our target assets; our financial performance, including our core earnings, economic return, comprehensive income and changes in our book value; our ability to continue performance trends; the stability of portfolio yields; interest rates; credit spreads; prepayment trends; financing sources; cost of funds; and our leverage in equity allocation. In addition, words such as believes, expects, anticipates, intends, plans, estimates, projects, forecasts and future or conditional verbs such as will, may, could, should and would as well as any other statement that necessarily depends on future events are intended to identify forward-looking statements. Forward-looking statements are not guarantees and they involve risks, uncertainties and assumptions. They could be no assurance that actual results will not differ materially from our expectations. We caution investors not to rely unduly on any forward-looking statements and urge you to carefully consider the risks identified under the captions risk factors, forward-looking statements and management's discussion and analysis of financial condition and results of operation in our annual report Form 10-K and quarterly reports Form 10-Q, which are available on the SEC website at www.sec.gov.

All written or oral forward-looking statements that we make or that are attributable to us are expressly qualified by this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns out to be inaccurate.

To view the slide presentation today, you may access our website at invescomortgagecapital.com and click on the Q3 2018 earnings presentation link you can find under the Investor Relations tab at the top of our homepage. There you may select either the presentation or the webcast option for both the presentation slides and the audio.

Again, welcome, and thank you for joining us today. And I'll turn the call over to our CEO, John Anzalone. John?

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Kevin M. Collins, Invesco Mortgage Capital Inc. - President [3]

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Good morning, and thank you for joining Invesco Mortgage Capital's Third Quarter Earnings Call. I'm pleased to report core earnings of $0.41 and a positive economic return of 1.1% for the third quarter. Book value was relatively stable during the quarter, down 1.3% as the impact of higher rates and wider agency spreads was partially offset by tight spreads on seasoned credit.

As Brian will discuss in more detail in a moment, we were quite active during the quarter, repositioning the portfolio out of rotating seasoned, 15 year and Hybrid ARM agencies and into newly issued 30-year agencies and Agency CMBS. Taking advantage of the very attractive return profiles offered in those sectors.

Since the repositioning took place over the course of the quarter, the full impact was not fully reflected in the third quarter. This repositioning sets us up well for the future as we expect our core earnings to remain relatively stable in coming quarters. We feel strongly that active management and our ability to invest across many different types of opportunities within the mortgage market are going to be the keys to successfully navigate in this environment.

While investment activity has been largely -- has been concentrated largely in the agency space this quarter, we still have about half of our equity invested in residential and commercial credit. And I'd like to take a moment to discuss our views on credit. As you'll see later in the presentation, our credit book is very seasoned and the underlying collateral has had the benefit of years of property price appreciation on average. This book would be nearly impossible to construct today, particularly if the book yields where they were added and we remain extremely comfortable holding these positions. We expect fundamentals to continue to support these investments even as we move later in the credit cycle. However, given relatively tight spreads across much of the residential and commercial credit sectors, the return profile has become relatively less compelling and we prefer to invest in agencies recurrent ROEs are quite attractive. This also allows us to stay liquid and gives us the opportunity to take advantage when credit assets cheapen. Our ability to make tactical asset allocation decisions across sectors is the reason we play so much value on the flexibility offered by the hybrid REIT structure.

While agency spreads have been under some pressure as rate volatility has picked up and the impact of the Feds balance sheet reduction settles in. We do believe that agencies will hold up well in -- when broader credit markets experience periods of spread-widening pressure. Of course, while adding agencies reduces our credit risk, it also introduces more duration in convexity risk. This is mitigated by our security selection as we have added prepay protected specified for collateral and locked out Agency CMBS as well as by an active risk management process, which has led us to reduce our duration exposure by adding more hedges as we've increased our agency allocation.

I'll stop here and let Brian talk about the portfolio in more detail.

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

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Thanks, John. I'll start on Slide 6, which provides the breakdown between agency and credit exposures in our portfolio, both on an equity and total asset basis. As you can see, we remain well diversified across sectors, with a modest uptick in equity committed to our agency book, increasing from 48% on June 30, to 51% as of September 30. This is largely due to the redeployment of proceeds from our commercial loan paydowns and to the agency book as ROEs on both Agency RMBS and Agency CMBS improved given spread widening in the first half of the year. Overall, leverage increased modestly quarter-over-quarter to 6.4x from 6.1x as average earning assets increased over $600 million due to the redeployment of the unlevered commercial loan paydowns into levered agencies and CMBS.

Moving on to Slide 7. I would like to highlight the repositioning of our Agency RMBS book during the quarter. We sold approximately $2.9 billion of seasoned Agency RMBS pools, the majority of which were in the 15 year and Hybrid Arm sectors. We reinvested the proceeds into higher-yielding, 30-year, low-payout specified pools as hedged ROEs improved during the first half of the year given the sharp widening in the 30-year sector to the 13% to 14% range. The improvement in book yields on the redeployment was notable as yields on purchases were 1.5% to 2% higher than the bonds we sold given their seasoning. Prepayment speeds remain well contained and we expect to see some benefit as speeds slowdown as winter seasonal impacts take hold.

We continue to see accretive investment opportunities in 30-year fixed-rate agency mortgages with hedged ROEs over 14%, given additional widening in the sector in October and will continue to act on opportunities to increase the earnings power of the portfolio while maintaining our disciplined approach to risk management.

Turning to Slide 8 for a few brief comments on our growing Agency CMBS book. We repurchased $440 million of predominately 10-year Agency CMBS during the quarter, which brought our total exposure to the sector close to $600 million as of 9/30. Agency CMBS is a nice complement to our Agency RMBS assets given the prepayment protection embedded in the securities in the form of prepared penalties and lockout provisions. Spreads tightened during the latter half of the quarter, reducing our activity, but have widened backout to attractive levels in the fourth quarter, allowing us to purchase an additional $100 million in October. The widening incurred in sympathy with AAA CMBS credit bonds as heavy supply from the GSEs pressured spreads and hedged ROEs are now around 12%.

Moving on to commercial credit on Slide 9. Fundamentals in commercial real estate remain positive as growth in the broader economy continues to support property valuations. Our CMBS portfolio consists of a combination of well-seasoned single A and BBB bonds financed via repo and AAA and AA bonds financed at the Federal Home Loan Bank. While tighter credit spreads in the third quarter made it more difficult to find accretive opportunities in CMBS, we continue to find pockets of value in the sector and purchased $167 million of subordinate CMBS during the quarter with ROEs in the low teens.

Our commercial loan portfolio continues to run off with a balance of $32 million at quarter-end and a weighted average of maturity of about 2 years.

Slide 10 highlights the credit quality of our commercial portfolio. The chart on the left shows the average LTV of our CMBS assets, which has continued to improve and is down to approximately 35%. The chart on the right highlights the seasoned nature of our CMBS book, with over 80% in the 2014 vintage or earlier. Positively, spreads on seasoned subordinate bonds are benefiting from increased investor demand due to a 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, with 42% of assets in the -- and GSE CRT paper, 37% in legacy bonds and Re-Remics, and 21% in post-2009 Prime paper. Spreads tightened notably in the sector during the quarter, primarily in CRT and legacies.

Fundamentals are also strong here as economic strength and healthy consumers are helping to offset declining affordability due to the rise in home prices and mortgage rates. As you can see from the chart at the bottom of the slide, durations are very low across the portfolio and with the majority of our holdings paying a floating-rate coupon, earnings in the sector are largely protected against higher funding costs.

During the quarter, we funded an initial investment of $45 million and a loan participation interest secured by mortgage servicing rights with a commitment to fund an additional $30 million over the next 2 years. The transaction serves as another example of our ability to provide shareholders with access to unique investment opportunities.

Slide 12 provides some detail around the credit quality of our residential credit portfolio. 72% 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. Our legacy positions consist of Prime and Alt-A paper that we purchased relatively early in the recovery at high book yields, while our CRT positions are concentrated in earlier postcrisis vintages, which have higher credit quality and lower spread volatility than newly issued securities. Since quarter-end, we have been able to take advantage of spread widening and attractive financing in CRT, selectively adding bonds in the 11% to 12% ROE range, which is particularly attractive given the floating-rate coupon.

I'll end on Slide 13 with financing and hedging. At quarter-end, we had $14.4 billion of repo outstanding with 29 counterparties and $1.7 billion of secured financing to the Federal Home Loan Bank. To reduce the risk associated with changes in repo funding costs, we held $9.9 billion of interest rate swaps, which we increased by $1 billion during the quarter.

In addition to our interest rate swaps, we increased our treasury futures position during the quarter to $1.5 billion, up from $285 million on June 30. Since quarter-end, we have added $500 million of interest rate swaps and $500 million of treasury futures notional to protect against higher funding costs and interest rates. Higher funding costs are further mitigated by our $1.9 billion book of variable rate assets, which effectively pushes our hedge ratio near 75%. As we move through quarter -- fourth quarter, we will continue to actively manage our portfolio to optimize our earnings capacity while limiting the impact of higher interest rates.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) First question from Doug Harter from Crédit Suisse.

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Joshua Hill Bolton, Crédit Suisse AG, Research Division - Research Analyst [2]

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This is Josh on for Doug. First on the $45 million loan participation in MSR. Can you just talk a little bit about the ROEs you're expecting from that investment?

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David Lyle, Invesco Mortgage Capital Inc. - COO [3]

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Yes, this is Dave. I can provide a little more detail around that. We are able to get repo funding to further benefit returns on that loan participation agreement. It's fairly modest, but with that additional leverage, we expect ROEs on that investment in the 13% to 14% type range.

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Joshua Hill Bolton, Crédit Suisse AG, Research Division - Research Analyst [4]

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Got you. That's great. And then just one more, given the spread moves we've seen in the fourth quarter, are you guys able to give us a sense as to your book value performance quarter-to-date?

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John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [5]

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Yes, sure, this is John. We're down a little bit less than 3% quarter-to-date, and that's basically a combination of wider agency spreads and impact of higher rates. Credit spreads have -- are maybe modestly wider, but that impacts a lot less.

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Operator [6]

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Next question from Eric Hagen from KBW.

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

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On the decision to rotate out of a seasoned Agency MBS, can you just give me a little color, I mean, I guess, my sense is that seasoned collateral typically has some sort of prepayment -- favorable prepayment characteristics that are -- presumably have some value, and I can appreciate wanting to rotate out of those for the higher yield that you captured, but just kind of walk me through the -- kind of the -- how you balance the prepared characteristics versus the yield that you'd capture on the back then?

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

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Sure, Eric. Thanks. This is Brian. Yes, we -- the bonds that we sold were, like I said, primarily 15 year and hybrid, and certainly 15 years do have a stronger prepayment protection versus kind of new issues 30 years. But those bonds were purchased between 3 to 6 years ago at much lower yields and have held in really well as rates rose and spread widened particularly in 30 years. So we felt like the third quarter was a really good time, an opportune time to rotate out of those sectors and into prepaid protected, 30-year newly issued specified pools. In agency hybrids, in particular, are going to face some more issues going forward particularly as the curve continues to flatten and borrowers are rotating out of hybrids and into fixed-rate collateral.

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

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Got it. And then on hedging, I mean, the CMBS, I mean, the Freddie K, I mean, are those -- when you guys kind of think about the construct of your hedging profile, I mean, is -- are those bonds being sort of hedged kind of for -- there is no prepayment kind of sensitivity or very little anyway. I mean, are you hedging those bonds, I guess, is kind of the most direct question? Or is it really kind of the Agency RMBS that we should sort of think about as the hedged piece of the portfolio with swaps?

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Kevin M. Collins, Invesco Mortgage Capital Inc. - President [10]

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Sure. This is Kevin. The short answer is, yes, we're hedging those. And I'll expand on that in a bit and say that one of the reasons we like them is that they're very easy to hedge just given that they have minimal extension risk relative to, say, Agency MBS.

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

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Got it. Okay, so as you think about growing the portfolio potentially, I mean, you guys talked about attractive returns. Where do you think about adding new hedges? What part of the curve is what I'm asking?

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David Lyle, Invesco Mortgage Capital Inc. - COO [12]

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I'll start there and others can add. I think just looking at different tenders of swaps, very short swaps don't make a lot of sense because they really isn't a whole lot of uncertainty around short rates in the next 3 to 6 months here. On the other end, it doesn't -- very long swaps aren't particularly appealing as well as there isn't a lot of value in extending well beyond the remaining expected life of the Fed hiking cycle. So somewhere between, say, 2 to 3 years, maybe on the tail of that is probably the sweet spot because it really covers the uncertainty around the magnitude of further hikes from the Fed in the next couple of years. We can still take advantage of locking in NIM to create greater visibility around earnings by doing those type of swaps. And really as opposed to making a very defined call on what we expect to happen to rates, we're able to kind of position the portfolio to be successful across a range of potential outcomes.

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John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [13]

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Yes, and I would add that when you look at our hedging book, there's 2 different aspects to it. I think there's the hedging your net interest margin, which is having swaps that offset the impact of debt rate increases, which we seek through high repo cost, which I think Dave is mostly talking about -- personally talking about when he talks about swaps. But also when we look at our book value protection, we're looking much more holistically the portfolio about hedging across the entire interest rate spectrum and making sure our key rate duration exposures are where we want them to be. So it's really 2 parts to that. So I think from a -- where we're putting our swaps, I think Dave is absolutely right, we're targeting sort of that maybe middle of the curve, sort of that belly of the curve, I guess, if you will. And then we use treasury futures to target more directly where we want to put our hedges for sort of book value protection.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [14]

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Got it. Last one on just the kind of hedged and levered ROEs that you guys quote, especially on the credit side. I mean are we -- I just want to make sure I'm clear that we're talking about kind of the coupon interest and any premium amortization or discount accretion and not any sort of expectation for price appreciation or spread tightening that's factored into that -- kind of that yield that you quote?

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David Lyle, Invesco Mortgage Capital Inc. - COO [15]

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That's correct. It's the former. We don't assume any kind of spread tightening to get to those ROEs.

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Operator [16]

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Next question from Steve Delaney from JMP Securities.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [17]

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Noting the CMBS investment, the $400 million in the quarter, agency CMBS. Can you tell us what percentage is Fannie Mae does versus Freddie K? I've heard you mention Freddie K, but have not heard you mention Fannie bonds?

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Kevin M. Collins, Invesco Mortgage Capital Inc. - President [18]

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Sure, this is Kevin. Just note there that we focused at this point, all on Freddie K in terms of the deployment at Agency CMBS.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [19]

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Okay, got it. And historically, you've been working with other parts of Invesco, you guys have long had the capability of making CRE whole loans, whether it's senior REMICs over the years. But it looks like that portfolio may be -- the loan portfolio may be in runoff, you're down to $32 million as shown on Page 10. Am I reading that right that anything you want to express on commercial credit, you're going to use CMBS rather than whole loans at least for the near term?

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Kevin M. Collins, Invesco Mortgage Capital Inc. - President [20]

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Yes, I guess, I would -- this is Kevin again. And I would say that big picture, we entered the direct commercial real estate loan origination business in 2013. And if you kind of go back to that time period, we were doing it when very few were originating loans. And as you can see with what it's left us with in terms of a commercial real estate loan portfolio, that's throwing off around at 10% yield on levered currently. So it's been a really nice and attractive earn for us. I think what's changed is that competition has become pretty fierce there. I don't think we've seen a lot of flexibility in credit terms. That said, we have seen a notable contraction in yield bring ins. And as a result, you've seen our loan portfolio continue to decline because we haven't, on risk-adjusted basis, found it to be as attractive. So it's not to say we won't continue to look at opportunities there. We certainly will. We're just going to be a lot more selective about where we compete. Because in contrast, if you think about CMBS, it's always been a really nice way to lock in a rate hedge net interest margin. But it doesn't just constantly force you to go out and reinvest into what is flattening yield curve and that's because unlike a lot of those floating rate commercial real estate loans where you're recycling capital, it's always coming back to you, you have the benefit of prepayment protection in CMBS. And you can go back in time, so to speak and invest in exposure, or fine exposure to loans that were originated several years ago, which means they're using underwriting that was arguably more conservative as well as appraisals that were notably lower than where properties are going to be valued today. And so we think that, that gives us a benefit as well.

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John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [21]

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Yes. Add one little piece to is that, being part of larger organization, we don't really face the same sort of cost structure in terms of entering and exiting business as some of our peers might. So you don't see us taking like big cost to exit or enter, so we can kind of be selective about our entry points into that market.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [22]

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No, understood. You're not having to underwrite an entire platform every time you decide to crank it up. And my last one. Didn't hear much about -- on the residential side beyond CRT and legacy. Is there anything in the evolving residential whole loan market, specifically thinking nonagency in QM type paper? Are you watching those markets and the private RMBS market to evaluate whether there's anything for you to do there in the near term?

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David Lyle, Invesco Mortgage Capital Inc. - COO [23]

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Yes, this is Dave again. We certainly are. We spent a lot of time looking at non-QM, reperforming loan securitizations, NPLs, single-family rentals. We cover all those sectors and invest in those sectors as a platform. But in a levered vehicle like IVR, really just with the combination of available yields and available funding in terms of repo haircuts and financing, they're not particularly attractive relative to other opportunities that we have. I would say for non-QM, single-family rental, it's probably about a 7% to 9% type ROE right now. So again, we're seeing better opportunities, Agency MBS and CMBS and kind of on the edges of CRT and Prime 2.0.

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Operator [24]

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At this time, there's no question in queue. (Operator Instructions)

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Brandon Burk, Invesco Mortgage Capital Inc. - Director of IR [25]

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All right. Well, I'd like to thank everybody for joining us and we'll -- until next quarter.

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Operator [26]

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Thank you. That concludes today's conference. Thank you for joining. You may now disconnect.