Earnings Call Transcript - IVR Q4 2023

Operator, Operator

Welcome to Invesco Mortgage Capital Inc. Fourth Quarter 2023 Investor Conference Call. All participants will be in a listen-only mode until the question-and-answer session. As a reminder, this call is being recorded. Now, I would like to turn the call over to Greg Seals, an Investor Relations. Mr. Seals you may begin the call.

Greg Seals, Investor Relations

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, 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 or guarantee the accuracy of our earnings teleconference transcripts provided by third parties. The only authorized webcast is 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 fourth quarter 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 enter the fourth quarter, 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 assets, reducing risk by decreasing leverage as volatility increased. The 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 ending the quarter at $10, representing an increase of 0.7% from September 30th. 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 30th. 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 income on our target assets, favorable funding and low-cost pay-fixed swaps. For the quarter, earnings available for distribution per common share was $0.95 compared to $1.51 for the third quarter, 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 16th, our book value per common share is down moderately, estimated to be between $9.50 and $9.88. As we entered 2024, both the FOMC and the Federal Fund futures market forecast the next policy move by the FOMC will be a rate cut, although they have had different 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, CIO

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 to the agency mortgage markets 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 fourth quarter. Yields on maturities from two years to 30 years declined between 65 and 80 basis points, and the disinflationary trend and economic data persisted, while estimates of future Treasury funding needs declined. By the end of the fourth quarter, pricing in the Fed Funds futures market reflected expectations for a 25 basis point cut in the target rate in the first quarter of 2024 and nearly seven cuts in total by the end of January 2025. Despite further runoff 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 fourth quarter 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 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 3% or 6% specified pools in November and December as interest rate volatility declined. We remain focused on 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 allocation to the 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 priced in this risk, 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 7. Our allocation to agency interest-only securities remain largely unchanged, totaling $75 million at quarter end. The modest decline from $78 million at the end of the third quarter to $75 million this quarter primarily due to paydowns 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 paydowns. Our credit investments remain high quality with 68% rated AA or higher. Although, we anticipate limited near-term price depreciation in our credit and Agency IO investments, we believe these assets provide attractive yields for unlevered holdings. Slide 8 details our funding and hedge book at quarter end. Repurchase agreements collateralized by HC RMBS declined 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 commensurately with our reduction in specified pool holdings during the quarter. We continue to reposition the hedge book, unwinding our remaining received fixed interest rate swaps and a portion of our legacy pay-fix 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 retain 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 a weighted average maturity at 6.6 years. Leverage ended the quarter with 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 yield and funding cost. Interest rate on our repurchase agreement 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. Yield on our HC 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 expected 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 fourth quarter of 2023 began 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 first half of 2024. Despite significant tightening of spreads in the asset class in the fourth quarter, we believe the Agency RMBS valuations remain attractive for long-term investors, given our expectations 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 the 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, Operator

Thank you. We will now begin our question-and-answer session. Our first question comes from Trevor Cranston with JMP Securities. Your line is open.

Trevor Cranston, Analyst

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

Brian Norris, CIO

Yes. Hey good morning, Trevor, it's Brian. Yes, we haven't really made any significant changes to our yield curve exposures. We're positioned slightly for a steeper curve, given our expectations for Fed policy in 2024. The sharp rally that we saw in interest rates during the fourth quarter did shorten our mortgage investments. So, you saw the shortening in our hedges as well. But really, 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, Analyst

Okay, got it. Appreciate the color. Thank you.

Operator, Operator

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

Jason Weaver, Analyst

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

Brian Norris, CIO

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

Jason Weaver, Analyst

And on that subject, what is the typical type of specified pool for the new high coupons in the 6s?

Brian Norris, CIO

Yes, it's pretty consistent with the rest of our portfolio, leaning a little bit heavier into loan balance, but also higher loan balance, call them, $225,000, $250,000, but also a fair amount in the lower pay-up stories like LTV and FICO and geo stories.

Jason Weaver, Analyst

Got it. All right. That's helpful. And finally, I see cash 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, CIO

I wouldn’t say we are looking to raise leverage at this time. We could consider it if the market stabilizes and valuations improve, but for now, I think we are comfortable with our current position. There is still uncertainty regarding the timing of Fed policy, and we expect this to continue until things become clearer. However, we do have the capacity to increase leverage if the right conditions emerge.

Jason Weaver, Analyst

All right. Thank you for that color and congrats, guys.

Brian Norris, CIO

Thank you.

Operator, Operator

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

Doug Harter, Analyst

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

John Anzalone, CEO

Yes, Doug, it's John. The dividend is set by the Board, and currently, the earnings available for distribution, despite a decline due to changes in the swap book, still support the current dividend level comfortably. We consider whether our dividend is significantly different from our peers and also evaluate our cash flows and earnings available for distribution as we project these for the upcoming quarters. So far, the situation looks well-supported, and as long as conditions remain stable, I don't anticipate any changes. However, it's still early to draw definitive conclusions.

Doug Harter, Analyst

Thanks John. Regarding the capital structure, how are you planning to reduce the preferred equity percentage? Additionally, do you view leverage as something that will increase or in relation to total equity?

John Anzalone, CEO

We consider leverage from both perspectives, but we typically focus more on leverage in relation to common equity as it pertains to our risk assessment. Regarding our capital structure, we have been gradually buying back preferred shares in the market, though it's been a slow process due to the activity level of those shares. Currently, we have two types of preferred shares, and our Series B will be callable at the end of this year, which will require us to make a decision in the fourth quarter about whether to call it or pursue other options. We continue to seek opportunities to buy preferred shares, and when market conditions are favorable, we are also looking to raise funds through our ATM to help balance our capital structure. These strategies will be ongoing throughout the year.

Doug Harter, Analyst

Great. Appreciate that.

Operator, Operator

Thank you. Our next question comes from Eric Hagen with BTIG. Your line is open.

Eric Hagen, Analyst

Hey, good morning. How are you doing? Hey, on the specified pools, can you give us a sense for how much pay-ups are right now for the bonds that you're focused on buying 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 interest rate rallies?

Brian Norris, CIO

Hey Eric. Good to hear from you. It's Brian. As I mentioned earlier, payouts for specified pools have improved in the fourth quarter due to changes in the rates market, although those rates have decreased slightly. So far in the first quarter, rates have increased by 45 to 50 basis points since the end of the year, which you would expect to lead to some softening in payouts, and we have noticed that. Our weighted average payout is around 0.4 points, indicating our exposure to these changes is quite limited. The factors related to FICO, LTV, and geography have relatively low pay-ups, so there aren't significant changes there. The variation is mainly influenced by changes in loan balances, which have slightly higher pay-ups, approximately between 0.5 to 0.75 points. These numbers will adjust as the interest rate markets fluctuate. However, this does not alter our targeting for attractive additions at this moment. We still believe the TBA market will face challenges, leading to higher implied financing there compared to specified pools. Therefore, if we consider adding at this time, it would likely be within specified pools.

Eric Hagen, Analyst

Do you feel like there's anything that would catalyze dollar roll specialness aside from the Fed shutting off Q2 or making adjustments to Q2?

Brian Norris, CIO

Yes, I think if we were to see a significant return from banks. We have seen some encouraging signs from them over the last few months, and they've at least stopped running off their portfolio as significantly as they had been. But I do think that banks are really the primary driver of demand for those generic type securities. And so that PPA market is really driven by supply and demand dynamics. And until that starts to improve, it's hard to envision the dollar roll market improving all that much because, quite frankly, the other aspect of that is the convexity profile of the deliverables. And that is not appearing to get any better as loan balances continue to increase.

Eric Hagen, Analyst

Right. That's helpful. The book value range that you gave quarter-to-date, is that inclusive of the approved dividend? Or are you netting out the accrued dividend?

Brian Norris, CIO

That nets out the dividend.

Eric Hagen, Analyst

Netted out. Okay. Thank you guys so much.

Brian Norris, CIO

Sure.

Operator, Operator

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

Greg Seals, Investor Relations

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

Operator, Operator

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