Invesco Mortgage Capital Inc. (IVR) Earnings Call Transcript & Summary

Welcome to the Invesco Mortgage Capital Inc. First Quarter 2020 Investors Conference Call. [Operator Instructions] As a reminder, this call is being recorded. Now I would like to turn the call over to Brandon Burke with Investor Relations. Mr. Burke, you may begin the call.

Thank you, and welcome to Invesco Mortgage Capital's First Quarter 2020 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 can 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 Q1 2020 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?

Good morning, and welcome to Invesco Mortgage Capital's first quarter earnings call. I will give some brief comments before turning the call over to our President and Head of Commercial Credit, Kevin Collins, who will provide greater detail on our current portfolio and our Chief Investment Officer, Brian Norris, who will expand on our go-forward strategy. Before getting started, I'd like to acknowledge the entire team at Invesco who have put in countless hours managing through this crisis, doing it with the added difficulty of working remotely. There's no way that we would be in the position we are in today without their efforts. So thank you to the entire team. I'd also like to acknowledge the support of both our Board of Directors and the senior management in Invesco who have provided all of the resources necessary to get through this crisis. Towards the end of the first quarter, the onset of the COVID-19 pandemic and the economic shutdown left in its wake caused unprecedented volatility and dislocations throughout the financial markets. Even with rates rallying significantly, prepay-protected specified pool agency mortgage-backed securities significantly underperformed as agency paper is being sold for cash settled at levels below TBA prices. The structured securities credit markets were hit particularly hard as liquidity was severely impacted and valuations became distressed. Despite IVR's relatively strong liquidity position coming into the crisis, we sold assets as margin calls accelerated across all of our asset classes. In late March, we decided to discontinue selling our holdings into a deeply distressed market to meet margin calls. So we suspended margin payments and entered forbearance negotiations with our lenders. Ultimately, we are able to capitalize on improving market conditions to pay off our repo counterparties rather than entering into an onerous comprehensive forbearance agreement. While we are providing information as of 03/31 on Slides 3 and 4 for informational purposes, that snapshot was taken in the middle of our delevering and does not reflect the portfolio today. Slide 6 gives a picture of the portfolio as of May 31. As you can see from the pie chart, our $1.6 billion securities portfolio consists of predominantly non-Agency CMBS and residential credit positions. $540 million of that total is unencumbered. The only borrowings we have left are secured Federal Home Loan Bank advances of $837 million, which are collateralized by high-quality AAA- and AA-rated CMBS. As of 05/31, we estimate that our book value is between $2.65 and $3.15 per share, reflecting the continued delevering that took place post quarter end. Currently, we are holding a credit portfolio with modest leverage that we believe has potential to drive book value upside as credit markets continue to recover. Going forward, our strategy is to reinvest proceeds from these future credit sales into what will become an increasingly agency-focused portfolio. Currently, the outlook for agency mortgages is quite attractive with strong support from the Fed and attractive funding environment. This is in contrast to the non-agency credit market where the pandemic has revealed new risk to the strategy and the cost and stability of short-term mark-to-market funding are not attractive. We believe that we will be able to generate attractive ROEs in coming quarters as we redeploy into the agency strategy. I'll stop here and let Kevin give some details on the credit portfolio.

Thanks, John, and thanks to everyone on the line for your interest in Invesco Mortgage Capital. As John noted, our portfolio is now largely comprised of mortgage-backed credit investments. So that's about 92% comprised of commercial mortgage credit and about 7% that's comprised of residential credit. So look, the COVID-19 pandemic and related decline in economic activity has made it pretty difficult for many borrowers to meet their financial obligations. So not surprisingly, lodging and retail property markets have been impacted the most, just due to travel restrictions as well as the slowdown in retail activity. So looking ahead, we do expect many tenants to continue to forgo rent payments or seek relief. But despite our expectations for fundamental weakness, we do believe that bonds at the top or near the top of the capital structure offer attractive value as they've been impacted by the lack of liquidity just as much as heightened concerns regarding COVID-19. We ultimately believe that nonmark-to-market term financing via the Term Asset-Backed Securities Loan Facility, which is a New York Fed program known as TALF, should really continue to assist in creating renewed investor interest in these bonds. The roughly 9% of our bonds, our CMBS bonds, would be eligible for TALF financing if they will purchase today. However, I do want to note that we expect a much larger portion of our portfolio to benefit indirectly as many of the investments sit just beneath these bonds in the capital structure, which makes them, we think, very well positioned to benefit from any future credit curve flattening. Now to quantify, I'd ask you to take a look at the chart by credit ratings and vintage on Slide 7. And as of 05/31, you'll see that about 85% of our credit investments were rated single A or higher, and about 90% of our commercial mortgage credit was rated single A or higher. And further, over 75% of our CMBS portfolio was rated AA or higher. On Slide 7, in the chart to your right, we've also illustrated that significant subordination levels are available to help support the expected increased cumulative collateral losses. Nearly 90% of our CMBS benefits from 15 or more points of subordination and positively, roughly 93% has subordination levels in excess of '07 vintage cumulative collateral losses. And we think that's worth noting because, not surprisingly, loans originated in '07 have experienced notable losses just given that they've had to endure the global financial crisis, and they don't benefit from recently improved underwriting. I'll now turn the presentation over to Brian to discuss our strategic outlook for the portfolio.

Thanks, Kevin, and good morning to everyone listening to the call. As John mentioned, the latter half of the first quarter and extending well into the second quarter proved to be a tremendously challenging environment for the company. Our team worked extremely hard towards the goal of reducing the company's reliance on short-term mark-to-market financing for our credit assets as well as overall company leverage. To that end, by early May, we successfully reduced our reliance on credit repo to 0 with current overall company leverage below 0.8x debt to equity. With over $1 billion of equity, we believe we are well positioned to reconstruct a portfolio that can offer investors compelling returns and dividend income. We have reengaged Agency RMBS repo and interest rate swap counterparties to build the necessary capacity to prudently invest proceeds from a further reduction in credit exposure as our credit assets continue to recover from the liquidity and do sell off in the first quarter. Given current and past Fed support and the enduring availability of Agency RMBS repo through multiple crises in the financial markets, moving forward, we anticipate the asset class will be the primary use of capital to achieve the company's long-standing goals of providing attractive dividend income and book value stability. We believe we can reliably achieve low double-digit ROEs with a mixture of Agency RMBS specified pools in addition to a modest allocation to TBA securities. Fed intervention has fostered an attractive investment environment. While we plan to transition from the current portfolio, which is almost exclusively credit investments, to an agency-focused strategy in the coming quarters, we will continue to evaluate opportunities to achieve target returns on credit investments without reliance on short-term mark-to-market funding. Lastly, our external manager, Invesco, remains committed to devoting the necessary resources to the company. Invesco enjoys a long history of managing the Agency RMBS asset class, and many of our team members have supported the trading and management of the Agency RMBS allocation in IVR since the IPO in June 2009. Combined, our team members have over 80 years of experience managing the asset class through multiple market cycles and crises, with over $23 billion of Agency RMBS assets under management as of 12/31/2019. That ends our prepared remarks, and now we will open the line for Q&A.

[Operator Instructions] Our first question will come from Eric Hagen from KBW.

On the asset sales to wind down the FHLB line, which assets do you think you might sell in order to accomplish that? Would they come from more of the AAA, AA category or something or the positions that are lower-rated than that? And then on the CMBS portfolio, the stuff that's remaining, what's the level of unrealized losses that are sitting in that portfolio? And what's the unlevered yield in the CMBS portfolio now?

Yes. I'll start with the home loan. So the bonds underlying the home loan advances are AA and AAA predominantly. So those are the ones that would be sold to pay down that line. And again, as we anticipate the top of the capital structure improving as the TALF bid starts to get underway, we expect that to be relatively soon. I'll let Kevin answer the second part.

Yes, Eric. So just to give you a sense for where we're seeing things trade today and putting in context to what we currently own in our portfolio, I guess that started the top of the capital structure for us, which is, I believe, about 30% of our portfolio that's currently in AAA CMBS. Those are -- excuse me, said differently, 38% of our CMBS portfolio is AAA. Those are largely junior AAA-rated positions. So in terms of where they are trading, again, it's certainly dependent on transactions, but I'd call it around 160 basis points AA-rated paper, anywhere from 250 to as wide as 400 basis points; and single A paper around 440 -- excuse me, 450 basis points on the spread level; and BBB looks more like 800 to anywhere, 1,300 over in terms of current yields.

Great. That's helpful color. And maybe I can press you on the unrealized losses that are sitting in the portfolio today. We could see where it was at the end of the quarter, but based on the sales that have taken place since then -- yes, just what the mark is on the overall portfolio, and how much of that is in unrealized loss position. And then I'll just ask my second question, too. I mean just how much leverage do you think you might run in the Agency RMBS portfolio as you transition back to that strategy?

Yes. So I don't have those specific numbers in front of me, Eric. But what I can tell you is, to kind of go back to what I walked you through, if you think of the junior AAA-rated positions, what is largely junior AAAs, as I mentioned, about 9% are TALF eligible. So those would be more senior positions. But at 05/31, those were around 250 basis points on a spread level. It looks more like 160 today. For the AA position at 05/31, that was 400 basis points. It looks more like 250 for single A-rated, 650 at 05/31 looks more like 450 today. And 05/31 for BBB, 1,300 looks more like 800. So that should provide some context in terms of what we've seen in the way of improving them. Just continue to see slowly increasing demand in the CMBS sector. Since TALF has come online that certainly helped. And as the economy begins to slowly restart here, we've seen some new entrants into the space or crossover investors. So I think that that's helped as well.

Yes, Eric. I'll take the leverage question. We anticipate it's -- the transition from our current portfolio to predominantly agency-only portfolio will likely take 1 or 2 quarters. So it's going to take us a while to kind of build up to this number, but it's likely to be in the 7 to 8x debt to equity on agency investments.

And our next question will come from Doug Harter with Crédit Suisse.

Can you just talk about how you're thinking of the capital structure, Preferreds are a very big part of your total equity base and kind of what your thoughts are on that?

Yes. Thanks, Doug. We are looking at opportunities, obviously, to raise capital that makes sense for shareholders. And over time, we are looking to get the preferred to common ratio back in line. So I think post this call, post the filing of our Q, we're going to start evaluating the best path forward in terms of capital structure. But yes, I mean, we realize that the preferred to common ratio is clearly not where it was, and we would prefer to get it back to more in line with historical averages.

Okay. And is there anything on -- around kind of the REIT rules and whole pool test that would kind of cause you to need to accelerate the transition back to agency? Or do you have flexibility around that?

Yes. There's some flexibility around timing. So we have a number of quarters to get back into whole pool compliance. But given the leverage on agencies, it wouldn't take that long to get back up to 55% whole pools. But we do anticipate getting there relatively quickly.

And our next question will come from Trevor Cranston from JMP Securities.

A follow-up question on the FHLB financing, which remains in place. Can you say if -- when you choose to pay that off, are there any sort of frictional costs associated with that in terms of make-whole payments or termination fees?

No. No. No. So we are free to prepay those kind of as we sell assets. So there's no penalties or anything like that.

Okay. Got you. And then another follow-up on the question about unrealized losses. It sounds like -- or it sounded like you're suggesting that spreads have tightened pretty meaningfully in June. Is there any chance you can sort of estimate what that means in terms of your book value estimate relative to where it was at May 31?

Yes. I mean, book value since 05/31 is up, I would say, up modestly. We have seen some valuation increases. So yes, I mean, it's up a bit.

Okay. And then it sounded like there were some sort of extraordinary costs that might have been admitted G&A line in the first quarter relative to everything that happened in March. Can you say kind of where you expect the G&A level to run going forward?

Yes. Dave, do you have a spin on that?

Yes, Trevor. We don't expect it to change dramatically. We do -- there are some additional costs incurred in association with kind of navigating the COVID-19 crisis that we'll see come through in Q1 and Q2. But beyond that, we don't expect really a dramatic change in G&A from historical levels within a reasonable band.

With the exception of the management fee. This is Lee Phegley. The management fee will be coming down since it's based on the NAV of the portfolio. Dave's correct, there were some costs associated with advisory work that you'll see this quarter and in the second quarter, but those were not material numbers, but you will see the management fee come down.

Okay. Got it. And then just to clarify, when you mentioned the low double-digit ROEs on the agency strategy, was that a gross ROE estimate? Or is that net of expenses and everything?

That was gross.

Our next question will come from Jason Stewart with JonesTrading.

All my questions have been answered.

I am currently showing that was our last question for today. I'd like to now turn it back over.

Okay. Well, again, I'd like to thank everybody for your interest in Invesco Mortgage Capital, and we look forward to talking to you next quarter. Thank you.

This concludes today's conference. All participants may disconnect at this time. Thank you for your participation on today's call.