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In this column, we check back in on Invesco Mortgage Capital (NYSE:IVR). The biggest risk to the company right now continues to be the rising and very volatile interest rate environment. Let us not forget, and there is not much attention on this, but the unwinding of the Fed’s balance sheet has also been an added factor in the action in this sector. But the rates are the huge driver. While the raising of rates can be beneficial to a degree, depending on the speed at which they are done, the mortgage market is just tough right now. There is some horrible volatility in mREITs right now. Here is the thing. After all of the horrific carnage in the sector, which has led to the destruction of book value, and also a recently announced dividend cut from the company, we now believe IVR is a buy on the next selloff. The reason we see this as a good play is the rate hike cycle is coming to an end. Sure, we are getting another hike or two, but the Fed has signaled it is ready to slow down, and the economic data just needs to justify it. That is the wildcard in this entire sector right now.
As we look longer out, the company’s portfolio, which has seen losses mount, should slowly improve. While the dividend payment has consistently been at risk, the company finally pulled the band-aid off with the latest cut. While that hurt current investors, it is great for traders like us to come in and start doing some buying. It is a speculative stock in speculative sector, but could offer a high-reward, rapid-return play. It is a dice roll however, for a nice stream of income while you wait for the bounce. We see mREIT performance bottoming out in H1 2023 when rate volatility calms down. Let us check back in on the just reported earnings to get a feel for the critical metrics. The critical metrics which are summarized below for Invesco Mortgage Capital as of Q3 2022:
|
Key Metrics of Interest |
Invesco’s Performance |
|
Q3 2022 Book value and % change from Q2 2022 |
$12.80 (-20.8%) |
|
Net interest rate spread in Q3 |
2.51% |
|
Dividend |
$0.65 |
|
Q3 Distributable income |
DI $1.39, EPS -$2.78 |
|
Dividend covered?** |
yes |
|
52-week share price range |
$9.60-$31.50 |
*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.
Discussion
We derived these metrics from the Q3 earnings slide deck in which management also updated on its portfolio. We were most pleased to see that earnings available for distribution was supported the company making a strategic shift into higher yielding Agency residential mortgage backed securities, or RMBS for short. Look we have to tell you that IVR’s portfolio is not overly complex as pretty much all of their $4.5 billion investment portfolio was invested in Agency residential mortgage-backed securities. That said, the company is sitting on some cash waiting for the moment to strike as they have $504 million in cash and equivalents, or 11% of the port value is in cash, ready to pounce.
Overall Agency residential mortgage-backed securities have had mixed performances, and their values have been demolished with the crazy moves in rates this year. The spreads have been all over, but a huge problem has been yield curve inversion. It has been extremely tough to borrow short money and invest in longer-term yielding assets given this issue. Costs of funds have exploded higher, and in many cases, these costs have outpaced the increased yield on the assets being traded. It’s important to note that the costs of funds exploded higher from last quarter (from Q2), rising 150 basis points, while yields on the portfolio ticked higher by just 53 basis points. This in turn squeezes the margins being made, as margins fell 97 basis points on average to 2.51%. In the release management stated:
The difficult environment for Agency RMBS persisted during the third quarter, as the sector recorded its worst quarterly performance in over a decade. Book value declined as valuations on our Agency RMBS holdings were pressured lower by sharply higher interest rates, elevated volatility, reduced liquidity and a general risk off tone in financial markets. Given a rapidly evolving monetary policy landscape, our outlook on the sector remains cautious in the near term. However, we believe the Agency RMBS sector currently represents a compelling long-term opportunity, as valuations remain at historically attractive levels.
So that is a nice summary of that happened. The company really is cautious the next few months, and should be, as there are still more hikes to come for rates, and markets are likely to get volatile in H1 2023 as we see recessionary signals brewing.
With the carnage in the value of assets and the spread issues, book value got crushed. There was a massive $3.36 drop in book value from Q2, or a 20.8% falloff. Book value stands at $12.80, at least entering Q4.
Now one thing we always say is that book value drives the share price of mREITs, in addition to the dividend and its coverage. Examining book value helps us decide if an mREIT stock is trading at a discount or at a premium. This lets us know if the mREIT stock is undervalued by chance. Right now, shares remain about fairly valued at $12.75 a share. We would prefer a buy if shares were at a bigger discount, which means that we would like shares to dip lower, preferably under $12.00 again, for a speculative buying. We think you wait and then do some buying. You can open here, and then plan to add in the following blocks, just about doubling your position each buy, for a target 1,600 shares (adjust accordingly to your sizing comfort and portfolio allocations). So, here is what we have.
The play
Target entry 1: $12.75 25 shares
Target entry 2: $12.30 50 shares
Target entry 3: $12.05 100 shares
Target entry 4: $11.75 200 shares
Target entry 5: $11.30 425 shares
Target entry 6: $10.50 800 shares
Now, in the open we mentioned how we are still coming into a volatile time, we think you will get a good chance to buy this lower, so add in blocks. The dividend is now well covered at the reduced rate. But risks persist. The company’s debt-to-equity ratio was 5.1x, a huge increase from 3.9X in Q2 2022 but was a result of the big decline in book value, and some repurchase activity on the preferreds. Speaking of preferreds, while we outline a trade in commons, investors should note that preferred shares are often far superior in the mREIT space, in our opinion.
Final thoughts
Wider spreads on the portfolio’s target assets have created an attractive reinvestment environment that is supportive of the earnings power of the portfolio going forward. While we suspect some more volatility in the near-term, we think the environment bottoms out by spring. We think you can start scaling in here, for not just income, but also stabilization and expansion of book values once rates calm down and managing the port becomes easier. The yield curve inversion is the problem, but we see this as normalizing in 2023.
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