Invesco Mortgage Capital Inc. (NYSE:IVR) Q2 2022 Earnings Conference Call August 5, 2022 9:00 AM ET
Jack Bateman - Investor Relations
John Anzalone - Chief Executive Officer
Brian Norris - Chief Investment Officer
Conference Call Participants
Doug Harter - Credit Suisse
Trevor Cranston - JMP Securities
Welcome to Invesco Mortgage Capital Inc. Second Quarter 2022 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 Jack Bateman in Investor Relations. Mr. Bateman you may now begin the call.
Thank you to all of you joining us on Invesco Mortgage Capital's quarterly earnings call. In addition to today's press release, we have provided a presentation that covers the topics we plan to address today. The press release and presentation are available on our website invescomortgagecapital.com. This information can be found by going to the Investor Relations section of the website. Our presentation today, which will include forward-looking statements and certain non-GAAP financial measures. Please review the disclosures on slide 2 of the presentation regarding these statements and measures as well as the appendix for the appropriate reconciliations to GAAP.
Finally, Invesco Mortgage Capital is not responsible for and does not edit or guarantee the accuracy of our earnings teleconference transcripts provided by third parties. The only authorized webcasts are located on our website. Again welcome and thank you for joining us today.
I'll now turn the call over to John Anzalone. John?
Good morning and welcome to Invesco Mortgage Capital's second quarter earnings call. I'll give some brief comments before turning the call over to our Chief Investment Officer, Brian Norris to discuss the current portfolio in more detail. Also joining us on the call to participate in the Q&A are President, Kevin Collins; our CFO, Lee Phegley, and our COO, Dave Lyle.
The challenging environment to characterize the first quarter of 2022 continued into the second quarter as the Federal Reserve responded to worsening inflation data by raising the Fed funds rate by 125 basis points, which was followed by an additional 75 basis point hike in late July. Risk assets broadly underperformed during the quarter in response to tightened financial conditions. The S&P 500 Index declined approximately 17% over the quarter and the Bloomberg US Aggregate Bond Index declined roughly 4.4% over the same period. Mortgages were no exception given increasing interest rate volatility and heightened expectations of a more aggressive balance sheet reduction.
As we communicated on June 27th, our book value declined during the quarter ending June at $16.16. Since the beginning of the third quarter, agency mortgage performance has stabilized as wider spreads have attracted investors and our book value was up high single digits through the end of July. Over the course of the quarter, we've continued to reduce risk through active portfolio management. Given the elevated market volatility, we decreased our overall exposure to agency mortgages by reducing economic leverage from 6.5 times to 3.9 times. We also reduced our exposure to lower coupons, which are predominantly owned by the Federal Reserve increased our exposure to higher yield in current coupons. Our liquidity position remains strong with $677 million of unrestricted cash and unencumbered assets at quarter end.
Despite a reduction in risk, our earnings available for distribution remains well-supported. Our net interest margin has expanded due to the wider spreads available on new investments in higher coupon mortgages, continued favorable funding rates and our low-cost legacy swaps. We also made significant progress in improving our capital structure as we repurchased approximately 30% of our preferred shares outstanding since the beginning of the second quarter. The bulk of these accretive purchases occurred in early July and accounted for about 3% of our quarter-to-date book value increase.
Going forward we see conditions in the Agency RMBS market is becoming more favorable. Elevated interest rate volatility and the potential for mortgage sales from the Fed remain headwinds, but we expect the environment for mortgages to improve given wider spreads on higher coupon mortgages, attractive funding and reduced supply resulting from lower origination volume.
I'll stop here and let Brian go through the portfolio.
Thanks John and good morning to everyone listening to the call. I'll begin on Slide 4 which provides an overview of the changes in the macro environment within the fixed income markets over the past year. Persistently elevated inflation data continue to pressure interest rates higher across the yield curve, as detailed in the upper left chart, while the monetary policy response from the Federal Reserve has impacted funding markets as shown in the upper right chart.
Market expectations for future adjustments and monetary policy have evolved as well with further tightening expected in the near term, now followed by easing in the latter half of 2023 as indicated in the bottom left chart. Since the end of the second quarter inflationary pressures have led to further tightening of monetary policy with the Federal Reserve increasing the Fed funds rate by an additional 75 basis points at their July meeting. In addition, escalating of recessionary risk have resulted in lower yields and longer dated maturities and continued flattening of the yield curve with one and two-year treasury yields now higher than 10-year yields by 35 to 40 basis points.
As shown in the lower right-hand chart, US commercial banks slowed their purchases of agency mortgages during the second quarter concurrent with the end of net asset purchases by the Federal Reserve, resulting in significantly lower demand for the sector during the quarter. Runoff of the Federal Reserve's Agency mortgage portfolio began in June at a cap of $17.5 billion per month.
With paydowns on the agency mortgage portion of the Fed's balance sheet averaging just over $30 billion per month in the second quarter it is unlikely the $35 billion cap on runoff starting in September will be restrictive absent a significant drop in mortgage rates and increase in refinancing and housing activity.
Moving on to slide five, where we provide more detail on the Agency RMBS market. In the upper left-hand chart, we show 30-year current coupon agency mortgage performance versus treasury hedges over the past year, highlighting the second quarter of 2022 in gray. Agency RMBS performed poorly during the quarter as elevated interest rate volatility and increased market expectations for Agency RMBS sales from the Fed's balance sheet pressured valuations sharply lower resulting in wider spreads.
In contrast, the sector performed very well in July, as cheaper valuations and a reduction in expectations for Fed sales from the balance sheet attracted significant investor demand. As shown in the upper right chart specified pool pay-ups stabilized at very low levels during the second quarter, while implied financing in the TBA market continue to converge with short-term funding rates as indicated in the lower right chart.
Moving on to slide six, where we provide more detail on our Agency mortgage investments and the changes in the portfolio during the second quarter. We significantly reduced leverage by lowering our exposure to Agency RMBS given the continued challenges in the sector. In addition, we rotated the remainder of our lower coupon investments into more attractive higher coupons, expanding our net interest margin and supporting the earnings power of the company despite the overall reduction in assets.
The period end weighted average yield on our Agency RMBS investments improved from 2.54% at the end of the first quarter to 4.07% at the end of the second quarter, capturing a significant improvement in available returns given wider spreads and higher interest rates during the quarter.
Our Agency RMBS investments are well diversified across coupons and we have largely eliminated direct exposure to potential sales from the Federal Reserve's balance sheet by selling our 30-year, 2% and 2.5% coupons. Given attractive valuations on specified pools, we rotated into higher quality prepayment attributes, increasing our allocation to loan balance stories, which historically performed well in both a premium and discount environment. Despite expectations for a deterioration in the dollar roll market as the reduction in demand from the Federal Reserves and commercial banks weighs on valuations, production coupon TBA remains modestly attractive. We believe cheaper valuations on production coupon specified pools and TBA represent attractive investment opportunities with current ROEs in the mid-teens.
Our remaining credit investments are detailed on Slide 7 and with non-Agency CMBS representing 55% of the $79 million portfolio. Our allocation to credit securities declined from $98 million during the quarter, given paydowns on our CMBS portfolio. Our $52 million of remaining credit securities are high quality with nearly 90% rated single A or higher. Although we anticipate limited near-term price appreciation, we believe these assets are attractive holdings as 100% are held on an unlevered basis and provide attractive yields.
Lastly Slide 8 details our funding book at quarter end as shown in the chart on the upper left. Repurchase agreements collateralized by Agency RMBS declined to $3.3 billion as of June 30, given the reduction in our specified pool holdings and hedges associated with those borrowings also declined to $2.2 billion net notional of current pay fixed received floating interest rate swaps.
In order to hedge additional exposures further out the yield curve, we continue to hold $1 billion of notional of forward starting interest rate swaps with starting dates in 2023. Our weighted average repo cost increased to 1.38% and have continued to climb higher as the funding markets price and tighter monetary policy in the coming months. Our economic leverage when including TBA exposure decreased significantly during the quarter to 3.9 times debt to equity, given the further reduction in risk as financial market volatility remains elevated.
Post quarter end, economic leverage increased modestly to approximately 4.4 times debt to equity at the end of July, as the reduction in our preferred equity provided an opportunity to benefit from a more positive tone in Agency RMBS. To conclude our prepared remarks, although the tone and Agency RMBS has improved since the end of the second quarter, challenges remain in the sector as volatility remains elevated and the sharp reduction in demand from commercial banks and the Federal Reserve reduces the number of potential buyers.
However, given the historic underperformance in the sector over the past year, attractive valuations provide an opportunity for investors to benefit from a potential return to a less volatile market environment. While we believe that lower coupon investments have limited value given current valuations and headwinds from the reduction in the Federal Reserve's balance sheet Agency RMBS investments higher in the coupon stack are attractive given a reduction in mortgage origination and cheaper valuations.
We remain somewhat cautious given elevated market volatility. However, we do believe today's valuations and production coupons represent an attractive entry point for those with longer time horizons. Thank you for your continued support for Invesco Mortgage Capital and now we will open the line for Q&A.
[Operator Instructions] Our first question comes from Doug Harter with Crédit Suisse. Your line is open sir
Thanks. Just a big picture question. As you're thinking about portfolio construction capital structure, what are you looking to do to try to mute some of the volatility in book value?
Yes. Hey Doug, it's Brian. I'll take a crack at that and if John has anything to add he can. We have certainly lowered our leverage. So, we're -- given the imbalance in our capital structure with our preferred shares elevated as a percent of the total, we have been as we mentioned being able to repurchase shares to reduce that amount which is going to reduce -- which has reduced the volatility to our common equity.
And so the combination of lower overall leverage and also rightsizing our capital structure should be able to mitigate the volatility that we've seen. And then also clearly market volatility remains quite elevated. So, once that starts to return to more normalized levels then we'll also see a further reduction in both.
Yes, I'd just point out that the 30% reduction in preferred -- or 30% we were able to buy back the bulk of that occurred post quarter end in the early part of July. And we continue to look for opportunities to either buy back more preferreds or if conditions are appropriate to continue to issue stock either through the ATM or through block trades.
But -- so both of those would help balance the capital structure which would -- absent any change in the portfolio would obviously change the amount of volatility to the common. So, that's kind of the goal.
Got it. And I guess as you're thinking what is kind of like a range of work towards a normalized capital structure? What is the right range for preferreds?
Yes, I think historically we've been in the low 20s. So, I think that's what we're targeting. So, we'll see as we get closer and depending on how much we can get done. We'll work to get closer to that level?
Great. Thank you.
[Operator Instructions] Our next question comes from Trevor Cranston with JMP Securities. Your line is open sir.
Thanks. You mentioned some of the factors that drove spreads tighter in July. It sounds like you're a little bit cautious still on the environment overall in the near-term. So, I was curious if you could talk about kind of how you think about the trade-off between protecting book value and being cautious with low leverage near-term versus potentially missing out on some spread tightening if there is a meaningful decline in volatility.
Yes. Hey Trevor, it's Brian. The improvement that we saw in July was -- it was kind of a combination of a few different things. I think the increase in recessionary risks, kind of, pushed off the potential for asset sales from the balance sheet, which helped lower coupons recover some of their underperformance from the previous months. And also volatility did come down a little bit. I think we've actually seen that return here in early August and reversed some of that move that we've seen in July.
But I think to the extent that market volatility remains pretty elevated, we're more comfortable kind of keeping leverage at the low end of the range, just to help try to offset some of that volatility. With our EAD pretty well supported at these levels, we're pretty comfortable keeping it where it is.
Okay. And then on the question of the dividend and the earnings level, I mean so obviously the dividend is pretty well supported by earnings at this point. But at the same time, the stock is quite a high yield compared to some of the other companies out there. So can you maybe talk about kind of how you weighed potentially retaining some extra earnings to grow book value versus keeping the yield the size of this?
Yes. Hey, Trevor, I'll answer that one. Yes, I mean, so obviously this quarter we retained about 40% of EAD which went back into book value. And going forward, obviously, the dividend decision is a Board decision and we'll be having those discussions as we go forward in terms of the decision to make -- to put excess EAD over the dividend back into how much excess dividend there is, I guess, is the decision.
And I think it's, we'll kind of see how that goes to the stock reacts over the next couple of months. And -- yes, I mean, that's the question is, how much we want to retain. So that will be a Board decision over the next couple of months.
Okay. That makes sense. Thank you.
There are no other questions in queue.
All right. Well I'd like to thank everybody for joining us on the call and we look forward to reconvening next quarter. Thank you.
That concludes today's call. All participants may disconnect at this time. Thank you for joining.