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Invesco Mortgage Capital Inc. (NYSE:IVR)

Q4 2013 Earnings Conference Call

February 20, 2014 8:30 a.m. ET

Executives

Richard King – Chief Executive Officer

John Anzalone – Chief Investment Officer

Don Ramon – Chief Financial Officer

Analysts

Nick Agarwal -Wells Fargo

Steven DeLaney – JMP Securities

Mark DeVries – Barclays

Kenneth Bruce – Bank of America Merrill Lynch

Unidentified Participant

This presentation and comments made in the associated conference call today may include forward looking statements. Words such as believes, expects, anticipates, intends, plans, estimates, projects, forecasts and future or conditional verbs such as will, may, could, should and would as well as any other statement that necessarily depends on future events are intended to identify forward looking statements. Forward looking statements are not guarantees and they involve risks, uncertainties and assumptions, there can be no assurance that actual results will not differ materially from our expectations.

We caution investors not to rely unduly on any forward looking statements and urge you to carefully consider the risk identified under the captions, risk factors, forward looking statements and management discussion and analysis of financial conditions and results of operations in our annual report on Form 10-K and quarterly reports on Form 10-Q which are available on the Security and Exchange Commission’s website at www.sec.gov. All written or oral forward looking statements that we make or that are attributable to us are expressly qualified by this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward looking statement later turns out to be inaccurate.

Operator

Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital investor conference call. All participants will be on a listen-only mode until the question-and-answer session. [Operator instructions] Now, I would like to turn the call over to your speakers for today, Richard King, Chief Executive Officer; John Anzalone, Chief Investment Officer; and Don Ramon, Chief Financial Officer. Mr. King, you may begin.

Richard King

Good morning and as always thank you for joining us. Our goals for the call today are to give our shareholders an understanding of what drove the fourth quarter results and then more importantly share our vision of the future of this company. We want investors to understand where we intend to take Invesco Mortgage Capital and why we’re so excited about it. First, let me take a few minutes to cover the Q4 results.

Our goal in the fourth quarter was to continue to reposition the portfolio for stability of book value and the dividend. We use cash flows to do primarily two things. The first was to buy back our shares which was an attractive use of capital because the discount was nearly 20% and we bought 10.7 million shares and spent just over $160 million in the fourth quarter.

The second use of cash was to invest in each of our three initiatives which are also attractive because we believe they’ll help us to stabilize book value, stabilize core earnings and ultimately that should help the shares to trade at a premium. We did put meaningful capital to work in each of the commercial real estate loans, risk sharing transactions and our prime jumbo securitization where we've retained the subordinate tranches.

As agency mortgage prices rallied early in the fourth quarter following the no taper decision at the September Fed meeting, we sold some 30 year agency mortgages and used proceeds to buy several [ph] hybrids to further reduce duration and agency mortgage spread duration.

We were able to generate core earnings of $0.48, very close to the $0.50 dividend and importantly reposition the portfolio to better maintain that dividend in 2014. Book value grew during the quarter by 1.9%. You can see in the book value graph on the lower left of the Slide 2. The gains from interest rate swaps, which are meant to hedge the rate risk in our agency, mortgage and our CMBS, were nearly equal to the combined net book value decline in those two sectors. The $0.17 per share improvement in the value of our non-agency, residential mortgage-backed securities portfolio, which is largely adjustable rate and fairly interest insensitive along with a positive $0.23 impact of share, repurchases drove the increase in book value.

It is interesting to note that rates on 5 and 10 year treasury notes rose 35 to 40 basis points in the fourth quarter and we managed to grow book value even before share repurchases. Year-to-date in 2014 with rates on five and ten year treasury notes lowered by 23 to 30 basis points respectively, we estimate book values up another 2%. We’re transitioning industrial mortgage capital from being diversified on securities i.e. agency MBS, legacy non-agency RMBS and CMBS to a strategy that also includes significant commercial real estate lending providing -- and providing private subordinate capital to the residential mortgage market.

On the next slide, let me tell you what we believe, and our strategies based on IVR’s core principles. Our primary mission is to create and maintain shareholder value. Create and maintain shareholder value means generating attractive core earnings and dividends, and removing much of the book value volatility that we’ve seen in the past. We believe investing in quality underlying assets creates more predictable outcomes and provide principal preservation.

We believe that finding relative value across the entire U.S. mortgage market where we have expertise and competitive advantage. We believe asset liability management is important to stability and it starts on the asset side -- that means we'll invest in assets that need less leverage or need less hedging or are more hedgable.

We'll also focus on those mortgage assets that lend themselves to more permanent and resilient funding sources. Again, our goals for the future are to focus on book value stability and generate attractive dividends over the long-term.

We believe we have all the necessary people, resources, scale, sourcing, counterparty relationships, platform and risk management to deliver a diversified portfolio with the necessary expertise and competitive advantage. And given that expertise and resources, a more diversified set of assets and risks will generate higher risk adjusted returns for our IVR shareholders.

We also believe that there exists a void in the mortgage market, a void that we can help to fill by helping the government to shrink tax payer risk related to housing and by working with banks to supply capital displaced by a regulatory change. Our CIO, John Anzalone will now tell you more about out investment strategy.

John Anzalone

Thanks Rich, and thanks again to everyone joining us on the call. I will expand on Rich’s comments starting with a review of where the portfolio is today, how it’s evolved over the past year and where we see opportunities in the future. I’ll start on Slide 4 with the portfolio update.

As Rich just discussed, during the quarters of 2013 we reallocated the portfolio to significantly reduce our interest rate exposure -- to increase our exposure to improving fundamentals by adding credit assets. The pie charts on the left side of the graph illustrate the shift.

In terms of reducing interest rate risk, we reduced our overall exposure to agency mortgages from 72% of assets, down to 56.8% of assets, which is a reduction of $2.4 billion during 2013. We also reduced our exposure to 30-year collateral within our agency book, which I'll talk about in more detail in a minute.

As such, we reduced our equity duration, which is duration gap times leverage, to approximately 5.4 years at year end. As we moved away from agencies, we were also able to reduce our leverage allocated to repo from 6.1 to 5.7 times. As we moved away from agencies we reallocated capital to the credit side. Non-agency RMBS increased from 16.6% of assets, up to 19.6%, an increase of $696 million and our allocation to CMBS increased from 11.1% of assets, up to 13.6% which represented $584 million.

We also made progress on the loan side, participating in five securitizations on the residential side which represented $1.8 billion and four CRE loans representing $64 million. I'll now talk in greater detail in each sector.

I’ll start with agency mortgages on Slide 5. As you can see on the pie charts, not only did we reduce our absolute exposure to agencies, we also reduced our exposure to 30-year collateral considerably. 30-year fixed rate agencies now represent 61% of our agencies, down from 75% a year ago. The difference is made up in hybrid ARMs which went from 5% last year up to 18.5% at this year-end.

Within agencies we continue to favour hybrids over 30-year collateral as valuations still look attractive and we prefer the short duration and convexity profile in the sector. Over the year we also reduced our leverage on the sector by half a turn and while we reduced our agency book, we did not reduce our hedges. This brought the percentage of our agencies hedged up from 76% to 137% at year end.

We also had seen a couple of tailwinds in agencies as prepayments have slowed dramatically with our 30-year collateral now paying about six CPR and hybrid speeds falling to eight CPR. And repo rates on agencies have trended lower over the past few months.

As our investment in the agency side has fallen, we’ve increased our investment in credit assets. Turning to Slide 6, I’ll start with our non-agency book. As I mentioned earlier we increased our exposure to non-agencies by $696 million during 2013. The composition of this book has also changed quite a bit as we went from just under 16% senior re-REMIC in December 2012 to 38% at the end of last year. This is largely result of prepayments and we reinvested those proceeds and then some into assets that have a greater exposure to the recovery in housing. These investments have been made in a combination of legacy bonds, new issue bonds as well as GSE risk sharing transactions which I’ll talk about in more detail on a few slides.

Moving to Slide 7 on CMBS, there is similar story in the CMBS side as we were able to increase our CMBS balance by $584 million during 2013. Investments in recently originated credit CMBS 2.0 has increased to two-thirds of our CMBS book, up from 56% at 12/31/12. Fundamentals in the commercial real estate have continued to improve albeit at a more moderate phase. Given this backdrop we've been favouring higher quality bonds off of new issue credits.

At this point, I'd like to expand on some of the opportunities that we see ahead of us. When thinking about the current environment, there are several characteristic that we are looking for in any opportunity. The first is that we favour assets that can achieve maturing targets using less repo financing. CRE loans, subordinates off of newly originated residential collateral and GSE risk sharing deals all meet that criteria. The second thing we are looking for are investments that are either floating rates or have minimal rate exposures. CRE loans, the GSE risk sharing deals as well as agency hybrids meet that one.

Finally, we want to increase our exposure to improving credit fundamentals. On that front, CRE loans, subordinates off of newly issued residential loan and the GSE risk sharing deals fit that profile. So increasing our exposure to meet opportunities will result in less interest rate exposure, less dependence on repo financing as well as the more diversified asset mix. I’ll go through these opportunities in more detail starting with commercial real estate loans on Slide 9.

The opportunity in commercial real estate lending is significant. The chart on that right shows the CRE loan maturity schedule and it’s not hard to see that the need for mezzanine financing is going to continue to grow. There are $360 billion of loans collateralizing CMBS that will need new refinancing over the next four years and there is more than $1.3 trillion in total CRE maturing over that same period. We expect that approximately $100 billion of CRE mezz debt will be created over the next five years, we would like to see our allocation here grow significantly over that timeframe.

So as these make sense for us, I've really talked about how CRE fits our desire for short duration assets, as well as giving us exposure to improving credit fundamentals. We also believe that we can finance these via exchangeable notes into [ph] a warehouse facility to enhance our returns. And as our portfolio grows, we'll have the options to securitize loans and redeploy capital.

We also believe that we have the competitive advantage in this space through Invesco’s real estate platform. IVR work synergistically with our Invesco real estate team to not only source loans but to provide due diligence and provide us with 30 years of equity real estate experience if we ever need to take over our property. Importantly, access to this platform comes in no additional expense to IVR shareholders.

We are beginning to gain momentum as our pipeline grows and we begin to close loans. So far we have closed four loans, investing $64 million and you can just see these numbers grow over the coming quarters. The economics of this opportunity are attractive with unleveraged yields ranging from approximately 4% to 10% and by utilizing modest leverage can achieve our target ROE in this sector of 10% to 12%.

The second opportunity that I want to discuss is residential securitizations on Slide 10. Much like the CRE opportunity, the potential size of the private label securitization space is very large. The U.S residential market is just under 10 trillion and if you look at the chart on the upper right of the slide, private label securitization has been very slow to recover. However we believe that we will see volumes grow over the next three to five years.

IVR has been active in this space as we are participating in five securitizations as of year-end. We've retained the subordinate classes of these structures, giving us exposure to loans that have been made in an environment with excellent underwriting standards. And our five deals which totaled just under 2300 loans in $1.8 billion, we have zero 60 plus delinquencies, we have seen the average LTV of these loans improved from 68% to 62% as home prices have increased.

The target ROE of these deals is 10% to 12% and we saw the execution of triple A tranches improve late last year. We expect that trend will continue, which will help support ROEs. This has [ph] been attractive ROEs securitizations are for IVR several other benefits, these include the ability to replace repo financing with permanent match funded non-recourse leverage and also gives us access to the interest only tranches which help protect us from interest rate risk.

The last opportunity I want to discuss is GSE risk- sharing on Slide 11. Like the last two opportunities, we believe the potential opportunity here is large. GSE pool issuance [ph] has averaged over 1 trillion per year and risk-sharing is the key part of FHFA’s plans to reduce the government's role in housing finance.

During 2013 these deals referenced almost $88 billion loan balance and approximately $1.8 billion in securities were issued. These deals have been very well received by the market and we believe that issuance will be larger to this year than last and that they will be commonplace thereafter. We also expect the GSEs to offer senior substructures which will represent another great opportunity for us to participate.

Underwriting residential loans is one of IVR strengths and we are well positioned to provide private, first loss capital in this space. We participate in each of the risk sharing deals so far and we are targeting the return of approximately 12% when employing modest leverage. We started giving us access to subordinate bonds and well under collateral. These deals also lessen our dependence on repo financing endeavour [ph] and because they have a floating rate coupons they also help protect us from rising rates.

With that I'll turn it back over to Rich to wrap up.

Richard King

Thanks, John. Invesco Mortgage Capital is positioned to capitalize on the future of the U.S mortgage market. In 2009 through 2012 mortgage investors were rewarded to simply accept interest rates and credit risk, but that was not the case in 2013 and it will require more for mortgage rates to thrive in the future and prices of shares in the mortgage REIT space reflects that view. Our goal in 2014 is to differentiate Invesco Mortgage Capital giving investors' confidence that we can and will continue to earn strong dividend, but with significantly lower book value volatility. We’ve outlined today the strategies we believe will best capture attractive returns prospectively.

On Slide 12 why we believe we’re the best positioned to executive on these initiatives? We have a business model that’s flexible. We have a strategy that’s forward looking and an opportunity set that is broad. We have a team with a breadth, experience and expertise needed to underwrite properties and borrowers. A team that is stable and one that avoid the mistakes that led to the mortgage crisis. Finally, we have a platform that provides the necessary resources, among them unique loan sourcing opportunities and strong counterparty relationships that improve sourcing and funding. We aim to provide investors with a way to capture the opportunities available today and a very well underwritten mortgage credit without accepting inordinate interest rate risk and volatilities associated with rising rates.

That concludes our prepared remarks. Operator, please open up the line for questions.

Question-and-Answer Session

Operator

Thank you. [Operator instructions] And our first question comes from Trevor Cranston from JMP Securities and sir your line is open.

Richard King

Trevor I’m sorry we can’t hear you are you on [Indiscernible]

Operator

Mr. Cranston your line is open. Please proceed with your question.

Richard King

Operator let's proceed with the next and then we can come back to Trevor.

Operator

Thank you. And our next question comes from Nick Agarwal, Wells Fargo Securities. And sir your line is open.

Nick Agarwal -Wells Fargo

Hey, good morning, guys. A quick question on the active pipeline, can you give us a sense of what the size is on the CRE?

John Anzalone

We have a deal log, it's relatively long. I can’t give you a number but we have a number of deals that we’re working on now.

Nick Agarwal -- Wells Fargo

Okay. So is it safe to assume that roughly the $64 million is a good run rate on a quarterly basis then?

John Anzalone

We -- I think we hope to do more than that but that that may be a good assumption for the short-term.

Nick Agarwal -Wells Fargo

And on the resident securitization side, did five deals last year, are you also still targeting roughly a deal a quarter?

John Anzalone

Yeah, we can -- if we can get that we would like to do that.

Nick Agarwal – Wells Fargo

And are you able to continue to see those deals given the bank appetite for this collateral?

John Anzalone

Yeah, I mean, we've been seeing one approximately one every quarter, so we'd expect that continue.

Nick Agarwal -Wells Fargo

Okay. Great thanks guys.

Operator

[Operator instructions]

Richard King

Operator, are there any other further question?

Operator

And excuse me I do have Steve DeLaney, JMP Securities. Your line is open.

Steven DeLaney – JMP Securities

Hi, good morning every one and apologies Trevor was on the call but from New York and I think he lost the connection somewhere and probably off the cell phone. So I’m going to jump in for him if I may?

Operator

And we have Mark DeVries and that was with Barclays, your line is open.

Mark DeVries – Barclays

Okay. Sorry about that Steve. So first question, I know you mentioned that you didn’t really change your hedge position even though you are selling agencies. Could you just talk a little bit about kind where you think your net duration is at this point, particularly factoring any kind of other non-agency CMBS you may have some positive duration associated with it?

Richard King

Yeah. At year end I think we pointed out net – an equity duration of around little over five and it’s somewhat less than that now, but still probably in the four to five range. Just commenting on that, we have been seeing a lot of book value volatility around rate note and we've pointed out that in the fourth quarter we saw rates up quite a bit, book value was up a little bit and so far this quarter rates are down, book value is up a little bit. So we definitely are in a position where the direction of movement in rates isn’t having a great impact on our book value.

Mark DeVries – Barclays

Okay. And then the next question on just a little more detail on the GSE risk-sharing transactions. I think John you mentioned you're looking for kind of 12% level returns on that. Can you just give us a little bit more detail and kind of what the yields are on that and what kind of expected losses are embedded and what amount of leverage you would look to apply?

John Anzalone

Right so on the, I guess, on all the deals on the lower tranche –two [ph] tranche – spreads are approximately LIBOR plus before in a quarter and they've kind of settled in around that range. So applying a couple turns of leverage on there, on them, gets us to low double digit yields. Financing on that has been pretty attractive and we’ve seen haircuts in the 20%-ish range with rates kind of somewhere in that LIBOR plus one fifty.

Richard King

And losses on those pools are likely to be absorbed by the first 30 day basis points [ph] that GSEs are keeping.

Mark DeVries – Barclays

Got it. Okay, thanks.

Operator

And our next question comes from Ken Bruce, Bank of America Merrill Lynch. Your line is open.

Kenneth Bruce – Bank of America Merrill Lynch

Hi. So thank you for the information just in terms of what you’re, kind of directing or redirecting the portfolio into. Is there a target portfolio or an allocation that you have kind of in your mind as to what would be optimal at this point? Is that the proper way to think about it that you are trying to get to a kind of a target portfolio and that – at the point that you’re at that steady state that we can effectively model it or do you expect this strategy to drift around a bit more over the next year or so?

Richard King

Well, we have a hybrid business model. And we’re looking for the best risk adjusted returns across the mortgage space. We’re not targeting X percentage of the portfolio to be in each category, ad infinitum. But we do believe that we’re moving towards lower repo balances and more assets where they either don’t need financing or needs less to earn close to 12% ROE. So we’ve outlined that we could get CRE loans up to 25% or 30% residential securitization. We expect that that will continue to grow over time and that we will see more opportunities than say the one quarter. And we also expect the risk sharing to grow. So the absolute percentage of the entire portfolio that’s in each of those things and then the securities finance at repo will depend on the opportunities set as we go forward.

Kenneth Bruce – Bank of America Merrill Lynch

And is it appropriate to think about IVR as it’s trying to manage the portfolio to that hurdle rate, say, maybe it’s 12% today. That will likely drift around a bit. But, as you see the alternative opportunities to invest in the portfolio that the company is going to deleverage over time, I guess I’m just trying to think about how to model your business understanding that there are these different opportunities to invest today. They seem to have very good returns with a lot less leverage given where rates are likely headed. I think that’s probably a good position to be taking, but just trying to think through how it’s going to evolve over time is I guess, one of the challenges that we’re having given the broader diversity today.

Richard King

Yeah, that’s exactly right. We’ll be deleveraging over time. So you could assume that the securities portfolio may remain leveraged cost five and a half times like it is today. But the percentage of our equity that’s invested in that space will continue to decline. You should see every quarter we should make progress in terms of the new initiatives. And every one of those new initiatives is either no leverage or at most maybe in the risk sharing made to terms. You’ll continue to see our leverage decline.

Kenneth Bruce – Bank of America Merrill Lynch

Okay. Thank you for your color and comments this morning.

Operator

[Operator Instructions]

Richard King

Operator, there are no further questions?

Operator

Excuse me. There are no further questions on the phone line. Thank you.

Richard King

All right, thank you for listening today and we’re excited to talk to you at the next available opportunity.

Operator

And ladies and gentlemen, that does conclude the conference call today. We thank you for your participation and ask that you please disconnect your line at this time. Thank you.

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