Invesco Mortgage Capital Inc. (IVR) Q4 2016 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital Incorporated’s Fourth Quarter 2016 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, Investor Relations. Mr. Semak, you may begin the call.

Thank you, Frank and good morning everyone. Again, we want to welcome you to the Invesco Mortgage Capital fourth quarter 2016 earnings call. I'm Tony Semak with Investor Relations and our management team and I are very delighted that you’ve joined us as we look forward to sharing with you our prepared remarks during the next several minutes before we conclude with our usual question-and-answer session. Before we begin, we’ll provide a customary forward-looking statements disclosure, and then we’ll proceed to management's remarks. Comments made in the associated conference call may include statements and information that constitute forward-looking statements within the meaning of the U.S. securities laws, as defined in 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 return, and comprehensive income and changes in our book value, our ability to continue performance trends, the stability of portfolio yields, interest rates, credit spreads, pre-prepayment trends, financing sources, cost of funds, our leverage and equity allocation. In addition, words such as believes, 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 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 Conditions 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 Web site 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, if any forward-looking statement later turns out to be inaccurate. To view the slide presentation today, you can access our Web site at InvescoMortgageCapital.com and click on the fourth quarter 2016 earnings presentation link. You can find under the Investor Relations tab at the top of our home page. There you could select either the presentation or the webcast option for both the presentation slides and the audio. Again, we want to welcome you and thank you so much for joining us today. We’ll now hear from our Chief Executive Officer, Rich King. Rich?

Thanks Tony. We’re pleased to have generated attractive economic returns to our shareholders in 2016, as well as over the last three and five year period, an absolute turndown relative to our peers. I am also excited about the future of IVR due to our very strong team, which will now be lead by John Anzalone. Many of you are aware that several months ago we announced my retirement and John's elevation from Chief Investment Officer to become the Company's new CEO. John has served as our CIO since the Company’s inception, and is well equipped as he has keen instincts for value and timing in our markets, and of course, he has a very eminent understanding of IVR in 25-year carrier in real-estate debt markets. He is highly familiar to many of you as well as he has been a very visible figure representing IVR at numerous analyst and investor events, and has been a consistent contributor to this quarterly call and other public forums. John enjoys a strong endorsement by our Board, from me personally, and I am delighted he is our new CEO. Our shareholders can look forward to benefitting from John's guidance and his commitment to working in their best interest. Let me say thank you now to the team here for a job well done and to you, our shareholders, for the faith you’ve placed in us since 2009. And now I introduce our incoming CEO, John Anzalone.

Thanks, Rich. First of all, on behalf of team, I would like to thank Rich congratulate him on his retirement. We obviously wouldn’t be where we are right now without his leadership over the last seven and half years. While Rich is apart it's going to leave a big hole to fill, we have an extremely deep and talented team that will meet the challenge. I am honored to have the opportunity to continue the legacy of working for our shareholders and delivering on our commitments. I would like to highlight the individuals that have been elevated within the Company and will be taking on expanded roles. Beginning officially on March 1st, Rob Kuster, our Chief Operating Officer will become President and Chief Operating Officer; Jason Marshall, our Head of Mortgage Backed Security Portfolio Management at Invesco, will become our Chief Investment Officer; and Dave Lyle and Kevin Collins, our Heads of Residential Mortgage-Backed Securities and Commercial-Backed Securities Credit at Invesco, will become Executive Vice Presidents in-charge of Residential and Commercial Credit, respectively. This Group has worked closely together since IVR’s inception in June of 2009, so we anticipate this transition should be seamless. As for today's call, I’ll provide some brief remarks about the quarter, and then I’ll give the floor to Jason Marshall, who will talk about our portfolio in greater detail, before opening the call to Q&A. IVR's economic performance has been strong during 2016. Despite a slight negative economic return of minus 1.1% during the fourth quarter, IVR's overall economic return for 2016 was a robust 11.3%, which compares very favorably to our peers and you can see that on slide five. Going into the fourth quarter, we drove most in 2016, we sought to actively reduce the risk profile of our portfolio in anticipation that the market might experience heightened volatility caused by the presidential election, the potential for the FOMC to increase the fed-funds rate in the ongoing Brexit negotiations. You'll notice that we’ve reduced the overall size of the portfolio and have been biased to add shorter duration agencies. This too put pressure as the markets were quite volatile during the fourth quarter after the largely unexpected result of the U.S. presidential election, followed by the FOMC’s decision to increase the fed funds rate by 25 basis points in December. We saw interest rates rise sharply and yield curve steepen meaningfully, as the market priced in a high probability, the new administration will quickly enact fiscal stimulus, tax cuts and regulatory reform. Risk markets reacted favorably as equities rally and spreads on credit assets tightened nearly across the board while longer duration ADC spreads had trouble keeping up with the sharp moving rates. During the fourth quarter, our core EPS was $0.36 per share. Our reduced core earnings number was largely result of our conservative positioning, lower leverage, faster than expected prepayment speed, and increased funding cost after the FOMC and into year-end. As we head into 2017, all of these headwinds have reversed, and we expect our core run-rate to recover to levels more in line with our current dividend. We observe a material slowdown in prepayment speeds recently as the impact of higher rates makes refinancing less attractive. Repo rates have decreased as the year-end balance sheet pressures on our counterparties to reach. And because we’re conservatively positioned, we’ve plenty of dry powder to redeploy capital into investments in a more favorable environment where rates are higher and yield curve is steeper. While our more conservative stance led to the temporary reduction in our core run-rate, it also helped to protect our book value. For the quarter, our book value is down 3.3% to 17.48, while for the full year our book value increased by 2%. This is despite the 10-year treasury rate rising by 84 basis points during the quarter, and 18 basis points during the year with the trading rates of 124 basis points and peak the trough. While spreads in our credit assets tightened during Q4, this was not enough to offset the widening of agency spreads that occurred. Since year-end, rates have traded in a much narrow range, while credit spreads continued to tighten. And our current book value is up approximately 2% year-to-date. Looking forward to 2017, we believe we are very well positioned for the uncertainty environment that we now face. While the risk markets have priced in a high probability that fiscal stimulus, tax cuts and regulatory reform will have a positive impact on the economy, none of these are sure things. And even if they happen, the timing is quite uncertain. On the flip side, we believe the market may be underestimating the risk of protections, trade policies and the chaotic news out of Washington. As such, we remain cautious on adding additional credit assets at these valuations. Our credit portfolio is highly seasoned in high quality and is benefited from the rallying of risk assets, but we are waiting for more opportune time to deploy capital out of liquidating to securities. While the opportunities in credit are limited currently, we have taken advantage of the wider spreads on the third year ADCs and the greater hedged ROEs they generate and have increased our earning assets during the first quarter. This should also increase our earnings power, going forward, while preserving our ability to be ready to capitalize on opportunities as they become available. I’ll stop here and let Jason talk about the portfolio in more detail.

Thank you, John and good morning everyone. As John mentioned, we were positioned more considerably in the fourth quarter, because of the expectations when volatility around the presidential elections and the December FOMC meeting. We primarily accomplished this by foregoing reinvestment of pay-downs during the quarter to decrease leverage and spread risk. We did end-up experiencing significant volatility, as John mentioned, with the 10-year note, up 84 basis points for the quarter and risk assets rallying rather significantly. Given our desire to reduce risk during the quarter, our activity was limited during the quarter. But we did add credit risk transfer bonds in December as we view the prospects for housing has improved and the ROE in the sector was attractive. If you look at page six of the earnings deck, you'll see our equity allocation at year-end was 41% in agency MBS, 32% in commercial credit and 27% in residential credit. Our allocation through agency MBS does give us the flexibility to shift into credit assets should spread levels reach levels were U.S. attract. I'll speak now more specifically about each of the sectors. If you turn your attention to slide seven, you'll see our agency MBS portfolio remains wealth of our supply with limited exposure to 30-year -- to lower coupon 30-year MBS which widened its interest rates in the fourth quarter. Our allocation to 15-year and hybrids benefitted us during the quarter as the 15-year sector held in relatively well versus 30s, and hybrid arms tightened significantly as rates go up and prepayment risk diminished. We've continued to favor only specified pool stories that view as offering relative value instead of generic collateral or TBA. Moving on to commercial credit, our allocation was little changed during the quarter, and continues to be concentrated at higher seasoned collateral. We continue to benefit from property price appreciation in commercial real-estate with our effective LTV, including subordination declining to over 35% in the quarter, and that's illustrated on slide 12. This has resulted in rating agency upgrades on many of our bonds, which improves financing terms and helps improve the NIM as well. I should also note that our loan portfolio benefitted from the increase in the federal funds rate in December as those coupons are directly indexed to LIBOR. As I mentioned earlier on the residential credit side, we did add to our credit risk transfer position in December because of the fact there is limited duration profile and attractive ROEs. House price trends remained positive and demand has increased but our supply remains limited. Relative to other residential credit alternatives, CRT remains the most efficient alternative for gaining exposure with compelling ROEs. I'll now provide an update on our portfolio activities since quarter-end. Having been conservatively positioned in the fourth quarter, we had capital and continue to have capital available to the full-end of portfolio. We recently put capital to work in the 30-year MBS sector for the first time in several years, because of the steeper yield curve, improved financing terms, slower prepayments speeds and an improved complexity profile. Also, we have found attractive ROE opportunities further down the capital structure and agency MBS deals, but remain relatively cautious because of mainly the most spread tightening that has occurred in the last several months. Lastly, we continue to use CRT as an attractive investment alternative but are remaining patient with the better at the place since our December purchases. That concludes my prepared remarks on the portfolio. I’ll now turn it over to back to the operator for the Q&A session.

Thank you. We will now begin the question-and-answer session [Operator Instructions]. Our first question comes from the line of Mr. Trevor Cranston of JMP Securities. Sir, your line is now open.

Question on sort of near-term asset allocation, so obviously, you guys took up the agency position this quarter. When I think about the trend that had been going on for last couple of years you’d been making a concerted effort to move more into shorter duration [indiscernible] type assets. Are you thinking about the increase in the position in fixed rate agencies as a temporary place folder as you wait for better entry points in credit, or with the changing can actually profile. Are you guys thinking of that as an asset cost that you’re more comfortable holding again? Thanks.

I think that we view it as really evaluating the different classes against each other for risk return. For the first time in a long time, we’ve seen agency ROEs in the, call it 12% to 13%, range hedged, and with rates 100 basis points higher essentially, the complexity profile looks better. So, right now that looks like the most attractive place to go. We still have a lot of assets in shorter duration ADCs also and hybrid arms in 15 years. And also we had a lot of legacy, especially on the residential side, with a lot of legacy assets that continue to pay-down that we need to redeploy also. So, I would say, going forward, we think right now ADCs look best, but we do see credit opportunities we have plenty of dry powder to make that happen.

And on the funding side for agencies, can you comment on where you're seeing repo rates trending in the first quarter versus where they were towards the end of the year, and on an absolute basis or versus LIBOR or anything else you would like to talk to.

We see them trend, while you always have the year-end funding pressures, we saw low to mid 90's going into year end, anything that was capturing. And we’ve seen that come off 10 to 15 basis points. So, right now, one month repo on agency MBS is in the low 80's.

Thank you, Mr. Cranston. Our next question comes from the line of Mr. Joel Houck from Wells Fargo. Sir, your line is open now.

So, given the commentary about where spreads gone, which is I guess a huge mystery. I'm wondering what you’re thoughts are in terms of selling credit assets into strength there. I mean, obviously, a lot of these are legacy in there, their money good. But maybe give us your thoughts if you can parse it out between the various subsectors of residential credit. Where you might be looking to sell and where you’re comfortable holding through the cycle?

I think at current spread levels we’re still comfortable holding, and that’s primarily based on our fundamental view in both residential house and in commercial credit. Certainly, there is spread levels where you would likely become a seller. But I think if we were to give another significantly tighter, we most likely consider potentially selling. Or if our fundamental view deteriorated at all, we might consider selling. So, long as our fundamental review remains relatively positive, we’ll still probably continue to hold our current position and look for opportunities to add refi bonds that make sense. But you have to summarize, clearly there will be a spread level if we continue to tighten remaining, start to lighten up and move into agencies or other sectors that might appear attractive or have lagged the tightening.

And is there a hard limit in terms of the agency exposure? Obviously, you pointed out, it's more attractive for a lot of reasons right now. But is there some type of limit, or is this is one of those things where as long as agency remains as -- the complexity profile looks good, there are reasons where you could simply take that up, and there aren’t any limits?

No, there is no hard limit really to tending the sector, subject to the accruals that agency MBS are the most probably relative to the whole full test. So, no, there is no effective limit for agency exposure.

Thank you, Mr. Houck. Our next question comes from the line of Mr. Bose George of KBW. Sir, your line now is open.

It’s Eric on for Bose. I'm trying to square-up the market you reported on your CMBS segment this past quarter. I think we expected spreads to be tighter there. So, if you can just comment on what drove that negative $0.81 and hit the book value?

I think that reflects just dollar prices on the bond for the duration. I would say our average duration on our CMBS book is probably five to six years. So, you can get 85 basis points move in rates, and that’s going to have pretty significant impact. So, we did see spread tightening but not offset just the deterioration move there.

And we do, obviously, hedge that in our swap portfolio as well.

So, that’s not -- when we break that out, the swaps just separates but they’re not attached to the assets that are hedging in that [indiscernible].

But I typically associate the swaps with just the agency book. Is that -- should I continue doing the same thing going forward?

It's really the CMBS and the agency book where all the duration lies. The residential credit book has very little duration. So, yes, really those two sectors that the swaps are hedging.

And what are your expectations around fed policy this year? And the core, the three core segments of yours, have you changed the way you approach any of those strategies with regard to hedging or asset allocation based on your expectations for the short-end of the yield curve?

We really haven’t. I would say our expectations are not very far off of market with potentially to degree news by the fed. We do think on the longer end we established a higher trading range here. Certainly, the expectation for fiscal policy has driven this reflation or Trump trade. But you kind of see tax will go on this will be pushed off or rather more present matters. We’ve got issues in the EU with reason the headlines again and we’re trying to get momentum. And we do see a lot of continued factors that could hold the long end lower and potentially calling the question, how many times the fed move? So, right now if the data continues on its current trajectory, borrowing any order of that risk, I think two to three probably is the right answer. But certainly we do see some risk out there that could call that into question.

Thank you. At this time, there are no further questions [Operator Instruction]. And that concludes today's conference. Thank you all for participating. You may now disconnect.