Invesco Mortgage Capital Inc. Q3 FY2022 Earnings Call

Welcome to Invesco Mortgage Capital Inc's Third Quarter 2022 Investor Conference Call. As a reminder, this call is being recorded. Now I would like to turn the call over to Matt Seitz in Investor Relations. Mr. Seitz, you may now begin the call. Thank you.

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. 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 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 nor 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 Third 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 our President, Kevin Collins, our CFO, Lee Phegley, and our COO, Dave Lyle. Financial conditions tightened during the third quarter of 2022 as the FOMC increased the Fed funds rate on two separate occasions by a total of 150 basis points and then subsequently added a further 75 basis point hike yesterday in response to inflation levels that persist at multi-decade highs. Equity markets declined, credit spreads widened and volatility increased from already elevated levels as recession fears mounted in the market priced at a more aggressive pace of tightening by the Fed. The challenging environment for agency mortgages persisted during the third quarter as the sector recorded its worst quarterly performance in over a decade. Mortgages have now performed poorly for four consecutive quarters, and the drivers have largely remained the same. Persistent inflation, rapidly tightening monetary policy, elevated volatility, reduced liquidity and a general risk-off tone in financial markets. Given this challenging backdrop, our book value declined during the quarter ending September at $12.80. Since the beginning of the fourth quarter, agency mortgage performance has remained volatile, leading to a further decline in our book value of approximately 4.5%. On a positive note, earnings available for distribution for the third quarter remained strong at $1.39 per common share given our rotation into higher-yielding agency mortgages, along with favorable funding and a relatively low-cost legacy swap portfolio. Further, wider spreads on our target assets have created an attractive reinvestment environment that continues to be supportive of the earnings power of the portfolio. We remain focused on improving our capital structure and during the third quarter, we made progress on that front by repurchasing preferred stock and issuing common stock through our at-the-market program. Since the inception of the repurchase program in May of '22, we have repurchased 5.3 million shares of our Series B and Series C preferred stock, representing approximately 30% of our preferred stock outstanding prior to the start of the program. Given the decrease in book value and repurchases of preferred stock, our economic leverage increased to 5.3x. At quarter end, substantially all of our $4.5 billion investment portfolio, including TBAs, was invested in agency mortgages, and we maintained a sizable balance of unrestricted cash and unencumbered investments totaling $504.3 million. Because of the drivers I mentioned earlier, we remain relatively cautious on mortgages in the near term. However, we are starting to see some potential tailwinds. Mortgage spreads are now at levels not seen since the great financial crisis, and they have been highly correlated to volatility. As the Fed's path for future policy action becomes clearer, we should see interest rate volatility subside over the next few quarters, which would be very positive for mortgages. The technical outlook for mortgages is also improving as sharply higher borrowing rates limit the issuance of new agency mortgages, which helps reduce the pace of runoff in the Fed's portfolio, while also reducing the impact of prepayments. I'll stop here, and Brian will 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. During the third quarter, persistently elevated inflation and the acceleration of monetary policy tightening by the Federal Reserve continued to pressure interest rates higher, leading to another bear flattening move, a consistent theme over the past year. During the quarter, yields on maturities less than 1 year increased approximately 150 basis points, while longer-dated maturities increased roughly half that amount, reflecting the expectation that longer-term inflation should decline from the heightened levels of the current environment. Market expectations for future adjustments and monetary policy have evolved as well with further tightening expected in the near term, followed by easing in the latter half of 2023, as indicated in the bottom left chart. As shown in the lower right-hand chart, U.S. commercial banks reduced their holdings of agency mortgages during the third quarter, concurrent with the end of net asset purchases by the Federal Reserve, resulting in significantly lower demand for the sector during the quarter. The cap on runoff of the Federal Reserve's agency mortgage portfolio increased to $35 billion per month in September versus the previous cap of $17.5 billion, leading to a modest increase in net supply to the market. With paydowns on the agency mortgage portion of the Fed's balance sheet approximately $20 billion to $25 billion per month in the third quarter, it is unlikely the $35 billion cap will be restrictive absent a significant drop in mortgage rates and resulting increase in refinancing and housing activity. Moving on to Slide 5, where we provide more detail on the agency mortgage market. In the upper left-hand chart, we show 30-year current coupon Agency RMBS performance versus treasury hedges over the past year, highlighting the third quarter of 2022 in gray. Agency RMBS performed poorly again during the quarter, as elevated interest rate volatility and the uncertain path of monetary policy pressured valuations sharply lower, resulting in wider spreads. 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 from the money manager and hedge fund communities. However, sentiment quickly shifted negative in August and worsened in September, resulting in September representing the worst month for the sector on record and the third quarter representing the worst quarter in 11 years. Combined with the previous three quarters, the sector also concluded its worst year ever. As shown in the upper right chart, specified pool pay-up stabilized briefly before continuing their descent as demand for prepayment protection declined further given the sharp increase in mortgage rates. While implied financing in the TBA market continues to converge with short-term funding rates, as indicated in the lower right chart. Slide 6 provides detail on our Agency RMBS investments and the changes in the portfolio during the third quarter. We continue to rotate our lower coupon investments into more attractive higher coupons, expanding our net interest margin and supporting the earnings power of the company. The period-end weighted average yield on our Agency RMBS investments improved from 4.07% at the end of the second quarter to 4.65% at the end of the third 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 given the reduction in lower coupons. With almost all of the coupon stack trading at discount prices, we continue to specify pool allocation on those characteristics, which are expected to perform well in both a premium and discount environment. Higher turnover states, such as Texas and Florida, lower loan balances and low FICO stories typically provide attractively priced prepayment characteristics that lead to faster speeds when trading at a discount and slower speeds when trading at a premium. Despite that expectation for a deterioration in the dollar roll market as the reduction in demand from the Federal Reserve and commercial banks weighs on valuations, production coupon TBA remains attractive. Although we continue to anticipate heightened near-term volatility as the Federal Reserve tightening cycle persists, we believe cheaper valuations on specified pools and TBA represent very attractive investment opportunities with current ROEs in the mid- to high teens. Our remaining credit investments are detailed on Slide 7 with non-Agency CMBS representing approximately half of the $72 million portfolio. Our credit allocation declined modestly during the quarter given paydowns on our credit securities. Our remaining $45 million of credit securities are 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 100% are held on an unlevered basis and provide favorable unlevered yields. Positively, our remaining commercial real estate loan, representing approximately $24 million market value, was repaid in full in October. 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 increased to $3.9 billion as of September 30. Given the increase in our specified pool holdings, hedges associated with those borrowings also increased to $3.1 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 $700 million net notional of forward starting interest rate swaps with starting dates in 2023. Consistent with changes in short-term funding rates as a result of tightening monetary policy, our weighted average repo cost increased sharply to 3.27%. Positively, 80% of our repo costs are hedged by current pay interest rate swaps, and the increase in our asset yields as a result of our rotation into higher coupon Agency RMBS also served to offset the increase in our funding costs. Economic leverage, when including TBA exposure, increased during the quarter to 5.3x debt to equity as a result of our preferred equity repurchases and the decline in book value. Leverage as of the end of October was roughly unchanged from quarter end. To conclude our prepared remarks, the third quarter of 2022 represented another extremely challenging environment for Agency RMBS investors. Hedged performance for the sector was among the worst quarters ever and combined with previous quarters resulted in the worst 9-month and 12-month performances on record. Positively, the significant underperformance experienced over the past year has resulted in very attractive valuations with historically modest leverage expected to generate mid- to high-teen ROEs on production coupon specified pools and TBAs. In addition, the Agency RMBS market should benefit from the anticipated reduction in volatility as the Federal Reserve nears the conclusion of the monetary policy tightening cycle and improving technicals given the impact of higher mortgage rates on supply. While we remain cautious given continued near-term market volatility, we do believe today's Agency RMBS valuations 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.

Our first question comes from Doug Harter with Credit Suisse.

Given that a lot of the weakness in the third quarter kind of happened at the tail end of September. Can you just talk about any portfolio actions you took that might have spilled over into October and kind of where a portfolio size leverage sits today?

Doug, it's Brian. Yes, leverage is mostly unchanged since the end of September. So around 5.3x debt to equity, including TBA. So book value performance quarter-to-date is, like John said, down roughly 4%, 4.5%. So we may have modestly reduced exposure to agency mortgages, but not too much to really make a big difference.

Great. And then kind of you've been making steps to reduce the amount of preferred equity, but obviously, kind of common book value has continued to fall. Just talk about where you're trying to get the preferred as a percentage of total equity and kind of what other steps you're looking to take?

Doug, this is John. We remain focused on rebalancing our capital structure. Our target is to keep preferreds in the 20% to 25% range. We are actively seeking accretive opportunities, including repurchasing preferreds and potentially increasing common equity through the ATM or block trades. We plan to explore these options in the near future.

Our next question comes from Trevor Cranston with JMP Securities.

You guys are obviously earning a pretty strong spread income with leverage is where it's at today. But I guess with some of the tailwinds emerging for agencies that you mentioned in the prepared remarks. Can you talk about what you'd need to see to meaningfully increase your leverage from here in order to potentially get some book value appreciation if or when the spread is eventually tight?

Yes. Trevor, it's Brian. We definitely need to see a reduction in volatility. I think that's the primary thing in the market that we're looking for at this point. We think that we'll start to see that. And actually, Powell's comments on yesterday's press conference, talking about potentially a more shallow but longer time frame for monetary policy tightening. We think that, that should be a volatility reduction or we should see a reduction in volatility as a result of that. But again, just the near-term volatility continues to be relatively high. So we think over the longer term that, that should play out. And if that were to play out, then we would look to potentially increase leverage into that. But until that happens, we're going to remain somewhat cautious.

Okay. Got it. Then on the prepayment speed for the portfolio, obviously, it's still very low. You mentioned in the prepared remarks some of the spec pools potentially paying faster when they're trading at discounts. Can you just talk about kind of generally what sort of projected lifetime speed for the portfolio would be at this point?

Yes. As we transition to higher coupons, our prepayment speeds remain relatively low since we are mainly purchasing newly issued mortgages. Therefore, we are still experiencing a high 3 CPR range. We expect turnover to be around the 4% CPR range, and our move towards higher coupons might increase that a bit. However, we anticipate that the long-term CPR for our current holdings will be in the high single digits.

Our next question comes from Jason Stewart with JonesTrading. Yes. We believe that as we continue to move into higher coupon mortgages, our prepayment speeds will remain relatively low since we are primarily purchasing newly issued mortgages. Therefore, we are still observing a high 3 CPR range. We expect turnover to hover around the 4% CPR range, and our transition to higher coupons may slightly boost that figure. However, we anticipate that the long-term CPR on our current holdings will be in the high single digits.

How do you guys view the political nature of the Fed at this point?

Jason, it's Brian. Yes, yes, that's a tough one. I think clearly, there were some statements or sentences added to the statement yesterday that seemed to be a little bit more dovish than the press conference was. So I think clearly, the Chairman is likely more hawkish than some of the other committee members. And so I think his goal and the way he views it is that it's easier to be hawkish now and dovish later than to be dovish now and potentially lose control of inflation.

Yes, this is John. I agree with that perspective. I believe being slightly more aggressive or hawkish in the short term is beneficial for quickly bringing inflation under control and avoiding complications during the upcoming presidential cycle. That seems to be part of the current strategy. Another aspect that wasn't mentioned is the potential for selling mortgages, which has long been a concern in the mortgage market. With discussions about a potential dovish pivot fading, the likelihood of selling mortgages appears to be diminishing. Most of the Fed's holdings are at significant discounts, which could lead to paper losses and potential politicization. The Fed seems keen to steer clear of overt political conflicts. Regarding Brian's point, it seems the focus on the future endpoint is more significant than past actions, suggesting perhaps a longer but less aggressive approach to rate hikes at each meeting. This could be favorable for the mortgage market and may reduce volatility, which we view positively.

Got it. And then in terms of TBAs, some of your peers used to be a little bit more aggressively than you guys do. What would cause you to change your view on the way you use TBA?

Yes, TBAs remain quite appealing. We have noticed some decline as production ramps up in the newer coupons, especially since more are emerging as mortgage rates continue to rise. The 30-year, 5.5 and 6 coupons are still relatively attractive. However, as production increases in those coupons, we expect their appeal to lessen, which has limited how much we are willing to invest in the TBA market. If banks begin to reenter the market and rates stabilize, we expect those higher coupons to still be somewhat appealing. In such a scenario, it might make sense for us to increase our exposure there.

There are no other questions in queue at this time.

All right. Well, I'd like to thank everybody for joining us, and we look forward to meeting you again next quarter. Thank you.

That concludes today's call. All participants may disconnect at this time. Thank you for joining.