Invesco Mortgage Capital Inc (IVR) 2011 Q4 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 views on the economy including the effect of economic stimulus by the US and foreign governments, Federal Reserve policy, current prices of mortgage-backed securities, the positioning of our portfolio to meet current or future economic conditions and the SEC concept release on mortgage REITs, our ability to continue performance trends, our current or future book value, our portfolio pre-payment speeds, the credit quality of our assets and performance compared to the market, our level of debt, our ability to obtain additional financing and our capital strategy.

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 may 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 condition 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 those cautionary notes. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statements later turn out to be inaccurate.

Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital Inc.'s investor conference call February 23, 2012. 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 the speakers for today, Richard King, Chief Executive Officer; John Anzalone, Chief Investment Officer; and Don Ramon, Chief Financial Officer. Mr. King, you may begin.

Good morning, everyone, and thanks for joining us. As you have already seen from our earnings press release, a key theme we want to emphasize to you this morning is stability. Our book value stabilized in the quarter, moving from $16.47 at the end of the third quarter to $16.41 at year end. A bit later in the call, we'll go into more detail about how and why our book value has since increased, recovering about 5% year to date, and how we will continue to work diligently to continuous improvement.

Fourth-quarter earnings per share of $0.66 is broadly consistent with the current earnings power of the Company in today's rate and investment environment. The drop from $0.80 in earnings per share from Q3 was the result of reinvestment at lower yields, our last forward starting slot coming on at the beginning of the quarter, the higher financing costs into year end and slightly lower asset balances. As far as the potential stability of the dividend is concerned, we do believe the Company's portfolio is well-positioned to generate similar dividends to what was generated in the fourth quarter, barring any significant economic changes.

One of the most important developments we have followed with great interest has been the unprecedented amount of stimulus provided by central banks around the world over the last six months. A few of the more noteworthy examples include extraordinary actions by the Fed including reinvesting their mortgage portfolio, Operation Twist and extending their zero interest rate policy to a total of about six years, as well as the long-term refinancing operation by the European Central Bank and the Bank of Japan's significant asset purchase program. This massive global easing appears to be prompting credit market participants to buy previously out-of-favor higher yielding assets, including commercial mortgage-backed securities and non-agency residential mortgage-backed securities instead of essentially hiding out in Treasury bonds that have negative real yields.

We believe this massive stimulus at a period where economic indicators are already surprising to the upside could cause financial assets to outperform and cause growth to surprise somewhat to the upside in the near-term and also heighten inflation risks for the medium-term. The higher beta commercial mortgage-backed securities market began to recover in November and has been on a steady climb ever since, supported broadly in the market by money managers, insurance companies, hedge funds and others. While slower to follow, the non-agency market has begun to recover, though not at the same pace, and we believe the non-agency market still represents relative value.

In addition, our agency MBS book has been outperforming our swap hedges even as rates continued to rally earlier this year, and we believe our agency MBS book should outperform meaningfully in any rate selloff. As such, as I mentioned at the top of the call, our book value has recovered in 2012 by about 5%. Over the course of the fourth quarter we used portfolio cash flows and proceeds from the sales of outperforming TALF CMBS and newer-issue RMBS at high dollar prices to invest largely in agency MBS at very attractive levels and to pay off some higher-cost liabilities. As you will note on our balance sheet, we ended the quarter with $197 million in cash. This enabled us to maintain a comfortable liquidity position during the quarter while achieving our portfolio goals. We are pleased with this level of liquidity, given the headline environment.

Portfolio adjustments and changes in valuation increased our agency position as a percentage of equity from about 51% to 55% in the quarter, while non-agency exposure declined from about 30% to 25%. CMBS exposure as a percentage of our equity increased from about 14% to 17%. This movement was largely a result of price increases.

In the CMBS market, as I mentioned, we sold bonds that were trading at higher dollar prices in the rate rally and we held onto bonds with felt had better potential for further spread tightening, namely CMBS 2.0 subs. Positively in January and February, these 2.0 bonds have notably outperformed. The remaining CMBS portfolio has higher yields and haircuts than our bonds originally financed via TALF, and thus our leverage declined.

Our non-agency RMBS is now composed of nearly 70% senior re-REMICs, that is, re-securitizations of legacy non-agency RMBS. These positions are of very high credit quality with highly predictable cash flows and low interest rate exposure, which is a valuable characteristic, given that we are near all-time lows in rates. Because of their low volatility, haircuts are quite low and offer higher leverage and return on equity.

Looking forward, we are more balanced in our views with respect to relative value as agency prepaid protected pools still look more attractive than generic agency, but pay-ups are at all-time highs. Meanwhile, pockets of RMBS and CMBS credit continue to look attractive.

Overall, it's important to emphasize that we are focused on improving book value and maintaining an even earnings stream in coming quarters. And unless conditions change materially, we have no plans to raise capital. Instead, we will continue to improve margin by paying off higher-cost liabilities and reinvesting portfolio cash flows in an accretive manner.

Now I'm going to turn it over to Don Ramon, our CFO, who will cover the financials.

Thanks, Rich. I will begin on page 3 of the presentation. During the fourth quarter we saw a decline in our net income, primarily driven by the decline in net interest income. One contributing factor was the portfolio realignment which resulted in lower yields for the quarter but a better risk return profile. The second is higher borrowing costs. Compared to the previous quarter, interest expense increased $4.6 million. During the quarter, we saw an increase in rates across the board on all categories. The most significant was seen in non-agency financing, where average borrowing costs increased 28 basis points. The overall increase in rates accounted for approximately $3.3 million of the increase in interest expense. With the start of Q1, we have seen rates coming down as counterparties are no longer requiring that year-end balance premium that they had.

Another contributing factor to the increase in interest expense was higher swap costs of approximately $1 million. As we've discussed on previous calls, our hedging strategy involves using forward starting swaps and the fourth quarter was the first time that all of the swaps will pay. Since we have not added any swaps since the previous quarter and all the swaps are now paying, you can expect that this is really our current run rate.

For the quarter, we had EPS of $0.66, and we declared a $0.65 dividend that was paid in January. As Rich mentioned earlier, we do believe that the portfolio is well-positioned to generate similar returns in the current environment.

Turning to page 4, you can see that the overall portfolio yield declined 21 basis points to 3.94% as we increased our allocation to agency RMBS. This resulted in our net portfolio yield declining 26 basis points to 2.13%. The most significant challenge we faced during 2011 was the decline in our book value, which was caused by the dislocation between our asset prices in the value of our swaps. The fourth quarter saw stabilization of the book value as CMBS prices improved throughout the quarter and swap prices leveled out. We did not recognize any impairment charge during 2011, and we continue to believe that the decline in book value was temporary. As Rich mentioned earlier, we have seen significant improvements in economic conditions in the first quarter. This increase in asset prices has resulted in our book value increasing approximately 5% since quarter end.

Now keep in mind, this increase or estimated increase that we have excludes any earnings and really should be viewed as our increase in our current net asset value.

With that, I think it's a good transition to turn it over to John to talk about the portfolio.

Thank you, Don. Slide 6 shows how we were positioned at year end. We increased our allocation to agencies to 55% as we felt that specified full collateral looked attractive. Our CMBS allocation also increased and our allocation to CMBS now represents almost 17% of equity. This increase was primarily a result of higher dollar prices and some reduction in borrowings. We reduced our exposure to non-agencies as we packaged and sold a group of 40-plus odd lot legacy positions to a counterparty and bought back 60% of the exposure in the form of a single senior re-REMIC position. This served to reduce our credit exposure and at the same time allowed us to apply leverage to the position much more efficiently.

Frankly, our investment in PPIP and equity investments decreased as cash was returned when we obtained financing for the Atlas portfolio. Total leverage on the portfolio was virtually unchanged at 6.4 times.

Now I will cover each of our main sectors. I will start with agencies on slide 7. Net yields were down slightly, approximately 10 basis points, as yields were lower with a modest pickup in prepayment speeds, up approximately 2 CPR for our fixed-rate lateral. Since the end of the year, we have seen speeds on our portfolio fall modestly. We expect that trend to continue as we believe our portfolio is well protected from the effects of the new HARP program.

As I mentioned earlier, we put more equity into agencies and that has turned out to be a good move so far. Not only have agency mortgages outperformed their swap hedges, but pay-ups on the type of high-coupon specified [pulled] paper that we favor have expanded materially. This is been brought on by lower rates as well as by fears of faster speeds brought on by the HARP implementation.

While we are still finding pockets of value in agencies, this outperformance has prompted us to take a more balanced approach when reinvesting cash flows.

Moving to slide 8 and non-agencies, we reduced our equity allocation in non-agency to just under 25% during the fourth quarter. This is accomplished through the re-REMIC trade that I mentioned as well as through some selected sales. 10-year re-REMIC bonds now make up nearly 70% of our position. Accordingly, our yield on the non-agency portfolio is lower and our leverage is up from 3.7 to 4.1 times.

Given that senior re-REMICs have continued to become a larger part of our portfolio, we believe it's important to go into a little more detail about why we find this sector so attractive. In the simplest terms, senior re-REMICs are legacy non-agency bonds which are restructured such that the senior piece has added credit enhancement which varies but is typically an additional 35% to 50% and also receives priority for prepayments.

This added credit enhancement allows these bonds to enjoy positive loss-adjusted yields and stress scenarios, where home prices fall by as much as 30%. On top of that, the fact that these bonds receive priority of prepayments serves to create cash flows with a very stable profile. In simple terms, convexity risk is very low. These two factors combine to make these bonds appealing candidates to leverage.

Our repo counterparties also recognize the low credit risk and cash flow stability of these bonds, which translates to very low price volatility and provide attractive financing terms on these positions. Haircuts averaging 15% to 20% and financing rates of 125 to 150 basis points combined with base yields of approximately 5% produce a very attractive ROE.

Given the extremely low rate environment, we expect that solid fundamental cash flows will continue to be sought after. In fact, we've seen prices on legacy non-agencies increase by 3 to 4 points in the first quarter of 2012 and feel that our non-agency portfolio will continue to benefit for investors' ongoing search for yield.

Finishing with slide 9, you will see our equity allocation to CMBS increased during the fourth quarter, largely as a result of higher dollar prices as well as a slight reduction in borrowings. Legacy bonds of 2005 and 2006 vintage in particular were well bid with dollar prices on those bonds up approximately 5 points. As Rich mentioned earlier in the call, we took advantage of this move by selling some of our higher-priced legacy positions. This resulted in a higher yield on the portfolio at year end as well as reduced leverage as the bonds we sold were lower yielding and more levered.

Despite the strong rally into year end, we saw more of the same as we entered 2012. All sectors within CMBS have seen strong gains year-to-date, with our CMBS 2.0 bonds up nearly 4 points on average, our legacy bonds up over 3 points and our [front EK] multi-family bonds up nearly 7 points. Despite the run-up in prices, we remain positive on this sector. It's much the same story here as in non-agencies. The low rate environment is forcing investors to look for yields, and CMBS is one of the few high-quality sectors that offers it.

With that, let's open the floor up to questions.

(Operator instructions) Douglas Harter, Credit Suisse.

I was wondering if you could talk about with the increased book value, whether that means that you will be adding some additional assets or just using it to take down leverage.

I think that we are saying that we think that the current earnings power of the Company is broadly consistent with the fourth quarter. So we will take some of the cash flow and re-invest in assets and some to pay down higher-cost liabilities.

Okay, that's helpful. And then, John, I was hoping you could just walk through maybe the return differences between the bonds that you sold and then reinvested back into the re-REMIC and how you thought about that trade from a return that you were giving up and a return that you were getting back type (multiple speakers).

On the non-agency side?

Yes, on the non-agency side.

Yes. Well, what happened was we had a large number of odd lot line items that mostly consisted of positions that we purchased when the Company was much smaller. So we had 40-odd line items of relatively small position sizes. And while those -- the underlying credit on those was fine, it was just those positions are a little bit more difficult to leverage, and selling them is a little bit tougher in terms of the quality of bids you get on odd lot positions.

So we felt that if we could package them, keep the top portion of that restructuring, it makes for a larger position size. And again, senior re-REMICs have much better financing terms than legacy bonds, and in particular they have much better financing terms than odd lot legacy bonds.

So really, in terms of yield give-up, it wasn't really that dissimilar in terms of what we gave up, particularly when you factor in that we could now apply leverage to those.

Great, thank you.

Trevor Cranston, JMP Securities.

First, just to follow up on the question about the re-REMIC portfolio -- the transaction you did in the fourth quarter primarily an opportunity to improve the kind of finance ability of the portfolio related to the odd lot positions, or should we expect that there's going to be some opportunities to maybe do some similar type of transactions on the remaining legacy stuff?

No, I would think of it more as a one-time thing.

Okay.

It's not really all that material in the overall scope of things. Just we do like the re-REMICs, as we said before, for all the various reasons in terms of great profile. So --

Okay, and just one point of clarification on the book value comments in the first quarter. Did the up 5% number include any retained or accrued earnings so far in the quarter? Was that just purely mark to market?

No, Trevor. As I mentioned, that's -- we are looking at that from a net asset value, not from a retained earnings perspective. So, again, we are looking at it purely on changing valuation of the assets and swaps.

That does not include retained earnings.

That's correct.

Okay, perfect, thanks, guys.

Bose George, KBW.

I had a couple of questions. First I wanted to just go back to the comment you had made about the temporary nature of the book value decline. Is that just really based on your portfolio is going to be relatively stable? You guys said you won't raise capital for a while, so then the negative marks on the swaps just roll off over time?

Bose, I think, when you look at the book value decline, again, in the components of OCI when we talk about it from a temporary decline, most of it is from the swaps. And as you know, over time those swaps are going to do one of two things. Either as you approach maturity you are going to amortize that decline back into book value. Say if it's a 4.5-year swap on average life, which they are now, you're are going to get about a quarter of that back each year. So we are naturally going to get that back and we have the ability to hold the swaps to term. Or what's going to happen in that nature is that the rates are going to go up, and so therefore the book value will come back. So we do believe that the swaps are definitely a temporary impairment.

When you look at the assets, again, we are always looking on a quarterly basis for the decline in value of the assets versus what the market value -- or market value versus book value on those two. And again, when we look at it and we look at the present value of the cash flows from the portfolio, they're more than enough to cover what the book value is. So again, in our opinion, these declines are purely temporary in nature and they are cyclical and we do expect them to eventually come back.

Okay, that makes sense, thanks. And just actually switching to your PPIP investment, it looked like it was roughly flat this quarter. I was just wondering, is the mix of that similar to your portfolio, or your main portfolio are different? We had assumed it would be down a little bit, just given the RMBS concentration.

Yes, the PPIP portfolio is similar to our non-agency legacy position in IVR. So it's not re-REMICs, it's not agencies, it's totally legacy, 2006-2007 primarily prime and Alt-A hybrids.

Okay, but that still performed -- because given the move down it had in the quarter -- RMBS had in the fourth quarter, I would have thought that PPIP would have been down a little bit. But it looked like that was more kind of roughly flattish.

Yes. Bose, keep in mind that now we have -- it's PPIP and we also have that equity investment that we did. So that's not pure PPIP. So while you are right, you would see some of the unrealized losses on the non-agencies moving down in the quarter, which we factor in, we also have the Atlas transaction that we did that actually improved the earnings stream. So we've got a little mix of both in there, so that's probably why it's balancing out.

Okay, great.

And on that front, the first quarter -- obviously, we saw a nice return in the PPIP portfolio.

Right, right, that makes sense. And then just one last thing -- on the agency prepayment side, any sort of surprises there, or was that pretty much in line with what you guys were thinking?

No, it was pretty much in line. We saw a slight, a couple of CTR increase during the fourth quarter, and I think that was broadly in line with what happened in the market. We are still much lower than generics, but as generics go up, we are going to go up slightly also. They're going to be the first couple prints of this year; we've seen speeds come back down a couple CPR. So we felt pretty good about that, and we have not seen any -- the effects of HARP come through yet. We think that's going to happen over the next quarter or two; we will start to see that impact. And again, we feel pretty comfortable that our portfolio is protected from that.

Okay, great, thanks and good to see the book value heading back up.

Jason Weaver, Carnegie.

Hey, guys, this is [Calvin Hotrim] standing in for Jason today. A lot of my questions were kind of touched on before in the previous call. But I just had a quick question. If you guys could give me some insight just as to -- you said before the recent kind of rally in non-agency CMBS. Basically, going forward, how do you think or maybe how have you seen -- how this is going to affect -- or what do you believe -- or sorry. How do you think this is going to affect your cost of funds going forward and maybe your leverage strategy?

I'll kick in there. So in the CMBS space, you did say non-agency CMBS, yes, we have seen some pretty strong price movements, as we've said, since November. What we didn't mention is actually the agency side of CMBS, the Freddie bonds -- they have had an incredible move up as well. This year. And in terms of cost of funds on CMBS, we really haven't seen any meaningful differences.

And Calvin, as you know, we have seen agency RMBS repo costs coming down since the end of the year a little bit. But again, the overall rate environment has improved but not -- not tremendously, but it has improved.

Okay, great, thanks guys.

Dan Furtado, Jefferies.

Earlier in the called, you had mentioned paying off some high-cost liabilities. Could you help me understand what liabilities those were?

Those liabilities -- it's really as it relates to CMBS. It's just our financing on those. What we are doing is, again, as we get our cash flows we are making a determination when the cash flows come in what is the best use of that cash. So do we invest in certain assets? Do we pay down some higher-cost liabilities, which would be our borrowing when costs? That's what those were talking to.

(multiple speakers) repo.

Understood. And then just a small question on the change in non-agency CPRs during the quarter. Can you help me or provide some color on the change in CPR that you saw there? And really what I'm trying to figure out is, is this change due to a mix shift in the portfolio, or is it due to some underlying current in the non-agency market itself?

When you look at that, we showed a graph, and non-agency speeds slowed a little bit. But we have a large percentage of the portfolio in re-REMICs, as we said, in the non-agency space. And so what we did is just used a consistent method to look at the speeds on the re-REMICs, because that was a relatively new phenomenon in the book. We went back and restated speeds in the non-agency book, going back to the beginning of the year.

Got you. But I guess what I'm trying to figure out is, I assume you are buying these super seniors at or above par, and thus you don't have the same type of discount accretion that you would have on a discounted bond. So -- in agency (multiple speakers) --

No, it's not as much accretion, but there's still accretion. The majority of those bonds are in the mid-90 range.

So generally speaking, faster CPRs are better for the non-agency portfolio, like it was in the past? Or is that not necessarily true?

It's still better, yes. It's more important to get prepayments on a $70 priced bond than on a $95 priced bond. But it's still beneficial.

Understood. Okay, that was my only point of clarification. Thanks for the time, everybody.

(Operator instructions) Mike Widner, Stifel Nicolaus.

Just one quick clarification. As you'd think about investments going forward and where the portfolio stands today, if I hear you right, is it pretty much expect kind of same allocation you've had today, or are there more shifts going on? If you could just maybe clarify that a little bit.

I think where we are now, we are pretty happy with the portfolio. It does reflect broadly where we see value right now. We are still finding interesting opportunities in all three sectors. In agencies, it has become a little bit harder, I would say, just given that some of the stories that we've favored in the past have really had very material increases in pay ups. But there's always going to be value in agencies, especially given how broad that market is. So we are still putting money to work there.

The re-REMICs we've talked about quite a bit -- we still like that story. And again, in CMBS, even with all the run-up we've seen in price, we really do think that, given just the need for yield out there and given that it's -- CMBS, in particular, because it's a rated asset class, is a much broader investor base. We think that as those investors look for yield that CMBS is really going to continue to be one of the favored asset classes. So I'd say all three we are finding value.

Okay, and then so just to be clear, if the environment stays as it is, all else equal, of course, and things do move. But all else equal, 55%, 25%, 17%-ish are kind of the allocations you see across agency RMBS/CMBS?

Yes, I think probably that's fair.

Yes. I think, obviously, we look at not just the asset side, but also the financing side. And if we see changes in that side, that could change our mix as well.

And just one other quick one -- in the past, whether by design or sort of -- however it came about, I think the portfolio was reasonably positioned for an increase in the rate environment, whether that was sort of by choice or design or whatever. Obviously, that didn't happen. Just wondering how you guys are thinking about the economy now, the environment and what -- what are you looking at and what might cause you to make any further shifts in terms of whether you think the economy is getting better or worse, or are we just going to kind of sit here for a while?

I'd think about it like this. Last year we did have a larger percentage of our book hedged, and we had longer swap hedges. But the biggest issue really was when rates dropped, asset spreads widened in every sector, in CMBS, in RMBS, in agencies. And what has happened in the fourth quarter and -- in the fourth quarter, we had what was designed to happen kind of happened where you have diversification helping you and CMBS spreads were tightening. Rates stayed low but didn't drop tremendously. And then, interestingly, at the beginning of this year you had rates dropping pretty strongly from like 122, say, on five-year, down to 96 basis points or something. And in that period, our book value is increasing and it's really because of the asset side. Spreads were actually tightening in the agency space. And so -- and we put on more agencies, obviously, in the fourth quarter.

But going forward, I think we feel much better about that from an interest rate standpoint and we think that, even in the low rate environment, we are going to be stable. And if we get an increase in interest rates, I think we outperform.

I may just add one thing. I think one of the things that really happened in the second half of last year was, to the point of agencies not keeping up with swaps, obviously policy risk was very heightened during the second half of last year. And I think the latest, when during the State of the Union, there was talk of that mass refi program. And I think the market kind of shrugged it off, thinking that that's really not going to happen. And I think investors getting more comfortable that policy risk, at least in the, call it near to medium term, is probably less likely to impact speeds, has really allowed agencies to trade much more closely correlated with swaps, which has really helped. So as long as that continues, I think that's a real positive also.

Okay, I appreciate that. And so, when you guys talked about or made reference to book value is up nicely so far, quarter to date, and obviously you would like to see book value come up further. In an ideal world, if you are perfectly hedged, then book value to stays flat in all scenarios. If there's an expectation of rising book values, then I'm not sure there's a way to do that without implicitly making bets one way or the other, either that or being much smarter than everybody else about buying low and selling high, but that's kind of hard to do.

So should our expectation be that it's nice that book values rose, but are you guys seeking to maintain book value, or is there sort of an implicit strategy one way or the other that if rates go one way, book value is going to go with it; if it goes the other way, etc.?

Yes. Obviously, we can't say book value is going to go up no matter what. But the reality is, we think that there probably is going to be a continuation of -- if rates stay low, investors just need yield. And so the assets we have, we believe, are going to improve in that environment, and -- relative to swaps. And if rates go up, we think we are well-positioned in the upping coupon on the agency side is going to perform well. And if rates are going up because the growth is stronger and so forth, we should continue to see spread tightening in CMBS and RMBS.

So if you are trying to think of it both ways, our swaps, as we said earlier -- they are priced into book value at extremely low rates. We think more likely than not, they stay here or go higher and we get some of that value back.

All right, great, I appreciate the comments and the thoughts, guys.

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

Okay, operator, thanks, then we will end the call with that and I would like to thank everybody for their time this morning.

Thank you. Ladies and gentlemen, that does conclude today's conference call. We thank you for your participation and ask that you please disconnect your lines at this time. Thank you.