Invesco Mortgage Capital Inc. Q3 FY2025 Earnings Call

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 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 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 Invesco Mortgage Capital's CEO, John Anzalone.

Good morning, and welcome to Invesco Mortgage Capital's Third Quarter Earnings Call. I'll provide some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss our portfolio in more detail. Also joining us on the call this morning for Q&A is our President, Kevin Collins, our COO, Dave Lyle; and our CFO, Mark Gregson. The strong momentum that began in mid-April continued throughout the third quarter as expectations for easing monetary policy, strong corporate earnings, and improved economic growth fueled rallies across the financial markets. Financial conditions remained accommodative as volatility measures declined sharply and equity markets have performed well with the S&P 500 Index and NASDAQ both posting strong gains. Inflation measures continue to run hotter than the Federal Reserve's 2% target over the quarter, with a headline consumer price index rising to 3% in September, up from 2.7 in June, while the core CPI increased from 2.9% to 3%. Investor expectations for future inflation seen through TIPS breakeven rates increased modestly, reflecting concerns about the potential impact of fiscal and trade policies on consumer prices. Meanwhile, prior to the pause in data caused by the government shutdown on October 1, labor market data pointed to continued sluggish growth. The economy added an average of 51,000 jobs in July and August, down slightly from 55,000 per month in the second quarter, while the headline unemployment rate increased to 4.3% in August. Despite persistent inflation above the Fed's target, the FOMC lowered its benchmark Federal funds target rate by 25 basis points in mid-September, citing signs of a weaker labor market. On Wednesday, the FOMC cut its target rate an additional 25 basis points to a range of 3.75% to 4% and announced the end of quantitative tightening. Futures pricing now indicates that investors expect three more cuts before the end of next year. Interest rates declined across the treasury yield curve during the quarter with shorter maturities leading the way. This also reflected market expectations for a more accommodative policy stance from the Federal Reserve and continued weakness in the labor market. Industry volatility declined notably throughout the quarter on growing consensus for easing monetary policy. As a result, agency mortgages performed well during the third quarter, benefiting from the persistent decline in interest rate volatility as well as the overall supportive environment for risk assets. While demand from commercial banks and overseas investors remained relatively subdued, the steepening of the yield curve in the front end improved investor sentiment for agency mortgages. The outperformance was broadly distributed across the 30-year conventional mortgage coupon stack with discount coupons recording the largest gains. Performance in higher coupons was dampened by elevated prepayment risk as 30-year mortgage rates declined approximately 50 basis points during the quarter. Positively, premiums on specified pool collateral improved in higher coupons as investors saw prepayment protection. Agency CMBS risk premiums declined quarter-over-quarter as investor demand increased with broader financial markets. These factors led to a 4.5% increase in book value per common share to $8.41 at quarter end. And when combined with our $0.34 dividend, resulted in a positive economic return of 8.7% for the quarter. Leverage ticked up slightly as our debt-to-equity ratio increased to 6.7% at the end of the quarter, up from 6.5x as we continue to reduce the percentage of our capital structure comprised of preferred stock and position the company to further benefit from positive Agency RMBS performance. During the quarter, we raised $36 million by issuing common stock through our ATM program, maintaining a disciplined approach to ensure that this activity benefits existing shareholders. At quarter end, our $5.7 billion investment portfolio consisted of $4.8 billion agency mortgages and $0.9 billion agency CMBS, and we retained a sizable balance of unrestricted cash and unencumbered investments totaling $423 million. As of last night's close, we estimate book value was up approximately 1.5% since quarter end. Given the notable decline in interest rate volatility, we remain constructive on agency mortgages, and we view near-term risks as balanced following its recent strong performance. Our longer-term outlook for this sector remains favorable as we expect investment demands to broaden given the lower interest rate volatility, a steeper yield curve, attractive valuations, and the end of quantitative tightening. In addition, Agency CMBS continues to offer attractive risk-adjusted yields and diversification benefits relative to our Agency mortgage holdings supported by its stable cash flow profile and lower sensitivity to interest rate fluctuations. Lastly, we believe anticipated changes to bank regulatory capital rules would increase investor demand for agency mortgages and agency CMBS, providing further tailwinds for both sectors. Now I'll turn the call over to Brian to provide for more details.

Thanks, John, and good morning to everyone listening to the call. I'll begin on Slide 4, which provides an overview of the interest rate markets over the past year. As depicted in the chart on the upper left, despite further easing of monetary policy in September, treasury yields declined only modestly during the quarter as the deterioration in employment data was offset by robust economic growth, fueled in part by the boom in AI investment. Positively, the yield curve continued to steepen with 2-year treasury yields falling 11 basis points, while 30-year yields were down just 4 basis points. The difference between 2-year and 30-year treasury yields ended the quarter at 112 basis points, roughly 65 basis points steeper than a year ago, and remains supportive of longer-term investments, such as our Agency RMBS and Agency CMBS. The chart in the upper right reflects changes in short-term funding rates over the past year, with the third quarter highlighted in gray. While financing capacity for our assets remained ample and haircuts unchanged, the 1-month repo spread began to indicate funding pressures in late September and continued into October, widening approximately 5 basis points. Steady issuance of T-bills caused dealers to become very long collateral, squeezing balance sheets and putting upward pressure on repo rates. We believe that the FOMC announcement on Wednesday to end quantitative tightening at the end of November was largely in response to this pressure, but further adjustments may be necessary before repo spreads can unwind the recent widening. Lastly, the bottom right chart highlights the significant decline in implied interest rate volatility since the middle of April. This improvement has provided a tailwind for risk assets in recent months, particularly Agency RMBS and is largely driven by diminishing tail risks across fiscal, monetary, and trade policies as well as potential deregulation measures that should encourage greater investment in fixed income securities. 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 past year, highlighting the third quarter in gray. Agency mortgage performance was impressive during the quarter as the decline in interest rate volatility supported persistent demand from money managers and mortgage REITs, while net supply continued to undershoot expectations. Although bank and overseas demand remains subdued, steady inflows into money managers and robust capital raising by mortgage REITs helped to offset the weakness, resulting in strong returns for the sector. Third-year mortgage rates declined during the quarter as tighter mortgage spreads, lower interest rates, and compression in the primary-secondary spread led to a decline of nearly 50 basis points. This decline in mortgage rates dampened the performance of higher coupons relative to those lower in the stack as investors were reluctant to increase prepayment risk in their portfolios. While generic collateral and discount coupons outperformed treasury hedges by 90 to 130 basis points, similarly, generic collateral in 6% and 6.5% coupons outperformed by a more modest 30 to 70 basis points. In the upper right-hand chart, we show higher coupon specified pool pay-ups which are the premium investors pay for specified pools over generic collateral and are representative of the bonds that IVR owns. Positively, payoffs improved during the quarter, offsetting a portion of their underperformance relative to lower coupons given increased investor demand for additional prepayment protection and premium coupons. Although IVR's prepayment fees were relatively unchanged during the quarter at just over 10 CPR, higher coupons did indicate a faster refinancing response to the decline in mortgage rates in September, and we expect a similar response in speeds this month. This recent increase in refinancing activity is expected to be somewhat short-lived, however, as increased refinancing efficiencies result in swifter responses and reduced flag comps with November speeds expected to decline. We continue to believe that owning prepayment protection via specified pools, particularly in premium price holdings remains a beneficial way to hold attractively priced mortgage exposure. Slide 6 details our Agency RMBS investments and summarizes the investment portfolio changes during the quarter. Our Agency RMBS portfolio increased 13% quarter-over-quarter as we invested proceeds from ATM issuance and maintained leverage at book value improved. The majority of our net purchases occurred in 4.5% versus 5.5% coupons with a decline in our 6% and 6.5% allocations, a result of paydowns and the growth in the overall portfolio. Although we continue to focus our specified pool allocation on prepayment characteristics that are expected to perform well in both premium and discount environments, price appreciation in our holdings has resulted in a higher percentage of our pools valued at premium dollar prices. Therefore, while we remain most comfortable with lower loan balance specified pool stories, we increased our exposure to borrowers with higher loan-to-value ratios, given our expectations for slowing price appreciation resulting in a reduced refinancing response for these borrowers. Overall, we remain constructive on Agency RMBS as supply and demand technicals are favorable and lower levels of interest rate volatility should continue to encourage strong demand for the sector. We believe near-term risks have become more balanced following recent outperformance with nominal spreads tightening approximately 20 basis points during the quarter. However, valuations remain attractive with the current coupon spreads on a 5- and 10-year SOFR blend ending the quarter near 170 basis points, equating to leverage gross returns in the upper teens. Slide 7 provides detail on our Agency CMBS portfolio, risk premiums tightened during the quarter consistent with broader financial markets. Given the more attractive relative value in Agency RMBS, we did not add to our agency CMBS position during the quarter and maintained current holdings, with our allocation declining modestly due to the growth in the portfolio. Despite the lack of new purchases, we continue to believe that Agency CMBS offers many benefits mainly through its prepayment protection and fixed maturities, which reduces our sensitivity to interest rate volatility. Levered gross ROEs are in the low double digits and consistent with ROEs in lower coupon Agency RMBS, and we have been disciplined on adding exposure only when the relative value between Agency CMBS and Agency RMBS accurately reflects their unique risk profiles. Financing capacity has been robust as we continue to fund our positions with multiple counterparties at attractive levels. We will continue to monitor the sector for opportunities to increase our allocation as the relative value becomes attractive, recognizing the overall benefits to the portfolio as the sector diversifies risk associated with an Agency RMBS portfolio. Slide 8 details our funding and hedging book at quarter end. Repurchase agreements collateralized by our Agency RMBS and Agency CMBS investments increased from $4.6 billion to $5.2 billion, consistent with the increase in our total assets, while the total notional of our hedges increased from $4.3 billion to $4.4 billion as our hedge ratio declined from 94% to 85%. The table on the right provides further detail on our hedges at year-end. The composition of our hedges shifted modestly towards treasury futures quarter-over-quarter with 77% of our hedges consisting of interest rate swaps on a notional basis. While on a dollar duration basis, the allocation declined to 63% given the higher allocation of interest rate swaps closer to the front end of the curve. Swap spreads widened during the quarter, unwinding a portion of the tightening experienced in the second quarter, serving as a tailwind for our performance. Despite the recent widening, we continue to believe swap spreads are still historically tight and should continue to normalize, benefiting the company, and we maintain our preference for interest rate swaps over treasury futures. Slide 9 provides detail on our capital structure and highlights the improvement made in recent quarters to reduce our cost of capital. Further improvement in the capital structure remains a focus of our management team as we seek to prudently maximize shareholder returns. To conclude our prepared remarks, financial market volatility has declined notably since the beginning of the second quarter, resulting in strong performance from most risk assets in the last 5 months. IVR's economic return of 8.7% during the third quarter is a result of that positive momentum but also reflects our disciplined approach to capital activity and our focus on shareholder returns. In recent years, we have taken significant yet prudent steps towards improving our capital structure and reducing the cost of capital to our common stock shareholders. We remain committed to that approach as we seek to further reduce expenses while enhancing returns and improving scale. We believe our liquidity position provides a substantial cushion for further potential market stress while also providing sufficient capital to deploy into our target assets as the investment environment evolves. While we view near-term risks as somewhat balanced, we believe further easing of monetary policy will lead to a steeper yield curve and lower interest rate volatility, both of which will provide a supportive backdrop for Agency mortgages over the long term. Thank you for your continued support for Invesco Mortgage Capital, and now we will open the line for Q&A.

We will now begin the question-and-answer session. Our first question comes from Trevor Cranston with Citizens JMP.

You're just talking about the changes in the hedge portfolio moving a little bit towards treasuries this quarter. Can you talk in general about kind of where your net duration exposure is at? And kind of if you have any general position on with respect to the shape of the yield curve? And then a second question on the hedge portfolios, how you guys are thinking about potentially using options given the decline in the cost of volatility.

Thank you for your question, Trevor. I'll address the yield curve first. We've been holding a slight bias towards a steepener for some time and have recently started to scale that back a bit, opting to shift more of our hedges towards the front end of the curve. The Fed's decision to cut rates on Wednesday has added some uncertainty regarding future cuts, as expressed by Chair Powell, which could lead to a flatter curve compared to what we've been observing. As those cuts are potentially eliminated from market expectations, we still prefer a modest steepener but have made slight adjustments. Regarding the portfolio's overall net duration, we typically aim for empirical duration close to zero. However, since a larger portion of our tools is now at premium prices, we're anticipating a bit more risk of interest rate rallies. Consequently, we are managing our model duration to be slightly long as opposed to our usual flat position. We continue to favor interest rate swaps and expect swap spreads to normalize, which will encourage us to invest more in treasury futures due to their liquidity and margining advantages. We still believe there's room for widening in this area, so we will focus more on swaps.

Got it. Okay. That's helpful. And then with the tightening that we saw in agency spreads in the last quarter, can you talk about where you're seeing returns on marginal capital deployment relative to the existing dividend level?

Yes. So at the end of the quarter, levered gross returns were in the upper teens, so net returns were kind of in the mid-teen area. So that's pretty consistent with where our dividend to book yield is. So we feel like it is supportive of that level. And we've seen a little bit of compression so far in October, just given further outperformance in mortgages that recently, we have seen those levels kind of back up a little bit since the Fed meeting. So I think it's mostly in line with what the earnings power of the portfolio currently is.

Our next question comes from Doug Harter with UBS.

Can you talk about your appetite for continuing to kind of change the capital structure with the buyback of the preferred issuance common? And I guess, as you look at those transactions, the combined effect of that transaction, does that have any impact on book value in the quarter?

Yes, Doug, it's John. Regarding the preferred buybacks, those are relatively small and had a minimal impact, around $2 million. It's challenging to execute on those buybacks because the trading volume is low. We will continue to buy them back as long as it makes sense and they are trading below 25%, which means it didn’t significantly affect the capital structure, although it was a step in the right direction. Concerning common stock, we have been trading at a discount, and we haven’t issued any recently, which would help improve the capital structure. In the past, we have actively bought back shares when the price-to-book ratio is consistently low for a prolonged period. It fluctuates quite a bit, so we look for persistent discounts and situations where investment opportunities are not accretive. Currently, we are still seeing relatively accretive investment opportunities, so we are not buying back shares at this time. If those conditions change, we will definitely consider it.

Great. And then moving back to the investment opportunities, just how you're seeing the relative value between Agency CMBS and Agency RMBS today?

Yes, Doug, it's Brian. Agency RMBS continues to offer a more attractive return on equity. As I mentioned earlier, the potential returns from Agency CMBS are more closely aligned with what we consider lower coupon Agency RMBS, which still has numerous advantages. Therefore, as long as Agency RMBS remains in the mid to upper teens, we would likely see some more convergence between the two before we consider significantly transitioning towards Agency CMBS. However, we appreciate holding those securities since they provide valuable convexity benefits for the portfolio.

At this time, I'm showing no further questions. I'll turn the call back over to the speakers.

Thank you, everybody, again for joining and look forward to speaking to you next quarter.

Thank you. And this does conclude today's conference. We thank you for your participation. At this time, you may disconnect your lines.