Dissecting Invesco Mortgage 12.99% Dividend Yielder

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Invesco Mortgage Capital’s (NYSE: IVR) diversified MBS portfolio gives the company an edge over the rest of the mortgage REITs under the prevailing macroeconomic situation, where the Fed is committed to keep the yield curve flat through its various initiatives. The mortgage rates have declined to the record low due to QE3 and Operation Twist. The 15-year mortgage rates declined to 2.65%, while the 30-year US mortgage rates plunged to 3.37%. Invesco has a diversified MBS portfolio supporting its net interest margin. The company has low prepayment speeds on its MBS portfolio. Therefore, I recommend investors invest in Invesco Mortgage Capital. American Capital Agency (NASDAQ: AGNC) and Armour Residential (NYSE: ARR) are among my other favored mortgage REITs. I recommend investors to stay away from Annaly Capital Management (NYSE: NLY).

Business Mix

Invesco Mortgage Capital seeks to invest most of its MBS portfolio in residential and commercial mortgage backed securities and mortgage loans. Besides Agency residential MBS, the company’s charter allows the addition of non-Agency residential MBS, which in the prevailing macroeconomic situation is the best cure for mortgage REITs.

 

The chart above shows the percentage of Agency and non-Agency MBS in the portfolio of Invesco Mortgage Capital at the end of the third quarter of the current year. Around 14% of the entire company’s MBS portfolio is non-Agency residential MBS with a weighted average coupon of 4.12%, while the 9% commercial MBS have a weighted average coupon of 5.44%. These elevated coupons are compared to 4.1% and 4.37% weighted average coupons for the company’s 15-year and 30-year Agency securities, respectively.

 Net Interest Spread

 

The above graphs shows that Agency RMSB was around 52% of the company’s equity at the end of the third quarter, while non-Agency formed 27%, followed by CMBS at 19% and 2% other investments. This means, around 48% of the company’s invested in securities other than Agency RMSB, which the Fed is purchasing.  

The company yielded 3.55% on average on its assets during the most recent quarter, while it earned a 4.24% yield on it assets during the same quarter of the prior year. The cost of funds during the most recent quarter was 1.67% down from 1.76% in the third quarter of the previous year. This enabled the company to earn a net interest margin of 1.64% during the most recent quarter compared to 2.4% at the end of the same quarter of the last year. The decline in the net interest margin was blamed to the higher hedged cost of funds.

The abundance of non-Agency securities in the company’s possession makes me believe that Invesco’s net interest spread should not face as much pressure as Annaly’s should. Annaly stands to be the largest US mortgage REIT. However, it invests exclusively in Agency RMBS with high average coupons and high prepayment speeds. Therefore, I favor Invesco over Annaly.  

Recent Performance

From a year ago, the net interest income of $140.5 million increased 1.6%, while the interest expense increased 19.5%. This resulted in a net interest income decline of 8.7% to $80.15 million. Other income, including a resulting gain on sale of investments increased over fourfold. Total expense over a year increased to $10 million from $8.7 million. Net income surged 5.6% to $86.77 million.

The net interest margin that the company earned during the third quarter of this year was 1.64%. This is compared to the 2.4% net interest margin that Invesco earned during the third quarter of the prior year. The decline in net interest margin was blamed to the higher hedged cost of funds related to an increase in average borrowings and interest swaps and a decrease in the portfolio yield.  

During the most recent quarter, amortization cost was $38.8 million partially offset by discount accretion of $4.14 million on the company’s non-Agency securities. Much of the amortization cost was associated to Agency MBS.

Prepayments

The conditional prepayment rate (CPR), which impacts the company’s premium or discount on the securities purchased, was 14.3% at the end of the most recent quarter, compared to 13.3% at the end of the linked quarter.  This is compared to a CPR of 12%, 13% for American Capital and Armour Residential, respectively. The two have some of the lowest prepayments speeds for their portfolios. Annaly Capital reported a CPR of 20% at the end of the most recent quarter.

Shareholder Distribution

The stock offers an elevated dividend yield of 12.99%, where the 10-year treasury offers 1.81%. Invesco remains one of the few mortgage REITs that have maintained its quarterly dividend for the past one year. The company recently announced $0.65 per common share as the shareholder distribution.

Valuations

Invesco Mortgage trades at a 4% discount to its third quarter book value, while Two Harbors trades at moderate 1% premium to its book value. American Capital Mortgage Investment is currently trading at 4% discount to its third quarter book value. American Capital Mortgage and Invesco have prepayment protected MBS portfolios, which is why they were considered for a comparison. I believe Invesco Mortgage has attractive valuations compared to most of its peers.

Conclusion

I recommend Invesco Mortgage as the company has a diversified MBS portfolio, which supports the company’s net interest margin in difficult macroeconomic situations. Besides, the company’s prepayment protected portfolio and attractive relative valuations add to the benefits offered by the stock.


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