IVR - Invesco Mortgage Capital: Income Investors Just Got Crushed (Rating Downgrade)

2023-03-27 18:35:35 ET

Summary

• The fact is the near-term investing world changed in March, with banks collapsing and yields plummeting.
• The rapid move in rates has hit Agency RMBS, and portfolios holding these instruments have been nailed.
• The Invesco Mortgage Capital Inc. dividend cut of 38.5% caught us slightly by surprise, but was done to preserve book value and capital.
• Could be a long-term opportunity, but we are Invesco Mortgage Capital Inc. sellers on this.

In this column, we revisit Invesco Mortgage Capital Inc. ( IVR ), which just cut its dividend by 38.5%. This is a painful but perhaps not unsurprising cut. In just one month the entire landscape has changed. Banks are failing. Yields collapsed. The Fed raised rates once again. The climate is a far cry from last month when the company reported earnings . We think Invesco Mortgage Capital is a sell here. It is just too uncertain. It is better to wait for stabilization. You just got a 38.5% cut to income if that is why you bought.

When the company presented its Q4 earnings , the earnings available for distribution was supported by the company making a strategic shift into higher yielding Agency residential mortgage backed securities (or RMBS) last year. We had learned at the time that almost the entire $4.5 billion investment portfolio was invested in Agency RMBS in Q4. If you look at what has happened in recent weeks, the extreme volatility in rates has wreaked havoc.

We may see more pain in the sector in coming weeks. With the volatile action, the net interest rate spreads have been wild. We still have yield curve inversion, but rates have made one of the biggest moves in a few weeks in a long time. It is just a tough macro situation. Rates are still higher on the short end than the long end, but the rapid drop in rates strongly suggests recession is around the corner. We are selling stocks. We have to assume the costs of funds have moved quite a bit and that the income potential of the portfolio has been decimated for this cut to be made. Back in Q4, cost of funds rose 152 basis points from Q3, while yields on the portfolio increased 99 basis points. The net interest margin fell 53 basis points on average to 1.98%. With that said, book value stabilized in Q4, but in order to further stabilize the book value and have necessary capital to invest, management made this cut :

"Our investment portfolio continues to generate strong earnings available for distribution despite the sharp increase in short-term interest rates given a high percentage of our funding is hedged with a relatively low-cost legacy swap portfolio. We reduced our common stock dividend to retain capital and enhance book value by continuing to invest in agency residential mortgage-backed securities at historically attractive valuations. We believe this represents a compelling environment for longer-term investors. The dividend reduction allows us to pay a competitive dividend consistent with Agency RMBS market levered returns and helps increase the ratio of our common stock to total stockholders' equity."

So, if you are a long-term investor, management is suggesting this is a buy. We tend to agree that the move certainly protects book and preserve capital, but as an income investor you just got nailed. It is likely best to sell, let things stabilize, then come back to the stock.

When Q4 was reported , we learned book value per common share finished largely unchanged for the quarter at $12.79 and had actually increased in the first 6 weeks of 2023 primarily due to improved Agency RMBS valuations. But that has quickly changed in recent weeks. What is wild about this cut is that earnings available for distribution through February were about $1.00, which covers the old quarterly payout of $0.65. Now we are down to $0.40. So, March must be quite a disaster. Keep in mind real estate investment trusts ("REITs") have requirements to pay out 90% of such incomes, so we have concerns.

We did learn the book value fell into March, and as of March 17 was $11.96. We think Invesco Mortgage Capital Inc. will remain cautious the next few months, but were surprised. Obviously the book value dropped heavily from $12.79. So, this effort is being made to stabilize book and preserve capital. Where yields go is anyone's guess right now. We think it is simply better to sell and move on as shares are likely to fall on this news. Further, your yield has been reduced dramatically. Assuming the stock sells down to $11.00 or lower on this, the new yield is 10.9%, or 12% if it falls to $10.00. But we were at nearly 24%, which in itself was likely a warning sign.

Final thoughts

We had thought when Invesco Mortgage Capital Inc. earnings were reported that things were stabilizing and that led to some strong earnings, and the dividend was covered. The spread narrowed on the portfolio's target assets, which coincided with book value being very stable. We knew that management was cautious going forward, but this announcement, and the level of the cut, did surprise us.

If you are a long-term investor, this may prove to be an entry point for Invesco Mortgage Capital Inc., but income investors just got nailed. We see IVR stock falling on this news, because investors buy these equities for income. We did not see this coming right now, but we are not exactly surprised given what has happened with rates. We have discussed this in depth with our members about the pain REITs are experiencing, particularly mREITs, but this level of cut is a surprise. The portfolio likely was crushed in March. We are sellers of Invesco Mortgage Capital Inc.

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