Invesco Mortgage Capital Inc. (IVR) Q1 2012 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital, Inc. Investors Conference call May 8, 2012. [Operator Instructions] As a reminder, today's call is being recorded. I would now like to turn the call over to your speakers for today: Richard King, Chief Executive Officer; John Anzalone, Chief Investment Officer; and Don Ramon, Chief Financial Officer. Mr. King, you may begin.

Thank you, operator. Good morning, and welcome to IVR's first quarter earnings call. Presenting with me on the call today are CFO Don Ramon and Chief Investment Officer John Anzalone. On our previous quarterly call in February, we mentioned we had 2 ongoing areas of emphasis for the benefit of our shareholders. We said our efforts remained focused on increasing book value and providing a stable dividend. We're pleased to report that we had a strong start to the year in both of those areas. Book value increased about $2 per share during the quarter or approximately 12%. And importantly, since the end of the first quarter, despite the somewhat weaker domestic economic numbers and problems in Europe, book value has continued to improve. With the value of our equity increasing by $234 million in the quarter, we were able to strengthen our balance sheet by lowering our leverage. We've maintained ample cash and believe we're well positioned to take advantage of investment opportunities in the market. We also maintained our dividend at $0.65. The company did generate an additional $0.07 in earnings over the dividend during the quarter. Our decision to retain the extra earnings was driven by a desire to continue to strengthen our balance sheet, increase book value and provide for future dividend stability. The earnings power of the portfolio remains strong despite the low rate environment. One reason is our prepayment experience in agency MBS has remained much lower, i.e., better than the cohorts. Slow prepayments have 2 benefits: first, positive effect on book value because we avoid losing the premium dollar-priced bonds at par; and second, we maintain an attractive yield, since we have less to reinvest. In today's rate and investment environment, we believe the portfolio should continue to generate its current earnings power. It's important to note that we were able to significantly reduce our credit leverage over the quarter without impacting earnings. Rising asset prices reduced negative OCI, improving our equity position. We also used cash flows to pay down higher-cost non-agency repo. That reduced our RMBS leverage from just over 4x at the end of the fourth quarter to about 2.8x in the first quarter, a modest level for the quality of our RMBS portfolio. This significantly improved our risk position while maintaining about 15% ROE in that asset class. CMBS leverage also declined as asset prices improved. Against lower leverage in RMBS and CMBS, agency MBS leverage was increased modestly because we're seeing, and expect to continue to see, prepayments remain low. We therefore added over $1 billion of agency MBS in the quarter. We also made incremental new investments in select credit assets. John will discuss the portfolio further in a few minutes. Overall, we are very pleased with our positioning. And now I'll pass the call to Don to cover the earnings highlights.

Thank you, Rich. Four key things we discussed today: continued improvement in book value; the stable dividend; the reduction of leverage; and the increase in earning assets that played out well in our financial results. During the first quarter, net income rose by 10% to $84.1 million or $0.72 a share. This allowed us to maintain a stable dividend of $0.65 while adding $0.07 to retained earnings. We've accomplished this by increasing our average assets to $15.3 billion as our equity position improved. The higher earning asset total increased our net interest income by 5% to $142 million. We also strategically sold some assets that resulted in a gain on sale of approximately $6 million or $0.05 a share. Looking at the yield table on the lower left of Page 3, you can see that the additional agency-RMBS that we acquired during the quarter reduced our portfolio yield by 22 basis points to 3.72%. This was somewhat offset by an 11 basis points decrease in our cost of funds, but the net result was a decline of only 11 basis points in our net yield to 2.02%. The increase in our portfolio balance offset the decline in yield, and we accomplished this with lower leverage. We believe that the current portfolio composition puts us in an excellent position to continue to deliver stable earnings in this environment. Turning to Page 4. Let's take a few minutes to discuss the improvement in our balance sheet. The changes we implemented in the portfolio over the last 3 quarters continue to strengthen the balance sheet, reduce the leverage and make the company less sensitive to interest rates risks. Book value improved 12% to $18.42 as we saw positive contributions from all aspects of the portfolio. With that, I'll turn it over to John here to discuss the portfolio impact on book value.

Thanks, Don. As Rich emphasized, we've had a very strong start to 2012. Assets values are up across each sector of the portfolio. We have improved our risk position by reducing the leverage on our credit assets, and our portfolio is well positioned to provide a stable dividend going forward. The most significant increase was seen in our CMBS portfolio, which contributed $0.80 per share in book value. CMBS 2.0 bonds were especially strong as investor demand for quality bonds pushed yields lower. The non-agency book also benefited from the price rally and contributed $0.59 per share. We also saw pricing on our specified pool agencies move higher. Valuations reflected the excellent actual prepayment performance of these pools and contributed $0.40 per share of book value. Finally, swap rates were slightly higher, adding an additional $0.15 per share. The improvement in our portfolio values added $234 million in additional equity for the quarter, which allowed us to reduce leverage while increasing our average portfolio by 9%. Let's turn to Slide 5 to see the impact of the additional equity. Slide 5 provides a snapshot of the portfolio at quarter end. The overall leverage in the portfolio decreased from 6.4xto 6x. As I'll discuss in more detail in a moment, the composition of the leverage has changed. The increase in asset value to -- served to improve our equity position. Roughly $190 million in equity was added to the credit book, and about $60 million was added to the agency book. We also received cash as we liquidated the bond side of our PPIP investment. The reduction in credit leverage where we shifted our borrowing mix away from higher-cost repo served to reduce risks while keeping asset levels constant. The additional capital in the agency space allowed us to add more MBS assets, where we continue to find good opportunities in specified pool paper. Moving to Slide 6, you'll see it was a very good quarter for our agency book. Higher-coupon agencies outperformed swaps, and the pay ups at our specified pool paper increased materially. We opportunistically added assets throughout the quarter and continue to find good opportunities in this sector. We focused primarily on longer-dated hybrids, as they were attractive relative to 15s. The hybrids have appreciated materially. We also bought more 30-year prepaid protected pools focusing on geographic, FICO and other credit stories. Net interest margin increased by 16 basis points to 140 basis points. This was driven primarily by high-cost year-end repo rolling off, as well as by a slightly lower hedge ratio, as no new hedges were added in the quarter. The prepayment rate in the portfolio continues to be remarkably slow, as our fixed rate collateral paid a bit over 10 CPR. Our 3-month speed slowed by 14% quarter-over-quarter and our fixed rate book paid at roughly half the rate of comparable generic collateral. Looking ahead, we still believe that agency mortgages look attractive despite their recent performance. Technicals are very positive, with limited supply and robust demand out of banks, insurance companies, REITs, as well as the Fed. And it's important to note that capacity constraints and borrowers' continued inability to qualify for credit has reduced the convexity risk of the sector. Moving to Slide 7. It was also a very good year -- start to the year for credit assets, particularly for high quality credit assets, which is where our portfolio is concentrated. On previous calls, we've talked about the need for yield in the marketplace and how high quality cash flows would benefit, as investors are forced away from Treasurys by extremely low yields. This is exactly what we've seen this year. In non-agencies, we reduced leverage to 2.77x from 4.07x. There are a number of factors that allowed us to accomplish that. We paid down $218 million in borrowings on non-agencies through a combination of cash paydowns, factoring [ph]changes and bond sales. We also saw an increase in OCI of around $68 million as assets prices went up. This increase in equity in the sector led directly to the reduction in leverage without materially changing the amount of dollars we have invested in this sector. This allowed us to capture the price rally in book value, while repositioning our borrowings. We believe these moves leave us well positioned. Reduced leverage on the credit book reduces risk as banks' willingness to lend on credit is impacted by macro events. This also leaves us with plenty of dry powder to capitalize on future opportunities. Even with the reduction in leverage, our high-quality book still generates ROEs in the mid-teens, allowing us to maintain our earnings power. I'll finish up on Slide 8 and CMBS. It was a very similar story in the CMBS sector, as the demand for high-quality assets remained robust and led to significant increase in asset prices. The CMBS 2.0 bonds that we owned, for example, were up on average 10 points during the quarter. In fact, we have seen this demand carry over into the current quarter with a successful disposition of the latest Maiden Lane bid list. We reduced leverage slightly in CMBS to 2.4x, as some minor repositioning as well as an increase in OCI combined to increased equity by $45 million. The CMBS book continues to generate an ROE in the mid-teens, with the added benefit of reducing the convexity risk of the portfolio. We continue to see good opportunities in this sector as well. We were able to add some assets recently as we participated in the Maiden Lane sale, and we will selectively add assets as they become available. One final thought. We stated in our previous earnings call in February that our goals for the first quarter were to reduce credit leverage, given the volatile macro landscape; to continue to improve book value; and to maintain a stable dividend. We plan to continue to emphasize those 3 areas in this market environment. With that, I'll open the floor to questions.

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

John, I was hoping you could sort of help quantify that comment about dry powder on the RMBS non-agency portfolio. What would you guys think about the appropriate leverage for further risk, given -- in that portfolio?

I think we're targeting 2.5x to 3x on the credit book. So we're going to keep it in that range. And we do have, even given the slow prepayment speeds, we do have a significant amount of cash coming in every month from prepayments. But it does allow us, if we see something that we like before prepayments come in, we can capitalize on those opportunities. It's been pretty lumpy in terms of how we've seen bonds come into the market, given some of these bigger dispositions. So it is nice to have some dry powder to take advantage of those.

Great. And then to the extent that you guys said that the book value has continued to improve here in the second quarter, should we expect that, that would lead to higher average assets as well, or just further paydown of leverage?

Just as we said, I think, on the fourth quarter earnings call, when we get an increase in equity with assets up, we will look to do some of both. I mean, we can use some of it to increase assets and some to pay down higher-cost repo.

The next question does come from Bose George of KBW.

Given the strong performance of your securities pretty much across the board, I was just wondering how the incremental spreads versus your existing portfolio, how should we think of the trend there?

I would say in agencies, things have remained fairly stable. We're still seeing, call it 275-ish ballpark for newly purchased 30-year collateral. So I mean, that hasn't change all that much. Non-agencies roughly the same, call it 5% to 5.5% yields on Re-Remics, legacy paper, maybe a little bit higher than that. And then in CMBS, we haven't seen a rally, so those have come in a bit over the quarter. But I wouldn't say it's materially different, where we've seen things.

And then actually just -- you mentioned on Maiden Lane, did you just mention that you guys actually got some stuff out of that? And is that a way to potentially get some decent commercial assets?

It is, and we've seen -- there is a couple of things. One is we expect there is going to be more of that kind of activity going forward. What we saw was a fairly large list, well over 100 line items to -- closer to 200 line items. And out of that, I think we bid on handful of bonds. So really, I think the general credit quality of what's in a lot of those vehicles was a lot lower than we normally like to see. So we did -- I mean, there was a few that we did like and those were very, very well bid in the market. I think there was a decent amount of demand for those. So I mean, that did a couple things. One, it served to show that there was -- credit tiering is happening and continuing in CMBS, or higher quality assets are doing quite well. So I think there will some opportunities there. I wouldn't expect it -- I wouldn't expect to see the kind of bonds that we're buying to come out, certainly, in a huge way. But I think we are picking our spots as we go forward. [indiscernible]I think technicals are really going to be driven by what we see coming out of some of those types of business issues, though.

Our next question does come from Steve Delaney of JMP Securities.

First, I wanted to ask you about your Re-Remic securities that make up over 60% of the non-agency RMBS book. You gave us sort of an indication on CMBS. I think, John, you mentioned a 10-point price move. Can you give us some sense of how those senior Re-Remic bonds performed from a change in market value in the first quarter?

Absolutely, yes. So for bonds that we held throughout the quarter, the average price was up about a $1.35. And that's compared to -- on legacy RMBS that we held through the quarter, they were up about 4.25 points. So I mean, they are obviously higher-quality, closer to par-type bonds, so…

Exactly. I know this is a tough question, but on the A-1s, is there a good proxy for us to look at in the market to try to track prices there? Are we looking at something with like a 3- to 4-year average life?

Yes, that's right on the average life. It's tough to say. I mean, I know PrimeX is out there, but that hasn't really been very good at predicting that. So yes, I don't have anything.

Well, we'll work on it. I think we were little light on that particular number. And just, I guess, my last question. This is big picture. I mean, your stock's made a really nice comeback since the third quarter, but still trading, as of this morning, a little bit under this elevated book value. Would you guys look at preferred stock? We've seen some nice offerings, 8%-ish kind of straight preferreds. And just how would you view that in terms of being a plus or minus for your balance sheet right now?

Right now, we're really not thinking about issuing. I mean, in the future, we'll consider kind of all options, but we just don't see near-term need or benefit in issuing preferred.

And Steve, it's one of the things -- we'll always continue to look at those opportunities. And there are some opportunities on that, that could be good. But right now, again, we continue to look at all of the options. But we're certainly not going to commit to that that's something we're going to do right now.

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

First of all, I just wanted to get some color. And you might have addressed this in your prepared remarks earlier, about how you're thinking about the hedging strategy, just given the rate backup and how they came right back in, in terms of interest rate risk over this quarter.

Yes. The thing to really keep in mind was that the second half of last year was actually quite unusual in terms of the kinds of assets we owned, particularly on the agency side, really decoupled from swaps quite a bit. And what we've seen this year and so far this year is -- or so far this quarter is that higher-coupon mortgages have really started to trade -- they're trading much closer to swaps. They are actually outperforming swaps, but they have been much more highly correlated to swaps. And so that has been a real positive, in terms of like the hedges actually doing what they're supposed to, given that they are moving in the same direction. So that's been very, very helpful in terms of how things are going. So right now, the empirical duration of our book is probably closer to under -- certainly under a year, and probably between 0 and one years.

And just to add to that, I think last summer and into the fall, the market traded like there weren't enough Treasurys out there, and everybody kind of held their breath. And I think when people started breathing air again, they realized that the bigger problem is yield. And as John said, we have high quality assets that have yield. And really the market, I think -- that goes for both the agency side and the non-agency side. We've talked to over number about how our cash flows are really stable. And over time, people realize it and are willing to pay for that cash flow stability, and so that's what we're seeing. And we wouldn't expect that to change because, even in a risk-off environment, I mean, people need some yield. And they're going to want high quality-type cash flows to generate that yield.

The next question does come from Joel Houck of Wells Fargo.

I guess, first question has to do with the spec pools in the agency book. And given kind of the significant outperformance of that collateral, what are your thoughts, both with respect to kind of the embedded gains in that book, as well as, as you kind of deploy runoff and even perhaps raising new capital. It just seems like some type of backup in rates could cause the spec pools to underperform generic collateral. Be interested in your thoughts on that.

I would say, in terms of the spec pools, I mean, we're not -- some of the higher coupon made a kind of break between things, sort of a super premiums, 5.5s and higher, and 5s and under. And the 5.5s and over, I almost characterize as kind of museum pieces. They've run up a lot. TBA is just awful in those, and I think a lot of the pay up increases have been more of the TBA is terrible, given, if they are right in HARP wheelhouse, they're not going to look very good. So those are -- we're just letting them do their thing. They are still very paying very, very well, a lot of balance paper in those coupons that we own. In general, with higher pay ups, our thought is that in a rate backup, sort of buying IOs, would you want to own IO in that case? So I don't know that I'd necessarily agree that higher coupons would underperform lower coupons in a backup. Anyway, I guess we'll see what happens, if that ever does happen. So in terms of what we're buying now, certainly, during the quarter, we bought across all the different sectors of agency mortgages. We did buy a decent amount of hybrid ARMs, which we thought looked pretty attractive earlier in the quarter versus 15. And we are adjusting some of what we're buying in terms of mix, buying some more sort of investor property pools, some maybe slightly higher loan balance pools -- not the lowest low balance pools, trying to minimize some of the pay ups there for cost. But I mean, that's kind of what we're doing. It's not like -- I wouldn't characterize that the specified pool market is incredibly cheap, but it's certainly -- there are spots that we think that look attractive.

I would add that, since those bonds have real duration and so when rates drop, their prices go up and obviously -- I mean, I'm sorry, when rates have gone down the prices have gone up. And when we do see a rate rise, I'd totally agree with you, prices are going to come down and fast [ph]are going to come down. But that's why we have interest rate hedges in place. And we feel like we're well protected there.

And if I may, just a follow-up, did you guys do anything with the swaps on the agency side? It just says in the slide that it came down from 73 to 66, but did you actually…

No. That was purely just additional assets.

Our next question does come from Ken Bruce of Bank of America Merrill Lynch.

My first question really, I think, is more of a follow-up to your previous response on pay ups. We've seen a number of companies that have expressed that they believe pay ups are too expensive in this market. And maybe you could just drill down a little bit more granularly in terms of where you see value, or how you're trying to navigate what is a expensive market in certain segments.

Yes. I think, given how we hedge -- and we tend to be a little bit more philosophical on the buy and hold side of things, what we're seeing in our agency book is that the bonds we purchased are doing exactly what we thought they were going to do. And we drew up hedges against them and they are producing a hedged NIM that we think is sustainable for certainly the medium term, at least. So in that respect, I think that's where we're quite happy with that portfolio. I mean, we have moved out of things that we think that -- where the prepayment performance for one reason or another -- obviously, the landscape changes quite a bit in terms of regulatory or different types of programs. So certainly, HARP-eligible sort of bad credit bonds we sold ahead of HARP and other -- those were [ph]there. But in some ways, I think that the bonds -- in some ways, the pay ups are justified, I mean, in terms of where they are. I mean, rates are quite low, and your alternative is TBA, which is -- in a lot of aspects could be quite bad. I think the quality of TBA is deteriorating quite a bit. So I mean, you do need to pay up especially given how we hedge in that. I think that's bigger picture. I mean, in terms of things we're looking at, I mean, certainly post-HARP pools, we are focusing there. I mean, you want to avoid that where you can, because I think in some ways with -- capacity of origination has not really increased much and all of a sudden now, you have originators are focusing a significant amount of resources on a HARP pools, which leave less capacity than there was on anything that's non-HARP. So I think that's what -- we saw that in a big way, in this latest prepay print, in that lower coupon slowed quite a bit and so anything not HARP-eligible really slowed. So picking spots in post- 2009 pools has been kind of where we've been spending lot of our time.

And just as you looked at book value, obviously the quarter was quite good and obviously, I think, as everybody's going to point out, it was very good to see a kind of a strong book value quarter. Is there any way to protect that? Or maybe, getting a little bit at Steve's point about is there any better transparency that we can get as to how book or certain segments of book are going to move around, just so we don't have any surprises to the degree that the market backs up in some of these areas?

I think the portfolio moves that we made through the second half of last year and into the first quarter, really provide for a much greater stability. I think there is just a real disconnect we spoke of last year, where book value dropped because even high quality assets fell and so the interest rate hedges didn't work. But if you look at the amount of assets that we've put on without any additional swaps and just model out the durations and so forth, I mean, we are in a much better position at this point. And it's proven out. As I said, since the end of the quarter, rates dropped 25 basis points. Book value continues to increase.

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

A lot of my questions has been asked, but wondering if maybe you could talk a little bit more about how you're thinking of the leverage on the different segments of the portfolio you're in right now. On the agency side, leverage came up bit; on the non-agency side, down quite a bit. I know some of that was just the revaluation of the assets, but as we look forward, I wonder if you could talk a little bit about how you think about the leverage in the different segments.

We think about it in each segment and then also, obviously, overall. And I think in the credit side, we wanted to get it in the 2.5 to 3 range, but again, that's going to depend on the type of credit assets that we own. And we are very comfortable, because we have a very high quality credit portfolio, a lot of Re-Remics, a lot of very solid CMBS with that range. And we feel like that gives us the flexibility we need for price movement or for opportunities, as John said, if we want to put on some assets we can do that for a period of time. On the agency side, again, if we had highly negatively convex current coupon TBA-type stuff, we wouldn't run leverage where we run it because rate moves are a lot harder to hedge. But given that we have really stable prepayments, we saw the ability to add to our earning assets on that side in the mid-9s. We are comfortable there. But -- and then when you put the whole thing together, bringing the leverage down to around 6x and having the benefit of having credit assets that tend to widen and spread when the economy is weaker, along with having a positive duration gap driven on the agency side, we think it gets us to place where we are able to generate a nice ROE and greater book value stability than we had.

So in short, things kind of remaining as they are in the marketplace, with assets kind of being priced where they are today. And then am I hearing that you're reasonably comfortable at this overall level and also comfortable kind of within the individual segments?

You're exactly right. Yes, we are comfortable where we are. We like the risk position of the portfolio here.

And one other one. I was just wondering if you had handy the -- and I apologize if this is in here somewhere and I missed it, but the amortization expense on the agency portfolio in the quarter.

Mike, this is Don. I'll have to follow up with you. I don't have it right at my fingertips, but we do have it in there. And it will also obviously be in the Q, which should be out probably today, tomorrow -- somewhere around there.

At this time, we show no further questions.

Okay, operator, we'll end the call here. And thanks again for participating with us today.

Thank you. Today's conference has ended. All participants may disconnect at this time.