INVESCO MORTGAGE CAPITAL INC

we plan to address today. The press release and presentation are available on our website, ambescomortgagecapital.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 the 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 or guarantee the accuracy of our teleconference transcripts provided by third parties. The only authorized webcasts are located on our website. Again, welcome. Thank you for joining us today. I'll now turn the call over to IVR's CEO, John Anzalone. John? All right.

Good morning, and welcome to Invesco Mortgage Capital's second quarter earnings call. I'll provide some brief comments before turning the call over to our Chief Investment Officer Brian Norris to discuss our portfolio in more detail. Also joining us on the call this morning are President Kevin Collins and our CFO Lee Febley. The second quarter was characterized by elevated interest rate volatility as uncertainty regarding near-term monetary policy persisted. After initially rising by 50 basis points in April, The yield on the 10-year Treasury reversed course and rallied during May and June to end the quarter only 14 basis points higher. The sharp reversal was driven by data showing slowing inflation and increased confidence in a soft economic landing. As market expectations for interest rates cuts changed throughout the quarter, agency mortgages generally underperformed compared to Treasury hedges. This underperformance was primarily in higher coupons, which are more affected by volatility and seasonal increases in supply. These factors led to a negative economic return of 4.1% for the quarter, consisting of an 8% decline in book value combined with our 40 cent common stock dividend. Our debt to equity ratio ended the quarter at 5.9 times, up from the 5.6 times at the end of March. As of the end of the quarter, our $5 billion investment portfolio primarily consisted of 4.6 billion of agency RMBS, including agency TVA. and $400 million of agency CMBS, and we continue to maintain a sizable balance of unrestricted cash and unencumbered investments totaling $446 million. Earnings available for distribution was supported by attractive interest income on our target assets, favorable funding, and low-cost pay fix swaps. For the quarter, EAD for common share was $0.86, unchanged from last quarter and still comfortably above our $0.40 dividends. Entering the third quarter, the decline in interest rates that began in May accelerated due to weaker-than-expected employment data, raising concerns about economic growth. Since the end of June, the 10-year Treasury yield declined by over 50 basis points, and the two-year Treasury yield fell by 85 basis points. This shift also caused the market to expect four to five cuts by year-end, according to FedBus Futures. Despite these sharp declines in interest rates and continued elevated volatility, Agency mortgage performance has been modestly positive to start the quarter, with lower coupons in particular benefiting from lower rates and a steeper yield curve. This has resulted in our book five remaining approximately unchanged since quarter end as of yesterday's close. Given our expectations for a steeper yield curve and an eventual decline in interest rate volatility, our outlook for agency mortgages is positive. In particular, we believe investors in agency mortgages stand to benefit from attractive valuations,

I'll stop here, and Brian will go through the portfolio. All right. Thanks, John, and good morning to everyone listening to the call. I'll begin on slide four, which provides an overview of the interest rate and agency mortgage markets. As shown on the chart in the upper left, U.S. Treasury yields increased across the yield curve largely in a modest bear steepener during the second quarter. Yields on maturities from 2 to 30 years rose between 13 and 22 basis points. fiscal policy. This change has more than reversed since quarter end, as reflected by the purple line, which represents the yield curve as of Wednesday, August 7th. Recent employment data was softer than expected, increasing fears that monetary policy has been kept too tight for too long, leading to a sharp, bold steepening in the yield curve since quarter end. The chart on the bottom left details pricing in the Fed Funds futures market since year end. By the end of the second quarter, the market expected two 25 basis point cuts in 2024, consistent with the Fed's median dot plot and down from over six expected cuts at the beginning of the year. Since the end of the quarter, however, recent weak employment data has led to more than four cuts anticipated in 2024. The increased uncertainty about monetary policy and the economy has caused interest rate volatility to rise sharply. leading to modest underperformance in agency markets. The chart in the upper right reflects the recent sharp decline in three months so far, highlighting the volatility in short-term interest rates. Positively, our repo market counterparties have begun to price these cuts into their longer-term rates, offering more attractive financing for agency RMBS and CMBS. Lastly, the bottom right chart details agency RMBS holdings by the Federal Reserve and U.S. banks. Runoff of the Fed's balance sheet continues, with agency RMBS declining by 15 to 20 billion per month, while U.S. banks have added modestly to their balance sheets. We expect bank demand to rise as monetary policy eases, creating a more attractive investment environment with a steeper yield curve and less interest rate volatility. Additionally, the finalization of Basel III guidelines, likely by late 2024 or early 2025, should give banks more regulatory clarity and confidence, boosting demand in the sector. Slide five provides more detail on the H2 mortgage market. In the upper left chart, we show 30-year current coupon performance versus U.S. Treasuries over the past 12 months, highlighting the second quarter in gray. Current coupons modestly underperformed during the quarter as interest rate volatility spiked both in April and late June. Since the end of the quarter, strong performance in July has been offset by increased interest rate volatility and a general risk-off tone in early August due to a weaker-than-expected August employment report. Although nominal spreads on higher coupons are now narrower than in the second half of 2023, they are still historically attractive as ongoing interest rate volatility is limiting demand. Specified pool pay-ups fell in the second quarter due to rising interest rates but have partially recovered as the abrupt decline in rates has led to more demand for prepayment protection. Lastly, as shown in the lower right chart, the dollar role market for certain TVA securities improved dramatically in the second quarter, as heavy demand for higher coupon Gini collateral from CMO desks led to a significant imbalance in the supply and demand technicals in those coupons. This imbalance has since normalized, however, and the dollar role market for most 30-year TVA securities is, once again, largely unattractive relative to repo financing on specified pools. Slide 6 details our agency RMBS investments and summarizes investment portfolio changes during the quarter. We continue to rotate a portion of our lower coupon specified pools into agency CMBS at the beginning of the quarter. However, continued outperformance in agency CMBS limited the amount of the rotation as contracting premiums throughout the quarter made the sector less attractive relative to agency RMBS. We remain focused in higher coupons. which should benefit from a decline in interest rate volatility and are largely insulated from direct exposure to assets held by both commercial banks and on the Federal Reserve's balance sheet. We focus our specified pool allocation on prepayment characteristics that are expected to perform well in both premium and discount environments, with our largest concentration in lower loan balance collateral, given more predictable prepayments. In addition, during the quarter, we added $200 million notional in higher coupon GENI TBA to benefit from the very attractive levels in the dollar role market. Although we anticipate interest rate volatility to remain moderately elevated in the near term, we believe current valuations on production coupon agents to RMBS largely reflect this risk and represent attractive investment opportunities with current gross ROEs in the mid to high teams. Slide seven provides detail on our agency CMBS purchases as well as an overview of the benefits of the sector. We purchased 120 million in the second quarter bringing our exposure to approximately 7% to 8% of our total investment portfolio. We believe the agency CMBS provides numerous benefits to the portfolio, primarily through its prepayment protection and bullet-like maturities, which reduces our sensitivity to interest rate volatility. Gross ROEs on new purchases were in the low double digits at the beginning of the second quarter, but given the strong performance of the sector, that declined to the high single digits. Financing capacity has been robust. we have been able to finance our purchases with numerous counterparties and attractive funding levels. We will continue to monitor the sector for opportunities to increase our allocation as they become available, recognizing the overall benefits to the portfolio as the sector diversifies risks associated with an agency RMBS portfolio. Our agency CMO allocation is detailed alongside our remaining credit investments on slide 8. Our allocation to both agency interest-only and credit securities remained unchanged, with $75 million allocated to agency IO and $18 million allocated to credit at quarter end. Although we anticipate limited near-term price appreciation in these investments, we believe they provide attractive yields for unlevered holdings, with returns in the high single digits. Slide 9 details our funding and hedge book at quarter end. Refurnace agreements collateralized by agency RMBS. our AG and the agency CMBS declined modestly from $4.4 billion to $4.3 billion, and our notional pay fix interest rate swaps decreased as well from $4.3 billion to $3.9 billion as the ratio of our hedges to borrowings decreased to 92% from 97% last quarter. The increase in interest rates led to further repositioning of the hedge book as the interest rate sensitivity of our assets increased. warranting a similar increase in the weighted average maturity of our interest rate swap hedges. Reflecting this change, the weighted average maturity of our hedges increased from 7.2 years at the end of the first quarter to 7.5 years, resulting in a modest increase in the weighted average coupon on our pay fixed swaps from 1.17% to 1.22. Economic leverage ended the quarter at 5.9 times debt to equity, up from 5.6 times at the end of March, mostly reflecting the decline in book value. Slide 10 provides further detail on our asset yields and funding costs. Interest rates on our repurchase agreements and swap receive rates were largely unchanged to quarter end, while yields on our HSC RMBS portfolio increased five basis points to 5.4%, consistent with the five basis point increase in our swap pay rate. To conclude our prepared remarks, Despite a near consensus that easing in monetary policy will begin in the third quarter, financial markets remain quite volatile as investors debate the probability of a recession and magnitude and timing of near-term policy easing. The recent sharp decline in interest rates has provided a supportive backdrop for lower coupon agency mortgages since quarter end, while higher coupons have modestly lagged given the spike in interest rate volatility. We believe IVR is well-positioned to navigate future mortgage market volatility and selectively capitalize on historically attractive agency RMBS spreads, given our balance of discount and higher coupon agency mortgages and agency CMBS. In addition, we believe the easing of monetary policy will eventually lead to further declines in interest rate volatility and a steeper yield curve, both of which provide a supportive backdrop for agency mortgages. Lastly, our liquidity position remains robust provides a cushion for further potential stresses in the market while also providing capital to deploy into our target assets as the investment environment improves. Thank you for your continued support for Invesco Mortgage Capital. And now we will open the line for Q&A.

Thank you. As a reminder, if you'd like to ask a question, please press star then one on your phone. Remember to unmute your phone and record your name and company clearly when prompted. If you'd like to withdraw that question, you would press star two. Again, to ask a question, please press star then 1. Okay, and our first question comes from Jason Weaver with Jones Trading. Your line is open. Hey, good morning. Thanks for taking my question.

Brian, I appreciate your comments around leverage, and I understand it was book value-related, the change in the quarter. But can you comment on your comfort zone going forward? It seems like with the comments around leverage, easier monetary policy leading to tighter spreads, it might be appropriate to get more aggressive at some point in the near future?

Yeah. Hey, Jason. Good morning as well. Thanks. Yeah, I mean, right now we would consider our leverage to kind of be in the middle of our range. You know, I think, I mean, you're right. If we start to see a decline in interest rate volatility and a steeper yield curve, that would potentially warrant an increase in leverage. But as of right now, we're still in a pretty volatile environment. So I think remaining somewhat in the middle of that range is proven.

Got it. That makes sense. And just one clarification. You made the comments on agency CMBS. Is that not likely to become a much growing portion of your portfolio going forward?

We certainly like the benefits that it brings to the portfolio. You know, like I said, you know, spread got a little too tight for it to make sense later in the second quarter. But, you know, if we were to see some, you know, compression between

Got it. Thank you for that. Thank you. The next question comes from Doug Harder with UBS. Your line is open. Okay, moving on to our next question. Jason Stewart with Janie. Your line is open.

Hey, good morning. Thanks. Can you give us an update on where taxable income stands relative to the dividend and then how you see that evolving going forward?

Hey, Jason. Yeah, it's Brian. Yeah, taxable income is a challenging one. You know, I think, you know, that's going to be in our queue. So, you know, I think, you know, the thing that we look at certainly is, you know, EAD, which is comfortably above the dividend. And, you know, taxable income typically gets driven kind of by, you know, derivatives pricing. So that tends to be a little bit more volatile depending on what rates are doing during the quarter. So it makes it a little bit more challenging to use that as a guide.

Okay. Maybe generally, and I'm looking it up right now, could you give us, like, are we in a position of being over-distributed or under-distributed, just generically kind of mid-year?

Relative to our taxable income. Is that the question?

Correct. Yeah.

Hey, Brian.

Yeah. You want me to address that? Sure. So we have operating loss carry forward that allow us to sustain the delta between taxable income right now being in excess of the disclosure or in excess of the dividend that we're paying. If that's the question in terms of is tax going to drive a need to increase the dividend, we have flexibility there based on our operating loss carry forward.

Okay. Okay. That's helpful. And then you guys addressed where I think marginal economic returns were in the mid to high teens on a gross basis. Where do you see them on the existing book today? And what do you think the best path forward is? I mean, given your view of the basis and the macro environment, is it raising capital to deploy at incremental returns? You know, how does that look relative to the existing book? You know, taking the benefit of swaps,

um into account i mean how do you think about those two factors going forward yeah hey jay uh you know i think you know the current book has been mostly added at at wider spreads than where we are now um so i would say you know the um the yields on those are the rle's are you know in the high teens to 20 area um because you know we've seen over the last couple years you know more attractive environments on a spread basis than we currently see right now. So that, sorry, what was the second part of the question?

I guess, how do you see, you know, the benefit of the swaps today and the current economic returns on the book, how do you balance that versus raising capital to invest in marginal economic returns? And I guess... Yeah, sorry, Jason.

Given our current capital structure is, you know, it's not optimal. You know, raising capital and deploying in new assets becomes quite accretive given where spreads are right now. So, you know, that we view as a relatively attractive option for us.

Okay. All right. I'll jump out and let Doug get back in here. Thanks.

As another quick reminder, if you'd like to ask a question, please press star followed by one. Show no further questions, but we'll allow one moment. Okay, and I'm showing no further questions at this time.

All right, well, thank you, everybody, for joining us, and we look forward to next quarter's call. Thanks.

Thank you, and that concludes today's conference. You may all disconnect at this time. Speakers, you may stand by for a post-conference.