Invesco Mortgage Capital Inc. (NYSE:IVR) Q2 2023 Earnings Call Transcript
Invesco Mortgage Capital Inc. (NYSE:IVR) Q2 2023 Earnings Call Transcript August 4, 2023
Operator: Welcome to Invesco Mortgage Capital Inc.'s Second Quarter 2023 Investor Conference Call. All participants will be in a listen-only mode until the question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded. Now, I would like to turn the call over to Greg Seals in Investor Relations. Mr. Seals, you may begin.
Greg Seals: Thanks, operator, and to all of you joining us on Invesco Mortgage Capital's quarterly earnings call. In addition to today's press release, we have provided a presentation that covers the topics we plan to address today. The press release and presentation are available on our website, invescomortgagecapital.com. This information can be found by going to the Investor Relations section of the website. Our presentation today will include forward-looking statements and certain non-GAAP financial measures. Please review the disclosures on Slide 2 of the presentation regarding these statements and measures as well as the appendix for the appropriate reconciliations to GAAP. Finally, Invesco Mortgage Capital is not responsible for and does not edit nor guarantee the accuracy of our earnings teleconference transcripts provided by third parties.
The only authorized webcasts are located on our website. Again, welcome, and thank you for joining us today. I'll now turn the call over to John Anzalone. John?
John Anzalone: All right. Well, good morning and welcome to Invesco Mortgage Capital's second quarter earnings call. I'll give some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss the current portfolio in more detail. Also joining us on the call are our President, Kevin Collins; our CFO, Lee Phegley; and our COO, Dave Lyle. Our financial conditions improved throughout the second quarter as equity markets rallied and credit spreads tightened given the swift resolution of the U.S. debt ceiling negotiations increased market expectations of a soft landing for the U.S. economy. The positive environment across most risk assets was further spurred by continued moderation in most inflationary measures, led by the decrease in the headline consumer price index to 3%.
Interest rates were sharply higher during the quarter, largely reversing the rally spurred by the uncertainties surrounding the regional banking system that we saw during Q1. Agency mortgage performance generally improved during the second quarter as lower coupon valuations recovered the majority of their underperformance in the first quarter, while high coupon valuations improved modestly as short dated interest rate volatility remained relatively elevated. In addition, premiums on specified pool collateral declined as a result of higher mortgage rates as prepayment protection became less valuable. Increased demand for risk assets by mortgage investors is largely offset by faster than anticipated sales of failed bank assets, particularly specified pool collateral by the FDIC and the increased supply caused by stronger housing seasonals.
Against this backdrop, our book value per common share ended the quarter at 1198, representing a decline of 5% from March 31st and when combined with our $0.40 per share common dividend produced an economic return of negative 1.8% for the quarter. Despite the negative impact on book value, IVR's earnings available for distribution was resilient, decreasing slightly at $1.45 from $1.50 last quarter. Our focus on higher yielding higher coupon mortgages and combination with the hedging strategy continues to benefit from low cost pay-fixed swaps drove the strength of the EAD. Over the coming quarters, we expect EAD to remain well supported as we continue to hedge nearly all of our borrowings. Importantly, these hedges provide benefits for long-term as the weighted average maturity of our pay-fixed swap portfolio is approximately seven years.
ROEs on new investments have also been a positive contributor to EAD, benefiting from attractive spreads, favorable funding and our legacy swaps. Our debt-to-equity ratio ended the second quarter at 5.9 times, up marginally from 5.8 as of March 31st. As of the end of the quarter, substantially all of our $5.5 billion investment portfolio is invested in Agency mortgages and we maintain a sizable balance of unrestricted cash and unencumbered investments totaling $492 million. The FMC's [ph] monetary policy tightening cycle is expected to conclude by the end of the year, with perhaps one more 25 basis point increase in the federal funds rate reflected in the futures market. While the timing remains uncertain the potential decline in interest rate volatility in conjunction with the end of the monetary policies tightening cycle should be supported for higher coupon Agency mortgage valuations.
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Further, Agency mortgage supply and demand technicals are expected to improve in the second half of the year as the liquidation of assets from the FDIC uses inclusion [ph] and high mortgage rates limited supply. Commercial bank should also gain greater clarity on the regulatory environment as capital requirements are finalized. This could encourage further deployment of capital away from loans and into lower risk weighted assets such as Agency mortgages. Finally, valuations and production coupon mortgages remain historically attractive and funding capacity is robust. Taken together we believe that the decline in industry volatility and improving technical environment, combined with compelling valuations and favorable funding conditions should represent an attractive investment opportunity in Agency mortgages for the remainder of 2023.
I'll stop here and Brian will go through the portfolio.
Brian Norris: Thanks, John, and good morning to everyone listening to the call. I'll begin on Slides 4 and 5, which provide an overview of the interest rate and Agency mortgage markets over the past year. As John mentioned and as shown in the upper left chart of Slide 4, yields on U.S. Treasuries largely reversed their move in the first quarter, ending the second quarter sharply higher across the yield curve as the regional bank crisis dissipated. The debt ceiling was swiftly resolved and the economy proved resilient despite persistent tightening of monetary policy. Short-term rates rose in line with further increases in the Fed funds rate as the Federal Reserve raised the benchmark rate an additional 50 basis points during the quarter.
Pricing in the Fed funds futures market reflected the higher for longer policy stance by the Federal Reserve, pushing the expectations for cuts into the first half of 2024. As shown in the lower right chart, U.S. commercial banks further reduced their holdings in Agency MBS during the quarter concurrent with runoff of the Federal Reserve's balance sheet, resulting in an increased reliance on money manager and foreign investments to support valuations. In addition, organic net supply of Agency mortgages to the market increased during the quarter as housing seasonals improved, while over 60% of the Agency RMBS held by the FDIC as a result of recently failed banks we liquidated by the end of the quarter. The FDIC liquidation has been executed on a significantly faster timeline than the original 8 to 10-month expected time frame and could conclude in roughly half that time.
Slide 5 provides more detail on the Agency RMBS market. In the upper left chart, we show 30-year current coupon Agency RMBS performance versus U.S. Treasuries over the past 12 months, highlighting the second quarter in gray. Performance and production coupons was volatile during the quarter. As the sharp move higher in interest rates in May kept short-term volatility elevated, while the decline in volatility in June coinciding with the debt ceiling resolution resulted in a positive environment for valuations. Current coupon valuations ended the quarter mixed versus hedges, modestly outperforming treasuries while lagging interest rate swap hedges. As shown in the lower left chart, valuations remain attractive for current coupon MBS as uncertainty regarding monetary policy keeps interest rate volatility elevated and bank demand remains tepid.
As indicated in the upper right chart, specified pool pay-ups ended the quarter lower as higher interest rates resulted in lower premiums for prepayment protection, while high financing and dollar roll market for TBA securities remained unattractive as shown in the lower right chart. Slide 6 provides detail on our Agency RMBS investments and the changes in the portfolio during the quarter. We remain focused in more attractively priced higher coupons which are largely insulated from direct exposure to assets held by the FDIC and on the Federal Reserve's balance sheet. In addition, we have no exposure to the deterioration in the dollar roll market for TBA securities as we are invested exclusively in specified pools. We continue to focus on specified pool allocation on pools that are expected to perform well in both a premium and discount environment and modestly improved the quality of our specified pool holdings by increasing our allocation to loan balance stories given more attractive valuations during the quarter.
Although we anticipate elevated interest rate and volatility to persist as the fixed income market continues to reflect uncertainty in near-term monetary policy, we believe current valuations on production coupon Agency RMBS largely priced in this lack of clarity and represent attractive investment opportunities with current gross ROEs in the mid-to-high teens. Our remaining credit investments are detailed alongside our Agency CMO allocation on Slide 7. Our credit allocation was unchanged during the quarter at $45 million and remains high quality with 87% rated single A or higher. Although we anticipate limited near-term price appreciation, we believe these assets are attractive holdings as they are held on an unlevered basis and provide favorable yields.
Our allocation to Agency interest only securities detailed on the right side of Slide 7 remain largely unchanged as well totaling $78 million at quarter end. These holdings also provide an attractive unlevered yield and benefit from the current slow prepayment environment given minimal housing turnover and limited refinance activity. Slide 8 details our funding book at quarter end. Repurchase agreements collateralized by Agency RMBS increased to $5 billion given the modest increase in our specified pool holdings as a result of the deployment of proceeds from our common stock ATM program and our weighted average repo costs increased to 5.2% consistent with changes in short-term funding rates due to tightening monetary policy. Positively, we also increase the hedges associated with those borrowings $4.7 billion net notional of current pay-fixed to receive floating interest rate swaps, increasing our hedge notional to 95% of borrowings and largely mitigating the impact of higher borrowing rates on the earnings power of the company.
In order to hedge additional exposures further out the yield curve, at quarter end we held 200 million net notional of forward starting interest rate swaps. These forward starting swaps became effective in July and increased our hedge ratio to 99%. Our economic leverage ended the quarter largely unchanged at 5.9 times debt-to-equity versus 5.8 times at the end of March, reflecting our positive outlook on higher coupon Agency RBS given historically attractive valuations and a likely end to the monetary policy tightening cycle in the second half of 2023. Lastly, Slide 9 provides further detail on our interest rate swap portfolio. At the end of the second quarter, we held 6.3 billion notional of low cost pay-fixed swaps and 1.6 billion notional of receive fixed swaps.
Because the balance of our low cost pay-fixed swaps exceeds our repo balance, we had an opportunity to grow our investment portfolio through purchases of Agency RMBS, hedged with swap rates notably below current market rates resulting in significantly improved ROEs versus hedging at current market rates. Further, the weighted average maturity of our pay-fixed interest rate swaps, including foreign starters, is over seven years, providing substantial benefits for the foreseeable future. To conclude our prepared remarks, the second quarter of 2023 resulted in an improved environment for Agency RMBS, as interest rate volatility declined modestly, while the attractiveness of the asset class remained elevated. We believe our bias for more attractively priced higher coupon specified pools leaves us well positioned for the second half of the year given the potential for a further decline in interest rate volatility as the Federal Reserve seeks to conclude monetary policy timing.
Further, earnings remain well supported given a high hedge ratio on our funding costs and our liquidity position is robust as leverage remains well below historical averages for an Agency RMBS focused strategy. While we anticipate potential near-term volatility as monetary policy tightening concludes, we believe current valuations provide a supportive backdrop for long-term investment. Thank you for your continued support for Invesco Mortgage Capital and now we will open the line for Q&A.
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