Invesco Mortgage Capital Stock: Give up the common for the privileged (NYSE: IVR)

I have to keep this yellow piggy bank safe. If you’re investing in IVR, it seems the privileged are the way to go.

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Invesco Mortgage Capital (New York stock market :NYSE: RVI) is a mortgage-based real estate investment trust (mREIT) that has been hammered in recent years. The stock price has fallen from a high of $157 in February 2020 to $15.63 today, a decline of 90%. Historically the company has paid a large number of dividends, so total returns are more informative. According to data from Seeking Alpha, IVR total returns haven’t been great either with five-year total returns at -78.75%.

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Fortunately, there’s a better way for dividend seekers to protect their capital and invest in IVR if they’re interested: their preferred stock. The company has two fixed-to-floating preferred shares outstanding, Series B (IVR.PB) and Series C (New York stock market :NYSE:IVR.PC). Over the same period, preferred stocks have at least generated a positive total return, although they notably tracked the S&P 500.

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The short version of this article is that investing in preferred IVR seems safer than investing directly in IVR. Let’s turn to the company and the story to understand why.

Invesco Mortgage Capital Overview and Capital Stack

As an mREIT, IVR seeks to generate profit through net interest margin on its investment portfolio primarily focused on agency residential mortgage-backed securities (RMBS). We can see over the last quarter that the company’s investment allocation is 97% concentrated in these agency RMBS.

Presentation of IVR Q2'22 results

Presentation of IVR Q2’22 results

These types of companies typically have high leverage as a means of generating greater interest income between the spread of leverage ratios and the rates of investable securities. We can see that the IVR is no different with a leverage ratio of 3.4x. The 2.86% net interest margin gives a data point on profitability, but if we look at last quarter’s income statement, we can learn a bit more detail.

IVR Q2'22 10-Q

IVR Q2’22 10-Q

From this, we can observe that for each reference period, the company actually generated positive net interest income and yet negative net income due to losses in other income. We can also observe that preferred dividends are covered by interest income. It seems that the company’s hedging strategies are generating significant losses for them.

The result of a constant negative net result: the destruction of equity value. If we look at the total value of equity over time, we can see that it has decreased significantly since 2019, when it was $2,931 million, to the last quarterly value of $959.5 million. dollars. That’s a 67% drop in total equity value.

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But it’s even worse if you consider the value of common stocks during this period.

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Here we can see that from 2019, the value of common stock has decreased by 76.8%. We can see that the value of preferred shares has remained constant over the past two years at $563.3 million.

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The recent decline in the value of preferred shares is due to the company repurchasing preferred shares in the market with a program launched in May 2022. Since their last quarterly earnings press release, they have repurchased 30% of the shares preferred at this stage. With $677.1 million in cash and liquid investments, the company could elect to redeem all of its preferred shares tomorrow if it chooses, eliminating its dividend charge which was $37.795 million in 2021.

This would allow management to have more flexibility in the distribution of dividends for the common shares and eliminate the interest rate risk inherent in their floating rate preferred shares. It seems to me that the company’s strategy is to buy as many of its favorite stocks below par in the market as possible, which is immediately accretive to the company.

Let’s move on to preferred stock directly and a comparison between the two and common stock.

IVR Preferred Shares and Dividend Yield

Many IVR investors may be attracted by the historically high dividend yield, which currently stands at 22.53%. Management actually raised the dividend by 2.8% in the last quarter, which seems pretty bold to me given the consistent net losses. With $677.1 million in cash at present and a large loan book, the company doesn’t go bankrupt immediately without a shock in the RMBS market.

We could have a debate about whether this dividend is sustainable or not. Given what I’ve shared above about annual net losses and declining common stock values ​​over time, I think this dividend is unlikely to be sustainable. In a situation of capital scarcity, the first dividend to be cut would be the commons. As REITs, they can manage their dividend needs by first paying through their preferred stock and then offering whatever payment target they need to meet through the commons.

Either way, if you want to look for a 22.53% return, be aware that this likely comes with capital losses built into the common position. Total return may be lower.

Rather than chasing yield with common stocks, I think dividend investors get a much safer return with preferred stocks. Let’s look at a comparison table of the three titles.

Price

Dividend yield

Shares outstanding (m)

Average volume

Call date

IVR

$15.45

22.53%

33.024

597,500

N / A

IVR.PB

$20.80

9.21%

4.537

28,600

27/12/2024

IVR.PC

$19.98

9.27%

7.817

82,200

09/27/2027

With IVR you get a high dividend yield and a high risk of capital loss. Both preferred stocks have healthy dividends and offer possible capital gains if they return to par. Management accelerated redemptions past quarterly date and disclosed in 10-Q”Between July 1, 2022 and August 4, 2022, we redeemed 1,618,546 Series B Preferred Shares for $35.0 million and 3,063,389 Series C Preferred Shares for $65.6 million.“The number of shares outstanding in the table is already adjusted for these buybacks.

The buyback program is authorized for 1,337,634 additional shares of IVR.PB and 1,316,470 shares of IVR.PC. If one thinks that IVR a few years from now will still generate interest income, those preferred shares are probably worth their face value. And as redemptions are made, the value of those preferred stocks is actually more secure in the capital stack. Both preferred stocks have nosedived since August, so I suspect it’s likely the company has executed or will execute the remainder of its buyback program.

So if one is invested in IVR common stock, I think it might be a no-brainer here to reallocate that position to one or other of the preferred stocks over the next year. As the buyout is executed, dividend expenses will be deducted from the income statement, which should help profitability. If the preferred shares continue to trade at a significant discount to par, management may institute another buyback program.

The mechanism therefore seems to be there for the preferred shares to at least retain their value, or even appreciate while receiving the dividend. Common stock may decline along with a continuing trend of book value destruction. I think a good strategy would be to switch from IVR to either preferred stock until redemptions are complete and start showing in their income statement. Now might be the time to reconsider whether an allocation to their favorites or the common is a better risk-reward setup.

A final note regarding preferred stocks is that both are fixed to floating rate, which means that when their call date arrives, these stocks are affected by interest rates. If interest rates remain high until 2024, for example, it is possible that the yield of the IVR.PB will jump significantly. After the call, the yield is determined by the 3-month LIBOR plus 5.18%. The current 3-month LIBOR is 3.17%, which would total 8.35% on face value, which translates to $2.09 per annum. This would imply a 10% return on IVR.PB at current prices.

Final Thoughts

For full disclosure, I don’t have a position here in the common or favorites. I’m also not particularly interested in establishing a position. The reason for this is what I pointed out above: a history of stock destruction.

Despite this, I thought it was worth writing this reflection given that there are those who are invested in IVR and from my analysis it seems that a tactical reassignment towards the preferred be justified for those who invest.

The company has a history of falling stock values ​​which has caused IVR’s stock price to drop and I suspect that will continue. Despite this, the company has enough cash to redeem all preferred shares, which provides some support.

Sallie R. Loera