Invesco Mortgage Capital Inc (IVR) 2011 Q2 法說會逐字稿

This presentation and comments made in the associated conference call today may include forward-looking statements. Forward-looking statements include information concerning future results of operations, our ability to access capital markets, our estimate of expected returns on assets purchased with our recent capital raises, our outlook on the economy, our view on the US debt ceiling debate, the impact on the mortgage industry and our ability to capitalize on the changes, our ability to continue performance trends, the impact of economic trends have on our book value, our level of debt and our ability to obtain additional financing. 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 Discussion and Analysis of Financial Conditions and Results of Operations in our annual report on Form-K and from 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.

Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital Inc.'s investor conference call, July 28, 2011. All participants will be on a listen-only mode until the question-and-answer session. (Operator Instructions). As a reminder, this call is being recorded.

Now, I'd like to turn the call over to the speakers for today, Richard King, Chief Executive Officer; John Anzalone, Chief Investment Officer; and Don Ramon, Chief Financial Officer. Mr. King, you may now begin.

Thank you and good morning, everybody. Sorry for the slight delay. Welcome to the Invesco Mortgage Capital second-quarter 2011 earnings call. The speaker announced the people who are going to be on the call. We'll discuss our results here for the second-quarter of 2011 as well as assessment of the current market environment and then open it up for questions.

We're pleased that we had another strong quarter of earnings. We continue to like the environment, the continued steep yield curve, the Fed keeping short rates low. Pre-pays on our Agency mortgage portfolio are very well-behaved. And our Non-Agency pre-pays remain pretty fast. Our credit portfolio is performing as we expect. And we continue to concentrate on buying assets that have a lot of credit enhancement relative to expected loss and ones that have predictable cash flows. And we're not seeing anything of concern on that front at all.

In the quarter, we earned $0.99 per share despite ramping capital raises at the beginning and end of the second quarter. We paid out a $0.97 dividend. Our book value declined to $19.34 driven by lower rates on our interest rate swap hedges. These hedges are put in place to provide for attractive financing rates well into the future. We're able to swap out a large percentage of our borrowings, which will protect book value in the long run and still achieve expected returns in our target ROE range of 16% to 18%.

From period to period, the pricing on our assets and on our hedges move independently. This quarter, our Agency prices went up, but less than our hedges. Still, fundamentally, the hedges are doing what they're intended to do; that is protecting book value in the long run, maintaining an attractive net interest margin. And our asset yields remain high because of the favorable pre-pays and sound credit. Rates are very low, and while we do expect the Fed to keep short rates low and stimulative for the next year, we do see risk of rising rates and longer maturities before an eventual rise in short rates.

The capital raise we completed was meant to accomplish several things. It was accretive to our earnings and to book value, and we continue to add the scale, increase our stock's liquidity. We are efficient in getting the new capital to work to minimize drag, and we believe the recent raise will generate ROEs more like 18% to 20%. And we continue to believe that for the rest of 2011, there will be no recovery in housing and the government budget headwinds will keep growth contained and the Fed on hold.

The debt ceiling debate is largely a lot of posturing, and while we are glad to see more focus on cutting the deficit, we've also seen benefit via an improved opportunity set. We remain focused on locking in the low borrowing rates. We still see opportunities to reinvest capital at high teens ROEs in both credit and Agency space. And while we like this low rate environment, we're also set up well for when rates eventually rise. And we remain patient for opportunities that will arise when the government reduces its role in the mortgage market.

I'm going to now turn it over to Don Ramon to go over the Q2 financials.

Thank you, Rich. Turning to page 3 in the presentation, you can see that we continue to grow our net income with the increased capital levels. EPS for the second quarter, as Rich mentioned, was $0.99 compared to the dividend we paid of $0.97. We continue to see only minor differences between our GAAP and taxable income. Net income increased to $74.4 million, and the key driver of this was the interest income as we saw our average investment portfolio grow by $3.8 billion to $10.2 billion following the March and June capital raises. We expect to see this trend to continue well into the third quarter as we invest the funds from the June offering and those move into the portfolio.

During the quarter, we also recorded approximately $3.6 million in gains from sale of assets compared to $1.2 million in Q1. The remaining portion of the other income in our income statement primarily relates to revenue from our PPIP investment and the credit default swap that we have. And we consider both of these part of our investment income.

On the next page, we show a summary of the change in our book value for the quarter. As Rich mentioned in his opening comments, we enter into swaps in an effort to protect book value and income over the long run by locking up low borrowing costs. Our swaps have an average maturity of 5 years. Swap rates declined 43 basis points during the quarter, and Agency MBS prices rose, as you can see, having a positive impact on book value.

The Maiden Lane selling during the second quarter sparked a softening in the credit market. Our decision to hold higher credit quality assets really benefited us as we saw only modest declines in prices of our Non-Agency and CMBS positions and limited impact on book value. We've not had to recognize any other than temporary impairment on these assets in 2011. We believe this emphasis on quality is the right strategy. The June capital raise, as you can see, was accretive to book value, adding approximately $0.15.

Looking at the portfolio performance on the next slide, you can see that gross ROE increased 80 basis points from Q1 as the March capital raise was fully deployed during the quarter. The trend on our portfolio yield continued in the second quarter, coming in at 4.3% or unchanged from the previous two quarters. We did see a decline in our net yield of 30 basis points to 2.8% as our overall cost of funds increased related to our hedging strategy.

I'll now turn it over to John Anzalone, our Chief Investment Officer, to review the details of our portfolio.

Thanks. Thank you, Don. Let me start off by giving some portfolio highlights. The portfolio continued to grow throughout the quarter, and the chart on the upper left of slide 6 reflects that we had 68% of the equity from our June 21 capital offer invested by June 30. Once again, we invested closely to plan, with 55% in the Agency strategy and 45% going to credit. Our leverage increased to 5.7 times from 5.3 times reflecting greater leverage on higher-quality credit assets. We saw very good opportunities in both strategies and estimate that our gross ROEs will be in the 19% to 20% range. Our overall allocations of credit increased as we took advantage of improving risk-adjusted returns in both Non-Agency mortgages as well as in commercial mortgages.

Let's take a closer look at each sector. In Agency, the story remains intact with an extremely favorable pre-pay environment and low funding cost. We continue to find value in higher-coupon, specified full paper focusing on collateral backed by credit impaired borrowers, borrowers with low loan balances and pools backed by investment properties.

Leverage on the Agency sleeve was 9.5 times at quarter end. The real highlight here is the speeds in our portfolio remained extremely well-contained. All three buckets, 30 years, 15s, as well as hybrids, had CPRs in the single digits. We saw great opportunities as we ramped the latest capital raise and projected gross ROEs in this sector would be right around 20%.

Now turning to page 8, let's move on to the Non-Agency sector. As I noted earlier, we increased our equity allocation to non-agencies from 31% of equity to almost 43%. Average yields on our book declined, which reflect our emphasis on senior Re-REMICs. These bonds have a lower risk return profile, but because they have high levels of subordination and stable cash flow profiles, we are comfortable applying more leverage to these bonds. Because of this emphasis on senior Re-REMICs, our leverage on this bucket increased to 1.9 times. With the softness that we saw across the credit space, we're able to find very good opportunities here also with new capital put to work at loss-adjusted gross ROEs in the high teens.

Finally, let's move on to CMBS. We were quite active in CMBS this quarter, moving our equity allocation from 7.7% up to 13.4%. We are active in both new-issued paper as well as in legacy bonds. The large new issue pipeline has afforded us a nice opportunity as spreads have widened and should provide very good opportunities going forward. We estimate that our loss-adjusted gross ROEs will average in the high teens in this sector.

With that, I'll open up the floor to questions.

(Operator Instructions). John Weaver, Agee.

Hi. Good morning. It's actually Jason Weaver from Sterne, Agee, but no problem. First, on the hedge book. I heard your earlier comment about protecting book value long term and keeping -- ensuring low borrowing cost. But specifically, can you tell me what the 7.2 year swaps are hedging? Unless you can see like single digit CPRs on the 30 year, I don't see which assets are actually that long.

What we look at is we have key rate durations on mortgages. So even though the duration of a mortgage might be five years, let's say, on something that's paying in the single digits, you still -- your prices are going to be impacted by what long rates do because there are cash flows throughout. And then we also have new-issue CMBS bonds that are longer duration. So that's the reason, those two things.

All right. That clears it up quite a bit. And secondly, I know you're talking about the new Non-Agency and CMBS activity over the quarter, can you just tell me what spreads you were seeing on those new assets that you picked up?

Sure. In Non-Agencies, I mean, keep in mind, these are pretty heavily subordinated senior Re-REMICs, but we saw unlevered yields on that sector averaging around 5.5%. Our cost of funds are around 140.

Got you. I'm assuming that the character of those assets are pretty much consistent with what you already have on, mostly like senior portions of Alt-A?

Yes, senior portions of prime and Alt-A. Yes.

Got it. And just finally, can you comment on the decision to take the dividend back down to $0.97? Was that an intra-quarter decision when the Non-Agency was a little bit more under pressure?

No, Jason. It's Don. The decision, we look at our dividend on a quarter-by-quarter basis based on what we are estimating the income to be for that particular quarter. And so again, we've never gone out and said that our dividend is going to be an exact amount every single month like some others do. Ours is -- it more fluctuates with what the income is going to be for that particular period of time. So it was just a decision on what we saw the estimation of the income coming in at and where we wanted to pay the dividend out. So again, we consider a $0.01 or $0.02 movement in either direction to be basically the same level.

Okay. Thanks guys.

Bose George, KBW.

Yes, good morning. I've got a couple of questions. First, just was curious about the amount of leverage you used just on that AAA Re-REMIC trade that you guys had?

Yes. So on that trade, advance rates are anywhere from 85% to 90%. And if you look at our leverage, I think what makes the most sense is to really look at overall because we're really fungible in terms of having different assets that we can finance. And the senior Re-REMIC bonds are attractive to finance because they're a nice advance and they're also lower cost funding. But we look at the whole Non-Agency book together, and it's 1.9 times.

So I guess you're saying, the other, you essentially fund through this -- instead of funding through the others so -- (multiple speakers)

Essentially, that's right. I mean, we're really looking at levered IRRs and looking at the portfolio and saying, okay, if we finance a legacy Non-Agency bond, it's maybe a lower advance rate, a higher funding rate. And when you kind of look at it, it just doesn't finance quite as well from an IRR perspective. So we're really actively managing all the time -- what we're advancing on and what we're holding.

Okay. Great. And then in terms of the 18% to 20% guidance on the new capital you're deploying, is that pretty similar across the asset classes that you're investing in?

Yes, actually the Agency trade is probably a little bit closer to 20%. The CMBS is probably mid, mid-ish teens, maybe a little higher than that. And then Non-Agencies are kind of right in the middle. But they're all within a couple percent of each other.

Okay. Great. And then just let me ask the obligatory question about the ratings downgrade, the sovereign potential downgrade of sovereign debt. Do you think it could have an impact on the repo markets? And I'm fairly curious also more about the Non-Agency side. Do you think either side of that could be impacted?

That's an interesting question because all the talk has really been about what happens in Agency haircuts and so forth. And I'll just go through the whole repo market. On the Agency side, broadly, supply/demand in the repo market is still favorable. We've seen increasing supply. We've expanded the number of counterparties in the last quarter. And I will say like, this week, we've seen our financing rates on repo rolls go up like a basis point or two, but no change in haircuts.

If there's a rating downgrade, our view is, we'd probably see the guys who are at the lower end of haircuts, raise them. So there are some guys who are at three, some at four, some at five right now, and from what our discussions -- the guys at five broadly may not move at all. The guys at three probably move but not a lot. And really, what drives it more than ratings are really price vol. And capital ratios are important, obviously, in the repo markets. And there's no difference there. So it's really the price vol that's in focus.

So that's what we see there. On the Non-Agency side, obviously, there are -- the haircuts are much, much bigger already. We've got stuff anywhere from 10% like on the best senior Re-REMIC stuff all the way to 50%. And we haven't heard anybody contemplating raising those. And when you think about it, I mean, we're not really focused on buying stuff with AAA ratings that could get downgraded. We're -- most of our senior Re-REMICs we're buying are unrated. So we really don't see a lot of risk in that space if that answers your questions.

Thanks a lot.

Doug Harter, Credit Suisse.

Thanks. I was just talking about -- I was hoping you could talk a little bit about how you might position or protect the book value if rates were to fall further from here, given the amount of swaps that you guys have on.

I mean, we are -- I would say that we have a duration gap that has expanded since the last capital raise. We were running like kind of a half to a year, and we've kind of let it expand out. Really, a lot of the exposure there is really more Agency spread versus swaps rather than really rate movement. So I don't think that, at this point, I think that the Agency spread is really the bigger component versus rates.

All right. Thank you.

Trevor Cranston, JMP Securities.

Most of my stuff has been asked already. Could you give us any color on changes you've seen in Non-Agency and CMBS pricing since quarter-end?

Since quarter-end? It's, I would say, broadly -- flat to maybe a little bit softer. But the bigger thing has been -- I mean, in CMBS it's been -- prices have definitely been -- our spreads have been a little bit wider. I mean, the new-issue pipeline is pretty big right now. There's a lot of dealers trying to offload risk and get deals done. So we're definitely seeing some widening pressure on the new-issue side in CMBS.

Non-Agencies, we saw, as we mentioned, Maiden Lane caused some softening in that sector. Once that ended, really, what we've seen is a real slowdown. It feels very summer-like, if you will. I mean, it's been very quiet. So it's a little bit harder to tell how much prices have moved in Non-Agencies, but I'd say flat to maybe just a little bit softer in Non-Agencies.

Okay. That's helpful. And then on the expense ratio, it looks like it ticked up a little bit this quarter. I was just wondering if you could comment on that and how we should think about that going forward.

Yes, Trevor. It's really just a matter of when a couple of costs came in. We still think that it's probably going to hover around about the same level it's at -- say, 1.7 in total. I think if you look at it, it's still the 1.5% is the management fee and then we've got probably 0.2 associated with other G&A. But it's going to remain kind of flat about that level.

Okay. That's helpful. Thank you.

Dave Walrod, Ladenburg.

Good morning. Don, I had a quick question. You commented during your remarks that you view the credit default swap income as core. I guess, is that because that's just the way things flow but that is kind of your normal course of operations?

Yes, Dave. That's our take on it because, basically, if you think about it, the credit default swap is backed by Non-Agency securities. That's in our investment wheelhouse. That's where we're investing in. And when we look at that particular investment, it is part of our core earnings cost. I mean, as you would define -- we don't define core earnings, but the way we see it is, that's part of our investment portfolio.

Right. And then, I guess, the follow-up would be then -- when you're thinking about your dividend, you're accounting that as part of your -- as more of a core piece when you're thinking about where to set your dividend level?

Yes, that's correct.

Okay, thanks.

Joel Houck, Wells Fargo.

Good morning. Just to clarify on the duration gap, I think you didn't give a specific number but you mentioned it had moved out from 0.5 to 1 year. Where is it exactly, and is that on the Agency only or is that the total portfolio?

It's moved out to about 1.25 years. And essentially and after the last raise, we put on a lot of assets, and obviously, in the second quarter, if you look at our cash flow duration gap, it was positive at 0.5 to 1 year, but effectively, empirically, it was acting shorter. And we always said one of the benefits we have is we tend to have -- we had a positive duration gap on the Agency side. When rates go down, you typically see a little softening in the credit side. And we try to manage that. Obviously, it's moving around a little bit on us. But in this capital raise, as I started to say, we've put on more Agency assets and credit assets and just put on fewer hedges.

Okay. Switching gears, the ARM pre-payment rates are obviously, as you've mentioned, they're in the single digits. That's quite dramatic difference relative to generic collateral as well as some of your peers that focus on ARMs. Can you talk about specific types of asset you have in ARMS that are resulting in low pre-payment speeds?

Yes. We have been focusing mostly on newer issues, 7/1s. And so these guys are guys who have taken rates -- taken loans out at pretty low, at a low point in the rate cycle. So that is part of the reason we like that. I mean, we're already evaluating sort of the ARM and where -- we sort of evaluating where ARMs are and are likely to prepay versus 15s and there's been quite a bit of fluctuation between those two sectors recently.

But I would say, when you see some of the bonds, especially in the ARM space that have been paying really fast, I mean, those tend to be more slightly seasoned bonds that had -- the borrowers took out rates before -- obviously, before we had this big decline here, and they tend to be higher-quality borrowers and much more responsive to changes in rates. So it really, to our view, the decision -- it's very different than the decision to what kind of ARM to buy and when to buy ARMs is very different than, say, a fixed-rate mortgage where you can actually choose your collateral type. With ARMs, it's much more of a timing and where in the rate cycle you are, so that drove our decision in terms of putting more ARMs on. It also drove the fact that pre-payments were slightly -- were slow.

Okay. That's helpful it. And then I'm wondering if you -- in the Q, I know it's not out yet, you disclose the premium amortization on the Agency book and the discount accretion on the Non-Agency. Do you have those numbers offhand?

No, Joel, right at this second I don't. But we'll have the Q out shortly, and it will be in there. I apologize I don't have it right with us today.

Okay. And then just lastly, can you give us a sense for the total collateral that you have pledged against your Agency MBS and Non-Agency MBS book? In other words, how much free collateral is not unpledged?

I think what -- again, that's going to be in the Q, right?

Right.

And we're not going to give interim data for a spot in time --.

But the information as of 6/30, we'll have that in the Q.

Okay. Thank you very much.

Gabe Poggi, FBR.

Hi. Good morning, guys. A quick kind of 20,000-foot question. You guys moved the asset allocation kind of up, you moved the credit dial in the second quarter. From kind of where we're sitting right now in light of all the debt ceiling noise, et cetera, where are you guys finding the most or where are you seeing the most attractive investment opportunities right now, all else being equal?

I don't think things have changed all that much. I mean, we just got done ramping only a couple -- a week or so, two weeks ago. So I would say things are about where they were. I think CMBS, if you ask me what I think will be over the short-term, which sector might present the best opportunities, I'd say, probably CMBS because there is a pipeline out there that needs to get placed and we've seen pressure on that. And as a lot of the deals are in pipeline and you've got a lot of uncertainty over the next week or two in terms of debt ceiling, so you might see some pressure there.

Non-Agencies, we just see kind of a slowing down in that market a little bit. Part of it's the normal summer slowdown, part of it is uncertainty over what's going on. And then in Agencies, I would say the opportunity there looks just as good, if not better, than it has because we've seen widening in that sector. I mean, they just haven't kept up with the rally in rates at all. The big question there is -- next week, we'll kind of see what happens, but as of right now, (multiple speakers)

We're right in front of this weekend. I think next week, there will be a lot more clarity.

That's helpful. I just want to kind of get a gauge of CMBS, on the credit side of things, if you guys were looking to take advantage of the significant vol we've seen or at least widening in spreads in CMBS.

CMBS, absolutely. I would say that's the number one area we'll be looking.

Okay. Thank you.

Yes, as far as that movement, I mean, it was more late in the quarter that we added all that credit. We were able to take advantage of that.

Ed McCormick, Stevens Asset Management.

Hi there, good morning. Sorry if you've discussed this already, but just going back to the book value impact from the swaps. Is the Agency spread versus swaps movement related to debt ceiling talks, or is there something more systemic impacting this relationship? Thanks.

Yes. It's the debt ceiling. There are concerns that if the government gets downgraded, or worse, actually defaults, what that does to Fannie and Freddie, and so that's the big concern. So that's really what's driving it I think. (multiple speakers)

Of the potential solutions out there, how do you think that relationship would be impacted if we got the Boehner plan versus the Reid plan. In other words, if we get to do this all over again in 6 to 9 months, do you think there's anything that we could see elevated spreads for a while?

No, not really. I think if there's a plan and the debt ceiling gets raised, I think things will normalize. I mean, we might see another episode of it, but broadly, it's really digital, either the government defaults or they don't here.

It's interesting because Agency mortgages, on a fundamental basis, if you take away all the sort of debt ceiling noise, are actually fundamentally very attractive right now. You've got a premium market where everything is trading over par and you've got a pre-pay environment that has been extremely benign. I mean, we've seen rates pretty much rally pretty consistently here, and we haven't seen material pickups in pre-payments which, all things equal, that's a very good environment to own mortgages in.

So the one thing mortgages don't like and whenever you buy a mortgage, you're basically selling options, your short an option portfolio, they don't like increases in volatility. So I think that is the one thing that if -- in this scenario, you're talking about where there's just increased volatility for a long period of time, that could pressure valuations. But I mean, other than that, I think the actual fundamental picture for mortgage is actually quite good. Supply is pretty low and we've seen good demand out of all --

The other thing is, I mean, the market, nobody likes kind of sudden change especially when it's coming from politicians. But the reality is we're in a really low rate environment here, and there is definitely a need for yield out there among pension plans and others, insurance companies, et cetera. And once the dust kind of settles, people still need yield, and they still have obligations that require that. And we do believe that spreads are going to come back down and may tighten more than they were before.

(Operator Instructions). Mr. King, there are no further questions from the phone lines at this time.

Okay. Then we'll end it there, and I just want to say thank you to everybody.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.