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Edited Transcript of IVR earnings conference call or presentation 9-May-19 1:00pm GMT

Q1 2019 Invesco Mortgage Capital Inc Earnings Call

ATLANTA May 20, 2019 (Thomson StreetEvents) -- Edited Transcript of Invesco Mortgage Capital Inc earnings conference call or presentation Thursday, May 9, 2019 at 1:00:00pm 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. - 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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* 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

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Presentation

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Operator [1]

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Welcome to Invesco Mortgage Capital Inc. First Quarter 2019 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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Well, thank you, and welcome to the Invesco Mortgage Capital First 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 during the next several minutes before concluding 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; Dave Lyle, our Chief Operating Officer; and Brian Norris, our Chief Investment Officer.

Before we begin, I'd like to direct your attention to Slide 2 of our earnings presentation, which discusses forward-looking statements in detail.

Statements made in this conference call regarding Invesco Mortgage Capital that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not guarantees and they involve risks, uncertainties and assumptions. There can be no assurance that actual results will not differ materially from our expectations. We caution investors not to rely unduly on any forward-looking statement and urge you to carefully consider the risks identified under the captions Risk Factors, Forward-Looking Statements, the Management's Discussion and Analysis of Financial Condition and the Results of Operations in our annual report Form 10-K and quarterly reports on Form 10-Q, which are available on the Securities and Exchange Commission's 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 statements later turn out to be inaccurate.

To view the slide presentation today, you may access our website at invescomortgagecapital.com and click on the Q1 2019 earnings presentation link. You can find it 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. I'll now turn the call over to our CEO, John Anzalone. John?

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

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Thank you, and I'd like to welcome everyone to Invesco Mortgage Capital's First Quarter Earnings Call.

I will provide a brief recap of our results as well as an update on our outlook before handing the call over to our CIO, Brian Norris, to go through our portfolio activity in more detail.

We are pleased to announce that IVR had a strong start to 2019, delivering an economic return of 9.6% for the quarter. This result was driven by higher asset valuations across our portfolio, leading to a 6.7% increase in book value combined with a 7% increase in our dividend to $0.45 per share. Our core earnings per share increased to $0.47, comfortably covering our new dividend despite an increase in share count in connection with our successful common stock offering in February.

The heightened volatility that the financial markets experienced during December subsided in January, and our portfolio of seasoned credit and agency assets enjoyed strong appreciation during the quarter. Our Agency MBS portfolio, which consists almost entirely of prepayment-protected specified pool paper, saw notable gains, as did our Agency CMBS positions. On the credit side, our seasoned CMBS and CRT bonds continue to benefit from positive fundamental trends, and spreads on these positions also rebounded nicely during the quarter.

Our core earnings of $0.47 topped our recently increased dividend rate of $0.45, and there are several factors that help -- that support this increased run rate. Our recent rotation out of lower-yielding 15-year and Hybrid ARM securities into specified pool agencies and Agency CMBS was particularly well-timed. These bonds have led to a higher net interest margin while also helping to mitigate convexity risk. Our capital raise in February has also contributed to our higher run rate, as we invested those proceeds while spreads were not fully recovered from December's wides.

While prepayment rates have increased due to both seasonal factors as well as lower rates, the specified pools that we own, along with our increased allocation to Agency CMBS, have been effective at reducing the impact of broadly faster speeds.

Finally, our hedging strategy was effective not only in protecting book value but also helped protect our net interest margin. We are well insulated from the impacts of volatility in the basis between 1- and 3-month LIBOR given our concentration in 1-month LIBOR swaps, which more closely track changes in our repo funding cost.

One of the things that was very clear during the past few quarters is the value of the hybrid model. Our ability to allocate capital to the best opportunities across the entire mortgage base has been instrumental in producing consistent high-quality earning stream. While we have had some book value volatility during the past 2 quarters, our risk management discipline allowed us to not only weather the storm but to take -- but to capitalize on it once it was over.

Of course, central to this flexibility is our platform, which allows us to access the breadth of the mortgage market without incurring elevated costs to our shareholders. In fact, our expense ratio is among the lowest of our peers, a tremendous value proposition considering that it enables our shareholders to tap into the expertise and resources of a leading global asset manager.

Looking ahead, we are enthusiastic about the future and our ability to continue to deliver strong results for our shareholders. Our portfolio is well diversified, with Agency MBS and CMBS balanced with a seasoned credit portfolio that would be nearly impossible to replicate today. As we progress further into the credit cycle, we believe that our strategy will continue to support a strong core earnings stream while allowing us to take advantage of opportunities in the mortgage market wherever they may exist.

So I'll stop here and turn the call over to Brian to go over the portfolio activity in more detail.

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

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Thanks, John. I'll start on Slide 6, which provides a breakdown of the broad sector allocations on our portfolio, both on an equity and total asset basis.

As indicated by the pie chart in the upper left-hand corner, our equity allocation to agencies and credit remains well balanced, with a modest increase in agency assets from 49% to 50% quarter-over-quarter. On a total asset basis, our allocation to agency assets increased from 69% to 73% as a result of the capital deployment from the February common equity raise going predominantly into Agency RMBS and Agency CMBS. ROEs on both agency sectors were attractive during the quarter as wider spreads during the fourth quarter produced attractive entry points. Our Agency CMBS assets have grown since the second quarter of 2018 to approximately $2 billion or roughly 10% of our total assets as of quarter-end as the total asset allocation to Agency RMBS reduced from 69% 1 year ago to 63% and credit assets down from 31% to 27%.

With the increase in the agency asset allocation, our leverage increased modestly quarter-over-quarter to 6.9x from 6.7x. Given Agency CMBS continues to be an attractive complement to our Agency RMBS and credit assets, reducing risks to both an increase in interest rate volatility and spread widening, we remain comfortable with a modest increase in leverage.

Moving on to Slide 7. The repositioning within our Agency RMBS portfolio during the second half of 2018 proved to be well-timed, as we shifted from agency hybrid and 15-year collateral into 30-year specified pools. Not only did the repositioning increase the earnings power of the company, but we also benefited from a significant increase in the value of the prepay protection in our specified pool holdings during the fourth -- first quarter. The weighted average pay-up of our agency TBA on our 30-year specified pool holdings improved nearly 0.5 point during the quarter as demand for prepay-protected specified pools increased substantially due to lower interest rates and a weakening technical environment in agency TBA. This focus on prepay protection has served the company well, as the increase in our prepayment speeds over the last 2 months has been significantly dampened relative to generic collateral.

We continue to favor loan balance, LTV and geographic-specific stories to help mitigate the impact of prepayments, and as you can see from the pie chart in the upper left-hand corner of Slide 7, this makes up the vast majority of our Agency MBS holdings. Although valuations are higher and returns modestly lower, we believe the Agency RMBS sector remains attractive given the low volatility environment, as hedged ROEs are near 14%. With monetary policy on hold for now, we expect Agency RMBS to remain an attractive asset class as volatility remains low and further Fed hikes are priced out of the forward curve.

Turning to Slide 8. You can see in the lower left-hand table that our allocation to Agency CMBS has grown to approximately $2 billion. We purchased $948 million of Agency CMBS during the quarter, predominantly in the Fannie Mae DUS program, as wider spreads and an improving financing environment led to an increase in opportunities in that sector. Agency CMBS complements our Agency RMBS assets given the prepayment protection embedded in the securities in the form of prepaid penalties and lockout provisions. Spreads widened during the fourth quarter, allowing us to add exposure in the first quarter at attractive levels and remain attractive with hedged ROEs in the low double digits. We anticipate continuing to add exposure to the sector at these levels, as we believe it provides substantial benefits to our portfolio given the stable nature of its cash flows and attractive financing terms.

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 increased demand in the sector during the quarter led to strong book value gains.

In addition, we were able to add $162 million of non-Agency CMBS during the quarter with ROEs in the low to mid-teens, as wider spreads during the fourth quarter led to attractive opportunities. One loan in our commercial loan portfolio paid down, reducing our holdings from $32 million to $24 million quarter-over-quarter, and the maturity on the remaining loan is now less than 2 years.

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 over 2/3 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 $683 million benefiting from rating agency upgrades 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 with 42% of assets in GSC CRT paper, 30% in legacy bonds and Re-Remics, 25% in post-2009 prime paper and a 3% allocation to a loan participation interest secured by MSRs. Spread widening during the fourth quarter provided opportunities to add assets at accretive levels, as we purchased approximately $170 million in assets split between GSE CRT and new issue prime. Fundamentals remain supportive here, as healthy borrower balance sheets combined with lower mortgage rates and accelerating wage growth are helping to offset declining affordability due to the rise in home prices.

Slide 12 provides some detail around the credit quality of our residential credit portfolio. 68% 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 mostly in earlier post-crisis vintages, which have higher credit quality and lower spread volatility than newly issued securities.

Finally, Slide 13 summarizes our financing and hedging strategy. At quarter-end, we had $16.8 billion of repo outstanding with 31 counterparties and $1.7 billion in secured financing through the Federal Home Loan Bank. We have seen improved financing terms for our credit assets, improving the net interest margin on that portion of our book. To reduce the risk associated with changes in repo funding cost, we held $12.9 billion notional of interest rate swaps, which we increased by $500 million during the quarter. We also took advantage of lower swap rates during the quarter by locking in longer-dated hedges. We have mitigated the impact of changes in the spread between 3-month and 1-month LIBOR by extending maturities in our repo book, while also shifting a portion of our swap hedges to receiving 1-month rather than 3-month LIBOR. The combination of these adjustments protects the company's earnings stream from reliance on a positive spread between 3-month and 1-month LIBOR as monetary policy shifts from a tightening to accommodative stance. We believe this produces a more reliable and predictable income stream, and along with the increased earnings power of our assets due to the portfolio repositioning in 2018 and an accretive equity raise in February, allowed us to increase our dividend in the first quarter from $0.42 to $0.45.

That ends my prepared remarks. Now we'll 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) Our first question comes from Doug Harter with Crédit Suisse.

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

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When you look at -- I guess first off, how do you view available returns kind of across your portfolio, given the kind of assets that you said you're targeting today versus 3 months ago?

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

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Thanks, Doug. This is Brian. Agency RMBS ROEs are kind of low teens, say, 13%, 14%. Agency CMBS, I would say, is kind of low double digits, as I mentioned there during the commentary. I don't know if Kevin or Dave want to comment on credit assets.

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Kevin M. Collins, Invesco Mortgage Capital Inc. - President [4]

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Yes. This is Kevin. I'm happy to jump in and talk about in terms of what we're seeing in CMBS land. Really, low double digits there as well, call it anywhere 11% to 14%, mostly focusing on new issue BBB credit as well as seasoned to a lesser extent.

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David Lyle, Invesco Mortgage Capital Inc. - COO [5]

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Yes, and -- this is Dave on the resi side -- certainly, ROEs are a bit lower than 3 months ago, as we've continued to see recovery in credit assets from the spread widening that we saw late last year. In CRT, I'd say M2s are kind of very high single digits, maybe borderline double digits there. Nonrated CRT B1s are pretty attractive with a mid-teens type ROE. The rest of our universe is tight to the point where it's not especially relatively attractive versus our other target assets. Prime jumbo, very high single digits. Legacies, probably our least favorite part of our market right now, we see about mid-single digits there. Not a lot of opportunity for book value upside in legacies in our view. And then some of the newer resi credit subsectors, SFR, non-QM, we continue to like the credit quality of those assets and think that those -- non-QM especially is going to be an increasingly important market going forward, but at this time, don't really -- they would not really provide attractive ROEs to a levered vehicle.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [6]

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Great. And then as prepays kind of increase in the second quarter, can you kind of help size the magnitude impact that would have on yields or earnings?

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Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [7]

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Yes. So we just received the April prepayment report just a few days ago, and speeds broadly for our portfolio were up about 20%. The market, I believe, was up 24%. But generic 30-year 4%s and 4.5%s were up pretty significantly month-over-month. We would anticipate a similar increase in speeds next month -- for next month's report. So our core earnings in the first quarter was at $0.47, and we set our dividend at $0.45. So we believe that that's repeatable.

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Operator [8]

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Our next question comes from Eric Hagen with KBW.

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

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Just on leverage, I guess, just how comfortable are you with leverage in the agency portfolio right now? I guess, on its face, it seems like that would imply that you're comfortable with the mortgage basis. And I guess the question is kind of twofold: one is, again, just kind of gauging your comfort level with leverage in the agency portfolio against the backdrop of the mortgage basis; and any sort of commentary around your views on the basis would be helpful.

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John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [10]

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Yes. This is John. I think, as we've always said, the leverage is always a function of asset mix, and even within agencies that's true. So as we've been moving more towards Agency CMBS -- like Brian mentioned, the 30-year portion of our book actually went down a little bit this quarter, whereas the Agency CMBS portion has increased. So all things equal, Agency CMBS, we'd be slightly more comfortable levering a little bit more, because there's no convexity risk and a lot less spread volatility. So I think that's kind of where we are. But -- so we don't anticipate much more leverage other than what might be a function of just asset mix.

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Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [11]

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Eric, I think it's important to keep in mind that this -- that we value the fact that we are managing a hybrid REIT, and we are looking for our best way to find financing across the portfolio. So while I think you're focusing on the leverage on the agency book itself, we really are looking for cheapest cost of funds. So we may put leverage on and post collateral of agencies, but it's really the overall book that we are levering. And we -- the turns of leverage is very minute in terms of the change. I think we went from 6.7x to 6.9x. So we don't view it as individual assets that are important on what's the leverage on agencies versus what's the leverage on credit. It's the total portfolio leverage that we are focused on.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [12]

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Fair enough. And I -- no, please go ahead.

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Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [13]

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Sure, yes. Eric, I'll just comment briefly on kind of agency mortgages. You asked about, kind of, spreads there and valuations, and we think valuations are pretty fair in that space. I think there's not a lot of room for tightening potential, but our leads are still kind of attractive where valuations are right now. So the withdrawal of the Fed from the market is largely priced in. I think the market is fairly accepting of prepayments fees increasing over the next couple of months, although we have bounced off the lows in rates so the refinancing activity that we're seeing has mitigated a bit there. So I think we're pretty comfortable with where spreads are on agency mortgages right now.

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

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Got it. So just kind of sticking on the leverage theme, how much dry powder or, I guess, unencumbered assets do you guys have at this point?

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John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [15]

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That's a number that changes on a daily basis. I think it's hard for us to pinpoint that number. But we run this from a very risk-management standpoint. And so our cash and unencumbered is well in excess of what we see as our bar risk, which is the way that we measure what we need to keep in order to manage through any of the scenarios.

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Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [16]

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As we mentioned, our exposure to Agency RMBS and to credit assets has been reduced over the last couple of quarters. So our portfolio as a whole is less risky than it has been, so we feel pretty comfortable with the increase in leverage.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [17]

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Okay. And then on the commercial credit, it looks like the position at the Federal Home Loan Bank is overcollateralized by around 20%. What are the haircuts that the FHLB offers on commercial credit? I guess it's AAA kind of credit, but what -- how much more could you lever that position if you wanted to is kind of what I'm asking.

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

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Yes, sure. This is Kevin. I guess in terms of how we're looking at things there, we're -- we basically have $1.65 billion of advances. So that amount is going to stay with us and we'll look to utilize as much leverage as we can there. And the nice thing about that portfolio is the net interest margin is very healthy just given the fact that the funding rates are attractive. So I think that's really the way that we look at that portfolio.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [19]

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But the position itself, it looks like on the press release, is overcollateralized by around 20%. Is there wiggle room? I mean is that kind of capped out from a leverage standpoint? Or is there more that you could go there?

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

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So we really look at things holistically, as -- kind of as was said before, in terms of what our cash and unencumbered is. So we're less focused in terms of where it might be on certain lines and more focused at an entity or company level: what is our cash and unencumbered that we have set aside of irrespective of what line it's associated with. So not a lot of focus there.

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

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The intent is to optimize our cost of funds.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [22]

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Got it. Got it. Okay. And any update on book value quarter-to-date?

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John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [23]

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So I think the -- we're slightly up above where we were at end of the third quarter, but it's not material. So you can think about it as above where we were.

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Operator [24]

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Our final question comes from Trevor Cranston with JMP Securities.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [25]

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Question on the effective net interest margin. I guess I was a little surprised to see both the asset yield improve and the cost of funds decline. So I was wondering if maybe you guys could provide a little bit of color around what the drivers of each of those components were this quarter.

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Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [26]

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Sure. I'll cover the -- on the hedge side. This is Brian. And we'll -- we did reposition the swap book a bit during the first quarter to take advantage kind of the inversion in the swap curve that we saw. So we did extend maturities, which helped lower the interest rate that we were paying on those hedges. And then from an asset yield perspective, that still continues to kind of be the result of the repositioning that we did really in the latter half of 2018 and a little bit more in the first quarter as well as the accretive levels that we were able to deploy, the capital raise in February.

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David Lyle, Invesco Mortgage Capital Inc. - COO [27]

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This is Dave. I'll add one more note on that. The financing spreads on our credit assets on repo also tightened in the first quarter by about 10 basis points on average, so that helped the NIM as well. Though I would point out some of that tightening was a little bit later in the quarter, so we won't realize the full benefit of that until Q2.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [28]

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Got it. Okay. That's helpful. And then, I guess, listening to the commentary on the opportunities you guys are seeing, it sounded like you were maybe leaning towards agencies as continuing to be relatively attractive even though there are still some opportunities in other asset classes. Can you talk about sort of how you're seeing the asset allocation mix sort of trending over time given where markets are today, and how high you'd be willing to take the agency allocation within the overall portfolio?

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Brian P. Norris, Invesco Mortgage Capital Inc. - CIO [29]

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Yes. Thanks, Trevor. With the hybrid model, we prefer to maintain some flexibility around that, obviously. And right now, we see better opportunities in agencies, both RMBS and CMBS. But from a credit perspective, we are still able to add some accretive assets, and we'll certainly continue to look for opportunities there. They've tended, over the last quarter or 2, to be a little bit fewer opportunities, but we'll continue to be searching for those as they come available. And then as far as kind of the total asset allocation to agencies, we're certainly kind of at the higher end of where we've been in the past, but that's not necessarily something that we're overly monitoring or concerned about from a risk perspective, as those assets tend to be lower volatility spread assets.

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Operator [30]

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At this time there are no further questions. I will now turn the call back over to Mr. John Anzalone for closing remarks.

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John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [31]

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All right. Well, thanks, everybody, for your time. And we will look forward to the second quarter call. Thanks.

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Operator [32]

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Thank you. That does conclude today's conference. All participants may disconnect. Thank you for your participation.