Q1 2023 Invesco Mortgage Capital Inc Earnings Call
Participants
Brian P. Norris; CIO; Invesco Mortgage Capital Inc.
Greg Seals
John M. Anzalone; CEO; Invesco Mortgage Capital Inc.
Douglas Michael Harter; Director; Crédit Suisse AG, Research Division
Matthew Erdner; Research Associate; JonesTrading Institutional Services, LLC, Research Division
Trevor John Cranston; MD & Equity Research Analyst; JMP Securities LLC, Research Division
Presentation
Operator
Welcome to Invesco Mortgage Capital Inc.'s First Quarter 2023 Investor Conference Call. (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 the call.
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 loaded on our website. Again, welcome, and thank you for joining us today.
I'll now turn the call over to John Anzalone. John?
John M. Anzalone
All right. Well, good morning and welcome to Invesco Mortgage Capital's first 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 to participate in the Q&A are our President, Kevin Collins; our CFO, Lee Phegley; and our COO, Dave Lyle.
As we entered 2023, agency mortgages continued the strong performance we saw during the fourth quarter of 2022 as industry volatility eased in anticipation of the end of the Fed's tightening cycle. However, favorable market conditions quickly deteriorated as several regional banks failed and concerns around the health of the banking system grew. These concerns impacted mortgage valuations as interest rate volatility spiked, and investors became concerned about the potential liquidation of mortgage assets seized by regulators.
Swift actions by both the Federal Reserve and the FDIC were effective in reducing fears of further contagion, and mortgage spreads ended the quarter only modestly wider. Since quarter end, regional banking troubles were ignited and mortgage spreads continued to be pressured as volatility remains heightened.
Despite heightened market volatility, IVR's earnings available for distribution remains strong, increasing to $1.50 per share versus $1.46 last quarter. Our focus on higher-yielding, higher-coupon mortgages in combination with the hedging strategy benefiting from low-cost, pay-fixed swaps drove the increase in EAD.
Over the coming quarters, we expect EAD to remain well supported as our repo hedge ratio remains elevated and forward-starting swaps come online. Importantly, these hedges provide benefit for the long term as the weighted average maturity of our pay-fixed swap portfolio, including the forward-starting swaps is over 7 years.
ROEs on new investments have also been a positive contributor to EAD as wider spreads on new purchases are attractive and we enjoy the benefit of having retained low-coupon legacy swaps.
Given the underperformance of mortgages, our book value ended the quarter at $12.61, down 1.4% from last quarter. Combining the change in book value with our $0.40 dividend produced an economic return of 1.7% for the quarter. With continued pressure on mortgage spreads, our book value has fallen by approximately 3% since quarter end through last Friday, May 5.
Our economic leverage increased modestly during the quarter, moving from 5.3x to 5.8x. At quarter end, substantially all of our $5.4 billion investment portfolio was invested in Agency RMBS, and we maintained a sizable balance of unrestricted cash and unencumbered investments totaling $464 million.
During the quarter, we reduced our dividend from $0.65 to $0.40 per share. Importantly, this dividend reduction was not in response to downward pressure on EAD as EAD has increased the past 2 quarters, rather reducing the dividend enables us to retain excess earnings to enhance book value and improve our capital structure while continuing to pay a competitive dividend.
This also allows us to further invest capital into what we see is an increasingly positive environment for the agency mortgage market. The wide spreads currently available on agency mortgages and the potential for reduced bank demand should continue to provide good opportunities to invest in capital. Finally, we expect that the conclusion of the Fed's tightening cycle will bring about a reduction in volatility, providing a tailwind for agency mortgages.
So I'll stop here, and Brian can go through the portfolio.
Brian P. Norris
Thanks, John, and good morning to everyone listening on 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. After a strong start for fixed income in January, interest rate volatility moved higher in February as the pace of disinflation slowed. During the first half of March, volatility then spiked sharply higher given the turmoil in the banking sector before declining into quarter end as measures were taken by the FDIC, Treasury and Federal Reserve to mitigate further distress for banks.
Yields on U.S. treasuries ended the quarter roughly 40 basis points lower at maturities from 2 to 10 years. Meanwhile, short-term rates rose in line with further increases in the expected Fed funds rate as the market pushed out anticipated timing of a pause in monetary policy tightening.
As shown in the lower-right chart, U.S. commercial banks further reduced their holdings of Agency MBS during the quarter, concurrent with runoff of the Federal Reserve's balance sheet, resulting in increasing reliance on money manager and foreign investments for the sector.
Positively, the organic supply of agency mortgages to the market continued to decline into the -- in the quarter as refinancing activity and housing turnover slowed substantially, largely offsetting the decline in demand.
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 first quarter in gray. Exceptional performance in January was offset by underperformance in February and March with the sector ending the quarter modestly weaker.
As shown in the lower-left chart, nominal spreads remain attractive for current coupon MBS as uncertainty regarding monetary policy, further stress in the banking sector and asset liquidations weigh on valuations.
As indicated in the upper-right chart, specified pool pay-ups ended the quarter largely unchanged, while implied financing in the 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 first quarter. We increased leverage during the quarter from 5.3x debt to equity to 5.8x, reflecting a modestly more positive outlook on the sector with valuations at attractive levels and tightening of monetary policy nearing an end.
In addition, we further diversified our coupon allocation, investing proceeds from our ATM activity during the quarter into 30-year 4% specified pools, decreasing our sensitivity to interest rate volatility given purchase prices well below par.
We are largely insulated from direct exposure to asset liquidations from the FDIC as a substantial portion of their holdings are in lower-coupon 30-year and 15-year collateral while we remain in higher-coupon 30-year. In addition, we have no exposure to the deterioration in the dollar roll market for TBA securities as we were invested exclusively in specified pools at quarter end.
We continue to focus our specified pool allocation on pools that are expected to perform well in both a premium and discount environment. Although we anticipate elevated interest rate volatility to persist as the fixed income market continues to reflect the uncertainty in the banking sector, we believe current valuations on production coupon Agency RMBS largely price in this uncertainty and represent attractive investment opportunities with current ROEs on production coupons in the mid-teens.
Our remaining credit investments are detailed alongside our Agency CMO allocation on Slide 7. Our credit allocation was largely 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 unchanged as well, totaling $81 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.
Lastly, Slide 8 details our funding book at quarter end. Repurchase agreements collateralized by Agency RMBS increased to $4.8 billion given the increase in our specified pool holdings. And our weighted average repo cost increased to 4.9%, consistent with changes in short-term funding rates due to tightening monetary policy.
Positively, we also increased the hedges associated with those borrowings to $4.5 billion net notional of current pay-fixed received floating interest rate swaps, increasing our hedge notional to 93% 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. Our economic leverage ended the quarter modestly higher at 5.8x debt to equity versus 5.3x at year-end, reflecting our positive outlook on Agency RMBS given historically attractive valuations and unlikely and to the monetary policy tightening cycle.
To conclude our prepared remarks, the first quarter of 2023 was another challenging period for the Agency RMBS sector as uncertainty regarding monetary policy and its impact on the banking sector kept volatility elevated. However, our relatively modest leverage, combined with a bias for higher coupons that remain at attractive valuations and are largely insulated from bank liquidations, along with a notably high percentage of our funding cost hedged, leaves us well positioned for the current environment.
Further, earnings are well supported and our liquidity position is robust. While we anticipate potential near-term volatility, 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.
Question and Answer Session
Operator
(Operator Instructions) Our first question comes from Douglas Harter from Credit Suisse.
Douglas Michael Harter
Hoping you could talk about how you kind of see your current leverage and what capacity you would have to, if any, to take advantage of kind of current wide spreads?
Brian P. Norris
Doug, it's Brian. I think we would view current leverage kind of in the midpoint of where we would see our range. We certainly have capacity to add. We're somewhat hesitant to do that at this point just given continued elevated volatility. But as that volatility declines, we believe given current valuations that it would be attractive to do so.
Douglas Michael Harter
And just on that being attractive to do so, do you view that as kind of a longer-term attractive carry? Or do you see kind of meaningful potential for the basis to tighten?
Brian P. Norris
Yes. That's a good question. I think given what's going on with banks lately, the question is how involved they'll be with the sector on a longer-term basis. We do believe that they'll be somewhat involved, maybe not as much as they had been in the last couple of years. And certainly, the liquidations from the FDIC over the next, call it, 7 to 9 months will likely keep spreads relatively attractive over that time period.
So I think we're probably not in an environment where spreads will go back to where they were, call it, pre-COVID, but they will -- they should tighten modestly from here over the long-term period.
Operator
Our next question comes from Trevor Cranston from JMP Securities.
Trevor John Cranston
Can you talk a little bit more about how you guys are thinking about Agency MBS performing going forward as bank sales continue to hit the markets and if you think any other -- any further underperformance from here would likely be concentrated in the coupons that are being sold or if you think there could be some sort of sympathy widening in the higher coupons as well?
Brian P. Norris
Yes. Trevor, it's Brian. We do think that there will likely be continued kind of near-term volatility as liquidations work their way through the system. The lower coupons has held in relatively well this month. But we do think as we're only 3 weeks into liquidations and we still have, like I said, another probably 7 to 9 months of selling. So over that time period, we do think that spread volatility will remain somewhat elevated, which is why we're keeping our leverage kind of in the midpoint of our typical range.
So as those liquidations start to work their way through the environment, we think that it will probably make sense to take advantage of relatively attractive valuations at this point to move leverage mostly higher.
Operator
Our next question comes from Matthew Erdner from JonesTrading.
Matthew Erdner
Matthew on for Jason this morning. How are you valuing deploying capital in new investments versus share repurchases? And then in addition to the share repurchases, could you talk about the preferred a little bit?
John M. Anzalone
Yes. Thanks. This is John. Yes, I think the decision between new purchases and share buybacks, I mean, for new purchases like I think Brian mentioned on the call, we're seeing solidly mid-teens ROEs on new purchases. And depending on -- obviously, our book value and as mortgage valuations have been quite volatile. It's been bouncing around quite a bit.
So I think if we hit a time when our evaluations are low enough, I mean, we'll certainly look at buying back common. But given where we're seeing ROEs right now, we're not quite there yet. And buying back common would further make our common-to-preferred ratio out of line. So there's that hurdle also.
As far as preferreds go, I mean, we are certainly looking and we're aware that the preferred market in general, I mean, is another sort of secondary victim of the regional banking crisis given that whole sector is mostly made up of financials. And most mortgage REIT preferreds got swept up in that also recently.
So certainly, I think that where we are seeing them trading now, they've become much more attractive to try to go back and buy some. The challenge there always is just the limited trading volume that we see on a daily basis, but certainly we're going to make every effort to try to repurchase preferreds where we can.
Operator
I'm showing no further questions at this time.
John M. Anzalone
Okay. Well, thanks, everybody, for joining us, and we look forward to meeting again in about 3 months for our second quarter call. Thanks.
Operator
That concludes today's conference. Thank you for participating. You may disconnect at this time.
