Invesco Mortgage Capital Inc. (NYSE:IVR)
Special Conference Call
September 11, 2012 8:15 am ET
John Anzalone – Chief Investment Officer
Donald Ramon – Chief Financial Officer
No identified analysts
Good morning. We’re going to get started with our next speakers. From Invesco Mortgage Capital, we have John Anzalone, and Don Ramon, the CFO here today. For those of you out there, Invesco is a mortgage REIT that invests in agency and non-agency RMBS and CMBS, and a result with the bond market rally has seen some nice book value appreciation along with a strong yield over the last year.
So with that brief introduction, I’ll hand it over to John for his comments.
All right, thank you. I’ll just go through a little bit about the company, then a look at the portfolio in a little bit greater detail and then some of the dynamics we’re seeing in the market today.
On Slide 2, just starting with a quick overview of the company, IVR is managed by Invesco, a large asset manager, about $659 billion in AUM. Market cap of IVR is 2.3 billion, current dividend yield at 12.7%, and total assets just over 16 billion. And as of 8/31 – these numbers are a bit stale – book value was 18.40 per share.
On Slide 3, talk a little bit about our competitive advantage. You know, one of the advantages of being part of a large asset manager is we have a large experienced team, well established investment process. We really benefit from Invesco’s platform and take full advantage of that, and that’s led to pretty strong performance over the past few years – about 67% total return over the past three years.
Slide 4, I’ll just over this quickly, but again highlighting the performance that we’ve established over the past three years. You can see these numbers are both versus the Bloomberg Mortgage REIT Index as well as versus the S&P, and strong performance across the board – year-to-date almost 57%, one year 38%, and I mentioned three-year about 67% total returns.
Slide 5 is really here for more informational purposes. A lot of numbers on the page, so certainly not going to go through all of them, but some of the highlights – earnings per share and dividends remain competitive through some challenging times over the past few years. Asset selection and diversification and leverage are really what drives the strong ROE of the portfolio, and again the scalability of Invesco’s platform, one of the ways I think that shows through in is in the low operating cost, so that’s one of the places where aside from the people and that, just purely in operating cost perspective, we really benefit from IVZ.
So with that, I’ll just move into the portfolio. We’re a hybrid REIT so we invest both in resi and commercial asset classes. We find opportunities in both asset classes and really feel that the ability to move between sectors and go anywhere where we feel returns are good is one of the big advantages of the way we’re structured. The portfolio I mentioned was 16 billion. Current yield is about 3.58% with 6.3 times leverage, and I’ll move through each of the sectors in a little more detail over the next few slides.
On the agency side, the majority of our portfolio is in fixed rate prepaid protected pools. One of the things that’s been going obviously are you can see yields have continually declined over time as rates have gotten lower and prepayments have increased over the past couple years, but our net yield is still 130 basis points, has remained fairly stable over the past few quarters. The thing that’s really driving that is the box on the lower left – our agency prepayments have remained very stable considering how high the dollar prices in the mortgage market have gotten, so that really is a big driver of returns in terms of just keeping prepayment speeds under control. And you can see on the bottom right versus similar collateral, our speeds have been much, much slower, so that’s really been the driver of returns on the agency side. It’s been the entire key to that asset class (inaudible).
In non-agency, again, really on the credit side I think the one thing we try to stress both in non-agencies and in CMBS is just having a high quality portfolio. In the non-agency sector, we’re about 70% senior re-REMIC with the remainder a mixture of seasoned prime and Alt-A, but those are also top of the capital structure. I think we have one subprime bond that makes up that 0.4%. But anyway, again, nice prepay history here. Obviously when bonds are at a discount, our prepay speed will be faster and we’ve seen pretty good voluntary prepay. I think in terms of the prepayments you see here, they’ve been in kind of the mid-teens. Really, that’s been about half and half between recoveries and actual volunteer prepayments, so that’s been a very good story for that sector. And the one thing I’ll also highlight is just how much this sector has rallied over the past couple years. You can see it in the yields – I mean, we were at 7.25 just a year ago and now we’re at 5.37, and there’s two things going on there. One is obviously your selection, so if you’re in more senior REMICs that’s going to be lower because they just have lower spreads; but really, I mean, it’s been a pretty tremendous rally across the board in the non-agency space.
And really, a couple things are going on there. One is yields are going down, so overall market yields; but also, it really reflects demand for yield in the marketplace, so there’s been a real grab for yield and non-agency mortgages are definitely one of the few places that offer yield. And as fundamentals have improved, I think we see people get more comfortable with the asset class and have really boosted demand over the past couple quarters especially. So that’s really all I have here.
In terms of how we look at this, again, with the platform we have, we use loan level analysis. We have lots of data in our systems to look at these things, and one thing that is key is that we re-underwrite our entire book every month to really try to pick up trends in both underwriting and in performance and things like that, so I’ll talk about that a little bit when I go through the market slides.
In CMBS, again, stress the credit quality of the book. It’s really a similar story in that we’ve see yields decline pretty markedly over this past year. A lot of the same reasons – it’s again improving fundamentals, real reach for yield by investors. I think that’s been a big part of the story here. For us, we really like CMBS, and number one, we have a pretty large team that looks at this stuff, so that’s a big advantage. I mean, it really takes a lot of resources to be able to go across both resi and commercial, and also in a portfolio context it really provides a nice diversification in that it provides high fixed coupons but also has a very good convexity profile. Obviously there’s no prepayment worries in CMBS, so it offsets the agency book quite nicely. And really, I mean, CMBS especially—I mean, non-agency to some extent but CMBS especially has shown a negative correlation to rate, so as over the past several quarters. That’s been nice in terms of providing book value stability and book value improvement over the past couple quarters.
So with that, I’m just going to do a couple quick slides on what we’re seeing in the market today and then I’ll open it up for questions if there are any. But I’ll start on the agency side. It’s interesting if you look on the upper left part of the slide, the refi index has been going up, obviously, but that really is a reflection of rates; and given the level of rates and the refi incentive that exists out there, actually it seems to us that the refi index is pretty well contained given what people are facing, that really credit concerns –and I’ll talk about capacity constraints in a second. If you look on the right, specified pool pay-ups, what I show here is the price of Fannie 4.5’s has gone up to, what is it, around 1.09, 1.08 I guess over the past couple of months, and it just shows the pay-ups on loan balance—low loan balance and medium loan balance paper has really just exploded over the past couple of months—couple of quarters, actually. If you look, those things are trading at pay-ups in the teens as recently as last fall, and now we’re talking it’s over 100/32nds of three, four point pay-ups are not unusual anymore. Really, that reflects the higher dollar price and just really how much yield advantage you get by having pools that are at 1.08 dollar price. If you get them to prepay slowly, it’s just a huge benefit. I think the markets recognize how important that really is.
And then on the lower left, this is an interesting graph, I think anyway, from a mortgage guy—interesting is a relative term. But anyway, this shows mortgage finance employment, and basically what that is is brokers and credit analysts employed in the mortgage market and it really shows the just incredible drop-off during kind of ’07, ’08 through ’09, and we’ve seen a small uptick the last quarter but really that hasn’t really gone up all that much, and so really capacity constraints are one of the reasons that we think the refi index is not—is high, that refinancings aren’t as high as you might think given that. And part of it is credit concerns and people can’t qualify, so why would you hire analysts when no one going to qualify. But anyway, really this one’s something we look at and as we see upticks in that, you’re going to need to see that increase in order for prepayments to really get out of control, and I think that’s an important thing.
So overall, while I think in terms of agencies the market is—you know, dollar prices are high, pay-ups are high, people are worried about refinancing but really I think things are in pretty good shape in the agency market. We still are finding pockets of value there.
Moving to non-agencies and just housing in general, if you look on the upper left of Slide 11, prices year-over-year have gone up for the past five months, and that’s the first consecutive gains since the buyer tax credit in 2011 so that’s a positive sign, obviously, for the mortgage market. Really what we’re seeing is that really modifications and credit burnout have really been the story behind the improving sort of fundamentals. It really—you know, what’s going on it’s more the supply side than the demand side is what’s improving in the mortgage market right now, so modification efforts and credit burnout are really reducing the inventory of—sort of the shadow inventory out there has been going down, which has been a big positive. But again, tight credit, appraisal issues continue. It’s the same in non-agencies as it is in agencies, and you can see on the lower left, existing home sales, that has been really slow to grow and I think that kind of reflects the demand side that I was talking about.
So really while there are some positives, it really is reflecting improvement on the supply side as the demand side remains pretty weak, so that’s kind of what we’re seeing out there. We still remain pretty cautious on housing. We still like the top of the capital structure type bonds. Still would rather own senior REMICs at lower yields and apply a little bit of leverage because we’ve seen the funding markets have been very robust in non-agencies, so we’re taking advantage of that.
And then finally the last slide in terms of the commercial real estate market, again we’ve seen slow recovery here. If you look at the rebound in prices, the graph on the upper left, you can see obviously the bottom two lines are reflect the commercial prices. While they’ve gone up quite a bit, they’ve recovered less than half from the peak in 2007. If you look at non-major markets, they’ve actually done a lot better, so the gateway markets are kind of leading the way in terms of valuations. Vacancies continue to improve, rents are slowly stabilizing, so we’re seeing a slow recovery generally, and then on the financing side better quality assets are finding financing. We’ve seen that trend for a while now; that’s continuing, but not enough to close the equity gap entirely, so that’s important. Having the new issue market in CMBS is really critical to getting a lot of these loans refinanced and a lot of these are obviously balloon payments that have to get—have to find some sort of funding one way or another. So we are seeing that happening.
The new issue market is quite active right now. I think that’s a really positive sign for the market and that’s something we’re not seeing in non-agencies, which is a big positive for CMBS. And again, the secondary market in CMBS is still really—I mean, it’s a very liquid market. I think that’s one of the things we’ve noticed. We’re trafficking in top of the capital structure generally or high quality bonds. They’re extremely liquid and they tend to react a lot faster in price both on the upside and the downside in terms of trading. I think a lot of (inaudible) used as a proxy for credit in general because they’re so easily traded, so we’ve seen that continue. But anyway, I think the new issue market continuing to have a robust pipeline is a real positive, and that’s something obviously we play in and continue to take advantage of.
So with that, I guess I’ll just open it up for questions if there’s any.
Question and Answer Session
Thanks. Was just wondering if you could talk a little bit how you’re managing your leverage and hedging here with potential QEIII on the way.
Well as far as the leverage, what we intend on doing is, again, we think that our leverage levels are pretty effective. I mean, we’re at about 6.3 times total debt to equity over the last couple of quarters and things have been running in that range. So right now, we haven’t seen any need to make any adjustments to that with QEIII coming.
As far as hedging, we still—we’re pretty well hedged on our book and think that our duration gap, we still try to maintain anywhere from around 1 to 1.25 years or so, so pretty short duration gap and we think we’re in pretty good position with QEIII.
Yeah, I think the big key for the duration gap and how—I mean, there’s two things when we talk about duration gap. I think people don’t—if you manage a portfolio, it becomes clear pretty quickly that there is your model duration gap and your empirical duration gap. So model duration gaps have been—in our book have been longer than empirical, obviously, and we saw that 2011 was one of the things where we saw decoupling between agencies and swaps. We’ve see that really recover quite a bit recently. You know, pay-ups going up as rates fall has helped quite a bit, so spec pool mortgages have sort of kept up with swaps and outperformed swaps actually, and that’s been a pretty big driver of our book value improvement. So I think right now it feels like the market is kind of normalizing. I think the gap between our empirical durations and our sort of model have come back in, so it seems like we’re in a much better spot in terms of that.
Yeah, first I want to go back to the topic of the pay-ups. I think you mentioned that clearly they’ve been increasing, but I think you also said you’re still seeing some pockets of value. Could you talk about that a little more specifically, and also is the rally that you’ve seen in pay-ups gotten to the point where it’s also changing your perception of kind of relative value of non-agency and CMBS relative to the agency?
Sure. Yeah, I mean, clearly I think when we did our preferred, we talked that we were leaning more towards (inaudible) credit, and that continues although credit’s run a lot too. It’s not like that hasn’t seen price improvements. But no, I think generally speaking we’ve been—I mean, the market’s moved quite a bit down in coupon. We used to be looking at 5’s and 5.5’s, and that’s really moved down the coupon stack quite a bit. So I think we’ve still been finding some value in lower coupon mortgages. I mean, obviously the pay-ups I showed were for higher coupon mortgages. They haven’t gone up that much in lower coupon mortgages. Again, that’s another sort of play on QEIII. It seems like that’s becoming more and more likely, so that’s been part of it. But I mean definitely if given the choice, I think we’d prefer to move into credit over that. I mean, we think that sort of drive for yield by investors is going to continue, and if QEIII happens it’s not only going to help the agency side in terms of book values, but if rates go lower it’s going to be a little bit tougher with handling prepayments. But it’s really going to—I mean, we’ve seen a just huge demand for yield. I mean, any sort of asset that people can get their hands around has just seen this massive demand right now, so that’s part of what we’re trying to play also.
How have you guys been positioning for QEIII? I mean, now that it’s looking, I guess the consensus is more certain than it was even last week, do you let your duration gap widen out a little bit, or--?
Yeah, I think we’ve been—you know, in terms of, like I mentioned, empirical durations, they have been widening out a little bit just as mortgages kept up with everything else, and so we’ve kind of let that drift a little bit. You know, we keep it within bands, but we definitely let it get a little bit longer. We’re probably on the side where we would think it’s more likely than not, and certainly it almost doesn’t have to happen as long as the market keeps thinking it’s going to happen. It’s just as good as it happening, so we’ve certainly seen that.
Great. Another question – can I get you to kind of grade yourself on security selection over the last year? How do you think you’ve done? Clearly the bond market rally has helped. How do you think you’ve done relative to kind of relevant indices in the different asset classes?
Yeah, I think—agencies, I think we’ve done pretty well. I think the prepayment history has been pretty good. We’ve been—I think in security selection, it doesn’t show up in the slide as much but we’ve been successful in moving out of some of the non-prepay story bonds, like we’ve reduced our exposure to hybrid arms and things like that, so that’s been a big positive. But on the credit side, I think it’s been very good, actually. CMBS jumps to mind immediately. I think a lot of the sort of high quality bonds from—especially the legacy bonds, I think have performed really well, so we’ve seen just huge price improvements there but also those bonds have done well fundamentally, which has been a big part of it, too. I mean, our philosophy is kind of a little bit different in that we’re—the credit side of our shop is very strong and we really have never done anything on the credit side that we would consider a trade, so we wouldn’t look at, say, subprime bonds that we don’t necessarily like fundamentally. We didn’t think they’re cheap and oh, we’re going to buy them, hope they can tighten a bunch and then sell them without liking the credit. So we’ve been very disciplined about staying the course in terms of asset selection in fundamental terms.
On the non-agency side, the senior REMIC trade is actually interesting because those bonds are much higher quality in terms of the amount of subordination they have, a lot of them anywhere from 30 to 50% subordinated so the yields are going to be a lot lower but they lever real well. So we’ve seen from that perspective—I mean, those bonds have performed exactly as we thought. I think there are some parts of the non-agency market that have probably seen greater price increases, but in terms of—you know, from our perspective we’d rather be in kind of a low volatility asset class that provides a very good ROE. I guess the biggest worry there is on the funding side in terms of just the availability of non-agency funding, and we’ve seen that’s been very, very stable so we haven’t really had any concerns about that.
So I think it’s been pretty good in terms of—you know. And I think also when you look at the credit bonds, if you want to look to another example about the credit underwriting. You know, you ask about how do you grade yourselves. If you look at we haven’t had to take any other than temporary impairment on the bonds that we own, it goes to show that, again, we’ve been really very good about selecting in the right assets, and those assets have performed as we expected them to do. So I think from that grade, it’s also been very good. So again, I think very strong performance there.
Okay, great. Just one more question from me. How do you—when you evaluate capital raising, particularly common, how do you think about the importance of accretion to turnings, book value, dividend – kind of each individually, and how would you prioritize and rank those?
I don’t think it’s one thing you can sit there and prioritize or rank any one in particular. I think you’ve got to look at the body of work. Any time you look at raising capital, it’s always—first and foremost, it has to be accretive to the shareholders and accretive to the common shareholders. How we define that obviously is we’re just not interested in issuing stock that’s below book value. We don’t think that that’s appropriate to the shareholders. We think that there needs to be assets to buy that generate good returns, and those are the two key factors that we always look at. I wouldn’t say that one is more important than the other. I think they run hand-in-hand. But the main thing as we look at it is you’ve got to be disciplined to make sure that there’s a great opportunity there.
You know, I’ll look at, for example, the preferred offering that we did. We thought that was a great entry point for the preferred offering. It gave us a diversified pool of equity that we could go after. It was very well received by the marketplace, and it also added a little bit of accretion to the common shareholders in that there were some leftover earnings associated with that that’s not being paid out to the preferred shareholders.
So again, overall that’s the way we look at it. We’re just always looking for the right opportunity, and as you know the last—you know, this past year we’ve been disciplined because, again, we don’t feel that we’ve been trading at a premium to book. Even though there’s been some opportunities to buy assets out there, we’ve just really been disciplined about doing that and we’ll continue to do that.
Thank you. I’m just curious – and probably I missed it – so what kind of yield are you guys seeing right now in the credit space in both CMBS and also non-agency, and do you guys use leverage to lever it up?
Oh yeah. Yeah, it’s on Slides 7 and 8. Yeah, so right now the yields non-agencies – I think average yield is about 5.37. I would say for new purchases, yields are going to be slightly lower than that, probably for a senior REMIC anywhere from 4.25 to 4.75%. Now, obviously so the yields that we’re buying new stuff at are going to be lower than the yields shown here, because that’s the average yield on the portfolio, but also the cost of funds obviously is heck of a lot lower than 177 going forward too. And on the non-agency side, our leverage has been about 2.5 times, so.
And then on the CMBS side, it’s fairly similar. Yields are 5.30 on the entire book. The new issue bonds are going to be a little bit lower than that; but again, cost of funds are going to be a little bit lower also with rates down. So that’s been—you know, spreads on CMBS have been coming in along with rates, so we’re seeing new money being put to work, slightly lower yields but again with lower cost of funds.
Has the rally you’ve seen in the non-agency space changed at all where you’re looking in the capital stack? Have you thought about going down from the triple-A (inaudible)?
Yeah, I mean, I guess it’s a chasing yield question again in terms of that. No, we haven’t per se. I think one of the things that we do when we underwrite bonds every month—I mean, we tend to see trends a little bit quicker than the market generally. I mean, that’s been very helpful in the past, and on the positive side that helps, too. So I think as—so the way it works in our world is we’ll see changes in performance, in fundamental performance, adjust models to reflect that and then as we run new bonds you’ll get different answers, obviously, if you’re not projecting the world going straight down anymore. You’re sort of seeing things flat or even turning up. That’s going to really change your prospective yields on bonds, so we have seen a little bit of that. I think part of the update on that—I mean, we have seen some improving fundamentals, so that’s helped. It hasn’t been enough to move us into different asset classes. I mean, it’s been more—maybe we’ve seen slightly more bonds that make sense to us, whereas things like subprime and option arm, we still feel like they’re just—at least in our portfolio, they don’t make as much sense given the very, very low coupon and your returns are very back-ended in terms of recoveries and things like that. So that hasn’t really changes sector-wise, but I think bond-wise it has.
And just one more follow-up on that point – it seems like home prices are stabilizing faster than most people would have assumed, at least in what are usually kind of bearish assumptions with valuing non-agency bonds. Could you talk about what the implications could be for both your GAAP taxable earnings if the housing market continues to improve fro here?
Well really, Mark, when you look at it, our GAAP and tax earnings for the most part, there is not a lot of difference between them, so I think really when you—with the types of assets I think that we own, the earnings aren’t coming from that back end like they would on a subprime bond or something like that. So you really won’t see much of a difference on the impact to us. I mean, basically with the housing market improving as an example, where you’re probably going to see things is maybe your prepayments are going to be a little bit better on your non-agency bonds, so you’re going to get a little better performance out of them. But it’s not going to be that there’s going to be a huge windfall, the GAAP or tax for our example, because again there’s really no difference between the two of our numbers.
Yeah, and I think any improvement in housing, for us at least, would flow more through book value as people get more comfortable with the bonds and require less yield to own them. That helps us in terms of book value.
Well fantastic. Well, we appreciate everybody taking the time to listen this morning, and if there’s any follow-up questions please let us know.
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