Invesco Mortgage Capital Inc. (IVR) Q1 2021 Earnings Report, Transcript and Summary

Welcome to the Invesco Mortgage Capital Inc.'s First Quarter 2021 Investor Conference Call. [Operator Instructions] As a reminder, this call is being recorded. Now I would like to turn the call over to Jack Bateman in investor relations. Mr. Bateman, you may begin.

Thank you, and welcome to the Invesco Mortgage Capital First Quarter 2021 Earnings Call. The management team and I are delighted you've joined us and we look forward to sharing with you our prepared remarks and conducting a question-and-answer session. Before turning the call over to our CEO, John Anzalone, I wanted to provide a reminder that statements made in this conference call and the related presentation may include forward-looking statements, which reflect management's expectations about future events and our overall plans and performance. These forward-looking statements are made as of today and they're not guarantees. They involve risks, uncertainties and assumptions, and there can be no assurance that actual results will not differ materially from our expectations. For discussion of these risks and uncertainties, please see the risks described in our most recent annual report on Form 10-K and subsequent filings with the SEC. Invesco makes no obligation to update any forward-looking statement. We may also discuss non-GAAP financial measures during today's call. Reconciliations of these non-GAAP financial measures may be found at the end of our earnings presentation. To view the slide presentation today, you may access our website at invescomortgagecapital.com and click on the Q1 2021 earnings presentation link under Investor Relations. Again, welcome and thank you for joining us today. I'll now turn the call over to John Anzalone. John?

Good morning, and welcome to Invesco Mortgage Capital's first quarter earnings call. I will give some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss the current portfolio in more detail. Also joining us on the call to participate in the Q&A are our President, Kevin Collins; our CFO, Lee Phegley; and our COO, Dave Lyle. I'm pleased to announce the core earnings came in at $0.11 per share for the quarter, exceeding our recently increased dividend of $0.09 per share and $0.01 better than last quarter. The increase core run rate reflects the benefit of having our portfolio fully reallocated to an agency-focused strategy, as well as a successful deployment of $161 million of common equity that we raised during the quarter. Our book value is down 5.4% for the quarter to $3.65 per share. The decrease in book value reflected the under-performance of lower coupon mortgages, as well as the repricing of pay-ups on specified pool collateral, which fell as the market priced in slower prepayment speeds as mortgage rates increased. The combination of the increased dividend and the decline in book value produced an economic return of negative 3.1% for the quarter compared to increases of 11% and 13.5% during the third and fourth quarters of 2020, respectively. Our cumulative economic return since June 30, 2020, was 22.1%. During the quarter, optimism around the prospects for increased economic activity was driven by the potential impact of stimulus programs, the continued rollout of vaccinations and the significant decline in new infections. While this renewed optimism was supportive of many risk markets through the quarter, fixed income investors began pricing in the potential for higher inflation. In fact, we saw price increases across commodities as well as in broader inflation gauges during the quarter. In Treasury breakeven rates, which reflect the market's expectation of future inflation, reached multi-year highs. These inflation fears led to sharp increases in both rate volatility and in the long end of the yield curve. These factors contributed to the under-performance of lower coupon agency mortgages during the quarter despite continued strong demand from the Fed. While a steeper curve and slowing prepayment speeds contribute to a better environment for prospective ROEs, these factors also caused repricing of pay-ups on some specified pool collateral as the value of prepayment protection decreased. Brian will get into the details in a minute, but we ended the quarter with 99% of our assets and 91% of our equity invested in agency mortgages, reflecting the completed reallocation of the portfolio. Our liquidity position remains strong, as we had $693 million of unrestricted cash and unencumbered assets at quarter end. As you look out over the next several quarters, we expect demand from the Federal Reserve and commercial banks to be supportive of valuations despite relatively tight spreads, elevated interest rate volatility and an increase in net supply. Our focus on active management and security selection when purchasing specified pool collateral helps to mitigate these risks, and we believe the steeper yield curve, slowing prepayment speeds and attractive funding environment should improve agency mortgage ROEs. I'll stop here and let Brian go through the portfolio.

Thanks, John, and good morning to everyone listening to the call. I'll begin on Slide 4, which details the changes in the U.S. Treasury yield curve during the first quarter in the upper left-hand chart. The successful early rollout of the COVID-19 vaccine and improving economic recovery and higher inflation concerns led to a fair steepening move in interest rates, as the short end remained anchored, while maturity 7 years and longer increased approximately 80 basis points during the quarter. This sharp move higher in interest rates resulted in elevated interest rate volatility during the quarter, as indicated by the light blue line in the lower left hand chart. The contrast between interest rates and equity market volatility, as indicated by the dark blue line in the same chart, is notable, as equity markets continue to improve despite the volatility in fixed income markets. The sharp move higher in interest rates and volatility negatively impacted our agency RMBS valuations, as the resulting increase in mortgage rates and slowing prepayment speed expectations led to lower specified pool pay ups and longer durations on our holdings. Positively, the upper right hand chart displays the impact monetary policy has had on short-term funding rates, which continued to improve during the quarter and is supportive of ROEs for our target assets. Lastly, in the bottom right chart, we detailed the growth in both commercial bank and Federal Reserve holdings of agency RMBS, which has been consistent and kept valuations relatively rich, despite their under-performance in the first quarter. While expectations for net supply in 2021 have increased to over $600 billion, eclipsing 2020s total of just over $500 billion, we anticipate demand from the Federal Reserve and commercial banks to more than absorb the increased amount, keeping supply and demand dynamics in the sector supportive of valuations in the coming quarters. Moving on to slide 5, where we provide more detail on the agency RMBS market. In the upper left-hand chart, we show generic lower coupon agency RMBS cumulative performance versus swap hedges since June 30 of last year, highlighting the first quarter of 2021 in gray. As you can see, strong support from the federal reserve and commercial banks drove strong performance in 30-year 2% and 2.5% coupons in the second half of 2020. However, the sharp increase in interest rates and volatility led to under-performance in the first quarter, particularly in late February, before recovering modestly in March. In addition, specified pool pay-ups, as shown in the upper right, reflected higher mortgage rates and increased expectations of slowing prepayment speeds, as they continued the modest descent that began in the fourth quarter and ended the first quarter sharply lower. The chart in the lower left shows the continued increase in prepayment speeds for lower coupon mortgages during the quarter, as the impact from the increase in mortgage rates in February is unlikely to impact speeds until the report for April is released later today. We expect prepayment speeds and lower coupons to slow meaningfully in the coming months, while higher coupons are likely to decline more modestly and remain elevated as increased mortgage industry capacity focuses on more seasoned loans that had yet to refinance. Finally, the lower right-hand chart details the implied financing rate for dollar roll transactions in 30-year 2%, 2.5% and 3% TBAs. The implied financing rate is the reinvestment rate for which an investor is indifferent between taking delivery of a mortgage pool or rolling the TBA contract forward 1 month and investing the cash. As indicated in the chart, implied financing rates increased during the quarter, modestly reducing the attractiveness in dollar rolls. Despite this decline, the dollar roll market remains attractive, providing more attractive returns and higher liquidity over specified pools for agency RMBS investors. Slide 6 provides detail on our agency RMBS investments. As indicated in the upper left-hand chart, in addition to the 15% allocation to agency TBA, our agency RMBS portfolio is well diversified across specified pool of collateral types. We remain focused on lower price collateral stories, mitigating our exposure to elevated pay-ups and historically tight spreads, as our specified pool holdings had a weighted average pay up of 0.5 point as of 3/31, a decline of approximately 0.25 point during the quarter. We increased our investment in agency RMBS inclusive of TBAs to $10.5 billion during the quarter, reflecting the deployment of proceeds from capital raises during the quarter into the sector. In addition, we continue to optimize the portfolio through active management, rotating out of $5.5 billion of lower yielding specified pools during the quarter, reinvesting proceeds into more attractive, higher yielding pools, underscoring the superior liquidity of the asset class. Lastly, we reduced our allocation to agency TBA investments by $200 million notional, given the modest decline in the attractiveness of the dollar roll market. Our specified pool holdings paid 6.3% CPR during the quarter, as our relatively newly issued pools had a weighted average loan age of 4.3 months at quarter end. We anticipate expected prepayment speed increases from further seasoning on our holdings will be largely offset by higher mortgage rates, as our lower coupon holdings are no longer refinanced targets. We remain focused primarily in 30-year 2% and 2.5% coupons, as those coupons provide the most attractive combination of lower prepayment speeds and strong support via consistent Federal Reserve and commercial bank demand, but continue to search for attractive higher coupon options to diversify our asset composition. Our remaining credit investments are detailed on Slide 7, with nonagency CMBS representing 66% of the $138 million portfolio. The modest decline during the quarter is reflective of pay-downs, as the disposition during 2020 have resulted in an appropriately sized unlevered credit portfolio, which represents 9% of our total equity. Our $102 million of remaining credit securities are high quality, with 65% rated A or higher. And we remained comfortable with the credit profile of our remaining holdings. Although we anticipate limited near-term price appreciation, given the significant improvements experienced since the lows were reached in the second quarter of 2020, we believe these assets are attractive holdings, as 100% are held on an unlevered basis and provide attractive unlevered yields. Lastly, Slide 8 details the growth of our funding book during the first quarter, as shown in the chart on the upper left. REIT purchase agreements collateralized by agency RMBS grew to $8.2 billion as of March 31, reflecting the growth in our total assets, given the successful deployment of proceeds from capital raises during the quarter into agency RMBS assets. Hedges associated with those borrowings remained unchanged during the quarter at $6.3 billion notional of fixed to floating interest rate swaps, as further confidence in the duration of the Federal Reserves accommodative monetary policy stance provided an opportunity to reduce our hedge ratio from 88% to 77% during the quarter. The weighted average interest rate on our hedge book remained unchanged at 41 basis points, while further improvements in the funding rates on our agency RMBS holdings led to a weighted average funding rate of 15 basis points as of March 31. In order to mitigate the negative impact of rising interest rates on our new purchases, we entered into $1.3 billion notional of forward-starting interest rate swaps with starting dates in 2022 and 2023, concurrent with our expectations for potential adjustments in monetary policy. Our economic leverage when including TBA exposure remained unchanged during the quarter at 6.6x debt to equity, as we remain conservatively positioned given the rich valuations in our target assets. To conclude our prepared remarks, we are very pleased with the transition of the portfolio since June 30 of 2020 and our ability to restore meaningful dividends for our investors. We believe our cumulative economic return of over 22% since the second quarter of 2020 reflects the benefits of our strategy and management's ability to provide attractive returns to our investors. The agency RMBS market continues to be well-supported by the Federal Reserve purchase program as well as commercial bank demand. And while agency RMBS spreads appear tight, recent under-performance and bear steepening of the yield curve will benefit investment opportunities, as higher mortgage rates and slowing prepayment speeds provide an improved environment for ROEs in the coming quarters. In addition, monetary policy remains very supportive and we expect that to continue throughout 2021, as the Federal Reserve communicates a desire to maintain an accommodative a stance over the medium term. Lastly, our careful security selection and active management will mitigate the impact of potentially higher interest rate volatility as the Fed approaches an expected tapering of asset purchases in early 2022. Thank you for your continued support for Invesco Mortgage Capital, and we will now open the line for Q&A.

[Operator Instructions] Mikhail Goberman with JMP Securities.

Just wanted to get a sense of maybe where you're seeing book value trending thus far in the second quarter.

Yes, this is John. Book value has been relatively flat since quarter end.

I'm currently showing no additional questions. [Operator Instructions] [ Jason George with JG Investments. ]

My question is, do you see any more headwinds in the future quarters like we had in Q1, for example, the steepening of the yield curve or higher mortgage rates that will affect the portfolio?

Yes, this is Brian. I think agency mortgage spreads are pretty tight, so valuations are relatively rich. But practically, the entire fixed income universe is hit pretty rich and valuations pretty tight as well. So I think that will help keep a lid on spread widening. And also pretty strong demand from the Fed and commercial banks will also prevent a significant amount of widening. But risks -- at this point, risks are likely to be skewed wider more so than tighter at this point.

[Operator Instructions]

Okay. Well, I guess if there's no further questions, we'd like to thank everybody for joining the call and we'll talk to you in another 3 months.

Thank you for your participation in today's conference. You may disconnect at this time.