Business context and reporting period
Invesco Mortgage Capital Inc. (NYSE: IVR) filed this Form 10-K for the fiscal year ended December 31, 2017. The externally managed REIT invests primarily in agency and non-agency residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), GSE credit risk transfer securities and mortgage loans. Its stated objective is to generate risk-adjusted returns primarily through dividends. The filing also provides fourth-quarter results.
Financial performance and position
| Metric | 2017 | 2016 |
|---|---|---|
| Interest income | $545.1 million | $478.7 million |
| Interest expense | $196.6 million | $157.4 million |
| Net interest income | $348.5 million | $321.3 million |
| Net interest rate margin | 1.87% | 1.92% |
| Net income attributable to common stockholders | $320.5 million | $231.5 million |
| Diluted EPS | $2.75 | $1.98 |
| Core earnings per common share (non-GAAP) | $1.73 | $1.65 |
| Common dividends declared per share | $1.63 | $1.60 |
Net income and EPS improved substantially, while the reported net interest margin narrowed. Management attributed higher net interest income chiefly to larger average earning assets; higher funding costs, particularly on short-term repo borrowing, weighed on margins. Core earnings are a company-defined non-GAAP measure and should not be treated as GAAP earnings or cash available for dividends.
Operating cash flow was $318.0 million, compared with $329.7 million in 2016. Investing activities used $3.12 billion, principally reflecting $6.28 billion of MBS and GSE CRT purchases; financing activities provided $2.73 billion. Year-end cash and cash equivalents were $88.4 million, down from $161.8 million.
At December 31, 2017, total assets were $18.66 billion, total equity was $2.66 billion and mortgage-backed and credit risk transfer securities were $18.19 billion. Repurchase agreements were $14.08 billion, secured loans $1.65 billion, and exchangeable senior notes $143.2 million. The reported debt-to-equity ratio was 6.0x; the company’s non-GAAP repo debt-to-equity ratio was 6.1x. Repo borrowings had a 25-day weighted-average remaining maturity, underscoring refinancing and collateral-liquidity exposure. Book value per diluted common share rose 5.0% to $18.35.
Portfolio equity allocation shifted year over year: Agency RMBS 45% (41% in 2016), commercial credit 35% (32%), and residential credit 20% (27%). Holdings of 30-year fixed-rate Agency RMBS increased substantially; they represented 42% of the investment portfolio at year-end versus 20% a year earlier.
Material changes versus the prior comparable period
- Net income attributable to common stockholders rose by $89.0 million. The comparison benefited from a swing in net derivative results to an $18.2 million gain from a $62.8 million loss in 2016, alongside higher net interest income.
- Net interest income increased $27.1 million, but net interest rate margin decreased from 1.92% to 1.87% as short-term funding costs rose faster than longer-term asset yields amid a flattening yield curve.
- Average earning assets increased to $17.0 billion from $15.6 billion, supported in part by the August 2017 Series C preferred-stock offering. The offering raised $287.5 million gross, with $9.4 million of issuance costs.
- The company retired $256.6 million par value of 5.00% exchangeable notes during 2017, recording a $6.8 million loss on extinguishment. $143.4 million remained outstanding at year-end and was due March 15, 2018.
- Unrealized losses on available-for-sale securities reduced other comprehensive income by $8.4 million, while total other comprehensive loss was $33.1 million. The company also recorded $12.0 million of other-than-temporary impairment losses, mainly on RMBS interest-only securities.
Outlook, commentary, risks and unusual items
Management expected moderate U.S. economic growth in 2018 and core inflation to remain below the Federal Reserve’s 2% objective, while anticipating continued monetary tightening and a relatively volatile rate environment. It described the Agency RMBS outlook as mixed: rising rate volatility and reduced Federal Reserve reinvestment were potential headwinds, while muted refinancing and possible bank demand could support the sector. Management also noted tighter CMBS and GSE CRT spreads and improving real-estate fundamentals during 2017. No specific earnings, book-value or dividend guidance was provided.
The central financial risks are interest-rate and spread moves, prepayment and extension risk, credit losses, and dependence on short-term repo funding. Margin calls could require additional collateral or forced asset sales; the filing states there is no assurance liquidity will be sufficient to meet all such calls. A static-portfolio sensitivity analysis estimated that a 100-basis-point rate increase would reduce projected net interest income by 26.60% and portfolio value by 1.74%; these are model-based estimates, not forecasts. The company reported $9.1 billion of interest-rate swaps fixing floating rates on borrowings and also used foreign-currency forwards.
Other risks include geographic concentration in mortgage collateral, including California exposure; lower-credit-quality and subordinated securities; commercial mezzanine-loan risk; valuation estimates for less actively traded assets; counterparty and derivative exposure; REIT and Investment Company Act compliance; and reliance on its external manager, with related conflicts of interest. The company reported no legal proceedings at year-end. Management and the auditor concluded internal control over financial reporting was effective, and the auditor issued an unqualified opinion on the financial statements and controls.
Unusual or notable items include a disclosed auditor-independence question relating to SEC Regulation S-X’s Loan Rule. Management intended to rely on SEC staff no-action relief, which was extended indefinitely in 2017; circumstances outside that relief could require a different auditor and create filing or financing complications. The company also deferred declaring its next Series B preferred dividend until February 2018, while treating accumulated dividends as a current capital cost in core earnings. The Tax Cuts and Jobs Act, enacted in December 2017, could affect the company and its investors; management noted some effects remained unclear.
Important facts for investors to verify
- Whether the $143.4 million notes due March 15, 2018 were repaid, refinanced or otherwise addressed after year-end; the filing said liquidity and borrowing capacity were expected to be sufficient.
- Current repo financing availability, maturities, counterparties, haircuts and liquidity available for margin calls, given the short average repo maturity and 6.0x debt-to-equity leverage.
- Whether net interest margin and core earnings can withstand further short-rate increases and yield-curve flattening; assess the company’s non-GAAP reconciliations as well as GAAP results.
- Whether the $1.63 per-share 2017 common dividend was supported by recurring earnings and taxable income, noting that the REIT distribution requirement is based on taxable income and the board has not established a minimum dividend.
- Portfolio credit quality, geographic concentrations, fair-value assumptions, impairment judgments and the performance of commercial mezzanine loans and subordinated securities.
- Any subsequent developments regarding the auditor-independence matter, REIT and Investment Company Act compliance, and the external manager relationship.