Invesco Mortgage Capital Inc (IVR) 2016 Q1 法說會逐字稿

Good morning, ladies, gentlemen. Welcome to the Invesco Mortgage Capital's first-quarter 2016 investor conference call.

(Operator Instructions)

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

Thank you, John, and good morning, everyone. Again, we really want to welcome you to the Invesco Mortgage Capital first-quarter 2016 earnings call. Tony Semak, with Investor Relations. Our management team and I are very delighted you joined us. We're really looking forward to sharing with you our prepared remarks, as we always do, in 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'll provide the customary forward-looking statement 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 return, 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. In addition, words such as believes, expects, anticipates, intends, plans, estimates, projects, forecasts, and future or conditional verbs such as will, may, could, should, and would, as well as any other statement that necessarily depends on future events, are intended to identify forward-looking statements.

Forward-looking statements are not guarantees and they involve risks, uncertainties and assumptions. There can be no assurance that actual results will not differ materially from our expectations. We caution investors not 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 Conditions 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 this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns out to be inaccurate.

An archive of this presentation is available on our website and the auto replay can be accessed through May 24 by dialing 800-925-1940, or for international callers,1-402-998-1654.

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

Thanks, Tony and good morning, ladies and gentlemen. Appreciate you joining today.

So we will start out with slide 3 of the deck. In the first quarter, Invesco Mortgage Capital earned core income of $0.44 and in the quarter we declared a $0.40 dividend. Core earnings benefited during the quarter from multiple sources including reduced interest expense on our hedging book, favorably slow prepaid speeds, and accretion from share repurchases.

In the first quarter, we continued to reduce the size of the portfolio, both asset balances and repurchase agreement financing balances; and so duration hedging needs declined as well. Therefore we have continued to reduce interest-rate hedges and still have maintained our overall low-equity duration. As for the reduced asset balances, we chose to sell lower ROE assets with shorter durations because we are positive on credit conditions and wanted to maintain upside from spread tightening. We reduced hedging costs by taking off primarily shorter slots that would not help us a great deal in terms of interest-rate protection, given that we believe the Fed is going to move cautiously for this year at a minimum.

Book value declined 3.6% in the first quarter due to credit-spread movements. Given the spread widening in Q1, our economic return -- that is the change in our book value plus dividends paid -- was slightly negative at minus 1.2%. The good news there is when book value declines like this, due to spread widening, it doesn't leave any permanent mark. Book value comes back when spreads come back; and, by the way, they already have and we estimate that our book value per share now is about where we started the year -- so up about 3.5%.

We think in this low-rate environment, with slow but steady economic growth, credit spreads are going to end up tighter over time. Historically, that is what happens: the longer we stay at a given level of rates, spread gets tighter. The volatility we saw in the first six weeks of the quarter have subsided, the financial conditions have improved and the outlook is favorable now.

In April, we gained back, like I said, I think in April, about 3%; and then the rest since then, out here in May. And I am very pleased with the way the Company responded to the volatility. The changes we've made over the past few years to reduce book value volatility really paid dividends, pun intended. And we will likely repurchase stock and we'll be opportunistic and buy shares when that is in the best use of capital. We are optimistic about economic returns and about our stock performance for 2016.

In the quarter, we funded four CRE loans totaling $70 million, roughly. And in a quarter where we had really limited time to operate in the open we bought back $25 million of our shares. Over the past three quarters, we have now bought back close to 10% of our outstanding shares. With that, let's turn to slide 4 in the presentation and talk more specifically about the Q1 book value. As I mentioned, the first quarter was a volatile environment for financial markets and credit spreads widened in January and early February and then recovered to end only modestly wider. In early February, the volatility was significant and the credit cash liquidity risk repriced in a correlated fashion.

The quarter actually ended with spreads only nominally wider, but rates ended the quarter significantly lower despite that recovery in spreads. And falling rates in Q1 caused temporary reduction in a component of book value due to our swap hedges and we label those as derivatives on the page by $1.86 per share. The market yields on our assets fell also, along with risk-free rates, but by less than swaps. And that constitutes the spread widening. And the others we're hedging predominantly on the chart here labeled as Agency MBS and CMBS, together contributed $1.23 to book value, so less than the hedges cost us, $1.86.

Our residential portfolio has little duration and, with weaker spreads, the contribution to book value was to take book value down $0.11. On the positive side, we accreted about $0.09 of book value from share repurchases. Obviously, we paid out most of our core income of $0.44 via the $0.40 dividend.

We are in a good place going forward, with an attractive dividend, strong improving asset quality, low interest-rate risk, and declining book value volatility. We're positive on credit spreads and credit fundamentals as well. And we also see that with increased regulation ongoing for securitization, we are well-positioned to be in an opportunity to capture some trades that work for private capital and earn attractive returns and continue to reduce leverage.

With that, I'm going to turn it over to John Anzalone, our CIO, who will now tell you about our portfolio and strategy.

Thanks, Rich; and thanks again to everyone joining us on the call this morning. I will start with slide 6. As you can see from the pie charts, our portfolio is still well-diversified, with 66% of our equity allocated to credit and 34% allocated to agency mortgages. While we kept our overall sector allocations fairly stable compared to last quarter, we did shift equity to commercial real estate loans. Since these loans are held unlevered, they consume more capital than bonds that we finance. As such, we sold lower-yielding assets in each sector to fund these loans as well as to fund share repurchases. Accordingly, we also unwound swaps that rolled down the curve and were no longer providing much protection from changes in rates.

The portfolio experienced some pretty significant spread widening during January and February, but we saw that trend largely reverse in March and April, leaving spreads roughly unchanged at the quarter end. I want to reiterate Rich's point that we view volatility and spreads on high-quality assets as a temporary phenomenon. And given the solid fundamental backdrop in both residential and commercial real estate, we expect that credit spreads will continue to be well-supported.

While we like high-quality credit, we continue to position the Company conservatively with regard to interest-rate risk. In fact, the empirical duration of the portfolio continues to hover around zero, meaning the changes in interest rates have not had a meaningful impact on book value. We think this is important because if you have a large interest-rate exposure, the cost of constantly resetting hedges becomes more expensive as rate volatility increases.

Let's take a closer look at each sector, starting with agency mortgages on slide 7. We kept the allocations within our agency book relatively stable this quarter and our focus continues to be on bonds backed by collateral with shorter duration profiles and stable cash-flow characteristics. As you can see on the chart, we finished through a combination of hybrid ARMs,15-year collateral, and higher coupon well-seasoned specified pool 30-year paper. Prepayments moderated during the quarter as we hit the seasonal lows in January. We have since seen spread increase with the March print and, given lower mortgage rates increased seasonal housing activity, we expect these to remain somewhat elevated over the next several months.

Let's move on to our residential credit, starting on slide 8. Our residential book is made up of 60% legacy paper and 40% new issue bonds. Fundamentals still look positive, as limited inventory and low mortgage rates support home prices. Additionally, a strengthening labor market and favorable demographic trends are helping to drive an increase in housing demand, spread through our mix during the quarter, with legacy paper ending the quarter a touch weaker, and CRT bonds rallying sharply in March to close the quarter slightly higher. I'd like to point out the duration profile of our residential credit book in the table at the bottom of the slide. With the exception of new issue RMBS at 1.5 years, the average duration for the various asset classes is less than half a year, meaning that this part of the portfolio is well-insulated from interest-rate risk.

On slide 9, we provide an update on the credit quality of our residential portfolio. The chart on the left shows that over 65% of our non-agency holdings have dollar prices above $90. This is important, because high dollar priced bonds have a limited exposure to collateral performance issues, lower price volatility, and are generally more attractive to finance. The chart on the right breaks out the vintage data for the various sectors. The legacy paper is focused in prime and Alt-A securities, as well as senior re-REMICs. These all represent bonds that are at the top of the capital structure. The GSE transfer bonds are largely 2013 and 2014 vintages. These bonds reference loans with significant embedded home price appreciation and these seasoned transactions tend to demonstrate lower price volatility compared to more recent issuance.

On slide 10, we show a breakout of our commercial credit portfolio. As the legacy portion continues to pay off, the portfolio is now dominated by post-crisis paper. The A, BBB paper was issued in 2013 or earlier, and benefits from collateral appreciation as well and strong underwriting. The AA, AAA paper benefits from higher subordination levels and enjoys favorable financing. Fundamentals remain strong as favorable trends in rent and occupancy rates support the market. Credit spreads were quite volatile during the quarter, widening earlier in the quarter and recovering most of the widening by quarter end. Additionally, we closed four new commercial loans totaling $70 million during the quarter which brings us to slide 11.

On slide 11 is a breakout of our commercial loan investments. I will not go through all of the details on the slide, but the important highlights are: the portfolio was $317 million at quarter end; we've had $112 million of principal returns to the realization of borrower business plans; we've experienced no delinquencies and the weighted-average LTV of the portfolio was 66% at quarter-end; we've made mezzanine investments behind five different balance sheet lenders; and the portfolio is diverse both geographically as well as by property type.

On slide 12, we give a picture of the credit quality of our commercial credit. On our CMBS portfolio, the average LTV is 36%; and, as I just mentioned, the LTV on our CRE book is 66%. We show the vintage breakout of our CMBS portfolio on the right. This shows that 95% of the loans backing our bonds were originated in 2014 or earlier; and these benefit from notable property-price appreciation.

Finally, on slide 13, we give some highlights of our financing. The financing remained stable through quarter, with cost of funds modestly higher, in line with the December rate hike.

That is it for our prepared remarks; we would like to open the line for Q&A.

(Operator Instructions)

First question is from Douglas Harter from Credit Suisse.

Rich or John, can you talk about how your interest-rate exposure looks today compared to last quarter, given some of the swap repositioning that you've talked to.

This is John. It looks pretty similar.

If we run our empirical generations and we still see very little correlation to rates the way we are positioned right now. A lot of the swaps that we took off had rolled down the curve. Most of them were inside of a year left and so weren't really providing a whole lot of protection, anyway. Taking them off didn't really impact our interest-rate position.

Great. And given your comments that spreads have fully tightened and book value has fully recovered, how do you see the return environment for new investments compared to repurchasing your stock?

On share repurchases, that's going to depend on where the stock is obviously, during the quarter. And we look every day at what our opportunities are and where the stock price is. And I think it's likely that we will continue to buy back shares during the quarter.

As far as the return opportunities, with the tightening that has happened, we are probably high single digits to low double digits on most securitized opportunities; and maybe with the exception of risk-sharing, which is somewhat higher. And obviously, the commercial loans, we'll continue to look to be in the market there and look for opportunities to buy the bond at capital stack partnering with issuers in the CMBS space under the new risk retention rules, which we expect to start seeing deals pretty soon.

Our next question is from Bose George of KBW.

Just a follow-up on the question about incremental investments. Can you go through the different buckets and highlight what is the most attractive areas in terms of ROEs?

In terms of, on the bond side, I think within agencies, we're favoring 15 years both from a shorter duration profile and on evaluation basis versus hybrids. Like Rich said, I think most of the sectors are going to be in the low double-digits, call it right around 10%, ROE. So, we favor 15s. CRT bonds, we have not been adding recently. That has been a pretty volatile sector. But I think we're beginning to get a little more comfortable. There's been some positives in that market over the last couple quarters.

We've seen trading volumes hit have increased, which has really been notable for the sector. New issue deals have been pretty well received. Fundamentals look good; we saw the first upgrades. So we are becoming more positive on that story. The bad news is that ROEs have tightened in. We went from probably solidly mid double-digits, 15 call it, ROEs into maybe 10 to 12 type ROEs on CRT.

And then on CMBS, again, that is the same kind of story. It is lower double-digit type ROEs. We have been less active there because we are not as positive on the underwriting that's occurred more recently. Although we do expect to see underwriting improve over the course of the year as some of the regulations come in and issuers have to get in the game with the risk retention rule. So do we expect to see an improvement in underwriting, and we will probably wait to start seeing that materialize before we get involved in that market.

Okay. Great. That's helpful.

In terms of the performance of the commercial book this quarter, between the two big buckets that you have, the AAAs and BB and BBB, was the performance pretty similar, the widening and then come back in? Or did one sector perform meaningfully different?

The lower rating definitely saw more volatility, as you'd expect. And they both had the same trend, in that they widened in January or February and then came back since. I would say triple Bs definitely had, had a little bit more volatility.

And some more of that gain that you had in the quarter was really from the AAAs, presumably?

Yes. That's right.

Okay.

Just one more on prepayments. In terms of the prepayment outlook for the next couple quarters, you mentioned the expected increase; can you quantify that in terms of what you might expect?

So we had the first quarter prints, which you can see on the slide. But then, in the beginning of April, we had our term the March prepay in print; and that was up probably 2 or 3 CPR, something in that range. Percentage-wise it's pretty big because it's only off of pretty low, double-digit number, so it's up by 20% or 30%, something like that.

So we expect it to stay in that mid-teens over the next couple -- probably the next quarter or two. Which is pretty typical as we hit spring seasonals and then we expect -- and a lot obviously is going to be dependent on rates, just our level of rates. But, I know if rates pay around here, but we expect REITs to stay elevated for a quarter or two and then start to trail off as we get into summer.

Thanks a lot.

And we now have a question from Brock Vandervliet with Nomura Securities.

Just wondering if you can talk more about risk retention and how that may impact the playing field in CMBS. We've seen one deal in the residential space and Mortgage REIT was able to by the subordinate piece of third-party transaction. Is that kind of what you are expecting to see in CMBS as well?

I think we really not sure what form it is going to take yet. In terms of what structure is going to look like, whether it is going to be vertical slices or horizontal slices in terms of that 5% risk retention. A little bit uncertain what is going to look like. But we do expect that we will have opportunities like that go forward. We haven't seen it yet.

I would just add that we think that really no matter the outcome of what ends up being the most attractive to issuers that there will be increased opportunity for us because typically the BP spires didn't have to retain any risk, and the BPs spires could sell their positions whenever they wanted to. And so now with the requirement that whoever holds the risk position has retain it for 5 to 10 years; it is going to be more permanent capital players that participate there. And it is going to require higher yields and the buyers will have even more say over the collateral.

So in our ability to dictate what risk we are willing to accept and what loans get funded in the deal et cetera. And then, in addition to that, the Reg-AB is also causing greater scrutiny in the space. If issuers want to do a vertical slice and take 5% of each tranche, then a lot of the bottom tranche will be available and won't have to be held for a long period of time. And so we'll see, but it is exciting and I think it fits us perfectly.

And the risk retention rule has already changed, so we should see this occurring?

It actually goes into effect in December of this year, so people are just preparing for it and modeling out what the best structure is and how much loan rates would potentially have to go up to borrowers to make it economic.

Thank you.

Our next question is form Mark DeVries from Barclays.

Sorry if I missed this, but could you help me understand the comment that commercial credit was accretive to book value during this quarter. It seems a little surprising given the weakness we saw and spreads on commercial loans.

Well, look, if you disaggregate. If you look at it as a spread, yes. That was part of the reason book value declined. But when you break down as say, okay, wait; we lost book value from our derivative hedges on an absolute basis and then compare how much we gained from commercial prices up during the quarter. Because basically rates fell, on balance our CMBS went up in price; they just didn't go up in price as much as they should have, given the rate in those. Does that make sense?

Yes. That does it for me. Thanks.

And our next question is from Trevor Cranston of JMP Securities.

Just a couple detailed follow-ups. First, can you give us the notional balance of the swap book after the changes you made in the first quarter and also the weighted average term of the remaining swaps?

I don't have that right in front of name, but the average maturity is about four years of the swap book. And I'm sorry, what was the other question? Oh the notional side? The notional side is approximately $6.9 billion. So with the Q, will come out later today.

And then, I may have missed this one. John was going through the returns on the various asset buckets. Can you talk about where you are seeing the loan rates in the mid-loan market and how those moved around with changes in CMBS spreads?

On the loan market. We actually are seeing -- we saw somewhat better opportunities from the volatility in the market reduced the ability for borrowers to borrow in the CMBS market. I would say, just generally, not necessarily higher rates, but similar rates for better risk in our wheelhouse, I'll call it, of LIBOR plus 7 to 10.

Okay. That's helpful. Thank you.

Our next question from Max Meyer of Wells Fargo.

I just had a question with regard to the agency portfolio. We known some of your peers have taken out their extended agency to leverage a little bit and duration was a bit -- somewhat counteracted spread widening in other areas of the portfolio. Can you talk about how you see agency leverage moving forward and duration as a whole?

We're pretty focused on keeping our impairable duration profile as close to zero as we as we can. That is really what has driven a lot of our positioning within agencies. So that is why we've been -- if you look at our agency portfolio over the last, even, couple of years, we had pretty large migration from 30s into 50s, and hybrids and even in the 30 book, if we just let it season with mostly higher coupons that are now shorter duration also. That is how we are thinking about agency at this point.

Because really, we think there is a lot more risk to spread volatility and it's harder to control that. Versis. I think we have a very good ability to control our credit risks, so that is kind of how we are thinking about it. I don't see that we will really change our agency allocation. It'll remain important obviously to provide liquidity and all of those things and meet hopeful tests, but certainly within that book we want to try to drive out as much interest-rate risk as we can.

That's helpful. And then one other question, with regard to the taking on the hedges, the swaps, and also specific to the commercial portfolio, I noticed you pulled some your K-series position and then also some of your legacy CMBS, can you give us an idea of the timing of those events within the quarter?

It was throughout the quarter. Not necessarily all at once, but I would say generally earlier in the quarter going when we took off most of the swaps and sold most of the assets. And basically, driven by the share repurchases that occurred, really in the fourth quarter and into the first quarter we were still repositioning the portfolio.

Keep in mind that the bonds we sold tended to be ones that we've held for a long time that have really rolled down the curve that we didn't feel like had a lot of upside left. So they tended to be shorter duration and weren't as impacted by some of the volatility because they were much shorter cash flows. So they were kind of funds that we felt like weren't helping us so much and could redeploy into buying back shores, like I said, or funding some of the commercial stuff, commercial real-estate loans.

That's helpful. And one last question, if I may.

Do you think that level of swaps or hedges and that high level of agency leverage around 10 times is more normal for the future, or do you think we can expect those things to revert in coming quarters?

I think it is probably fairly normal. I'd say the type of agencies we own, I don't think you can emphasize enough that, if you have 9 times leverage, let's say, on 30-year threes is much, much riskier than 9 times on hybrids and 15s and up in coupon-type assets that just don't have a lot of price volatility. So I would say maybe not 10, but probably 9 times.

Okay. That's helpful. Thank you very much.

We have Brock Vandervliet again from Nomura Securities.

Just as a follow-up to the last question and, given the movements you made this quarter and going forward, should we expect essentially a rebuild in part of the swap position and therefore a higher cost of funds or is this essentially sustainable here?

I think where we are, given our level of assets, we are hedged appropriately here.

So unless you decide to take up the book, this is a reasonable level right here?

Yes. And I don't anticipate it's putting on a lot of long-duration assets.

Thanks.

At this time, we don't have any questions on queue. I would now like to hand the call over back to our speakers.

Thanks. I appreciate everyone dialing in today and we'll talk to you next time. Thanks.

Thank you. And that concludes today's conference. Thank you for participating. You may now disconnect.