Invesco Mortgage Capital Inc (IVR) 2013 Q3 法說會逐字稿

This presentation and comments made in the associated conference call today may include forward-looking statements. 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.

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Welcome to Invesco Mortgage Capital Inc.'s Investor Conference Call. 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 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 now begin.

Thank you. Good morning, everybody. And as always, thank you for dialing in today. We made great progress in the quarter on the goals we laid out at the beginning of the year, reducing interest rate risk, reducing reliance on short-term funding, and generally strengthening our overall risk positioning. We believe this sets our Company up well to also accomplish our long-term goals; that is to deliver an attractive dividend, and do so with improved book value, stability and growth.

We utilized portfolio flaws throughout the quarter to reduce our exposure to short-term Agency repo. We also reduced our duration exposure in the Agency portfolio by adding to hybrid ARMs and increasing hedges. Leverage in the Agency Mortgage-Backed Securities portfolio was down by 1.5 turns quarter-over-quarter. Credit leverage overall was unchanged as we found some attractive value in CMBS, legacy RMBS, and subordinate credit underlying newly-underwritten residential loans. We're now less exposed to interest rate volatility than in prior quarters, and we're in a much better position to capture credit spread tightening in residential and commercial markets.

For the third quarter we had core earnings of $0.50 which equaled the dividend paid. The reduction in earning assets, coupled with additional hedges, including forward-starting slots coming on did reduce our core earnings relative to prior quarters. We opportunistically traded the portfolio, offsetting gains recorded in the second quarter to reposition the portfolio towards more credit and under-valued hybrid ARMs. Our swaption positions and futures hedges are mark-to-market with changes in the valuation going through the income statement. The combination of hedge positions, and realized losses on portfolio repositioning explains the difference this quarter between GAAP and core earnings.

Portfolio positioning for the present environment. The actions taken in the third quarter leave our Company's portfolio well-positioned for the current environment where both fundamentals and technicals are positive. We believe risk premia on our assets will contract producing appreciation on our credit position and RMBS and CMBS from here. In fact, we're already seeing that occur quarter-to-date. Book value is up about 3.5%.

The technical environment in the Agency mortgage market is favorable, with low rates, low volatility, full prepayment, and the Federal Reserve continuing to support the market with purchases. Supply-versus-demand technicals remain very positive in the mortgage credit space as well, with robust demand for bonds and limited supply. Fundamentals in both residential and commercial real estate debt markets are sound as recovery in each continues to take hold.

It's important to note that we're not generating the dividends primarily by accepting interest-rate risk. Our strategy is to isolate the value in mortgage spreads by hedging the interest-rate component of residential and commercial loans. It is for that reason that we especially find attractive those assets with predictable cash flows that we can hedge effectively.

Our earnings are generated by the detailed credit work and cash flow analysis we did. We're bullish on credit spreads now, and believe that in addition to the attractive yield on our shares, we are likely to see book value appreciation as credit spreads improve.

I'll take a minute to talk about new initiatives for the future. We're also making progress on these new initiatives and we're focused on three that will further broaden our assets in the higher yielding opportunities that reduce our reliance on borrowings, and increase our exposure to floating-rate spread income. First, our commercial real estate debt origination platform is taking shape as we build out a pipeline of deals which we expect to begin closing in Q4. Second, we see the government raising up the risk sharing deals next year, and continue to think that those will be an attractive way to earn attractive returns on well-underwritten loans. And third, we continue to add subordinate credit positions on newly-originated residential and commercial loans.

Before turning the call to John, let me emphasize why I'm so excited about Invesco Mortgage Capital. We are well positioned to capitalize on what we believe are strong fundamentals and technicals in the US mortgage market that will cause risk premia to contract, creating appreciation in our holdings. We have been and will continue to reduce our reliance on short-term borrowings, and reduce our exposure to interest rate risk. Finally, new initiatives in commercial real estate and residential loans generate attractive yields now, will further reduce our exposure to the short-term funding market, and provide a long-term source of attractive investment opportunities.

Now John's going to discuss our investment strategy and portfolio in further detail.

Thank you, Rich. And again, thanks to everyone listening to the call. I'll start out on slide four. As Rich talked about, and as we've indicated over the past few quarters, we've been focused on positioning the portfolio to capture spread tightening and away from exposure to interest rates. The chart on the upper left shows how the portfolio has changed over the past year. Agency mortgages now represent just over 60% of the portfolio, down from over 75% a year ago. The composition of the Agency book has also evolved which I'll talk about in more detail in a moment.

Both our cost of funds and our portfolio yields were fairly stable over the past quarter, despite the volatility in rates. Slide five provides a snapshot of our equity allocations and leverage, and how it's changed over the past quarter. This is where you can see how we've moved to reduce our interest rate exposure. Overall leverage is down to 6.9 times, while leverage allocated to repo is down to 5.8 times. This is largely accomplished through a reduction in leverage in our Agency book to 8.1 times. The composition of our credit leverage changed slightly, but overall credit leverage was largely unchanged.

In addition to simply delevering the Agency book, we also took steps to reduce interest rate exposure by adding more hedges. We added additional $600 million in ten-year swaps during the quarter, in addition to adding some 30-year hedges via treasuries features. We did reduce our swaps-in-book in favor of swaps-in-futures, and the net result is that a larger percentage of our repo book is hedged, our duration gap has been reduced, and we have seen less volatility in our book value as rates move.

Over the next few slides, I'll talk about the asset stocks side, starting on slide seven in Agency mortgages. As I mentioned earlier, we reduced the size of our Agency book with reduction of $1 billion, which resulted in a reduction in leverage of about a turn and a half. The reduction in the portfolio was largely the expense of 30-year collateral, as a percentage of 30s has been reduced to 72%. We added hybrid ARM collateral over the course of the quarter, nearly doubling that exposure quarter-end. We've continued to add exposure there into the fourth quarter. The performance of hybrid ARMs lagged significantly during the second quarter, and adding a relatively cheap asset with a shorter duration profile really fits in with our theme of reducing the overall interest rate risk.

Prepayment speeds were down slightly for the quarter, but we expect those to fall further as reduced capacity and seasonality kick in. Our first trade of the fourth quarter confirmed this view.

While we have been reducing our Agency exposure, I do want to emphasize that we have been doing so as a strength. Our outlook for Agencies over the near-term is quite positive as the Fed continues to buy a disproportionate share of the net supply.

Slide eight provides a snapshot of our Non-Agency book. We have continued to focus our purchases in the legacy prime and Alt-A sectors as these bonds have more upside as the housing market continues to improve, as well as relatively short duration profiles. Given our view that the housing recovery is likely to persist, albeit at a slower rate, and the fact that the technical picture remains very positive with persistent negative net supply, we believe the outlook for spread-tightening is very good. This outlook is reflected in the pie chart in the upper left. The percentage of our non-Agency book that is devoted to legacy securities continues to grow, and is over 60% with senior re-REMICs dropping to under 40%. Leverage kicked up to 4 times, but that was simply a timing issue that was offset in the CMBS migration. Again, overall credit leverage was stable.

Moving to slide nine and CMBS, a lot of our views in the residential space carry over to CMBS. We see a gradually improving fundamental picture that should continue to support spread-tightening. One difference is the new issue market has developed much more quickly here than on the residential side, so the technical picture is not quite as robust with flat net supply. That said, we are focusing purchases on a high quality paper that should perform well as the commercial real estate recovery continues.

Before opening the floor up to questions, on slide ten we wanted to highlight the performance of the residential hopefuls that were contained in our securitizations earlier this year. This provides a pretty good illustration as to why we are looking to increase our exposure to newly underwritten credit. I'll just point out a couple of highlights. First, out of over 1,900 loans served in 0 serious delinquencies. More importantly, look at the LTV performance. In the course of about six months, the LTVs on these loans has decreased by over 700 basis points, from 67 LTV down to 60 LTV which further strengthens the credit quality of the portfolio. On that note, I'll stop and open up the floor for questions and answers.

Thank you. (Operator Instructions). One moment for the first question, please.

Douglas Harter of Credit Suisse. Sir, your line is open.

Thanks. John, I was hoping you could talk about the return profile on some of the new initiatives like the subordinated bonds on whole loans. It seems like those returns are a little bit less attractive today. Just wanted to see where you see those returns.

Doug, it's Rich. I'll answer that. I think with what we're looking at on a lot of the new initiatives are opportunities that are floating rate assets like in the commercial mezz space, in the risk-shared deals, for instance. And so there, when you look at the potential IRR, you know, we usually look at everything relative to forward curves, so you have an upward sloping curve, and when you factor all that in you get to kind of low double-digit IRRs without leverage on those type deals. And then yes, we get to about the same place on the residential loan securitizations we've done where we're buying the subordinate sub-stack plus IOs, and again, getting to kind of the low double-digit IRR.

Great. And then just you said the pipeline was building on the commercial mezz loans. Could you just give us a sense as to maybe what that magnitude is, and when we'll start to see that become a more meaningful part of your balance sheet?

Sure. You know, I think what we want to see there is to close a few deals each quarter, and the size of those deals may be somewhat chunky and they could be $10 million, or they could be $50 million. So it's really going to be -- it's not something I could give you a precise estimate on.

Alright. Thank you.

Dan Altscher of FBR. Your line is open.

Thanks. Good morning, everyone. I was wondering if you can just give us generically, since there's a lot of different moving pieces going on right now in terms of investments, you know, for every $1 of capital today, what is the priority? Is it more hybrid ARMs? Is it more credit? Is it more commercial home loans? What is number one on the priority list?

I would say credit versus agency. Clearly credit would be the first priority. And then how that's split up, I mean, in large part it depends on, I would say the new initiatives would be first priority. But again, those tend to be, as Rich just mentioned, they tend to be a little bit more chunky in how they come. So it's not like if you gave me $1 today we could put it to work in a commercial loan opportunity tomorrow. The lead times tend to be quite long on those. I would say credit, in general, and there it's kind of split between [resi] and commercial.

Got it. On the agency portfolio, for the cost of funds, I may have missed it in the slide deck, but can you maybe tell us what the all-in kind of cost of funds is for the Agency portfolio with, I guess, the cost for hedges this quarter? I think maybe the last quarter it was 1.53%.

Yes. Dan, this is John. We did break it out a little bit differently this time to show, because when we look at hedging the entire (inaudible) we're looking, you know, it's not just purely the Agency book. But I think if you were to look at it, it's probably something like it would have been up about, I think, to around 1.97% or something like that in total.

Right.

Yes. So it was up a little bit. But again, purely a function of the forward-starting swaps that we put on last quarter until fourth that are now starting to pay.

Okay, great. I'll drop back in the queue because I'm sure there's plenty of other questions.

Trevor Cranston of JMP Securities. Your line is open.

Alright. Thanks. I just wanted to follow up a little bit on the new residential loan transactions and the bullet on slide two that says that you're hopeful that you can get another deal done in the fourth quarter. It seems like the headlines that we're seeing about deals that have been in the market this quarter seem to indicate that the market is pretty difficult for the new issued securitizations. Can you just give us some color on how you're seeing things and if you think that, as you see things today, the market would be open for a new deal or not.

Sure. And I don't want to talk specifically about a specific deal that we may do in the fourth quarter, if you understand. I just can't do that. But broadly, you're right. The spread on the triple-As are quite attractive at this point. And so we're looking at, kind of, some creative ways to gain exposure to that new underwriting without [replacing] triple-As.

And then switch to the Agency side a little bit, obviously the trend in the quarter is that leverage went down and the asset mix moved a little bit shorter in duration. Are you guys kind of comfortable where you're at, or do you see that trend continuing into the fourth quarter (inaudible)?

I would say, I think we're comfortable where we're at from a duration perspective and how we're hedged right now. But that said, we continue to look at hybrid ARM collateral because it still looks relatively cheap to us, and it also has a pretty nice duration profile, they're easier to hedge, things like that. So you might see that trend continue. But I would say, near term, we like how we're positioned. I think our leverage numbers are -- they feel right for the environment we're in. We've seen -- given how we've repositioned the book, we've seen book value stability throughout most of the -- since -- over the course of the last quarter, book value's been relatively stable so we like that also. So I would say we won't see a lot of changes in the agency book. Maybe more evolution towards shorter duration-type assets, but that would be more around the edges than a big wholesale shift.

Okay. That's helpful. Thanks guys.

Joel Houck of Wells Fargo. Your line is open.

I guess more of a conceptual question. I mean, you guys have obviously taken out leverage on the Agency side and shortened duration. What would it take -- I guess, what would you guys -- looking for to kind of releverage yourself relative to the Agency investments. Or are you guys, at this point, looking at it as more defensive, and we're just kind of, you know, the allocation Agency is just going to be minimally allocated, kind of 55% whole loan pool tax to pass to kind of the REIT rules? Or is this -- is the business model still opportunistic in that you're looking for more attractive spreads or is it the institutional view that the taper is just a matter of time and you want to minimize exposure in this sector for the foreseeable future? Thank you.

Yes, sure. I mean, it really goes back to our long-term goals are to deliver an attractive dividend, and minimize book value volatility, and hopefully grow book value. And we just think the best way to do that at this point is to reduce leverage on the Agency side, and move more equity towards new opportunities and credit. We think credit spreads are going to tighten, and therefore that's how we get growth in book value. And as far as, at some point, if interest rates are much higher in the future and agency spreads are more attractive, we certainly would be opportunistic and take advantage of that. But we just don't believe that's the best opportunity in the market right now.

Alright, thanks for the comments, Richard.

Dan Furtado of Jefferies. Your line is open.

Thank you for the opportunity. My first question is how should investors be thinking about the size of the commercial loan platform you're talking about as a new initiative?

We'd like to grow it to about 25% of our equity capital. But like John said, it's not something that we can do. I mean, it takes a great deal of work on each particular deal, obviously. We have a very large commercial real estate team working on sourcing deals and closing deals and so forth. So we think we can ramp it up but I can't really give you a date.

Understood. And then it seems like you still have some room to take the Agency exposure down considering the asset test rules. But then I hear John and the rest of you say that, for now, you guys feel pretty good about what your exposure is. Can you give us a timeframe what for now encompasses? Are you talking the next quarter or two? Or how do I think about that because, I mean, like you said, it seems like you could take that leverage down quite a bit further from here considering the whole loans you're bringing on on the residential side?

Right. Right. And that's one of the things that's nice about the whole loans on that side is that it gives us more degrees of freedom on the Agency side, obviously. So that's part of it.

Yes, I would say on the Agency side, I mean, we're -- I mentioned we're bullish now. We do like -- we think agencies over the next -- and I would say probably over the next few quarters should remain -- we'll be positive over them for the next few quarters. I think given the supply, demand, technicals, Fed, and either they seem to be on course to buy a disproportionate number of bonds over the next -- certainly into several quarters. And that's where it gets a little bit more difficult to forecast how mortgages will perform once we get into talk of tapering again, how far that's pushed off. You know, we certainly expect that that will happen at some point. And we view this as an opportunity to kind of re-adjust the portfolio again into strength by reducing some agency exposure, getting more exposure to newly-underwritten credit which we think is a much more persistent opportunity. And that should last for a longer period of time.

Understood. Thank you for the clarity on everything. I appreciate it.

Cheryl Pate of Morgan Stanley.

Hi. Good morning. I wonder if we could spend a little time -- obviously, you guys have spent some time reducing repo exposure and building up some [component] financing. Can you maybe give us, sort of, your view of the repo markets, maybe moving forward a little bit given some of the regulatory changes coming through, and how you think about the repo exposure over time? And secondly, maybe if there's a little bit of an update on how haircuts have been trending on the Agency repo side.

Yes. I'll start the first part. So what we've seen recently is there hasn't really been much of a change at all. We did see Agency repo rates during the quarter go up a little bit as, I guess it was -- the debt ceiling was going on. We saw repo rates maybe go from the high-30s -- mid- to high-30s to maybe the low- to mid-40s. And then once that debt ceiling thing passed, right back to where it was, kind of in that 37, 38 range. So really, we haven't seen changes in haircuts or repo rates. Now I'll let Rich talk about the longer term regulatory environment.

Cheryl, so you know we don't know the outcome, obviously, of all the regulatory issues that are out there, but we're certainly well aware of them and preparing for potential changes. And so our plan coming into the year was to reduce repo balances and we're happy to move along that path. But part of that is we lowered leverage, check; we've moved out of Agencies which had more turns of repo relative to credit. So that's a check. As you mentioned, we issued some notes, and we're incubating these opportunities to buy assets that don't require repo, and exploring other financing arrangements as well. But I guess what I'd say is we're reducing our repo faster than our counter parties (inaudible) and I think they collectively would want to do more with this so we feel like we're in a good place there.

Repo's an attractive way to borrow against liquid high-quality assets. And so we're not looking to eliminate repo. We see it as a great way to finance our assets. We just want to get a head of any potential changes. And I think playing around that score, we're a good partner with most of the big dealers, obviously, that we finance into short-term markets and long-term markets. And I think as time goes on, that's a big asset that you want to be a good partner to people providing repo to you. But I also think if we do see regulatory change on banks limiting leverage and so forth, that you'll see other players, non-bank providers created. I don't think the repo market is going to go away. I think it's important just to the entire financial markets. But we like the position we're in.

Thanks. Very helpful.

(Operator Instructions). Jim Young of West Family Investments.

Yes, hi. You had mentioned that your book value quarter-to-date is up about 3.5%, so that would suggest around $18, $17 a share. Does that include any benefit from credit spreads tightening at this time?

Yes. It was really -- I mean, I'll just talk generally about what we've seen in October. We've seen strength across the board in October. Yes, I think once the -- the view on the market has sort of evolved that Fed tapering is put off for a while. I think the market has generally been risk-on for the month of October. So we've seen strength in Agency, CMBS, and residential mortgages this quarter. So it's been -- yes, I think it's been a pretty positive environment pretty much straight through.

Yes, we believe that given the lower rate volatility and kind of the recent economic numbers being a little softer, there's going to be a need for yield out there. Rates are holding and pretty low, and expect credit spreads to continue to tighten in.

So how much do you have -- in this month, how much have credit strikes tightened on the (inaudible) senior portfolio?

You know, we can't give you an exact number on that, but I'd say in the CMBS market generally, we've probably seen maybe 10 or 15 basis points of spread tightening just as an example. Agency mortgages have outperformed pretty consistently as John mentioned.

And could you just give us some sense of the sensitivity? So if we saw another, like, 15 basis points tightening in your residential Non-Agency and CMBS, would that suggest that you'd have another 3% to 4% upside in your book value?

We just don't have the specifics right in front of us, Jim, to give you that number but -- and a lot of it depends, obviously, on if spread duration in the Agency book and the CMBS book, and RMBS -- but I can't give you a number right now.

Okay. Thank you.

Douglas Harter of Credit Suisse. Your line is open.

Thanks. You guys have mentioned that you've reduced your duration gap. I was just wondering if you had those numbers as to where it stands today and how that compares to where it was last quarter.

Yes. You know, we've really looked at looking at kind of overall risk, and certainly the gap is interesting. But we -- what I'd rather talk about, actually, is kind of our equity duration, if you will. And it was out at around 12.5% or 13% earlier in the year, and it's down in the 7.5% range. And we really don't want that number to come down to zero because as this point, A, because we aren't expecting rates in the near-term to go up dramatically. But also, it's a nice counter-balance in that we do expect a credit spread tightening and to have a zero equity duration -- if we saw a difficult situation from an economic perspective, it's going to be helpful to have a little bit of duration to up that credit asset. But I think that's the best number. So rates up 100 basis points, you'd see overall book value decline about 7%-ish.

Great. Thanks.

And I'm talking without any spread changes anywhere.

Right. And then you guys, you increased the hybrid ARM portfolio substantially during the quarter. Where do you see the attractiveness of hybrid ARMs today? How much of the second quarter widening has been recouped to date?

Yes. I would say they've tightened along with the rest of the Agency market. But they've kind of tightened along with it; they haven't really outpaced it. So we still, on a relative basis, we still think they're attractive versus 15s in terms of what we see as hedge returns. So that's how we kind of compare them to the 15-year market. So they still (inaudible) to be pretty cheap.

Thanks, John.

Mark DeVries of Barclays. Your line is open.

Yes, thanks. I just want to get an update on where you're seeing relative value in your credit investments. I know you mentioned supply is stronger on a relative basis than CMBS. Do you see any signs of froth in the underwriting there or still attractive, you know, loss adjustment spreads? And on the residential side, how levered are your investments at this point, to the further HPA appreciation?

Yes. I'll start on the CMBS side. We have seen underwriting standards loosen up a little bit from, say, a year ago. So we're definitely seeing that trend. And that's caused us to become more selective on the CMBS side. So really, it's about, again, like a lot of what we do. I mean, it's a lot of detailed credit work, so I would say we're still doing that and trying to find bonds. And that is really what's limiting the amount of new money we're putting to work in CMBS is really finding bonds that we like from a credit perspective. So you're certainly correct in that sense.

The other part of the question was --

Levered HPA.

So we saw in the pie chart, we've been adding legacy prime and Alt-A bonds, and the upside's not huge like it was a few years ago, but we could add a percent or two to what we project is IRRs if we see house prices continue to go up and delinquencies continue to decline, and severities continue to fall.

Okay, got it. And sorry if I missed this, did you indicate what your unlevered returns are on your CMBS investments today?

Our unlevered returns on CMBS?

Yes.

Well, I mean, we're kind of overseeing things. For new issue subs we're probably in the 4.75% to 5%-ish range. I mean for unlevered, just for flat out --

That would be like single (inaudible).

Right. Right.

Okay. And on a levered basis?

You're probably getting up into the lower -- the upper single-digits to low double-digits depending on -- yes, it kind of depends on the bond and what kind of haircut you get in that. But that range would be in the high single-digits.

We had a decent amount of CMBS earlier in the quarter when spreads were wider. Not as much recently.

Okay. Got it. Thanks.

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

Thank you. Appreciate it.

That does conclude today's conference call. Thank you and all participants may now disconnect.