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Edited Transcript of IVR earnings conference call or presentation 21-Feb-19 2:00pm GMT

Q4 2018 Invesco Mortgage Capital Inc Earnings Call

ATLANTA Mar 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Invesco Mortgage Capital Inc earnings conference call or presentation Thursday, February 21, 2019 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. - CIO

* David Lyle

Invesco Mortgage Capital Inc. - COO

* John M. Anzalone

Invesco Mortgage Capital Inc. - CEO

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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 the Invesco Mortgage Capital Inc. Fourth Quarter 2018 Investor Conference Call. (Operator Instructions) I would now like to turn your 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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Okay. Well, thank you, and welcome to the Invesco Mortgage Capital Fourth Quarter 2018 Earnings Call. The management team and I are delighted that you've joined us. 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 would 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 may 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 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 operations in our annual report Form 10-K and quarterly reports on 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 at 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 Q4 2018 earnings presentation link. You can find it under the Investor Relations tab at the top of our homepage. There you may either select 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 fourth quarter earnings call. I will provide a recap of our results and an update on our outlook before turning over the call to Brian Norris, who will go through the portfolio in a little more detail as well as providing some color on the successful deployment of the proceeds from our recent capital raise.

The volatility that the financial market's experienced during the fourth quarter impacted nearly all risk assets, and our mortgage investments were no exception. We saw wider spreads across our entire portfolio, and agency mortgages had a particularly rough quarter, sharply underperforming treasuries. This led to a decline in our book value of 9.3% during the fourth quarter. Importantly, this price action was not due to any deterioration in the fundamental credit quality of the assets underlying our investments, who reflected turmoil across markets caused by a host of macro factors, uncertainties surrounding Fed policy, trade policy, the government shutdown, Brexit amongst others. As the concern over these factors began to recede, we saw a meaningful recovery in recent weeks, and our book value has since recovered about half of the fourth quarter decline.

On the positive side, we increased our core earnings for the quarter by $0.05 to $0.46 per share, easily covering our $0.42 dividend. This reflects the portfolio repositioning we executed during the second half of 2018, moving out of lower yielding 15-year and Hybrid ARM agency mortgages and buying current coupon agency mortgages and agency CMBS with more attractive ROEs. The portfolio rotation in our active interest rate hedging strategy allowed our net interest margin to increase by approximately 13 basis points despite an increase in funding costs. Our outlook for the portfolio is quite positive, as credit fundamentals in both residential housing and commercial real estate remain supportive of our seasoned credit assets. Additionally, the decreased rate volatility brought on by a more dovish Fed should be supportive of agency mortgages.

To that end, we executed a $250 million equity offering early in February, which allowed us to capitalize on attractive opportunities in agency mortgages, agency CMBS and to a lesser extent in credit assets. We expect this offering to be solidly accretive to earnings and help us to maintain the positive earnings momentum we've been experiencing. Given the focus on deploying this new capital into agency securities, we have been very successful in putting this money to work with minimal drag to future earnings. While this was a difficult quarter for book value performance in our sector, we believe that we are extremely well positioned for the current environment. Our diversification across both residential and commercial credit as well as the agency investments has allowed us to see the best risk-adjusted returns within the mortgage market.

Looking ahead, we believe our strategy will help us continue to identify attractive risk-adjusted returns, which should prove beneficial to our shareholders.

Now, let me turn the call over to our Chief Investment Officer, Brian Norris.

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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 the breakdown of the broad sector allocations in 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, even as our allocation within the agency bucket shifts modestly into agency CMBS, as we've increased that balance to $1 billion of total assets. ROEs on both agency RMBS and agency CMBS remained attractive during the fourth quarter, and we were able to continue the portfolio rotation we started in the third quarter at levels accretive to earnings. The benefits of the portfolio rotation can be seen in our portfolio yield and effective net interest margin, which have both improved despite our higher borrowing costs, improving the long-term earnings power of the company. Overall leverage increased quarter-over-quarter to 6.7x from 6.4x as investment spread widening led to an increase in the amount of assets pledged for repo financing.

Moving on to Slide 7. The repositioning within our agency RMBS portfolio during the second half of 2018 was mostly out of season shorter duration 15-year and hybrid collateral and into newer production 30-year specified pools. This is reflected in the pie chart in the upper left-hand corner of the slide as 30-year specified pools now comprise close to 90% of our agency RMBS portfolio. We continue to favor loan balance, LTV and geographic-specific stories to help mitigate the impact of prepayments. Valuations remain attractive given spread widening in 2018 as hedged ROEs are approximately 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 for a few brief comments on our agency CMBS book. We purchased $398 million of predominantly 10-year agency CMBS during the quarter, which brought our total exposure to the sector close to $1 billion as of 12/31. 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 at attractive levels, and remained attractive in the first quarter of 2019 with hedged ROEs near 12%. 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. While higher volatility during the fourth quarter limited opportunities to add in the secondary market, we were able to add approximately $115 million of subordinate CMBS during the quarter with ROEs in the low to mid-teens largely through the new issue market. Our commercial loan portfolio remained unchanged during the quarter, with a balance $32 million at quarter end and a weighted average maturity of less than 2 years.

Slide 10 highlights the credit quality of our commercial portfolio. Fundamentals in commercial real estate remained 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 average LTV of our CMBS assets, which has continued to improve and is down to approximately 35%, while the chart on the right highlights the seasoned nature of our CMBS book, with over 75% in the 2014 vintage or earlier. Positively, spreads on seasoned subordinate bonds are benefiting 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 40% of assets in GSE CRT paper, 33% in legacy bonds and re-REMICs, 24% 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 $60 million new issue prime and $10 million in new issue CRT. 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 this sector are largely protected against changes in funding costs. Fundamentals remain supportive here as well 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. 75% 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 consistent 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 post-crisis vintages which have higher credit quality and lower spread volatility than newly issued securities.

Moving on to Slide 13, which summarizes our financing and hedging strategies. At quarter end, we had $13.6 billion of repo outstanding, with 29 counterparties and $1.7 billion of secured financing through the Federal Home Loan Bank. To reduce the risk associated with changes in funding and repo funding costs, we held $12.4 billion of notional of interest rate swaps, which we increased by $2.5 billion during the quarter. Our $1.9 billion of variable rate investments in addition to our interest rate swaps provides a large degree of stability to our net interest margin and ultimately the stream of earnings we provide to our investors.

Lastly, I would like to provide a brief update on our common equity raise, which closed on February 7 of this year. Including the full exercise of the [shoe], we sold 16.1 million shares of common equity, raising approximately $250 million of proceeds for deployment into our target assets. The deployment of the new equity was successful. We were able to fully invest the proceeds across our target assets within a reasonable timeframe at levels accretive to earnings. Approximately 90% of the proceeds were allocated to 30-year agency RMBS specified pools with the remainder allocated to agency CMBS and credit assets within both the commercial and residential sectors. In addition to our asset purchases, we have increased our hedge portfolio by $1.8 billion to help protect our NIM from changes in borrowing costs. With the additional earnings power of the company given the equity raise and attractive hedged ROEs in our target assets, we believe the company is well positioned to achieve our stated goals of attractive income and long-term book value stability.

That ends my prepared remarks. Now 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) And our first question comes from Doug Harter of Credit Suisse.

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

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Can you just talk about where you might be in terms of portfolio rotation just thinking about whether we have -- there's more room for asset yield improvement, or has most of that kind of been reflected in the 4Q results?

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

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This is Brian, and thanks, Doug. We've mostly made it through a lot of the rotation. As rates have fallen, or fell in the fourth quarter, that produces fewer opportunities to rotate out of lower book yielding assets. And as you see in the slides there, our 15 year-end Hybrid ARM exposures are pretty low at this point. So we've mostly worked through the rotation at this point.

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

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Great. And then just thinking about the dividend given the strong core earnings you had for the quarter plus your commentary that this capital was accretively deployed, can you just tell us how you're thinking about the dividend?

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

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Right, this is John. Yes, so I mean, first of all, our board sets the dividend, so I'll put that out there first. But I think we're pretty positively -- we're thinking pretty positively about the core earnings trajectory we have at this point. There's some time between now and the next declaration, so as long as trends continue, we'd be thinking favorably towards that.

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Operator [6]

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Our next question comes from Eric Hagen of KBW.

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

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Thanks for the comments at the end about the deployment of the capital raise. Maybe you can just provide a little color on where leverage stands as a result of having made that deployment. I guess I can sort of reverse engineer based on the comments, but hopefully you can just tell us.

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

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Sure, Eric, thanks. This is Brian again. As we've kind of noted in the past, our leverage number is mostly a function of our asset mix. And so as we transition more into agency RMBS and CMBS at this point, our leverage will tend to tick a little bit higher. During the fourth quarter, leverage did go higher due to spread widening, and we've seen that reverse a little bit. Certainly as spreads have tightened, the leverage number had recovered a little bit and fallen. But given the composition of our equity raise, which was predominantly in agency securities, we would anticipate leverage to tick modestly higher.

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

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Modestly higher. Great, thanks. And then I know you guys have maybe seldom hedged the volatility risk in the agency portfolio by buying things like swaptions, but as the agency portfolio grows a bit more, and I know that in your prepared remarks you said that you expect volatility to be low, but what would -- besides just an expectation for higher volatility, would you guys consider hedging the volatility in your portfolio going forward if you expect the volatility to actually increase?

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

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Sure. Yes, swaptions is certainly something that we can use, and we consider it quite often. But as you've noted, it's not something that we typically have been doing. So what we prefer to do is on the asset side is to select specified pools with favorable convexity characteristics or prepayment characteristics to help mitigate the impact of volatility on our assets.

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

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Okay, great. And then on the CRT side, I mean, can you just provide maybe a little color? Are you guys buying the first loss piece, or do they have some attachment point that's above that? And are they high LTV or low LTV loans?

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

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Yes, hey, this is Dave Lyle. Our portfolio, we don't have any first or -- we don't have any B classes in our CRT portfolio. It's all essentially the lowest M class in what Fanny and Freddie have done and what they've been issuing over time has changed. And then if you go back a few years, it depends on which shelf you're looking at, but it's mostly -- or it's really all M2s and M3s. So it's sort of the mezzanine risk with a significant amount of credit enhancement that we've seen grow over time as the structures have delevered. And as to LTVs, we own both. We feel that it's a pretty balanced risk profile between standard LTV and high LTV exposure with the additional credit enhancement that's added on the high LTV deals.

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

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Great. And then on the ratings upgrade, do they typically -- are those typically done after a certain seasoning point? How should we think about the upgrades on those bonds going forward as far as when we can maybe expect to see individual issues get upgraded, potentially get upgraded?

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David Lyle, Invesco Mortgage Capital Inc. - COO [14]

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Yes, frankly, it's a little unpredictable. Each of the rating agencies kind of has their own approach to how often they review the ratings. We get monthly reports on delinquencies and enhancement levels, and you can kind of look at that information and see at which points they have been leading indicators of coming upgrades on certain bonds. So you can get an idea of which bonds are next in line, but you don't know necessarily when it's going to happen. But we do anticipate -- a lot of the upgrades are behind us given the seasoning on the collateral, but I think there's still a fair amount of room to run because the trends that have led to the upgrades continue in terms of delevering, rolling down the curve, continued strong load performance.

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Operator [15]

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Our next question comes from Trevor Cranston of JMP Securities.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [16]

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Given your comments about the portfolio rotation largely being completed out of the lower yielding assets and the attractiveness of new investment opportunities you're seeing pretty much across all the buckets of the portfolio, can you comment on your potential appetite for potentially another capital raise given that the first one's complete and new investments sound like they would continue to be accretive if you could deploy?

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John M. Anzalone, Invesco Mortgage Capital Inc. - CEO [17]

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This is John. Yes, I think we approach it -- we've always approached both issuing equity and buying back equity, frankly, to do what's best for shareholders. So in this case, we felt like the accretive nature of what we were buying was very good. So if those conditions persist, then we would likely make the same decision if we see the same sort of opportunity. But obviously we just got done with this one, so we're going to take a little bit of a breather. But certainly I think if you listen to all the different -- think about all the different sectors, I mean, we are seeing pretty good opportunities across, and we're pretty positive on the outlook for most of the sectors just given low volatility, and this environment's pretty good for structured securities.

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

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Got it, okay, that's helpful. And then, on the resi credit side, it says that you guys purchased $60 million or so in the fourth quarter of post-2009. Could you elaborate a little bit on that if that's new issue jumbo deals, and maybe add some color around exactly what opportunities you're seeing in the resi credit market currently?

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

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Yes, that's correct. This is Dave again. The bonds that we purchased are new issue prime jumbo AAAs, so the senior tranche there, the spreads, got pretty wide there in the fourth quarter as they did on many of our target assets. And the repo terms available for leverage on those investments have continued to improve, so we were able to add those at pretty materially accretive ROEs. Again, the market has firmed here a little bit in the first quarter. That particular investment's a little more borderline, because we think about -- the risks that we take with CRT and adding that sort of profile to our portfolio is a nice complement to our agency exposure. CRT is a 1 month LIBOR floater, so it's very easy to edge. It's a little bit more of an accrued credit asset, whereas prime jumbo seniors are much more agency MBS-like. There's a yield pick there because they're a bit less liquid, and there's a small credit -- or probably materially less liquid than agencies, obviously. And there is theoretically a credit component that we've seen very, very, very clean credit profiles in these bonds. So the point being they don't add a lot of diversification of risk to the portfolio, so it's going to be pretty healthy ROEs on prime jumbo to continue adding. If we continue to see the market tighten and risk continue to do well, I wouldn't expect us to add a significant amount of prime jumbo. But resi credit overall, those are -- CRT and prime jumbo are the most accretive opportunities. There has been talk, obviously, of non-QM and RPL securitizations. We do like those deals from a fundamental perspective. We manage those assets in unlevered portfolios away from the REIT, so we like the asset classes. But given where the spreads are relative to funding terms, they only lever into the high single digits, so not very compelling for the REIT compared to other opportunities that we have.

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

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Got it, okay. And then one last question. Just a detail on the hedges you guys mentioned that you added subsequent due to capital raise. Can you just give us the approximate duration of the swaps that you put on?

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

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Yes, our swap book kind of ranges from 1 to 10 years, and I believe the hedges that we added in the fourth quarter reflected kind of a mixture of shorter swaps, like in the 2 to 3-year range mixed with some longer 5 to 7-year swaps.

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Operator [22]

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And we have no other questions from the phone line.

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

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Okay, well, I'd like to thank everybody for joining us, and we'll talk to you next time. Thanks.

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Operator [24]

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Thank you for your participation in today's conference. You may now disconnect at this time. Have a wonderful day.