Invesco Mortgage Capital Inc (IVR) 2013 Q4 法說會逐字稿

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Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital investor conference call. (Operator Instructions). 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, and as always thank you for joining us. Our goals for the call today are to give our shareholders an understanding of what drove the fourth quarter results and then, more importantly, share our vision of the future of this company. We want investors to understand where we intend to take Invesco Mortgage Capital, and why we're so excited about it.

First let me take a few minutes to cover the Q4 results. Our goal in the fourth quarter was to continue to reposition the portfolio for stability of book value and the dividend. We used cash flows to do primarily two things. The first was to buy back our shares, which was an attractive use of capital because the discount is nearly 20%, and we bought 10.7 million shares, spent just over $160 million in the fourth quarter.

The second use of cash was to invest in each of our three initiatives, which are also attractive because we believe they'll help us to stabilize book value, stabilize core earnings, and ultimately that should help the shares to trade at a premium. We did put meaningful capital to work in each of commercial real estate loans, risk-sharing transactions, and prime jumbo securitization where we retained the subordinate tranches.

As agency mortgage prices rallied early in the fourth quarter following the no-taper decision at the September Fed meeting, we sold some 30-year agency mortgages and used proceeds to buy 7/1 hybrids to further reduce duration and agency mortgage spread duration. We were able to generate core earnings of $0.48, very close to the $0.50 dividend, and importantly reposition the portfolio to better maintain that dividend in 2014.

Book value grew during the quarter by 1.9%. You can see in the book value graph on the lower left of slide two the gains from interest rate swaps, which are meant to hedge the rate risk, and our agency mortgage and our CMBS were nearly equal to the combined net book value decline in those two sectors. The $0.17 per share improvement in the value of our non-agency residential mortgage-backed securities portfolio, which is largely adjustable-rate, and fairly interest rate-insensitive, along with a positive $0.23 impact of share repurchases, drove the increase in book value. It is interesting to note that rates on five and ten-year Treasury notes rose 35 to 40 basis points in the fourth quarter, and we managed to grow book value even before share repurchases.

Year-to-date in 2014 with rates on five and ten year treasury notes lowered by 23 to 30 basis points respectively, we estimate book value was up another 2%. We're transitioning Invesco Mortgage Capital from being diversified on securities, i.e., agency RMBS, legacy non-agency RMBS, and CMBS, to a strategy that also includes significant commercial real estate lending, and providing private subordinate capital to the residential mortgage market.

On the next slide, let me tell you what we believe, and our strategy is based on IVR's core principles. Our primary mission is to create and maintain shareholder value. Create and maintain shareholder value means generating attractive core earnings and dividends, and removing much of the book value volatility that we've seen in the past. We believe investing in quality underlying assets creates more predictable outcomes and provides principle preservation. We believe that finding relative value across the entire US mortgage market where we have expertise and competitive advantage. We believe asset liability management is important to stability and it starts on the asset side. That means we'll invest in assets that need less leverage or need less hedging or are more hedgeable. We'll also focus on mortgage assets that lend themselves to more permanent and resilient funding sources.

Again, our goals for the future are to focus on book value stability and generate attractive dividends over the long term. We believe we have all the necessary people, resources, scale, sourcing, counterparty relationships, platform, and risk management to deliver a diversified portfolio with the necessary expertise and competitive advantage. And given that expertise and resources, a more diversified set of assets and risks will generate higher risk-adjusted returns for our IVR shareholders.

We also believe that there exists a void in the mortgage market, a void that we can help to fill by helping the government to shrink taxpayer risk related to housing, and by working with banks to supply capital displaced by regulatory change. Our CIO John Anzalone will now tell more about our investment strategy.

Thanks, Rich, and thanks again to everyone joining us on the call. I will expand on Rich's comments starting on a review of where the portfolio is today, how it evolved over the past year, and where we see opportunities in the future. I'll start on slide four with you portfolio update.

As Rich just discussed, during the course of 2013, we reallocated the portfolio to significantly reduce our interest rate exposure, and to increase our exposure to improving fundamentals by adding credit assets. The pie charts on the left side of the graph illustrate this shift. In terms of reducing interest rate risk, we reduced our overall exposure to agency mortgages from 72% of assets down to 56.8% of assets, which is a reduction of $2.4 billion during 2013. We also reduced our exposure to 30-year collateral within our agency book which I'll talk about in more detail in a minute. As such, we reduced our equity duration, which is duration gap times leverage, to approximately 5.4 years at year-end.

As we moved away from agencies, we are also able to reduce our leverage allocated to repo 6.1 to 5.7 times. As we moved away from agencies, we reallocated capital to the credit side. Non-agency RMBS increased from 16.6% of assets up to 19.6%, an increase of $696 million, and our allocation to CMBS increased from 11.1% of assets up to 13.6%, which represented $584 million. We also made progress on the loan side, participating in five securitizations on the residential side, which represented $1.8 billion and four CRE loans, representing $64 million.

I'll now talk in greater detail on each sector. I'll start with agency mortgages on slide five. As you can see on the pie charts, not only did we reduce our absolute exposure to agencies, we also reduced our exposure to 30 year collateral considerably. Thirty-year fixed-rate agencies now represent 61% of our agencies, down from 75% a year ago. The difference is made up in hybrid ARMs which went from 5% last year up to 18.5% at this year-end. Within agencies we continue to favor hybrids over 30-year collateral, as valuations still look attractive and we prefer the shorter duration and convexity profile of the sector.

Over the year, we also reduced our leverage on the sector by half a turn, and while we reduced our agency book we did not reduce our hedges. This brought the percentage of our agency's hedge up from 76% to 137% at year-end. We also have seen a couple of tail winds in agencies, as prepayments have slowed dramatically with our 30 year collateral now paying about 6 CPR, and hybrid speeds falling to 8 CPR, and repo rates on agencies have lower over the past few months.

As our investment in the agency side has fallen, we've increased our investment and credit assets. Turning to slide six, I'll start with our non-agency book. As I mentioned earlier, we increased our exposure usual to non-agencies by $696 million during 2013. The composition of this book has also changed quite a bit, as we went from just under 60% senior re-REMICs in December 2012 to 38% at the end of last year. This is largely a result of prepayments, and we reinvested those proceeds and then some into assets that have a greater exposure to recovery in housing. These investments have been made in a combination of legacy bonds, newer issue bonds, as well as GSE risk-sharing transactions, which I'll talk about in more detail in a few slides.

Moving to slide seven on CMBS, it's a similar story on CMBS side, as we were able to increase our CMBS balance by $584 million during 2013. Investments in recently originated credit, CMBS 2.0, has increased in two-thirds of our CMBS book up from 56% at 12/31/12. Fundamentals in commercial real estate have continued to improve, albeit at a more moderate pace. Given this backdrop, we've been favoring higher-quality bonds off of new issue credits.

At this point I'd like to expand on some of the opportunities that we see ahead of us. When thinking about the current environment, there are several characteristics that we are looking for in any opportunity. The first is that we favor assets that can achieve return targets using less repo financing. CRE loans, subordinates off newly originated residential collateral and GSE risk-sharing deals all meet that criteria.

The second thing we are looking for are investments that are either floating-rate or have minimal rate exposure. CRE loans, GSE risk-sharing deals, as well as agency hybrids meet that one.

Finally, we want to increase our exposure to improving credit fundamentals. On that front, CRE loans, subordinates off of newly issued residential loans, and the GSE risk-sharing deals fit that profile. So increasing our exposure to these opportunities will result in less interest rate exposure, less dependence on repo financing, as well as a more diversified asset mix. I'll go through these opportunities inmore detail starting with commercial real estate loans on slide nine.

The opportunity in commercial real estate lending is significant. The chart on the right shows the CRE loan maturity schedule, and it's not hard to see that the need for mezzanine financing is going to continue to grow. There are $360 billion of loans collateralizing CMBS that will need refinancing over the next four years, and there is more than 1.3 trillion in total CRE maturing over that same period. We expect that approximately $100 billion in CRE mezz debt will be created over the next five years, and we would like to see our allocation here grow significantly over that time frame. So I think this makes sense for us.

I have already talked about how CRE fits our desire for short-duration assets, as well as giving us exposure in improving credit fundamentals. We also believe we can finance these via exchangeable notes and our warehouse facility to enhance our returns, and as our portfolio grows, we'll have the option to securitized loans and redeploy capital. We also believe that we have a competitive advantage in this space through Invesco's real estate platform. IVR works synergistically with our Invesco real estate team to not only source loans, but to provide due diligence, and to provide us with 30 years of equity real estate experience if we ever need to take over a property. Importantly, access to this platform comes with no additional expense to IVR shareholders.

We are beginning to gain momentum as our credit line grows and we begin to close loans. So far we have closed four loans, investing $64 million, and you should see these numbers grow over the coming quarters. The economics of this opportunity are attractive, with unlevered yields ranging from approximately 4% to 10%, and by utilizing modest leverage can achieve our target ROE in this sector of 10 to 12%.

The second opportunity that I want to discuss is residential securitization on slide ten. Much like the CRE opportunity, the potential size of the private-label securitization space is very large. The US residential market is just under $10 trillion, and if you look at the chart on the upper right of the slide, private-label securitization has been very slow to recover. However, we believe that we will see volumes grow over the next three to five years.

IVR has been active in this space, as we participated in five securitizations as of year-end. We have retained the subordinate classes of these structures, giving us exposure to loans that are being made in an environment with excellent underwriting standards. In our five deals, which total just under 2300 loans and $1.8 billion, we have zero 60+ delinquencies, and we have seen the average LTV of these loans improve from 68% to 62%, as home prices have increased. The target ROE of these deals is 10% to 12%, and we saw the execution of AAA tranches improve late last year. We expect that trend will continue, which will help support ROEs.

Besides an attractive ROE, securitizations offer IVR several other benefits. These include the ability to replace repo financing with permanent match fund at non-repurch leverage. It also gives us access to the interest only tranches which helps protect us from interest rate risk.

The last opportunity I want to discuss is GSE risk sharing on slide 11. Like the last two opportunities, we believe the potential opportunity here is large. GSE pooled issuance has averaged over $1 trillion, per year and risk-sharing is a key part of FHFA's plan to reduce the government's role in housing finance. During 2013, these deals referenced almost $88 billion in loan balance, and approximately $1.8 billion in securities were issued. These deals have been very well received by the market and we believe the issuance will be larger this year then, last and that they will be commonplace thereafter. We also expect the GSEs to offer senior substructures which will represent another great opportunity for us to participate.

Underwriting residential loans is one of IVR's strengths, and we are well positioned to provide private first loss capital in this space. We participate in each of the risk-sharing deals so far, and we are targeting return of approximately 12% when employing modest leverage. Besides giving us access to subordinate bonds, and well-underwritten collateral, these deals also lessen our dependence on repo financing, and because they have a flow to rate coupon, they also help protect us from rising rates.

With that, I'll turn it back over to Rich to wrap up.

Thanks, John. Invesco Mortgage Capital is positioned to capitalize on the future of the US mortgage market. In 2009 through 2012, mortgage investors were rewarded to simply accept interest rate and credit risk. But that was not the case in 2013, and it will require more for mortgage REITs to thrive in the future. And prices of shares in the mortgage REIT space reflect that view. Our goal in 2014 is to differentiate Invesco Mortgage Capital, giving investors confidence that we can and will continue to earn a strong dividend, but with significantly lower book value volatility. We have outlined today the strategies we believe will best capture attractive returns prospectively.

On slide 12, why do we believe we're the best positioned to execute on these initiatives? We have a business model that's flexible. We have a strategy that's forward-looking and opportunity set that is broad. We have a team with the breadth, experience, and expertise needed to underwrite properties and borrowers, a team that is stable and one this avoids the mistakes that led to the mortgage crisis. Finally, we have a platform that provides the necessary resources, among them unique loan sourcing opportunities and strong counter party relationships that improve sourcing and funding. We aim to provide investors a way to capture the opportunities available today in a very well underwritten mortgage credit without accepting inordinate interest rate risks and volatility associated with rising rates.

That concludes our prepared remarks. Operator, please open up the line for questions.

Thank you. (Operator Instructions). Our first question comes from Trevor Cranston from JMP Securities, and, sir, your line is open.

Trevor, I'm sorry, we can't hear you. Are you on mute?

Mr. Cranston, your line is open. Please proceed with your question.

Operator, let's proceed to the next, and then we can come back to Trevor.

Thank you. And our next question comes from Nick Agarwal, Wells Fargo Securities. And, sir, your line is open.

Good morning, guys. Quick question. On the active pipeline, can you give us a sense of what the size is on the CRE?

We have -- we have a field log. It's relatively long. I can't give you a number, but we have a number of deals that we're working on now.

Okay. So is it safe to assume that roughly the $64 million is a good run rate on a quarterly basis, then?

I think we hope to do more than this. But that's maybe a good assumption for the short term.

Great. And then on the residential securitization side, the five deals last year, are you also still targeting roughly a deal a quarter?

Yes. If we can get that done, we'd like to do that.

And are you able to continue to see those deals given the bank appetite for this collateral?

Yes. We've been seeing one -- approximately one every quarter, so we'd expect that to continue.

Great. Thanks, guys.

(Operator Instructions).

Operator, are there any further questions?

And excuse mow, I do have Steve DeLaney, JMPSecurities. Your line is open.

Hey, good morning everyone and apologies, Trevor was on the call from New York, and I think he lost the connection somewhere, probably off with his cell phone. So I'll jump in for him if I may.

Good morning.

And we have Mark DeVries, and that was with Barclays. Your line is open.

Okay. Sorry about that, Steve. So first question. I know you mentioned that you didn't really change your hedge position even though you've been selling agencies. Can you talk about where you think your net duration is at this point, particularly factoring in any kind of other non-agency CMBS that may have some positive duration associated with it?

Year-end, I think we pointed out net and equity duration of around a little over five, and it's somewhat less than that now but still probably in the four to five range. You know, just commenting on that, we haven't been seeing a lot of book value volatility around [indiscernible]. We've pointed out that in the fourth quarter, we saw rates up quite a bit, book value was up a little bit. So far this quarter, rates are down, book value's up a little bit. So we've definitely are in a position where this directional movement in rates isn't having a great impact on our book value.

Okay. And then next question on just a little more detail on the GSE risk-sharing transactions I think John you mentioned you're looking for kind of 12% levered returns on this. Can you give us a little more detail on kind of what the yields are on that, what kind of expected losses are embedded, and what amount of leverage you would look to apply?

Right. So on the -- I guess on all fields on the lower tranche, the M2 tranche, spreads are approximately a LIBOR plus 4.25%. They have kind of settled in around that range. So applying a couple turns of leverage on there, gets us to low double digit yields. Financing on that has been pretty attractive, and we've seen haircuts in the 20, 20%ish range with rates kind of somewhere in that LIBOR plus 150.

Losses on -- on that, on those pools are likely to be absorbed by the first 30 basis points that the GSEs are keeping.

Got. It. Okay thanks.

Our next question comes from Ken Bruce, Bank of America Merrill Lynch. Your line is open.

Good morning.

Good morning, Ken.

Hi. So thank you for the information just in terms of what your kind of directing or redirecting the portfolio into. Is there a -- is there a target portfolio or an allocation that you have kind of in your mind as to what would be optimal at this point? And is it -- is that the proper way to think about it, that you're trying to get to kind of a target portfolio and that it -- at the point that you're at that steady state that we can effectively model it? Or do you expect the strategy to drift around a bit more over the next year or so?

Well, we're -- we have a hybrid business model so we're looking for the best risk-adjusted returns across the mortgage space. We're not targeting X percentage of the portfolio to be in each category, ad infinitum, but we do believe that we're moving towards lower repo balances and more assets where, they either don't need financing or need less to earn -- call it the 12% ROE.

So we've kind of outlined that we thought we could get CRE loans up to 25% or 30%, residential securitization. We expect that that will continue to grow over time, and then we'll see more opportunities in, say, the one deal a quarter. And we also expect the risk sharing to grow. So the absolute percentage of the entire portfolio that's in each of those things and then in securities finances repo will depend on the opportunities set as we go forward.

and is it -- is it appropriate to think about IVR as it's trying to manage the portfolio to that hurdle rate say maybe it's 12% today. That will likely drift around a bit. But that as you see the alternative opportunities to invest in the portfolio that the company's going to deleverage over time? I guess I'm just trying to think about how to model your business, understanding that there are these different opportunities to invest today. They seem to have very good returns, with a lot less leverage. Given where rates are likely headed, I think that's probably a good position to be taking but just trying to think through how it's going to evolve over time is I guess one of the challenges that we're having given the broader diversity today.

Yes. That's exactly right. We'll be deleveraging over time. So you can assume that the securities portfolio may remain leveraged 5.5 times like it is today. But the percentage of our equities invested in that space will continue to decline. You should see in every quarter, we should make progress in terms of new initiatives. And every one of those new initiatives is either no leverage or you know at most maybe in the risk sharing two turns. So you'll continue to see our leverage decline.

Okay. Thank you for your color and comments this morning.

You bet.

(Operator Instructions).

Well, operator if there are no further questions.

Excuse me. There are no further questions on the phone line. Thank you.

All right. So that's -- thank you for listening today and we're excited to talk to you at the next available opportunity.

Ladies and gentlemen, that does conclude today's conference call. Thank you for your participation, and you may disconnect your line at this time.