Invesco Mortgage Capital, Inc (NYSE:IVR) is an externally managed company that primarily invests in residential and commercial mortgage-backed securities and other related assets. I am bullish on the company because it has taken several initiatives in the commercial and non-agency area, which is expected to increase its return in the second quarter. It will reduce the pressure on its core EPS, which is trailing its dividends for the past two quarters. Overall, IVR offers a compelling total return opportunity of 19%.
The company has increased its exposure to non-agency MBS. It has diversified its portfolio by investing in GSE credit risk transfer and prime jumbo loans. In the first quarter, IVR added $182 million in GSE CRT and $287 million in jumbo prime. The company has also closed down another jumbo loan investment in the second quarter. Similarly, on the commercial side, the company increased its investment by $70 million. In the mortgage Stanley conference, IVR's management indicated that they continue to see attractive opportunities in these areas and the company will continue to increase its capital allocation in non-agency and commercial MBS in the second quarter.
This approach makes sense because the asset yield for these MBS is way higher than traditional agency RMBS. This will enhance the net interest margin and consequently improve core EPS.
The primary reason behind the first quarter's earnings miss was the increase in interest expense. In the second quarter, the company would be able to better manage its cost of funds because of two reasons. Firstly, one of IVR's subsidiary gains an access to the Finance Home Loan Bank [FHLB]. It gives the company the right to use cheaper FHLB funds. These loans also have higher durations than the repo-agreement, which means a lower mismatch between assets and liabilities. It also reduces the dependency on repo market.
Secondly, the fear of volatile interest rates has declined, which will cause the management to reduce its swap positions in the second quarter. The Fed chairman has made it clear in his recent testimony to the Senate Banking Committee that the regulatory authority will continue with the expansionary monetary policy, as the labor force participation rate is still low. Also, the economy has not experienced a growth in wages. So, the rates will remain low, which means the company can reduce its hedge positions and decrease the cost.
The company slightly increased its leverage (debt-to-equity) in the first quarter to 7.0x. It is not only significantly higher than its hybrid peers, but it is also higher than simple RMBS companies. This limits the company's ability to increase its investments to non-agency and commercial MBS.
Dividends and Valuation
One worrying sign for investors is that the core EPS is not covering dividends payments for the last two quarters. However, the management is keen to maintain its dividends, and I am expecting the core EPS to improve in the second quarter. So, I believe that investors should not worry about a future dividend cut.
In the first quarter, the book value improved by 3% and it is expected to improve by nearly 5% in the second quarter. Richard J. King, the President and CEO of the company, said in the Mortgage Stanley Conference, " This quarter, we continue to see book value improve and at this point, I think we announced up like 3.5% to 4% one of the last conferences, it's now like closer to up 5%."
So, I am raising my estimated BVPS for the second quarter to $19.4 (1Q BVPS*1.05), which in turn increases my price target to $18.5 per share (0.95*estimated BVPS). This means price appreciation of 7.7% and a total return of 19%.
I believe the company has rightly diversified both its asset portfolio and source of funds. It will not only improve the company's core EPS, but also decrease its dependency on the repo market. Also, the company offers an attractive opportunity to earn a total return of 19%.
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