IVR - Invesco Mortgage Capital: Wild Moves In Interest Rates A Massive Headwind

Summary

• The stabilization in Q4 of Agency RMBS helped Invesco Mortgage Capital Inc. book value.
• Distributable earnings more than covered the dividend.
• Q1 rates have been volatile once again.
• Invesco Mortgage Capital management is cautious.
• Wait for a discount to book value.

In this column, we return to Invesco Mortgage Capital Inc. ( IVR ), which just reported earnings . The stock has pulled back heavily since recently eclipsing $15. The stock is now at $13. We think Invesco Mortgage Capital is setting up for another round of buying, but wait for sub-$12. With rates moving heavily in the last few weeks, and volatility picking up, we expect shares to pull back to a better price.

We discussed this in December. Once again, the biggest risk to Invesco Mortgage Capital Inc. right now continues to be the rising and very volatile interest rate environment. With the Fed unwinding is balance sheet and the recent volatility in rates, we have seen some severe weakness in mREITs (mortgage real estate investment trusts) the last few weeks. We are almost guaranteed to be getting another rate hike or two. The economy remains hot, so its looking more and more likely that there will be pain ahead.

With that said, Invesco has reacted as it can. It has suffered losses and has cut its payout. We still see mREIT performance bottoming this summer when rate volatility calms down, and that is when we predict the Fed pauses hikes. Let us review the key metrics as of Q4 2022.

Invesco Mortgage Capital key metrics in Q4 2022 earnings

*Based on dividend paid in the quarter

**Determination based on distributable earnings report; however, caution should be exercised in interpreting distributable earnings measures across companies in the sector. It is also not a measure that should be a complete substitute for net income.

Invesco Mortgage Capital sees spread compression in Q4 2022

We derived these metrics from the Q4 earnings slide deck. 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. Nearly the entire $4.5 billion investment portfolio was invested in Agency RMBS in Q4. That said, the company put money to work in Q4, as they ended Q3 with over $500 million. Invesco Mortgage Capital Inc. is now sitting on $175 million in cash and equivalents.

Q4 was more favorable overall for Agency RMBS, rebounding and their values were crushed badly last year with the volatility in rates. With the volatile action, the net interest rate spreads have been all over the map, but the largest issue continues to be yield curve inversion. Rates are higher on the short end than the long end. That causes a lot of issues trying to borrow short money and invest in longer-term yielding assets given this issue. Costs of funds have jumped, and even though there has been an increased yield on the assets being traded, we have seen spread compression, though that tends to lead to book value benefits.

Well, the cost of funds jumped, rising 152 basis points from Q3, while yields on the portfolio increased 99 basis points. Given the higher increase in cost of funds compared to the yields on the portfolio, this led to the net interest margin falling 53 basis points on average to 1.98%. With that said, book value stabilized.

Invesco Mortgage Capital Book value stabilizes

One strong positive in the quarter was that book value stabilized. We have some concerns about Q1 2023 given the huge spike in yields and rates the last few weeks, but in Q4, we saw some benefit. In the release, management stated:

The environment for Agency residential mortgage-backed securities remained turbulent during the fourth quarter, as interest rate volatility persisted at a historically elevated level. Book value per common share finished largely unchanged for the quarter at $12.79 and has increased in 2023 primarily due to improved Agency RMBS valuations.

While that was positive, as we have seen in recent weeks the uncertainty is building. That said, management was very cautious:

While further changes in monetary policy by the Federal Reserve may bring challenges in the coming months, we believe that a potential reduction in interest rate volatility combined with compelling valuations and favorable funding conditions will support an attractive investment environment for Agency RMBS in 2023."

We think the company will remain cautious the next few months, and should be, as there are still more hikes to come for rates. Markets are getting uncertain again but the stable book value was great to see. While book value stands at $12.79, at least entering Q1 2022, it has likely moved a bit lower with the moves in rates (assuming similar action in spreads and values of RMBS that we saw on the last yield spikes in 2022).

Invesco Mortgage Capital has an attractive share price relative to book value

Book value is a huge driver of the share price of mREITs, in addition to the dividend and its coverage. We were pleased that earnings available for distribution of $1.46 more than covered dividend payments. So, that is a benefit for share prices. Right now, shares have retraced to having only a very slight premium-to-book. The stock is at $13.10 a share, so this is a 2.4% premium to the last known book value. The real premium may be slightly higher now. We would prefer a buy if shares were at a 5% discount, which means that we would like shares to dip lower. Once again, we think sub-$12 is a strong level, all things considered.

Final thoughts

The stabilization in Q4 of Agency RMBS helped Invesco Mortgage Capital Inc. book value. While rates remained volatile, they calmed down enough for funds to be put to work. This 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.

But management is cautious. We think you need to wait for Invesco Mortgage Capital Inc. stock to come down to a 5% discount-to-book in our opinion. The yield curve inversion remains a problem for the overall market, as it is indicating strongly a recession is coming. However, we see rate hikes being completed by this summer, and at that point, we think the mREIT sector will find some footing.

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