Executive Summary / Key Takeaways

• Invesco Mortgage Capital (NYSE: IVR) is navigating a volatile macroeconomic landscape by focusing its investment portfolio almost exclusively on Agency mortgage-backed securities (MBS), emphasizing higher coupons and Agency CMBS for their risk-mitigating characteristics.
• The company delivered positive economic return in Q1 2025, driven by net interest income and investment gains from falling interest rates, though subsequent market volatility in April negatively impacted book value.
• Strategic capital structure optimization, including the redemption of Series B preferred stock and ongoing Series C repurchases, aims to reduce the cost of capital and enhance shareholder returns, complemented by accretive common stock issuance.
• While near-term caution persists due to policy uncertainty and interest rate volatility, management maintains a favorable long-term outlook for Agency MBS, anticipating increased demand from banks and other investors as monetary policy eases and the yield curve potentially steepens.
• Key risks include sensitivity to interest rate fluctuations, potential margin calls from asset value declines, and the impact of broader financial market conditions on portfolio valuation and funding costs, necessitating prudent leverage and robust liquidity management.

Setting the Scene: A Pure Agency Focus in a Shifting Landscape

Invesco Mortgage Capital Inc. operates as a real estate investment trust (REIT) primarily engaged in investing in, financing, and managing mortgage-backed securities (MBS) and other mortgage-related assets. Its core objective is to deliver attractive risk-adjusted returns to stockholders through a combination of dividends and capital appreciation. As an externally managed REIT advised by Invesco Advisers, Inc., the company leverages its manager's expertise while adhering to strict REIT distribution requirements and operating to maintain its exclusion from the Investment Company Act of 1940.

IVR's strategic journey has seen notable shifts, particularly in recent years, in response to evolving market dynamics and a focus on optimizing its risk profile and capital structure. Historically, the portfolio included a broader mix of assets, including loans, securitizations, and non-Agency credit investments. However, the company has strategically transitioned to a portfolio composed entirely of agency securities, completing the sale of its remaining non-Agency CMBS investment in the first quarter of 2025. This move underscores a deliberate focus on the Agency MBS market, which includes residential (RMBS) and commercial (CMBS) securities guaranteed by U.S. government agencies or federally chartered corporations like Fannie Mae, Freddie Mac, and Ginnie Mae.

Within this Agency-centric strategy, IVR has emphasized acquiring specified pools of Agency RMBS with characteristics designed to manage prepayment risk, such as those with lower loan balances or loans to borrowers with lower credit scores, particularly as it rotated into higher coupon securities. Concurrently, the company has significantly increased its allocation to Agency CMBS, recognizing its benefits in providing prepayment protection and fixed maturities, which help reduce sensitivity to interest rate volatility and diversify risks inherent in a pure Agency RMBS portfolio. By the first quarter of 2025, Agency CMBS represented approximately 15% of the total investment portfolio.

In terms of competitive positioning, IVR operates within a landscape dominated by larger players like Annaly Capital Management (NLY) and AGNC Investment Corp. (AGNC), alongside other significant competitors such as Ellington Financial Inc. (EFC). While precise market share figures can fluctuate, IVR holds an estimated 2-3% share, with a growth rate that has recently lagged some larger peers. Competitors like NLY benefit from greater scale, potentially leading to cost efficiencies and broader market access. EFC, while smaller than NLY, offers greater portfolio diversification.

IVR's competitive advantages stem primarily from its regulatory expertise as a REIT and established relationships with government entities, which can facilitate quicker deal processing and potentially stronger pricing power in agency-guaranteed segments. Its niche focus on certain specified pool characteristics and Agency CMBS also provides differentiation. However, the company faces disadvantages, including higher operating costs per unit compared to more efficient peers and elevated debt levels relative to some competitors, which can impact net margins and cash flow. While the company mentions R&D investment in innovative debt instruments as an area where some competitors may have an edge, specific details on IVR's own technological differentiators or R&D initiatives with quantifiable benefits were not detailed. The competitive landscape also includes indirect threats from alternative investment vehicles and emerging technologies like blockchain-based lending platforms, which could potentially erode market share by offering lower transaction costs.

The company's history of optimizing its capital structure, notably addressing the disproportionate preferred stock component post-COVID through repurchases and the recent redemption of its Series B preferred stock using lower-cost repurchase agreements, is a critical element of its strategy to reduce the cost of capital and enhance shareholder value in this competitive environment.

Performance and Operations: Navigating Volatility with a Focused Portfolio

The first quarter of 2025 provided a snapshot of IVR's performance amidst tightening financial conditions and shifting market expectations. The company reported net income attributable to common stockholders of $16.3 million, or $0.26 per share, a decrease from $23.7 million, or $0.49 per share, in the first quarter of 2024. This change was primarily influenced by the volatile nature of investment gains and losses and derivative performance.

Net gains on investments totaled $82.2 million in Q1 2025, a significant improvement from net losses of $66.2 million in the prior-year quarter. This swing was largely driven by net unrealized gains of $87.6 million on MBS accounted for under the fair value option, benefiting from a sharp decline in interest rates during the quarter that boosted the valuation of fixed-rate securities. Conversely, Q1 2024 saw net unrealized losses of $62.5 million as interest rates rose.

However, this positive impact was substantially offset by net losses on derivative instruments, which amounted to $76.7 million in Q1 2025, a stark contrast to net gains of $93.2 million in Q1 2024. These derivative results reflect changes in interest rate expectations and the fair value of hedging instruments like interest rate swaps and futures contracts.

Net interest income, a core component of IVR's earnings, saw a notable increase, rising to $18.8 million in Q1 2025 from $7.0 million in Q1 2024. This improvement was primarily attributable to a lower cost of funds, which decreased by 111 basis points year-over-year, partially offset by an increase in average borrowings. The company's effective net interest income and margin, which adjust for the contractual net interest income/expense on interest rate swaps, decreased, however, due to a decrease in contractual net interest income on swaps, partially offset by the lower Federal Funds target rate. This highlights the impact of hedging costs on the overall profitability spread.

Operationally, IVR finances the majority of its investment portfolio through repurchase agreements. As of March 31, 2025, repurchase agreements outstanding totaled $5.35 billion, with a weighted average remaining maturity of 25 days and a weighted average interest rate of 4.47%. The company actively manages its leverage, which stood at 7.1 times debt-to-equity at the end of Q1 2025. The hedge book, primarily consisting of interest rate swaps and futures contracts, had a notional amount of $4.54 billion, with a hedge ratio of 85% relative to borrowings. These hedges are crucial for mitigating interest rate risk, although their fair value fluctuations can introduce earnings volatility.

Liquidity remains a key focus. As of March 31, 2025, IVR held $181.5 million in cash, cash equivalents, and restricted cash, along with approximately $328.9 million in unencumbered investments and $42.9 million in unrestricted cash. The company believes its current liquidity and borrowing capacity are sufficient for anticipated short-term needs, though long-term requirements depend on obtaining additional financing.

Operating activities provided $19.3 million in cash in Q1 2025, while investing activities used $516.5 million (driven by $884.4 million in MBS purchases). Financing activities provided $467.8 million, largely from net repurchase agreement proceeds ($460.6 million) and common stock issuance ($36.1 million).

Capital management efforts continued in Q1 2025 with the issuance of 4.21 million shares of common stock, generating $36.1 million in net proceeds. The company also repurchased and retired 90,146 shares of Series C preferred stock. These actions, following the redemption of all Series B preferred stock in December 2024, are aimed at optimizing the capital structure. Despite these efforts and positive net income, book value per common share saw a modest decrease of 1.2%, from $8.92 at December 31, 2024, to $8.81 at March 31, 2025, primarily due to derivative losses and dividends, partially offset by investment gains and net interest income.

Outlook and Risks: Policy Uncertainty vs. Long-Term Potential

Management's outlook reflects a cautious stance in the near term, primarily driven by the potential impacts of recently proposed U.S. fiscal and trade policies. These policies have already contributed to tightening financial conditions, increased market volatility, and concerns about slower economic growth and higher inflation. The underperformance of Agency mortgages relative to Treasuries in early April 2025, following trade policy announcements, and the resulting decline in book value (estimated between $7.74 and $8.06 as of April 30, 2025) underscore the sensitivity to these factors. While financial markets showed some stabilization in early May, policy uncertainty remains a key concern.

Despite near-term headwinds, IVR maintains a favorable long-term outlook for Agency MBS. Management anticipates that eventual easing of monetary policy will lead to a steeper yield curve and a decline in interest rate volatility. The Fed funds futures market as of the Q1 2025 call reflected expectations for a further 75 basis point reduction by the end of 2025, with 3 to 4 cuts anticipated in 2025 and the target rate potentially bottoming near 3% in 2026. These conditions are expected to drive increased demand for Agency MBS, particularly higher coupons, from key investor segments, including commercial banks, overseas investors, money managers, and other REITs. Agency CMBS is also expected to receive favorable support from limited issuance, strong fundamental performance, and stable cash flow profiles.

However, this outlook is subject to significant risks. Interest rate risk remains paramount, impacting the yield on assets, the cost of borrowings, and the fair value of the portfolio and hedges. Changes in prepayment speeds, influenced by interest rates and housing activity, can affect interest income recognition. Extension risk could arise if asset lives extend beyond hedge terms in a rising rate environment. Spread risk, the difference between asset yields and risk-free rates, can impact book value and liquidity. Market value risk exposes the company to potential margin calls under repurchase agreements, especially given lenders' discretion in valuing collateral. While now 100% agency, the company still retains credit risk on its residential mortgage investments, evaluated based on macro and loan-level factors, and deteriorating conditions could impact performance. The company must also maintain compliance with financial covenants in its lending and derivative agreements.

Management's decision to reduce leverage in April 2025, bringing it closer to the mid-6s, reflects a proactive approach to managing risk in response to increased uncertainty and leverage levels ticking higher with book value declines. Maintaining robust liquidity is viewed as crucial for meeting potential margin calls and capitalizing on improved investment opportunities when volatility subsides.

Conclusion

Invesco Mortgage Capital is strategically positioned as a focused player in the Agency MBS market, emphasizing risk management through portfolio composition and hedging in a volatile macroeconomic environment. While the first quarter of 2025 demonstrated the potential for positive performance driven by favorable interest rate movements and effective net interest income, the subsequent market reaction to policy uncertainty in April highlighted the inherent sensitivity to external factors and the challenges of navigating periods of elevated volatility.

The company's ongoing efforts to optimize its capital structure, transition to a pure agency portfolio, and selectively allocate capital within the Agency RMBS and CMBS sectors reflect a deliberate strategy to enhance long-term shareholder value. Despite near-term caution warranted by policy-driven market swings, the favorable long-term outlook for Agency MBS, supported by expectations for monetary easing and increased investor demand, provides a potential tailwind. Investors should closely monitor interest rate volatility, the trajectory of monetary and fiscal policy, and the company's ability to manage its leverage and liquidity effectively in response to these dynamics, as these factors will be critical determinants of IVR's performance and the realization of its investment thesis.