Invesco Mortgage Capital's (IVR) CEO Richard King On Q1 2014 Results - Earnings Call Transcript

| About: Invesco Mortgage (IVR)

Invesco Mortgage Capital Inc. (NYSE:IVR)

Q1 2014 Results Earnings Conference Call

May 5, 2014 9:00 AM ET

Executives

Richard King - Chief Executive Officer

John Anzalone - Chief Investment Officer

Don Ramon - Chief Financial Officer

Analysts

Trevor Cranston - JMP Securities

Doug Harter - Credit Suisse

Nick Agarwal -Wells Fargo

Dan Altscher - FBR

Dan Furtado - Jefferies

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 Incorporated Investor Conference Call. All participants will be on 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 the speakers for today, Richard King, Chief Executive Officer; John Anzalone, Chief Investment Officer; and Don Ramon, Chief Financial Officer.

Mr. King, you may now begin.

Richard King

Thank you. Good morning. And welcome to the First Quarter of 2014 Invesco Mortgage Capital Earnings Call. IVR’s management team believes we can deliver optimal shareholder value over the long-term by managing risk to provide relative both value and stability and by producing a high level of current income to shareholders. Income generated through core earnings and passed along to common and preferred shareholders in the form dividends.

With that in mind, we have been addressing book value stability and maintenance of strong core earnings, both through the asset and liability side of the balance sheet, as well as in the area of risk management. I’ll get back to some of things that we are doing along those lines specifically, but first, let’s briefly cover the first quarter results.

As shown in the financial highlights on slide three of the presentation, in the first quarter we earned core earnings per share of $0.46, a penny lower but very consistent with the fourth quarter’s core earnings. We are focused on keeping core income high while maintaining or improving book value.

In the first quarter, our book value was up $0.56 or 3% to $18.53. One way we look at value added to the quarter is adding the dividend we paid to the change per share in our book value. We paid a $0.50 per share dividend, generating economic value added of $1.06 per share in the first quarter or 5.9% roughly return on book value.

That follows the book value gain of $0.33 and dividend of $0.50 or $0.83 combined per share or about 4.7% economic value added in the fourth quarter. So far in the second quarter with spreads improving further, book value is up another 2.5% to 3%, so we are on track for another strong quarter.

We like the progress we have made, but we have focused on doing more to maintain or grow book value. I will cover what drove the book value improvement in the first quarter in a few minute. But first, I mentioned things we’re doing on the assets and liability side and in risk management to improve stability.

On the asset side, our team remained committed to providing our shareholders with increasing exposure to three key strategies or initiatives listed on the left of page three. We find this to be the most attractive in the mortgage market, namely, participation in GSE risk transfer, CRE loans and jumbo prime residential loans.

Beside liking this assets from an earnings perspective, the enhance book value stability by reducing interest rate risk, reducing our necessity for repo borrowings and generally providing better matching of asset liability cash flows.

In Q1, we invested $470 million across these three strategies, taking the total assets among three to over $2.5 billion or 12% roughly of our assets, that is up from zero at the beginning of 2013. We continue to make progress on these initiatives in the present quarter.

On the liability side, we have also made progress, we are continuing to reduce short-term debt-to-equity leverage, our repo leverage declined 0.2 terms to 5.5 times and during the first quarter, we reduced the repo borrowings by about $600 million.

We also continue to diversify funding sources, adding several new counterparties and setting up a captive insurance company that will be helpful to us in the future. We reduced 30-year agency mortgage backed securities in favor of agency ARMs and hybrid ARMs, thereby cutting interest rate risk, extension risk and agency spread risk.

While our model equity duration or overall interest rate risk is targeted at four to five years, we have reduced the overall interest rate sensitivity to a point where empirically we are not seeing correlation between our book value and the directional movement in interest rates. We are very hedged on the rates perspective and this shows up a significantly lower value at risk in our model and lower book value volatility empirically…

On slide four, a few words on the investment environment, our economic indicators were generally softer than expectations in the first quarter, especially in January and February as it was the coldest winter in North America in decades.

Economist reduced estimates of U.S. GDP growth for the year even though many believe the weaker growth in the quarter was due to the climate as well as pay back for inventory build in the fourth quarter of 2013.

The economy to us seems neither too hot and too cold, and inflation remains quite low giving the Federal Reserve reason to stay on the current path of keeping rates low. In the first quarter of 2014, market interest rates declined even though the Federal Reserve began tapering asset purchases.

As I mentioned, we believe market expected a more robust recovery coming into 2014 and those expectations were moderated in the first quarter. Similarly, market expectations for the pace of tightening once its start will reduce. Long rates therefore fell but shorter rates were actually higher by a little bit.

Investor’s push for yield intensified in this environment and credits spread that is the additional yield above U.S. treasuries offered by non-U.S. Treasury Security fell, declining credit spreads, cost prices of CMBS and RMBS to increase more than similar -- similar maturity treasury securities.

At the same time, interest rate volatility fell rather dramatically reducing the value of options. Further, the supply of new mortgage loans was restrained by a lack of refinancing volumes and by relatively weak purchase mortgage volumes due to the harsh winter on top of already slow seasonal factors.

Given the low supply of mortgage-backed securities, the Federal Reserve reduced purchase volumes were still large relative to gross supply of newly issued MBS. Low volatility, tighter credit spreads and favorable supply dynamics, supported agency mortgage prices. All things considered, the mortgage market environment was favorable for our company in the first quarter.

Fundamental loan performance also continues to be favorable, legacy residential loan performance continues to improve with fewer delinquencies and diminished shadow inventory.

We believe slower existing home sales numbers recently are due in large part to fewer distressed sale in addition to the weather. We believe house prices should be up about 5% this year, a more sustainable rate than the 13% in 2013.

On the commercial side, we continue to see higher prices as far as due to lower cap rate but also due to better rents and net operating income growth. As a result, commercial property prices have recovered all the 6% of the fall from the peak prior to the crisis.

With that backdrop, please note the book value table on the left of Page 5. With rates lower, our interest-rate swap hedges offset much of the improvement in prices due to interest rates. Our hedges are largely meant to offset the rate risk in our agency mortgage-backed securities and our CMBS buckets.

Note that the combination of agency mortgage-backed securities and CMBS were up a $1.03 and our derivatives were $0.84. This is different that $0.19 represents improvement in yield premiums or credit spreads. Also the $0.33 per share rise in RMBS bucket is largely the benefit of tighter credit spreads.

The improved prices of non-agency RMBS and CMBS were the driving force behind our increase in book value by $0.56 per share. Modest share repurchases added a few cents as well. Core earning on the other side of the page were down a penny as I mentioned, due largely to our efforts to reduce risk and volatility.

Taxable earnings are running slightly higher than core at present such that we estimate paying a $0.50 dividend is consistent with our current run rate on earnings. We continue to focus on reducing interest cost and evolving the portfolio and liability to keep earning strong.

Our continuing efforts to improve book value performance and keep core earnings strong should be reflected in comprehensive income NAR. Comprehensive income was strong in Q1 at a $1.02 per share as you can see on the right.

John Anzalone, our [CFO] (sic) CIO, will now talk about our investment strategy.

John Anzalone

Thanks Rich and thanks again to everyone listening in. I’ll start with slide six in portfolio update. And as Rich talked about, we continue to move the portfolio away from interest rate risk and toward a greater exposure to an improving credit environment. The graph here provides a clear picture of our progress over the past several quarters and that progress continued during Q1.

During the quarter, we reduced our exposure to agency fixed rate collateral by approximately $0.5 billion mainly due not with reinvestment data. The majority of those dollars were reallocated towards hybrid ARMs where our balance increased by about $400 million. This resulted in shortening our duration profile, reduced the extension risk and made our portfolio easier to hedge.

On the credit side, we are active across a number of sectors as Rich mentioned, adding exposure to our GSE credit risk transfer position, participating in another jumbo prime securitization as well as adding propositions in commercial real estate loans and CMBS. Going forward, we’ll continue to add exposure to these areas.

Moving to slide seven in agencies. The bar chart on the right illustrates move away from 30 year fixed-rate collateral and toward hybrid ARMs. The current environment which has been characterized by very low prepayments speeds which you can see in the graph on the lower right, limited supply, low volatility continued said purchases has been supported to mortgage spreads.

This has allowed us to reduce our exposure into strength. Over the next few quarters, we do expect the mortgage basis to struggle as the supply-demand dynamic shifts to meet the slowdown in said purchases and a seasonal demand mortgage increases off of multiyear buzz.

As we said now, we’ve reduced our equity allocated to agencies by about 12.5% to 36.5%. Leverage on our agencies was 10.9 times but that was offset by lower credit leverage bringing our overall leverage down from 7.3 times to 7 times. We also reduced our repo leverage from 5.7 times to 5.5 times.

Moving to slide eight in non-agency. As you can see on the bar chart on the right, our non-agency asset mix is evolving. Our Re-REMIC continues to pay down and that represents 35% of our exposure here. That exposure has been largely replaced by GSE credit risk transfer deals.

We added $182 million during the quarter bringing our total to $350 million at quarter end. We also closed one jumbo prime deal during the quarter to $287 million and that settled another one early in the second quarter.

We took down leverage in this sector, moving from 3.5 times to 2.7 times and our equity allocation in non-agency now stands at about 44%. Performance in this sector has been very good as spread on the GSE credit risk transfer bonds continue to tightened and legacy bond prices have been supported by good credit fundamentals.

Finally moving to slide nine in CMBS, our CMBS position increased slightly during the quarter. Our balances are up about $70 million. The mix has been slowly evolving away from legacy paper, which is growing down the curve and towards new origination paper.

We reduced our leverage here also, moving the leverage on CMBS to 3.1 times at 3.31, down from 3.6 times last quarter. We were active during the quarter, taking advantage of positive market conditions to reduce subordinate exposure to underperforming retail assets. We also purchased subordinate bonds that have since benefited from further credit curve flattening.

That concludes our prepared remarks. Now we will open up the lines for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question today is from Trevor Cranston, JMP Securities. Your line is open.

Trevor Cranston - JMP Securities

Hi. Thanks and congratulations on a nice quarter. I guess first on the new initiatives you guys have been pretty active in the GSE credit risk sharing deals obviously. But it seems like spreads in that space have kind of continually ground tighter and tighter. Can you just comment on, kind of, where you are seeing returns there now and if your appetite for that asset class is still as high as it was during the first quarter or get worse where it’s at today?

John Anzalone

Yeah. Hi, Trevor, this is John. Yeah, I would say on the credit risk transfer deals, I mean, obviously you are right. It did have a fair amount of tightening little bit in the last couple of quarters. We are still finding ROEs in the very low single or very low double digits there even at current spread levels. So, I mean, it still looks attractive. We still like the credit profile. I think we will see going forward, as the GSE look like they are going to have expand, the types of collateral they are going to include in this deals. So, maybe we will see a little bit more opportunity for investing in slightly flatter OEs going forward. But as of right now, I mean, we are still pretty positive right now on that asset class.

Trevor Cranston - JMP Securities

Okay. That’s helpful. And then on the commercial side you guys added a little bit of commercial loan assets and some more CMBS this quarter. Can you maybe give us an update on just the pipeline for commercial loans and also maybe talk little bit about where in the capital stake you are investing in this CMBS space right now?

John Anzalone

Sure. So, yeah, so we close what $123 million preferred equity positions in the quarter. The pipeline, we always have a number of deals we are working on. It is a competitive space and some of them through due diligence fall out and some of them were upset on. But we are still pretty optimistic in the space that we continue to make progress. It’s lumpy, so it’s hard to say that we think we will get x amount done, but I still estimate two or three deals a quarter is what we are shooting for and the average deal is generally around $20 million. So if that gives you a good idea. And we will continue to focus dollars in this space. Right now, I think we have a term sheet towards the deals of $40 million. So with that help work out and we are working out portfolio loans. We also think there could be some opportunities in Europe. So we are optimistic going forward and we are excited about this space.

Don Ramon

Yeah. On the CMBS side, we are still on the new origination paper, we are still taking that. On average, our single A space.

Trevor Cranston - JMP Securities

Got it. Okay. And then I guess last thing on -- obviously your credit spreads, it looks like we are the primary driver of book value in the first quarter and for everything we’ve seen it looks like spreads have continue to tighten so far in the second quarter. Can you maybe give a little of an update directionally on the impact that’s had on your book value so far in the second quarter?

Don Ramon

Credit spreads overall -- oh, out of book value?

Trevor Cranston - JMP Securities

Yes.

Don Ramon

I think Rich mentioned on the call, it’s -- as we get, it was up about between 2.5% and 3%.

Trevor Cranston - JMP Securities

Sorry, I missed that. Okay, great. Thank you.

Don Ramon

Okay.

Operator

Thank you. Our next question is from Doug Harter, Credit Suisse. Your line is open.

Doug Harter - Credit Suisse

Thanks. You guys mentioned that you’re looking to improve your funding costs and restructure some of the liabilities, give a little more detail about that?

Richard King

Sure. So, I mean, we’ve got -- we’ve continued to increase counterparties. We also set up a captive insurance company and our goal is to revive capital to the U.S. residential and commercial mortgage market. Then, this is in line with the Federal Home Loan Banks mission to revive low cost financing to member institutions. And so we have our captive insurance company as a member of the Home Loan Banks, and we do think that we can finance through that captive insurance company mission-related assets and that would be banks like CMBS-based higher rated CMBS, new issue, residential loans and commercial mortgage loans.

Doug Harter - Credit Suisse

Great. I appreciate the color there. Thanks, Rich.

Operator

Thank you. Our next question is from Nick Agarwal, Wells Fargo. Your line is open.

Nick Agarwal -Wells Fargo

Hey, good morning, guys. Hey, piggyback on the HPA part, I guess you guys were talking about I think roughly low-to-mid single digits. And with tighter credit spreads, how much do you guys think that the lower HPA environments reflected in the current non-agency bond pricing?

Don Ramon

I think it might be a little bit discipline to the subprime market, which were really not involved in. For higher quality kind of assets slow and steady increases in prices is kind of the best environment. So I think in the legacy space, generally there is just fewer and fewer bonds around, and so the technicals are quite strong, definitely more buyers than sellers. It doesn’t feel like there is much risk of a significant winding. And I think it would take house prices going down again to cause any pick up in that market.

Nick Agarwal -Wells Fargo

Okay. And then next, are you going to be -- I know you don’t really own this asset class so much, but are you going to be looking at the HUD SFLS still coming up in June, that’s something of interest?

Don Ramon

We haven’t focused on that. We may.

Nick Agarwal -Wells Fargo

And then lastly, your Q2 resi securitization is broadly roughly the same size to the one you did in Q1?

Don Ramon

Yes, it’s in the ballpark.

Nick Agarwal -Wells Fargo

Okay. All right. Thanks, guys. And Don, good luck to you.

Don Ramon

Thanks.

Operator

Thank you. Our next question is from Dan Altscher, FBR. Your line is open

Dan Altscher - FBR

Hey, thanks for taking my question, and good morning. I was wondering, as you migrate the portfolio to less credits, I mean, less rate sensitive on the agency side, clearly, the pickup in hybrid ARMs is there. But, is that pool getting harder and harder to find and why not try to go more into the 15-year side as well, as there might be some similar duration there, as maybe on some of the longer-term hybrid ARMs?

Don Ramon

Right -- so, right, I mean, that’s exactly. We generally speaking look at 15s and hybrids. We choose between those in terms of overall value call and lately we just like hybrids a little bit better. On the supply side, I would say it’s hard to put a ton of money to work in hybrids, I mean, it is a very limited supply right now. But the good news is, we are not and we are migrating the portfolio.

We’re not trying to -- we don’t need to put enormous amounts of money to work in that space. So as we’ve been not reinvesting paydowns or reinvesting paydowns out of 30-year fixed into ARM hybrids, there’s been enough supply for that. So I mean, that’s kind of where we’ve been going. So I think that kind of the answer.

Don Ramon

We’re reducing agencies overall so the whole book is….

Dan Altscher - FBR

Right.

Don Ramon

(Indiscernible) little bit.

Dan Altscher - FBR

Right. Okay. On the new captive insurance subsidiary, are you guys formally now a member of the FHLB or have access there. And can you also describe how that process went in terms of -- if you’re -- in process, how that process is going? How thorough is FHLB to take on exposure from mortgage re or maybe just give us a feel to how that’s going?

Richard King

So just to be clear, so our insurance subsidiary is a member, the mortgage re is not. And as of right now, we have moved some of our assets down to the subsidiary and finance in the AA CMBS space. And we’ll continue to grow advances in line with the mission of the FHLBI in line with our mission.

Dan Altscher - FBR

Okay. And I assume that for the FHLB for the insurance company to exist, there has to be, I guess, insurance product that is provided. Can you just talk what that is actually?

Don Ramon

Yeah, Dan, it’s Don. We don’t want to get into the details of that. Basically, it’s a captive insurance and organized and licensed as it should be and meet all the requirements to be a member. And we’re very excited about the opportunity.

Dan Altscher - FBR

Okay. And finally just one quick one, there’s no taxable implications like, I think, one of your peers has like they don’t have a tax issue with insurance sub?

Richard King

No, there is no tax issues with an insurance subsidiary. I mean, again, its all in how you structure it. I mean, I think the way the people should be looking at this, it’s a great counterparty, it’s a great source of funding. And we think it meets the mission of the Federal Home Loan Bank but -- and they do as well. Our goal is to basically, again, continue to reduce funding cost for the company and improve our liquidity position and we think this does really help.

Dan Altscher - FBR

Thank so much.

Operator

(Operator Instructions) Our next question is from Dan Furtado, Jefferies. Your line is open.

Dan Furtado - Jefferies

Hi, good morning. Thank you. I apologize if you hit this already but I’m just looking for yields and/or expected IRRs on the recent jumbo securitizations have -- maybe not absolute levels if you're uncomfortable there but how they’ve changed over the past 90 days. If you’re seeing any movement on credit enhancement levels or discussions with the rating agencies as well? Thank you.

Richard King

Nothings changed dramatically recently. Volumes are definitely low in the loan space as far as trading volumes. But in terms of ROEs, we’re still looking in double digit, call it 11%, 12% ROE.

Dan Furtado - Jefferies

Understood. Okay. Great. Thank you for the commentary.

Richard King

Sure.

Operator

Thank you. And at this time, I’m showing no further questions.

Richard King

Excellent. Okay. Well, thank you. Let me close by saying we’re very excited about where we are in the positive direction we’re heading. [Technical Difficulty] everybody for listening today.

Operator

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for joining.

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