Invesco Mortgage Capital Inc. (IVR) Q3 2023 Earnings Call

Invesco Mortgage Capital Inc. (NYSE:IVR) Q3 2023 Earnings Conference Call November 7, 2023 9:00 AM ET

Company Participants

Greg Seals - Investor Relations

John Anzalone - Chief Executive Officer

Kevin Collins - President

Lee Phegley - Chief Financial Officer

David Lyle - Chief Operating Officer

Brian Norris - Chief Investment Officer

Conference Call Participants

Trevor Cranston - JMP Securities

Matthew Erdner - JonesTrading

Operator

Welcome to Invesco Mortgage Capital Inc.'s Third 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 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 Web site at invescomortgagecapital.com. This information can be found by going to the Investor Relations section of the Web site.

Our presentation today will include forward-looking statements and certain non-GAAP financial measures. Please review the disclosures on slide two 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 Web site. Again, welcome, and thank you for joining us today.

I'll now turn the call over to John Anzalone. John?

John Anzalone

Good morning, and welcome to Invesco Mortgage Capital's third quarter earnings call. I'll make some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, who will discuss the current portfolio in more detail. Also joining us on the call are President, Kevin Collins; our CFO, Lee Phegley; and our COO, David 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 [trends reached] (ph) multiyear wides across the coupon stack, and specified pool payouts declined. These conditions contributed to a 17% decline in our book value per share for the quarter. Elevated volatility and rising interest rates continued into the first few weeks of the fourth quarter, accelerating agency mortgage underperformance.

[Sentiment] (ph) 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 the 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 6.4 times, 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. Post 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 4.3 times the end of October. This reduction in risk will impact our earnings or commensurate with our reduction in assets.

We remain cautious on the near-term outlook for the sector given the uncertain impact of fiscal and 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 face of elevated rates and seasonal factors. Commercial banks should also soon receive clarity on the regulatory requirements, which could encourage further deployment of capital away from loans and into lower risk-weighted assets such as the agency mortgages.

Finally, valuations in 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 and a supportive technical environment combined with compelling evaluations 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 Norris

Thanks, John, and good morning to everyone listening to the call. And I'll begin on slide four, which provides an overview of the interest rate and agency mortgage markets year-to-date. As John mentioned, and as shown in the chart in the upper-left, yields on longer maturity U.S. treasuries rose sharply in the third quarter in a bear-flattening move. Short-term rates rose modestly as the slowdown in inflation data signaled an impending pause in monetary policy tightening, while yields on treasuries maturing between five and 30 years increased between 45 and 85 basis points, as investors price the risk that 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 the expectations for cuts into the second-half of 2024. These trends intensified into October as the 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 run-off 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 our money manager 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 housing seasonals strengthened. While the remaining specified pools held by 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 five provides more detail on the Agency RMBS market. In the left chart, we show 30-year current coupon Agency RMBS performance versus U.S. treasuries since yearend, 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 RBMS spreads widened approximately 20 to 25 basis points across the coupon stack. In addition, specified pool pay-ups continued to decline as interest rates increased 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 pre-payment 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 details 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 remained focused in more attractively priced higher coupon, which are largely insulated from direct exposure to assets held by the FDIC and on the Federal reserves balance sheet.

In addition, we remained 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 along side our agency CMO allocation on slide seven. Our credit allocation declined during the quarter to $34 million due to pay-downs. Our credit allocation remains high quality with 83% rated double A or higher. Our allocation to Agency interest only securities detailed on the right side of the slide seven 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 eight details 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 remained strong.

Positively, we increased the hedges associated with those borrowings to $5 billion net notional of current pay-fixed receive-floating interest rate swaps. As you know, increasing our hedge notional to 99% of borrowings and mitigating the impact of higher borrowing rates on the earnings power of the company quarter. Our economic leverage ended the quarter modestly higher at 6.4 times debt to equity versus 5.9 times 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 nine 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 receive-fixed swaps. Given the significant challenges presented during the quarter, we modestly repositioned the hedge book to extend the weighted average maturity of pay-fixed swaps and reduce the maturity of our receive-fixed swaps. Because the tenure of our low cost pay-fixed swaps is over 7.5 years, we were largely able to avoid adding new pay-fixed swaps 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 portfolios 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 short declines in our Agency RMBS valuations. As a result, our debt-to-equity leverage declined from 6.4 times to 4.3 times 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 in 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 swaps 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 policy tightening. Further, our liquidity position is robust as leverage remained 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

The phone lines are now open for questions. [Operator Instructions] The first question in the queue is from Trevor Cranston with JMP Securities. Your line is open.

Trevor Cranston

Hey, thanks. Good morning. I think you took leverage down to a pretty conservative level as of the end of October. Can you talk about if that level is one you're comfortable for 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? Thanks.

Brian Norris

Yes, hey, Trevor, it's Brian. Good morning. And I'll start with the leverage comment before turning it over to John for the dividend. Leverage, yes, it's certainly well below 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 [volatile] (ph) 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 warranted.

John Anzalone

Yes, and hi, Trevor, it's John. And you mention the the dividend. First of all, the dividend is driven by our Board, and I can't comment directly on interaction through these turbulent wait next month. But I can say the earnings power has declined along with our leverage, but keep in mind that EAD had been covering its dividend by a fairly significant margin in the 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 and prospective return profile of our target assets, and then dividend yields available in the sector. So, there's a bunch that goes into it, but that will be determined later by our Board.

Trevor Cranston

Okay, that's it. Thank you.

Operator

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

Matthew Erdner

Hey, good morning, guys. Thanks for taking the question. So, you mentioned as part of the portfolio 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 Norris

Yes, Matt. Hey, it's Brian, good morning. Yes, it's likely that as we move forward here, 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.

Matthew Erdner

Got it, thank you.

Operator

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

John 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.

Greg Seals

Thank you.

Operator

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