AGNC Investment Corp. Q3 FY2020 Earnings Call

Good morning, and welcome to the AGNC Investment Corp's Third Quarter 2020 Shareholder Call. All participants will be in listen-only mode. Please note that this event is being recorded. I would now like to turn the conference over to Katie Wisecarver, Investor Relations. Please go ahead.

Thank you all for joining AGNC Investment Corp's third quarter 2020 earnings call. Before we begin, I'd like to review the Safe Harbor statement. This conference call and corresponding slide presentation contains statements that, to the extent they are not recitations of historical facts, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecasts due to the impact of many factors beyond the control of AGNC. All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of AGNC's periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law. Participants on the call include Gary Kain, Chief Executive Officer; Bernie Bell, Senior Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President; Aaron Pas, Senior Vice President; and Peter Federico, President and Chief Operating Officer. With that, I'll turn the call over to Gary Kain.

Thanks, Katie, and thanks to all of you for your interest in AGNC. We were extremely pleased with the performance of our portfolio in the third quarter, with economic return totaling almost 9%. We have now recovered the vast majority of our Q1 economic loss over the past two quarters. Importantly, as demonstrated by our strong net spread and dollar roll income for the quarter, we remain optimistic about the earnings power of our portfolio. During the third quarter, equity markets continued to strengthen, and interest rate volatility remained muted, despite the upcoming election and the inability of lawmakers to agree on a new stimulus package. The continued resilience in financial markets is a testament to the tremendous liquidity provided by global central banks and the market's confidence that future monetary and fiscal support will bridge the remaining economic gap before a vaccine becomes widely available. Agency MBS performance was generally strong during the quarter, with the exception of 30-year threes, which comprise a very small percentage of our portfolio. MBS continued to benefit from ongoing Fed support, negligible interest rate volatility, favorable funding conditions, and the plateauing of prepayment speeds on many cohorts, albeit at elevated levels. In aggregate, specified pool performance was somewhat stronger during the quarter, with performance dependent on coupon and other attributes. Lower coupon TBAs, which benefited from both solid price performance and very strong dollar roll funding levels, were the best performing component of our portfolio, both in terms of earnings and economic returns. Looking ahead, the investment environment for agency MBS should remain attractive given the favorable funding backdrop, ongoing Fed support, and lack of exposure to credit risk. With respect to dollar rolls, we expect the implied funding advantage relative to repo to contract somewhat from the very strong levels experienced in Q3, but to remain a significant positive contributor to our financial results in light of the combination of heavy origination volumes and ongoing Fed purchases. At this point, I will turn the call over to Bernie to review our financial results for the quarter.

Thank you, Gary. Turning to Slide 4, we had total comprehensive income of $1.28 per share for the third quarter. Net spread and dollar roll income excluding catch-up amortization was $0.81 per share for the quarter, which is our highest level in over five years. TBA dollar roll specialness and very low funding costs, which are now fully reflected in our aggregate cost of funds, were the primary drivers of our net spread and dollar roll income for the quarter. Looking ahead over the next several quarters, we expect some downward pressure on net spread and dollar roll income as a significant funding advantage of our TBA position likely declines somewhat and portfolio turnover continues to be reinvested at prevailing asset yields. That said, we do expect the majority of the improvement in our net spread and dollar roll income experienced in Q3 to be maintained over the coming several quarters. Tangible net book value increased 6.4% for the quarter, as our portfolio of largely lower coupon assets and higher coupon specified pool holdings significantly outperformed our interest rate hedges. Including dividends of $0.36 per share, our economic return on tangible common equity was 8.8% for the third quarter. So far, fourth quarter to date as of last Friday, we estimate that our tangible net book value is up about 2%. Turning to Slide 5, our investment portfolio at quarter-end totaled $97.6 billion, largely unchanged from the second quarter. Our ending leverage was 8.8 times tangible equity, down from 9.2 times as of last quarter-end, largely due to book value appreciation. Our liquidity position remained very strong in the third quarter with cash and unencumbered agency assets totaling $5.2 billion at quarter-end, which excludes both unencumbered CRT and non-agency securities as well as assets held by our broker-dealer subsidiary, Bethesda Securities. Actual prepayment speeds on our portfolio increased to 24.3% for the quarter, but importantly, this does not include the lower coupon component of our holdings, which is held in TBA form. Our forecasted life CPRs decreased to 15.9% as of the end of the quarter from 16.6% at the end of Q2, largely due to changes in asset composition. Lastly, during the third quarter, we repurchased $154 million of our common stock at a meaningful discount to our tangible net book value for an average repurchase price of $13.95 per share. With that, I'll turn the call over to Chris to discuss the agency market.

Thanks, Bernie. Let's turn to Slide 6. Much like the second quarter, interest rate volatility was muted. The yield curve continued to modestly steepen, with two-year treasury yields ending the quarter two basis points lower at 13 basis points, while 10-year treasury yields ended the quarter three basis points higher at 69 basis points. Agency MBS spreads generally tightened, with lower coupon TBAs outperforming higher coupons. Specified pools generally held on to their gains from the second quarter, but pay-up changes were mixed depending on coupon and underlying TBA performance. The continued support from the Fed purchasing $40 billion in agency MBS per month, in addition to reinvesting paydowns on its portfolio into production coupon MBS, drove the outperformance in lower coupons. As you can see in the lower left table on Page 6, 30-year twos increased in price by more than a point, despite 10-year treasury prices selling off a little more than a quarter of a point. Higher coupon TBA performance was mixed, with 30-year threes clearly the worst performer during the third quarter. However, given rich valuations and prepayment concerns, we materially reduced our generic holdings in the coupon during the second quarter. Let's turn to Slide 7. You can see in the top left chart that the size of the investment portfolio at $98 billion was little changed as of September 30. However, we continue to shift the composition to lower coupons in both 30-year and 15-year MBS. During the third quarter, we reduced holdings in 2.5% coupons and above by approximately $18 billion, versus adding 30-year and 15-year twos and one and a halves. As I mentioned on the call last quarter, we expected dollar roll financing to trade well, as the combination of heavy origination and Fed purchases creates an ideal backdrop for dollar rolls. Given this favorable backdrop, we increased the size of our TBA roll position and carried an average balance of $28 billion during the third quarter, which was up from an average balance of $16 billion during the second quarter. TBA roll financing on lower coupons averaged around negative 60 basis points during the third quarter. Since quarter-end, roll specialness has moderated somewhat, especially in more KOSPI coupons like 30-year two and a half's, but 30-year twos continue to trade exceptionally well currently at around negative 65 basis points, or about 80 basis points through repo. 15-year production coupon role financing is currently trading around 10 to 20 basis points through repo. As we mentioned last quarter, roll specialness can contribute materially to total returns, though the degree of specialness over time will likely trend to more modest levels. While mortgage spreads have tightened, we remain optimistic about the investment environment, given attractive roll carry and low interest rate volatility. And while the prepayment backdrop is challenging, our diversified portfolio of higher coupon specified pools and production coupon TBA has offsetting risk characteristics that position us well for the environment. I'll now turn the call over to Aaron to discuss the non-agency market.

Thanks, Chris. I'll quickly recap the quarter, our current positioning, and then update you with our outlook on credit. Please turn to Slide 8. The significant rally in Q2 across structured products continued in the third quarter with fore selling well behind us down, and credit led the way as the credit curve both flattened across most asset classes. With respect to our holdings, we reduced exposure to higher rated CMBS, RMBS, and RPL bonds by close to $100 million. Demand has been strong for these securities, and in many cases, they have retraced a majority of the widening that occurred in the first quarter. Additionally, our CRT portfolio contracted marginally over the quarter by a sales and paydowns. I'll touch on the composition shift in a moment. Our outlook for house prices and in turn residential credit performance remains relatively favorable. While the mortgage credit box is tight in some ways, affordability levels are back at the most attractive level in years, coupled with historically low housing supply. Additionally, conventional forbearance rates continue to tick lower, declining about 30% during the quarter. In light of this, we've tilted the CRT portfolio a bit further down in credit and in dollar price in deals where we think the risk of loss remains fairly remote. I'll quickly touch on repo as it relates to our non-agency holdings. We continue to see favorable trends on the repo side, both in improving rates and haircuts. While the depth and availability of repo across structured products is not what it was pre-COVID, this is a welcome improvement. As we said on last quarter's call, with the Fed's actions as a tailwind, we expect structured product spreads for good credits to remain well supported over the coming years. However, the economic recovery clearly still presents risks and significant challenges in certain areas. As such, any longer run tightening in spreads will likely face bouts of widening along the way in some sectors such as retail and hospitality, and the commercial space are clearly not out of the woods. With that, I'll turn the call over to Peter to discuss funding and risk management.

Thanks, Aaron. I'll start with our financing summary on Slide 9. As expected, our average repo funding costs dropped to 40 basis points in the third quarter from 76 basis points the prior quarter. This improvement reflects the Fed's very accommodative monetary policy stance and short-term forward rate guidance. I expect this favorable funding environment to continue, with borrowing costs from overnight to one year, staying in the 15 to 30 basis point range. As such, I expect repo costs to trend marginally lower over the next several quarters. Our aggregate cost of funds, which includes the funding costs associated with our TBA position, as well as the cost of our swap hedges, declined more sharply in the third quarter. Our average cost of funds for the quarter was 15 basis points, down meaningfully from 88 basis points the prior quarter. This improvement was due to the combination of lower repo costs, very attractive dollar roll funding levels on TBAs, and materially lower swap hedging costs. The improvement in our cost of funds more than offset the decline in our asset yield, and as such drove the significant improvement in our net interest margin, which for the quarter increased to 215 basis points from 168 basis points the prior quarter. Looking ahead, I expect our net interest margin to be somewhat lower as asset paydowns and portfolio repositioning will likely push the yield on our asset portfolio gradually lower. On Slide 10, we provide a summary of our hedged portfolio, which totaled $59 billion and covered 71% of our funding liabilities. While our aggregate hedge position was largely unchanged, we did continue to alter the composition and tenor of our swap portfolio. Most notably, we continued to shift to SOFR index swaps, as we believe these swaps will be correlated well with repo funding. At quarter-end, about 70% of our swap portfolio was indexed to the secured overnight financing rate, and we had no LIBOR-based swaps. This transition to SOFR swaps drove the decline in our swap costs during the quarter. The average maturity of our swap portfolio also increased again this quarter to 5.3 years, as we added slightly longer-term swaps. Lastly, on Slide 11, we show our duration gap and duration gap sensitivity. Our duration gap at quarter-end was flat, relatively unchanged from the prior quarter. Given the current asymmetry in our risk profile and the potential for some incremental volatility in longer-term rates associated with the election and prospects for fiscal stimulus, we will continue to actively manage this extension risk. With that, I'll turn the call back over to Gary.

Thanks, Peter. And at this point, we'll open up the call to questions.

We will now begin the question-and-answer session. The first question comes from the line of Doug Harter with Credit Suisse. Please go ahead.

Thanks, Gary. Can you talk about how you're thinking about the dividend? Clearly, you guys are significantly covering it from kind of a spread income basis. As you mentioned, economic growth return has kind of recovered the Q1 decline. So how are you thinking about the dividend?

Sure, and thanks, Doug, for the question. Look, first of all, our priority really continues to be on generating risk-adjusted returns and enhancing the earnings power of the portfolio, rather than on how we allocate these returns between dividends and reinvestment into the business. However, that said, as we talked about in the prepared remarks, we are really confident about the outlook for net spread and dollar roll income. We expect that measure to be well above the current dividend for the foreseeable future, and not only that, we expect our true economic earnings to exceed the dividend as well. Importantly, though, as I said on the last call, we believe that having a tailwind to book value really is a positive for investors. Against this backdrop, management and the board will look at the market landscape and the earnings picture over the next several months. We will evaluate what dividend level we think is optimal for shareholders as we enter next year. The decision whether to raise the dividend, by how much, or if we do is really just a function of assessing the optimal or appropriate cushion between expected earnings and the dividend in a way that facilitates some growth in book value over time, because we really do think that's important. So, big picture, though. I mean, the most important thing here is, this is a great problem to have as we're currently paying, and comfortably, as you mentioned, a dividend in excess of 10%, which is extremely attractive in today's environment, while we're building book value and buying back our stock. So that's a great combination where we sit right now. So thanks again for the question.

Great, thank you, Gary.

The next question comes from the line of Bose George with KBW. Please go ahead.

Well, good morning. Can you just give us an update on where returns are now?

Yeah. Sure.

Go ahead, Chris.

Okay, no, I was just going to say, so spreads are certainly tighter now than they were last quarter, given the outperformance of mortgages versus hedges. With respect to higher coupon specs, given the strong performance and the prepayment environment, the ROEs are generally in the very high single digits. But I'd say the majority of our incremental purchases have been concentrated in production coupons where the gross ROE, for example, on 30-year twos is around 11% without real specialness, but if you assume a 25 basis points roll advantage, that adds a little over 2% ROE, which puts the gross ROEs around 13% before convexity cost.

Okay, great. Thanks. And then in terms of the size of your TBA long position, I guess this quarter understandably it's increased. What are your thoughts just in terms of where that could go? Is this kind of the level or if things are attractive enough, could this go up further? How do you think of that in terms of the size of the portfolio?

Sure. I'd say, given the environment, it's likely that our roll position is going to stay in the $25 to $30 billion average balance area, but it is early in the quarter-end, so that's just a best guess based on current conditions. I'd say generally speaking, it's tough to project the size of the TBA position, because there are going to be technical situations where roll spikes or temporarily get hit will move the TBA position versus our pool position when there's an economic reason to do so. But again, based on current conditions, which are favorable for roll financing, we'll likely continue to carry a significant TBA position in lower coupons. The backdrop is very supportive with heavy supply from origination and the Fed absorbing $115 billion of the worst delivered each month, so the technicals are extraordinarily supportive. I think it's reasonable to assume that production coupon rolls will trade better than long-term in historical averages for some time to come.

Okay, thanks a lot.

The next question comes from the line of Trevor Cranston with JMP Securities. Please go ahead.

Hey, thanks. Good morning. You mentioned a couple of times the potential for some volatility in rates in markets around the election and other things. Can you comment more specifically on the duration profile of the portfolio, more specifically around the long end of the curve as opposed to the sort of parallel shifts that you've given in the slide deck?

So, I mean, what's important is first in a sense, it's not quite 50-50. I mean, we still have more higher coupon season specified pools than we do lower coupons, but it's getting closer. Those two pieces of the portfolio will react very differently to changes in interest rates, and that's something that we really like about the composition of our portfolio. So we have our new low coupons, which to your point are clearly going to track the seven to 10-year kind of part of the curve. Whereas the higher coupons, while in a model, they show a fair amount of duration or exposure to kind of the back end of the curve. For the first 50 basis points of a move, we really don't expect them to be very reactive because basically if the back end of the curve were to sell off, they benefit on the prepayment front in terms of slower expectations over time, and that's going to help them more than they're going to get hurt on the discounting front. So we think we'll be up for relatively small upward moves, let's say sub 50 basis points, the spec portfolio, the higher coupon portfolio isn't going to show a lot of sensitivity to the back end of the curve. Whereas obviously, lower coupons have to ration, and that's why we have hedges. We feel like we're pretty well hedged for kind of an initial move, if we were to get it in the back end of the curve. I focus this discussion on the back end of the curve because I think for obvious reasons, we're unlikely to see a movement really inside of five years, given kind of everything we've heard from the Fed and the obvious economic backdrop. So big picture, like as we have sold off this quarter, as we mentioned earlier, book value looks to be up a couple percent as of last Friday, and we've seen the benefit from our hedges. We've actually seen the higher coupon portion of our portfolio do very well. And lower coupons, twos have actually done okay, relative to hedges. We've continued to see weakness in the middle of the coupon stack like two and a halves and threes, but again, that's a smaller component of the portfolio at this point.

Okay, that's helpful. Then in terms of the share buybacks, I mean, first can you say what the weighted average price you bought back shares was in Q3 and then more generally, can you comment on how you're thinking about the share repurchase opportunity versus doing new investments into the portfolio today? Thanks.

Yeah, let me start on the big picture question. I think that it was $13.95 I think was our weighted average purchase price. In terms of a discount to book, ballpark, over that was in the upper 80s percent of book, give or take. So that was noticeably higher than where we bought back stock in Q2, which was lower 80s, very low 80s, on average. But if you went back to August of 2019, we repurchased shares, and what we said at the time was that those repurchases were low 90s of book. So that gives you a range of three different time periods with three different kind of price to book spots. Big picture, we look at the overall environment and what we think in terms of what the opportunities are to reinvest, to deploy capital in investments in the mortgage market, first, the discount versus the liquidity environment. I can't stress enough that for AGNC, we have so much liquidity in our mortgage portfolio, in particular, given the large TBA position that when we think about buying back shares, we're not forced to think of increasing our leverage by buying back shares. We can do that on a completely leverage-neutral basis, where if we buy back $100 million in shares, we sell a billion in TBA mortgages. Everything else is neutral and we're really isolating the discount to book. Investors should take confidence, both in what we say, but more so in our actions, which is that we're going to look at this logically, we're going to look at the conditions in the market, but we're very willing to buy back shares when they make sense. The liquidity of our portfolio affords us the ability to do that in almost any environment.

Okay, I appreciate the comments. Thank you.

And our last question comes from the line of Rick Shane from JP Morgan. Please go ahead.

Hey, guys, thanks for taking my questions this morning. Look, I think we're in a unique environment. Your portfolio construction and hedging is always sort of multi-variant in terms of having to balance potential direction of rates and timing of movements. I think realistically, rate risk is as asymmetric as it's ever been during the existence of the company. But I'm curious how you guys think about this? Does it mean, from your perspective, that risk is lower than it would normally be? And then how do you use this opportunity to either generate excess returns or what's the long-term implication? And then if that sort of framework is correct, I think the biggest challenge for you guys is managing the timing of sort of giving up some of those excess returns. How do you think about that and manage that timing risk?

Well, I think you bring up two really good points. One is that the cost of hedges right now is historically very low, just given how low swap rates are? On the risk management front or the asymmetry, you're right, as long as you believe rates can't go substantially negative, then the downside of a short position or a pay-fixed position is much lower than it's been in the past. We absolutely talked about that on prior calls; we feel that way, but you also don't want to lose track of one thing that we are very focused on is that we are more concerned that mortgage spreads would widen into a rally from here. They would actually perform reasonably well, like what we've seen quarter-to-date, particularly higher coupons, if we sell off. So one of the other factors that your model doesn't capture is the performance of mortgages and mortgage spreads in different rate moves. So the one thing that gives us pause from hedging even more than what we're doing today is that we do believe, at least for smaller upward moves in rates, mortgages would perform pretty well. Whereas, if we were to retest sub 50 basis points on tenure nodes, that environment would likely be one that puts pressure on mortgage spreads. So we overlay that into the overall hedging equation. But in the end, what you see from us is a portfolio that's pretty well hedged. As you can see in our swap portfolio, we've put on a lot of swaps near the lows in rates. I don't know if Peter, you want to add any further comments?

Well, yeah, I'd just add, Rick, if you look at the composition of our swap portfolio, it is gradually increasing over the last couple quarters. I would expect that to continue. We're at a 71% hedge ratio now, and to the extent we add swaps, as I mentioned this quarter, we're adding longer-term swaps. I would expect that marginal swaps that we add to our portfolio will look to add options to our portfolio once we get better clarity on the interest rate environment. They're going to be more in the 5-, 7-, and 10-year part of the curve to give us that protection against the back end of the yield curve moving. As Gary mentioned earlier, the front end of the curve has very little volatility given what the Fed is going to do. So I think over the next couple quarters, as we get better clarity on the interest rate environment post-election, it wouldn't be unreasonable to expect our hedge portfolio to increase a little further.

Great, that's kind of what I expected and very helpful. Thank you, guys, very much.

Okay. Thank you, Rick.

Thanks, Rick.

And our last question comes from the line of Mark DeVries of Barclays. Please go ahead.

Yeah, thanks. Could you talk a little bit more about your prepayment expectations and what kind of risk you see from speeds accelerating? If you were to see more of a compression in the primary-secondary spread as originators add capacity, which a lot of them have really been doing in recent months?

Yeah. Sure.

Chris, why don't I go first, and then you can chime in. Look, first off, while the average speed in our portfolio increased a lot quarter-over-quarter, if you look at this increase in the market, it has really been in these KOSPI coupons, two and a halves and threes. If you actually look at our portfolio, we added - we have the one-month speeds on three and a halves, fours, and four and a halves; you see, there was like a one CPR increase in fours and four and a halves on our portfolio, from like in the case of fours, from 29 to 30. So we're not seeing a big increase in those speeds on the higher coupon portion of the portfolio. Even if mortgage rates were to continue to come down, we do think those have plateaued. So, it's going to be very much a function of what mortgage rates are in the two and a halves, threes, and to some degree three and a half percent coupon. Those are not insignificant to us certainly, but they're a very manageable component of the portfolio. So I think what's first and foremost to keep in mind is we really do like the split between mostly twos in 30-years in lower coupons and then the higher coupon season specified pools, where again, we're already seeing the plateauing of speeds. Now that said, I don't think there's as much room for primary-secondary spreads to compress as many people think, based on history or look at a time period prior to the pandemic. There are changes to the market servicing multiples that are lower, and they're going to stay lower for good reason. Other kinds of hindrances to the primary-secondary spreads getting back to historical norms, and they don't normally get there in the midst of a big re-fi boom like what we are seeing here. Big picture, we expect to see prepayments pick up on two and a halves and threes, and particularly pick up on two and a halves, but that's a coupon that we've been shrinking our exposure to. So when we look at it as a whole for the portfolio, yes, you have to manage speeds, and yes, there is a risk of faster prepayments, but it's something we feel that we can manage. I hope that answered it, and Chris, I don't know if you want to add anything.

No, I think you covered it well.

Okay, great. Thank you.

I'd like to thank everyone for their participation in our Q3 earnings call, and we look forward to talking to you again next quarter. Thanks again.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.