From muratdeniz
Introduction
Invesco Mortgage Capital Series C Fixed-to-Floating Preferreds (NYSE: IVR.PR.C) has slightly outperformed the iShares Preferred and Income Securities ETF (PFF) so far in 2024, delivering high single-digit gains versus the benchmark ETF's mid-single-digit total returns.
I believe this strong performance will continue as dividends are well covered by both net income and common stock. Additionally, the reset date for the Series C shares is September 2027, providing current income in an environment where Fed interest rates are expected to be cut, and a free call option at significantly lower interest rates in the event of a downturn.
Company Profile
You can access all the company's performance here. Invesco Mortgage Capital (IVR) is an mREIT focused almost exclusively on agency securities, with residential mortgage-backed securities (RMBS) making up 92.8% of its portfolio.
To boost earnings, mREITs have employed significant leverage, with debt-to-equity ratios standing at 5.6x as of the end of 1Q24.
Preferred Dividends
In the first quarter of 2024, Invesco Mortgage Capital paid $5.6 million in accumulated preferred dividends, which represents 5.2 times its $29.1 million net income before preferred dividends. Looking back further on a trailing 12-month /TTM/ basis (which better captures the dynamic changes in the valuation of the company's portfolio as interest rates change), we see that the company last paid a preferred dividend in September 2021, prior to the start of federal funds rate hikes in 2022.
That said, performance has been stable over the past two quarters and we expect coverage to turn positive over the next 12 months.
Federal Reserve Interest Rate Outlook
Futures prices indicate that the Federal Reserve is likely to cut interest rates to 4.00-4.25% in July 2025, 1.25% below current levels. Thus, the favorable trend in preferred dividend coverage is expected to continue for the foreseeable future. Moreover, in their June 2024 economic forecast summary, Fed officials indicated that they expect further rate cuts beyond 2025 to a level of around 2.8% in the long run.
The June US employment report painted a nuanced picture for the US labour market, with solid employment growth offset by rising unemployment, which fell to 4.1%, the highest since November 2021. Markets are now focused on the unemployment rate, with the Fed increasing its interest rate cut of 0.25% through July 2025 from four to five following the release of the economic data.
Comparison of preferred stocks
Invesco Mortgage Capital has two series of preferred stock outstanding: Series C (IVR.PR.C) preferred stock currently pays a fixed interest rate of 7.5% per annum, but is scheduled to reprice to a floating rate, specifically 3-month CME Term SOFR plus a spread of 5.289%, on September 27, 2027 (10th Quarter Report for Q1 2024).
The current interest rate on the Series B Preferred Stock (IVR.PR.B) is 7.75% per year, with a reset date fairly soon on December 27, 2024. After the reset date, interest rates will be determined by 3-month CME Term SOFR plus a spread of 5.18%.
Overall, I like the Series C stock, and here's why:
The yield is 8.16%, slightly higher than the 7.9% of Series B. With the current 3-month SOFR of 5.35% and the outlook for Fed rate cuts this year, the Series B yield will reset to around 10%, but it is true that it will fall throughout next year when the Fed cuts rates further. Series C has an 8.8% upside on the $25 par value, while Series B only has 2.1%. In essence, the incremental yield you get after the Series B yield resets may be offset by smaller capital gains. In the long run, the Series C yield is slightly higher given the larger spread (5.289% vs. 5.18%). If the recession continues through 2027, Series C will significantly outperform given the fixed coupon. Therefore, Series C can be considered a call option against a recession and the resulting more significant Fed rate cuts.
Priority coverage by market capitalization
Invesco Mortgage Capital had $293.5 million par value of Series 2 preferred stock outstanding as of the end of the first quarter of 2024. The preferred coverage is 1.47x against a market cap of $430 million, which is excellent coverage.
Additionally, shareholders' equity (net of preferred shareholders) was approximately $492 million, further increasing coverage.
risk
Given the broad coverage of preferred dividends in both net income and shareholders' equity for the first quarter of 2024, the primary risks facing shareholders are either a disruption in the mortgage market (which would widen mortgage spreads and negatively impact valuations) or an increase in the federal funds rate (a view supported by some economists given robust 2-3% inflation), which would significantly reduce demand for fixed-income investments such as real estate.
I would argue that these risks are well contained, given the outlook for monetary policy and the focus on agency securities, which are likely to outperform non-agency RMBS in a mortgage market downturn. That said, if you believe the Fed will cut rates significantly less than current market prices suggest, then I would recommend choosing Series B preferred stock, which will continue to outperform Series C in such an environment.
Conclusion
Invesco Mortgage Capital suffered heavy losses during the Fed rate hike cycle and had low preferred dividend yields, but the company appears to have turned things around over the past year, especially in the last two quarters, as its dividend yield metrics have improved. Given the company's improving financial position, the outlook for monetary policy, and the current prices of its Series B and Series C preferred stock, I believe the Series C preferred stock is the better option. Here's why:
From a total return perspective, these bonds will likely outperform if the Fed cuts interest rates at the pace that the market is currently pricing in. If a recession occurs through 2027, these bonds will likely outperform significantly. This is not a prime investment idea, but it is a good call option that is currently discounted in the market.
That's why we recommend buying the Series C preferred stock.
thank you for reading.