Invesco Mortgage Capital Inc. (IVR) Q1 2015 Earnings Report, Transcript and Summary

Good morning ladies and gentlemen. Welcome to Invesco Mortgage Capital Inc First Quarter 2015 Investor Conference Call. All participants will be in a listen-only mode until the question and answer session. [Operator Instructions] As a reminder, this call is being recorded. Now I would like to turn the call over to Tony Semak in Investor Relations. Mr. Semak, you may begin the call.

Thank your Dexter, good morning everyone. Again we want to welcome you to the Investor Mortgage Capital First Quarter 2015 earnings call. I'm Tony Semak with Investor Relations and our management team and I are really delighted you joined us today, as we look forward to sharing with you our prepared remarks during the next several minutes before we conclude with the question-and-answer session. Joining me today are Rich King, Chief Executive Officer; Lee Phegley, Chief Financial Officer; John Anzalone, Chief Investment Officer and Rob Kuster, Chief Operating Officer. Before we begin I'll provide some customary forward-looking statements, disclosures, and then we'll proceed to managements' remarks. Comments made in this conference call and related press release and presentation may include statements and information that constitute forward-looking statement within the meaning of U.S. security laws as defined in the Private Securities Litigation Reform Act of 1995. And such statements are intended to be covered by the Safe Harbor provided by the same. Forward-looking statements include our views on the risk positioning of our portfolio, domestic, and global market conditions, including the residential and commercial real estate market. The market for our target assets, mortgage reform programs, our financial performance including our core earnings, economic concerns and comprehensive income and changes in our book value, our ability to continue performance, trends, stability in portfolio yield, interest rates, credits spreads, prepayment trends, financing sources, cost to funds and our leverage and equity allocation. In addition, words such a believe, expects, anticipates, intends, plans, estimates, projects, forecasts and future or conditional verbs such as will, may, could, should and would, as well as any other statement that necessarily depends on future events are intended to identify forward looking statements. Forward-looking statements are not guaranteed and may involve risk and uncertainties and assumptions. There could 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 Securities 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 and any public disclosure in any forward-looking statement later turns out to be inaccurate. An archive of this presentation will be available on our website and a telephone recording can be accessed through May 21st by dialing 888-562-2797 or for international callers 1203-369-3747. To view this live presentation today you may access our website at www.invescomortgagecapital.com and click on to Q1 2015 earnings presentation link, you can find under the Investor Relations tab at the top of our home page. There you may select either the presentation or the webcast option for both the presentation slides and the audio. Again, welcome and thank you so much for joining us today. We'll now hear from our Chief Executive Officer, Rich King.

Thanks Tony. Good morning everybody and welcome to the first quarter IVR earnings call. In the first quarter we were pleased to report core earnings of $0.50 per share. We paid a $0.45 dividend, our book value grew $0.55 per share to $19.37 per share, or an increase of nearly 3%. Combining the dividend we paid and the increase in book value, our economic return for the quarter was 5.3%. We remain well balanced across commercial, residential and agency and have had success modulating risk exposures as we find new sources of value across mortgage markets. In the first quarter we added value in a number of ways. Equity allocations, target assets and positioning on yield curve added value. But asset selection, earning the right assets within these allocations was the real driver. We're also seeing benefits of investments we made in distressed commercial real estate several years ago. These JV interests which we co-manage with Invesco Real Estate and WL Ross added $0.05 to Q1 earnings. These investments are a small component of our equity as assets that we expect -- we expect the contributions of their earnings to be positive, but not at this magnitude. Our Book value at $19.37 per share has been on an upward trajectory for the 3.5 years and has had little correlation with rates over that period. We hedged the preponderance of the interest rate duration of our assets. First that, we remain largely neutral to overall direction of interest rates and primarily earn income through prudent exposure spread risk. On Page 4 we present a bar of our book value on the left, and here let me explain why our book value grew $0.55 in the quarter. First, we were well positioned from a sector standpoint as commercial and residential markets performed better than the agency MBS market broadly in Q1. We used hedging to actively shift our net key rate duration exposures because that is more efficient than trading assets to shift curve positioning. Our hedges were positioned, first that we benefited from yield turn of honest amount. Repay each of agency MBS residential credit and commercial credit, asset selection valuations. In the agency MBS allocation selection was quite We owned on longer hybrids, 15 year fixed and specified up in coupon 30 years, all of which outperformed the broad MBS market. Agency MBS on a gross basis before hedging contributed $0.59 to our overall increase in book value as shown in the bar chart. Within the residential non-agency allocation, selection was positive as the credit risk transfer and re-performing loan securities that we appreciated, while the larger part of the market, the legacy RMBS were close to flatten price. To this sector we added $0.13 to book value and there is no associated hedging cost there. Within the commercial allocation CMBS 2.0 performed quite well and the seasoned subordinates we have did better still. CMBS evaluation added $0.40 growth of hedging costs. Rates were lower in the quarter, so our hedges derivates in the bar chart lost $0.60 in value. But the agency CMBS components combined for $0.99 outperforming the rate hedges by $0.39 for the quarter. On the right, we show two measures of income. Core is a non-GAAP measures which we define, unlike GAAP excludes changes in valuation of our hedges and of course both don’t include changes and our asset values. So we believe this is a more stable and consistent of measure of earnings. We earned $0.49 of core in Q4 and $0.59 in Q1. But keep in mind both quarters benefited from low prepayments and significant income from the JV's. The JVs added $0.05 as I said in Q1. We expect faster prepays to be inside the second quarter and we anticipate that we'll have a negative impact on core in Q2. But with the recent backup in rates, we expect prepayment space to peak in April-May and then slow down. We have no assurance that the JV's which added the $0.05 to earnings in Q4 or in Q1 will be accretive to earnings going forward. As I said we expect some contribution. Comprehensive income also shown as a deducted GAAP measure, it include the changes in valuation of assets and liabilities and earnings, making it a more vocal earnings number than core. It is generally similar in its size to economic return. Comprehensive income was $0.12 for Q4 at $1 per share for Q1. Over the long run, we expect core and comprehensive income to average out, but core will be more stable. On Page 5 you can see as I said before that our allocation of equity is balanced in the first quarter. This is consistent with where it was in the fourth quarter 2014. We believe this allocation aligns shareholder outcomes with strong underwriting and economic fundamentals in both residential and commercial real estate. At the same time, it provides the safety and liquidity of agency MBS and we balanced it with hedges that we believe raised our fair market value, largely and correlated to interest rates. The table below was meant to give you a better sense of how we were into market not long away that really matters what you own within the market. This is David from widely recognized industries, Barclays Capital. To illustrate that the selected sectors outperformed the broader market, improving IVR’s book-value some lift. The mortgage index is dominated by 30-years and specifically mortgages with coupon less than reported 4%. John will show that we own very little of that. On the table, which show the 30-year fixed rate, have returned a negative 51 basis-points excess return. So, set another way, if you bought that index and has good treasuries, you will have a negative, call it 0.5%, economic return. We have been adding longer hybrid-arms and CMBS over the last couple of years. And you can see here that they continue to perform very well in the first quarter. I’ll leave more detail to John to talk about on our portfolio. But I’d the fact that we have a very high quality seasoned credit portfolio. It has embedded depreciation and the underlying loans. And the assets we own are shortly rolling down the curve. As for the assets that are performing well fundamentally shorten with the passage of time the market yield investors are willing to accept that it’s lower, due to both the yield curve and the credit component and this has been significant wind at our back. Before I turn the call to John a quick update on our outlook. The underpinnings of commercial and residential real-estate is very favorable, employment is growing, rents are growing occupancy is growing, as well. Prices of homes have settled into what we expect to be a 3% to 5% annual improvement, a healthy and sustainable rate which we believe is attractive for perspective buyers, home buyers as well. Credit underwriting and residential remains restricted, and the performance of loans reflects that. Agency conforming and credit jumbo has a very, very little serious delinquencies. We expect credit premiums to continue to contract to the fundamentals and owing consecutive net supply generally. John Anzalone, our CIO, will now discuss our investment strategy in more detail.

Thank you, Rich, and thanks everyone who’s dialed in this morning. As Rich had discussed, the portfolio performed better than expected during a fairly volatile interest rate environment. As we discussed over the past year, we have been rotating away some interest rate risk towards credit risk and the portfolio saw the benefits of this active management this quarter. We believe that both credit and agency will be supported as investors continue to hunt for attractive yields. Starting on slide eight of our two different parts of the portfolio. Here you can see that we have our equity allocated about equally between agencies, residential credit and commercial credit, roughly unchanged since year-end. This gives us a high diversified portfolio with a mix of residential and commercial exposure, government guarantees and private label as well as a combination of legacy securities in newly underwritten credits. 66% of our equity is allocated to credit strategies where fundamentals are continuing to improve. This allocation has significantly reduced our interest rate risk as the duration of our equity has been hovering around zero meaning that our book value is not be meaningfully impacted by changes in interest rates and that was certain evident this past quarter. This outcome aligns with our strategy of generating earnings from credit spreads and leveraging the company to improving credit fundamentals. In fact this is just a scenario that we saw during the first quarter with increased rate volatility and tightening credit spreads. Next I’ll go through each sector and outline how we are positioned to take advantage of the current environment let’s start with the agency mortgages on slide nine. While we have made a deliberate move towards credit assets over the last year, we still have one third of our equity and about half of our assets dedicated to agency mortgages. We really like how our agency portfolio is positioned with respect to interest rate and complexity risk. By actively increasing our allocation to 15 year collateral and hybrid arms the portfolio significantly outperformed lower coupon on 30 year collateral. In 30 years we continue to focus on higher coupons specified pull paper. The average coupon of our 30s is 4.3% and consisting variety of prepayment protected collateral storage as you can see in the pie chart breakout. Prepayments remained contain with CTR is in the low to mid teens and while we saw small increase in April due to seasonal factors, speeds moderated in May and we expect that prepayments should continue to subside as rates have driven to the top of the original range. One thing that I want to point out is that while we have been focused on reducing the interest rate and complexity risk of our agency book we are still positive on agency spreads. And certainly like having half of our assets in extremely liquid bond intended performed well in stressed market conditions. Given the significant yield advantage in agency mortgages has over most competing assets and certainly over other global bonds with government backing. We feel that mortgage spreads are going to be well supported in the near term. Let’s move on to our residential credit book on slide 10. Over the course of the quarter, we consolidated one additional securitization and recently originated prime jumbo loans. Otherwise, we do not make any material changes in the residential credit portfolio as we continue to like the composition of the book. We are well diversified within resi credit, with exposures to both seasoned collateral which is benefiting from the improving housing fundamentals as well as newly underwritten collateral which benefits not only from an improving housing market but with start underwriting. We saw modest tightening of spreads on our legacy book reflecting not only the improving fundamentals but also the strong demand for shorter duration spread assets. Looking at our newly underwritten collateral, depositions benefit from strong borrower and collateral performance. A particularly note, our GSE credit risk transfer bonds experienced significant tightening over the quarter, as not only this collateral performance was very good but investor demand continues to be very strong for new issued deals and the investor base in this asset class continues to grow. Another pure positive for our ready credit book is that depositions have very little interest rate exposure and therefore should be well insulated from any potential volatility in rates. Moving to slide 11 and commercial credit. As Rich discussed earlier, we really benefited from superior security selection in CMBS. Credit spreads are on seasoned CMBS 2.0 position tend modestly while the tightening in our seasoned subordinated bonds was more significant. Distorted commercial credit is very similar to distorted residential credit, and improving fundamental picture continues to support both CMBS and CRE investment. And the demand for high quality credit assets remains extremely strong. Within our commercial book, we also benefit from the diversity of our collateral with a mix of legacy and new issue bonds as well a combination of AAAs and subordinates. Our legacy positions are short duration on average over a year and newer production bonds have bullet-like maturities and going to therefore easily hedged. Again, this hedge portfolio has little interest rate risking as position has take advantage of straightening fundamentals. On slide 12 I want to talk briefly about our efforts on the financing side. Since we have the most highly diverse asset mix amongst our peers, we believe that diversifying on the opinion side is equally important. To this end, we now have a combination of repo, preferred stock, convertible notes, securizations and federal home loan bank advances. During the quarter, our cap has increased this borrowing through the Home Loan bank by 300 million and we completed our first direct repo transaction. Repo funding now represents 71% of our financing, down from 100% a few years ago. Now let me turn it over to Rich to wrap up.

Thanks John. In closing I’d like to make three points. First, we like the way we’re positioned in this environment. The assets we own and the lack of correlation we’re seeing with rates. Second, we’ve been focused on stable attractive and growing or keeping stable our book value. And we’ve delivered with the strong start to the year and favorable results over the last year in three years. And then finally and probably most importantly, it’s our discipline that can sustain a strong performance numbers. We leverage the platform that find value, values like the JVs that we invest in several years ago, or the $50 million mezz loan we just closed on with the help of our real-estate teams. Our credit team does phenomenal work, we protect capital at no other than temporary impairments and in the crisis this team kept Invesco out of harm’s way. We modulate exposures and do it well and that shows up in our team across the board top quartile performance. We’re disciplined about hedging interest rate risk and taking credit spread risk and we’re disciplined about risk management and clearly continuing to improve funding sources and we’ve made significant changes and progress there. I can tell you without a question I am very proud of what this team has done and really like being a stockholder of this company. Operator, let’s open up for question-and-answer.

This is actually Cole Allen on for Dan Altscher. Thanks for taking my questions. So, I guess to start off, you guys have really, really good book number and you talked about a lot on this call and I guess, I just want to get a little update on how we're tracking through 2Q? And then secondly, you said prepayments ticked up a little bit in April. Is that kind of actually going to be like a blessing in the skies as rates have spikes since then and you can maybe redeploy capital quicker to your credit strategy, or what's your thoughts on that?

So first of all the progress in the second quarter and in terms of book value it’s not materially changed from where we were at the end of first quarter. On the prepayments I think I just reiterate that we have a update coupon agency book, obviously, it's great because of its short duration but it is impacted by faster prepayment. So, the numbers in April with cost core earnings to be down a little bit, but you are right we kind of welcome horizon rates and the pickup in pre phase its April or associated with rates of over 50 basis points slower and more than that from where we are now. So I think it's temporary and we welcome the better investment range.

Prepayment report came out last night that showed speed moderating a bit from April. So we expect that to continue through the next several months, even with higher rates you're going to get seasonal factors even if rates haven’t gone up we would expect prepays to moderate a bit. But yes certainly rates are helpful for the agency buffering.

For sure, thanks. And then one more question. You guys have been investing in a couple of quarters now and a lot of your peers are starting to get bigger end to it, but the GSE credit risk transfers, what is your guys current outlook on those? Are those maybe one of the best uses of capital out there, for you guys or if not, if where you're seeing the best opportunities?

I think that this remains one of our best opportunities from an ROE perspective. I mean spreads, although they've tightened quite a bit or still call it for unrated bonds in 375 to 400 range depending on the bond. So we still like that and in fact one of the issues that I think that market has had, is been a limited investor base and see more of our peers and other investors become interested in stories, only have been helpful for spreads. For us the way we look at it, the more liquid this market gets and bigger the investor base grows, better for our holdings.

Okay. [Operator Instructions] Our next question comes from the line of Mr. Steve DeLaney of JMP Securities. Sir your line is open.

Good morning everyone. Please to be on with you, on Trevor behalf this morning, and two of us want to congratulate you guys on what we think is the best performance in the first quarter among any other residential mortgage REITs so great job to start the year. I would like to start with this $50 million mezz that you announced on April 29 in a separate release on the Atlanta building. I just wondered if you could talk a little bit more about your LPD attachment points. Maybe on this loan specifically, but also kind of where you see yourself sort of in the capital stack generally on this product, and maybe if you could talk about the yield on this relative to the 8.5% average yield that you have your CRE loan books so far? Thanks.

Steve, so this is Rich. I think in terms our disclosure on that particular loan -- I'll get back on how much we're going to disclose about each loan. But broadly -- we're very comfortable with the investment. We think it is a class A quality investment. The target or the return is in line with what we've done to respect something like 8.5 higher on this investment.

Okay, I think that level for those are floaters, generally what two to three year kind of initial terms, so the rate kind of reflects the duration. Right?

That’s correct.

Yeah exactly, so even better right. And as we look at the portfolio, this seems, CRE credit seems to be where you guys are trying to reallocate capital. You're continuing to sort of rotate within resi credit too, but the growth has been 34% now. Where might that go over the next year or so, and should we expect the actual whole loan portfolio to increase relative to the CMBS 2.0 positions?

Well, I think in terms of the overall mix, we're happy with the balance that we have right now. And I think, broadly people always underestimate the agency market. It's two effects overtime Steve and look at the risk adjust return and the agencies phase, it's pretty dramatic how strong it is. It just continues to deliver, I mean people always kind of overestimate the prepayment sensitivity and the efficiency of borrowers and so forth. So we're not really looking to continue to reduce that, I think it serves our equities where we want to be. In terms of the commercial, we are focused on continuing to originate CRE loans, but we're very-very credit sensitive and do a lot of work on each one. And so it’s a little bit difficult to predict how much that can grow.

I would say the loan growth is likely to come from our legacy books that are starting to pay down both in legacy and agency they’re in CMBS and the residential. So I mean that’s where we likely to a shift in assets because I mean the legacy CMBS but obviously is from 2005 through ’07 so those one and then on the resident side same thing it’s get up to 5, 6, 7 production.

We do have some interesting things in the pipeline and on the CRE side.

Well, we’ll stay tuned and keep an eye on to those as they -- as you announce some. Just one final thing on your Home Loan Bank membership, remind me whether you are in Indianapolis or Dumoine I can’t recall?

We are in Indianapolis.

And the 1.5 billion that you’re up to now, how much additional capacity do you have with your relationship with Indi?

There’re 950 million, 2.5 million total.

And it looks like mostly CMBS posted currently. Just curious whether you’re looking at any other possible asset types to pledge to Federal Home Loan Bank? That’s my last questions. Thanks.

We view some agency CMO as well Steve against that we will probably look to grow that I guess agencies as opposed to more credit.

And at us what have you right to assume that there's no way that a CRE mezz loan is going to be eligible at the FHLB assuming you want to do just very modest leverage.

That’s correct.

Thank you very much. Our next question comes from the line of Mr. Charles Nathan of Wells Fargo. Sir your line is open.

Thanks, good morning guys. I was wondering if you could comment on the BP space and if that's an area that you would potentially be interested in within your CRE allocation. And I guess looking ahead when you think about Dodd-Frank risk retention requirements upcoming if you see that as a potential opportunity within that investment set?

Yes, the BP space is something we look at in addition to home loans and mezz loans in the CRE space. The second part of your question on Dodd-Frank, could you repeat that?

Yes, I was just hoping you'd comment on Dodd-Frank risk retention requirements and if you see that as a potential opportunity and how you're thinking about that change in the landscape over the next couple of years?

I think over the next couple of years, I mean we do expect to see some more opportunities in the CRE side, just because of the big number of maturities that are coming up and partnering on getting specific loans refinanced within the CMBS space. I don’t really have any additional comment on the Dodd-Frank component at this point.

Thank you very much [Operator Instructions]. Our next question comes from the line of Mr. Dave Walrod of Ladenburg Thalmann. Sir your line is open.

Good morning. Just wanted to hear an update and your thoughts on share buyback given where the stock is trading?

Stock buyback is something that we always consider and as you know we thought bought back a fair amount of our stock at similar levels I guess towards the end of 2013, beginning in 2014. If you see the -- I mean the biggest benefit of that is accreting both value. But we do -- I mean we continue to be able to have book value previously as I said over the last 3.5 years and we’re also balancing that against retain financial flexibility and put in capital opportunities that we see to really improve the spending of our company over the long term like funding our captive insurance company in order to get some attractive financing and to make new investments in CRE and so forth. So, -- but it’s something we like to consider.

Thank you very much. Our next question comes from the line of Mr. Mike Widner of KBW. Sir your line is open.

My questions have been answered. Thanks a lot.

And our next question comes from the line of Mr. Brock Vandervliet of Nomura. Sir your line is open.

Thanks for taking my question. Regarding the real-estate, the JV that you mentioned, the earnings for the last two quarters are just been a little over a million, obviously, there's much more visible this quarter. Can you at all kind of frame out what we should be looking for it? It sounds like that's going to drop back, but any comments on magnitude would be helpful?

Well, so no, years back, we started a fund that was associated with that program and one side of it was the actual piece that’s where we bought the securities and used that at government financing. And on the other side was a distressed commercial loan component. And our total commitment to that was about 100 million, both of which got invested and it was probably close to half each. And then in addition to that we bought a distressed portfolio together with the same group which was probably an additional like 15 million of our capital. So, that’s not a huge percentage of our assets. But what’s happened recently is we -- our real-estate teams done a fantastic job of repositioning that portfolio, releasing in certainly cases, realizing sales in certain cases. And we do can say that that probably will continue to be good news. But in the fourth quarter the valuations that came back were significantly higher than in previous periods. So as we made realizations in that portfolio some of that depreciation that we expect to get those realized realizations is now come through an income unrealized. So I can’t tell you the future. I don’t know what will happen over the next two years. But it’s been a good investment for us and I would caution not to extrapolate the type of income we got in the first quarter.

Yes, absolutely. Separately on expenses, by the way, I didn't catch the size of your securitization, but the expenses seem particularly well controlled, even including the 2.2 million in securitization expenses. So if you could talk about those items that would be great.

One thing that we focused on this quarter is given people a better understanding of our expenses and breaking down basically what are we consider are operating expenses relative to the expenses of the consolidated trust themselves. In other words, we are retaining the subordinate tranches of these structures. IVR doesn’t have a liability an economic sense past our investment in those subordinate tranches. But because of the consolidation on our balance sheet, we have the home loan book as an asset and the asset backs that we have -- the securitization trust issue has a liability. So A, I want to make clear that that shows up in our leverage numbers and makes our leverage look higher if you think about what we actually hope. And B, the expenses of those trusts are consolidated on our balance sheet. So those are in our expenses. So if you look at what our true expense ratio is, it’s more like about 1.8% which demand 1.5, so I think we run a pretty tight ship here. And so we’ve got our expenses down overall actually when you look at operating expenses.

And how large was the securitization?

I think 300 million.

Thank you very much [Operator Instructions].

We’ll end the call here. And thanks everybody for listening. We look forward to next quarter.