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Invesco Mortgage Capital Inc (NYSE:IVR)
Q3 2019 Earnings Call
Nov 8, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to Invesco Mortgage Capital Inc.'s Third Quarter 2019 Investor Conference Call. All participants, will be on a listen-only mode until the question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded.

And now, I would like to turn the call over to Brandon Burke in Investor Relations. Mr. Burke, you may begin.

Brandon Burke -- Investor Relations

Well, thank you, and welcome to the Invesco Mortgage Capital third quarter 2019 earnings call. The management team and I are delighted you've joined us, and we look forward to sharing with you our prepared remarks and conducting a question-and-answer session. Before turning the call over to our CEO, John Anzalone, I wanted to provide a reminder that statements made in this conference call and the related presentation may include forward-looking statements, which reflect management's expectations about future events and our overall plans and performance.

These forward-looking statements are made as of today and are not guarantees. They involve risks, uncertainties and assumptions and there could be no assurance that actual results will not differ materially from our expectations. For a discussion of these risks and uncertainties, please see the risks described in our most recent Annual Report on Form 10-K and subsequent filings with the SEC.

Invesco makes no obligation to update any forward-looking statement. We may also discuss non-GAAP financial measures during today's call. Reconciliations of these non-GAAP financial measures may be found at the end of our earnings presentation. To view the slide presentation today, you may access our website at invescomortgagecapital.com and click on the Q3 2019 Earnings Presentation link under Investor Relations.

Again, welcome and thank you for joining us today. I'll now turn the call over to John Anzalone. John?

John Anzalone -- Chief Executive Officer

Good morning, and welcome to IVR's third quarter earnings call. Joining me on the call this morning are Brian Norris, our CIO; Kevin Collins, our President and Head of Commercial Credit; Lee Phegley, our CFO; and Dave Lyle, our COO and Head of Residential Credit.

I am pleased to announce core earnings of $0.47 per share, which once again exceeded our $0.45 dividend. Our book value remained stable, despite a relative volatile backdrop, increasing 0.6% to $16.31 per share. The combination of our dividend and our increase in book value, produced an economic return of 3.4% for the quarter, bringing our year-to-date economic return to 15.7%.

Our team achieved this performance despite another fairly tumultuous quarter in which we saw the 10-year trade in a 67 basis point band, volatility increased across most asset classes, and funding markets disrupted to the point that the Fed had to intervene. Despite the turmoil, IVR was able to raise another $219 million of capital during the quarter. That capital was put to work quickly at accretive levels as we were able to invest the proceeds in late August when the agency market had just experienced a significant widening event as interest rates bottomed.

Before turning the call over to Brian, I want to spend a few minutes explaining at a high level how we've constructed IVR's portfolio in a way it has resulted in book value stability while producing a repeatable core earning stream. Over the course of the past year or so, we have been deliberate in allocating capital to strategies that minimize our exposure to prepayment risk, as increased prepayments have a detrimental impact on core earnings. Over that period, our overall exposure to Agency RMBS has been reduced, and what we do own in Agency RMBS is backed by collateral that, in one way or another, is less exposed to refinancing activity.

At the same time, we have steadily increased our exposure to Agency CMBS. These investments have several favorable attributes, the main ones being that their credit is -- the credit is guaranteed by government agency, they are fixed rate and thus easy to hedge, and they benefit from notable prepayment protection. They also have exhibited limited spread volatility relative to non-guaranteed credit assets, which makes them very attractive to finance. All of this makes them ideal candidates for inclusion in our portfolio.

We have generally avoided the Agency RMBS TBA market, where, as we've seen recently, returns can be quite volatile. These periods of volatility can often be persistent and difficult to forecast. We have also largely avoided the MSR and IO market, where returns can often look attractive, but are extremely dependent on prepayments remaining well behaved. We don't think it makes sense to double down on convexity risk in that market when we spend so much time avoiding it in the rest of our portfolio.

We have also been very active on the hedging side of our portfolio. We have adjusted our hedge book during the course of the year as the rate environment has changed our duration profile and as we have added capital through equity raises. Our goal is to keep our portfolio and thus book value well hedged against changes in interest rates, and we have been quite successful in doing that.

I will also point out, this applies to both the long and short end of the interest rate curve. Regarding the short end, we've generally looked to match the index rate of our swaps with the index rate of our repo to avoid basis risk between one- and three-month LIBOR. This ultimately helps create a more stable effective net interest margin.

Again, our objective of constructing the portfolio is to produce a repeatable core earning stream, while keeping book value stable. Looking forward, we believe that we are in a -- we are very well positioned. We see several tailwinds that should continue to be supportive of the positive trends we've produced in core earnings. The Fed has signaled that they are on hold, and we have seen a steepening of the yield curve, which is supportive of future ROEs. Volatility has fallen as we've entered the fourth quarter, and this of course is supportive of mortgage assets.

Fundamentals in both residential and commercial credit remains strong, which supports our credit investments. And perhaps, most importantly, prepayment speeds have likely peaked with the recent October report as seasonal factors and higher rates impact borrowers. So overall, we see a very positive outlook for the coming quarters.

Finally, I want to point out that we have simplified our management fee calculation starting in Q4. Going forward, we'll calculate our fee using our shareholders' equity, which will bring further alignment between shareholders and management. Details of this can be found in our recently filed Q.

With that, I'll turn the call over to Brian.

Brian Norris -- Chief Investment Officer

Thanks, John, and good morning to everyone on the call. I'll start on Slide 6, where we detail our sector allocations on an equity and asset basis.

As you can see in the pie charts on the left, we remain well diversified across asset classes. Our actively managed hybrid strategy continues to provide a stable book value and consistent core earnings, despite a difficult third quarter in the financial markets as volatility increased. The common equity raise in August, provided an opportunity to capitalize on this volatility, as we were able to add assets at attractive levels given spread widening in the first half of the month.

Proceeds were deployed primarily into Agency CMBS and Agency RMBS, increasing our overall allocation to agency assets to 76% as of September 30. As John mentioned, the most significant change in our portfolio is the increased allocation to Agency CMBS, which now represents 21% of total assets, an increase from 13% in the second quarter. This increased allocation to Agency CMBS is largely attributable to the August equity raise in addition to the reinvestment of paydowns and sales from the Agency RMBS allocation, given that we viewed Agency CMBS as a more attractive use of capital during the quarter as Agency RMBS remained under pressure from the increase in interest rate volatility and faster prepayments speeds.

Moving on to Slide 7, which details the composition of our Agency RMBS assets. Prepayment speeds on our holdings increased during the quarter, reflecting lower mortgage rates and higher seasonality, negatively impacting the effective yield on our pass-through securities by 4 basis points from 3.69% to 3.65%. Positively, our Agency RMBS allocation is largely comprised of 30-year specified pools, which contain some level of prepayment protection and experienced CPRs 25% to 30% slower than the market on average. The value of this protection continue to increase as interest rates fell, improving approximately 0.25 point on our 30-year specified pools during the quarter.

We believe October's prepayment speeds represent the near-term peak for our holdings, and thus we should see improvement on this front in the coming months and quarters. Given more attractive valuations and improved financing, ROEs on the sector have improved to 13% to 15%.

Turning to Slide 8, you can see in the lower left-hand table that our allocation to Agency CMBS has grown to nearly $5 billion. We purchased $1.9 billion of Agency CMBS during the quarter, predominantly in the Fannie Mae DUS program. Spreads widened modestly during the quarter, allowing us to add exposure at attractive valuations, both during the deployment of our capital raise as well as the reinvestment of monthly cash flows from our Agency RMBS holdings.

The prepayment protection embedded in our holdings in addition to muted spread volatility, has played a large role in the reduction of our overall book value volatility, and increases the consistency and repeatability of our core earnings.

Slide 9 details our Company's allocation to commercial credit. Our holdings continue to benefit from improved credit fundamentals, and strong demand during the quarter led to modestly tighter spreads and book value gains. In addition, similar to Agency CMBS, this portfolio benefits from notable prepayment protection. We were able to add $140 million of recently issued non-Agency CMBS during the quarter, with ROEs in the low-to-mid teens.

Slide 10 highlights the credit quality of our commercial portfolio. Fundamentals in commercial real estate remain supportive, particularly given the season nature of our portfolio as property price appreciation since issuance, reduces embedded leverage in our holdings. The chart on the left shows the seasoning of our CMBS assets, indicating roughly two-thirds of our holdings were originated five or more years ago, while the chart on the right highlights the strong credit performance of our holdings, with $720 million benefiting from rating agency upgrades.

Slide 11 covers our residential credit portfolio. This portfolio remains well diversified as indicated in the pie chart in the upper left. Spreads were mixed during the quarter as recent issued CRT spreads tightened, while season CRT widened on faster prepayments speeds. Credit fundamentals remained supportive here as wage growth and lower mortgage rates have improved affordability. We were able to add $112 million in residential credit during the quarter, as improved financing and increased issuance provided opportunities to add assets at attractive levels.

Slide 12 provides some detail around the credit quality of our residential credit portfolio. 62% 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, where approximately two-thirds of our assets were issued prior to 2015 and benefit from the strong recovery in the housing market.

Lastly, Slide 13 summarizes our financing and hedging. At quarter end, we had $18.1 billion of repo outstanding, with 34 counterparties and $1.65 billion of secured financing through the Federal Home Loan Bank. We have seen improved financing across our assets as repo spreads tightened and LIBOR declined.

Positively, we saw minimal impact from repo market turbulence during September. We intentionally stagger repo maturities, so only a small portion of our book had to be rolled during this period. And we limited the tender of those roles given our view that the market would quickly stabilize. To reduce the risk associated with changes in repo funding cost, we held $14.4 billion notional of interest rate swaps, an increase of nearly $2 billion quarter-over-quarter as our portfolio grew.

In closing, we are very pleased with the performance of our Company year-to-date, and believe the actions we've taken will continue to produce a stable book value and attractive core earning stream that is repeatable across numerous market environments. Given the steepening of the yield curve since quarter-end and a Federal Reserve that expressed a high bar for further action, we believe the current environment is very attractive, both for the performance of our current assets as well as for potential investment opportunities in our target asset classes.

That ends my prepared remarks. Now, we will open the line for Q&A.

Questions and Answers:

Operator

Thank you. [Operator Instructions] Our first question today is from Eric Hagen from KBW.

Eric Hagen -- KBW -- Analyst

Hey guys. Thanks. Nice quarter. Just a couple of housekeeping items for me I think. The press release noted the effective yield on Agency CMBS was 3.44% for the period, and in the presentation the period ending yield on the DUS bonds, which are your largest position, were 286%. Did the market really tightened that much during the quarter or was there some timing-related impact from when you guys raised capital and deployed it? I'm just trying to square that up. Thanks.

Kevin Collins -- President and Head of Commercial Credit

Yeah. Eric, this is Kevin. Much of that is timing related. In fact, I would say that Agency CMBS spreads actually widened a touch over the quarter. And during the time of the capital raise, we were able to take those proceeds and invest at more attractive levels.

Eric Hagen -- KBW -- Analyst

Okay. All right. Great. And then it looks like there was a bit of rebalancing in the period in the swap portfolio, like you guys touched on in your remarks. You guys locked in lower pay rates, which I think is really good to see. I'm just curious around the timing impact of that too. I mean, when did that take place? I mean, how much of the quarter's earnings are reflective of that rebalancing?

Brian Norris -- Chief Investment Officer

Yeah. Eric, this is Brian. I mean, we did a lot of that rebalancing kind of throughout the quarter. I mean, some of it certainly was during the August capital raise, as we were adding swaps at lower levels at that time. But as we add Agency CMBS, the duration of those are significantly longer than the bonds that we're replacing it with. So Agency RMBS are a much shorter. So we've been adjusting our hedges to account for that.

Eric Hagen -- KBW -- Analyst

Okay. Yeah. To your point on the duration, can you just give us a sense for your duration gap at the end of the quarter? I mean, I know that, in the past, you guys have articulated [Indecipherable] really look at the portfolio in a duration gap standpoint, but any clarity there would be helpful.

John Anzalone -- Chief Executive Officer

Yeah. Hey, Eric. This is John. I mean, we try to keep our empirical duration as close to zero as we can. So I mean, that's kind of how we look at it. So, I mean, you can back out that if we do that, then our duration gap would effectively be close to zero also. So I mean that's what we've experienced lately. Our model duration is a little bit longer than that, but I think empirical is the one we look at more closely and is more relevant.

Eric Hagen -- KBW -- Analyst

Okay. And can you give us a sense for book value since quarter end?

John Anzalone -- Chief Executive Officer

It's down a little bit less than 1%.

Eric Hagen -- KBW -- Analyst

All right, guys. Thank you very much.

Operator

Thank you. [Operator Instructions] And our next question is from Trevor Cranston from JPM [Phonetic] Securities.

Trevor Cranston -- JMP Securities -- Analyst

Hey, thanks. Good morning. A couple of questions on the Agency CMBS book. And you guys are continuing to allocate capital there. I guess, when I listened to you describe why you find that sector attractive, the lack of convexity risk, relatively low spread volatility, it seems like a strategy that would support using higher levels of leverage versus Agency RMBS or certainly credit. So I guess, I was a little surprised to see leverage not really change much this quarter as you've added to the Agency CMBS.

Can you talk about how you guys are looking at overall leverage as that position grows and specifically how much you're willing to lever the Agency CMBS book? Thanks.

Brian Norris -- Chief Investment Officer

Hey. Thanks, Trevor. Yeah, this is Brian again. Yeah, our leverage overall on the portfolio was marginally down quarter-over-quarter, and really the Agency CMBS book has been largely replacing Agency RMBS, which we lever about the same. So it's really no change in leverage between those two sectors.

Trevor Cranston -- JMP Securities -- Analyst

Okay. Got you. And then I think, I heard in the prepared remarks, I think you guys said returns in Agency RMBS were low-to-mid teens currently. I missed it if you said where you're seeing ROEs on the Agency CMBS, so if you could comment on that, that would also be helpful. Thanks.

Kevin Collins -- President and Head of Commercial Credit

Sure. This is Kevin. In terms of non-Agency CMBS, we're in the low-double-digit ROE territory at this point. For -- excuse me, for Agency CMBS to clarify.

Trevor Cranston -- JMP Securities -- Analyst

Okay. Got you. Perfect. And then one follow-up question on the adjustments made to the swap portfolio. Do you have the weighted average maturity of the swap book as of September 30?

Kevin Collins -- President and Head of Commercial Credit

I do not have that in front of me, but we can get that to you.

Trevor Cranston -- JMP Securities -- Analyst

Okay. Thank you. I appreciate the comments.

Operator

And I am showing no further questions at this time. I'll just turn the call back to John Anzalone.

John Anzalone -- Chief Executive Officer

Okay. Well, thanks everyone for joining us, and we look forward to seeing you again next quarter. Thanks.

Operator

[Operator Closing Remarks].

Duration: 19 minutes

Call participants:

Brandon Burke -- Investor Relations

John Anzalone -- Chief Executive Officer

Brian Norris -- Chief Investment Officer

Kevin Collins -- President and Head of Commercial Credit

Eric Hagen -- KBW -- Analyst

Trevor Cranston -- JMP Securities -- Analyst

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