Invesco Mortgage Capital Inc. (NYSE:IVR) Q1 2019 Earnings Conference Call May 9, 2019 9:00 AM ET
Brandon Burke – Investor Relations
John Anzalone – Chief Executive Officer
Brian Norris – Chief Investment Officer
Kevin Collins – President
Dave Lyle – Chief Operating Officer
Conference Call Participants
Doug Harter – Credit Suisse
Eric Hagan – KBW
Trevor Cranston – JMP Securities
Welcome to the Invesco Mortgage Capital Incorporated First Quarter 2019 Investor Conference Call. All participants will be in a listen-only mode until the question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded.
Now, I would like to turn the call over to Brandon Burke, Investor Relations. Mr. Burke, you may begin the call.
Thank you, and welcome to the Invesco Mortgage Capital first quarter 2019 earnings call. The management team and I are delighted you’ve joined us, and we look forward to sharing with you our prepared remarks during the next several minutes before concluding with the question-and-answer session.
Joining today are John Anzalone, our Chief Executive Officer; Kevin Collins, our President; Lee Phegley, our Chief Financial Officer; Dave Lyle, our Chief Operating Officer; and Brian Norris, our Chief Investment Officer.
Before we begin, I would like to direct your attention to Slide 2 of our earnings presentation, which discusses forward-looking statements in detail. Statements made in this conference call regarding Invesco Mortgage Capital that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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 to 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 Condition and Results of Operations in our annual report on Form 10-K 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 if any forward-looking statement later turns out to be inaccurate. To view the slide presentation today you may access our website at invescomortgagecapital.com and click on the Q1 2019 earnings presentation link. You can find it under the Investor Relations tab at the top of our homepage. There you may select either the presentation or the webcast option for both the presentation slides and the audio.
Again welcome and thank you for joining us today and I’ll now turn the call over to our CEO, John Anzalone. John?
Thank you. And I’d like to welcome everyone to Invesco Mortgage Capital’s first quarter earnings call. I will provide a brief recap of our results as well as an update on our outlook before handing the call over to our CIO, Brian Norris, to go through our portfolio activity in more detail. We are pleased to announce that IVR had a strong start to 2019 delivering an economic return of 9.6% for the quarter. This result was driven by higher asset valuations across our portfolio leading to a 6.7% increase in book value, combined with a 7% increase in our dividend to $0.45 per share.
Our core earnings per share increased to $0.47 comfortably covering our new dividend despite an increase in share count in connection with our successful common stock offering in February. The heightened volatility of the financial markets experienced during December subsided in January and our portfolio of seasoned credit and agency assets enjoyed strong appreciation during the quarter. Our Agency CMBS portfolio which consists almost entirely prepayment protected specified pool paper saw notable gains as did our Agency CMBS positions. On the credit side, our seasoned CMBS and CRT bonds continue to benefit from positive fundamental trends in spreads on these positions also rebounded nicely during the quarter.
Our core earnings of $0.47 topped our recently increased dividend rate of $0.45 and there are several factors this help to support this increased run rate. Our recent rotation out of lower yielding 15 year in Hybrid ARM securities into specified pool agencies and Agency CMBS was particularly well timed. These bonds have led to a higher net interest margin while also helping to mitigate convexity risk. Our capital raised in February has also contributed to our higher run rate, as we invested those proceeds while spreads were not fully recovered from December’s wides [ph]. While prepayment rates have increased due to both seasonal factors, as well as lower rates. The specified pools that we own along with our increased allocation to Agency CMBS have been effective at reducing the impact of broadly faster speeds.
Finally, our hedging strategy was effective not only in protecting book value, but also help protect our net interest margin. We are well insulated from the impacts of volatility in the basis between one and three month LIBOR given our concentration in one month LIBOR swaps, which more closely track changes in our repo funding costs.
One of the things that was very clear during the past few quarters is the value of the hybrid model. Our ability to allocate capital to the best opportunities across the entire mortgage space has been instrumental in producing consistent high quality earning stream. While we have had some book value volatility during the past two quarters, our risk management discipline allowed us to not only weather the storm, but to take – but to capitalize on it once it was over.
Of course, center of this is flexibility as our platform, which allows us to access the breadth of the mortgage market without incurring elevated costs to our shareholders. In fact our expense ratio is among the lowest of our peers a tremendous value proposition considering that it enables our shareholders to tap into the expertise and resources of a low – leading global asset manager.
Looking ahead, we are enthusiastic about the future and our ability to continue to deliver strong results for our shareholders. Our portfolio is well diversified with Agency CMBS and CMBS balanced with the seasoned credit portfolio that would be nearly impossible to replicate today. As we progress further into the credit cycle, we believe that our strategy will continue to support a strong core earnings stream while allowing us to take advantage of opportunities in the mortgage market wherever they may exist.
So I’ll stop here, and turn the call over to Brian to go over the portfolio activity in more detail.
Thanks, John. I’ll start on Slide 6, which provide the breakdown of the broad sector allocations on our portfolio both on an equity and total asset basis. As indicated by the pie chart in the upper left hand corner, our equity allocation to agencies and credit remains well balanced. With a modest increase in agency assets from 49% to 50% quarter-over-quarter.
On a total asset basis, our allocation to agency assets increased from 69% to 73%. As a result of the capital deployment from the February common equity raise going predominantly into Agency RMBS and Agency CMBS. ROEs on both agency sectors were attractive during the quarter as wider spreads during the fourth quarter produced attractive entry points. Our Agency CMBS assets have grown since the second quarter of 2018 to approximately $2 billion or roughly 10% of our total assets as of quarter end. As a total asset allocation to agency RMBS reduced from 69% one year ago to 63% and credit assets down from 31% to 27%.
With the increase in the agency asset allocation our leverage increased modestly quarter-over-quarter to 6.9 times from 6.7 times. Given Agency CMBS continues to be an attractive complement to our agency RMBS and credit assets reducing risk to both an increase in interest rate volatility and spread widening. We remain comfortable with the modest increase in leverage.
Moving on to Slide 7, the repositioning within our agency RMBS portfolio during the second half of 2018 proved to be well timed, as we shifted from agency hybrid and 15 year collateral into 30 year specified pools. Not only did the repositioning increase the earnings power of the company, but we also benefited from a significant increase in the value of the prepaid protection and our specified pool holdings during the first quarter.
The weighted average pay-up over agency TBA on our 30 year specified pool holdings improved nearly a 0.5 point during the quarter. As demand for prepay protected specified pools increased substantially due to lower interest rates and weakening technical environment in agency TBA. This focus on prepay protection has served the company well, as the increase in our prepayment speeds over the last two months hasn’t significantly dampened relatives to generic collateral. We continue to favor loan balance, LTV and geographic specific stories to help mitigate the impact of prepayments.
And as you can see from the pie chart, in the upper left hand corner of Slide 7, this makes up the vast majority of our Agency CMBS holdings. Although, valuations are higher and returns modestly lower, we believe the Agency RMBS sector remains attractive given the low volatility environment as hedged ROEs are near 14%. With monetary policy on hold for now, we expect Agency RMBS to remain an attractive asset class, as volatility remains low and further fed hikes are priced out of the forward curve.
Turning to Slide 8, you can see in the lower left hand table that our allocation to Agency CMBS has grown to approximately $2 billion. We purchased $948 million of Agency CMBS during the quarter predominately in the Fannie Mae DUS program, as wider spreads and an improving financing environment led to an increase in opportunities in that sector. Agency CMBS complements our agency RMBS assets given the prepayment protection embedded in the securities in the form of prepaid penalties and lockout provisions.
Spreads widened during the fourth quarter allowing us to add exposure in the first quarter at attractive levels and remain attractive with hedged ROEs in the low-double digits. We anticipate continuing to add exposure to the sector at these levels, as we believe that provides substantial benefits to our portfolio given the stable nature of its cash flows and attractive financing terms.
Moving on to commercial credit on Slide 9. Our CMBS portfolio consists of a combination of well seasoned single A and BBB bonds financed via repo and AAA and AA bonds financed at the Federal Home Loan Bank. Our holdings continued to perform very well from a credit fundamentals perspective and increased demand in the sector during the quarter led to strong book value gains.
In addition, we were able to add $162 million of non-Agency CMBS during the quarter with ROEs in the low-to-mid teens as wider spreads during the fourth quarter led to attractive opportunities. One loan in our commercial loan portfolio paid down reducing our holding from $32 million to $24 million quarter-over-quarter and the maturity on the remaining loan is now less than two years.
Slide 10 highlights the credit quality of our commercial portfolio. Fundamentals in commercial real estate remains supportive of our assets, particularly given the seasoned nature of our portfolio as property price appreciation since issuance reduces embedded leverage in our holdings. The chart on the left shows the seasoning of our CMBS assets, indicating over two-thirds of our holdings were originated five or more years ago, while the chart on the right highlights the strong credit performance of our holdings with $683 million benefiting from rating agency upgrades since purchase. Positively spreads on seasoned subordinate bonds continue to benefit from increased investor demand due to rating agency upgrades, contracting spread duration, embedded property price appreciation, and in some cases deleveraging from loan pay downs.
Slide 11 covers our residential credit portfolio. This portfolio remains well diversified with 42% of assets in GSE CRT paper, 30% in legacy bonds and Re-REMICs, 25% in post 2009 Prime paper and a 3% allocation to a loan participation interest secured by MSRs. Spread widening during the fourth quarter provided opportunities to add assets at accretive levels, as we purchased approximately $170 million in assets. Split between GSE CRT and new issue Prime. Fundamentals remain supportive here as healthy borrower balance sheets combined with lower mortgage rates and accelerating wage growth are helping to offset declining affordability due to the rise in home prices.
Side 12 provide some detail around the credit quality of our residential credit portfolio. 68% of our CRT investments have been upgraded by at least one rating agency since issuance as shown on the chart on the left. The upgrades are result of significant underlying home price appreciation and low default rates. The chart on the right reflects the vintage distribution of our investments. Our legacy positions consistent of Prime and Alt-A paper that we purchased relatively early in the recovery at high book yields. While our CRT positions are mostly in earlier post-crisis vintages, which have higher credit quality and lower spread volatility than newly issued securities.
Finally, on Slide 13, summarizes our financing and hedging strategy. At quarter end, we had $16.8 billion of Repo outstanding with 31 counterparties and $1.7 billion of secured financing through the Federal Home Loan Bank. We have seen improved financing terms for our credit assets improving the net interest margin on that portion of our book. To reduce the risk associated with changes in Repo funding cost, we held $12.9 billion notional of interest rate swaps, which we increased by $500 million during the quarter.
We also took advantage of lower swap rates during the quarter by locking in longer dated hedges. We have mitigated the impact of changes in the spread between three month and one month LIBOR by extending maturities in our Repo book, while also shifting a portion of our swap hedges to receiving one month rather than three month LIBOR. The combination of these adjustments protects the company’s earnings stream from reliance on a positive spread between three month and one month LIBOR, as monetary policy shifts from a tightening to accommodative stance.
We believe this produces a more reliable and predictable income stream and along with the increased earnings power of our assets due to the portfolio repositioning in 2018 and an accretive equity raise in February allowed us to increase our dividend in the first quarter from $0.42 to $0.45.
That ends my prepared remarks. Now, we’ll open the line for Q&A.
Thank you. [Operator Instructions] Our first question comes from Doug Harter with Credit Suisse. You may go ahead.
Thanks. When you look at, I guess first off, how do you view available returns kind of across your portfolio kind of given – given kind of the assets that you said you’re targeting today versus three months ago.
Yes. Thanks, Doug. This is Brian. Agency RMBS, ROEs are kind of low teens say 13%, 14%. Agency CMBS, I would say is kind of low-double digits, as I mentioned there during the commentary. I don’t know, if you could please, Kevin or Dave want to come on credit assets.
Yes. This is Kevin. I’m happy to jump in and talk about in terms of what we’re seeing in CMBS lands. Really low-double digits there as well, call it anywhere to 11% to 14%. Mostly focusing on new issue BBB credit as well as season to a lesser extent.
Yes. And this is Dave on the resi side, certainly, ROEs are bit lower than three months ago as we’ve continued to see the recovery in credit assets from the spread widening that we saw late last year. In CRT, I’d say M2s are kind of very high-single digits maybe borderline double-digits there. Non-rated CRTB1s are pretty attractive with the mid-teens type ROE. The rest of our universe is tied to the point, where it’s not especially relatively attractive versus our other target assets, prime jumbo very high-single digits. Legacies probably are least favorite part of our market right now, we see about mid single digits there, not a lot of opportunity for book value upside in legacies in our view. And then some of the newer resi credit subsectors SFR non-QM, we continue to like the credit quality of those assets and think that non-QM especially is going to be increasingly important market going forward. But at this time, they would not really provide attractive ROEs to a levered vehicle.
All right. And then as prepay is kind of increased in the second quarter. Can you kind of help size the magnitude impact that would have on yields or earnings?
Yes. So, we just received the April prepayment report just a few days ago, and speeds broadly for our portfolio were up about 20%. The market I believe was up 24%, but generic 30-year 4s and 4.5s were up pretty significantly month-over-month. We would anticipate a similar increase in speeds next month – for next month’s report. So, our core earnings in the first quarter was at $0.47 and we set our dividend of $0.45, so we believe that that’s a repeatable.
Great. Thank you.
Thank you. Our next question comes from Eric Hagan with KBW. You may go ahead.
Thank you, gentlemen. Good morning. Just on leverage, I guess just how comfortable are you with leverage in the agency portfolio right now. I guess on its face, it seems like that would imply that you’re comfortable with the mortgage basis and I guess the question is kind of two-fold. One is, again just kind of gauging their comfort level with leverage in the agency portfolio against the backdrop of mortgage basis and any sort of commentary around your views on the basis would be helpful? Thank you.
Yes. This is John. I think as we’ve always said, the leverage is always a function of asset mix and even with an agency that’s true. So, as we’ve been moving more towards agency CMBS like Brian mentioned the 30-year portion of our book actually went down a little bit this quarter, whereas the Agency CMBS portion has increased. So, all things equal Agency CMBS will be slightly more comfortable levering a little bit more, because there’s no convexity risk and a lot less spread volatility. So, I think that’s kind of where we are. But – so we don’t anticipate much more leverage other than what might be a function of just asset mix.
Eric, I think it’s important to keep in mind that this – we value the fact that we are managing a hybrid REIT and we are looking for our best way to find financing across the portfolio. So while, I think you’re focusing on the leverage on the agency book itself. We really are looking for cheapest cost of funds. So, we may put leverage on and post collateral of agencies, but it’s really the overall book that we are levering and we – the turns of leverage is very minute in terms of the change. I think we went from 6.7% to 6.9%. So, we don’t view it as individual assets that are important on what’s the leverage on agencies versus what’s the leverage on credit. It’s the total portfolio leverage that we are focused on.
Fair enough. No please, go ahead.
Sure. Yes. Eric, I’ll just comment briefly on kind of agency mortgages you asked about kind of spreads there and valuations and we think valuations are pretty fair in that space. I think there’s not a lot of room for tightening potential, but ROEs are still kind of attractive, where valuations are right now. So that the withdrawal of the fed from the market is largely priced and I think the market is fairly accepting of prepayment speeds increasing over the next couple of months although we have bounced off the lows in rates. So, the refinancing activity that we’re seeing has mitigated a bit there. So, I think we’re pretty comfortable with where spreads are on the agency mortgages right now.
Got it. Yes. Thanks for that – addressing that follow-up. So, just kind of sticking on the leverage theme, how much dry powder or I guess unencumbered assets do you guys have at this point?
That’s a number that changes on a daily basis. I think it’s hard for us to pinpoint that number, but we run this from a very risk management standpoint. And so our cash on unencumbered is well in excess of what we see as our VaR risk, which is the way that we measure what we need to keep in order to manage through any of the scenarios.
Got it. And the commercial. Yes, go ahead. I’m sorry.
All right. As we mentioned, our exposure to agency RMBS and to credit assets has been reduced over the last couple of quarters. So, our portfolio, as a whole, is less risky than it has been. So, we feel pretty comfortable with the increasing leverage.
Okay. And then on the commercial credit, it looks like the position at the Federal Home Loan Bank is over-collateralized by around 20%. What are the haircuts that the FHLB offers on the commercial credit. I guess, it’s AAA kind of credit, but what – how much more could you lever that position if you wanted to just kind of what I’m asking?
Yes. Sure. This is Kevin. I guess in terms of how we’re looking at things there were, we basically have $1.65 billion of advances. So that amount is going to stay with us and we’ll look to utilize as much leverage as we can there. And the nice thing about that portfolio is the net interest margin is very healthy just given the fact that the funding rates are attractive. So, I think that’s really the way that we look at that portfolio.
Thanks, Kevin. But the position itself, it looks like, on the press release, is over-collateralized by around 20%. Is there wiggle room? I mean, is that kind of tapped out from a leverage standpoint or is there more that you could go there?
So, we really look at things holistically as we’ve said before in terms of what our cash on unencumbered is. So, we’re less focused in terms of where it might be on certain lines and more focused at an entity or company level, what is our cash on unencumbered that we have set aside kind of irrespective of what line it’s associated with. So, not a lot to focus there.
The intent is to optimize our cost of funds.
Got it. Okay. And any update on book value quarter to-date?
So I think, we’re slightly up above where we were at the end of the third quarter, but it’s not material, so you can think about it as above where we were.
Yes. Great. Thank you guys. Thanks for the comments. Appreciate it.
Thank you. Our final question comes from Trevor Cranston with JMP Securities. You may go ahead.
Hi. Thanks. Good morning. Question on the effective net interest margin, I guess I was a little surprised to see both the asset yield improve and the cost of funds declined. So, I was wondering if maybe you guys could provide a little bit of color around what the drivers of each of those components for this quarter? Thanks.
Sure. I’ll cover on the hedge side. This is Brian. And we did reposition the swap book a bit during the first quarter. We were to take advantage kind of the inversion in the swap curve that we saw. So, we did extend maturities, which helped lower the interest rate that we were paying on those hedges. And then from an asset yield perspective that still continues to kind of be a result of the repositioning that we did really in the latter half of 2018 and a little bit more in the first quarter as well as the accretive levels that we were able to deploy the capital raise in February.
This is Dave. I’ll add one more note on that, the financing spreads on our credit assets on repo also tightened in the first quarter by about 10 basis points on average. So that helping them as well, so I would point out some of that tightening was a little bit later in the quarter, so we won’t realize the full benefit of that until Q2.
Got it. Okay. That’s helpful. Then I guess listening to the commentary on the opportunities you guys are seeing. It sounded like you were maybe leaning towards agencies as continuing to be relatively attractive even though there are still some opportunities in other asset classes. Can you talk about sort of how you’re seeing the asset allocation mix sort of trending over time given where markets are today and how high you’d be willing to take the agency allocation within the overall portfolio? Thanks.
Yes. Thanks, Trevor. We – with a hybrid model, we prefer to maintain some flexibility around that obviously and right now, we see better opportunities in agencies both RMBS and CMBS, but from a credit perspective, we are still able to add some accretive assets and we’ll certainly continue to look for opportunities there. They’ve tended over the last quarter or two to be a little bit fewer opportunities, but we’ll continue to be searching for those as they come available.
And then as far as kind of the total asset allocation to agencies, we’re certainly kind of at the higher end of where we’ve been in the past. But that’s not necessarily something that we’re overly monitoring or concerned about from a risk perspective as those assets tend to be lower volatility spread assets.
Great. Okay. Appreciate the color. Thank you.
Thank you. At this time, there are no further questions. I will now turn the call back over to Mr. John Anzalone for closing remarks.
All right. Well, thanks everybody for your time, and we will look forward to the second quarter call. Thanks.
Thank you. That does conclude today’s conference. All participants may disconnect. Thank you for your participation.