Welcome to Invesco Mortgage Capital Inc.'s fourth quarter 2021 Investor Conference Call. All participants will be in a listen-only mode until the question and answer session. At that time, to ask a question, press the star followed by the one on your telephone. As a reminder, this call is being recorded. Now I will turn the call over to Jack Bateman in investor relations. Mr. Bateman, you may begin the call.
Thank you, and welcome to the Invesco Mortgage Capital fourth quarter 2021 earnings call. The management team and I are delighted you've joined us, and we look forward to sharing with you our prepared remarks and conducting a question and answer session. Before turning the call over to our CEO, John Anzalone, I wanted to provide a reminder that statements made in this conference call and the related presentation may include forward-looking statements which reflect management's expectations about future events and our overall plans and performance. These forward-looking statements are made as of today and are not guarantees. They involve risks, uncertainties and assumptions, and there can be no assurance that actual results will not differ materially from our expectations. For a discussion of these risks and uncertainties, please see the risks described in our most recent annual report on Form 10-K and subsequent filings with the SEC.
Invesco makes no obligation to update any forward-looking statement. We may also discuss non-GAAP financial measures during today's call. Reconciliations of these non-GAAP financial measures may be found at the end of our earnings presentation. To view the slide presentation today, you may access our website at invescomortgagecapital.com and click on the Q4 2021 earnings presentation link under Investor Relations. Again, welcome and thank you for joining us today. I'll now turn the call over to John Anzalone. John?
Good morning and welcome to Invesco Mortgage Capital's fourth quarter earnings call. I'll give some brief comments before turning the call over to our Chief Investment Officer, Brian Norris, to discuss the current portfolio in more detail. Also joining us on the call to participate in the Q&A are our President, Kevin Collins, our CFO, Lee Phegley, and our COO, Dave Lyle. The fourth quarter was characterized by challenging market conditions as the Federal Reserve responded to surging inflation by signaling a significantly more hawkish policy stance. The yield curve flattened during the quarter as the market began to price in more aggressive rate increases by the FOMC.
As we enter 2022, the yield curve has flattened further and interest rates moved higher as the market responded to even higher inflation trends by pricing in not only more rate increases, but faster reductions in the Fed's $2.5 trillion agency mortgage holdings. Given the interest rate volatility, flatter curve and hawkish pivot by the Fed, mortgages significantly underperformed during the fourth quarter, leading to a decline in our book value of 10.5% during the quarter. This decrease, combined with our dividend, gave us an economic return for the fourth quarter of -7.7%. Our book value declined an additional 9% during January as the spread widening in agency mortgages accelerated and the payoffs on specified pool collateral collapsed amid much higher mortgage rates.
Our liquidity position remains strong as we held $871 million of unrestricted cash and unencumbered investments at year-end. Earnings available for distribution should continue to be supported by relatively attractive dollar rolls, as well as by an attractive reinvestment environment characterized by wider spreads and continued strong funding markets. We remain cautious on Agency mortgage valuations as the ultimate pace of Fed portfolio dispositions remains highly uncertain. I'll stop here and let Brian go through the portfolio.
Thanks, John, and good morning to everyone listening to the call. I'll begin on slide four with the upper left-hand chart, where the significant shift towards a more hawkish Federal Reserve has been reflected in the U.S. Treasury yield curve. As indicated by the dark blue line, the fourth quarter ended with a ten-year U.S. Treasury yield largely unchanged for the second consecutive quarter, rising only 2 basis points to 1.51%, while the rest of the yield curve continued the flattening twist that started during the second quarter. The two-year U.S. Treasury yield climbed 46 basis points to 0.73% during the fourth quarter, while the 30-year U.S. Treasury yield fell 14 basis points to 2.05%.
The yield curve is now 150 basis points flatter between the two-year and the 30-year maturities from March 2021 to this past Friday. The flattening yield curve has negatively impacted our book value as our longer dated hedges have underperformed those in the front end of the curve. The upper right-hand chart displays how the short-term funding markets began to price in tighter monetary policy by the end of January, with three-month SOFR reflecting a 25 basis point hike in March. While the lower left-hand chart details the changes in the market implied Fed Funds futures contracts, which were calling for approximately five interest rate hikes in 2022 by the end of January, a sharp increase relative to the one rate hike in 2022 that was expected at the end of September.
Since the end of January, this has now climbed to seven interest rate hikes this year, with a greater than 50% chance of a 50 basis point hike in March. While the Federal Reserve was still net adding Agency RMBS of $110 billion during the fourth quarter, despite the onset of tapering, commercial bank purchases continued to slow, with current estimates in the range of $60 billion-$70 billion for the quarter. Net purchases from the Federal Reserve will cease in March, leaving commercial banks and money managers as the most likely dominant sources of demand for Agency RMBS this year. Moving on to slide five, where we provide more detail on the Agency RMBS market.
In the upper left-hand chart, we show Agency RMBS performance versus swap hedges since the beginning of 2021 in generic 30-year 2%, 2.5%, and 3% coupons, highlighting the fourth quarter in gray. All three coupons underperformed during the quarter, particularly in November as the Federal Reserve signaled a more aggressive timeline for interest rate hikes and tapering of asset purchases. This underperformance has continued in the first six weeks of 2022, with the minutes of the December FOMC meeting indicating the increased likelihood of reductions in the Federal Reserve's balance sheet in the second half of this year. The January FOMC meeting reinforcing those plans and the minutes from the January meeting released earlier this week indicating some discussion by the Federal Reserve on outright asset sales from the balance sheet.
While the base case expectation is for the Federal Reserve to reduce the Agency RMBS portion of the balance sheet via pay downs, subject to monthly caps, recent market concerns in regards to potential outright asset sales by the Fed have led to continued underperformance in February. Positively, the seasonal slowdown in housing activity and modestly higher mortgage rates have slowed prepayment speeds, as shown in the bottom left-hand chart, supporting the earnings power of the company. However, the combination of slower speeds, higher interest rates, and a persistently attractive dollar roll market from lower -coupon TBA resulted in a notable decline in payoffs on specified pool collateral, indicated in the top right chart. These trends have also continued into 2022, given the significant increase in mortgage rates this year.
In the bottom right chart, implied financing rates on lower -coupon TBA remained negative in the fourth quarter, with 30-year 2% and 2.5% coupons trending towards positive financing rates over the past few weeks. Attractive implied financing rates and production coupons should persist in the coming months, although we expect some deterioration as the supply and demand technicals worsen in the second quarter. Slide six provides detail on our Agency RMBS investments and our activity during the fourth quarter. We reduced our allocation through outright sales of lower -coupon securities and pay downs on the total portfolio, given continued challenges in the sector, while the earnings capacity of the company remained robust through attractive funding markets and relatively slow prepayment speeds.
In addition, we continued to actively manage our overall allocation, moving up in coupons from 30-year 2% to 30-year 2.5% and 3% specified pools, and rotating a portion of our holdings into more attractive collateral stories. Despite moving up in coupon, the weighted average pay up on our specified pool holdings fell approximately 0.25 point to 0.7 points as demand for lower coupon specified pools declined given falling prepayment speeds and modestly higher mortgage rates. As noted on the previous slide, this trend has continued into 2022, with our weighted average pay up declining approximately another 0.25 point from year-end. Our allocation to TBA securities climbed from 15%-18% at year-end as a modest increase to higher -coupon TBA combined with the reduction in the overall portfolio.
The weighted average yield on our Agency RMBS holdings declined 4 basis points to 2.07% as of quarter end, as prepayments on our holdings increased modestly to 7.7 CPR for the quarter. Prepayment speeds on our holdings should remain low as the mortgage rate climbs from the low 3% range to 4%. Although we have seen a decline in the attractiveness of the dollar roll market in lower coupon TBA, opportunities higher in the coupon stack continue to support the earnings capacity of the company. We believe wider spreads in specified pools represent attractive investment opportunities. Current ROEs on production coupon dollar rolls are in the mid-teens, while specified pool ROEs have climbed into the low double digits.
We believe this trend will continue in the coming months as dollar roll and specified pool ROEs converge given the reduction in Fed purchases of TBA collateral and wider spreads on specified pools. Our remaining credit investments are detailed on slide seven, with non-agency CMBS representing nearly 60% of the $108 million portfolio. Our allocation to credit remained stable during the quarter, with no asset sales and limited price movements overall. Our $72 million of remaining credit securities are high quality, with 90% rated single A or higher, and we remain comfortable with the credit profile of our remaining holdings. Although we anticipate limited near-term price appreciation, we believe these assets continue to be attractive holdings as 100% are held on an unlevered basis and provide attractive unlevered yields.
Lastly, slide eight details our funding book at quarter end, as shown in the chart on the upper left. Repurchase agreements collateralized by Agency RMBS declined to $7 billion as of December 31, given the reduction in our specified pool holdings, and hedges associated with those borrowings also declined to $4.6 billion net notional of pay fixed, receive floating interest rate swaps. The weighted average interest rate on our hedge book fell to 30 basis points as we fully transitioned our interest rate swaps from LIBOR to SOFR, which resulted in a modest reduction in both fixed and floating rates given the elimination of the LIBOR credit spread.
In order to hedge additional exposures further out the yield curve, we continue to hold $1.3 billion notional of forward-starting interest rate swaps with starting dates in 2023. Our weighted average repo costs increased 2 basis points to 0.14% and have climbed modestly higher to a weighted average of approximately 0.17% currently as the funding markets begin to price in tighter monetary policy in the coming months. Our economic leverage when including TBA exposure declined during the quarter to 6.2x debt to equity, and we continue to maintain leverage in that context year -to -date.
To conclude our prepared remarks, significant challenges in the Agency RMBS market persist, and we are remaining conservatively positioned as pressure from widening spreads and lower payouts on our specified pool collateral has led to the decline in book value year -to -date. The Federal Reserve is set to conclude net purchases of Agency RMBS in March, and we expect runoff of the balance sheet to begin in the middle of this year. The worsening supply and demand technicals are likely to pressure spreads wider in the near term as we believe fair value given a balance sheet runoff scenario is approximately 15 basis points wider from current levels.
While outright sales from the Fed's balance sheet will likely remain an option while inflation remains elevated, we do not believe this to be a 2022 event and would expect outright sales to remain a low probability event if inflation moderates as expected in the second half of this year. In the meantime, we will remain conservatively positioned and ready to take advantage of more attractive entry points in the future. Thank you for your continued support for Invesco Mortgage Capital, and now we will open the line for Q&A.
Thank you. If you would like to ask a question, please press star one on your phone. To withdraw your request, press start two. Once again, to ask a question, please press start one. Our first question comes from Doug Harter with Credit Suisse. Your line is open.
Thanks. John, I believe you mentioned the January book value and you referenced kind of continued pressure in February. Just wondering if you could give us an update on how February has performed?
Sorry, I was on mute there. Brian, do you want to take that one, or do you want me to?
Yeah.
Yeah.
In February so far, we've seen continued pressure as we mentioned and, you know, book value through, you know, a few days ago was down another 5%-6%.
Okay. Another 5%-6% in February on top of, I think you said 9% for January?
Correct.
Got it. Just to clarify, when you were talking about kind of how you saw fair value, I guess you were saying we could see another 10, you know, 15-ish basis points of widening. Just to be clear, that would be from today's levels?
Yes, that's correct. Yeah, we're, you know, OAS, Treasury OAS is about 25 wider year -to -date, and about 50 basis points wide of the types that we saw last year. We expect another, you know, 15 if the balance sheet is allowed to just run off.
Got it. I guess just help us understand kind of what , you know, what it is about, you know, that level or, well, at that level, that kind of why you think that's fair value not versus, you know, kind of more or less, you know, just to help us understand that.
Yeah. It puts us back into the context kind of pre-pandemic levels, and maybe just a touch wider just given elevated volatility relative to that time period.
Got it. I appreciate the answers. Thank you.
Yep.
Once again, to ask a question, please press star one. Our next question comes from Trevor Cranston with JMP Securities. Your line is open.
Hey, thanks. Good morning. Follow up on the question about the, you know, the increased volatility in the first quarter so far, and the book value performance. I think I heard you say in the prepared remarks that leverage had been held flat from the end of the year. First question is, did I hear that correctly? And, you know, secondly, have there been any significant changes within the portfolio we should note, given how much rates have moved and spreads have widened so far in the quarter?
Yeah. Trevor, hey, it's Brian. Good morning. Yeah, leverage right now is right around the 6.2 level that it was at year-end. You know, it moves around a little bit, you know, throughout the year, but right now it's about that same level. We have continued to kind of move a little bit up in coupon since year-end. You know, just, you know, we've continued to reduce the size of the portfolio to help manage leverage. Most of those reductions have been in lower coupons.
Okay. Gotcha. With the size of the portfolio coming down somewhat, can you comment on how you guys are, you know, thinking about the dividend going forward? I guess there's an offset with prepay speeds slowing, but just curious to hear your thoughts on how the smaller asset base impacts , how you're thinking about the dividend. Thanks.
Yeah. So yeah, this is John. Yeah. The earnings available for distribution, you know, the flip side to the pressure on book value is that, you know, reinvestment rates are better with wider spreads. You know, slowing speeds certainly help support things because, you know, a lot of our bonds are held at higher book prices. You know, those two are both lifts towards EAD, which kind of offsets the impact of the smaller portfolio. Dollar rolls remain relatively attractive. Going forward, we expect those to, you know, as the Fed reduces their footprint, you know, we expect dollar rolls to feel some pressure, but as of right now, they still are pretty supportive to the earnings.
For what we see right now and where we are, you know, earnings remain pretty well supported.
Okay. Got it. Appreciate the comments. Thank you.
Once again, to ask a question, please press star one. One moment please. Our next question comes from Derek Hewett with Bank of America. Your line is open.
Good morning, everyone. I might have missed it earlier, but could you talk about potential additional investment opportunities that would kind of complement your kind of primary Agency RMBS strategy at this point?
Yeah, Derek. It's John. Sorry. Yeah, I mean, you know, we've been, you know, obviously pre-pandemic, you know, we were a hybrid REIT that had, you know, significant amount of assets in credit, and still feel like, you know, having some aspect of credit in our book would be important. I mean, we continue to look at different options for that that don't involve mark-to-market financing. You know, I think that's, you know. We're hopeful that over the next few quarters, we're able to share more information on what we're looking at and as that gets closer. So yeah. I mean, we're-
Okay.
Yeah, not there yet, but definitely exploring opportunities.
Okay. Also could you comment on your target capital structure given the year-to-date decline in common equity in terms of the percentage of common versus preferred?
Sure. Pre-pandemic, you know, we were in the low 20s% of preferred to common. I think that remains kind of our target for now. Getting that ratio back in line remains one of our top priorities for this year. Whether that's either through the ATM or through block trades, if those open up, you know, we're looking to do that, you know, as long as it's a benefit to shareholders. That's kind of the goal, to get into the low 20s%.
Okay. Thank you.
Once again, to ask a question, please press star one. One moment. I am showing no further questions at this time.
Okay. Well, thank you everybody for joining us, and we'll talk next quarter. Thanks.
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