Invesco Mortgage Capital, Inc. (NYSE:IVR)
Q4 2015 Earnings Conference Call
February 23, 2016, 09:00 ET
Tony Semak - IR
Rich King - CEO
John Anzalone - Chief Investment Officer
Douglas Harter - Credit Suisse
Bose George - KBW
Trevor Cranston - GMP Securities
Brock Vandervliet - Nomura Securities
Welcome to Invesco Mortgage Capital Incorporated's Fourth Quarter 2015 Investor Conference Call. [Operator Instructions]. Now I'd like to turn the call over to Tony Semak in Investor Relations. Mr. Semak, you may begin the call.
Thank you, Ray and good morning, everyone. Again, we really want to welcome you to the Invesco Mortgage Capital fourth quarter 2015 earnings call. I'm Tony Semak with Investor Relations and our management team and I are delighted you joined us. We really look forward to sharing with you our prepared remarks, as we've always done in the past, during the next several minutes, before we conclude with a question-and-answer session. Joining me today are Rich King, Chief Executive Officer; Lee Phegley, Chief Financial Officer; John Anzalone, Chief Investment Officer; and Rob Kuster, Chief Operating Officer.
Before we begin, I'll provide the customary forward-looking statements disclosure and then we will proceed to management's remarks. Comments made in the associated conference call may include statements and information that constitutes forward-looking statements within the meaning of the U.S. securities laws, as defined in the Private Securities Litigation Reform Act of 1995. And such statements are intended to be covered by the Safe Harbor provided by the same.
Forward-looking statements include our views on the risk positioning of our portfolio, domestic and global market conditions, including the residential and commercial real estate market. The market for our target assets, mortgage reform programs, our financial performance, including our core earnings, economic return, covenants of any material changes in our book value. Our ability to continue performance trends, the stability of portfolio yields, interest rates, credit spreads for payment trends, financing socialist cost funds, our leverage and equity allocation. The impact of the restatement of our financial statements for certain periods and the adequacy of our disclosure controls and procedures and internal controls over financial reporting.
In addition, 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 rely unduly on any forward-looking statements and urge you to carefully consider the risks identified under the captions Risk Factors, Forward-Looking Statements and Management's Discussion and Analysis of Financial Conditions and Results of Operations. And our annual report on Form 10-K, 10-K(a) and quarterly reports on Form 10-Q which are available on the Securities 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 and if any forward-looking statement later turns out to be inaccurate.
To view the low slide presentation today, you can access our website at InvescoMortgageCapital.com and click on the Q4 2015 earnings presentation link. You can find that under the Investor Relations tab at the top of our homepage. There you can select either the presentation or the webcast option for both the presentation slides and the audio. Again, I want to welcome you and thank you so much for joining us today. We will now hear from our Chief Executive Officer, Rich King. Rich?
Thanks, Tony. Good morning, ladies and gentlemen. In the fourth quarter, Invesco Mortgage Capital earned core income of $0.42 per share and declared a $0.40 dividend. Core earnings per share increased slightly from the prior quarter, benefiting from multiple sources, including favorable prepay speeds, income from our JV investments, accretion from share repurchases and some benefit from reducing general and administrative expenses.
The de-consolidation of our residential securitizations in Q4 will result in lower G&A going forward. In addition, it simplifies our financials, reduces GAAP leverage. It also reduces concentrated risk and the sales proceeds helped us to buy back shares during the quarter which was accretive. We had expected, going back a couple years, that non-agency securitization would return. But it has become evident to us that the private-label residential loans securitization market is unlikely to thrive any time in the near or medium term, due to many factors. Exiting that investment and focusing on better opportunities with our capital makes sense to us.
Given the actions we have taken, our ability to continue share repurchases and the re-emergence of higher investment yields, we're feeling good about our earnings stability potential and maintaining the current dividend in 2016. Book value per share was down 2.9% in the fourth quarter, due principally to spread movements that drive the mark-to-market pricing on our assets and hedges. And I will detail that on the next slide. Economic return, defined as the change in our book value plus dividends paid, was slightly negative for the quarter and slightly positive for the year, reflective of financial conditions and wider credit spreads.
The fundamentals underlying our investments are solid. Our asset quality is strong and improving, with a high credit-quality orientation. We've included more detail in this presentation on each of the residential and commercial asset portfolios to better illustrate that. John Anzalone will cover that in a few minutes.
On last quarter's call, we talked about our view that investors were overly worried about fed rate increases and that we did not expect those rate increases to materialize. Indeed, the majority of investors are no longer expecting multiple rate increases in 2016. But many are now growing more concerned about fudging energy prices, weakness in China, lower global growth generally and contagion, potentially leading to a U.S. recession. As a result, credit spreads have widened in a more pronounced way thus far in 2016, primarily in February. And bond market liquidity has been relatively poor.
We don't ascribe to a recession view, especially in the U.S. in 2016, because we do not see the traditional precedent conditions. Lending remains selectively tight, as it has been since the crisis. Economic growth has not been excessive, inventory is not overly large and consumers are benefiting from lower energy prices and low inflation, generally making their monthly mortgage payments more affordable.
Fundamentals do not seem to be driving valuations in our portfolio, nor in our stock price, however. Credit spreads on assets backed by conservatively underwritten loans that are actually becoming safer due to continued property price depreciation have been widening in an increasingly correlated fashion with energy prices.
We can understand why high-yield corporate bonds and corporate loans widen due to concerns about bankruptcies and the energy space. But it doesn't make sense that our asset should be highly correlated with energy prices. In the mortgage space, high-quality credit assets are being marked lower, regardless of their strength or credit profile. Consequently, our book value per share in January was down about 3% from year-end, with credit spreads having widened further in February. Credit spread movements remain fluid and we're confident in the credit quality of our assets and we believe our book value will improve once again as financial conditions stabilize.
We also discussed buying back IVR shares on last quarter's call and highlighted the compelling return profile in relation to our other investment alternatives. We like the strong asset quality in our portfolio, our limited rate risk due to hedging and our high dividend yield. So buying our shares at a large discount, rather than reinvesting, is a great use of capital, in our view. Consistent with that assessment, we spent $75 million to repurchase nearly 5% of outstanding shares in Q4 which follows the $50 million we spent to repurchase 3% of outstanding shares in Q3.
We believe this ranks us among the most aggressive with buybacks in our industry. We certainly do not think it is wise for our shareholders to sell their shares at these prices, but we've willingly bought them at large discounts and expect to continue buying back significant amounts of our shares to the extent that these large discounts persist. Importantly, our Board has just authorized the repurchase of an additional 15 million shares. So we have over 20 million shares authorized for repurchase.
Let's turn to slide 4 in the presentation and talk more specifically about book value. The fourth quarter was a modestly weak environment for interest rates, unlike Q3 or the current quarter, where interest rates are falling. But the risk-off environment for credit spreads persisted. Credit spread widening was modest, but it continued. Increasing rates in Q4 boosted the contribution to book value from our swap hedges, labeled here as derivatives, by $1.11 per share. Because spreads were soft, the yields on our assets rose a little more than on our swaps, such that the agency mortgage-backed securities and CMBS portfolio valuations, taken together, reduced book value by $1.43 per share.
Our residential portfolio has little duration and generally, prices have been relatively stable, at least in our assets in that part of the portfolio, with the exception of the GSE credit risk transfer. The de-consolidation of securitization accounted for most of the $0.22 decline shown in that segment. John will talk about the character of the RMBS portfolio shortly on an upcoming slide.
On the positive side, we experienced book value-per-share lift from share repurchases and from our JV equity investments. We're very focused on long term capital preservation and remain well-aware of the current volatility in financial markets. As an example, high-quality 2014 vintage AAA and AA CMBS have widened quite a bit, causing a decline in our book value. As rates have fallen in 2016, these funds have not gone up in price, as interest rate hedges have.
We do accept some degree of cyclical credit spread premium volatility, so long as we strongly believe the asset is money-good and that we can hold our positions and continue earning an attractive yield on them. Over time, when rates rise or just stabilize, we expect the spreads will narrow back down, lifting book value back up. Meanwhile, we collect net interest margin.
We maintain a diverse portfolio of agency, residential and commercial real estate-backed debt. In times like these, our lower volatility assets, such as agency MBS, shorter average life, credit bonds and CRE loans, provide stability and liquidity -- two characteristics that we consider cornerstone elements of our profile. We're committed to the CRE [indiscernible] business as well. We made a $52 million loan in Q4 and we have a nice pipeline in place for 2016.
In summary, while book value is near a cyclical low, we expect spreads to recover and for our book value to recover as well. In the meantime, we continue to earn interest on a high-quality portfolio and our earnings appear to have stabilized. John Anzalone, our CIO, will now tell you about our portfolio and our strategy.
Thanks, Rich and thanks again to everyone dialing in on the call. As Rich alluded to in his remarks, it has been a difficult past few months in the broader fixed income markets, as global concerns continue to weigh on asset prices. Unfortunately, the structured securities markets have not been immune and we have seen an environmental where valuations on our assets in many ways have been more correlated with the price of oil than with the value of the collateral they are backed by. Further compounding matters, we have seen a more challenging trading environment and the structured securities market is adjusting to a host of new rules and regulations.
That's the bad news. On the positive side, we continue to believe that this is a good environment for the types of bonds that we own. And I'm going to spend a little bit of time over the next few slides describing in more detail the types of high-quality credit bonds that we own.
Slide 6 shows our allocations on both an equity and asset basis. We still have nearly 2/3 of our equity and 40% of our assets allocated to credit. And despite the current environment, the fundamentals in both commercial and residential credit remains strong. Spreads were wider across all of our credit sectors during the fourth quarter and that spread-widening accelerated through January and into the beginning of February. And once again we saw swap spreads move in the opposite direction of credit spreads, tightening during the fourth quarter and continuing to tighten this quarter.
Slide 7 shows our agency portfolio and it contains a good mix of fixed rate and hybrid ARM collateral. The portfolio is generally made up of higher-coupon, seasoned bonds that exhibit less industry sensitivity than longer-duration current-coupon paper. We saw prepayment speeds slow during the quarter and that slowdown has continued in the first print of this year. We do expect to see speeds pick up as we head into the spring, reflecting seasonal factors, as well as the lower-rate environment that we're in now. However, absent a continued, improved, prolonged rally in rates, we expect the impact to our portfolio of these increases to be muted.
Slide 8 shows the diversification in our residential credit book. We have a combination of pre-crisis legacy bonds which make up 63% of the book and the remainder is split between new issue RMBS and GSE credit risk transfer bonds. As you can see in the box in the lower left of the slide, these bonds have very short duration profiles insulating them from interest rate risk.
We saw spreads on our residential credit portfolio move wider during the fourth quarter and that trend continued during the start of this year. That said, spread moves on legacy paper were muted compared to most other areas of fixed income, due to their seasoning and short-duration profile. Newer issued paper, particularly credit risk transfer bonds, did not fare quite as well, widening at the start of this year, as the new issue calendar put additional pressure on spreads. Despite the worsening technical environment, the underlying fundamentals of these bonds remained strong, as the housing market continued to be healthy during the quarter.
On slide 9, we want to give a better picture of the credit quality of our residential portfolio. On the upper left, we show the dollar prices of the assets we own. As you can see, over 70% of our residential holdings have dollar prices over $90. Why is this important? High-dollar-priced bonds have a few things going for them. One, they generally have limited exposure to collateral performance issues. Two, they tend to have lower price volatility which we just saw over the last quarter.
And finally, they are more attractive to finance, largely due to the first two reasons. This is in contrast to lower-dollar-priced bonds, where price volatility is higher, making them more difficult to finance. And performance can be highly sensitive to service or practices which can be difficult to predict. On the right, we show our resi holdings by vintage. On the left, in blue, are our legacy holdings. While some of these bonds were issued as late as 2012, they all have underlying collateral that dates from 2007 or earlier.
The other thing I'll point out is that our newer issue paper, particularly the CRT bonds, are predominately from 2013 and 2014 which gives them lower price volatility than more recent deals. And the reference loans in those deals have embedded home price depreciation. So we have seen increased volatility in spreads and resi credit recently. The excellent credit quality of our bonds, along with their attractive yield profile, gives us a lot of confidence that continuing to hold these positions has been the right call.
Over the next few slides, I will cover the commercial credit portfolio. The pie chart on the left of slide 10 shows a breakout of the commercial portfolio. The legacy slide continues to pay down and now represents only 9% of the book. The bulk of the portfolio is made up of post-2009 single-A and BBB paper that was purchased largely during 2011 to 2013 and more recent vintage AA and AAA paper that we're financing at the home loan bank.
The story in CMBS is very similar to what I just described in residential credit. Fundamentals still look positive in the face of a difficult financial market environment. CMBS was wider across the board during the fourth quarter and that trend really accelerated during the first part of this year. In CRE lending, we closed a $52 million mezzanine loan during the quarter, bringing our total commercial loan and joint venture investments to $247 million at year-end. A couple of notes on our CRE lending efforts. We're originating these loans to hold on our balance sheet, not for securitization. And we're not relying on warehouse financing to achieve our target returns.
Speaking of commercial loans, slide 11 provides a snapshot of our CRE loan and joint venture portfolio. As you can see, it is well-diversified geographically, as well as by property type. As I mentioned, as of year-end, this portfolio was $247 million. We closed an additional $28 million during the first quarter of this year. In addition, we've had $97 million returned which are shaded in purple, as borrowers realized their business plans. We've had no delinquencies and the weighted average LTV was 65% at year-end.
On slide 12, we want to give you a sense of the credit quality of our commercial real estate assets. The chart on the left shows how the LTVs on both our CMBS portfolio, as well as our CRE loan book, has declined as these assets have seasoned. The fundamental performance of the collateral underlying our CMBS book, in particular, has been pretty remarkable. We estimate that the average LTV on our CMBS book is now at 36%, down from over 60% in mid-2011.
The CRE loans have not had a chance to season as much, but the LTV in that part of the book has declined from mid-70%s in mid-2013 to 65% at year-end. And these loans are backed by institutional quality assets and strong borrowers.
The chart on the right points out how we've transition to higher-quality CMBS bonds over the last few years, as competition has caused underwriting standards to loosen. You can see that all of our single-A and BBB bonds were issued in 2013 and earlier, whereas the newer vintages moved up to AA and AAA bonds. So we have seen some pretty tumultuous spread volatility lately. The quality of our portfolio remains extremely strong, from a credit perspective.
Finally, let's take a quick look at financing. We did have some changes in our financing last quarter, as we de-consolidated our securitizations in the FHFA rule that captive insurers would be excluded from the Federal Home Loan Bank system. As far as the home loan goes, the ruling will have no impact on our existing advances. We included the box on the bottom left of the chart to show our average cost of funds for the quarter compared to last quarter. Funding was marginally more expensive, reflecting the rate hike at the end of the quarter. Generally, we've seen our funding costs go up commensurate with the 25-basis point fed hike. And we did not see any disruptions in funding around the fed hike or around year-end.
With that, we would like to open the call for Q&A.
[Operator Instructions]. Our first question is coming from Douglas Harter of Credit Suisse. Your line is open.
Can you talk about is what you guys actually did that caused the deconsolidation of the residential credit and what about that caused the book value was?
Essentially we solved the bottom of the stack and so some of it was -- the prices were lower, but some of it was also that you have some expenses that are capitalized do get taken out. So it was a combination of those two things.
And the decision to sell those was basic -- what was the rational to sell those? I guess you mentioned funding the buyback was part of it?
Right. Yes, part of it. But really just looking across the company and finding assets that had lower ROEs and using that capital to fund buybacks and we look across the Company and try to find assets with lower ROEs regularly and sell them and this one had a number of other benefits aside from improving accretion and ROE and so forth and that we could lower G&A expense going forward, lower our GAAP leverage numbers and so it made sense to do that.
So the remaining 18% of the residential credit book, that's a new issue. Were those higher credit rated tranches that you still hold then?
Yes, they are be rated tranches and primarily higher-rated.
Our next question is from Bose George with KBW. Your line is open.
First, just can you talk about you find the most attractive investment opportunities and then just give some characterization of ROEs in the different segments?
I would say right now buy back stock obviously is going to have the most attractive, so that was number one on the list. But aside from that, most of our investments have been going into CRE lending. We really like the profile -- I think we talked about that a little bit, the reasons why in terms of book value stability and also we do think as you move forward it's important to stay involved in the market and also we think there's going to be good opportunities coming up over the next year also with some of the new regulations start affecting the CMBS market that potentially can create some more opportunity within CRE lending. So I think CRE is second in terms of that.
In terms of where we see current ROEs, I think credit risk transfer is probably the highest in terms of if you just considering where spreads have moved to and where you can finance those, if you are talking high teens kind of numbers or mid to high teens kind of numbers. The issue there has been there is lot of spread volatility, you know the funding calendar is really impacted spreads and you have to be cognizant that in terms of finding counterparties that want to finance those.
I mean there are number of factors that limit the amount that you want to do and they are not lead friendly, in their current forms that's another limiter. In terms of ROEs across other sectors I think within commercial looking at low double-digit type numbers for AAAs, obviously that lower down the stack you go to hire the numbers get but we're not really interested in buying lower rated BBBs right now considering the underwriting and then within agencies I would say it really depends on where you’re looking within agency space, but for 30 year current coupon types you’re probably in the low double digits and [indiscernible] you’re probably in the high single-digit.
On the commercial loan side, is there a plan to use leverage over time?
Yes, so we buy the loans and they are unlevered so they are not -- they are not collateralized [indiscernible]. In the sense we do have leverage on them and that we have -- we have a 5% corporate note, $400 million outstanding so when you think of that you essentially get call it a close to 9% unlevered yield on the CRE book to a forward curve and then you've got a 5% financing so you’re 12% to 13% on the investment.
And then just actually one more, on the G&A expenses going forward, after the deconsolidations etcetera, is the run rate that you guys had this quarter a good run rate to look at?
I guess, I think so.
I'm sorry, I just kind of missed that -- your question it was G&A? Yes, that's right.
Our next question is from Trevor Cranston of GMP Securities. Your line is open.
I have a question on the hedge portfolio. Looking at the schedule on the 10-K there's fairly large amount that’s said to mature with fairly high rates over the course of this year, can you guys just talk about how you are thinking about that if there's any intention to replace some of that stuff as it matures or if you’re just kind of happy with the current [indiscernible] exposure you’re having, you’re going to let that expire? Thanks.
We actually have taken hard look at that and we've taken off in the first quarter a fair amount of those early because essentially they are not doing much good and we've reduced our overall duration over time of asset sales and seasoning, keeping our duration and the band that we have over a number of years' slightly positive duration. We're able to take those out so you should see a in the next quarter a lower balance there.
Our next question is from Brock Vandervliet of Nomura Securities. Your line is open.
I just wanted to start off, it sounded like you are pretty constructive on the earnings power and the dividend going forward from your opening remarks, just wanted to confirm that.
No, that's correct. We're seeing we saw a little bit improvement in the fourth quarter and that's continuing. So we think that the $0.40 dividend makes a lot of sense. I think there are things that are going to improve earnings a little bit going forward but we also, we recognize that with the drop in rates that we’ve seen lately and the seasonal is coming up in the second quarter that while we have some positives there also could be some negatives in the form of a somewhat higher prepayment. So we would say we're confident in the current run rate.
[Operator Instructions]. Carry on, sir.
Operator, if there aren't any further questions we will end the call here and I will like to thank everybody for joining today once again.
Thank you. That concludes today's conference. Thank you for participating. You may now disconnect.
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