Invesco Mortgage Capital Inc. (IVR) Q2 2012 Earnings Report, Transcript and Summary

This presentation, and comments made in the associated conference call today may include forward-looking statements. Forward-looking statements include information concerning future results of operations, our ability to maintain or improve book value, the stability of earnings and dividends, our ability to provide a competitive dividend, our views on the economy, current prices of mortgage-backed securities, the positioning of our portfolio to meet current or future economic conditions, our ability to continue performance trends, our portfolio prepayment fees, and the credit quality of our assets. In addition, words such as beliefs, expects, anticipates, intends, plans, estimates, projects, forecast and future or conditional verbs such as will, may, could, should, and would, as well as any other statements that necessarily depend 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’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report 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 to any forward-looking statements later it turns out to be inaccurate.

Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital Inc.’s Investor Conference Call, August 2, 2012. All participants will be on a listen-only mode until the question-and-answer session. (Operator Instructions) As a reminder, this call is being recorded. I would now 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 begin. Richard King – Chief Executive Officer: Thanks, operator. Good morning everybody and welcome to Invesco Mortgage Capital’s second quarter earnings call. We’re pleased to announce earnings of $0.68 and a book value of $18.40. In our first quarter earnings call in May, we emphasized important areas of focus for us in the second quarter. And those were most importantly maintaining a stable book value and providing our shareholders with a competitive dividend. We accomplished each of these goals in the second quarter, primarily by maintaining low agency prepayments, continuing to add duration into the rate rally, and maintaining a high-quality credit portfolio. As a result, we also continued to strengthen the balance sheet. Despite the recent weakness in the U.S. economy, we are decisively upbeat about IVR’s prospects in coming quarters. The housing market is showing signs of life and that’s benefiting the non-agency market. Operation Twist was extended and we believe the Fed is moving ever closer to QE3 shall be needed. Continued central bank intervention and risk aversion will likely keep rates low and may send them even lower. As we have seen in an unusual investment environment like this, fixed income investors are starved for yields. It’s leading them to seek out high-quality cash flows backed by collateral, collateral that is de-linked from all the ongoing uncertainty regarding the European debt crisis. Investors searching for income are definitely attracted to government guaranteed debt that yields more than U.S. treasuries. We believe IVR’s mortgage investments are well-positioned to benefit in this environment. We have seen a rallying credit that gained strength after the Greek elections and the Twist extension. There has been increasing rate commission on the part of investors that lower yields are here for a while and that they should consider transitioning away from treasuries, because the yield compression and credit assets is likely to continue. For that reason and the hopeful signs that have emerged in housing markets, we expect non-agency RMBS will perform well even as the economy continues to struggle and foreign markets remain under pressure. Agency mortgages have continued to rally as well due to only modestly higher prepayments and we do expect this trend to continue. The conviction behind our strategy is strong. The money raised from our successful preferred offering was invested within days in high-quality bonds as we found some attractive relative value opportunities in credit. At this point in time on the margin we prefer credit from a relative value standpoint. At the same time, we continue to believe agency mortgages will benefit from the muted prepayment environment and the positive supply demand dynamic. Most importantly we see this environment continuing to benefit IVR’s book value and our ability to maintain an attractive and competitive dividend. On July 19, IVR successfully issued $135 million of $25 par preferred stock. I’m also happy to report we’ll be closing on an additional $5 million today from the Greenshoe. We were able to procure a very attractive 7.75% coupon on the shares. We’ve raised the capital because as I mentioned earlier we see a great opportunity to buy credit assets. The timing was good on the preferred issuance because that market has seen multiple billions in redemptions and the demand for paper is strong. The result as we have diversified our capital structure in a way that will be accretive to common shareholders. We believe our growth ROE on the new assets should be in the mid-teens compared to the 7.75% coupon on the shares. Before I the call over to John Anzalone let me take a minute to comment on page three of the presentation and focus on book value. In Q2 our agency MBS performed well adding to book value by $0.62 per share. And with interest rates declining the agency portfolio more than offset our interest rate swap hedges. CMBS were pretty much flat for the quarter and non-agency MBS were down modestly. We were paying $0.03 and ended with book value down $0.02 per share so very nearly unchanged. This quarter end we’ve seen solid performance in book value and we expect that trend to continue. The strong agency mortgage performance that we saw in the second quarter has continued, but as noted earlier we’ve seen CMBS and RMBS prices rallying as a result we would estimate book value is probably up between 4% and 5% post quarter end. While reinvestment yields are lower, we do expect to continue providing competitive dividend and we’re pleased with the strength of the balance sheet. And with that I’ll pass the call over to John to go through the portfolio. John Anzalone – Chief Investment Officer: Thanks Rich. We are very pleased with the overall performance of the portfolio during the second quarter and we’re pleased to report we’ve had a nice start the third quarter as well. As you can see on slide four the portfolio’s sector allocations were very stable during the quarter. With the small changes attributable mostly to price moves, our leverage increased slightly from 6 times to 6.3 times. This quarter we are able to put the proceeds from a preferred offering to work quickly. With these new purchases we focused more on the credit side. We continued to see attractive opportunities in both the residential and commercial sectors. The theme that we’ve discussed in past calls with this low rate environment will force investors to search for yield and high quality credit assets is playing out as we had expected. We’ve seen strong rallies in both sectors this quarter attributing to the recent book value growth that Rich just spoke about. While our focus recently has been in credit, we’re still positive on the agency market, negative net supply strong demand out of region banks, low volatility, capacity constraints in lending and the prospect of the federal reserve embarking on a QE3 focused on mortgages are all favorable factors. Of course with other prices so high particularly on the types of specified pool collateral that we favor security selection has become even more important. But we have been able to pick our slots in the agency sector. On slide five, we were pleased with the performance of our agency book especially given the sharp rally in rates that we saw during the quarter. The yield on our books fell to 2.98% reflecting a combination of slightly faster prepayments fees in reinvestment at lower rate levels. Our prepayment experience continues to be positive with CPRs on our fixed book remaining in the low teens. More recently with dollar prices at all time highs, we’ve shifted our focus a bit. We’ve moved into lower coupon third year pools where specified payouts were lower and out of some of our hybrids that are at greater risk of prepaying given the level of rates. This has been beneficial if the market assigned the higher probability with another round of QE by the Fed. In non-agency space we continue to focus on senior re-REMIC with 667% of our non-agency book in that sector. The lower rate environment impacted this sector as well with our yield decreasing to 5.37% due to a combination of hybrid ARM coupons resetting lower and reinvesting at lower yield levels. While prices were marginally weaker during the second quarter, we’ve seen a material uptick in prices so far this quarter as investors seek out strong fundamental cash flows with relatively high loss adjusted yields. As I mentioned earlier, we expect this trend to continue. On slide seven, you will see that many of the themes that I talked about in non-agencies also applied at CMBS. We saw a decrease in portfolio yields through a combination of putting new assets on at lower absolute yield levels and by repositioning a portion of the portfolio by moving higher in the capital structure. Since the start of the third quarter, we have seen strong price performance in our CMBS book with prices up two to three points on average. Again, we are seeing the same scene play-out in CMBS that we are seeing in non-agencies. Investors that are starved for yield are training to strong credit stories for yield. With that, let’s open it up for Q&A.

Thank you. At this time, we are ready to begin the question-and-answer session. (Operator Instructions) Our first question does come from Bose George of KBW. Your line is open. Bose George – KBW: Hey, good morning guys. Actually, the first question can you just remind me with the PPIP liquidated, what investments are going to be flowing through that other line item and what came through this quarter?

Yeah, Bose, good morning. The Invesco Mortgage Recovery Fund is called – still has investments in some commercial real estate. There is the average portfolio that we purchased back in the fall. And then also some other distressed commercial real estate opportunities we have seen as well as some non-performing loan on the resi side. Bose George – KBW: Okay, great. And then actually just in terms of relative value, can you just talk about where you guys see the best relative value for new investments?

Yeah, I mean, I mentioned we are focusing on the credit side, so we continue to like the senior re-REMICs story in non-agencies. We think that’s on a loss adjusted yield basis, that’s the best relative value we are seeing. In CMBS, we’ve been active in both new issue sort of CMBS 2.0 as well as some legacy positions we’ve continued to add there. So, really in credit, we’ve been pretty active there. And then on the agency side, we’ve been much more focused on lower coupons mortgages. Like I mentioned, we are moving out of some of our hybrid ARMs that up higher coupons, because there is really not a lot of prepay protection in those pools. So, we’ve been focusing on some of the specified stories down in mostly in 30 or (3.5s). Bose George – KBW: Okay, great. And then just one broader question, I am just curious if you guys have any thoughts on the whole eminent domain discussions that are going on?

Yeah, I mean, we think that the eminent domain initiatives do not represent a material risk to our non-agency investments. And basically, we think there is a lack of legal precedent that the price to loans would have to be purchased out of the trust that would not or at least the ones that are being discussed and not represent fair value. And the big problem for the municipality is there that in those jurisdictions, their future borrowing costs would be (prohibitively) expenses. And the current borrowers that are targeted by the program are performing somewhat better in recent months. So, the problem is getting better. Some of those borrowers are getting released through higher rates of modification, short sales, and their rates resetting lower. And that so we just think successful implementation would provide very incremental benefit to borrowers, but long-term problems for those communities. We are monitoring the situation, but like I said we don’t see it as material to us. Bose George – KBW: Okay, great. Thanks a lot.

Next question does come from Douglas Harter of Credit Suisse. Your line is open. Douglas Harter – Credit Suisse: On the back of your recent preferred deal, could you talk about how big you think that, that funding source could be?

I mean, we obviously find it a favorable part of our capital structure, but the markets pretty limited in size. So, I would say, it’s – I mean it’s like 6% of our capital structure right now and it’s probably unlikely that we can get it significantly higher than that. And I think, Doug, the key thing think about on that is when we look at it, capital opportunities is it’s always something that reevaluate and what’s going to be most accretive to the company. And obviously we like the current situation with the preferred offering and how that was able to add to the common stockholders, but again we have to evaluate it each time the opportunity presents itself and what the rates are and so forth, but it is an extreme opportunity and we’ll keep evaluating as we go forward. Douglas Harter – Credit Suisse: Great, thank you.

Our next question does come from Trevor Cranston of JMP Securities. Your line is open. Trevor Cranston – JMP Securities: Hi, thanks. Just a follow-up on the comments about higher prices for the credit assets since quarter end, can you talk about where you seeing yields today versus what you have on your existing portfolio?

Sure. So, in terms of just flat out yields 30-year collateral I’d say we are putting on new purchases around 2.5%. Trevor Cranston – JMP Securities: Okay.

For specified pool collateral 15s in ARMs, we see those as significantly lower, so 1.5% to 1.75% on yields on those, so that’s probably we’ve been less active in that space actually reducing our exposures there. Trevor Cranston – JMP Securities: Okay.

On the credit side, senior re-REMICs anywhere from 4.25% to 4.5%, CMBS, call it anywhere from 4.5% to 5% for the type of top of the capital structure or hiring the capital structure type bonds. So, maybe those are obviously down with rates coming down so much over the past couple of quarters. Trevor Cranston – JMP Securities: Yeah.

But we expect things to kind of – I mean we seemed to level that a little bit here, so.. Trevor Cranston – JMP Securities: Okay, that’s helpful. And then one other thing on the non-agency yields, you guys commented that part of the drop was due to hybrid ARM coupons resetting lower, how much of the portfolio you expect to reset on a quarterly basis over the next few quarters?

Yeah, we haven’t said that number yet. So, it’s not something we can give you right this second, Trevor, but again something we’re continuing to evaluate.

Yeah, one thing I would say though is the vast majority of our positions were ‘06 and ‘07 vintage. Trevor Cranston – JMP Securities: Yeah.

So, as been there mostly 51 structures, so as we go through 2012, there wasn’t any really issued in 2008, so we – there will be a large preponderance of them would be done by the end of this year.

There is going to be some disclosure around vintages on the non-agency book in the Q, it’s coming out later Trevor that should help, but it’s mostly 2007 51s. Trevor Cranston – JMP Securities: Okay, that’s helpful. Thanks guys.

Our next question comes from Jason Weaver of Sterne Agee. Your line is open. Jason Weaver – Sterne Agee: Hey, good morning guys. Thanks for taking my question. First of all, I think in the first quarter versus just generic, I’ll say, out there, we were sort of surprised to the upside for your non-agency performance. And then this quarter it seems like it fell a little bit short, can you just talk about that a bit and is it endemic to the super senior or sorry the senior re-REMIC nature versus a normal CMS structure?

I say the senior re-REMICs are going to exhibit a lot less price volatility just because if you think about the amount of subordination they have. And there also – they trade very close to par and they are relatively short duration. So, they don’t really react a whole lot with rates and they don’t act as sort of credit sensitive as other thing. So, they are going to be much more stable in terms of price, whereas – and as that’s become a larger part of our book, that’s become just more stable in terms of price volatility. So, I mean, you think that’s largely going to be driving our non-agency performance like, for instance, since the end of the quarter, our legacy RMBS positions were up almost two points on average, whereas our senior re-REMICs are kind of flat given where there are in the curve and given the dollar price and the credit enhancement they have. Jason Weaver – Sterne Agee: Alright. Thank you. That’s fair. And you actually touched on that a bit in your answer there. But I was going to ask how you think about both for the senior re-REMIC and some of the higher price closer (indiscernible) maybe CMBS 2.0 assets you hold, how do you think about interest rate exposure there? I mean, do those assets generically trade on spread and with the durations in the CMBS sector probably being longer I would expect the 5.1% sort of nature of the re-REMICs to sort of limit the risk there?

Yeah. So, the re-REMICs that’s the flip side of what we said earlier, coupons are resetting, but at the same time we have literally no interest rate risk on that part of the book, because as rates go up, the coupons would go up. But so we don’t have to worry about hedging that. On the CMBS book, the legacy stuff is pretty short, but the CMBS 2.0 stock is something that we do hedge the interest rate risk on. So, when we look at our overall duration gap, we include the CMBS. Jason Weaver – Sterne Agee: Okay, that’s really helpful. Thank you, guys.

Our next question does come from (Vic Agarwal) of Wells Fargo. Your line is open. Vic Agarwal – Wells Fargo: Hi. Good morning. I had a quick question, you had mentioned that you found credit assets more attractive in the current yield environment, are you – it is suffice to say that you are potentially going to increase your non-agency allocation from where it is now to sort of mid 2011 levels?

I doubted we get that high. I think what we are trying to do is as we find bonds we like we are transitioning more – the more prepay sensitive agencies out of our book in inter-credit, where we can find credit. I mean, the issue with on the credit side is really just availability of bonds on the non-agency side, because it is a shrinking market. I mean, that’s one of the reasons we’re very positive on it, because right it’s – I mean, this is the supply of non-agencies, it gets smaller every month, but – so I mean, the positive side is that it’s good for the bonds we owned of negative side. It’s a little bit more difficult to add as many bonds as we like. But I mean I think we’ve been pretty successful in doing that. So, I think we are taking a fairly measured approach in terms of just doing analysis and finding bonds we like and adding where we can. Vic Agarwal – Wells Fargo: Okay. Thank you.

(Operator Instructions) Our next question does come from Gabe Poggi of FBR. Your line is open. Gabe Poggi – FBR: Hey. Good morning guys. Just a quick question and if you said it already I apologize. Can you give us an update on where you saw speeds come in for July on the agency side?

Oh, yeah, I did – we did not talk about that, but I can give you an update. So, yeah, the June print, so that would have been reported beginning of July. The agency book paid 13.5%, which was up about 0.5 a CPR from the prior months and not that different than where we paid during the second quarter. We saw 15s were slightly faster as were hybrids and we saw a little bit of slowdown in 30s, but nothing I mean everything was same kind of a CPR of where it had been the prior months. Gabe Poggi – FBR: Perfect, thank you.

At this time, I show no further questions. Richard King – Chief Executive Officer: Okay. Thank you, operator. We’ll talk to you next time.

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