Invesco Mortgage Capital - Q4 2023

Transcript

Operator (participant)

Welcome to Invesco Mortgage Capital Incorporated's Q4 2023 investor conference call. All participants will be in a listen-only mode until the question and answer session. At that time, if you'd like to ask a question, press Star followed by one on your telephone. As a reminder, this call is being recorded. Now, I would like to turn the call over to Greg Seals in Investor Relations. Mr. Seals, you may begin the call.

Brian Norris (Chief Investment Officer)

Thank you, 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. The press release and presentation are available on our website, investcomortgagecapital.com. This information can be found by going to the Investor Relations section of the website. Our presentation today will include forward-looking statements and certain non-GAAP financial measures. Please review the disclosures on slide two of the presentation regarding the 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 transcript 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?

John Anzalone (CEO)

Good morning, and welcome to Invesco Mortgage Capital's Q4 earnings call. I will give some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss the portfolio in more detail. Also joining us on the call are President Kevin Collins and our COO, Dave Lyle. As we entered the Q4, interest rate volatility accelerated as changes in investor expectations for the supply of U.S. Treasuries and the path of monetary policy led to substantial adjustments to both the level of interest rates and the shape of the yield curve. The heightened volatility drove notable underperformance in agency mortgages as investors reduced exposure to the asset class. During this period, we sought to maintain appropriate levels of cash and unencumbered assets, reducing risk by decreasing leverage as volatility increased.

As market sentiment improved, bolstered by incoming data supporting a soft landing narrative and market expectations for a quicker pace of interest rate cuts by the Federal Reserve, we returned to our target range. Despite the volatility we experienced during the quarter, our book value per common share ended the quarter at $10, representing an increase of 0.7% from September 30. When combined with our $0.40 common stock dividend, this produced an economic return of 4.7% for the quarter. Our debt-to-equity ratio ended the quarter at 5.7 times, down from 6.4 as of September 30. As of the end of the quarter, nearly all of our $5.1 billion investment portfolio was invested in agency mortgages, and we maintained a sizable balance of unrestricted cash and unencumbered investments totaling $422 million.

Earnings available for distribution for the period benefited from attractive interest rate interest income on our target assets, favorable funding and low-cost pay-fixed swaps. For the quarter, EAD per common share was $0.95, compared to $1.51 for the Q3, reflecting declines in interest income on investments and interest rate swaps in connection with our reduction in leverage and adjustments to our swap portfolio. Over the first six weeks of 2024, mortgage valuations have been challenged, with lower coupons underperforming higher coupons. As of February sixteenth, our book value per common share is down moderately, estimated to be between $9.50 and $9.88. As we enter 2024, both the FOMC and the federal funds futures markets forecast the next policy move by the FOMC will be a rate cut, although they have had differing expectations regarding the timing and quantity of these cuts.

While evolving expectations around the timing of changes in monetary policy may bring challenges in the coming months, we believe that a potential reduction in interest rate volatility, combined with compelling valuations and favorable funding conditions, will support an attractive investment environment for agency mortgages in 2024. I'll stop here. Brian will go through the portfolio.

Brian Norris (Chief Investment Officer)

Thanks, John, and good morning to everyone listening to the call. I'll begin on slide 4, which provides an overview of the interest rates and agency mortgage market since the beginning of last year. As shown on the chart in the upper left, U.S. Treasury yields fell sharply across the yield curve in a parallel fashion during the Q4. Yields on maturities from 2 years to 30 years declined between 65 and 80 basis points as the disinflationary trend in economic data persisted, while estimates of future Treasury funding needs declined. By the end of the Q4, pricing in the Fed Funds futures market reflected expectations for a 25 basis point cut in the target rate in the Q1 of 2024, and nearly 7 cuts in total by the end of January 2025.

Despite further run-up of the Federal Reserve's balance sheet during the quarter, the decline in interest rate volatility and expectations for the easing of monetary policy led to an improvement in domestic bank holdings of agency mortgages for the first time in nearly two years. Slide 5 provides more detail on the agency mortgage market. In the upper left chart, we show 30-year current coupon performance versus U.S. Treasuries over the course of 2023, highlighting the Q4 in gray. Despite notable underperformance to start the quarter, production coupon agency mortgages, mortgage valuations rebounded into year-end as interest rates and interest rate volatility declined. Ultimately, current coupons outperformed Treasuries during the quarter, with nominal spreads tightening approximately 30 basis points. In addition, specified pool payoffs improved as interest rates fell, as illustrated in the chart on the top right....

As shown in the lower right chart, the Dollar Roll market for TBA securities remained unattractive, as more recent issuance with higher loan balances have a worse prepayment profile, and the lack of consistent bank demand has negatively impacted technicals. Slide 6 provides detail on our Agency Mortgage investments and summarizes changes during the quarter. Our portfolio decreased by 7% quarter-over-quarter, as the sharp increase in in interest rate volatility in October warranted a reduction in risk. We net sold approximately $1.7 billion of Specified pools in October across our coupon holdings to reduce the risk of further declines in Book Value, before adding nearly $1.2 billion of exposure, predominantly in 30 or 6 percent Specified pools in November and December as interest rate volatility declined.

We remained focused in more attractively priced higher coupons, which are largely insulated from direct exposure to assets held by commercial banks and on the Federal Reserve's balance sheet. In addition, we remain exclusively invested in specified pools, which means we have no exposure to the deterioration in the dollar roll market for TBA securities. We focused our specified pool allocation on prepayment characteristics that are expected to perform well in both premium and discount environments, and modestly improved the quality of our specified pool holdings by increasing our allocations to lower loan balance stories. Although we anticipate interest rate volatility to remain moderately elevated in the near term, we believe current valuations on production coupon agency mortgages largely price in this risk and represent attractive investment opportunities, with current gross ROEs in the mid to high teens.

Our Agency CMO allocation is detailed alongside our remaining credit investments on slide seven. Our allocation to agency interest-only securities remained largely unchanged, totaling $75 million at quarter end. A modest decline from $78 million at the end of the Q3 to $75 million this quarter, primarily due to pay downs and a modest decline in the weighted average dollar price, given the rally in interest rates during the quarter. Our credit allocation declined during the quarter to $19 million as a result of pay downs. Our credit investments remain high quality, with 68% rated double A or higher. Although we anticipate limited near-term price appreciation in our credit and Agency IO investments, we believe these assets provide attractive yields for unlevered holdings. Slide eight details our funding and hedge book at quarter end.

Repurchase agreements collateralized by Agency RMBS declined by from $5 billion to $4.5 billion, and our net notional of pay fixed interest rate swaps declined from $5 billion to $4.1 billion, both commensurate with our reduction in specified pool holdings during the quarter. We continue to reposition the hedge book, unwinding our remaining receive fixed interest rate swaps and a portion of our legacy pay fixed swaps as the reduction in leverage during October warranted a proportionate decline in hedges. As we added specified pool exposure back to the portfolio in November and December, we also added new pay fixed swaps to hedge the additional borrowings. We ended the quarter with a hedge ratio of 91%. These changes resulted in a modest increase in the weighted average coupon on our pay fixed swaps, which negatively impacted earnings available for distribution.

Positively, we retained much of the benefit of our low-cost pay fixed swaps, with an attractive weighted average coupon on our hedging portfolio of 1.1% and weighted average maturity of 6.6 years. Leverage ended the quarter at 5.5-5.7 times debt to equity, down from 6.4 times at the end of September, given the net sales in specified pools and modest improvement in book value. Slide 9 provides further detail on our asset yields and funding costs. Interest rates on our repurchase agreements increased modestly from 5.4% to 5.5% at quarter end, largely offset by a similar increase in the receive rate on our interest rate swaps.

Yields on our Agency RMBS portfolio increased approximately 20 basis points to 5.3%, while the pay rate on our interest rate swaps increased 30 basis points to 1.1%. Overall, our effective interest rate margin remains very attractive at just over 5%, which includes the benefit of our remaining legacy swap portfolio. To conclude our prepared remarks, the Q4 of 2023 began as another very challenging quarter for Agency RMBS investors, as uncertainty regarding the path of monetary policy led to another sharp increase in interest rate volatility. Valuations rebounded, however, as the disinflationary trend persisted despite the notable strength in the economy, resulting in a pivot for expectations of monetary policy from further tightening to potential easing in the H1 of 2024.

Despite significant tightening of spreads in the asset class in the Q4, we believe agency RMBS valuations remain attractive for long-term investors, given our expectation for the potential reduction in interest rate volatility over the course of 2024, as easing monetary policy likely results in a steeper yield curve. Our preference for higher coupon specified pools should perform well in that environment. Further, our liquidity position remains robust. As a result, we believe IVR is well positioned to navigate future mortgage market volatility and selectively capitalize on historically wide agency RMBS spreads, which provides a supportive backdrop for long-term investment. Thank you for your continued support for Invesco Mortgage Capital, and now we will open the line for Q&A.

Operator (participant)

Thank you. We will now begin our Q&A session. If you'd like to ask a question, please press star one. Our first question comes from Trevor Cranston with JMP Securities. Your line is open.

Trevor Cranston (Managing Director)

... Hey, thanks. Good morning. Question on the, on the hedging side. You know, it looks like the, the net swap portfolio declined by more than the MBS portfolio did on the quarter. I guess, can you elaborate a little bit on, you know, if you guys have made any changes just to sort of your net duration exposure along any, any part of the yield curve, given the, you know, shifting outlook for what the Fed's going to be doing going forward, and, and just generally, how you're, how you're approaching hedging across the yield curve right now? Thanks.

Brian Norris (Chief Investment Officer)

Yeah. Hey, good morning, Trevor. It's Brian. Yeah, we haven't really made any significant changes to our yield curve exposures. You know, we're positioned slightly for a steeper curve, given our expectations for Fed policy in 2024. You know, the sharp rally that we saw in interest rates during the Q4 did shorten our mortgage investments. So you saw the shortening in our hedges as well. But really, you know, the changes that we made to the swap portfolio were pretty consistent across the curve, so there weren't any significant changes. As far as our duration gap goes, we're still just modestly positive, but very slight.

Trevor Cranston (Managing Director)

Okay. Got it. Appreciate the comments. Thank you.

Operator (participant)

Thank you. Our next question comes from Jason Weaver with JonesTrading. Your line is open.

Jason Weaver (Managing Director)

Hi, guys. Thanks for taking my question. I have sort of a 2-parter here. I've seen over the last, you know, 3, 4 quarters, you've been migrating higher in the coupon stack. Obviously, that's in response to the available ROE in the market, but what, what do you think of the convexity profile here, given your remarks on the timing of monetary easing, easing? I, I assume you're still migrating up to quarter to date.

Brian Norris (Chief Investment Officer)

Yeah. Hey, Jason, it's Brian. Good morning. Good to hear from you. Yeah, you know, we, we have moved slightly up in coupon. Obviously, we, we did buy some 6s, in the Q4 that do have, you know, slightly worse convexity profile. But just given our expectations for interest rate volatility, you know, we, we, we don't exactly mind taking a little bit of additional convexity risk from that perspective. And, you know, given our, our continued holdings in, in 4 through 5.5 that are still at, you know, decent discounts, you know, we, we certainly have a, a fair amount of protection, from that perspective as well.

Jason Weaver (Managing Director)

And on that subject, to the new coupon, new high coupons and the sixes are, what is the typical type of specified pool those guys are in?

Brian Norris (Chief Investment Officer)

Yeah, it's, it's pretty consistent with the rest of our portfolio. You know, leaning a little bit heavier into loan balance, but also, you know, higher loan balance cuts, call them, you know, $225-$250K. But also a fair amount in the lower payoff stores like LTV and FICO and Geo stores.

Jason Weaver (Managing Director)

Got it. All right. That's helpful. And finally, I see cash, you know, right now at around $77 million. I know you have some unencumbered as well, for enhanced liquidity, but does that imply you're inclined to raise leverage going forward?

Brian Norris (Chief Investment Officer)

I wouldn't necessarily say we're inclined to raise leverage. We do have the ability to do that if the market, you know, if volatility declines and we see improvement in valuations, you know. But I wouldn't say we're necessarily inclined to do that in the near term. You know, I think we still- you know, certainly there's still some uncertainty about the timing of Fed policy, and, you know, we would expect there continue to be some rate vol around that until that kind of comes to fruition. So, you know, at the moment, I think we're pretty comfortable with where we are, but we do have the ability to increase leverage if conditions warrant that.

Jason Weaver (Managing Director)

All right. Thank you for that color. Congrats, guys.

Brian Norris (Chief Investment Officer)

Well, thank you.

Operator (participant)

Thank you. Our next question comes from Douglas Harter with UBS. Your line is open.

Douglas Harter (Analyst)

Thanks. I was hoping to get your thoughts around the dividend. You know, if you look at it relative to the common book value, it kind of screens higher. But, you know, if you look at it relative to total equity, you know, factoring in the preferred, it seems, you know, kind of more in line. You know, just curious as to how you're thinking about the dividend.

Brian Norris (Chief Investment Officer)

Yeah. Hey, Doug, it's John. Yeah, I mean, you know, as always, the dividend is chaired by the board. So you know, that, that's the first thing. But, you know, I think given where EAD, even though it's trended lower with the adjustments in the swap book, you know, EAD supports the level of dividend pretty comfortably at this point. So, you know, we do look if our level of dividend is really an outlier versus peers, that's one consideration we think about. For, you know, the other consideration is really where we see cash flows and where we see EAD, and we're forecasting that over the next several quarters. So, you know, from that perspective, you know, it's been well supported.

So, you know, you know, I think as long as things stay relatively around here, you know, I don't see any catalyst to change things. But then again, it's pretty early. So, yeah, that's what I say.

Douglas Harter (Analyst)

... Thanks, John. And then, around the capital structure, you know, I guess, how are you thinking about, you know, you know, kind of plans to, to kind of bring the preferred you know, preferred equity as a percentage down? And then sort of along those lines, you know, how do you think about do you think about leverage as more leverage to common or, or leverage to total equity?

Brian Norris (Chief Investment Officer)

Well, we look at it both ways, you know, in terms of leverage, how we think about it. You know, leverage to common equity is probably the way we think about risk, you know, more often or, you know, so that's that, that's how we think about it. And, you know, as far as capital structure, you know, we've been buying back preferreds in the open market. It's been, you know, a very slow process, given just the amount of activity in those issues out there. You know, I think, you know, we have two preferreds out there. Our Series B is callable at the end of this year. So we'll have a decision to make, come Q4.

And, you know, we're looking, you know, we'll be starting and are starting to look at options around, you know, whether we call that or not, and, you know, how we kind of handle that coming event. So, you know, but we do continue to attempt to buy preferreds back, and then, you know, when the market is willing, when we're, you know, when market conditions are appropriate, we are also, you know, looking to raise money through the ATM, which would also help balance the capital structure. So both those two things we're looking to do throughout the year.

Douglas Harter (Analyst)

Great. Appreciate that.

Operator (participant)

Thank you, and if you would like to ask a question, please press star one. Our next question comes from Eric Hagen with BTIG. Your line is open.

Eric Hagen (Managing Director)

Hey, good morning. How we doing? Hey, on the Specified Pools, can you give a sense for how much payoffs are right now for the bonds that you're focused on buying, you know, relative to where those payoffs have been historically? And do you feel like there's a good way to think about how much relative strength those bonds can show in different, you know, interest rate rallies?

Brian Norris (Chief Investment Officer)

Hey, Eric, good to hear from you. It's Brian. Yeah, you know, I think, you know, Specified Pools, as I mentioned, the payoffs did improve in the Q4, given what we saw happen in the rates market. You know, those have come off a little bit so far in the Q1. You know, rates are now up 45-50 basis points since year-end, so you'd expect some softening in payoffs, and so we've seen that. But, you know, our weighted average payoff, I think, is, what? 0.4 points. So, you know, I think, you know, our exposure to those changes is fairly limited.

You know, I think the FICO and LTV stories, and even the Geo stories are, you know, pretty low payoffs, and so there's not a lot of change that goes on in those. It's really kind of driven by the changes in loan bal that are a little bit higher payoffs, so call it, you know, 0.5 point-0.75 point. So, you know, those will change as the interest rate markets kind of adjust around that. But we're still... You know, it hasn't changed kind of what we're targeting as far as, you know, attractive additions at this point.

You know, we still think that the TBA market will continue to have, you know, issues and that implied financing will continue to be higher there than it is in specified pools. So, you know, to the extent that we are looking to add, you know, at this point, it would certainly be in specified pools.

Eric Hagen (Managing Director)

Do you feel like there's anything that would catalyze Dollar Roll specialness aside from the Fed shutting off QT or making adjustments to QT?

Brian Norris (Chief Investment Officer)

Yeah, I think, you know, if we were to see a significant return from banks, you know, we have seen some encouraging signs from them over the last few months, and they've, you know, at least stopped running off their portfolio as significantly as they had been. But I do think that, you know, banks are really the primary driver of demand for, you know, those generic-type securities.

So, you know, that TBA market is really driven by supply and demand dynamics, and until that starts to improve, you know, it's hard to envision the dollar roll market improving all that much because, you know, quite frankly, the other aspect of that is, you know, the convexity profile of the deliverables, and that is not appearing to get any better, as loan balances continue to increase.

Eric Hagen (Managing Director)

Right. Hey, that was helpful. The book value range that you gave quarter to date, is that inclusive of the accrued dividend, or are you netting out the accrued dividend?

Brian Norris (Chief Investment Officer)

That nets out the dividend.

Eric Hagen (Managing Director)

It nets it out. Okay. Thank you guys so much.

Brian Norris (Chief Investment Officer)

Yep.

Operator (participant)

Thank you. At this time, we have no further questions. Greg, I'll hand it back to you.

Greg Seals (VP of Investor Relations)

Okay. Thank you very much. Thanks, everyone, for your participation, and look forward to speaking to you next quarter.

Operator (participant)

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