Q1 2024 Invesco Mortgage Capital Inc Earnings Call

Participants

Greg Seals; IR Contact Officer; Invesco Mortgage Capital Inc

John Anzalone; Chief Executive Officer; Invesco Mortgage Capital Inc

Brian Norris; Chief Investment Officer; Invesco Mortgage Capital Inc

Trevor Cranston; Analyst; Citizens JMP

Eric Hagen; Analyst; BTIG

Presentation

Operator

Welcome to Invesco Mortgage Capital Incorporated's first-quarter 2024 investor conference call. (Operator Instructions) As a reminder, this call is being recorded.
Now I would like to turn the call over to Greg Seals in Investor Relations. Mr. Seals, you may begin.

Greg Seals

Thanks, operator, and to all of you joining us on Invesco Mortgage Capital's quarterly earnings call. In addition to today's press release, we have provided a presentation that covers the topics we plan to address today. The press release and presentation are available on our website, invescomortgagecapital.com. This information can be found by going to the Investor Relations section of the website.
Our presentation available include forward-looking statements and certain non-GAAP financial measures. Please review the disclosures on slide 2 of the presentation regarding these statements and measures as well as the appendix for the appropriate reconciliations to GAAP. Finally, Invesco Mortgage Capital is not responsible for and does not edit nor guarantee the accuracy of our earnings teleconference transcripts provided by third parties. The only authorized webcast are located on our website.
Again, welcome, and thank you for joining us today. I'll now turn the call over to John Anzalone.

John Anzalone

All right. Well, good morning, and welcome to Invesco Mortgage Capital's first-quarter earnings call. I'll provide some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss our portfolio in more detail. Also joining us on the call this morning are our President, Kevin Collins; our CFO, Lee Phegley; and our COO, Dave Lyle.
The first quarter was characterized by sharply higher interest rates across the yield curve, as persistent inflation and strong economic data led to a repricing of the market's expectations of future monetary policy. These expectations, as reflected in the federal funds futures market, adjusted from projecting over six cuts in the Federal Reserve's benchmark rate during the balance of 2024 for less than two cuts today. Despite the sharp increase in interest rates, interest rate volatility fell as market expectations for monetary policy converged with official projections by the FOMC.
In addition, organic mortgage supply remains at very low levels, while demand from money managers, commercial banks, and overseas investors broadly outpaced expectations. Against this backdrop, higher coupon agency mortgages outperformed treasuries, given the decline in interest rate volatility and improvement in supply and demand dynamics in the quarter. These factors led to a positive economic return of 4.8% for the quarter, consisting of a 0.8% increase in our book value combined with a $0.40 common stock dividend.
Our debt-to-equity ratio ended the quarter at 5.6 times, down modestly from 5.7 times as of year-end. At the end of the quarter, 94% of our $5 billion investment portfolio was invested in agency mortgages, 5% invested in Agency CMBS, with the balance in credit assets. Our liquidity position remains strong as we maintained a sizable balance of unrestricted cash and unencumbered investments totaling $451 million at quarter end.
We began to build an allocation to Agency CMBS during the quarter, and we believe this position will benefit the portfolio in a number of ways, most notably by providing stable cash flows with minimal prepayment risk, attractive returns, and favorable funding. During the quarter, Agency CMBS spreads tightened as new issuance volumes remained relatively low, funding improved, and higher yields drove investor demand for fixed rate bonds.
Earnings available for distribution was supported by attractive interest income on our target assets, favorable funding, and low-cost pay fixed swaps. For the quarter, EAD per common share was $0.86, down from $0.95 last quarter, primarily due to adjustments to our hedge portfolio is still comfortably above our $0.40 dividend.
The trends of higher inflation readings combined with positive economic growth have continued into the second quarter.Interest rates have continued to move higher as expectations of the timing and magnitude of rate cuts adjust. This has led to an increase in interest rate volatility and has put pressure on mortgage valuations.
To that end, as of May 3, our book value was down approximately 2.5%. Given the increase in market volatility we have seen since quarter end, we remain cautious on the near-term outlook for the agency mortgage sector. Our recent allocation to fixed-rate Agency CMBS reduces our exposure to near-term interest rate volatility while providing attractive returns with favorable funding.
Over the longer term, however, the potential normalization of monetary policy and a steeper yield curve should be supportive of agency mortgages. We believe agency mortgage investors stand to benefit from attractive valuations, favorable funding, and robust liquidity as the macro environment evolves.
I'll stop here, and Brian will go through the portfolio.

Brian Norris

Thanks, John, and good morning to everyone listening to the call. I'll begin on slide 4, which provides an overview of the interest rate and agency mortgage markets since the beginning of last year. As shown on the chart in the upper left, US treasury yields increased across the yield curve, largely in parallel fashion during the first quarter. Yields on maturities from 2 years to 30 years rose between 25 and 40 basis points, given a pause in the disinflationary trend in the US amidst resilient economic growth. The chart on the bottom left details pricing in the Fed funds futures market over the past year.
At the end of the first quarter, market pricing reflected expectations for just three 25-basis-point cuts in the target rate in 2024 after beginning the year pricing at more than six. Since the end of the first quarter, this has declined to less than two cuts in 2024, as first-quarter inflation data remained elevated. Given the Fed's dot plots indicate two to three cuts this year, the market has moved from pricing in more accommodation than the Fed's projections to largely being in line, leading to a decline in interest rate volatility despite the increase in interest rates.
The decline in interest rate volatility, combined with the increase in interest rates, provided a supportive backdrop for higher coupon agency mortgages. While runoff of the Federal Reserve's holdings of agency mortgages continues to increase net supply to the market, domestic bank holdings in Agency MBS also increased, supporting the supply and demand dynamics of the sector.
Slide 5 provides more detail on the agency mortgage market. In the upper left chart, we show a 30-year current coupon performance versus US treasuries over the past 12 months, highlighting the first quarter in gray. Despite underperformance to start the quarter, production coupon agency mortgage valuations rebounded in March as interest rate volatility declined.
Ultimately, higher production coupons modestly outperformed treasuries during the quarter with nominal spreads relatively unchanged. Specified pool pay-ups were largely unchanged during the quarter as well as illustrated in the chart on the top right. Lastly, as shown in the lower right chart, the dollar roll market for TBA securities remained unattractive as implied financing rates continue to exceed short-term funding.
Slide 6 details our agency mortgage investments and summarizes the investment portfolio changes during the quarter. Our Agency RMBS portfolio decreased by 6% quarter over quarter, given the modest rotation into Agency CMBS through a combination of sales and paydowns during the quarter. We remain focused at more attractively priced higher coupons, which benefit from a decline in interest rate volatility and are largely insulated from direct exposure to assets held by commercial banks and on the Federal Reserve's balance sheet.
In addition, we remain exclusively invested in specified pools, where funding remains more attractive than what is available in the dollar roll market for TBA securities.We focused our specified pool allocation on prepayment characteristics that are expected to perform well in both premium and discount environments and modestly improved the quality of our specific pool holdings by increasing our allocation to lower loan balance stories.
Although we anticipate interest rate volatility to remain moderately elevated in the near term, we believe current valuations on production coupon Agency RMBS largely price in this risk and represent attractive investment opportunities, with current gross ROEs in the mid to high teens.
Slide 7 provides detail on our Agency CMBS purchases as well as an overview of the benefits of the sector. We purchased $264 million in the first quarter, which represents approximately 5% of our investment portfolio. We believe Agency CMBS provides numerous benefits to the portfolio, primarily through its prepayment production and [balloon-light] maturities, which reduces our sensitivity to interest rate volatility. Gross ROEs on new purchases were in the low double digits in the first quarter, but given strong performance in the sector so far in the second quarter, that has declined to the high single digits.
Financing has been robust, as we have been able to finance our purchases with numerous counterparties at attractive funding levels. We will continue to monitor this sector for opportunities to increase our allocation as they become available, recognizing the overall benefits to the portfolio as the sector diversifies risks associated with an Agency RMBS portfolio.
Our agency CMO allocation is detailed alongside our remaining credit investments on slide 8. Our allocation to both agencies interest-only and credit securities remains largely unchanged, with $75 million allocated to agency IO and $18 million allocated to credit at quarter end. Although we anticipate limited near-term price appreciation in these investments, we believe they provide attractive yields for unlevered holdings with returns in the high-single digits.
Slide 9 details our funding and hedge book at quarter end. Repurchased agreements collateralized by Agency [RMBS] declined modestly from $4.5 billion to $4.4 billion, while our net notional pay-fixed interest rate swaps increased from $4.1 billion to $4.3 billion as the ratio of our hedges to borrowings increased to 97% from 91% last quarter.
We continue to maintain a high hedge ratio as monetary policy remains restrictive. The increase in interest rates led to further repositioning of the hedge book as the interest rate sensitivity of our assets increased, warranting a similar increase in the weighted average maturity of our interest rate swap hedges.Reflecting this change, the weighted average maturity of our hedges increased from 6.6 years at the end of 2023 to 7.2 years, resulting in a modest increase in the weighted average coupon on our pay fixed swaps, negatively impacting earnings available for distribution.
Positively, we retained much of the benefit of our low-cost pay fixed swaps with an attractive weighted average coupon on our hedge portfolio of 1.17%. Leverage at the end of the quarter at 5.6 times debt to equity, down from 5.7 times at the end of December, given the modest improvement in book value.
Slide 10 provides further detail on our asset yields and funding costs. Interest rates on our repurchase agreements were largely unchanged at 5.5% at quarter end, and yields on our Agency RMBS portfolio increased modestly to 5.4%, while the pay rate on our interest rate swaps increased from 1.1% to 1.17%. Overall, our effective interest rate margin declined, but remained very attractive at just over 4%, highlighting the benefit of our remaining legacy swap portfolio.
To conclude our prepared remarks, we continue to believe IVR is well positioned to navigate future mortgage market volatility and selectively capitalize on historically attractive Agency RMBS spreads, which provide a supportive backdrop for long-term investment. Our recent allocation to Agency CMBS mitigates our exposure to further balance of heightened interest rate volatility, such as what was experienced in April of this year, while our remaining agency mortgage holdings should benefit from a potential normalization of the yield curve, interest rate volatility, and agency mortgage valuations.
Further, our liquidity position remains robust and provides more than adequate cushion for further stresses in the market, while also providing ample resources to deploy into our target assets as the investment environment improves.
Thank you for your continued support of Invesco Mortgage Capital, and now we will open the line for Q&A.

Question and Answer Session

Operator

(Operator Instructions) Trevor Cranston, Citizens JMP.

Trevor Cranston

On the new allocation to Agency CMBS, looking at the spread tightening that's happened in that asset class over the last several months, would you look to be continuing to add that to the portfolio where spreads sit today? Or is that something where you'd like to see spreads widen out further before increasing the allocation further there? Thanks.

Brian Norris

Sure, Trevor. Hey, it's Brian. Like I said, spreads have tightened really throughout the first quarter end and through April as well to where ROEs are kind of in the high single digits at this point. So we certainly slowed down our purchase activity at this point. It continues to be a relative value play between the two sectors. And right now, we think Agency RMBS is a little bit more attractive.
So certainly, there are benefits to the Agency CMBS portfolio to our overall portfolio. But at this point, we think that spreads there have gotten pretty stud here, so we've slowed down.

Operator

(Operator Instructions) Eric Hagen, BTIG.

Eric Hagen

Can you share any perspective on the supply of prepay-protected specified pools in the higher coupons and how active you guys have been there? And then just kind of separately, we're talking about the higher coupon products in your portfolio just in general, but how much prepayment variability do you maybe see, like, developing within the coupon stack at different levels of interest rates?

Brian Norris

Yes, sure. Eric, it's Brian. I think, at our size, the supply of specified pools is certainly not prohibitive. I wouldn't necessarily say we've been active. We haven't really been increasing the size of the portfolio, given where volatility is and are, I guess, hesitant to increase leverage at these levels. So we're pretty pleased with the allocation that we have currently, split between the various stories that you see in the presentation there. So I wouldn't say that we've been too active. And like I said, we were mostly, in the first quarter, reinvesting paydowns into the Agency CMBS allocation, so there hasn't been any additional purchases there.
As far as variability of prepayments, I think we've been hesitant, obviously, to add significantly higher coupons, 6.5 and 7s. Those prepayments have been fairly well contained at this point, just given what we've seen in rates. But our overall belief is that the Fed will be, at some point, cutting rates, rates should be moving lower, and that those very high coupons could come under some pressure in that scenario. So we're pretty comfortable continuing to own kind of 4s through 6s at this point.

Eric Hagen

Okay, great. That's helpful. Hen you set the dividend and you see the yield and the stock trading near the highest in the sector right now, how do you think the stock could trade at higher levels of leverage from here? Do you feel like there is support for the dividend if the Fed leaves rates higher for longer and you need to maybe raise your leverage at some point?

Brian Norris

I think it's mostly about interest rate [ball] for us. I think we certainly have the capacity to add to leverage if we're comfortable doing so. But at this level, at the current dividend, we feel pretty comfortable with where we are. So we don't feel the need that we need to increase leverage.

Operator

(Operator Instructions) And at this time, we have no further questions.

Greg Seals

Okay, well, thank you everybody for joining us, and we look forward to meeting you again next quarter. Thanks.

Operator

Thank you. That concludes today's conference. Thank you for participating. You may disconnect at this time.