Q3 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.

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 Third 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 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 the 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 or guarantee the accuracy of our earnings teleconference transcripts provided by third parties. The only authorized webcast 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

Good morning, and welcome to Invesco Mortgage Capital's Third 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.
The market environment was extremely challenging during the third quarter, given shifting expectations for fiscal and monetary policy. Interest rate volatility remained elevated while treasury yields increased to their highest level since 2007. This backdrop was particularly difficult for agency mortgages as fringe reached multiyear lives across the coupon stack and specified pool pay-ups declined. These conditions contributed to a 17% decline in our book value per share for the quarter.
Elevated volatility and rising interest rates continued in the first few weeks of the fourth quarter, accelerating agency mortgage underperformance. Sentiment turned more positive last week, fueled by investors' growing confidence that the FOMC's tightening cycle has ended. Positively, investors seeking to capitalize on historically cheap agency mortgage valuations have recently allowed the sector to recover a portion of this early fourth quarter losses.
We estimate that as of November 3, our book value has declined to a range of $9.07 to $9.45 per share. Despite the extreme volatility, earnings available for distribution remained strong during the quarter, coming in at $1.51 per share as we continue to benefit from our low-cost hedges as well as very attractive ROEs on new investments.
Our debt-to-equity ratio ended the quarter at 6.4x with substantially all of our $5.4 billion investment portfolio invested in agency mortgages, and we maintained a sizable balance of unrestricted cash and unencumbered investments totaling $392 million.
First quarter end, we responded to elevated interest rate volatility and further pressure on agency mortgage valuations by actively reducing the size of our portfolio, bringing our debt-to-equity ratio down to approximately 4.3x at the end of October. This reduction and risk will impact our earnings -- are commensurate with our reduction in assets.
We remain cautious in the near -- on the near-term outlook for the sector given the uncertain path of disciplined monetary policy and heightened geopolitical risks. However, the potential reduction in interest rate volatility associated with the eventual normalization of monetary policy should be supportive of our target assets. Agency mortgage supply and demand dynamics are expected to improve in the coming quarters as loan originations remain low in the case of elevated interest rates and seasonal factors.
Commercial banks should also soon receive greater clarity on the regulatory requirements, which could encourage further deployment of capital away from loans and into lower risk-weighted assets, such as agency mortgages.
Finally, valuations and production coupon agency mortgages remain historically attractive, and funding capacity is robust. While we remain cautious in the near term due to elevated volatility, we believe over time, the decline in interest rate volatility in a supportive technical environment, combined with compelling valuations and favorable funding conditions should create attractive agency mortgage investment opportunities for long-term investors.
I'll stop here, and Brian will go through the portfolio.

Brian P. Norris

Thanks, John. Good morning to everyone listening to the call. I'll begin on Slide 4, which provides an overview of the interest rates and agency mortgage markets year-to-date. As John mentioned and as shown on the chart in the upper left, yields on longer maturity U.S. treasuries rose sharply in the third quarter and a bear flattening move.
Short-term rates rose modestly as the slowdown in inflation data signaled an impending pause and monetary costs tightening, while yields on treasury is maturing between 5 and 30 years increase between 45 and 85 basis points, as investors price the risk at a resilient economy and substantial treasury issuance would impact the longer-term path of rates.
By the end of the third quarter, pricing in the Fed funds futures market reflected a higher for longer stance by the Federal Reserve, pushing expectations for cuts into the second half of 2024. These trends intensified into October as interest rates and interest rate volatility moved higher post quarter end.
As shown in the lower right chart, U.S. commercial banks further reduced their holdings of Agency RMBS during the quarter. Concurrent with runoff of the Federal Reserve's balance sheet, resulting in an increased reliance on money manager and overseas investment to support Agency RMBS valuations. While overseas investment in the asset class has been robust in recent months, mutual fund outflows dampened demand from a money management community that was already overweight the sector with little room to add exposure.
In addition, organic net supply of agency mortgages to the market increased during the quarter as housing seasonal strengthened while the remaining specified tools held by the FDIC were liquidated by the end of the quarter. Taken together, supply and demand technicals worsened during the quarter, providing a tenuous environment as interest rate volatility increased.
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. Treasury since year-end, highlighting the third quarter in gray. Production coupon Agency RMBS performed poorly during the quarter as investor expectations for monetary and fiscal policy fluctuated, leading to sharply higher interest rate volatility.
Current coupon valuations ended the quarter significantly lower versus treasuries and Agency RMBS spreads widened approximately 20 to 25 basis points across the coupon stack. In addition, specified pool pay-ups continue to decline as interest rates increase, as indicated in the chart on the top right. As shown in the lower right chart, the dollar roll market for TBA securities remained unattractive as more recent issuance with higher loan balance have a less attractive prepayment profile and the lack of consistent bank demand negatively impacted technicals. Although Agency RMBS underperformed in October, the market did stabilize in the latter part of the month as investors selling dissipated and volatility subsided modestly.
Slide 6 provides detail on our Agency RMBS investments and portfolio changes during the quarter. Our portfolio of Agency RMBS decreased marginally over the quarter as the combination of higher interest rates and wider spreads led to lower prices on our assets. We remain focused and 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 remain exclusively invested in specified pools with no exposure to the deterioration in the dollar roll market for TBA securities. We continue to modestly improve the quality of our specified pool holdings by increasing our allocation to lower loan balance stories given more attractive valuations during the quarter.
Although we anticipate elevated interest rate volatility to persist near term, we believe current valuations on production coupon Agency RMBS largely priced in this risk 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 declined during the quarter to $34 million due to pay downs. Our credit allocation remains high quality with 83% rated AA or higher. Our allocation to agency interest-only securities detailed on the right side of Slide 7 remained unchanged totaling $78 million at quarter end. Although we anticipate limited near-term price appreciation in our credit and Agency IO investments, we believe these assets are attractive unlevered holdings that provide favorable yields.
Slide 8 details our funding and hedge book at quarter end. Repurchase agreements collateralized by Agency RMBS remained at $5 billion, and our weighted average repo cost increased to 5.4% consistent with changes in short-term funding rates due to tightening monetary policy. Repo spreads were relatively steady during the quarter and counterparty appetite remains strong.
Positively, we increased the hedges associated with those borrowings to $5 billion net notional of current pay fixed to receive floating interest rate swaps, increasing our hedge notional to 99% of borrowings and mitigating the impact of higher borrowing rates on the earnings power of the company during the quarter.
Our economic leverage ended the quarter modestly higher at 6.4x debt to equity versus 5.9x at the end of June, mostly reflecting the decline in book value over the quarter. Positively, our liquidity position at quarter end remained robust with $392 million of cash and unencumbered investments representing approximately 7% of our investment portfolio.
Slide 9 provides further detail on our interest rate swap portfolio. At the end of the third quarter, we held $5.9 billion notional of low-cost pay fixed swaps and $950 million notional of received fixed swaps. Given the significant challenges presented during the quarter, we modestly repositioned the hedge book to extend the weighted average maturity of our pay fixed swaps and reduce the majority of our receive fixed loss.
Because the tenor of our low-cost pay fixed loss was over 7.5 years, we were largely able to avoid adding new pay fixed loss at higher rates, as the durations on our Agency RMBS extended into the most recent sell-off, with our average pay fixed rate increasing from 0.45% to 0.79% quarter-over-quarter.
Slide 10 provides an update on our asset and hedge portfolio as of October 31, which should offer a helpful picture of the changes we made post quarter end. Since the end of the third quarter, we aggressively reduced leverage as elevated interest rate volatility led to sharp declines in our Agency RMBS valuations.
As a result, our debt to equity leverage declined from 6.4x to 4.3x in October. Liquidity remained robust as our cash and unencumbered investments increased to $444 million. As you can see in the top left chart, we remain allocated to higher coupon Agency RMBS and our specified pool allocation is now of higher quality with nearly 50% of our holdings and loan balance collateral.
In addition, we also reduced the size of our hedge book commensurate with the reduction in our assets with our pay fixed swap hedges declining from $5.9 billion at quarter end to $3.9 billion at the end of October. Positively, our average pay fixed rate declined marginally from 0.79% to 0.76% and the weighted average maturity of our hedges is now 8.6 years, providing support for the earnings power of the company.
To conclude our prepared remarks, the third quarter of 2023 was yet another very challenging quarter for Agency RMBS investors, as interest rate volatility increased sharply once again. We believe our bias for more attractively priced higher coupon specified pools leaves us well positioned in the near term, given the potential for a further decline in interest rate volatility as the Federal Reserve seeks to conclude monetary positive tightening.
Further, our liquidity position is robust as leverage remains well below historical averages for an Agency RMBS focused strategy. As a result, IVR is well positioned to navigate future mortgage market volatility and selectively capitalize on historically wide Agency RMBS spreads. While we anticipate potential near-term volatility as monetary policy tightening concludes, we believe current valuations provide a supportive backdrop for the 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) The first question in the queue is from Trevor Cranston with JMP Securities.

Trevor John Cranston

I think you guys took leverage down to, I guess, pretty conservative level as of the end of October. Can you talk about if that level is when you're comfortable staying after the near term? And given the negative earnings impact of the asset sales you mentioned, can you maybe talk a little bit about how you're thinking about the dividend in that context?

Brian P. Norris

Trevor, it's Brian. I'll start with the leverage comment before turning it over to John for the dividend. Leverage, yes, is certainly well below kind of our longer-term average here as an agency mortgage only REIT. We do think that given the level of volatility currently in the market that a conservative approach is warranted.
And so while probably if we were to be in a modestly lower interest rate vol environment, leverage would probably look a little closer to where we were at the end of June. Given where we are right now, we think a more conservative approach is margin.

John M. Anzalone

Yes. And Trevor, it's John. I mentioned the dividend. Yes. So I mean, first of all, the dividend is driven by our Board, and I can't comment directly on interaction, this will be determined late next month. But I can't say the earnings power has declined longer-term leverage, but keep in mind that EAD had been covering a dividend by a fairly significant margin in recent quarters.
And then there are several factors that we consider when setting the dividend among them, EAD, obviously, one of them along with historical prospective return profile of our target assets and then dividend yields available in the sector. So I mean, there's a bunch that goes into it. It's like -- but that will be determined later by our board.

Trevor John Cranston

Okay. That's it.

Operator

And the next question in the queue is from Matthew Erdner with JonesTrading.

Matthew Erdner

So you mentioned part of the portfolio kind of going to the lower loan balance production coupon. I believe at the end of the quarter, the distribution amongst coupons was pretty balanced. So going forward, should we expect a higher percentage of the portfolio to be concentrated in those new production and higher coupons?

Brian P. Norris

Yes. Matt, it's Brian. Yes, it's likely that as we move forward here, we'll -- we would look to add in higher coupons. You'll notice on the October 31 slide that we did add a modest amount of 6% coupon, which was in addition relative to where we had been along the coupon stack. So I think that's a pretty good estimate of where new purchases would occur going forward.

Operator

And I'm showing no further questions at this time.

John M. Anzalone

Okay. Well, I'd like to thank everybody for joining us on the call, and we look forward to speaking, I guess, in February. Thanks.

Brian P. Norris

Thank you.

Operator

This concludes today's call. Thank you for your participation. You may disconnect at this time.