Q2 2023 Invesco Mortgage Capital Inc Earnings Call
Participants
Brian P. Norris; CIO; Invesco Mortgage Capital Inc.
Greg Seals; IR; Invesco Mortgage Capital Inc.
John M. Anzalone; CEO; Invesco Mortgage Capital Inc.
Douglas Michael Harter; Director; Crédit Suisse AG, Research Division
Trevor John Cranston; MD & Equity Research Analyst; JMP Securities LLC, Research Division
Presentation
Operator
Welcome to Invesco Mortgage Capital Inc.'s Second Quarter 2023 Investor Conference Call. (Operator Instructions) As a reminder, this call is being recorded.
Now I'd like to turn the call over to Greg Seals, 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 the presentation that covers the topics we plan to address today. 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 M. Anzalone
Hi. Good morning, and welcome to Invesco Mortgage Capital's Second Quarter Earnings Call. I will 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 President, Kevin Collins; our CFO, Lee Phegley; and our COO, Dave Lyle.
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 negotiation and 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 inflation measures, led by the decrease in the headline Consumer Price Index to 3%.
Interest rates were sharply higher during the quarter, largely reversing the rallies 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 the payment 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 $11.98, representing a decline of 5% from March 31, 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 to $1.45 from $1.50 last quarter.
Our focus on higher-yielding, higher-coupon mortgages in combination with the hedging strategy that continues to benefit from low-cost, pay-fixed swaps drove the strength of EAD. Over the coming quarters, we expect EAD to remain well supported as we continue to hedge nearly all of our [legal] borrowings.
Importantly, these hedges refined benefit for the long term as the weighted average maturity of our pay-fixed swap portfolio is approximately 7 years.
ROEs on new investments have also been a positive contributor to EAD, benefiting from attractive spreads, favorable funding in our legacy swaps. Our debt-to-equity ratio ended the second quarter at 5.9x, 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 was invested in agency mortgages, and we maintained a sizable balance of unrestricted cash and unencumbered investments totaling $492 million.
The FOMC's 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.
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 conclusion and high mortgage rates limit supply. Commercial bench 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 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 P. 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 of Agency MBS during the quarter, concurrent with runoff of the Federal Reserve's balance sheet, resulting in 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 were liquidated by the end of the quarter. The FDIC liquidation has been executed on a significantly faster time line 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 in 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 from prepayment protection; while implied financing and dollar roll market for TBA securities remains 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 of loan balance stories given more attractive valuations during the quarter.
Although we anticipate elevated interest rate 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 depreciation, 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 cost increased to 5.2%, consistent with changes in short-term funding rates due to tightening monetary policy.
Positively, we also increased 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 5.9x debt to equity versus 5.8x at the end of March, reflecting our positive outlook on higher-coupon Agency RMBS, 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 received fixed swaps. Because the balance of our low-cost, pay-fixed swaps exceed our repo balance, we have 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 7 years, providing substantial benefit 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 tightening.
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.
Question and Answer Session
Operator
(Operator Instructions) And our first question comes from Doug Harter with Credit Suisse.
Douglas Michael Harter
You referenced the economic leverage at 5.9x. I guess, what is the current leverage to common? And which do you view as kind of the more of a gating factor in terms of your portfolio size?
Brian P. Norris
Doug, it's Brian. Yes, I think our leverage to common is right around 10x at this point. So I think, yes, that's typically the number that we look at as far as measuring the risk in the portfolio.
Douglas Michael Harter
Got it. And I guess just with that, do you have -- to the extent that we continue to go through bouts of volatility, I guess, do you have the ability to kind of hold on to portfolio size if this first few days of August continues? Or do you kind of need to risk manage the portfolio down? Just I guess, how do you think about that?
Brian P. Norris
Yes. I mean that number 10 has drifted a little bit higher here in the first part of August, and that's our current number. So at that level, we still have ample liquidity and have no need to readjust the portfolio. And I think that still gives us plenty of room as volatility declines to add to leverage as we see fit.
Douglas Michael Harter
Great. And then just on that, I mean I guess how do you view the current risk/reward, kind of how much more widening could we see from here given the wide starting levels? And what's your outlook as to how much spreads might tighten as volatility -- as or if volatility comes down?
Brian P. Norris
Yes. Spreads on kind of higher coupon or production coupons are, call it, between 175 and 200 versus SOFR swaps. And at this point, given the underperformance that we've seen here over the last week, we're getting pretty close to the lives that we saw in March and in October of last year. So at maybe, call it, another 10 basis points wider, we saw a pretty significant demand come in from the money manager community. So we would expect, if volatility were to kind of fade from current levels, that we would see that amount of support again.
Operator
Our next question comes from Trevor Cranston with JMP Securities.
Trevor John Cranston
Can you guys talk about where you see the current duration gap on the portfolio and how much net exposure you have to steepening of the yield curve? And then I guess, as a second part of the question, could you just give us an update on where you're seeing book value currently this quarter?
Brian P. Norris
Yes, I'll take the first part of that on duration gap. We typically target between 0.5 year and 1 year, and that number will move around as interest rates change. So given the selloff that we've seen, we're probably towards the higher end of that range.
From a yield curve perspective, we try to stay relatively neutral. The swap book that we have, the reason that we have such longer-dated swaps is just given the profile of the mortgages that we own. So we stay relatively neutral from that perspective.
And then from a book value, we put a range out for the end of July, which showed relatively unchanged from quarter end. And there has been some underperformance certainly as we started the month of August here as rates have moved higher, and this volatility has also increased mortgages and underperformed.
Operator
I'm showing no further questions in queue.
John M. Anzalone
Okay. Well, thank you, everybody, for joining us on the call, and we look forward to speaking again next quarter. Thanks.
Operator
Thank you. And that concludes today's conference. You may all disconnect at this time.
