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In the event of nonexistent interest rates, one sector in the U.S. that has outperformed is mortgage REITs. Among mREITs, Invesco Mortgage Capital (IVR) has outperformed most of its peers, as reflected by its 40% YTD performance. We believe the price of a stock that offers a sustainable dividend yield of 14% will continue to appreciate, given that low interest rates continue to prevail. The stock's cheap valuations, along with its ability to generate sufficient operating cash flow, and talks of further easing by the Fed make us bullish on IVR. Based on the aforementioned reasons, which we discuss in detail below, we recommend investors buy Invesco Mortgage Capital.

Company Overview and Asset Portfolio Composition

Invesco Mortgage Capital is taxed as a mortgage REIT and operates in the U.S. financial sector. The company largely invests in commercial and residential mortgage-backed securities and mortgage loans, with an aim to provide superior risk adjusted returns to shareholders through dividends and capital appreciation. A large portion (approximately 53%) of the entire asset portfolio is invested in agency residential mortgage backed securities (RMBS); however, the company does not exclusively invest in agency RMBS. It also invests (27% of the assets portfolio) in securities whose principal and interest payments are not guaranteed by any government sponsored agency. The remaining is invested in Commercial Mortgage Backed Securities (CMBS) and other investments. The company uses short-term repurchase agreements to fund this asset portfolio.

Second Quarter Financial Performance

A company that historically on average missed revenue estimates by 2%, but exceeded expectations of EPS by 90bps, missed analyst estimates when it reported its second quarter performance. Both revenues and EPS of $82.3 million and $0.68 missed their expectations of $87.46 million and $0.69.

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Source: Reuters, Qineqt's Database

The company reported a top line of $82.3 million for the second quarter of the current year, against $86.7 million in the prior year. The 5% decline in revenues was primarily due to a 2% decline in interest income and a 2.5% surge in interest expense.

The flattening of the yield curve and the resultant low mortgage rates played a pivotal role in decreasing the average asset portfolio yield by 21bps compared to the previous quarter. The effect of a decreased asset yield was partially offset by a 4% increase in the average balance of interest earning assets. Invesco Mortgage Capital like MFA Financials (MFA) seems to have not benefited from the record low interest rates as far as the cost of borrowing is concerned. The average cost Invesco paid on its interest bearing assets declined only 1bp when compared with the previous quarter. The moderate decline in cost of borrowed funds was offset by a 3.6% increase in the average balance of borrowed funds, resulting in an increased interest expense.

Other income and operating expense largely remained flat when compared to the previous quarter, which is why the decrease in the top line was translated to a 5% decline in the bottom line.

The company, during the second quarter, increased its leverage from 6.0:1 to 6.3:1. Compared to this, MFA Financials and American Capital Agency (AGNC), the other major U.S. mortgage REITs, have leverage ratios of 3.6:1 and 7.9:1, respectively.

Dividends

Amidst the record low interest rate environment, Invesco Mortgage Capital's stock offers an attractive alternative to investors looking for dividend income. The stock offers a dividend yield of 14% against the prevailing 10-year treasury yield of 1.65%. Compared to this, Annaly Capital, a major mortgage REIT in the U.S. financial sector, offers a dividend yield of 12.9%. Invesco Mortgage Capital generated $393 million in operating cash flows, meaning an operating cash flow yield of 17.3% and a dividend coverage ratio of 1.19 times, which is sufficient to cover the current dividend yield. Therefore, investors can expect dividend distributions to continue in the near future.

Valuations

Invesco Mortgage Capital's stock is trading at cheap multiples. The stock, with a P/B value multiple of 1.07 times, trades at a discount of 8% and 6% to its major competitors, American Capital Agency and Two Harbors Investment Corp (TWO).

Bearish Scenario

Invesco Mortgage Capital, like most of its peers in the U.S. mortgage REITs, will continue to benefit from the record low interest rates due to lower borrowing costs. However, since most of the securities that the company holds are fixed-rate, if the interest rates increase, the cost of borrowing will rise, depressing the interest rate spreads that Invesco Mortgage Capital earns. Also, any further flattening of the yield curve as a result of further easing by the Fed would mean lower yields on interest earnings assets. This would also ultimately depress the interest rate spread for the company. We recommend investors to be cautious of both the flattening of the yield curve and an increase in interest rates.

Conclusion

The stock, with a 40% price appreciation since the beginning of the year, has tremendous potential to make new 52-week highs, as long as interest rates are kept low and the yield curve does not flatten any further. Therefore, we recommend our investors to buy the stock and benefit from both its significant dividend yield and capital appreciation.

Source: 14% Dividend Yield, Expected Price Appreciation Make Invesco A Great Buy