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Invesco Mortgage Capital Inc (NYSE:IVR)
Q4 2019 Earnings Call
Feb 20, 2020, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to Invesco Mortgage Capital, Inc's Fourth Quarter 2019 Investor Conference Call. [Operator Instructions]

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

Brandon Burke -- Investor Relations

Well, thank you, and welcome to the Invesco Mortgage Capital fourth 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 risk 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 Q4 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 fourth quarter earnings call. I'll be joined on this call this morning by 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.

We are pleased to announce core earnings for the fourth quarter of $0.52 per share, an increase of $0.05 from the third quarter as the portfolio has benefited from a full quarter of earnings power generated by the August capital raise, as well as lower effective cost of funds. The increase in core earnings allowed us to raise our common dividend for the quarter by 11% to $0.50 per share. Once again, our book value remained stable, ending the quarter relatively unchanged at $16.29. The combination of our increased dividend and our steady book value produced an economic return of 2.9% for the quarter.

While we produced strong results for the fourth quarter, I want to spend a few moments highlighting IVR's achievements for the full year. 2019 was a stellar year for IVR's stockholders as we increased our dividend 19% from $0.42 to $0.50 per share and improved book value nearly 7% from $15.27 to $16.29, delivering an economic return of 18.8%. We also raised over $500 million of equity capital during the year, which allowed us to increase scale and invest in additional accretive assets. As always, active management was a key to our success and we are quite active with respect to our investment portfolio, as well as our interest rate hedges during the year.

On the investment side, we continue to be deliberate in allocating capital to strategies that minimize our exposure to prepayment risk as increased prepayments have a detrimental impact on core earnings. Over 2019, we reduced our allocation to Agency RMBS and the assets we continue to hold in this sector are backed by collateral that is less exposed to refinancing activity. At the same time, we have steadily increased our Agency CMBS position, which constituted 16% of our equity and 22% of our assets at year-end.

Agency CMBS has several favorable attributes. It is guaranteed by government agency which limits spread volatility and allows us to finance them at attractive levels, and they are fixed rate with notable prepayment protection and thus more efficient to hedge. The combination of attractive financing and efficient hedging makes Agency CMBS a complementary asset class for our portfolio.

Although we were less active in the non-Agency residential and commercial sectors during 2019, we modestly increased our credit investments through selective additions of accretive assets through the year. In total, we purchased $422 million of subordinate CMBS and $340 million of residential credit assets during the year. Positively, the credit bonds we own continue to benefit from structural deleveraging and stable fundamentals and we are well positioned to take advantage of these sectors when new purchases are attractive. We also actively managed our hedge portfolio throughout 2019 as our duration profile reacted to the volatile interest rate environment and the deployment of new capital. We're able to take advantage of the significant decline in swap rates during the year to dramatically improve our effective cost of funds.

Our efforts to minimize our exposure to the basis between one and three month LIBOR on our borrowings and interest rate swaps largely insulated earnings from shifts in the LIBOR curve. Overall, we have been quite successful in utilizing hedges to protect book value and improve our effective interest rate margin despite a volatile year in interest rates. Again, our objective of constructing the portfolio is to reserve or improve our core earnings stream, while maintaining a stable book value.

Looking forward, we believe that we are very well positioned to continue the positive momentum we established in 2019. In fact, IVR has had a very good start to 2020 as we successfully raised $347 million in common stock earlier this month, which we have already invested into accretive assets. Book value since year-end is up 4.5% as Agency CMBS and credit assets continue to be very well bid. So overall, we see a very positive outlook for the coming quarters and feel very good about our ability to continue producing results that are reliably among the best in the mortgage REIT sector.

With that, I'll turn it over to Brian.

Brian P. Norris -- Chief Investment Officer

Thanks, John, and good morning to everyone on the call. I'll start on Slide 6 where we detailed our sector allocations on an equity and asset basis. As detailed 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 attractive core earnings and what proved to be a volatile year in the fixed income markets.

The common equity raise in August of 2019 provide an opportunity to capitalize on this volatility, and our strong core earnings in the fourth quarter reflect a full quarter of those new investments. Our asset allocation remain largely unchanged on the quarter with a slight reduction in our Agency RMBS holdings to fund purchases in Agency and non-Agency CMBS. Our activity in the fourth quarter was primarily on the hedging front as we extended hedges to lock-in low rates for longer and to more effectively offset our exposures in Agency CMBS and the extension of our Agency RMBS in the modest fair steapener in interest rates. As mentioned by John, we've had a strong start to this year and the common equity raise in February reinforced our ability to capitalize on market opportunities as we were able to quickly deploy proceeds into Agency RMBS given attractive valuations following spread widening in January.

Moving on to Slide 7, which details the composition of our Agency RMBS assets. Prepayment speeds on our holdings increased during the quarter as low mortgage rates in the second half of 2019 led to an increase in refinancings. Positively, our reduced allocation to Agency RMBS sector mitigated the overall impact of faster prepayment speeds to core earnings. Our Agency RMBS allocation is now 52% of total assets and remains largely comprised of 30-year specified pools, which contain some level of prepayment protection and experienced CPRs 25% to 30% slower than the market. Despite higher interest rates during the quarter, the value of this protection was largely unchanged as demand remains robust given continued challenges in the TBA market. Agency RMBS performed very well in the fourth quarter as attractive valuations, higher rates, steeper yield curve and lower volatility, all combined to produce a beneficial environment for the sector.

Turning to Slide 8, you can see in the lower left hand table that our allocation to Agency CMBS remained steady at nearly $5 billion or 22% of total assets. Asset spreads were stable during the quarter, but spread tightening through the end of the third quarter made additional accretive investments challenging to source. We remained positive on this sector and we'll look to increase exposure as valuations become more attractive. Given the prepayment protection on these holdings, we've been able to lock in an attractive net interest margin on nearly $5 billion of assets that should benefit the portfolio for the life of the investments.

Slide 9 details our company's allocation to commercial mortgage credit. Our holdings continue to benefit from improved credit fundamentals. And similar to Agency CMBS, this portfolio benefits from notable prepayment protection. We were able to add $19 million of recently issued non-Agency CMBS during the quarter with ROEs in the low to mid-teens as continued spread tightening in the sector provided few opportunities for accretive investments.

Slide 10 highlights the credit quality of our commercial mortgage portfolio. Fundamentals in commercial real estate remained supportive, 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 seasoning of our CMBS assets, indicating roughly two-thirds of our holdings were originated more than five years ago, while the chart on the right highlights the strong credit performance of our holdings with over $700 million benefiting from rating agency upgrades.

Moving on to slide 11, which covers our residential credit portfolio. This portfolio remains well diversified as indicated in the pie chart on the left. Credit fundamentals are supportive here as wage growth and lower mortgage rates have improved affordability. We were able to add $33 million in residential credit during the quarter. Strong fundamentals in the sector drive valuations higher, limiting our ability to add accretive investments.

Slide 12 provides some detail around the credit quality of our residential credit portfolio. 63% 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, indicating over 60% 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 year-end, we had $17.5 billion of repo outstanding with 33 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. To reduce the risk associated with changes in repo funding cost, we held $14 billion of notional of interest rate swaps, a decline of $425 million quarter-over-quarter. The decrease in notional amount was largely due to the reduction in assets given modest deleveraging during the quarter. The lower average funds -- average cost of funds can be attributed to the decline in LIBOR, as well as the active management of our interest rate swaps. Potential volatility in the year-end funding markets was largely avoided as we locked in longer maturity repo shortly after the FOMC meeting in October, which was the final Fed funds interest rate cut of the year.

In closing, with the 2019 economic return of 18.8% and a total return on common equity of 29%, our performance for the year was among the best in the industry. We remain focused on providing an attractive dividend supported by core earnings and stable book value and believe we are well positioned to benefit from the current market environment. We appreciate the support from our investors and are excited about our opportunities in 2020.

That ends my prepared remarks and now we will open the line for Q&A.

Questions and Answers:

Operator

Thank you. [Operator Instructions] And our first question is from Doug Harter with Credit Suisse. Your line is open.

Douglas Harter -- Credit Suisse Securities (USA) LLC -- Analyst

Thanks. Can you talk about the relative return characteristics of Agency CMBS, kind of where you see spreads leverage, ROE on that compared to Agency RMBS just to understand kind of the different profiles there?

Brian P. Norris -- Chief Investment Officer

Sure Doug. This is Brian. Agency RMBS is generally ROEs around 13% to 14% with Agency CMBS maybe 200 basis points behind that in the low-double-digits area. Leverage on both of those asset classes are pretty similar, we get similar financing on repo there. So leverage is going to be in the 9 to 10 range, 10 times on that.

Douglas Harter -- Credit Suisse Securities (USA) LLC -- Analyst

And I guess is that 200 basis points back is that factoring in kind of the strong move I guess you've seen in the first quarter. So I guess that's -- those returns probably were more comparable before kind of the first quarter move?

Brian P. Norris -- Chief Investment Officer

That's right. When we were more aggressive adding Agency CMBS back in kind of middle and late 2019, those ROEs were kind of on top of each other.

Douglas Harter -- Credit Suisse Securities (USA) LLC -- Analyst

And then I guess just with that, I guess how do you see the attractiveness of sort of continuing to hold it kind of given the strong move you've already captured versus the less volatility that you mentioned? I guess how do you see that trade-off today?

Brian P. Norris -- Chief Investment Officer

Sure. We'll certainly continue to hold it. We've been able to lock in the NIM on those holdings that we've already purchased. So we like the kind of dependable steady stream of earnings that that provides the portfolio. So in Agency RMBS, as I mentioned, it is a little bit more attractive right now, but certainly given the increased convexity risk that we see in those holdings, it's a bit of a balancing act. We'd like to add a little bit more Agency CMBS if we can see a little bit better valuations there.

Douglas Harter -- Credit Suisse Securities (USA) LLC -- Analyst

Great. Thank you.

Operator

Our next question is from Eric Hagen with KBW. Your line is open.

Eric Hagen -- Keefe, Bruyette & Woods -- Analyst

Thanks. Good morning, guys. Just kind of following up on the relative value conversation. I mean rates have already come down a lot this year and the MBA Refi Index just hit a multi-year high. I'm just curious, how you guys are thinking more holistically kind of longer term about your approach to prepayment risk and the relative value of being in Agency RMBS where the premiums on most of those securities have increased pretty meaningfully, but the yield and the liquidity are higher than they are in the agency DUS market where the prepay risk is obviously lower, but you don't have the same liquidity and the yield is also lower? So just how do you kind of think -- I mean you addressed kind of the current market, but more holistically, just from a risk management standpoint where rates are today? Just curious how do you think about that trade-off? Thank you.

Brian P. Norris -- Chief Investment Officer

Right. Yeah, that's exactly right, Eric. This is Brian again. And certainly given where the refi index is right now, we expect speeds to increase pretty meaningfully over the next few months. It hasn't really started yet. And as a matter of fact, we've seen slower speed so far this quarter. But moving forward, we'd like to be well diversified and that includes in the credit assets as well. We're at 52% of total assets in Agency RMBS. So we think that's a fairly manageable amount of kind of convexity risk from that perspective, certainly relative to the rest of our holdings that certainly mitigate that risk. So we're pretty comfortable with where we are right now. And like I mentioned, that Agency RMBS number will trend up modestly just given the equity raise that we just deployed into Agency RMBS.

Eric Hagen -- Keefe, Bruyette & Woods -- Analyst

Okay. All right, great. Thank you for that answer. And then it just looks like the funding basis, the receive rate on swaps relative to repo funding rates has tightened a bit over the last few weeks, I guess that depends though on what the receive rate is on your swaps. Can you guys just give us a breakdown again of how -- what percentage of your swaps are three month LIBOR as the receive rate versus one month LIBOR?

Brian P. Norris -- Chief Investment Officer

Sure. As of 12/31, we were about 24% three month LIBOR. And given the swaps that we've added so far this year that has trended down to about 16% of three month LIBOR of total notional. So yeah, we've seen LIBOR rates come down. So the spread between what we're receiving versus what we're paying has come in little bit.

Eric Hagen -- Keefe, Bruyette & Woods -- Analyst

Okay. And then the remainder of that breakdown is a one month LIBOR rate had to be dense, but just it's not like...

Brian P. Norris -- Chief Investment Officer

Yeah.

Eric Hagen -- Keefe, Bruyette & Woods -- Analyst

Okay, thanks.

Brian P. Norris -- Chief Investment Officer

Exactly, right. Yeah.

Eric Hagen -- Keefe, Bruyette & Woods -- Analyst

Okay. Thank you very much.

Brian P. Norris -- Chief Investment Officer

Yeah.

Operator

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

Trevor Cranston -- JMP Securities -- Analyst

Hey, thanks. On the book value change you guys mentioned that's occurred so far in 2020, can you say if any of that was due to having positive net duration in the portfolio or if it was kind of more purely related to spread tightening? And related to that, can you also just maybe talk generally about how you guys are currently managing the net duration portfolio and rate sensitivity of the portfolio?

Brian P. Norris -- Chief Investment Officer

Right. Yeah, I would say, yeah, it was a bit of both in terms of first quarter. I mean Agency CMBS has had a very good start to the year. So I mean clearly that. We benefited from that. Other spread, non-Agency spreads have also tightened during the quarter. And with the duration gap that you've questioned, we tend to run a -- our empirical duration has tended to be very stable. So our book value has been relatively stable over the course of the last year.

And part of trying to balance that is, you've got credit assets and that are going to react one way to interest rates. As interest rates fall, credit assets tend to widen. So we always tend to run somewhat of a longer duration gap model wise to offset that. And that's true now and was true -- has been true so far this year. So we did benefit a little bit from having a longer duration gap because it's not usual that you have spreads tightening and rates falling at the same time. So we did benefit from both sides of that. Throughout 2019, it was more normal where that was almost completely offset and we didn't see much book value movement at all.

Trevor Cranston -- JMP Securities -- Analyst

Okay. Got you. That's helpful. And then looking at the funding slide on Page 13 of the deck, it looks like the -- particularly the non-Agency portfolio had a pretty significant drop in cost of funds during the fourth quarter. I was curious if there was anything notable you guys are seeing on that side of the book in terms of like tighter spreads on the funding for non-Agency securities or if it was more so just related to lower LIBOR rates? Thanks.

Dave Lyle -- Chief Operating Officer

Hey Trevor, this is Dave Lyle. Yeah, most of that was definitely lower LIBOR, but there is a component that is resulting from just the further improvement in the credit quality of our assets. As they continue to season, as we're seeing rating upgrades and as we continue to see our repo counterparties be very competitive in terms of wanting to provide us with funding, we're seeing same benefits on the repo spread side as well.

Trevor Cranston -- JMP Securities -- Analyst

Okay, makes sense. Thank you.

Operator

At this time, I'm showing no further questions.

John Anzalone -- Chief Executive Officer

All right. Well, thank you everybody for joining us and we look forward to talking to you in May.

Operator

[Operator Closing Remarks]

Duration: 22 minutes

Call participants:

Brandon Burke -- Investor Relations

John Anzalone -- Chief Executive Officer

Brian P. Norris -- Chief Investment Officer

Dave Lyle -- Chief Operating Officer

Douglas Harter -- Credit Suisse Securities (USA) LLC -- Analyst

Eric Hagen -- Keefe, Bruyette & Woods -- Analyst

Trevor Cranston -- JMP Securities -- Analyst

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