The first quarter of 2024 was a turbulent time for the mortgage market, with interest rates soaring and volatility rampant. Yet, amidst this turmoil, Invesco Mortgage Capital (IVR) managed to secure a 4.8% economic return, primarily driven by a slight rise in book value and a consistent dividend. At first glance, it appears business as usual: IVR, like many of its counterparts, is heavily reliant on higher-coupon agency mortgages, taking advantage of favorable spreads and funding conditions. But the earnings call transcript reveals a more intricate strategy – suggesting IVR is playing a discreet, long-term game that may be flying under the radar of most analysts.

The secret weapon? Agency Commercial Mortgage-Backed Securities (Agency CMBS). While not exactly a flashy asset, IVR's strategic shift towards this less-hyped corner of the market is quietly reshaping its risk profile and boosting returns. During the first quarter, IVR allocated $264 million to Agency CMBS, roughly 5% of its $5 billion investment portfolio. This subtle move, almost casually noted in the transcript, could hold the key to IVR's resilience in an increasingly uncertain market.

Why the Focus on Agency CMBS?

The transcript highlights several reasons behind IVR's bet on Agency CMBS. The primary motivator is the pursuit of stability amid fluctuating interest rates. Unlike agency residential mortgages, Agency CMBS boast a fixed-rate, bullet-like structure with minimal prepayment risk. This inherent predictability offers a crucial safeguard against the recent volatility in interest rates that has rattled the mortgage market.

IVR's timing is also notable. The first quarter saw a surge in demand for Agency CMBS from investors seeking a haven from volatile interest rates and gravitating towards the security of fixed-rate bonds. This amplified demand, coupled with relatively subdued issuance volumes, led to tighter spreads, further augmenting IVR's returns and increasing the sector's appeal.

The intriguing element of this hypothesis is that, although IVR acknowledges the current Agency CMBS spreads might warrant a pause in acquisitions, the transcript clearly suggests this is a temporary measure. While IVR currently favors Agency RMBS for their higher returns, they clearly see Agency CMBS as an essential tool for diversifying portfolio risk, especially against interest rate fluctuations.

Balancing Act: High-Yield RMBS and Stable CMBS

This strategic balancing act between high-yielding Agency RMBS and stable Agency CMBS suggests IVR is preparing for a multi-faceted future. While they are banking on a normalization of the yield curve and potential easing of monetary policy to boost Agency RMBS valuations, they are simultaneously hedging their bets with the consistent, fixed-rate cash flows of Agency CMBS.

The data supports this thesis. IVR's current leverage stands at 5.6 times debt-to-equity, indicating a cautious approach given the recent market volatility. However, their liquidity remains robust, with $451 million in unrestricted cash and unencumbered investments – a substantial reserve ready to be deployed as the investment landscape shifts.

The implication is that IVR may be anticipating a scenario where the Fed maintains higher interest rates for a longer period than anticipated. In this scenario, the predictable cash flows of Agency CMBS would provide stability, while the favorable spreads on Agency RMBS would offer continued upside potential, even if valuations are suppressed due to elevated interest rate volatility.

A Dual-Pronged Strategy

This “dual-pronged” approach, discreetly embedded within the transcript, could be IVR’s ace up its sleeve. While other analysts may be fixated on the familiar narrative of Agency RMBS and dividend sustainability, IVR’s quiet shift towards Agency CMBS could be the silent driver of long-term, risk-adjusted returns. This ability to maneuver between these two contrasting asset classes, optimizing for both yield and stability, could be the differentiator that sets IVR apart in a mortgage market poised for continued turbulence.

Portfolio Breakdown

Here's a breakdown of IVR's portfolio as of Q1 2024:

Gross ROE Comparison

This chart illustrates the difference in Gross ROE between Agency RMBS and Agency CMBS, highlighting why IVR currently favors Agency RMBS but recognizes the strategic value of Agency CMBS for portfolio stability.

"Fun Fact: Agency CMBS are often backed by loans on income-producing properties like shopping malls, office buildings, and hotels. This makes them a unique blend of real estate and fixed income, offering investors exposure to both sectors."