Invesco Mortgage Capital Inc.
Q3 2013 Earnings Call Transcript

Published: 29 Oct 2013

[Unidentified Company Representative:]

This presentation and comments made in the associated conference call today may include forward looking statements. Words such believe, expects, anticipates, intends, plans, estimates, projects, forecasts and future or conditional verbs such as will, may, could, should and would as well as any other statements that necessarily depends on future events are intended to identify forward-looking statements. Forward-looking statements are not guarantees and they involve risks, uncertainties and assumptions. There can be no assurance that actual results will not differ materially from our expectations. We caution investors not to rely unduly on any forward-looking statements and urge you to carefully consider the risks identified under the captions, Risk Factors, Forward-Looking Statements and Management Discussion and Analysis of Financial Conditions and Results of Operations in our annual reports on Form 10-K and quarterly reports on Form 10-Q, which are available on the Securities and Exchange Commission's website at www.sec.gov. All written or oral forward-looking statements that we make or that are attributable to us are expressly qualified by this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns out to be inaccurate.

[Operator:]

Welcome to Invesco Mortgage Capital Inc.'s investor conference call. (Operator Instructions) Now, I would like to turn the call over to the speakers for today, Richard King, Chief Executive Officer; John Anzalone, Chief Investment Officer; and Don Ramon, Chief Financial Officer. Mr. King, you may now begin.

[Richard King:]

Thank you. Good morning, everybody. And as always, thank you for dialing in today. We made great progress in the quarter on the goals we laid out at the beginning of the year; reducing interest rate risk, reducing reliance on short-term funding and generally strengthening our overall risk positioning. We believe this sets our company up well to also accomplish our long-term goals, that is to deliver an attractive dividend and do so with improved book value, stability and growth. We utilized portfolio flows throughout the quarter to reduce our exposure to short-term agency repo. We also reduced our duration exposure in the agency portfolio by adding the hybrid ARM and increasing hedges. Leverage in the agency mortgage-backed securities portfolio was down by 1.5 turns quarter-over-quarter. Credit leverage overall was unchanged, as we found some attractive value in CMBS, legacy, RMBS and subordinate credit, underlying newly underwritten residential loan. We're now less exposed to interest rate volatility than in prior quarters and we're much better positioned to capture credit spread tightening in residential and commercial market. For the third quarter, we had core earnings of $0.50, which equal the dividend paid. The reduction in earning assets coupled with additional hedges, including forward starting swap coming on did reduced our core earnings relative to prior quarters. We opportunistically traded the portfolio, offsetting gains recorded in the second quarter to reposition the portfolio toward more credit and undervalued hybrid ARMs. Our swaption position and futures hedges are mark-to-market with changes in the valuation going through the income statement. The combination of hedge position and realized losses on portfolio repositioning explains the difference this quarter between GAAP and core earnings. Portfolio positioning for the present environment. The action taken in the third quarter, leave our company's portfolio well-positioned for the current environment, where both fundamentals and technicals are positive. We believe risk premia on our assets will contract, reducing appreciation on our credit position in RMBS and CMBS from here. In fact, we're already seeing that occur quarter-to-date, book value is up about 3.5%. The technical environment in the agency mortgage market is favorable with low rate, low volatility, slow prepayment and the Federal Reserve continuing to support the market with purchases. Supply versus demand technicals remain very positive in the mortgage credit space as well, with robust demand for bond and limited supply. Fundamentals in both residential and commercial real estate debt markets are sound, as the recovery in each continues to take hold. It's important to note that we're not generating the dividend, primarily by accepting interest rate risk. Our strategy is to isolate the value of end-mortgage spread by hedging the interest rate component of residential and commercial loan. It is for that reason that we especially find attractive those assets with predictable cash flows that we can hedge effectively. Our earnings are generated by the detailed credit work and cash flow analysis we do. We're bullish on credit spreads now and believe that in addition to the attractive yield on our shares, we are likely to see book value appreciation, as credit spread improve. I'll take a minute to talk about new initiatives for the future. We're also making progress on these new initiatives and we're focused on three that will further broaden our assets into higher yielding opportunities that reduce our reliance on borrowing and increase our exposure to floating rate spread income. First, our commercial real estate debt origination platform is taking shape, as we build out a pipeline of deals, which we expect to begin closing in Q4. Second, we see the government raising up the risk-sharing deals next year and continue to think that those will be an attractive way to earn attractive returns on well underwritten loans. And third, we continue to add subordinate credit positions on newly originated residential and commercial loans. Before turning the call to John, let me emphasize why I'm so excited about Invesco Mortgage Capital. We are well-positioned to capitalize on what we believe are strong fundamentals and technicals in the U.S. mortgage market that will cause risk premia to contract, creating appreciation in our holdings. We have been and will continue to reduce our reliance on short-term borrowings and reduce our exposure to interest rate risk. Finally, new initiatives in commercial real estate and residential loans generate attractive yields now, will further reduce our exposure to the short-term funding market and provide a long-term source of attractive investment opportunities. Now, John is going to discuss our investment strategy and portfolio in further detail.

[John Anzalone:]

Thank you, Rich. And again, thanks to everyone listening to the call. I'll start out on Slide 4. As Rich talked about and as we've indicated over the past few quarters, we've been focused on positioning the portfolio to capture spread tightening and away from exposure to interest rates. The chart on the upper left shows how the portfolio has changed over the past year. Agency mortgages now represent just over 60% of the portfolio, down from over 75% a year ago. The composition of the agency book has also evolved, which I'll talk about in more detail in a moment. Both our cost of funds and our portfolio yields were fairly stable over the past quarter, despite the volatility in rates. Slide 5 provides a snapshot of our equity allocations and leverage and how it's changed over the past quarter. This is where you can see how we moved to reduce our interest rate exposure. Overall leverage is down to 6.9x, while leverage allocated to repo was down to 5.8x. This is largely accomplished through reduction in leverage in our agency book to 8.1x. The composition of our credit leverage changed slightly, but overall credit leverage was largely unchanged. In addition to simply delevering the agency book, we also took steps to reduce interest rate exposure by adding more hedges. We added an additional $600 million and 10 year swaps during the quarter, in addition to adding some 30-year hedges via Treasury futures. We did reduce our swaption book in favor of swaps in futures and the net result is that a larger percentage of our repo book is hedged, our duration gap has been reduced and we have seen less volatility in our book value as rates move. Over the next few slides, I'll talk about the assets side, starting on Slide 7 in agency mortgages. As I mentioned earlier, we reduced the size of our agency book with reduction of $1 billion, which resulted in a reduction of leverage of about of 1.5 turn. The reduction in the portfolio was largely the expense of 30-year collateral and the percentage of 30 has been reduced to 72%. We added hybrid ARM collateral over the course of the quarter, nearly doubling that exposure at quarter end. We've continued to add exposure there into the fourth quarter. The performance of hybrid ARMs lagged significantly during the second quarter and adding a relatively cheap asset with a shorter duration profile really fits in with our theme of reducing overall interest rates risk. Prepayment speeds were down slightly for the quarter, but we expect those to fall further, as reduced capacity and seasonality kick in. Our first quarter to fourth quarter confirm this year. While we have been reducing our agency exposure, I do want to emphasize that we've been doing so with the strength. Our outlook for agencies over the near-term is quite positive as the Fed continues to buy a disproportionate share of net supply. Slide 8 provides a snapshot of our non-agency book. We have continued to focus our purchases in the legacy Prime and Alt-A sectors, as these bonds have more upside, as the housing market continues to improve as well as relatively short duration profiles. Given our view that the housing recovery is likely to persist, albeit at a slower rate and the fact that the technical picture remains very positive with persistent negative net supply, we believe the outlook for spread tightening is very good. This outlook is reflected in the pie chart on the upper left. The percentage of our non-agency book that is devoted to legacy securities continues to grow and is now over 60% with senior re-REMICS dropping to under 40%. Leverage ticked up to 4x, but that was simply a timing issue that was offset in the CMBS leverage. Again, overall credit leverage was stable. Moving to Slide 9 in CMBS. A lot of our views in the residential space carry over to CMBS. We see a gradually improving fundamental picture that should continue to support spread tightening. One difference is that the new issue market has developed much more quickly here than on the residential side. So the technical picture is not quite as robust with flat net supply. That said, we are focusing purchases on a high quality paper that should perform well, as the commercial real estate recovery continues. Before opening the floor up to questions, on Slide 10, one of the highlight performance of the residential whole pools, and were contained in our securitizations earlier this year. This provides a pretty good illustration, as to why we are looking to increase our exposure to newly underwritten credit. I'll just point out a couple of highlights. First, out of over 1,900 loans served in zero serious delinquencies, more importantly look at the LTV performance, in the course of about six months, the LTVs on these loans has decreased by over 700 basis points from 67 LTV down to 60 LTV, which further strengthens the credit quality of the portfolio. On that note, I'll stop and open up the floor for questions and answers.

[Operator:]

(Operator Instructions) Our first question does come from Douglas Harter of Credit Suisse.

[Douglas Harter:]

John, I was hoping you could talk about the return profile on some of the new initiatives, like the subordinated bonds on whole loans and what seems like those returns are a little bit less attractive today? And I just wanted to see where you see those returns?

[Richard King:]

I think what we're looking at on a lot of the new initiatives are opportunities that our floating rate assets, like in the commercial mezz space and the risk-sharing deals for instance. And so there when you look at the potential IRR, and we usually look at everything relative to forward curve, so we have an upward sloping curve. And when you factor all that in, you get to kind of low-double digit IRRs without leverage on those type deals. And then we get to about the same place, on the residential loan securitizations we've done, where we're buying the subordinate sub-stack plus IRRs. And again, get into kind of low-double digit IRR.

[Douglas Harter:]

And then just you said the pipeline was building on those the commercial mezz loans. Can you just give us a sense as to maybe what that magnitude is? And when we'll start to see that become a more meaningful part of your balance sheet?

[Richard King:]

I think what we want to see there is to close a few deals each quarter. And the size of those deals maybe somewhat chunky and that they could be $10 million or they could be $50 million. So it's not something I can give you a precise estimate on.

[Operator:]

Our next question does come from Dan Altscher of FBR.

[Dan Altscher:]

I was wondering, if you guys give us generic, we think there is a lot of different moving pieces going on right now in terms of investments. For every $1 of capital you had today what is the priority? Is it more Hybrid ARMs, is it more credit, is it more commercial whole loans? What is number one on priority list?

[Donald Ramon:]

I would say, credit versus agency, clearly credit would be the first priority, and then how that split up, I mean in large part it depends on -- and I would say the new initiatives would be first priority. I mean, but again those tend to be like Rich just mentioned, they tend to be a little bit more chunky in how they come. So it's not like if you gave me $1 today, we could put it to work in a commercial loan opportunity tomorrow. The lead times tend to be quite long on those. So I would say credit in general and there it's kind of split between resi and commercial.

[Dan Altscher:]

On the agency portfolio for the cost of funds, I may have missed in the slide deck, but can you maybe tell us what the all-in kind of cost of funds is for the agency portfolio with I guess the cost for hedges this quarter? I think maybe last quarter like 1.53%?

[John Anzalone:]

We did break it out a little bit differently this time to show, because when we look at hedging the entire book, looking it's not just purely the agency book. But I think if you were to look at it, it's probably something like, it would have been up about I think around 1.97% or something like that in total. So it was up a little bit, but again purely a function of the forward starting swaps that we put on last quarter and so forth at around starting to pay.

[Operator:]

Next question does come from Trevor Cranston of JMP Securities.

[Trevor Cranston:]

I just wanted to follow-up a little bit on the new residential loan transactions and the bullet on Slide 2 that says that hopefully you can get another yield on in the fourth quarter. It seems like the headlines that we're seeing about yields that have been in the market this quarter seem to indicate that the market is pretty difficult for the new issued securitizations. Can you just give us some color on how you're seeing things and if you think that as you see things today the market would reopen for a new deal or not?

[John Anzalone:]

I don't want to talk specifically about specific deal that we may do in the fourth quarter, if you understand, we just can't do that. But broadly, you're right. The spreads on the AAAs are quite attractive at this point. And so we're looking at kind of some creative ways to gain exposure to that new underwriting without replacing AAAs.

[Trevor Cranston:]

And then switching to the agency side a little bit. Obviously, the trend in the quarter that leverage went down and the asset mix moved a little bit shorter in duration. Are you guys kind of comfortable, where you're at or do you see that trend continuing into the fourth quarter?

[Richard King:]

I think we're comfortable where we're at from a duration perspective and how we're hedged right now. But that said, we continue to look at hybrid ARM collateral, because it still looks relatively cheap to us and also has a pretty nice duration profile, they're easier to hedge, things like that. So you might see that trend continue. But I would say near-term, we like how we're positioned. I think our leverage numbers are and if you right for the environment we're in, we've seen, given how we reposition the book, we've seen book value stability throughout most of, since or I guess over the course of the last quarter, book value has been relatively stable. So we like that also. So I would say, we want to see a lot of changes in the agency, but maybe more evolution towards shorter duration type assets. But that will be more around the hedges than a big wholesale shift.

[Operator:]

Joel Houck of Wells Fargo.

[Joel Houck:]

I guess more of a conceptual question. I mean you guys have obviously taken down leverage on the agency side in shortened duration. What would it take -- I guess, what would you guys looking for to kind of releverage yourself relative to the agency investments? Or you guys at this point looking at it as more defensive and where it just kind of reallocates and agency is going to be minimally allocated to that kind of 55% whole loan pool test to pass kind of the regrowth? Or if the business model still opportunistic in that you're looking for more attractive spread there, there is some institutional view that tapers as just a matter of time and you want to minimize exposure in this sector for the foreseeable future?

[John Anzalone:]

I mean it really goes back to -- our long-term goals are to deliver an attractive dividend and minimize book value volatility and hopefully grow book value. And we just think that the best way to do that at this point is to reduce leverage on the agency side and move more equity towards new opportunities in credit. We think credit spreads are going to tighten, and therefore, that's how we get growth in book value. And as far as, at some point, if interest rates are much higher in the future and agency spreads are more attractive, we certainly would be opportunistic and take advantage of that. But that we just don't believe that that's the opportunity in the market right now.

[Operator:]

Our next question does comes from Dan Furtado of Jefferies.

[Dan Furtado:]

My first question is, how should investors be thinking about the size of the commercial loan problem, you're talking about as new initiative?

[Richard King:]

We'd like to grow to about 25% of our equity capital. But like John said, it's not something that we can do. I mean it takes a great deal of work on each particular deal obviously. We have a very large commercial real estate team working on sourcing deals and closing deals and so forth. So we think we can ramp it up, but I can't really give you a date.

[Dan Furtado:]

And then, it seems like you still have some room to take the agency exposure down considering the asset test rules. But then, I hear John and the rest of you say that for now you guys feel pretty good about what your exposure is. Can you give us a timeframe for now it encompasses? Are you talking the next quarter or two? Or how do I think about that, because I mean, like I said, it seems like you could take that leverage down quite a bit further from here considering what whole loans are bringing on the residential side?

[John Anzalone:]

One of the things that's nice about the whole loans on that side is that it gives us more degrees of freedom on the agency side obviously. So that's a part of it. I would say on the agency side, I mean -- I mentioned we're bullish now. We think agencies over the next and I would say probably over next few quarters should remain -- will be positive for next few quarters, I think given the supply demand, technicals, Fed and they seem to be on course to buy a disproportionate number of bonds over the next certainly into several quarters. And that that's where it gets a little bit more difficult to forecast how mortgages will perform. Once we get into talk of tapering again, how are that's pushed off, we certainly expect that that will happen at some point and we view this as an opportunity to kind of readjust the portfolio again into strength by reducing some agency exposure, getting more exposure, to say newly underwritten credit, which we think is a much more persistent opportunity, I mean that should last for a longer period of time.

[Operator:]

Our next question does come from Cheryl Pate of Morgan Stanley.

[Cheryl Pate:]

Wondering if we could spend a little time, obviously you guys have spent some time reducing repo exposure and building up some permanent financing. Can you maybe give us sort of your view of the repo market maybe moving forward a little bit, given some of the regulatory changes coming through? And how you think about the repo exposure over time? And secondly maybe if there is a little bit of an update on how haircuts have been trending on the agency repo side?

[John Anzalone:]

I'll start with the first part. So what we've seen recently is there hasn't really been much of a change at all. We did see agency repo rates during the quarter go up a little bit. And debt ceiling was going on, we saw repo rates maybe go from the mid-to-high-30s to maybe low-to-mid 40s, and then once that debt ceiling thing passed right back to where it was kind of in the 37, 38 range. So really we haven't seen changes in haircuts or repo rates. Now, I'll let Rich talk about the longer-term regulatory environment.

[Richard King:]

We don't know the outcome obviously of all the regulatory issues that are out there, but we're certainly well aware of them and preparing for potential changes. So our plan coming into the year was to reduce repo balances and we're happy to move along that path. But part of that is we lowered leverage check, we moved out of agencies, which have more turns of repo relative to credit, so that's a check. As you mentioned we issued some notes and we're incubating these opportunities to buy assets that don't require repo and exploring another financing arrangements as well. But I guess what I'd say is, we're reducing our repo faster than our counterparties, who would like us too, and I think they collectively want to do more with us, so we feel like we're in a good place there. Repo is an attractive way to borrow against liquid high-quality assets. And so we're not looking to eliminate repo. We see that's a great way to finance our assets. We just want to get ahead of any potential changes. And I think finally on that score, we're a good partner with most of the big dealers, obviously that be it finance in the short-term markets and long-term markets, and I think as time goes on that's a big asset that you want to be a good partner to people providing repo to you. But I also think if we do see regulatory change on banks limiting leverage and so forth, that you'll see other players, non-bank providers created, I don't think the repo market is going to go away, I think it's important for the entire financial markets, but we like the position we're in.

[Operator:]

And our next question does come from Jim Young of West Family Investments.

[Jim Young:]

You had mentioned that your book value quarter-to-date is up about 3.5%, so that would suggest around $18.17 a share. Does that include any benefit from credit spreads tightening at this time?

[John Anzalone:]

I will talk generally about what we've seen in October, and we've seen strength across the board in October. I think the view in the market has sort of evolved and Fed tapering is put off for a while. I think the market has generally been risk on for the month of October. So we've seen strength in agency, CMBS and residential mortgages this quarter. So I think it's been a pretty positive environment, pretty much straight through.

[Richard King:]

We believe that given the lower rate volatility and kind of the recent economic numbers being a little faster, there is going to be a need for yield out there, rates are holding end pretty low and expect credits spread to continue to tighten in.

[Jim Young:]

So in this month, how much have credit strength tightened on the assets in your portfolio?

[Richard King:]

You know what, we can't give you an exact number on that, but I'd say in the CMBS market generally, we've probably seen maybe 10 or 15 basis point of spread tightening, as an example, agency mortgages have outperformed pretty consistently, as John mentioned.

[Jim Young:]

And could you just give us some sense of their sensitivity, so if we saw another like 15 basis points tightening in your residential non-agency and CMBS, would that suggests that you'd have another 3% to 4% upside in your book value?

[Richard King:]

We don't have the specifics right in front of us, Jim, to give you that number. And a lot of it depends, obviously, on if spread duration in the agency book and the CMBS book and the RMBS. But I can't give you a number, right now.

[Operator:]

Our next question does come from Douglas Harter of Credit Suisse.

[Douglas Harter:]

You guys have mentioned that you've reduced your duration GAAP, I was just wondering if you had those numbers as to where it stands today and how that compares to where it was last quarter?

[Richard King:]

Looking at kind of overall risk and certainly the GAAP is interesting. But what I'd rather talk about actually is kind of our equity duration, if you will. And it is now at around 12.5 or 13, probably earlier in the year and it's down in the 7.5 range. And we really don't want that number to come down to zero at this point; a, because we aren't expecting rates in the near-term to go up dramatically, but also it's a nice counterbalance and that we do expect to credit spread tightening. And to have a zero equity duration, if we saw a difficult situation from an economic perspective, it's going to be helpful to have a little bit of duration to offset the credit assets, but I think that's the best number. So rates up 100 basis point you'd see overall book value decline about 7%-ish, without any spreads changes anywhere.

[Douglas Harter:]

And then you increased the hybrid ARM portfolio substantially during the quarter. I guess, where do you see the attractiveness of hybrid ARMs today? How much of the kind of the second quarter widening has been recouped to date?

[John Anzalone:]

I would say, they've tightened along with the rest of the agency market, but they have kind of tightened along with it. They haven't really outpaced it. So on a relative basis, we still think they're attractive versus 15s in terms of what we see as hedge returns. So that's how we kind of compare them to the 15-year market, so they're still about pretty cheap.

[Operator:]

Our next question does come from Mark DeVries of Barclays.

[Mark DeVries:]

Just want to get an update on where you're seeing relative value in your credit investments? I know you mentioned supply is stronger on a relative basis in CMBS. Have you seen any signs of froth in the underwriting there is still attractive, a lot of different spreads? And on the residential side, how levered are your investments at this point to further HPA appreciation?

[John Anzalone:]

I'll start on the CMBS side, and we have seen underwriting standards loosen up a little bit from say a year ago, so we're definitely seeing that trend. And that causes to become more selective on the CMBS side. So really it's about, again like a lot of what we do. I mean it's a lot of detailed credit work. So now let's say we're still doing that and trying to find bonds. And that is really what's limiting the amount of new money we're putting to work in CMBS is really finding bonds that we like from a credit perspective, so that you're certainly correct in that sense.

[Richard King:]

We've showed in that pie chart, we've been adding legacy Prime and Alt-A bonds and the upside is not huge like it was a few years ago. But we could add a 1% or 2% to what we project is IRRs, if we see housing prices continue to go up and delinquencies continue to decline and so there it continue to fall.

[Mark DeVries:]

And sorry if I missed this, did you indicate what your unlevered returns are on your CMBS investments there?

[Richard King:]

Our unlevered returns on CMBS?

[Mark DeVries:]

Yes.

[John Anzalone:]

Well, I mean kind of what we're seeing things for new issue subs are probably in 4.75% to 5%-ish range. I think that they're unlevered, just for flat out.

[Mark DeVries:]

And on a levered business?

[John Anzalone:]

You'll be probably getting up into, say, upper-single digits to low-double digits depending on -- it kind of depends on the bond and what kind of haircut you get in that. But that range would be in the high-single digits.

[Richard King:]

We had a decent amount of CMBS earlier in the quarter when spreads were wider not as much recently.

[Operator:]

Mr. King, there are no further questions from the phone lines at this time.

[Richard King:]

Thank you. I appreciate it.

[Operator:]

That does conclude today's conference call. Thank you. And all participants may now disconnect.