Invesco Mortgage Capital Inc. — Q1 2018 Form 10-Q
Business context and reporting period. The externally managed mortgage REIT invests primarily in residential and commercial mortgage-backed securities, credit risk transfer securities and mortgage loans. This unaudited quarterly report covers the three months ended March 31, 2018; comparisons are with Q1 2017 unless otherwise noted.
Financial performance and position
- Interest income and earnings: Interest income was $153.2 million, up from $124.6 million. Net interest income was $85.1 million, down from $86.3 million. Net income attributable to common stockholders fell to $41.5 million from $87.1 million; diluted EPS was $0.37 versus $0.73. The prior-period diluted EPS includes the effect of exchangeable notes.
- Investment and derivative results: Net investment losses were $160.4 million, compared with $1.9 million of losses. Net gains on derivatives were $133.4 million, compared with $5.5 million. These largely offsetting, market-sensitive results contributed to lower GAAP earnings. Other comprehensive loss was $129.3 million, and comprehensive loss attributable to common stockholders was $86.2 million.
- Margins and costs: Net interest margin declined to 1.64% from 1.98%; average earning-asset yield increased to 3.38% from 3.06%, while cost of funds rose to 1.74% from 1.08%. Management attributed the margin compression mainly to higher funding costs rising faster than asset yields. Non-GAAP effective cost of funds was 2.22%; effective interest-rate margin was 1.28%, versus 1.30%.
- Non-GAAP core earnings: $50.4 million, or $0.45 per common share, compared with $44.9 million, or $0.40, in Q1 2017. The company cautions that core earnings are not GAAP earnings, cash flow or a measure of funds available for distributions.
- Balance sheet and leverage: Total assets were $18.32 billion and total equity was $2.52 billion at March 31. Borrowings totaled $15.56 billion: $13.91 billion in repurchase agreements and $1.65 billion in secured loans. GAAP debt-to-equity was 6.2x, up from 6.0x at year-end; the company’s non-GAAP repo debt-to-equity ratio was 6.8x, up from 6.1x. Book value per diluted common share fell 6.5% to $17.16 from $18.35 at year-end, principally due to higher rates reducing mortgage-security valuations.
- Liquidity and cash flow: Cash, cash equivalents and restricted cash totaled $119.5 million at quarter-end. Operating activities provided $76.8 million; investing activities provided $325.5 million; financing activities used $371.8 million. Financing uses included $143.4 million to retire the remaining exchangeable senior notes at maturity and $58.6 million for dividends. The company said it believes available cash flow and borrowing capacity can meet anticipated near-term needs, but noted that liquidity may not be sufficient for future margin calls.
- Dividends: The declared common dividend was $0.42 per share, versus $0.40 in Q1 2017. Preferred dividends were $11.1 million, up from $5.7 million, reflecting the Series C preferred issuance in 2017.
Material changes and management commentary
- Average earning assets grew to $18.1 billion from $16.3 billion, partly reflecting investment of proceeds from the 2017 Series C preferred offering. The portfolio emphasized 30-year fixed-rate Agency RMBS, which represented about 43% of investments at quarter-end, versus 28% a year earlier.
- Management described Q1 financial conditions as tighter, with higher Treasury rates, increased volatility and higher repo rates. It expected continued rate volatility and moderate U.S. growth, with core inflation below the Federal Reserve’s 2% objective; no specific earnings or book-value guidance was provided.
- Management said the outlook for Agency RMBS was mixed, citing rate volatility and reduced Federal Reserve reinvestment as pressures, while higher rates could temper refinancing and support investor demand. It viewed CMBS and GSE CRT spreads as supported by improving property values and investor demand.
- The company uses interest-rate swaps, Treasury futures and currency forwards to manage exposures. At quarter-end, swaps had $9.27 billion notional outstanding, excluding $1.3 billion of forward-starting swaps. These hedges may not fully offset asset or funding movements.
Risks, contingencies and unusual items
- Short-term repurchase agreements are subject to refinancing and margin-call risk. Repurchase agreements had a 25-day weighted-average remaining maturity; collateral was about 110% of repo borrowings. A decline in collateral values or higher haircuts could require additional cash or collateral and force asset sales.
- The filing’s modeled parallel rate shock estimated that a 100-basis-point increase would reduce projected net interest income by 26.92% and portfolio value by 1.75%; a 50-basis-point increase would reduce them by 11.65% and 0.64%, respectively. The filing emphasizes that these estimates rely on assumptions and actual outcomes may differ.
- Other principal exposures include spread widening, prepayments and extension risk, credit losses, real-estate values, counterparty default, and the effectiveness of hedges. Management stated it was in compliance with financing covenants at March 31.
- Unfunded commitments included $8.9 million to affiliated-manager-sponsored ventures and $4.1 million on commercial loans. The company reported no material legal proceedings, no defaults upon senior securities, and no material change to previously disclosed risk factors.
- Other notable items: the $143.4 million exchangeable-note retirement at maturity was financed using repo borrowings. The company disclosed an immaterial prior-period error in the amount of securities reported as pledged at December 31, 2017, and revised that disclosure.
Important facts for investors to verify
- Whether asset valuations and book value stabilize if interest rates or mortgage spreads move further, and how actual results compare with the disclosed rate-shock sensitivities.
- Repo renewal availability, lender haircuts, counterparty concentration and capacity to meet margin calls while maintaining the dividend.
- Whether net interest margin can withstand rising funding costs, and how hedges, prepayments and portfolio mix affect recurring earnings.
- The sustainability of the $0.42 common dividend relative to GAAP earnings, non-GAAP core earnings, cash generation and REIT distribution requirements.
- Credit performance and valuation assumptions for non-Agency RMBS, CMBS, GSE CRT and commercial loans, including the company’s geographic and vintage concentrations.