Invesco Mortgage Capital Inc. (IVR) Q2 2017 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital Incorporated Second Quarter 2017 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, [Riana], and good morning everyone. Again, we really want to thank you for being part of our call this morning and we welcome you to the Invesco Mortgage Capital second quarter 2017 earnings call. I am Tony Semak with Investor Relations and our management team and I are delighted that you have joined us as we look forward to sharing with you our prepared remarks during the next several minutes before we conclude with a question-and-answer session. Joining me today are John Anzalone, Chief Executive Officer; Rob Kuster, President and Chief Operating Officer; Lee Phegley, Chief Financial Officer; and Jason Marshall, Chief Investment Officer. Before we begin, I will provide the customary forward-looking statements disclosure and then we will 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 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, our financial performance, including our core earnings, economic return, comprehensive income and changes in our book value, our ability to continue performance trends, the stability of portfolio yields, interest rates, credit spreads, 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 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, if any forward-looking statement later turns out to be inaccurate. To view the slide presentation today, you can access our website at invescomortgagecapital.com and click on the Q2, 2017 earnings presentation link. You can find under the Investor Relations tab at the top of our home page. There you can select either the presentation or the webcast option for both the presentation slides and the audio. Again, we welcome you and thank you very much for being a part of our call today. And we are now going to hear from our Chief Executive Officer, John Anzalone. John?

Thanks, Tony, and thanks to everyone dialing into the call. I will give some brief remarks about our performance and market outlook before turning the call over to Jason, who will cover highlights of our asset positioning and the contribution to returns. I am pleased to report that Invesco Mortgage Capital had another strong quarter as we delivered core earnings of $0.41 per share versus our $0.40 per share dividend declared in June and a 1.8% increase in our book value per share. Active asset allocation, a highly diversified portfolio and beneficial security selection led to a 4% economic return for the quarter, among the highest in our peer group in relation to those reporting second quarter results to-date. For the first half of 2017, we have delivered an economic return of 9.1% likewise among the highest in our peer group year-to-date. This trend has continued as we entered the third quarter with book value higher by just under 2% since the end of June. One of our objectives has been to not only deliver attractive returns to our investors but to deliver consistent returns. On the lower right side of Slide 4, we illustrate how the volatility of our book value has declined meaningfully since the end of 2013 and has remained at historically low levels during the last several quarters. In large part, this is a function of the diversification of our portfolio as well as our investment selection. Coupling a good mix of agency mortgages and residential and commercial mortgage credit with a disciplined risk management framework and prudent liquidity management process has served us well again. During the second quarter, we received positive contributions to our book value per share from each of our core sector allocations, including agency CMBS, residential credit and commercial credit. The residential credit accounted for a substantial majority of the book value per share increase as exhibited in the bar chart on Slide 4. Our investment selection has also been instrumental and driving book value volatility lower, as we have had a very large percentage of our portfolio invested in seasoned credit, which is benefited from favorable fundamentals, favorable supply demand dynamics and contracting spread duration. This approach has also allowed us to maintain a steady $0.40 dividend for the past eight quarters while generating core earnings either in line with or in access of the declared dividend in seven of those past eight quarters. You may recall the only exception occurred in the fourth quarter of last year as a result of our short-term defensiveness to protect book value ahead of their approaching watershed moments including U.S. General Election in the December Fed meeting. On Slide 5, I would like to highlight that not only we delivered consistent returns but we have also compared favorably to our peers on a number of key industry metrics which we believe often gets overlooked. Our economic returns have exceeded the peer group average in each of the past three calendar years and have also outperformed on a trailing three and five year basis. On a book value basis, we also stack up quite favorably, having outperformed the peer group average by 9.5% over the past year, 8.5% over the past three years and by nearly 11% over the past five years. I felt compel to highlight these favorable comparative results because despite they consistent outperformance to remain a major disconnect between our common stock valuation versus these same peers, as we traded a significant discount to this group on a price to book basis. I continue to believe that this is unwarranted when considering the most commonly accepted measures as excess in our industry. I wrap up by making a few comments on our outlook for the rest of the year. We continue to feel good about our positioning and still see more tailwinds for the portfolio. As prepayments speeds are likely to remain subdued as we head into the fall in winter months. Credit fundamentals remain sound, asset seasoning continues to work on our favor, and we are still looking at negative net issuance and structured credit for the foreseeable future. While we believe the Fed will likely begin to taper their agency reinvestments soon, this has been well telegraphed and the market has been relieved that the pace of taper is going to be very gradual. We still see attractive incremental investment opportunities as ROEs in the low teens are still available in both agency mortgages as well as in CMBS, and we continue to look to add GSE credit risk transfer paper opportunistically. Importantly, we remain confident in our ability to generate a core earnings streams sufficient to meet or exceed our dividend -- current dividend in near term. I will stop here and turn the call over to Jason before taking questions.

Thanks, John. Consistent with our expectations, interest rates remained in a relatively narrow range during the second quarter as economic growth remain moderate and core inflation remain materially below the federal reserve target rate of 2%. Interest rates were hopped down to some degree by gridlock in Washington as no major legislation was passed during the quarter and the timeline for a potential comprehensive fiscal bill was pushed further out possibly into 2018. The continuation of the range period coupled with low spread volatilities in most major asset classes, resulted in a favorable environment for spread assets. With all the sectors that we invest in performed well during the quarter and led by credit risk transfer bonds. I'll now discus portfolio activity in a little more detail. The portfolio equity allocations remain stable during the quarter with purchased activity concentrated in 30 years, 3.5 and subordinated CMBS. On a net basis, these sectors are increased 230 million and 108 million respectively. While we continue to view residential credit fundamentals as positive, activity was limited during the quarter. Spread tightening has compressed the availability of the attractive returns of the sector. In agency space, we continue to add specified pools and stores that we believe offer the most compelling value. While in CMBS, we continue to capital on select opportunities and risk retention eligible transactions with strong loan underwriting, which further supports comparably high credit quality orientation of our portfolio. And lastly on the financing side, we did not add any new swaps during the quarter as asset balances and convexity remain relatively stable. Overall, our duration position was long with a slight bias towards flattening during the quarter. To further elaborate, our empirical duration was generally in the four areas for most of the quarter. And given our views on the economy inflation and interest rates, we remain comfortable with our current duration and current positions. And financing markets, both agency and credit repo remain broadly available and terms remain -- have improved slightly versus spread to LIBOR. So, we continue to see gradual improvements there. To summarize, while spreads have tightened in the sectors in which we participate, we continue to deploy capital at accretive levels. Additionally, we continue to see pockets of attractive ROE assets where we can direct discretionary or marginal cash. The fundamental environment coupled with our current equity reallocation will allow us to continue to generate dividends --attractive dividends for our shareholders. This concludes my prepared remarks. Operator, could you pleased open the lines for questions?

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Eric Hagen of KBW. Sir, your line is open.

I know that you already have some credit hedges in place. But how effective do you think it would be to hedge more of the market risk exposure in the CMBS portfolio? Specifically, using an instrument like CMBX? Thanks.

We continue to remain comfortable with our asset selection and still generally we have a positive fundamental view of commercial real estate. That’s something we do look at. We currently don’t have any CMBX hedges on, but they're relatively expensive from a carry perspective. So, you do gain a lot of that -- lot of the ROE on that book, if you put those hedges in place. I just don’t think we got -- if our fundamental view deteriorates that might be something we consider. But given our asset selection process, we do still remains comfortable with our exposures. Now, sure, if spreads -- spreads could widen and we could take some hit to book value, but we continue to be confident in our process and those bonds are money good. But it is something that we look at and certainly, it would be driven more by change in our fundamental view of CRE fundamentals.

And then it looks like the level of credit enhancement in your Re-REMIC's securities has moved lower over the last several periods. And I realize the Re-REMIC position is only about 10% of the resi credit portfolio, if you include the risk transfer. But how does the lower level of subordination impact the amount of leverage or able to take in that segment of the portfolio?

It's been relatively unchanged. A lot of that position has actually been paying off because we own the front portion of the bonds. So, I think some of the bonds with higher subordination as they de-levered with pay off as those have paid off that's pushing up or bringing down the overall subordination. But it's still at a high level on the remaining bonds, but we haven’t seen any deterioration in financing terms our ROE on those sector. But that sector is continued to pay down each quarter, so we continue to see that to manage as a portion of the overall residential credit book.

I think the financing levels in terms are largely determined by volatility of the asset class and like to Jason's point, these are becoming very short cash flows they are very stable. So, the financing terms have remained pretty stable also.

So just to be clear it doesn’t -- the level of subordination does not affect the actual hair cut or the amount of leverage you are able to take?

No, it hasn’t, no.

Next, we have Trevor Cranston of JMP Securities. Sir, your line is open.

I want to follow up on one of the John's comment in the prepared remarks about the improvement of book value since the end of June. Can you comment on because specifically what portions of the portfolio have been driving the strength since the end of June, if it's predominantly been constituted in resi credit or if it's more spread out than that?

It's Jason. It's been fairly spread out. We have actually seen -- we have seen some continued tightening in both commercial and resi credit space, but agency mortgages in spite the depending spread taper reinvestment have actually continued to tighten. So it's kind of at a slow grind tighter in most notably 30 year space, so it's been fairly broad based.

Okay. And when you guys look at the credit portfolio, it sounds like your fundamental view continues to be fairly positive. But with the amount of spread tightening we've seen in the last several months, are there any segments that you guys are sort of looking at opportunistically maybe selling at some point and reallocating the capital into agency CMBS for example or you still kind of comfortable holding what you have at June 30th?

Yes, at the margin we've been favoring agency CMBS. They've offered attractive ROE. With the credit assets, certainly, there is some point spreads continue to tighten where you think about lightening up from a relative perspective. But given our asset screening process and our credit process, we're hesitant to kind of swap in and out of different sectors just because it's not easy to kind of go out and then redeploy the capital and find bonds that were comfortable with and the exact vintages and such that we favor. So, the answer is, something we think about something we look at, and there I'm sure there are spread levels where we would do that, especially given if our fundamental view had change at all. But as of right now, we haven’t and don’t have any immediate plans to do anything broad sector rotation.

Well, I think the seasoning is the key because it is very difficult to replace the types of bonds we own -- so, I mean from those vintages and the assets -- that really is one of the drivers.

[Operator Instructions] We do not have any more questions at this time. [Operator Instructions]

Well, if there are no further questions, we're happy to conclude the call and we want to thank everyone for participating and the opportunity to report to you our results. We feel good about it. We are very much accepting of any further inquiries, if people want to reach out and ask further questions, happy to chat about that to the extent that we can. And again thank you for participating, looking forward to talking to you again. Have a great day.

Thank you. And that concludes today’s conference. Thank you for participating. You may now disconnect.