Invesco Mortgage Capital Inc. (IVR) Q4 2014 Earnings Report, Transcript and Summary

Welcome to Invesco Mortgage Capital Incorporated Investor Conference Call. [Operator Instructions]. Now I would like to turn the call over to the speakers for today. Richard King, Chief Executive Officer, Rob Kuster, Chief Operating Officer, John Anzalone, Chief Investment Officer and Lee Phegley, Chief Financial Officer. Mr. King, you may now begin.

Thank you. Good morning and welcome to our call this morning. I'd like to thank you for your interest and participation in our call and we look forward to answering your questions at the conclusion of our prepared remarks. I'm pleased to announce that after executing on our strategies to capture opportunities and manage risk in 2014, IVR is well positioned to deliver on our shareholder value proposition of delivering attractive income and stable book value in 2015. Starting on page 3 of the presentation in the fourth quarter, core earnings were $0.49 per share, driven primarily by higher average earning assets and lower interest expense. Book value per share ended the quarter at $18.82 which is down modestly, but we managed a positive economic return of 0.6% and comprehensive income of $0.12 per share for the quarter. For the full-year 2014, IVR produced a 15.6% economic return, as book value increased $0.85 per share or nearly 5% and we paid $1.95 in dividends per share. Comprehensive income was a healthy $2.80 per share. The strong 2014 results are principally the result of active portfolio reallocation accomplished over the last two years and designed to align our results with the improvement in both residential and commercial real estate markets. IVR's equity allocation is now 34% commercial real estate credit, 34% in investments backed by home loans without a government guarantee and 32% in agency MBS. Our deliberate modulation and credit exposure, relative to interest rate exposure, has added value and as a result our book value in 2014 was uncorrelated to interest rate movements, as we intended. We are well positioned for the market environment that we anticipate in 2015. As evidence of that, we estimate that book value is up about 2% year-to-date net of income, due primarily to improving risk premiums. It's a gratifying beginning to the year for us and we’re comfortable with our portfolio positioning, so we stand ready to adjust credit and interest rate risk exposures further, as appropriate. On page 4 of the presentation, I'll outline the fourth quarter performance. On the bar graph to the left, we illustrate how the book value components of the portfolio performed. Agency MBS and CMBS performed well, increasing by about $0.91 per share. The $0.70 decline in derivatives represents increased loss on interest rate hedges because rates fell in the quarter. CMBS and Agency MBS are the assets we are primarily interest rate hedging and put simply, they outperformed the hedges. The non-Agency bucket which includes credit risk transfer, plus the early declaration of a late first quarter preferred dividend of a few cents, explains the modest drop in book value. We see the book value change in the fourth quarter as a temporary aberration and as I said a minute ago, we estimate book value has already recovered the modest Q4 decline. For the full year 2014, book value increased $0.85 per share. The largest component of the appreciation was due to strong performance in our commercial credit investments where we had intentionally increased exposure. On the right on page 4, we show two measures of our earnings performance, core earnings and comprehensive income. Core earnings are presented to give investors a sense of our earnings without considering gains and losses. Core earnings were $0.49 in Q4 and $1.89 per share for the year. Drivers of higher core earnings in Q4 were higher average assets due to an additional securitization and also lower interest expense, because we had reallocated investments to achieve a reduced interest rate sensitivity that allowed us to remove some swap hedges and reduced costs. That drove our effective cost of funds down $0.11 and improved the effective interest rate margin by $0.18. Comprehensive income also shown includes both realized and unrealized gains and losses on assets and liabilities or hedges. Comprehensive income was lighter versus the fourth quarter at $0.12 per share due to modestly lower portfolio fair value, but over the full year comprehensive income at $2.80 per share was much stronger than core earnings of $1.89 due to materially higher portfolio fair value relative to the end of 2013. If you're following the presentation, please turn to page 5. I couldn't be more proud of what this team has accomplished over the last few years. One of our key disciplines is to actively seek the best risk-adjusted returns in the mortgage market and actively move the company into better opportunities. After the Fed started QE3 and began buying a huge percentage of new supply in the Agency market, we recognized that the best opportunities had moved away from the Agency MBS market and into credit, non-government, residential and commercial securities and loans. We wanted our company to benefit from the strength of the U.S. economy, the rise in real estate values and the strength of new underwriting. Our strategy, as announced early in 2013 was to sell Agency MBS on strength and that we did. We reduced our Agency position overall by selling fixed rate MBS and we put that allocation into credit. You can see in the equity allocation table that most of the reduction in Agency over the last two years which is down from 49% to 32% went into commercial credit which has increased to 34% from 22%. John will go over the portfolio in detail in a few moments and you'll see that our CMBS positions are spread throughout the credit stack from AAAs to BBBs and are primarily CMBS 2.0, i.e., the CMBS bonds created after the crisis. You can see on the table that is included below from Barclays Indices why our positioning helped us so much in 2014. Think of excess return in the table as the performance of the sector net of interest rate hedging. CMBS had a fabulous year in 2014 on an unlevered basis as shown in the table. We get additional benefit because we leveraged those returns. Consider that we use about three turns of debt in addition to equity on CMBS and on Agency, about nine turns of debt in addition to equity. So if you consider Agency fixed rate on the table versus A-rated CMBS and do a little math, you could estimate the levered return on CMBS 2.0 was significantly better than Agency fixed rate. The other big portfolio move we accomplished was within the Agency portfolio. We sold six straight MBS, again as I said was buying and bought Agency hybrids that they weren't buying. Agency hybrids meaningfully outperformed fixed rate and you can see that on the table. Since all of the returns in the table are essentially net of the cost of hedging interest rate risk, it's reasonable to multiply the excess return by the number of turns of leverage to estimate a leveraged return. Despite the fact that we have borrowing costs on top of hedging, this hopefully can give you a good idea of how we were able to generate a 15.6% economic return in 2014 without being correlated to interest rates. As you may recall in 2014 we spoke of three initiatives or areas of focus, residential loan securitization, floating rate commercial real estate loans and GSE credit risk transfer. Each of these initiatives serve to align our results with the improving economy, real estate markets and they reduced our interest rate risk and funding risk. Each have added value to our company and leverage what we believe to be core competencies. We continue to look for opportunities in all three areas. CRT created limited book value volatility for us in Q4 as spreads widened. However, the quality and performance of the referenced collateral underlying CRT is excellent. We were one of the early buyers willing to accept some liquidity and spread volatility risk because this sector is one of the best opportunities in the whole of the mortgage market. We stepped back in Q2 as spreads tightened too much, too fast but we are a big supporter of the program and continued to add at wider spreads in later Q3 and Q4. CRT have performed extremely well to-date in 2015 and while they are still less than 5% of our assets, we're probably one of the few largest holders. Our CRT position overall has appreciated since purchase and in addition to the appreciation, they have earned attractive income. In addition to the areas where we did find value, it's important to address some areas where we have not participated because of required cost scale and regulatory uncertainty. The best examples of these are MSRs and residential origination. While we think both of these businesses may prove attractive at some point, we think that our shareholders have been well served by the patience we have exercised as those markets are still evolving. There may be an opportunity forthcoming in servicing, but we are happy to have made an informed and active decision to avoid it so far. We believe we chose the right initiatives. Now let's talk about where we are today and how we see things playing out in 2015. The U.S. economy is creating jobs. You can point to a weakness like part-time employment, discouraged workers, etcetera, but it's hard to deny that as a whole, the job market is improving. Stronger employment is good for household formation and homes are still quite affordable in a historic context. We believe home prices will continue to increase at a sustainable 3% to 5% rate and that is great for the performance of home loans. More workers also create demand for commercial space and we see demand is increasing faster than supply, that dynamic is good for commercial loans. As far as exposure to the energy industry, the non-Agency RMBS market is very West Coast and East Coast centric, largely because they're high priced home areas where jumbo loans are prevalent. But these areas are very exposed to energy employment and the CMBS market and our CRE loan portfolio have little exposure, also. So in short, we see strong real estate fundamentals backing our investments with very little exposure to the weakness in the energy industry. The supply versus demand dynamic in our space is also positive. There are fewer new bonds than pay downs of existing debt. We expect more buyers and sellers of mortgage loans and securities in the market because of the positive fundamentals I spoke about, the strength of the U.S. economy relative to foreign economies and the need for additional yield by investors. I'm now going to turn it over to John Anzalone, who will discuss our investment portfolio and strategy.

Thanks Rich and thanks to everyone who's dialed in this morning. As Rich just discussed, we’ve been active in repositioning the portfolio in order to lessen the impact of interest rate changes and take advantage of continued improvement in both residential and commercial real estate fundamentals. I'm going to focus my remarks on how we're positioned for the current environment starting on slide 8. Here, you can see that we have now -- that we have our equity allocated about equally between agencies, residential credit and commercial credit. This gives us a highly diversified portfolio, with a mix of residential and commercial exposure, government guaranteed and private label, as well as a combination of legacy securities and newly underwritten credits. As of year-end, fully 2/3rds of our equity was allocated to credit strategies where fundamentals continued to improve. This allocation has significantly reduced our interest rate risk as the empirical duration of our equity has been hovering around zero meaning that our book value has not being meaningfully impacted by changes in interest rates. This outcome aligns with our strategy of reducing interest rate risk and increasing our credit risk exposure to properly mitigate the prospect for any increased volatility in rates and continued improvement in credit fundamentals. As we go through each of these sectors, I think you'll get a much better understanding of how we've achieved this. We'll start with agency mortgages on slide 9. Not only have we reduced our overall allocation to Agency mortgages, we have made significant changes within the Agency portfolio. 30-year paper now represents less than 50% of the Agency book, down from over 60% a year ago. Within the 30-year book, we own a variety of prepayment protected pools, you can see the breakout on the chart and we have continued to migrate up in coupon. The average coupon on our 30 year book is 4.3%. The balance of the Agency paper is made up of higher coupon 15-year paper, where the average coupon is over 4%, as well as newer production low coupon Hybrid ARMs. These moves have reduced our convexity profile leading to prepayment rates that have remained well contained in the low to mid-teens. Given the composition of our portfolio, we expect that our prepayments will remain favorable relative to cohorts. We believe that the portfolio is well-positioned for the current uncertain rate environment. Moving on to the residential credit book on slide 10, I want to take a few minutes to walk through the various positions that make up the residential credit portfolio. First, I'll point out that this shows our portfolio excluding loan consolidations which would distort the numbers. I'll start with the positions that involve legacy credit or legacy collateral. These are the Senior Re-REMICs, Legacy RMBS and reperforming RMBS and collectively they make up 75% of our residential credit assets. They share a number of traits, namely they are top of the capital structure. In the case of the Re-REMICs, they have additional credit enhancement and they have very little interest rate exposure. The average duration of these positions is between 0.3 and 0.6 of a year, as these positions are largely backed by Hybrid ARM collateral, whose coupons will increase as short rates rise. Our largest allocation legacy paper also provides potential upside to improving fundamentals. The balance of our residential credit exposure is made up of GSE credit risk transfer paper, new issue RMBS and residential loans. These sectors share excellent post-crisis underwriting standards which is why we are comfortable owning the bottom of the credit stack in these bonds. The CRT bonds have the additional feature of offering floating rate coupons which effectively eliminates their interest rate exposure. The residential loans and new issue bonds carry more interest rate risk, but they are a relatively small part of the portfolio and the loans have the added benefit of being funded by non-recourse match-funded securitizations. We continue to have a positive outlook on the CRT sector, as year-to-date they have recouped all of the widening they experienced during the fourth quarter of last year. We expect that as issuance increases and the buyer base continues to grow, these bonds will continue to outperform. Moving to slide 11 and commercial credit, as Rich discussed earlier, our largest increase in equity allocation over the past couple of years has been to commercial real estate credit and our timing there has been very good. Our CRE loan portfolio has a weighted average loan-to-value ratio of 63% and our CMBS portfolio has an LTV at the tranche level equivalent to approximately 55%. The portfolio has benefited from notable underlying property price appreciation and we expect improving employment trends to continue to be supportive for commercial real estate credit. Further, these fixed rate non-amortizing positions are easily hedged due to their bullet-like maturities and we are able to finance a large portion of them at very attractive levels which I'll talk about in a bit. Let's start with our Legacy CMBS positions. These are predominately bonds that were originally rated AAA and issued from 2005 through 2007. The underlying collateral of these positions is paying down, resulting in increased levels of credit protection and shorter average lives. Their average duration is now a little more than a year. These bonds have performed very well for us. We don't expect to meaningfully increase our exposure here as a substantial majority of these bonds will have matured and be gone in a couple of years. The bulk of the CMBS that we own was originated post-crisis and we bucket them into two groups. The first group is A/BBB paper, predominately underwritten between 2010 and 2013. These investments benefit from conservative underwriting and underlying property price appreciation as commercial real estate prices have increased by nearly 38% since mid-year 2012. We have seen a fair amount of credit-tiering in the CMBS market and the market has rewarded these early originations with tighter spreads. These bonds make up about 1/3rd of our commercial real estate debt exposure. As the commercial real estate cycle has progressed, we have moved up the capital structure and are now focusing on AAA and AA credit in more recent CMBS transactions. Our recently reduced cost of funds, achieved by forming our insurance captive and financing these physicians through the Federal Home Loan Bank, has allowed us to continue to produce very attractive ROEs. Finally, we continue to focus on floating-rate CRE loan opportunities which benefit from increased yields and a rising rate environment. Our current portfolio is well diversified across property types, with an emphasis in major markets including New York, Chicago and London. We expect this portion of the book to grow as the number of loan interest maturities increase. On slide 12, I want to talk briefly about our efforts in the financing side. Just as we have the most highly diverse asset mix amongst our peers, we believe that diversifying on the financing side is equally important. To this end, we now have a combination of repo, preferred stock, convertible notes, securitizations and Federal Home Loan Bank advances. Repo funding now represents less than three quarters of our financing, down from 100% a few years ago. Now that ends my remarks. I'll turn it over to Rich to wrap up.

Thanks, John. Let me close up by telling you why we think it's a great opportunity to be an IVR shareholder today. First thing, we believe 2015 will be another year of attractive economic return for IVR. We expect risk premiums to contract, whether interest rates rise or fall and risk premiums are the biggest driver of IVR's economic return. Second, we've delivered on our shareholder value proposition. We have among the highest economic returns in the industry at 15.6% in '14 and one of the highest three-year economic returns as well at over 16% annually over the past three years. And our disciplines, listed on page 13, are in place to keep us focused on strong economic performance despite the interest rate environment. The third reason is we see great value in IVR shares. We believe that the mortgage REIT space is generally undervalued with price-to-book on the low end of historic norms and relative to other mortgage REITs, IVR appears a bargain. We have 34% of our equity invested in commercial credit. Commercial mortgage REITs generally trade at a premium to book. We have 34% of our equity invested in residential credit and some mortgage REITs focused on non-Agency residential credit trade close to or above book. And finally, our equity allocation to Agency mortgages is heavily shorter-duration bonds up in coupon or lower-dollar hybrids with limited extension risk. And still, many Agency REITs even trade at a higher price-to-book. IVR isn't a hard portfolio to value. It's a relatively liquid portfolio. We have attractive funding, our investments are of high quality generally and our relatively easy to -- interest rate hedge portfolio also helps with interest rate risk. Our economic returns have been among the best in the space and our book value volatility is in-line with the industry. Finally, we're committed to delivering on our shareholder value proposition. We're looking forward to 2015 to finding additional value for IVR shareholders and we thank you for listening today. And now, please open up the lines for questions.

[Operator Instructions]. We have a question from Douglas Harter with Credit Suisse. Your line is open, sir.

John I was hoping you could give a little insight as to where you think your equity allocation amongst those three buckets would be trending over 2015?

Yes. I think where we are positioned now is how we want to be positioned for the current environment so unless we get meaningful changes in our outlook I don't think we'll materially change our equity allocations.

And looking at within those buckets or actually sorry in the financing how much more capacity do you guys have on the FHLB financing to continue to increase or to sort of better utilize those lines with things -- lines replacing other lines that might be more expensive on the street?

Our total capacity with the home loan banks is about 2.5 billion right now, as of year-end I think we've used about 1.25 billion of that. So we have additional capacity to use there.

Our next question is from Dan Altscher with FBR. Your line is open, sir.

Rich to use your words, [Technical Difficulty] is a bargain, so I guess at this point why not maybe look to buy back some stock then? Rich you were saying you think the stock is a bargain here at the current valuation. Maybe why not use some capital to buyback stock which I guess would be still a pretty accretive use of capital?

That's always something we consider as a use of capital. And as you probably know we were aggressive in the end of 2013 and 2014 buying about 9% of our shares which I think is probably one of the higher stock buyback programs in the industry. I think the reason at that point was that A, we saw the return on buying shares higher than the available returns and we really didn't have another use for the capital at the time that we needed. And we did like the book value accretion opportunity which at that time book value was in the 17's. So now is a different time, we actually do have opportunities to earn a similar or better yield than buying our dividends essentially and we also need the capital. Shrinking, we don't think is in the best interest of our shareholders. We've been able to deliver on economic returns in the 15% to 16% range last year and three years and we've been accreting book value. So buying shares in our opinion -- it's a great opportunity something we continue to look at but we also need capital to do other things and one is funding the insurance captive, take advantage of that attractive line. And to be prepared for opportunities that come along like in terms of return of securitization and servicing etcetera. Some distressed opportunities that may come about so we don't see anything urgent about buying shares now. Our goal is really to deliver high economic returns and that's what we're focused on.

You mentioned the dividend as well. Just maybe help us all understand a little bit maybe the disconnect if you will. Lower the dividend in the fourth quarter, clearly fourth quarter core earnings though were well in excess of the dividend which was at least nice to see. So as we think forward there is kind of like $0.49 - $0.50 kind of what you’re thinking the normalized earnings power of the company is going forward for '15 and then how does that maybe relate to the dividend which was just reduced modestly?

Yes. We try to set the dividend at a level obviously that we think is sustainable and as you recall last year our earnings were relatively steady in the $0.44 to $0.50 range and I say the fourth quarter was an extension of that. We also were distributing taxable income rather than core. We think $0.45 is sustainable for the future.

Okay and then just one quick follow up just on the credit risk transfers. The comments were that a lot of the price I guess recovered in the first part of this year. But John is there any rate maybe with the hedge, maybe the credit spreads -- the credit risk transfers or is that just not really even on the table or it's just kind of too hard to have sort of like a reference hedge again it.

Yes. There is nothing I'm aware of that would effectively hedge that and I mean that's the risk were looking to take. So we recognize that a lot of the volatility has been based more around technical factors, in terms of -- spreads tend to move around as the issuance calendar goes and also over time as we've seen more participants enter the market we've seen a little bit better pricing but I don't see any way to really hedge that. In fact that's what we're trying to capture, is those spreads.

Thank you. Our next question is from Trevor Cranston with JMP Securities. Your line is open, sir.

I guess the first thing, there has obviously been quite a bit of rate volatility since the end of the year and the 10-year dropped pretty low and has since been sold off. But can you talk a little bit about where you see prepays on the agency portfolio trending over the next few months?

Yes, I think we will see -- over the next couple of months we should see slightly higher prepayments, reflecting where rates were back in -- during the fourth quarter. But certainly going forward, we're pretty -- expect a pretty benign prepayment environment. Capacity constraints seems like -- well it seems like capacity constraints have really been showing up in some of the refinancing numbers we've seen. So while I expect a little bit of a bump over the next maybe quarter or so, I would expect things to come back down to the types of levels we've seen in the past.

But we also think that probably the most impacted part of the market is the more newly originated like 3.5, 4 stuff that hasn't been through a prepayment environment like this before, and we will see. It was a relatively short period where rates in January and maybe early February dropped to the lows on the 10-year, but have since backed off. So we'll probably see some spike and then settle down again, but for our portfolio, most of our 30-year stuff is pretty well seasoned and pretty up in coupon and has been through these rate cycles before.

Yes. As a follow-up to that, looking at slide 9 on the breakout of 30-year portfolio, just on those bottom two buckets, the credit and the seasoned other are those loans that you think might have the possibility to refinance, given the lower FHA premiums or are there characteristics there that will still kind of prevent them from taking advantage of that?

Yes, there might be a small risk of that, but nothing that we're terribly worried about. We haven't seen -- these are typically pretty [inaudible] type bonds that are barely high up in coupon that haven't had the ability to refinance through a lot of different rate cycles. So maybe at the margins we would see a little bit of a prepay bump, but I don't expect anything material there.

And then last thing for me, on the CMBS portfolio, you talked a little bit about the FHLB line, and how much room there still is on that. Can you just talk a little bit about how you'll think about kind of continuing that reallocation into the AA/AAA sector and what will be the drivers of how fast that happens?

I'm happy to take that offline and talk to you about it in more detail. I think right now a lot of it comes down to 40 odd constraints and how much equity we can move into the insurance captive, which is the primary limiter as to how much we can borrow from them right now, I think. If you saw us move some of the credit into more Agency paper, if that opportunity arose, then the opportunity may be there to borrow some more money from the Home Loan Bank.

[Operator Instructions]. Our last question at this time is from Brock Vandervliet with Nomura Securities. Your line is open.

Maybe you covered this earlier, but regarding the effective interest margin, I understand how that ticked up with some run-off of higher cost swaps. Do you look at that as being essentially sustainable here or were there other factors that might lead that to come in a bit? Thanks.

Essentially what happened is, as we kind of reduced interest rate sensitivity in the portfolio, we started bringing the overall equity duration of the portfolio down and we were able to take off swaps and so that's sustainable. We do have a couple of forward-starting swaps that come on over the next year and so that could raise interest costs a little bit if we're not -- don't actively change that in the meantime. So the answer to your question is yes, I think we're appropriately positioned with respect to interest rate sensitivity and as we said, we see our book value being uncorrelated, but forward-starting payers could bring core down a little bit.

Okay. And just last question with respect to the Agency book. I understand the overall allocations across the portfolio aren't likely to change, but specifically within the Agency book, might we see some of those weightings among the 15 and 30 and the hybrid product change? Are you pretty comfortable with that, and the duration going forward?

Yes. I think we're pretty comfortable with where we are. If anything, we'll continue to reinvest pay downs into some of the shorter duration-type things. So as our -- what 3.5%s we have, prepay, we'll reallocate those up into either higher coupon 30s or 15s or hybrids, depending on -- at this point, it's more of a relative valuation call in terms of how we reinvest pay downs. But as you've seen, the prepayment performance has been really good in terms of where we've been and I think -- I wouldn't be surprised if -- you shouldn't be surprised if you see it move even a little bit more out of 30s, as the portfolio evolves.

Gentlemen, we have no further questions.

Okay, operator. At this point, let me just thank everybody for listening today and we'll close it up there.