INVESCO MORTGAGE CAPITAL INC

Welcome to Invesco Mortgage Capital Inc's third quarter 2022 investor conference call. All participants will be in a listen-only mode until the question and answer session. At that time, to ask a question, press the star followed by the one on your telephone. As a reminder, this call is being recorded. Now I would like to turn the call over to Matt Seitz and Investor Relations. Mr. Seitz, you may now begin the call. Thank you.

Thanks, operator, and to all of you joining us on Invesco Mortgage Capital's quarterly earnings call. In addition to today's press release, we have provided a presentation that covers the topics we plan to address today. The press release and presentation are available on our website, Invescomortgagecapital.com. This information can be found by going to the investor relations section of the website. Our presentation today will include forward-looking statements and certain non-GAAP financial measures. Please review the disclosures on slide two of the presentation regarding these statements and measures as well as the appendix for the appropriate reconciliations to GAAP. Finally, Invesco Mortgage Capital is not responsible for and does not edit nor guarantee the accuracy of our earnings teleconference transcripts provided by third parties. The only authorized webcasts are located on our website. Again, welcome and thank you for joining us today. I'll now turn the call over to John Anzalone. John?

Good morning and welcome to Invesco Mortgage Capital's third quarter earnings call. I'll give some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss the current portfolio in more detail. Also joining us on the call to participate in the Q&A are our President, Kevin Collins, our CFO, Lee Fegley, and our COO, Dave Lyle. Financial conditions tightened during the third quarter of 2022. as the FOMC increased the Fed funds rate on two separate occasions by a total of 150 basis points and then subsequently added a further 75 basis point hike yesterday in response to inflation levels that persist at multi-decade highs. Equity markets declined, credit spreads widened, and volatility increased from already elevated levels as recession fears mounted and the market priced at a more aggressive pace of tightening by the Fed. The challenging environment for agency mortgages persisted during the third quarter as the sector recorded its worst quarterly performance in over a decade. Mortgages have now performed poorly for four consecutive quarters, and the drivers have largely remained the same. Persistent inflation, rapidly tightening monetary policy, elevated volatility, reduced liquidity, and a general risk-off tone in financial markets. Given this challenging backdrop, our book value declined during the quarter, ending September at $12.80. Since the beginning of the fourth quarter, agency mortgage performance has remained volatile, leading to a further decline in our book value of approximately 4.5%. On a positive note, earnings available for distribution for the third quarter remain strong at $1.39 per common share, given our rotation into higher-yielding agency mortgages, along with favorable funding and a relatively low-cost legacy swap portfolio. Further, wider spreads on our target assets have created an attractive reinvestment environment that continues to be supportive of the earnings power of the portfolio. We remain focused on improving our capital structure, and during the third quarter, we made progress on that front by repurchasing preferred stock and issuing common stock through our at-the-market program. Since the inception of the repurchase program in May of 22, we have repurchased 5.3 million shares of our Series B and Series C preferred stock, representing approximately 30% of our preferred stock outstanding prior to the start of the program. Given the decrease in book value and repurchases of preferred stock, our economic leverage increased to 5.3 times. At quarter end, substantially all of our $4.5 billion investment portfolio, including TBAs, was invested in agency mortgages, and we maintained a sizable balance of unrestricted cash and unencumbered investments, totaling $504.3 million. Because of the drivers I mentioned earlier, we remain relatively cautious on mortgages in the near term. However, we are starting to see some potential tailwinds. Mortgage spreads are now at levels not seen since the great financial crisis and have been highly correlated to volatility. As the Fed's path for future policy action becomes clearer, we should see interest rate volatility subside over the next few quarters, which would be very positive for mortgages. The technical outlook for mortgages is also improving, as sharply higher borrowing rates limit the issuance of new agency mortgages, which helps reduce the pace of runoff in the Fed's portfolio while also reducing the impact of prepayments. I'll stop here, and Brian will look through the portfolio.

Thanks, John, and good morning to everyone listening to the call. I'll begin on slide four, which provides an overview of the changes in the macro environment within the fixed income markets over the past year. During the third quarter, persistently elevated inflation and the acceleration of monetary policy tightening by the Federal Reserve continued to pressure interest rates higher, leading to another bear flattening move, a consistent theme over the past year. During the quarter, yields on maturities less than one year increased approximately 150 basis points, while longer dated maturities increased roughly half that amount, reflecting the expectation that longer term inflation should decline from the heightened levels of the current environment. Market expectations for future adjustments in monetary policy have evolved as well, with further tightening expected in the near term, followed by easing in the latter half of 2023, as indicated in the bottom left chart. As shown in the lower right-hand chart, U.S. commercial banks reduced their holdings of agency mortgages during the third quarter, concurrent with the end of net asset purchases by the Federal Reserve, resulting in significantly lower demand for the sector during the quarter. The cap on runoff of the Federal Reserve's agency mortgage portfolio increased to $35 billion per month in September versus the previous cap of $17.5 billion, leading to a modest increase of net supply to the market. With paydowns on the agency mortgage portion of the Fed's balance sheet approximately $20 to $25 billion per month in the third quarter, it is unlikely the $35 billion cap will be restrictive, absent a significant drop in mortgage rates and resulting increase in refinancing and housing activity. Moving on to slide five, where we provide more detail on the agency mortgage market. In the upper left-hand chart, we show 30-year current coupon agency RMBS performance versus Treasury hedges over the past year, highlighting the third quarter of 2022 in gray. Agency RMBS performed poorly again during the quarter, as elevated interest rate volatility and the uncertain path of monetary policy pressured valuations sharply lower, resulting in wider spreads. The sector performed very well in July, as cheaper valuations and a reduction in expectations for Fed sales from the balance sheet attracted significant investor demand from the money manager and hedge fund communities. However, sentiment quickly shifted negative in August and worsened in September, resulting in September representing the worst month for the sector on record and the third quarter representing the worst quarter in 11 years. Combined with the previous three quarters, the sector also concluded its worst year ever. As shown in the upper right chart, specified pool payouts stabilized briefly before continuing their descent as demand for prepayment protection declined further given the sharp increase in mortgage rates. while implied financing in the TBA market continued to converge with short-term funding rates as indicated in the lower right chart. Slide six provides detail on our agency RMBS investments and the changes in the portfolio during the third quarter. We continue to rotate our lower coupon investments into more attractive higher coupons, expanding our net interest margin and supporting the earnings power of the company. The period end weighted average yield on our agency RMBS investments improved from 4.07% at the end of the second quarter to 4.65% at the end of the third quarter, capturing a significant improvement in available returns given wider spreads and higher interest rates during the quarter. Our agency RMBS investments are well diversified across coupons, and we have largely eliminated direct exposure to potential sales from the Federal Reserve's balance sheet given the reduction in lower coupons. With almost all of the coupon stack trading at discount prices, we continue to focus on Best Fed Pool allocation on those characteristics, which are expected to perform well in both a premium and discount environment. Higher turnover states, such as Texas and Florida, lower loan balances, and low FICO stories typically provide attractively priced prepayment characteristics that lead to faster speeds when trading at a discount and slower speeds when trading at a premium. Despite expectations for deterioration in the dollar roll market, as the reduction in demand from the Federal Reserve and commercial banks weighs on valuations, production coupon TBA remains attractive. Although we continue to anticipate heightened near-term volatility as the Federal Reserve's tightening cycle persists, we believe cheaper valuations on specified pools and TBA represent very attractive investment opportunities with current ROEs in the mid to high teens. Our remaining credit investments are detailed on slide seven, with non-agency CMBS representing approximately half of the $72 million portfolio. Our credit allocation declined modestly during the quarter, given paydowns on our credit securities. Our remaining $45 million of credit securities are high quality, with 87% rated single A or higher. Although we anticipate limited near-term price appreciation, we believe these assets are attractive holdings, as 100% are held on an unlevered basis and provide favorable unlevered yields. Positively, our remaining commercial real estate loan, representing approximately $24 million market value, was repaid in full in October. Lastly, slide 8 details our funding book at quarter end, as shown in the chart on the upper left. Repurchase agreements collateralized by agency RMBS increased to $3.9 billion as of September 30th, given the increase in our specified pool holdings, and hedges associated with those borrowings also increased to $3.1 billion net notional of current pay fixed received floating interest rate swaps. In order to hedge additional exposures further out the yield curve, we continue to hold $700 million net notional of forward starting interest rate swaps with starting dates in 2023. Consistent with changes in short-term funding rates as a result of tightening monetary policy, our weighted average repo costs increased sharply to 3.27%. Positively, 80% of our repo costs are hedged by current pay interest rate swaps. And the increase in our asset yields as a result of our rotation into higher coupon agency RMBS also served to offset the increase in our funding costs. Economic leverage, when including TBA exposure, increased during the quarter to 5.3 times debt to equity as a result of our preferred equity repurchases and the decline in book value. Leverage as of the end of October was roughly unchanged from quarter end. To conclude our prepared remarks, the third quarter of 2022 represented another extremely challenging environment for agency RMBS investors. Hedged performance for the sector was amongst the worst quarters ever and combined with previous quarters resulted in the worst nine-month and 12-month performances on record. Positively, the significant underperformance experienced over the past year has resulted in very attractive valuations with historically modest leverage expected to generate mid- to high-teen ROEs on production coupons, specified pools, and TBAs. In addition, the agency RMBS market should benefit from both an anticipated reduction in volatility as the Federal Reserve nears the conclusion of the monetary policy tightening cycle and improving technicals given the impact of higher mortgage rates on supply. While we remain cautious given continued near-term market volatility, we do believe today's agency RMBS valuations represent an attractive entry point for those with longer time horizons. Thank you for your continued support for Invesco Mortgage Capital, and now we will open the line for Q&A.

If you would like to ask a question, please press star 1 on your phone. Unmute and record your name at the prompt. Again, that is star one. It'll be a moment for the questions to come in. Thank you. Our first question comes from Doug Harder with Credit Suisse. Your line is open.

Hi. Given that a lot of the weakness in the third quarter kind of happened at the tail end of September, Can you just talk about any portfolio actions you took that might have spilled over into October and kind of where portfolio size leverage sits today?

Yeah, hey, Doug. It's Brian. Yeah, leverage is mostly unchanged since the end of September, so around 5.3 times debt to equity, including TBA. So, you know, book value performance quarter to date is, like John said, down roughly, you know, four, four and a half percent. So, you know, we may have modestly reduced exposure to agency mortgages, but not too much to really make a big difference.

Great. You know, and then, you know, kind of you've been making some steps to reduce the amount of preferred equity, but obviously kind of common book value has continued to fall. You know, just talk about where you're trying to get preferred as a percentage of total equity and kind of what other steps you're looking to take.

Yeah, hey Doug, this is John. Yeah, I mean, you know, we're still obviously committed to getting our capital structure rebalanced and I think, you know, thinking about it in the context of, you know, in the 20 to 25% range for preferreds is kind of our target. And we're continuing to look for just accretive opportunities both on repurchasing preferreds as well as if we can accretively raise common through either the ATM or through block trades. So any of those avenues in the near future is how we're going to go about it.

Great, thanks.

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

Hey, thanks. You guys are obviously earning a pretty strong spread income with leverage as we're at that today. But I guess with some of the tailwinds, emerging for agencies that you mentioned in the prepared remarks. Can you talk about what you'd need to see to meaningfully increase your leverage from here in order to potentially get some book value appreciation if or when it spreads eventually tight?

Yeah. Hey, Trevor. It's Brian. We definitely need to see a reduction in volatility. I think that's the primary thing. you know, thing in the market that we're looking for at this point. We think that we'll start to see that. And actually, you know, Powell's comments on yesterday's press conference, you know, talking about potentially a more shallow but longer timeframe for, you know, monetary policy tightening. We think that that should be a volatility reduction. or we should see a reduction in volatility as a result of that. But again, just the near-term volatility continues to be relatively high. So we think over the longer term that that should play out. And if that were to play out, then we would look to potentially increase leverage into that. But until that happens, we're going to remain somewhat cautious.

Okay.

Got it.

Then on the prepayment speed for the portfolio, obviously it's still very low. You mentioned in the prepared remarks some of the spec pools potentially paying faster when they're trading at discounts. Can you just talk about kind of generally what the sort of projected lifetime speed for the portfolio would be at this point?

Yeah, we think Well, you know, as we continue to shift into higher coupons, that's kind of keeping our prepayment speeds relatively low because we're buying mostly newly issued mortgages. So, you know, we're still seeing kind of high three CPR range. You know, we would expect turnover to be in around the 4% CPR range, and our rotation into higher coupons should – should maybe increase that a little bit, but we would anticipate kind of high single digits for a longer-term CPR on what we hold currently.

Okay. Got it. Appreciate the comments. Thank you.

As a reminder, to ask a question, it is star 1. Our next question comes from Jason Stewart with Jones Trading. Your line is open.

Good morning. How do you guys view the political nature of the Fed at this point?

Hey, Jason. It's Brian. Yeah, that's a tough one. You know, I think, you know, clearly there were some statements or sentences added to the statement yesterday seemed to be a little bit more dovish than the press conference was. So, you know, I think clearly the chairman is likely, you know, more hawkish than some of the other committee members. And so I think, you know, his goal and the way he views it is that, you know, it's – it's easier to be hawkish now and dovish later than to be dovish now and potentially lose control of inflation.

Yeah, I think that's, yeah, this is John. Yeah, I agree with all that. And I think, you know, being more, you know, being slightly more aggressive or more hawkish in the near term is probably helpful just in terms of trying to get, first of all, get inflation under control more quickly but then also avoiding getting into the next presidential cycle and all of that. So I think that's part of the calculus probably. The other thing that didn't come up is the whole potential of selling mortgages, which has been an overhang for the mortgage market for a long time. It's sort of, with the whole talk of the supposed dovish pivot that we didn't get, you know, that talk went away a little bit. You know, I think going forward, you know, I think the possibility of selling mortgages as we go forward is kind of becoming less and less as we, as you realize, like, you know, most of the Fed holdings are, you know, massive discounts and that would create, you know, potential paper losses and things like that that could be, you could see easily becoming politicized. And I think the Fed really wants to avoid any sort of you know, overt political battles. So, you know, so I think that's where it is. I mean, you know, I think to Brian's point, though, I think the path that seems to be being laid out where the endpoint is kind of more important than the path and that it's going to be maybe a, you know, longer but more, you know, less aggressive hikes at each meeting is probably potentially good for mortgages and potentially good for volatility decreasing. So we view that positively.

Got it. And then in terms of TBAs, you know, some of your peers use TBAs a little bit more aggressively than you guys do. What would cause you to change your view on the way you use TBA pilot roles?

Yeah, I mean, certainly TBAs continue to be pretty attractive. You know, we've seen deterioration kind of as production comes online in the newer coupons. It's just that we've continued to see newer coupons being created as mortgage rates continue to march higher. So, you know, 30-year, 5.5s, and 6s are relatively attractive. But as we start to see more production come out of those coupons, you know, we would anticipate that to decline, which has kind of kept a limit on how much we're willing to invest in the TBA market. But if we were to see, you know, things kind of just, if we start to see, you know, banks start to come back in to the market and we start to see kind of rates stabilize a little bit, you know, we would anticipate those higher coupons to remain So, in that environment, I think it would make sense to maybe, you know, increase the exposure there. Got you.

So, more on the vols. I got you.

Okay. Thanks, guys.

There are no other questions in queue at this time.

All right. Well, I'd like to thank everybody for joining us, and we look forward to meeting again next quarter. Thank you.

That concludes today's call. All participants may disconnect at this time. Thank you for joining.