About a year ago, I went long on a little portfolio of Residential Mortgage Backed Securities, with the intention of participating in the high dividends available to shareholders of funds of this type. Three of the five I invested in -- Two Harbors (TWO), CYS Investments (CYS) and American Capital (AGNC) -- did reasonably well, retaining their market value plus throwing off a nice dividend stream in excess of 15%.
We did some introspection on Chimera some time ago, and today's project is to try to figure out what happened to Invesco, and if possible, develop a "Dump, Hold or Reinvest" plan for this fund as well.
I am going to compare IVR to AGNC, which everyone loves. The events of the last year are summarized as follows:
|Invesco||American Capital Agency Corp|
|Dividend Yield (1-24-2011)||17%||20%|
|Dividend Yield (Current)||18%||20%|
|Portfolio Value (Current)||$14.3B||$41B|
|% Agency Backing||50%||100%|
|Avg Net Interest Rate Spread||4.15%||3.18%|
|Portfolio Growth (9 month))||260%||315%|
Invesco is about a third of the size of AGNC and the company makes money originating mortgage loans for residential properties, some of which are backed up by government agencies, and some commercial properties as well. AGNC's porfolio is 100% agency backed residential mortgages. We did some analysis awhile back about what difference this makes but we can see right away that it has made IVR's average interest rate spread, the difference between what it pays for money and what it can charge for interest, slightly higher than AGNC's.
We can also see that both of these funds grew at an exceptionally high rate last year, and of the two, IVR is the cheaper at the moment based on PE. We can also see that the price of IVR shares managed to settle out at a point where the dividend yield is roughly the same as it was last year, or to say more precisely, when the dividend was cut, the market price adapted to the new dividend.
So what happened to IVR? I can do no better than to use the words of the management from their most recent quarterly report:
Our book value per share was $16.47 and $20.49 as of September 30, 2011 and December 31, 2010, respectively, on a fully diluted basis, after giving effect to our units of limited partnership interest in our operating partnership, which may be converted to common shares at the sole election of the Company. The decline in our book value was primarily due to the change in valuation of our investment portfolio and our interest rate hedges that is recorded in Other Comprehensive Income (Loss) on our balance sheet.
When the Euro contagion began last July, it had the effect of making people flee to the US Dollar, and as a result, long term interest rates went down, taking mortgage rates with them:
Here is a graph from Invesco's November investor's presentation to the effect that over this time, their margins declined:
Since in this business, the margin is passed through the fund to the shareholders in the form of dividends, lower margins directly equal a lower stock price.
So who would have predicted that a decrease in interest rates would have caused a big reduction in profits for Invesco? The management. The risks were clearly laid out in the 10Q issued in June, that a half percent decline in interest rates could lead to a 20% drop in net income.
All of these companies use derivative instruments to reduce their risk of a change in interest rates. It is quite clear that Invesco's management had the system of derivatives set up such that the company would make an abundance of money if interest rates would go up by a half percent.
Contrast this with AGNC's risk analysis for the June and September 10Q reports respectively:
AGNC's hedging strategy will cause a decrease in income if interest rates go either up OR down. The management set their system up for interest rate stability. Note that the bias changed a little between June and September.
So it is quite clear what happened: IVR's management set up its portfolio and hedging anticipating an increase in interest rates, and what they got was a decrease. Their projections were reasonably accurate as to what was going to happen, the decrease in income translated directly to a lower dividend and stock price. In fact, IVR issued an additional 20 million shares of stock last summer to right the ship a bit. According to their June earnings announcement they went from a cash position of $63M on December 31, 2010, to $66K in June:
Although the company's portfolio increased by a factor of 1.2, the derivative liability quadrupled between January and June:
So now what?
Well, there are worse things that can happen to you than to have invested in IVR when I did. I collected a year's worth of dividends, 18% roughly on my initial investment, and even though the stock has gone down by twice that, I am only negative about 20%, and there are plenty of other companies around that are at those levels year on year.
But, here is the upside: We know that if, and it is a big "if," the economy turns around and interest rates do go up, Invesco will make a lot of money, and in all probability more than reward us shareholders for our patience. We know that the management is good at forecasting. With mortgage rates at multiple decade lows, it seems like the risk is on the upside. Also note that the careful investor that goes long AGNC not anticipating any change in the system stands a chance to lose if IVR's management is correct.
You can also see why everyone loves AGNC. They are set up to make money if nothing happens to interest rates and things keep going along like they are. They happened to guess correctly in June: The management had the derivatives set up for a slight decline in interest rates and that is exactly what happened.
So, you can do all of the analysis you want about leverage, and what the agency backing is, and the HARP, and the portfolio allocations, the prepayment rate and everything else, but this comes down to one thing, it appears, and that is, the future direction of interest rates. If you think that the economy is going to pick up, and interest rates increase, then you could conceivably do quite well in IVR. If you think things will stay the same, you will do better with an investment in AGNC.
Of course both of these companies will release their December earnings in the next couple of weeks, and we will be able to see whether their strategies have changed. Between now and then we can look at some of the other companies in this group to see how good they are at forecasting as well. Diversification is also good. We have some time, as the dividend announcements for both companies are a month away.
Do with this information what you will. The world is chaotic, and there are no guarantees on anything.
Disclosure: I am long AGNC, IVR, CYS, CIM, TWO. I still have a limit order to go long ARR at below the current market price.