Invesco Mortgage Capital Inc. Q2 FY2020 Earnings Call

Welcome to the Invesco Mortgage Capital Inc., Second Quarter 2020 Investors Conference Call. All participants will be in a listen-only mode until the question-and-answer session. At that time, please press star followed by the one on your phone. As a reminder, this call is being recorded. Now, I would like to turn the call over to Jack Bateman, Investor Relations. Mr. Bateman, you may begin the call.

Thank you, and welcome to Invesco Mortgage Capital’s second quarter 2020 earnings call. The management team and I are delighted you’ve joined us, and we look forward to sharing with you our prepared remarks and conducting a question-and-answer session.

Okay. Thank you. Good morning and welcome to Invesco Mortgage Capital's second quarter 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. The second quarter was an eventful one. In the beginning of the quarter, the financial markets were still in the midst of an unprecedented liquidity event as the economic activity shut down to combat the COVID-19 pandemic. As we noted in our last update, this triggered dislocations across the structured security space that impacted our ability to meet margin calls. In response to the crisis, we took a number of steps to increase our liquidity position while reducing leverage. Over the course of the quarter, we sold $6.9 billion of investments and repaid $6.3 billion of repurchase agreements. We also reduced our secured loans by $610 million. We elected to hold $1.6 billion of mostly non-agency CMBS and GSE credit risk transfer paper that would benefit as market conditions improve. On Slide 3 of the deck, you can see a breakdown of the composition and credit quality of these holdings as of 6/30. Slide 4 provides more details about our response to the dislocations in the financial markets that we saw at the end of March. Our immediate goals were to reduce our exposure to mark-to-market financing and credit assets to increase liquidity and to retain credit assets that we felt were poised to benefit as markets recovered. To that end, we were successful in eliminating our credit repo entirely.

Alright. Thanks, John, and good morning to everyone on the call. I'll begin on Slide 7, which details the progress we've made in July towards the strategic transition John discussed in his prepared remarks. Given our success in building liquidity and reducing our reliance on short-term mark-to-market financing on our credit investments during the second quarter, we began the month of July with ample liquidity and repo capacity to begin implementing the transition towards an agency RMBS focused strategy. Our agency RMBS purchases in July totaled $2.2 billion and 30-year low coupon specified pools as detailed on Slide 7. We were able to source attractively priced new issue collateral stories, including loan balance, low FICO, high LTV, and geographic pools, which consist exclusively of borrowers in slower paying states, such as New York, Florida, and Texas. We also focused a significant portion of our purchases on lower pay-up stories, such as those originated and serviced exclusively by banks to mitigate our exposure to pay-up premiums. To hedge our funding costs and interest rate exposure associated with these purchases, we executed $1.8 billion of interest rate swaps with maturities between 4 to 7 years. In addition to our purchases, we sold $547 million of credit assets in July, as the recovery in prices continued with strong demand during the month. In particular, higher-quality CMBS benefited from the June launch of the TALF program, as spreads tightened dramatically, and the AAA and AA rated assets were refinanced at the FHLB through our captive insurance subsidiary. We sold $470 million of these assets and were able to pay down $435 million of advances from the FHLB during the month, resulting in a secured loan balance at the FHLB of $305 million as of July 31st.

Our first question will come from Doug Harter with Credit Suisse. Your line is now open.

Thanks. Can you help us think about what your spread income would be on the agency portfolio rotated into in July and how that would compare to the credit assets that you hold?

Yes, Doug. This is Brian. I can start answering that, and if the credit guys want to jump in. On agencies, our NIM is approximately 100 to 125 basis points. So on specified pools, that equates to roughly 10% to maybe 12% hedged ROE. And the credit investments, the ones that we're holding unlevered have book yields that are well below that. But like we said, we expect continued price appreciation there, which is certainly supporting our book value and adding value in that way.

Great. And then, I guess just help us think about within the agency side, given the appreciation in spec pools and the specialness of TBAs, kind of what part you're finding most attractive today and where that incremental capital might go?

Yes, we've been finding most value in lower coupon. So in 30-year, two, two and a half, and a little bit in threes as well. Significant size in whole pool is more difficult in higher coupons. Like I said, spec pools, in those lower coupons are still providing kind of very low double-digit ROEs. On the TBA front, that's not something that we've invested in at this point, but it's certainly on the radar and we're looking to do that here in the near-term. And ROEs on TBAs are a little bit more attractive just given the negative impact financing that you get off there, so those are more like mid-teens.

Our next question will come from Eric Hagen with Keefe, Bruyette, & Woods. Your line is now open.

Thanks and hope you guys are doing well. I'm curious what led to the decision not to raise capital back in June and early July since the market was more or less giving you that opportunity. Secondarily, have there been any options you've explored to rebalance the capital structure, including things like tendering for your preferred stocks?

Yes. Hi, Eric. It's John. We've looked at it. We're always looking at the capital structure and we're continuing to evaluate our options for kind of getting the preferred common ratio kind of more to our historical levels. So, we are continuing to look at that. In terms of raising capital in the quarter, it was just a little bit difficult to kind of get that done given the cost of raising capital with the markets still kind of in a bit of turmoil, but we absolutely are always looking at different ways to do that.

Okay. Got it. Thanks for that. And then what's the plan surrounding the funding for the CMBS portfolio, once your line with the FHLB gets wound down by year-end? Do you have any securities that are currently being funded through TALF? And finally, what's the funding rate on your agency repo right now? Thanks.

Yes, Eric. It's Brian. Yes, I hope you're doing well as well. So, I guess I'll answer last to first here. Financing on agencies is pretty attractive. They're LIBOR plus 8 or 9 basis points. So, we're talking maybe 24 basis points all-in for one month repo. And then, we did not finance anything through TALF because that required new purchases. I believe they had to be purchased within a month of kind of putting them into the TALF program. So, obviously, all of our holdings have been purchased much earlier than that. Finally, we don't anticipate going back into short-term mark-to-market financing for our credit assets. So, the intention is to continue to look for attractive dispositions in that space.

And our next question will come from Trevor Cranston from JMP Securities. Your line is now open.

When you discuss maintaining the CMBS book to benefit from expected price increases, can you share your thoughts on how much potential growth remains? Do you believe spreads could return to pre-COVID levels? Also, could you elaborate on how long you plan to hold the portfolio to realize this potential upside?

Yes, this is Kevin. Thank you for your question. We believe there is a possibility for further tightening. We are encouraged by the ongoing increase in investor demand for credit risk. The U.S. economy is gradually reopening, and while we have seen some improvements, challenges remain. We are pleased that the top programs have been extended for the rest of the year, which suggests there may still be a few months of potential upside. The possibility of additional appreciation is best evaluated by comparing current spreads to those before COVID. Most of our positions are AA rated, trading around 731 basis points, whereas they were about 350 basis points over swaps previously. Before COVID, these positions traded around 100 to 115 basis points. While we do not expect a complete recovery in the near term, we believe there is positive momentum. For single A-rated positions, the spreads are quite varied, typically around 350 to 780 basis points with an average around 731, which compares to about 160 basis points before COVID. BBB assets are currently about 900 basis points at 731, having traded as low as 350 before the pandemic. We see potential for appreciation, but we have already observed significant credit spread tightening in recent months. One favorable aspect for us is the notable lack of supply, as new issuances and loan originations have decreased significantly.

Okay, got you. Thanks for that color. And then as you guys are redeploying into the agency market, can you talk about the leverage levels that you're comfortable using on that trade right now?

Yes, hi, Trevor, it's Brian. So, leverage is ranging in the 7 to 8 times. Overall, leverage right now is around two, but obviously as we continue to transition, that will continue to decline up to that 7 times debt to equity range.

Okay, got it. And then just one more question on the capital structure, wondering if you could comment on specifically or something like a swap of common shares for preferred is sort of one of the angles you guys have looked at, and whether this is something that is feasible? Or if you think it isn't for some reason?

Yes, hi, Trevor. It's John. Yes, I mean, that is one of the things we were evaluating about whether it makes sense to do a swap like that. That's one of the things we've been looking at. We're trying to figure out what makes sense for shareholders depending on where we're trading in terms of common to book values and things like that. I think once we get past the financials released from last night, we're going to reevaluate where we are and what makes sense for that.

Our next question will come from Jason Stewart with JonesTrading. Your line is open.

Hey, good morning. Just curious if you could give us some thoughts on why you avoided the TBA trade and agency just your thought process there.

Yes. Hi, Jason, it's Brian. I wouldn't say that we're avoiding the TBA trade. It's certainly something that we're interested in putting on here in the near-term, but we had some things that we wanted to get on the books first in July. That included hopeful specified pools. So, the first thing was, we had to get back in line with the whole pool test.

Okay.

So, those were the pools where the first way to do that. As we move forward, we anticipate that the TBA trade will remain pretty attractive over the near to medium-term, just given the Fed support and kind of their medium-term outlook. So that's certainly something that we're going to be looking at here shortly.

Okay. Understood. And then on the additional credit assets that don't rely on short-term mark-to-market financing where you can put capital to work. Can you give us some color on what you're thinking there?

Yes. So, we own roughly $500 million on an unlevered basis away from the FHLB, and those are the bonds that we believe have the most significant upside potential. So, we're likely to hold onto those, as we realize that potential. Beyond that, we're continuing to explore our options in the credit space. It's certainly more challenging to finance on a non-recourse basis, so the opportunities will be fewer there, but it's certainly something that we're going to continue to explore.

We are currently showing no additional questions at this time.

Okay. Well, thank you everyone for joining us, and we look forward to talking to you again in November.

This concludes today's conference. Thank you for attending today's call. All participants can disconnect at this time.