Invesco Mortgage Capital - Q2 2023

Transcript

Operator (participant)

Welcome to Invesco Mortgage Capital Inc's second quarter 2023 investor conference call. All participants will be in a listen-only mode until the question and answer session. At that time, to ask a question, please press Star followed by one on your telephone. As a reminder, this call is being recorded. Now I'd like to turn the call over to Greg Seals in Investor Relations. Mr. Seals, you may begin.

Greg Seals (Head of Investor Relations)

Thanks, operator, and 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. 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. The presentation today will include forward-looking statements and certain non-GAAP financial measures. Please review the disclosures on slide two 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 nor guarantee the accuracy of our earnings teleconference transcripts provided by third parties. The only authorized webcasts are located on our website. Again, welcome, thank you for joining us today.

I'll now turn the call over to John Anzalone. John?

John Anzalone (CEO)

Good morning and welcome to Invesco Mortgage Capital's second quarter earnings call. I will 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 are President Kevin Collins, our CFO, Lee Phegley, and our COO, Dave Lyle. Financial conditions improved throughout the second quarter as equity markets rallied and credit spreads tightened, given the swift resolution of the U.S. debt ceiling negotiations and increased market expectations of a soft landing for the U.S. economy. The positive environment across most risk assets was further spurred by continued moderation in most inflation measures, led by the decrease in the headline Consumer Price Index to 3%.

Interest rates were sharply higher during the quarter, largely reversing the rally spurred by the uncertainty surrounding the regional banking system that we saw during Q1. Agency mortgage performance generally improved during the second quarter as lower coupon valuations recovered the majority of their underperformance in the first quarter, while high coupon valuations improved modestly as short-dated interest rate volatility remained relatively elevated. In addition, premiums on specified-pool collateral declined as a result of higher mortgage rates as prepayment protection became less valuable. Increased demand for risk assets by mortgage investors was largely offset by faster than anticipated sales of failed bank assets, particularly specified-pool collateral by the FDIC and the increased supply caused by stronger housing seasonals.

Against this backdrop, our book value per common share ended the quarter at $11.98, representing a decline of 5% from March 31st. When combined with our $0.40 per share common dividend, produced an economic return of -1.8% for the quarter. Despite the negative impact on book value, IVR's earnings available for distribution was resilient, decreasing slightly to $1.45 from $1.50 last quarter. Our focus on higher yielding, higher coupon mortgages in combination with a hedging strategy that continues to benefit from low-cost pay-fixed swaps drove the strength in EAD. Over the coming quarters, we expect EAD to remain well supported as we continue to hedge nearly all of our repo borrowings.

Importantly, these hedges provide benefit for the long term as the weighted average maturity of our pay-fixed swap portfolio is approximately seven years. ROEs on new investments have also been a positive contributor to EAD, benefiting from attractive spreads, favorable funding, and our legacy swaps. Our debt-to-equity ratio ended the second quarter at 5.9x, up marginally from 5.8 as of March 31st. As of the end of the quarter, substantially all of our $5.5 billion investment portfolio was invested in Agency mortgages. We retain a sizable balance of unrestricted cash and unencumbered investments totaling $492 million. The FOMC's monetary policy tightening cycle is expected to conclude by the end of the year, with perhaps one more 25 basis point increase in the federal funds rate reflected in the futures market.

While the timing remains uncertain, the potential decline in interest rate volatility, in conjunction with the end of the monetary policy's tightening cycle, should be supportive for higher coupon Agency mortgage valuations. Agency mortgage supply and demand technicals are expected to improve in the second half of the year as the liquidation of assets from the FDIC nears its conclusion and high mortgage rates limit supply. Commercial banks should also gain greater clarity on their regulatory environment as capital requirements are finalized. This could encourage further deployment of capital away from loans and into lower risk-weighted assets such as Agency mortgages. Valuations and production coupon mortgages remain historically attractive and funding capacity is robust.

Taken together, we believe that the decline in interest rate volatility and improving technical environment, combined with compelling valuations and favorable funding conditions, should represent an attractive investment opportunity in agency mortgages for the remainder of 2023. I'll stop here and Brian will look through the portfolio.

Brian Norris (Chief Investment Officer)

Thanks, John, and good morning to everyone listening to the call. I'll begin on slides 4 and 5, which provide an overview of the interest rate and agency mortgage markets over the past year. As John mentioned, as shown in the upper left chart of slide 4, yields on U.S. Treasuries largely reversed their move in the first quarter, ending the second quarter sharply higher across the yield curve as the regional bank crisis dissipated, the debt ceiling was swiftly resolved, and the economy proved resilient despite persistent tightening of monetary policy.

Short-term rates rose in line with further increases in the Fed funds rate, as the Federal Reserve raised the benchmark rate an additional 50 basis points during the quarter. Pricing in the Fed funds futures market reflected the higher for longer policy stance by the Federal Reserve, pushing expectations for cuts into the first half of 2024. As shown in the lower right chart, U.S. commercial banks further reduced their holdings of Agency MBS during the quarter, concurrent with runoff of the Federal Reserve's balance sheet, resulting in increased reliance on money manager and foreign investment to support valuations. In addition, organic net supply of agency mortgages to the market increased during the quarter as housing seasonals improved, while over 60% of the Agency RMBS held by the FDIC as a result of recently failed banks were liquidated by the end of the quarter.

The FDIC liquidation has been executed on a significantly faster timeline than the original 8-10 month expected timeframe and could conclude in roughly half that time. Slide 5 provides more detail on the Agency RMBS market. In the upper left chart, we show 30-year current coupon Agency RMBS performance versus U.S. Treasuries over the past 12 months, highlighting the second quarter in gray. Performance and production coupons was volatile during the quarter as a sharp move higher in interest rates in May kept short-term volatility elevated, while the decline in volatility in June, coinciding with the debt ceiling resolution, resulted in a positive environment for valuations. Current coupon valuations ended the quarter mixed versus hedges, modestly outperforming Treasuries while lagging interest rate swap hedges.

As shown in the lower left chart, valuations remain attractive for current coupon MBS, as uncertainty regarding monetary policy keeps interest rate volatility elevated and bank demand remains tepid. As indicated in the upper right chart, specified-pool payoffs ended the quarter lower as higher interest rates resulted in lower premiums for prepayment protection, while implied financing in the dollar roll market for TBA securities remained unattractive, as shown in the lower right chart. Slide 6 provides detail on our Agency RMBS investments and the changes in the portfolio during the quarter. We remained focused in more attractively priced higher coupons, which are largely insulated from direct exposure to assets held by the FDIC and on the Federal Reserve's balance sheet. We have no exposure to the deterioration in the dollar roll market for TBA securities, as we are invested exclusively in specified pools.

We continue to focus our specified-pool allocation on specified pools that are expected to perform well in both a premium and discount environment, and modestly improve the quality of our specified-pool holdings by increasing our allocation to loan balance stories, given more attractive valuations during the quarter. Although we anticipate elevated interest rate volatility to persist as the fixed-income market continues to reflect uncertainty in near-term monetary policy, we believe current valuations on production coupon Agency RMBS largely price in this lack of clarity and represent attractive investment opportunities, with current gross ROEs in the mid to high teens. Our remaining credit investments are detailed alongside our Agency CMO allocation on slide 7. Our credit allocation was unchanged during the quarter at $45 million and remains high quality, with 87% rated single-A or higher.

Although we anticipate limited near-term price appreciation, we believe these assets are attractive holdings as they are held on an unlevered basis and provide favorable yields. Our allocation to agency interest-only securities, detailed on the right side of Slide 7, remained largely unchanged as well, totaling $78 million at quarter end. These holdings also provide an attractive unlevered yield and benefit from the current slow prepayment environment, given minimal housing turnover and limited refinance activity. Slide 8 details our funding book at quarter end. Repurchase agreements collateralized by Agency RMBS increased to $5 billion, given the modest increase in our specified-pool holdings as a result of the deployment of proceeds from our common stock ATM program. Our weighted average repo cost increased to 5.2%, consistent with changes in short-term funding rates due to tightening monetary policy.

Positively, we also increased the hedges associated with those borrowings, $4.7 billion net notional of current pay-fixed receive floating interest rate swaps, increasing our hedge notional to 95% of borrowings and largely mitigating the impact of higher borrowing rates on the earnings power of the company. In order to hedge additional exposures further out the yield curve, at quarter end, we held $200 million net notional of forward-starting interest rate swaps. These forward-starting swaps became effective in July and increased our hedge ratio to 99%. Our economic leverage ended the quarter largely unchanged at 5.9x debt-to-equity versus 5.8x at the end of March, reflecting our positive outlook on higher coupon Agency RMBS, given historically attractive valuations and a likely end to the monetary policy tightening cycle in the second half of 2023.

Lastly, slide 9 provides further detail on our interest rate swap portfolio. At the end of the second quarter, we held $6.3 billion notional of low-cost pay-fixed swaps and $1.6 billion notional of receive-fixed swaps. Because the balance of our low-cost pay-fixed swaps exceeds our repo balance, we have an opportunity to grow our investment portfolio through purchases of Agency RMBS, hedged with swap rates notably below current market rates, resulting in significantly improved ROEs versus hedging at current market rates. Further, the weighted average maturity of our pay-fixed interest rate swaps, including forward starters, is over seven years, providing substantial benefits for the foreseeable future. To conclude our prepared remarks, the second quarter of 2023 resulted in an improved environment for Agency RMBS, as interest rate volatility declined modestly, while the attractiveness of the asset class, asset class remained elevated.

We believe our bias for more attractively priced higher coupon specified pools leaves us well-positioned for the second half of the year, given the potential for a further decline in interest rate volatility as the Federal Reserve seeks to conclude monetary policy tightening. Earnings remain well supported, given a high hedge ratio on our funding costs, and our liquidity position is robust as leverage remains well below historical averages for an Agency RMBS-focused strategy. While we anticipate potential near-term volatility as monetary policy tightening concludes, we believe current valuations provide a supportive backdrop for long-term investment. Thank you for your continued support for Invesco Mortgage Capital. Now we will open the line for Q&A.

Operator (participant)

Thank you. As a quick reminder, if you'd like to ask a question, please press star followed by one. Remember to unmute your phone and record your name clearly when prompted. If you'd like to withdraw that question, you may press star two. Okay, our first question comes from Doug Harter with Credit Suisse. Your line is open.

Doug Harter (Equity Research Analyst)

Thanks, and good morning. You, you referenced the economic leverage, you know, at 5.9 times. You know, I guess what is the current leverage to common, and which do you view as kind of the, the more of a gating factor in terms of your portfolio size?

Brian Norris (Chief Investment Officer)

Yeah. Hey, Doug, it's Brian. Yeah, I mean, our, our leverage to common is right around 10 times at this point. You know, I think, yeah, that's, that's typically the number that we look at as far as measuring the risk in the portfolio.

Doug Harter (Equity Research Analyst)

Got it. I guess just with that, do you have... You know, to the extent that we continue to go through bouts of volatility, you know, I guess, do you have the ability to, you know, to kind of hold on to portfolio size? You know, if, you know, this, you know, first few days of August continues, or do you kind of need to risk manage the, the portfolio down? You know, just I guess, how do you think about that?

Brian Norris (Chief Investment Officer)

Yeah, I mean, that, that number 10 has, has drifted a little bit higher here in the first part of August. That's, that's a current number. So, you know, at that level, you know, we still have ample liquidity and, and have no need to, you know, to, to readjust the portfolio. You know, I think that still gives us plenty of room, you know, as volatility declines, to, to add to leverage as we see fit.

Doug Harter (Equity Research Analyst)

Great. Just on that, I mean, I guess, how do you view the, the current risk-reward? You know, kind of, how, how much more widening could we see, you know, from here, given, you know, given the wide starting levels and, you know, what's your outlook as to, you know, how much spreads might tighten as volatility, you know, as or if volatility comes down?

Brian Norris (Chief Investment Officer)

Yeah, spreads on, on kind of higher coupon, or production coupons are, you know, call it between 175 and 200 versus SOFR swaps. You know, at this point, you know, given the underperformance that we've seen here over the last week, you know, we're getting pretty close to the, to the wides that we saw, in March and in October of last year. You know, at, at maybe call it another 10 basis points wider, we saw pretty significant demand come in from the money manager community. You know, we would expect if, if volatility were to kind of, you know, fade from, from current levels, that we would, that we would see that amount of support again.

Doug Harter (Equity Research Analyst)

Great. Appreciate the answers. Thank you.

Operator (participant)

Thank you. Next question comes from Trevor Cranston with JMP Securities. Your line is open.

Trevor Cranston (Equity Research Analyst)

Hey, thanks. Good morning. Can you guys talk about where you're, where you see the current duration gap on the portfolio and how much, you know, net exposure you have to steepening of the, steepening of the yield curve? I guess as a second part of the question, could you just give us an update on where you're seeing book value currently this quarter? Thanks.

John Anzalone (CEO)

Yeah, I'll take, I'll take the first part of that on duration gap. You know, you know, we typically target, you know, between a, a half a year and, and one year. You know, and that, and that number will move around as interest rates change. Given the sell-off that we've seen, you know, we're probably, you know, towards the higher end of that range. From a yield curve perspective, you know, we try to stay, you know, relatively neutral. You know, the, the swap book that we have, the reason that we have such longer-dated swaps is just given the, the profile of the mortgages that we own. You know, we, we stay relatively neutral from that perspective.

Then from a book value, we put a range out for the end of July, which showed relatively unchanged from quarter end, you know, and there has been some underperformance, certainly, as we started the month of August here. As rates have moved higher and as volatility has also increased, mortgages have underperformed.

Trevor Cranston (Equity Research Analyst)

Okay. Bye-bye. Thank you.

Operator (participant)

I'm showing no further questions in queue.

John Anzalone (CEO)

Okay. Well, thank you, everybody, for joining us on the call, and we look forward to speaking again next quarter. Thanks.

Operator (participant)

Thank you. That concludes today's conference. You may all disconnect at this time.