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Invesco Mortgage Capital Inc  (NYSE:IVR)
Q4 2018 Earnings Conference Call
Feb. 21, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to the Invesco Mortgage Capital Inc.'s Fourth Quarter 2018 Investor Conference Call. All participants will be in listen-only mode until the question-and-answer session. (Operator Instructions) As a reminder, this call is being recorded. I would now like to turn your call over to Brandon Burk in Investor Relations, Mr. Burk, you may begin the call.

Brandon Burk -- Director, Investor Relations

Thank you and welcome to the Invesco Mortgage Capital fourth quarter 2018 earnings call. The management team and I are delighted you've joined us. We look forward to sharing with you our prepared remarks during the next several minutes before concluding with a question-and-answer session.

Joining today are John Anzalone, our Chief Executive Officer; Kevin Collins, our President; Lee Phegley, our Chief Financial Officer; Dave Lyle, our Chief Operating Officer; and Brian Norris, our Chief Investment Officer.

Before we begin, I would like to direct your attention to slide two of our earnings presentation, which discusses forward-looking statements in detail. Statements made in this conference call regarding Invesco Mortgage Capital that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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 statements and urge you to carefully consider the risks identified under the captions risk factors, forward-looking statements and management's discussion and analysis of financial condition and results of operations in our Annual Report Form 10-K and quarterly reports on Form 10-Q, which are available on the SEC 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 and any public disclosure if any forward-looking statement later turns out to be inaccurate.

To view the slide presentation today, you may access our website at invescomortgagecapital.com. and click on the Q4 2018 earnings presentation link. You can find it under the Investor Relations tab at the top of our homepage. There you may either select the presentation or the webcast option for both the presentation slides and the audio. Again, welcome and thank you for joining us today.

I'll now turn the call over to our CEO, John Anzalone. John?

John Anzalone -- Chief Executive Officer

Thank you. And I'd like to welcome everyone to Invesco Mortgage Capital's fourth quarter earnings call. I will provide a recap of our results and an update on our outlook before turning over the call to Brian Norris, who'll go through the portfolio in a little more detail as well as providing some color on the successful deployment of the proceeds from our recent capital raise. The volatility that the financial markets experienced during the fourth quarter impacted nearly all risk assets and our mortgage investments were no exception. We saw wider spreads across our entire portfolio and agency mortgages had a particularly rough quarter, sharply underperforming treasuries. This led to a decline in our book value of 9.3% during the fourth quarter. Importantly, this price action was not due to any deterioration in the fundamental credit quality of the assets underlying our investments but reflected turmoil across markets caused by a host of macro factors, uncertainties surrounding Fed policy, trade policy, the government shutdown, Brexit among others.

As the concern over these factors began to recede, we saw a meaningful recovery in recent weeks and our book value has since recovered about half of the fourth quarter decline. On the positive side, we increased our core earnings for the quarter by $0.05 to $0.46 per share, easily covering our $0.42 dividend. This reflects the portfolio repositioning we executed during the second half of 2018, moving out of lower yielding 15-year and hybrid ARM agency mortgages and buying current coupon agency mortgages and agency CMBS with more attractive ROEs.

The portfolio rotation and our active interest rate hedging strategy allowed our net interest margin to increase by approximately 13 basis points despite an increase in funding costs. Our outlook for the portfolio is quite positive as credit fundamentals in both residential housing and commercial real estate remains supportive of our seasoned credit assets. Additionally, the decreased rate volatility brought on by a more dovish Fed should be supportive of agency mortgages.

To that end, we executed a $250 million equity offering early in February, which allowed us to capitalize on attractive opportunities in agency mortgages, agency CMBS and to a lesser extent in credit assets. We expect this offering to be solidly accretive to earnings and help us to maintain the positive earnings momentum we've been experiencing. Given the focus on deploying this new capital into agency securities, we've been very successful in putting this money to work with minimal drag to future earnings.

While this was a difficult quarter for book value performance in our sector, we believe that we are extremely well positioned for the current environment. Our diversification across both residential and commercial credit as well as agency investments has allowed us to seek the best risk adjusted returns within the mortgage market.

Looking ahead, we believe our strategy will help us continue to identify attractive risk-adjusted returns, which should prove beneficial to our shareholders.

Now let me turn the call over to our Chief Investment Officer, Brian Norris.

Brian P. Norris -- Interim Chief Investment Officer

Thanks, John. I'll start on slide six, which provides the breakdown of the broad sector allocations in our portfolio, both on an equity and total asset basis. As indicated by the pie chart in the upper left hand corner, our equity allocation to agencies and credit remains well balanced, even as our allocation within the agency bucket shifts modestly into agency CMBS, as we've increased that balance to $1 billion of total assets. ROEs on both agency RMBS and agency CMBS remained attractive during the fourth quarter and we were able to continue the portfolio rotation we started in the third quarter at levels accretive to earnings.

The benefits of the portfolio rotation can be seen in our portfolio yield and effective net interest margin, which have both improved despite our higher borrowing costs, improving the long-term earnings power of the Company. Overall, leverage increased quarter-over-quarter to 6.7 times from 6.4 times as investment spread widening led to an increase in the amount of assets pledged for repo financing.

Moving on to slide seven, the repositioning within our agency RMBS portfolio during the second half of 2018 was mostly out of seasoned shorter duration 15-year and hybrid collateral and into newer production 30-year specified pools. This is reflected in the pie chart in the upper left hand corner of the slide, as 30-year specified pools now comprise close to 90% of our agency RMBS portfolio.

We continue to favor loan balance, LTV and geographic specific stories to help mitigate the impact of prepayments. Valuations remain attractive given spread widening in 2018, as hedged ROEs are approximately 14%. With monetary policy on hold for now, we expect agency RMBS to remain an attractive asset class, as volatility remains low and further Fed hikes are priced out of the forward curve.

Turning to slide eight for a few brief comments on our agency CMBS book. We purchased $398 million of predominantly 10-year agency CMBS during the quarter, which brought our total exposure to the sector close to $1 billion as of 12/31. Agency CMBS complements our agency RMBS assets given the prepayment protection embedded in the securities in the form of prepay penalties and lock-out provisions.

Spreads widened during the fourth quarter allowing us to add exposure at attractive levels and remain attractive in the first quarter of 2019 with hedged ROEs near 12%. We anticipate continuing to add exposure to the sector at these levels, as we believe it provides substantial benefits to our portfolio given the stable nature of its cash flows and attractive financing terms.

Moving on to commercial credit on slide nine. Our CMBS portfolio consists of a combination of well seasoned single A and triple B bonds financed via repo and triple A and double-A bonds financed at the Federal Home Loan Bank. While higher volatility during the fourth quarter limited opportunities to add in the secondary market, we were able to add approximately $115 million of subordinate CMBS during the quarter with ROEs in the low to mid-teens, largely through the new issue market.

Our commercial loan portfolio remained unchanged during the quarter, with a balance of $32 million at quarter end and a weighted average maturity of less than two years.

Slide 10 highlights the credit quality of our commercial portfolio. Fundamentals in commercial real estate remains supportive of our assets, particularly given the seasoned nature of our portfolio as property price appreciation since issuance reduces embedded leverage in our holdings. The chart on the left shows the average LTV of our CMBS assets, which has continued to improve and is down to approximately 35% while the chart on the right highlights the seasoned nature of our CMBS book with over 75% in the 2014 vintage or earlier.

Positively, spreads on seasoned subordinate bonds are benefiting from increased investor demand due to rating agency upgrades, contracting spread duration, embedded property price appreciation and in some cases deleveraging from loan paydowns.

Slide 11 covers our residential credit portfolio. This portfolio remains well diversified with 40% of assets in GSE CRT paper, 33% in legacy bonds and Re-REMICs, 24% in post 2009 Prime paper and a 3% allocation to a loan participation interest secured by MSRs. Spread widening during the fourth quarter provided opportunities to add assets at accretive levels as we purchased approximately $60 million in new issued Prime and $10 million in new issued CRT, As you can see from the chart at the bottom of the slide, durations are very low across the portfolio and with the majority of our holdings paying a floating rate coupon, earnings in this sector are largely protected against changes in funding costs.

Fundamentals remain supportive here as well, as healthy borrower balance sheets combined with lower mortgage rates and accelerating wage growth are helping to offset declining affordability due to the rise in home prices.

Slide 12 provides some detail around the credit quality of our residential credit portfolio. 75% of our CRT investments have been upgraded by at least one rating agency since issuance as shown on the chart on the left. The upgrades are a result of significant underlying home price appreciation and low default rates. The chart on the right reflects the vintage distribution of our investments. Our legacy positions consist of Prime and Alt-A paper that we purchased relatively early in the recovery at high book yields. While our CRT positions are concentrated in earlier post-crisis vintages, which have higher credit quality and lower spread volatility than newly issued securities .

Moving on to Slide 13, which summarizes our financing and hedging strategies. At quarter end, we had $13.6 billion of repo outstanding with 29 counterparties and $1.7 billion of secured financing due to Federal Home Loan Bank. To reduce the risk associated with changes in funding and repo funding costs, we held $12.4 billion of notional of interest rate swaps, which we increased by $2.5 billion during the quarter. Our $1.9 billion of variable rate investments in addition to our interest rate swaps provides a large degree of stability to our net interest margin and ultimately the stream of earnings we provide to our investors. Lastly, I would like to provide a brief update on our common equity raise, which closed on February 7th of this year, including the full exercise of the issue, we sold 16.1 million shares of common equity raising approximately $250 million of proceeds for deployment into our target assets.

The deployment of the new equity was successful. We were able to fully invest the proceeds across our target assets within a reasonable timeframe at levels accretive to earnings. Approximately 90% of the proceeds were allocated to 30-year agency RMBS specified pools, with the remainder allocated to agency CMBS and credit assets within both the commercial and residential sectors.

In addition to our asset purchases, we have increased our hedge portfolio by $1.8 billion to help protect our NIM from changes in borrowing costs. With the additional earnings power of the Company given the equity raise and attractive hedged ROEs in our target assets, we believe the Company is well positioned to achieve our stated goals of attractive income and long-term book value stability. That ends my prepared remarks. Now, we will open the line for Q&A.

Questions and Answers:

Operator

(Operator Instructions) And our first question comes from Doug Harter of Credit Suisse. Your line is open.

Doug Harter -- Credit Suisse -- Analyst

Thanks. Can you just talk about where you might be in terms of portfolio rotation, just thinking about whether there is more room for asset yield improvement or has most of that kind of been reflected in the 4Q results?

Brian P. Norris -- Interim Chief Investment Officer

Yes, I think, -- this is Brian and thanks, Doug. We've mostly made it through a lot of the rotation, as rates have fallen or fell in the fourth quarter, that kind of produces fewer opportunities to rotate out of lower book yielding assets and as you see in the slides there, our 15-year and the hybrid ARM exposures are pretty low at this point. So we mostly work through the rotation at this point.

Doug Harter -- Credit Suisse -- Analyst

Great. And then just thinking about the dividend given the kind of the strong core earnings you had for the quarter, plus your commentary that this capital was accretively deployed, can you just tell us how you're thinking about the dividend?

John Anzalone -- Chief Executive Officer

Right. This is John. Yes, so, I mean, first of all, our Board sets a dividend, I'll just put that out there first. But I think we're thinking pretty positively about the core earnings trajectory we have at this point. There's some time between now and the next declaration, so as long as trends continue we'd be thinking favorably toward that.

Doug Harter -- Credit Suisse -- Analyst

Great. Thank you, John.

John Anzalone -- Chief Executive Officer

Yeah.

Operator

Thank you. Our next question comes from Eric Hagen at KBW. Your line is open.

Eric Hagen -- KBW -- Analyst

Great, thanks. Good morning. Thanks for the comments at the end about the deployment of the capital raised, maybe you can just provide a little color on where leverage stands as a result of having made that deployment. I guess I can sort of reverse engineer based on the comments, but hopefully you can just kind of tell us. Thanks..

Brian P. Norris -- Interim Chief Investment Officer

Sure, Eric. Thanks. This is Brian again. As we've kind of noted in the past, our leverage number is mostly a function of our asset mix. And so as we transition more into agency RBMS and CMBS at this point, our leverage will tend to tick a little bit higher. During the fourth quarter, leverage did go higher due to spread widening. And we've seen that reverse a little bit, certainly as spreads have tightened the leverage number had recovered a little bit and fallen. But given the composition of our equity raise, which was predominantly in agency securities, we would anticipate leverage to tick modestly higher.

Eric Hagen -- KBW -- Analyst

Modestly higher. Great, thanks. And then I know you guys have maybe seldom hedged the volatility risk in the agency portfolio by buying things like swaptions. But as the agency portfolio grows a bit more, and I know that in your prepared remarks you said that you expect volatility to be low. But what would, besides just an expectation for higher volatility, would you guys consider hedging the volatility in your portfolio going forward, if you expect volatility to actually increase? Thanks.

John Anzalone -- Chief Executive Officer

Sure. Yes, swaptions is certainly something that we can use, and we consider it quite often. But as you noted, it's not something that we typically have been doing. So what we prefer to do is, on the asset side, is to select specified pools with favorable convexity characteristics or prepayment characteristics to help mitigate the impact of volatility on our assets.

Eric Hagen -- KBW -- Analyst

Okay, great. And then on the CRT side, can you just provide maybe a little color? Are you guys buying the first loss(ph) piece or do they have some attachment point that's above that? And are they high LTV or low LTV loans? Thanks.

David Lyle -- Chief Operating Officer

Yes, hey, this is David Lyle. Our portfolio, we don't have any first or -- we don't have any B classes in our CRT portfolio. It's all essentially the lowest M class, and what Fannie and Freddie have done and what they've been issuing over time has changed. And if you go back a few years, it depends on which shelf you're looking at. But it's mostly -- or it's really all M2s and M3s, so sort of the mezzanine risk with significant amount of credit enhancement that we've seen grow over time as the structures have delevered. And as to LTVs, we own both. We feel that it's a pretty balanced risk profile between standard LTV and high LTV exposure with the additional credit enhancement that's added on the high LTV deals.

Eric Hagen -- KBW -- Analyst

Great. And then on the ratings upgrade, are those typically done after a certain seasoning point or how should we think about the upgrades on those bonds going forward as far as when we can maybe expect to see individual issues get upgraded, potentially get upgraded?

David Lyle -- Chief Operating Officer

Frankly, it's a little unpredictable. Each of the rating agencies kind of have their own approach to how often they review the ratings. We can look at -- we get monthly reports on delinquencies and enhancement levels, and you can kind of look at that information and see at which points they have kind of been leading indicators of coming upgrades on certain bonds. So you can kind of get an idea of which bonds are sort of next in line, but you don't know necessarily when it's going to happen. But we do anticipate -- a lot of the upgrades are behind us given the seasoning on the collateral, but I think there's still a fair amount of room to run because the trends have led to the upgrades continue in terms of delevering rolling down the curve, continued strong loan performance.

Eric Hagen -- KBW -- Analyst

Got it. That's really helpful color. Thank you.

David Lyle -- Chief Operating Officer

Sure.

Operator

Our next question comes from Trevor Cranston OF JMP Securities. Your line is open.

Trevor John Cranston -- JMP Securieties -- Analyst

Hi, thanks. Given your comments about the portfolio rotation largely being completed out of the lower yielding assets, and the attractiveness of new investment opportunities you're seeing pretty much across all the buckets of the portfolio, can you comment on your potential appetite for potentially another capital raise given that the first one is complete and new investments sound like they would continue to be accretive if you could deploy? Thanks.

John Anzalone -- Chief Executive Officer

Yeah. This is John. I think we approach it -- we've always approached both issuing equity and buying back equity frankly to do what's best for shareholders. So in this case, we felt like the accretive nature of what we were buying was very good. So if those conditions persist, then we would likely make the same decision if we see the same sort of opportunity. But, obviously, we just got done with this one, so we're going to take a little bit of a breather. But certainly I think if you listen to all the different -- think about all the different sectors, I mean, we are seeing pretty good opportunities across. And we're pretty positive on the outlook for most of the sectors just given the volatility and this environment is pretty good for structured securities.

Trevor John Cranston -- JMP Securieties -- Analyst

Got it. Okay, that's helpful. And then on the resi credit side, it says that you guys purchased $60 million or so in the fourth quarter of post-2009. Can you elaborate a little on that, if that's like new issue jumbo deals and maybe add some color around exactly what opportunities you're seeing in the resi credit market currently? Thanks.

David Lyle -- Chief Operating Officer

Yeah, that's correct. This is Dave again. The bonds that we purchased are new issue Prime Jumbo triple As, so the senior tranche there, the spreads got pretty wide there in the fourth quarter as they did on many of our target assets. And the repo terms available for leverage on those investments have continued to improve. So we were able to add those at pretty materially accretive ROEs. I think as the market has firmed here a little bit in the first quarter, that particular investment is a little more border line because we think about the risk that we take with CRT and adding that sort of profile to our portfolio is a nice complement to our agency exposure. CRT is one-month LIBOR floater, so it's very easy to hedge, so a bit more of a good credit asset, whereas Prime Jumbo seniors are much more agency CMBS light. There is a yield pick there because they are A bit less liquid and there's a small credit -- probably materially less liquid than agencies, obviously, and there is theoretically credit components that seem very, very, very clean credit profiles in these bonds. So the point being they don't add a lot of diversification risk to the portfolio, so it's going to be pretty healthy ROEs on Prime Jumbo to continue adding. So we are probably --- if we continue to see the market tighten and risk continue to do well, I wouldn't expect us to add a significant amount of Prime Jumbo, but resi credit overall thus our CRT and Prime Jumbo are the most accretive opportunities. There have been talk, obviously, of non-QM and RPL securitizations. We do like those deals from a fundamental perspective. We manage those assets in unlevered portfolios away from the REIT, so we like the asset classes. But given where the spreads are relative to funding terms, they only lever kind of into the high single digits. So not very compelling for the REIT compared to other opportunities that we have.

Trevor John Cranston -- JMP Securieties -- Analyst

Got it, OK. And then, one last question. Just a detail on the hedges you guys mentioned that you added subsequent to the capital raise, can you just give us the approximate duration of the swaps that you put on? Thanks.

David Lyle -- Chief Operating Officer

Yeah. Our swap book kind of ranges from one to 10 years, and I believe the hedges that we added in the fourth quarter reflected kind of a mixture of shorter duration -- shorter swaps like in the two to three-year range mixed with some longer five to seven-year swaps.

Trevor John Cranston -- JMP Securieties -- Analyst

Okay. That helps. Thank you.

Operator

Thank you. And we have no other questions from the phone lines.

Brandon Burk -- Director, Investor Relations

Okay. Well, I would like to thank everybody for joining us and we'll talk to you next time. Thanks.

Operator

Thank you for your participation in today's conference. You may now disconnect at this time. Have a wonderful day.

Duration: 26 minutes

Call participants:

Brandon Burk -- Director, Investor Relations

John Anzalone -- Chief Executive Officer

Brian P. Norris -- Interim Chief Investment Officer

Doug Harter -- Credit Suisse -- Analyst

Eric Hagen -- KBW -- Analyst

David Lyle -- Chief Operating Officer

Trevor John Cranston -- JMP Securieties -- Analyst

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