Invesco Mortgage Capital Inc. (IVR) Q4 2011 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital Inc. investor conference call, February 23, 2012. [Operator Instructions] Now I’d 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.

Good morning, everyone and thanks for joining us. As you have already seen from our earnings press release, a key theme we want to emphasis to you this morning is stability. Our book value stabilized in the quarter moving from $16.47 at the end of the third quarter to $16.41 at year end. In a bit later in the call we will go into more detail about how and why our book value has since increased, recovering about 5% year to date and how we will continue to work diligently to continue this improvement. Fourth quarter earnings per share of $0.66 is broadly consistent with the current earnings power of the company in today’s rate and investment environment. The drop from $0.80 and earnings per share from Q3 was the result of reinvestment at lower yields, our last forward starting slot coming on at the beginning of the quarter, the higher financing cost into year end, and slightly lower asset balances. As far as the potential stability of the dividend is concerned, we do believe the company’s portfolio is well positioned to generate similar dividends to what was generated in the fourth quarter barring any significant economic changes. One of the most important developments we have followed with great interest has been the unprecedented amount of stimulus provided by central banks around the world over the last 6 months. A few of them were noteworthy. Examples include extraordinary actions by the Fed including reinvesting their mortgage portfolio, Operation Twist and extending their 0 interest rate policy to a total of about 6 years, as well as the long-term refinancing operation by the European Central Bank and the Bank of Japan’s significant Asset Purchase Program. This massive global easing appears to be prompting credit market participants to buy previously out of favor higher-yielding assets including commercial mortgage-backed securities and non-agency residential mortgage-backed securities instead of essentially hiding out in Treasury Bonds that have negative real yields. We believe this massive stimulus at a period where economic indicators are already surprising to the upside, could cause financial assets to outperform and cause growth to surprise somewhat to the upside in the near term and also heighten inflation risks for the medium term. The higher beta commercial mortgage-backed securities market began to recover in November and has been on a steady climb ever since, supported broadly in the market by money managers, insurance companies, hedge funds and others. While slower to follow, the non-agency market has begun to recover though not at the same pace and we believe the non-agency market still represents relative value. In addition, our agency MBS book has been outperforming our swap hedges even as rates continued to rally earlier this year and we believe our agency MBS book should outperform meaningfully in any rate sell off. As such, as I mentioned at the top of the call, our book value has recovered in 2012 by about 5%. Over the course of the fourth quarter, we used portfolio cash flows and proceeds from the sales of outperforming top CMBS and new issue RMBS and high dollar prices to invest largely in agency MBS at very attractive levels and to pay off some higher cost liabilities. As you will note on our balance sheet, we ended the quarter with $197 million in cash. This enabled us to maintain a comfortable liquidity position during the quarter while achieving our portfolio of goals. We are pleased with this level of liquidity given the headline environment. Portfolio adjustments and changes in valuation increased our agency position as a percentage of equity from about 51% to 55% in the quarter, while non-agency exposure declined from about 30% to 25%, CMBS exposure as a percentage of our equity increased from about 14% to 17%. This movement was largely a result of price increases. In the CMBS market as I mentioned we sold bonds that were trading at higher dollar prices in the rate rally and we held on to bonds we felt had better potential for further spread tightening, namely CMBS 2.0 Subs. Positively in January and February these 2.0 bonds have notably outperformed. The remaining CMBS portfolio has higher yields and hair cuts than our bonds originally financed via TALF, and thus are leverage declined. Our non-agency RMBS is now composed of nearly 70% senior Re-REMICs, that is re-securitizations of legacy non-agency RMBS. These positions are of very high credit quality with highly predictable cash flows and low interest rate exposure which is a valuable characteristic given that we are near all time losing rates. Because of their low volatility hair cuts are quite low and offer higher leverage in return on equity. Looking forward we are more balanced in our views with respect to relative value as agency prepaid protective tools still look more attractive than generic agency pay-ups are at all-time highs. Meanwhile pockets of RMBS and CMBS credit continue to look attractive. Overall it is important to emphasize that we are focused on improving book value and maintaining an even earning stream in coming quarters. And unless conditions change materially we have no plans to raise capital. Instead we will continue to improve margin by paying off higher cost liabilities and reinvesting portfolio cash flows in an accretive manner. Now I am going to turn it over to Don Ramon our CFO who will cover the financials.

Thanks, Rich. I will begin on Page 3 of the presentation. During the fourth quarter we saw a decline in our net income primarily driven by the decline in net interest income. One contributing factor was the portfolio realignment which resulted in lower yields for the quarter, but a better risk return profile. The second is higher borrowing costs. Compared to the previous quarter, interest expense increased $4.6 million. During the quarter, we saw an increase in rates across the board on all categories. The most significant was seen in non-agency financing or average borrowing costs increased 28 basis points. The overall increase in rates accounted for approximately $3.3 million of the increase in interest expense. With the start of Q1 we've seen rates coming down as counterparties are no longer requiring that year-end balance premium that they had. Another contributing factor to the increase in interest expense was higher swap costs of approximately $1 million. As we’ve discussed on previous calls, our hedging strategy involves using forward starting swaps and the fourth quarter was the first time that all of the swaps were paying. Since we've not added any swaps since the previous quarter and all the swaps are now paying, you can expect that this is really our current run rate. For the quarter, we had EPS of $0.66 and we declared a $0.65 dividend that was paid in January. As Rich mentioned earlier, we do believe that the portfolio is well positioned to generate similar returns in the current environment. Turning to Page 4. You can see that the overall portfolio yield declined 21 basis points to 3.94% as we increased our allocation to agency RMBS. This resulted in our net portfolio yield declining 26 basis points to 2.13%. The most significant challenge we faced during 2011 was the decline in our book value which was caused by the dislocation between our asset prices in the value of our swaps. The fourth quarter saw a stabilization of the book value as CMBS prices improved throughout the quarter and swaps prices leveled out. We did not recognize any impairment charge during 2011 and we continue to believe that the decline in book value was temporary. As Rich mentioned earlier, we’ve seen significant improvements in the economic conditions in the first quarter. This increase in asset prices has resulted in our book value increasing approximately 5% since quarter end. Now keep in mind this increase or estimated increase that we have excludes any earnings and really should be viewed as our increase in our current net asset value. And with that I think it’s a good transition to turn it over to John to talk about the portfolio.

Thank you, Don. Slide 6 shows how we are positioned at year end. We increased our allocation to agencies to 55% as we felt that specified full collateral looked attractive. Our CMBS allocation also increased and our allocation to CMBS now represents almost 17% of equity. This increase was primarily a result of higher dollar prices and some reduction in borrowings. We reduced our exposure to non-agencies as we packaged and sold a group of 40 plus odd lot legacy positions to a counterparty and bought back 60% of the exposure in the form of a single senior Re-REMIC position. This served to reduce our credit exposure and at the same time allowed us to apply leverage to the position in a much more efficiently. Finally, our investments in PPIP and equity investments decreased as cash was returned when we obtained financing for the Atlas portfolio. Total leverage on the portfolio was virtually unchanged at 6.4 X. Now, I will cover each of our main sectors. I’ll start with the agencies on Slide 7. Net yields were down slightly approximately 10 basis points as yields were lower with a modest pickup in prepayment speeds, up approximately 2 CPR for our fixed rate collateral. Towards the end of the year, we’ve seen speeds on our portfolio fall modestly. We expect that trend to continue as we believe our portfolio is well protected from the effects of the new HARP program. As I mentioned earlier, we put more equity into agencies and that turned out to be a good move so far. Not only have agency mortgages outperformed our swap hedges, but passed on the type of high coupon specified pulled paper that we favored had expanded materially. This has brought on by lower rates as well as by fears of faster speeds brought on by the HARP implementation. But we are still finding pockets of value in agencies, as our performance has prompted us to take a more balanced approach with reinvesting cash flows. Moving to Slide 8 on non-agencies. We reduced our equity allocation to non-agency to just under 25% during the fourth quarter. This is accomplished through the Re-REMIC trade that I mentioned as well as through some selected sales. Senior Re-REMIC bonds now make-up nearly 70% of our position, accordingly our yield on the non-agency portfolio is lower and our leverage is up from 3.7 to 4.1 X. Given the Senior Re-REMICs have continue to become large part of our portfolio, we believe it’s important to go into a little more detail about why we find this sector so attractive. In the simplest terms, Senior REMICs are legacy non-agency bonds which are restructured such as the senior piece has added credit enhancement which varies, but is typically an additional 35% to 50% and also receives priority for prepayments. This added credit enhancement allow these bonds to enjoy positive loss adjusted yields in stress scenarios where home prices have fallen by as much as 30%. On top of that, the fact that these bonds receive priority of prepayments serves to create cash flows with a very stable profile. In simple terms, convexity risk is very well. These 2 factors combine to make these bonds appealing candidates to leverage. Our repo counterparties also recognize the low credit risk and cash flow stability of these bonds, which translates to very low price volatility and provide attractive financing terms on these positions. Haircuts average -- averaging 15% to 20% and financing rates of 125 to 150 basis points combined with base yields of approximately 5% produce a very attractive ROE. Given the extremely low rate environment, we expect that solid fundamental cash flows will continue to be sought after. In fact, we’ve seen prices on legacy non-agencies increase by 3 to 4 points in the first quarter of 2012 and feel that our non-agency portfolio will continue to benefit from the investors, for investors’ ongoing surge for yield. Finishing with Slide 9, you will see our equity allocation to CMBS increase during the fourth quarter, largely as a result of higher dollar prices as well as a slight reduction in borrowings. Legacy bonds at 2005 and 2006 vintage, in particular were well bid with dollar prices on those bonds up approximately 5 points. As Rich mentioned earlier in the call, we took advantage of this move by selling some of our higher prices legacy positions. This resulted in a higher yield on a portfolio at year-end as well as reduced leverage as the bonds we sold were lower yielding and more levered. Despite the strong rally into the year end, we saw more of the same as we entered 2012. All sectors within CMBS have seen strong yields year-to-date, with our CMBS 2.0 bonds up nearly four points on average, our legacy bonds up over 3 points and our 20K multi-family bonds up nearly 7 points. Despite the run-up in prices, we remain positive on this sector. It’s much the same story here as in non-agencies. The low rate environment is forcing investors to look for yields and CMBS is a one of the few high quality sectors that offers it. With that, let’s open the floor up to questions.

[Operator Instructions] Our first question does come from Douglas Harter of Credit Suisse.

I was wondering if you could talk about what the increased book value -- whether that means that you will be adding some additional assets or just using it to take down leverage?

I think Doug that we are seeing that we think that current earnings probably the company is broadly consistent with the fourth quarter and so we will take some of the cash and reinvest in assets and some to pay down higher cost liabilities.

And then John, I was hoping if you could just walk through maybe the return differences between the bonds that you sold and then reinvested back into the Re-REMIC and sort of how you thought about that trade from a return that you are giving up and the return that you are getting back type?

On the non-agency side?

Yes, on the non-agency side.

Yes, what happened was, we had a large number of odd lot line items that were mostly consisted of positions that we purchased when the company was much smaller. So we had 40 odd line items of relatively small positions sizes and the underlying credit on those was fine. Those positions are a little bit more difficult to leverage, and selling them is a little bit tougher in terms of quality that you get on odd lot positions. So we felt that we could package them, keep the top portion of that restructuring it makes for a larger position size and again you’ve seen Re-REMICs have much better financing in terms of legacy bonds and in particular they have much better financing terms than odd lot legacy bonds. So really in terms of yield give up, I mean it wasn’t really that dissimilar in terms of what we gave up, particularly when you factor in that we could now apply leverage to those.

Our next question does come from Trevor Cranston of JMP Securities.

First, just a follow-up on the question about the Re-REMIC portfolio, with the transaction you did in the fourth quarter primarily an opportunity to improve the kind of finance part of your portfolio related to the odd lot positions or should we expect that there is going to be some opportunities to maybe do some similar type of transactions on the remaining legacy stuff?

No, I would think of it more as a one-time thing. It’s not really all that material in the overall scope of things. But just we do like the Re-REMICs and as we said before for all the various reasons in terms of great profile so.

And just one point of clarification on the book value comments in the first quarter, does the up 5% number include any retained or crude earnings so far in the quarter, or is that just purely mark-to-market?

No, Trevor as I mentioned that -- we’re looking at that from a net asset value not from a retained earnings perspective. So again, we are looking at it purely on changing valuation of the assets and swaps.

But it does not include retained earnings.

That’s correct.

Our next question does come from Bose George of KBW.

Had a couple of questions; one, first I wanted to just go back to the comment you made about the temporary nature of the book value decline. I mean is that just really based on your portfolios going to be relatively stable or you guys said you won’t raise capital for a while so then the negative marks on the swaps is pull off over time?

Both, I think when you look at the book value decline, I mean again the components of OCI, when we talk about it from a temporary decline, most of it’s from the swaps and as you know overtime those swaps are going to do 1 or 2 things either as you approach maturity, you are going to amortize that decline back into book value say if it’s a 4.5 year swap on average like which they are now, you are going to get about quarter of that back each year. So we are naturally going to get that back and we have the ability to hold the swaps to term. Or what’s going to happen in that nature is that the rates are going to up and then so the book value will come back. So we do believe that the swaps are definitely a temporary impairment. When you look at the assets, again we’re always looking on a quarterly basis for the decline in value of the assets versus what the market value or market value versus book value on those 2, and again when we look at it, when we look at the present value of the cash flows on the portfolio, they are more than enough to cover what the book value is. So again in our opinion these declines are purely temporary in nature and they are cyclical and we do expect them to eventually come back.

And then just switching to your PPIP investment, it looked like it was roughly flat this quarter, I was just wondering is a mix of that similar to your portfolio or your main portfolio or different, I mean is it assumed to be down a little bit just given the RMBS concentration?

The PPIP portfolio is similar to our non-agency legacy position in IVR. So it’s not Re-REMICs, it’s not agencies, it’s totally legacy ’06, ’07 primarily prime and Alt-A hybrids.

But that still performed given the move down it had in the quarter, RMBS had in the fourth quarter, I had thought that PPIP would have been down a little bit, but it looked like there was more kind of roughly flattish?

Yes, both, keep in mind that now we have its PPIP and we also have that equity investment that we did. So that’s not pure PPIP. So while you are right, you would see some of the unrealized losses on the non-agencies moving down in the quarter which we factor in. We also have the Atlas transaction that we did, that actually improved the earnings stream. So we got a little mix of both in there so that’s how we like balancing out.

And then just one…

On that front, the first quarter obviously, we saw a nice return in PPIP portfolio.

And then just one last thing on the agency prepayment side, any sort of surprises there or was that pretty much in line with what you guys were thinking?

No, it was pretty much in line. We saw a slight, couple of CPR increase during the fourth quarter. I think that was broadly in line with what happened in the market and we are still much slower than generics, but as generics go up, we are going to go up slightly also. We did get the first couple prints in this year we’ve seen speeds come back down a couple of CPR. So we felt pretty good about that and we have not seen any of the effects of HARP come through yet. We think that’s going to happen over the next quarter or 2. We will start to see that impact. And again, we feel pretty comfortable that our portfolio is protected from that.

Our next question does come from Jason Weaver of Sterne Agee.

This is Calvin Hotrum standing in for Jason today. A lot of my questions were kind of touched up before in the previous call, but I just had a quick question if you guys could give me some insight on just as to the, you said before the recent kind of rally in non-agency CMBS. Basically, going forward how do you think, or maybe, have you seen, how is this going to affect, would you believe that, I am sorry-- how do you think this is going to affect your cost of funds going forward and maybe your leverage strategy?

So in the CMBS space, you did say non-agency CMBS. Yes, we’ve seen some pretty strong price movements as we said since November. What we did mention, actually the agency side of CMBS, the Freddie bonds, they’ve had an incredible move up as well this year. And in terms of cost of funds on CMBS, we’ve really haven’t seen any meaningful differences.

And Calvin, as you know, we have seen agency RMBS repo cost coming down since the end of the year a little bit, but again the overall rate environment has improved, but not tremendously, but it has improved.

Our next question comes from Dan Furtado of Jefferies.

Earlier in the call you mentioned paying off some high cost liabilities can you help me understand what liabilities those were?

Dan, this is Don. Those liabilities really as relates to CMBS it’s just our financing on those. What we are doing is again as we get our cash flows we are making a determination when the cash flows come in, what is the best use of the cash. So do we invest in certain assets, do we pay down some high cost liabilities, which would be our borrowing cost? That’s what we are talking to.

Understood. And then just a small question on the change in non-agency CPRs during the quarter. Can you help me or provide some color on the change in CPR that you saw there and really what I am trying to figure out is this change due to a mix shift in the portfolio or is it due to some underlying current in the non-agency market itself?

One, when you look at that we showed a graph, non-agency speeds slowed a little bit, but we have a large percentage of the portfolio in Re-REMICs as we said in the non-agency space and so what we did is just use a consistent method to look at the speeds on the Re-REMICs and because that was a relatively new phenomena in the book, we went back and restated speeds in the non-agency book going back to beginning of the year.

Got you, but what I am trying to figure out is that I assume you’re buying these super seniors at or above par and thus you don't have the same type of discount accretion that you would have on a discounted bonds, so is that…

No, I mean it’s not as much accretion but there's still accretion. The majority of those bonds are in the mid-90 range.

So generally speaking faster CPRs are better for the non-agency portfolio like it was in the past or is that not necessarily true?

It’s still better, I mean it’s more important to get prepayments on $70 price bond than on $95 price bond but it’s still beneficial.

[Operator Instructions] Our next question does come from Mike Widner of Stifel, Nicolaus.

Just one quick clarification, as you think about investments going forward and kind of where the portfolio stands today. If I hear you right, is it pretty much expect kind of same allocation you've had today or did you, are there more shifts going on if you can just maybe clarify that a little bit?

I think where we are now we’re pretty happy with the portfolio and it does reflect broadly where we see value right now. We are still finding interesting opportunities in all 3 sectors. In agencies it’s become a little bit harder, I would say just given that some of the stories that we've favored in the past and really had very material increases in pay outs but there's always going to be value in agencies especially given how broad that market is. So we are still putting money to work there. Everybody seems to talk about credibility [ph], we still like that story and again in CMBS even with all the run up we've seen in price we really do think that given the -- just a need for yield out there and given it’s -- CMBS in particular because it’s a rated asset class, it has a much broader industrial base. We think that those investors that look for yields CMBS is really going to continue to be one of the favored assets classes. So I’d say all 3 we’re finding value.

Okay. and then so just to be clear, I mean if the environment stays as it is, all else equal of course, and things do move but all else equal 55%, 25% and 17% are sure the kind of the allocations you see across agency RMBS, CMBS?

That’s it, broadly based, that’s fair.

I think obviously we look at not just the assets side but also the financing side and if we see changes in that side that could change our mix as well.

Okay. And just one other quick one. I mean in the past whether by design or sort of, however it came about, I think the portfolio was reasonably positioned for an increase in the rate environment. Whether that was by choice or design or whatever, obviously that didn’t happen. I was just wondering how you guys are thinking about the economy now, the environment and what are you looking at and what might cause you to make any further shifts in terms of whether you think the economy is getting better or worse or just kind of sit here for a while?

I mean, I would think about it like this. Last year we did have a larger percentage of our book hedged and we had longer swap hedges but I mean the biggest issue really was when rates dropped, asset spreads widened in every sector and CMBS and RMBS and agencies and what’s happened in the fourth quarter, we had what was designed to happen kind of happened where you have diversification helping you and CMBS spreads were tightening. Rates stayed low, but didn’t drop tremendously and then interestingly at the beginning of this year you had rates dropping, pretty strongly from like 122 5 year swap down to 96 basis points or something. And in that period our book value is increasing and it’s really because of the asset side of the spreads were actually tightening in the agency space and we put on more agencies obviously in the fourth quarter but going forward I think we feel much better about that from an interest rate standpoint and we think that even in the low rate environment, we are going to be stable and if we get an increase in interest rates, I think we outperformed.

And actually I would add just one thing. I think one of the things that really happened in the second half of last year was to the point of agencies not keeping up with swaps, I mean obviously policy risk was very heightened during the second half of last year. I think the latest when, we heard at the state of the union-- we heard talk of like sort of that, mass refi program and I think the market kind of shrugged it off thinking that that is really not going to happen. And I think investors getting more comfortable that policy risk at least in the call it near to medium term is probably less likely to impact speeds has really allowed agencies to trade much more closely correlated with swaps which has really helped some. So, I mean, as long as that continues, I think that’s a real positive also.

Okay, I appreciate that. And so, when you guys talked about or you either made reference to, your book value is up nicely so far, quarter-to-date. Obviously you would like to see book value come up further. In an ideal world, if you are sort of perfectly hedged and book value stays flat kind of in all scenarios, if there is an expectation, of kind of rising book values then, I am not sure there is a way to do that without sort of implicitly making bets one way or the other. Either that or being much smarter than everybody else about buying low and selling high, that’s kind of hard to do. So, should our expectation be that it’s nice the book values rose but are you guys seeking to kind of maintain book value or is there sort of an implicit strategy one way or the other that if rates go one way, book value is going to go with it. If it goes the other way, et cetera.

Yes, I mean obviously we can’t say book value is going to go up no matter what. But the reality is, we think that there probably is going to be a continuation of, if rates stay low, investors just need the yield. And so the assets we have, we believe are going to improve in that environment and relative to swaps and if rates go up, we think we’re well positioned in that, upping coupon in the agency side are going to perform well, and if rates are going up because the growths stronger and so forth, we should continue to see spread tightening in CMBS and RMBS. So, you kind of think of it both ways, I mean, our swaps, as we said earlier, they’re pricing the book value at extremely low rates. We think more likely than not, they’d stay here or go higher and we get some of that value back.

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

Okay. Operator. Thanks and we’ll end the call with that and I would like to thank everybody for their time this morning.

Ladies and gentlemen, that does conclude today’s conference call. We thank you for your participation and ask that you please disconnect your lines at this time. Thank you.