Invesco Mortgage Capital Inc (IVR) 2015 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the Invesco Mortgage Capital Incorporated second-quarter 2015 investor conference call.

(Operator Instructions)

As a reminder, this call is being recorded. Now I would like to turn the call over to Tony Semak in Investor Relations. Mr. Semak, you may begin the call.

Thank you, Keno, and good morning, everyone. Again, we want to welcome you to the Invesco Mortgage Capital second-quarter 2015 earnings call. I'm Tony Semak with Investor Relations, and our Management team and I are really delighted you joined us as we look forward to sharing with you our prepared remarks during the next several minutes before we conclude with a question-and-answer session. Joining me today are Rich King, Chief Executive Officer; Lee Phegley, Chief Financial Officer; John Anzalone, Chief Investment Officer; and Rob Kuster, Chief Operating Officer. Before we begin, I will provide the customary forward-looking statements disclosure, and then we will proceed to management's remarks.

Comments made in the associated conference call may include statements and information that constitute forward-looking statements within the meaning of the US Securities Laws as defined in the Private Securities Litigation Reform Act of 1995. And such statements are intended to be covered by the Safe Harbor provided by the same. Forward-looking statements include our views on the risk positioning of our portfolio, domestic and global market conditions including the residential and commercial real estate market. The market for our target assets; mortgage reform programs; our financial performance including our core earnings, economic returns, comprehensive income and changes in our book value; our ability to continue performance trends; the stability of portfolio yields, interest rates, credit spreads, prepayment trends, financing sources, cost of funds; our leverage and equity allocation, the impact of the restatement of our financial statements for certain periods and the adequacy of our disclosure controls and procedures and internal controls over financial reporting.

In addition, words such as believes, expects, anticipate, 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 statement 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-KA 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 this cautionary notice. We expressly disclaim any obligation to update the information in the public disclosure if any forward-looking statement later turns out to be inaccurate.

Again want to welcome everyone, and thank you so much for joining us today. We will now hear from our Chief Executive Officer, Rich King. Rich?

Thanks, Tony. Good morning, everybody. In the second quarter, we report core earnings of $0.41 per share, and we paid a $0.45 dividend. Our book value declined $0.75 per share in the second quarter to $18.62, reflecting a decrease of about 3.9%. Combining this dividend we paid with a decrease in book value, our economic return for the quarter was minus 1.5%. Year to date, we've made $0.91 per share of core earnings, paid $0.90 in dividends, and our book value is down $0.20. Our year-to-date economic return is therefore $0.70 per share, and that's on a beginning book value of $18.82, so 3.7% is our year-to-date economic return. This strength was the best in our peer group, and I think largely because our book value was only off about 1%, 1.1% in a difficult period. Our asset performance and our funding costs were generally in line with our expectations during the second quarter, though market conditions presented a few new challenges following the first quarter, which was generally pretty uneventful and accommodating.

First, let me talk about core earnings. In the first quarter, we earned $0.50 per share, and I will remind you on the call that followed the quarter, I mentioned that we didn't expect a repeat of the beneficial earnings impacts of our JV income, nor the slow prepays we saw in the fourth quarter and the first quarter. Each unfortunately proved to be true. In the second quarter, we earned less than $0.01 per share of JV income, and interest income was lower due to faster prepayments, higher amortization. In addition, it's becoming increasingly apparent that the Fed is planning to raise rates in the second half of the year, and we've been preparing for that by continuing to moderate interest rate risk which has contributed to our lower core earnings.

We've tactically invested available cash flow in this quarter -- in the second quarter -- in agency hybrids along with a strategic allocation to CRE loans to mute interest rate risks and keep some powder dry should we see volatility increase. We also increased our swap balances in the second quarter to protect NIM in the future should rates go up as expected. As a result of the foregoing actions, which we see as prudent from an economic and monetary policy outlook, our core earnings were $0.41 in the quarter, and that's probably a better indicator of go-forward core earnings than was the first quarter. We did see prepay speeds slow some in July, due to higher rates, and we believe prepay speeds should also benefit in the second half from lower seasonal housing turnover, but we also have some other impacts that go the other way. For instance, some higher ROE assets that we bought, legacy assets that begin to mature or pay down.

To summarize, earnings running a bit lower for now, but our portfolio definitely becoming less risky which we see as prudent at this time. We believe our Company offers investors attractive income and long-term book value stability. Before I elaborate further on asset positioning and market outlook and so forth, let me turn the call to Lee Phegley to discuss our recent 8-K.

Thank you, Rich. In connection with the preparation of our second-quarter financial statements, we examined our accounting per our investments in GSE CRTs and MBS IOs. In our previous financial reports, we accounted for these as investment securities with changes in fair value recorded in other comprehensive income. However, we have concluded these securities have features meeting the definition of embedded derivatives and that we should have been applying the derivative accounting guidance with changes in fair value of the derivative feature included in current income. We determined that these errors were material to previously issued 2013 and 2014 annual financial statements as well as our quarterly financial statements beginning with the first quarter 2013 and continuing through the first quarter of 2015.

Yesterday we filed a restated financial statement on Form 10-KA for the years ended December 2013 and 2014 and on Form 10-QA for the three-month period ended March 31, 2015. The corrections largely result in certain amounts previously recorded and other comprehensive income now being included in current income. As both OCI and net income are components of comprehensive income, there's no change in previously reported equity. During the restatement period, these assets were properly held at fair value on our consolidated balance sheet though our previously reported look book values are unchanged. Management believes this correction is a technical accounting issue with no meaningful effect on the Company's previously reported financial position or economic performance.

We have also consulted with tax advisors and confirmed that the change in accounting treatment has no impact on our taxable income or our compliance with REIT requirements. Without minimizing the meaningfulness of the accounting errors that occurred, it's important to note that in all affected periods, our equity, book value, core earnings per share, economic return and leverage measures reported were always correctly stated. In addition to correcting the GAAP financial statements, we have enhanced our financial reporting controls to ensure that instruments with complex accounting treatments are identified timely and accurately reflected in our financial statements. Rich?

Thanks, Lee. I want to emphasize that the restatement has in no way changed our investment strategy or favorable view on credit risk transfer securities or agency IOs. In fact, the CRT position has produced a double-digit IRR from a historic return perspective through Q2, and we currently expect that same return potential to continue. It's clearly an asset class aligned with our mission to provide private capital to the US mortgage market, and only about 0.06% of the reference mortgages underlying CRT are 60 plus days delinquent. Remarkably low level, reflecting the strong underwriting since the mortgage crisis and increasing home values. Both agency MBS IO and CRTs offer an attractive prospective return that should improve in the event that interest rates rise.

In Q2, we also continued making commercial real estate loans. We closed two loans totaling about $71 million. Importantly our pipeline is expanding. We are becoming a known mezzanine lender especially for large institutional quality assets, a space we believe is attractive, and we are seeing the benefits of increased market presence. We've closed an additional loan this quarter so far.

On page 5 of the deck, we present a roll-forward of our book value on the left. We've observed seasonal spread widening episodes the past few years, and this year's been no exception. Beginning in May, risk premiums increased due to the Greek crisis heavy seasonal supply calendar and in anticipation of a rate increase in the second half of the year. As a result, we saw some downward price volatility in the quarter. In the second quarter, the nonagency and credit risk transfer sectors were modestly lower due to credit spreads, and that caused a combined $0.06 of the decline in book value. Agency MBS and CMBS account for most of our interest rate duration in the portfolio, and we primarily use interest rate swaps to offset that duration.

Our hedges to swaps are positioned such that we are more protected from a rise in shorter maturity rates and hold a net positive duration and longer maturities, expecting the yield curve to continue to flatten. This flattening strategy has been beneficial for the previous five quarters, but it actually hurt us a bit in the second quarter counter to the trend, and we have seen the curve continue to flatten this quarter. In addition to the curve impact, CMBS spreads and agency mortgage spreads widened modestly in the quarter. MBS and CMBS together underperformed hedges by about $0.65, and we estimate the impact is roughly half spread widening and half the term structure that I described.

Year to date through the second quarter, our book value is down about 1% as I mentioned earlier, not a bad result considering what's gone on in markets. On the right, we show two measures of income. I already talked about core, which is a non-GAAP measure which excludes realized and unrealized changes in valuations of assets and liabilities. We earned $0.50 in Q1 and $0.41 in Q2. Core earnings as we said were impacted by natural prepayments and higher amortization. Also, our asset mix, higher swap balances and lower JV income.

Comprehensive income is also shown on the right which is also a GAAP measure. And that adds to changes in valuations of our assets and OCI to GAAP earnings, so it includes the fair value changes in both the assets and the hedges. It's generally similar to economic return. You will note comprehensive income was $1 for the first quarter, a loss of $0.30 for the second quarter, and so a positive $0.70 per share year to date which is equal to what we said economic return is.

On page 6 of the deck, we point out that IVR has changed its profile over the last 2.5 years, increasing credit and reducing interest rate risk. You can see however that this quarter, the allocation to agency MBS did increase some. We currently want to lean toward having some dry powder to invest as we approach the first Fed tightening which should occur in 2015. We believe our allocation of equity aligns shareholder outcomes with strong underwriting and economic fundamentals in both residential and commercial real estate. At the same time it provides the safety and liquidity of agency MBS, and we balance it with hedges that we believe gives our book value a reasonably low correlation to interest rates. As a result, our strategic positioning -- of this strategic positioning I should say - our book value volatility has declined markedly as shown in the bottom graph on page 6. I will now introduce John Anzalone, our CIO, to cover our investment strategy.

Thanks, Rich and thanks to everyone who's joining us on the call this morning. As Rich mentioned a few moments ago, we believe that the portfolio is well positioned for this environment where credit fundamentals are continuing to improve and interest rate uncertainty is prevalent. At quarter end, we had 62% of our equity allocated to credit assets split almost equally between residential and commercial credit. The remaining 38% is allocated to highly liquid agencies, and as I will discuss in a minute, we've constructed the agency portfolio to be less sensitive to prepayment risk. Overall the portfolio has continued to exhibit a limited correlation to changes in interest rates, and we believe we will continue to benefit from the diversification in the portfolio.

I'd look to some more detail on each sector starting with agency mortgages on slide 9. Our allocation in agencies changed slightly during the second quarter as we took the opportunity to reinvest portfolio cash flows into hybrid arms. 30-year fixed rate pools now make up 42% of the portfolio, and the collateral underlying these pools is higher coupon of 4.28% on average and is largely made up of well-seasoned specified pool paper. Likewise our 15-year paper is also higher coupon, about 3.75% on average, and well seasoned. Hybrid arms, which make up 37% of our agencies, have a shorter duration profile and limited extension risk. This gives us a portfolio that has a relatively short duration as well as more predictable cash flows, both of which are important rates are volatile.

We did see a modest decrease in prepayments due to seasonal factors as well as a lower rate environment last quarter. Given the increase in rates we just experienced, we expect prepayments fees to moderate over the course of the next few quarters. Our outlook on agencies remains constructive. Aside from the improving prepayment environment, there are a number of positive factors that favor agencies. Demand for agencies should remain strong as depressed global yields make agencies an attractive liquid and high-quality alternative to sovereign debt. Similarly, MBS yields are historically attractive relative to US investment grade corporates. And finally agency mortgages have tended to perform well in previous tightening cycles.

Now let's move on to slide 10 in residential credit. We continue to have a well-diversified mix of legacy bonds and newly underwritten credits. These bonds benefit from an improving fundamental backdrop where home sales, housing starts and home price gains indicate that the housing recovery continued to strengthen during the second quarter. Improving demand for housing is supportive of the credit profile of our nonagency RMBS and GSE credit risk transfer positions. The duration profile of these bonds is relatively short.

Our legacy [re-REMIC] book has durations of well under a year while the credit risk transfer bonds are floaters. The legacy positions continue to benefit from negative net supply and strong investor demand for short duration assets. As such legacy, RMBS spreads were well supported during the quarter. Credit risk transfer bonds widened as increased issuance and is still developing investor base weight on sector. As far as our outlook on residential credit, we think that this sector continues to be very attractive because of the factors I just highlighted. Improving fundamentals, negative net supply and strong demand for relatively high-yield short-duration assets.

Moving on to slide 11 in commercial credit, our commercial credit portfolio is also well diversified with a mix of legacy bonds post 2010 A and BBB, post 2010 AA and AAA positions which are largely financed at the homeland bank, and CRE loans. Property fundamentals continue to improve, and this provides support for our investments. Despite this, spreads were adversely impacted during the quarter as we saw a spike in new issuance as well as heightened macro volatility. We are benefiting from credit tiering as transactions with seasoned loans and stronger underwriting saw less spread widening. In particular, our subordinate positions were supported by strong underlying property price appreciation as well as investor demand for seasoned vintages. Our legacy portfolio which continues to pay down is benefiting from growing subordination levels and scarcity value. And finally, we closed two floating rate mezzanine loans during the quarter totaling approximately $71 million, and we expect increased growth here as our pipeline continues to build.

Before opening up the floor to questions, I will take a quick look at our financing. Our funding mix continues to be diversified with [repo] now accounting for 72% of our financing. The balance consists of federal home loan advances, exchangeable notes, preferred equity and securitization financing. Our cost of funds remained relatively stable during the quarter. Let me turn the call back over to Rich to wrap up before Q&A.

Thanks, John. The underpinnings of commercial and residential real estate credit are favorable. Underwriting is conservative as evidenced by agency conforming and prime jumbo loans having very, very little serious delinquency. We are favorable towards agency MBS as well. They performed actually very well historically in Fed tightening cycles.

In closing, we like the way we're positioned in this environment, we're leveraging the platform to find value, have enclosed the two mezzanine CRE loans in the quarter and expanding the pipeline. Our credit assets are aging nicely. They tend to roll down the yield curve and the credit curve over time, which brings down our book value volatility. We're very disciplined about risk management, hedging interest rate risk managing credit and spread risk, managing liquidity and continuing to improve our funding sources.

That includes -- finishes our prepared remarks, and I will open it up for Q&A now.

(Operator Instructions)

Keno, as we're waiting and allowing time for callers to queue up for questions, just as a reminder to everyone, we will have an archive of this presentation available on our website. The telephone recording can be accessed through September 1 by dialing (866) 369-3652 or for international callers 1(203) 369-0244. You can also view the slide presentation today. You can access it through our website at www.InvescoMortgageCapital.com. And you can click on the second-quarter 2015 earnings presentation link where you can find other Investor Relations tab at the top of our homepage. There you can select either the presentation or the webcast option for both the presentation slides and the audio. We have any questions?

Dan Altscher, FBR.

This is actually Cole Allen on for Dan Altscher. I had a few quickies. Let's start with the JV. So you told us before that obviously we weren't going to have a run rate like we did last quarter. Is this a better picture of what it's going to be like going forward, or you expect a little bit better performance than this quarter?

I would say more like this quarter. It's a relatively small investment. So I think $0.01 a quarter is actually not a bad result there.

All right. Cool. And then second, you talked a lot about the portfolio positioning and you guys closed the commercial loan subsequent to quarter. And you said you got a pretty robust commercial pipeline. Do you expect that to pick up the commercial as a percentage of your portfolio this quarter, or is this in the coming quarters you expect the pipeline to ramp up?

We're really pleased about the pipeline. And it's exciting because we've been able to focus on larger quality assets and provide [mes] behind some high-quality US and Canadian balance sheet lenders. And I think as we've become known partners to some of these guys, we're seeing more of the types of deals that we like. And they know we're committed to the space. I think over time it will continue to become a bigger part of our equity, but we're very selective and very careful in the underwriting in that part of the portfolio especially. Because they are large, chunky investments and they are mezzanine investments. So long answer, but I think we will continue to see it grow, not necessarily this quarter.

All right. Sounds good. I have one last one. Could you guys give a little bit more color on how you've seen 3Q fair? I know you said you expect CPRs to track down the back half of the year. Are you guys seeing that this quarter so far?

On CPRs, we have the first print from July was we saw speeds moderating a little bit. We do expect that to continue over the next couple of months. So that will be a bit of a positive.

Perfect. Thanks, guys.

Doug Harter, Credit Suisse.

How are you guys thinking about share buyback in the current environment?

We're thinking that buying our stock looks like an attractive investment in here. As we look across the landscape, it's just the stock's at such a large discount, that despite some of the things that we've talked about in the past, in terms of a lot of considerations, I think buying back our stock looks like one of our better investments at this point, Doug.

Great. Obviously in the past since 2013, you guys were fairly active in buying back your stock. Is there any way you can help us think about the pacing relative to the last time you guys were active?

No. I don't think I'm going to give any guidance on that at this point. But I'd say it would be fair to say that it would be out of cash flow.

Got it. Thank you.

Joel Houck, Wells Fargo.

The question is regarding -- I think it's a new disclosure you put in there, the annualized book value about [peak six]. And question is, does that just fall out from the overall asset allocation and resulting hedging strategy, or is this something that you're managing to show investors that there's less tolerance for quarterly volatility in book value?

No. It's really a long-term strategic initiative that we began at the beginning of 2013. And really just with the notion that we definitely want to provide an attractive income, and that hasn't changed. But there's certain levels of volatility that are just too high. And especially when you have a levered balance sheet. And this chart is really to remind shareholders that we have been successful in reducing our volatility. And I think in large part, if some of the discount in stock price in the sector relates to book value volatility, that our book value volatility is now lower than most. And it's certainly played out this year to date. So it's not in any way to say that we're going to continue to decrease risk and that will continue to have a negative impact on our earnings. I think we're happy with where we've gotten to in terms of risk management.

Thank you very much, Rich.

Trevor Cranston, JMP Securities.

On the resi credit side, looks like you didn't add any new prime jumbo securitizations to the balance sheet this quarter. Can you give us an update on what you're seeing in the new issuance market, how are you thinking about that opportunity versus CRT and other credit investments?

Trevor, it's John. We're just seeing that the ROEs just aren't as high in that space right now. I think the execution levels for AAAs are at the point where it doesn't make as much sense as buying CRTs or other uses of cash at this point.

Okay. Got it. And on the commercial side, from what we've seen, CMBS spreads seem to have widened out a decent amount in third quarter. Can you comment on if you guys think there's any -- if that's more of a technical that the market's been widening and you'd expect that to tighten in as we move into September? And can you also comment on whether or not that's had a meaningful impact on book value quarter to date?

Right. I will take the second question first. So book value year to date we see down maybe a couple percent -- quarter to date. I'm sorry. And really we've seen weakness across most credit spreads. I think if you look across any credit spreads away from structured securities, it has been a pretty weak quarter. I think in CMBS as well as CRT, it's been a bit of a question of large issuance calendar has weighed on the sector. And we've had these episodes in the summer also where it's a bit of a seasonal impact also. From our perspective, we've seen if you look at generic CMBS spreads, we see lower A and BBB type spreads out 40 to 50 basis points generically. We've seen a lot better performance in that. I think I referred to it briefly in my remarks, but we own -- in lower rated tranches we tend to own pretty well seasoned bonds and those held up a lot better and have really benefited from the improving CRE prices. So we have seen book value weakness because of that. But really I think our position has been really good through this.

And then to the second, third part of your question, with regards to what we think will happen, I think once we get past this issuance calendar, we should see spreads start to moderate. I think once we get into later this quarter, get past the Fed, Rich mentioned we wanted to have some dry powder. And I think that's the kind of thing we're looking for is to see an environment where we think spreads are moderating. But overall we think fundamentals look good. So waiting to pick our spots.

Great. Thanks, guys.

Mike Widner, KBW.

Let me ask you a quick one on the agency hybrid ARMS that you said you were adding to this quarter. A couple things on those. Specifically what kind of ARMS are you buying? Are they 10/1's new issue kind of seasoned? And then related to that, where do you see the yields in the net spreads on the incremental purchases you're making there these days?

In the hybrids, focusing mostly on 7/1s. Maybe a little bit of 5/1s involved, but predominantly 7/1. The yields on those, we said they're obviously lower yield, but obviously less complexity risk and less extension risk. We're probably in the 2% in terms of asset yields on those.

And those are new issue you're buying?

Yes.

Okay. You added some hedges this quarter. Mostly it looks like coming on replacing runoff, but doing anything different or thinking about anything different with the hedge book for those?

Right. No. Not really. We look at our hedge book holistically. So it's not like we think about it in terms of hybrids, but strategy's been pretty much the same.

Okay. Another small one, on you guys have a fair amount of variable rate assets in the portfolio, but on the CMBS specifically, the post 2010 stuff, that's all fixed rate. Is that right?

Yes.

Okay. Last question a little bit bigger picture, if I heard you right on your opening comments in response to some of the questions, you said that -- I think your words were 2Q is probably a better indication of run rate earnings than 1Q. And so given core earnings $0.41, is there an implication there about the dividend or how do you think about the dividend with respect to core earnings power, Fed tightening, et cetera?

Thanks, Mike. Our policy is to pay out taxable income. Tax accounting is different than GAAP accounting, obviously. Having said that, core is probably as close of approximation to taxable as we can give. So -- but the dividend is also declared by the Board, and no determination's been made for the rest of the year.

So it would be premature for me to comment on the dividend. I think it's fair to say that if $0.41 is more reflective than $0.50 and we're paying $0.45, you can make your own conclusions from that.

Fair enough. And related to that, I didn't see it in here, maybe you have it in the Q and I haven't found it, but is there any undistributed additional that you have to distribute any carryover from last year anything like that?

No.

Okay. Great. Thank you, guys. Appreciate the comments as always.

David Walrod, Ladenburg.

We've gone through most of my questions. Just had a question quick one on the FHLB. Your funding from that source quarter-over-quarter was flat. Can you give us an update on how we could expect you to access those funds?

We don't have any plans at this point to increase that funding. We do have additional capacity there that we can use at some point in the future.

You had been growing it pretty aggressively. Has something changed in that regard?

No. Not really. We have to manage that like we do anything else, to the investment company guidelines and REIT rules and so forth. So for right now, we like where we are with that.

Okay. Thank you.

Brock Vandervliet, Nomura Securities.

Most of my questions have been answered, but could you confirm the book value performance quarter to date? You touched on that in an earlier question.

Just estimate it's down about 2% since the end of the second quarter. And again, that's spread widening, not anything to do with interest rates.

Got it. Okay. Thank you. That's helpful. And in terms of earnings power, just asking a question a different way maybe, do you expect any clawback in net interest spread here assuming that the prepaid amortization settles back down in the back half?

Yes. We would. We would expect that we would see our net interest margin increase some from slower prepayments. And I was just saying that there are other factors that we also see on the other side of that, like higher-yielding legacy assets and runoff mode.

Got it. Okay. Thank you. That's helpful.

At this time, speakers, there are no questions in queue.

(Operator Instructions)

We want to thank everyone for joining us today and appreciate your participation. We are always happy to answer questions that may come up afterwards, so reach out to us anytime. We thank you very much.

Thank you, speakers. That concludes today's conference. Thank you for participating. You may now disconnect.