AGNC Investment Corp. Q1 FY2022 Earnings Call

Good morning, and welcome to the AGNC Investment Corp. First Quarter 2022 Shareholders Call. Please note that this event is being recorded. Now I'd like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.

Thank you all for joining AGNC Investment Corp.'s First Quarter 2022 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 fact, 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 forecast 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 Peter Federico, Director, President and Chief Executive Officer; Bernice Bell, Executive Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President and Chief Investment Officer; Aaron Pas, Senior Vice President of Non-Agency portfolio management; and Sean Reid, Executive Vice President, Strategy and Corporate Development. With that, I'll turn the call over to Peter Federico.

Thank you, Katie, and thanks to everyone for joining the call today. The investment environment was very challenging in the first quarter as the market faced increased geopolitical risk, growing inflation concerns and the expectation of significantly tighter monetary policy. Interest rates ended the quarter materially higher with the yield on the 2-year treasury increasing over 160 basis points. A rate move of that magnitude hasn't occurred in more than 30 years. This challenging environment led to a risk-off sentiment, pressured equity markets and caused fixed income prices to decline. The Bloomberg Aggregate Bond Index posted its worst quarterly performance in more than 40 years with a price decline of almost 6 points. That index is now down 9 points for the year. These extreme moves highlight how difficult market conditions were for all fixed income instruments. The Agency MBS market was also adversely impacted by uncertainty associated with the Fed's balance sheet. As a result, Agency MBS significantly underperformed swap and treasury hedges. The performance was weak across the coupon stack with higher coupon MBS experiencing the greatest underperformance in spread widening. Over the last 12 months, the Agency MBS market has experienced a dramatic repricing as the Fed abruptly shifted monetary policy. We began the year with short-term rates near 0 and the Fed growing its balance sheet. In contrast today, the market now expects a very aggressive series of short-term rate increases and balance sheet runoff to begin later this month. At the March meeting, the Fed indicated that the initial runoff plan will include an Agency MBS cap of $35 billion per month. Importantly, however, with the primary mortgage rate now nearing 5.5%, paydowns on the Fed portfolio will likely be well below the cap for the foreseeable future. Major monetary policy transitions are always challenging for the fixed income market. This is especially true for the Agency MBS market given the unique role it plays in monetary policy and in the economy. Agency MBS have remained under pressure in April with spreads widening about 10 basis points as the Fed's balance sheet reduction phases in over the next several months and with the long-term runoff plans still not fully understood, further spread widening is possible. This difficult environment adversely impacted AGNC in the first quarter. On average, spreads on our portfolio widened about 25 basis points during the quarter, which was the primary driver of our negative economic return. Based on our fourth quarter disclosures, a 25 basis point spread widening event was expected to generate a book value loss of 13.5%. The remainder of our book value decline can be attributed to the increase in interest rates, which as the numbers show was relatively small given the hedge position and intra-quarter rebalancing. As we discussed last quarter, we expected spreads between Agency MBS and other benchmark rates to widen given the uncertainty associated with the Fed's monetary policy position. But the spread widening that occurred in the first quarter was materially faster and larger than anticipated. We started the quarter with a defensive position characterized by lower leverage and a high hedge ratio. We also took meaningful steps during the quarter to further reduce our aggregate risk profile. These steps included reducing our asset position, adjusting our coupon profile and increasing our hedge portfolio. As the Fed aggressively raises short-term rates and ramps up its balance sheet runoff, we will likely remain defensive in our portfolio positioning. Despite this defensive positioning, we believe today's valuation levels reasonably compensate investors for the risks associated with the current environment. Levered returns on production coupon MBS are very attractive on both an absolute basis and relative to past cycles. As such, we believe further MBS weakness, if it occurs, will likely be characterized as an overreaction and will represent a compelling investment opportunity for AGNC. The mortgage market also benefits from a self-correcting mechanism in that higher mortgage rates will eventually lead to slower prepayment speeds, lower mortgage origination volume and less runoff on the Fed's portfolio. In addition, structural changes to the repo market since 2019 have meaningfully improved Agency MBS funding conditions, which is particularly beneficial to levered investors like AGNC. So in conclusion, with asset valuations considerably more attractive now and funding conditions strong, we remain very optimistic about the outlook for our business. With that, I'll now turn the call over to Bernie to discuss our financial results in greater detail.

Thank you, Peter. AGNC had a comprehensive loss of $2.23 per share for the first quarter. Economic return on tangible common equity was negative 14.4% for the quarter, comprised of the decline in tangible net book value and dividends declared of $0.36 per common share. Notably, despite the decline in our tangible net book value, our at-risk leverage remained below our normal operating levels throughout the quarter. Leverage as of the end of the first quarter was 7.5x tangible equity, slightly lower than the fourth quarter, while our unencumbered cash and Agency MBS also remained strong at $3.5 billion at quarter end, which excludes both unencumbered credit assets and assets held at our captive broker-dealer subsidiary. Our average projected life CPRs decreased to 7.9% from 10.9% as of Q4. Actual CPRs also continued to trend lower, averaging 14.5% for the quarter, compared to 18.6% for the prior quarter. Our net interest spread for the first quarter increased to 219 basis points from 215 basis points for the fourth quarter as the improvement in asset yields due to declining prepayment speeds and portfolio repositioning more than offset a modest increase in our cost of funds. Thus, despite a smaller asset base, our net spread and dollar roll income remained very strong at $0.72 per share for the quarter, down only $0.03 from the prior quarter. Additionally, given the size of our swap position relative to our repo funding, our net spread and dollar roll income is well protected against a significant increase in short-term rates that is expected to occur over the remainder of the year. As Peter mentioned, agency spreads widened further in April. As of last Friday, we estimate that our tangible net book value is down approximately 6% from quarter end, while our leverage remained largely unchanged. Looking ahead, although our asset balance is somewhat smaller, higher rates and wider spreads improved both the earnings profile in our existing portfolio and the expected return on new investments that we add over time. With that, I'll now turn the call over to Chris to discuss the agency mortgage market.

Thanks, Bernie. As Peter described, the fixed income markets had an extraordinarily difficult start to the year. 2-year and 10-year treasury yields increased 161 and 83 basis points, respectively, through March 31 and while agency MBS initially led the move wider in spread, most all fixed income sectors underperformed the move higher in treasury yields. 30-year production coupon MBS spreads widened more than 40 basis points during the first quarter. As the Fed guided the markets to price in 6 additional 25 basis point rate hikes for 2022, an accelerated timeline for tapering of net purchases and perhaps most surprisingly, a materially accelerated timeline for balance sheet normalization. Given the dramatic increase in mortgage rates, supply shifted to higher coupons and led to substantial underperformance versus rate hedges, while lower coupon MBS, on the other hand, continued to benefit from Fed purchases and a sharp decline in origination. We took advantage of the relative outperformance in lower coupons by repositioning the agency portfolio into production coupon MBS at much wider spreads with improved roll carry and improved liquidity. Over time, we believe this repositioning will benefit our portfolio through favorable earnings. During the quarter, we reduced holdings in 2.5% coupons and below by approximately $27 billion and increased our higher coupon position by $18 billion. Dollar roll specialness for production coupon MBS continued to trade extremely well as rates moved sharply higher and production shifted, redefining the TBA deliverable. Currently, production coupon rolls are trading very special. However, we do anticipate that this will moderate in coming months to levels more in line with historical norms. Since quarter end, markets have continued to reprice. Spreads on 30-year current coupon MBS have widened an additional 10 basis points, bringing the cumulative year-to-date widening to just over 50 basis points. Coupon stack performance, however, has shifted over the last few weeks with lower coupon MBS underperforming higher coupons, the opposite of what was observed during the first quarter. 30-year production coupon nominal spreads are now approximately 35 basis points wide of average levels observed when the Fed was last reducing its balance sheet in 2018 and 2019. Historically, some of the best investing environments occur when interest rate volatility is high and nominal spreads are wide. The technical headwinds for the MBS market, however, are challenging with heavy anticipated organic supply, at least in the short run, combined with the incremental supply from Fed balance sheet runoff. As such, we expect spreads to remain at historically wide levels for some time. And as Peter mentioned, there is a risk of a temporary overshoot over the near term. I want to stress though that given our relatively low leverage, these dynamics will likely create an excellent long-term investment environment for AGNC. Our hedge portfolio totaled $77.5 billion at quarter end, up $2 billion from the previous quarter, while the asset portfolio declined by just under $10 billion. Given the volatility and uncertainty associated with the current environment, we continue to favor a hedge portfolio that is well diversified by hedge type and by maturity. I'll now turn the call over to Aaron to discuss the non-agency markets.

Thanks, Chris. As Chris mentioned, the volatility in equity and fixed income markets was also felt in structured products. While credit spreads were not immune, they generally outperformed high-grade and high-quality assets. Spreads on AAA-rated assets moved meaningfully wider in Q1. To put the moves in perspective on the residential side, the price spread between private label RMBS and Agency MBS widened about 1 point through March and further in April, while non-QM AAA spreads widened roughly 70 basis points. AAA conduit spreads were about 30 basis points wider over the quarter and other commercial real estate-backed AAAs cheapened up significantly as well. Turning to residential credit. The entire capital structure in on-the-run CRT saw significant repricing and very poor price action for most of the quarter. Heavy supply, macro weakness, and structural changes put in place in the fourth quarter contributed to this underperformance. RMBS and CMBS issuance levels remained elevated with near record volume in many sectors. Exacerbating this impact was the change in the prepayment landscape. In 2021, RMBS issuance was at a similar level. However, this issuance was coupled with faster prepayment rates and thus manageable net supply. Today, issuance has remained high, while paydowns have declined, leading to a large increase in net supply and further pressure on spreads. Consistent with the actions we took in our agency portfolio, we were generally defensive on the non-agency side. Our non-Agency holdings declined from $2.3 billion at year-end to $1.7 billion at 3/31. This was driven primarily by reducing our AAA RMBS exposure in January and February by about $400 million. Additionally, we reduced our CRT position early in the quarter and subsequently added a portion of that risk back as spreads continued to widen. Turning quickly to the housing landscape. The strong underlying fundamentals, mainly the supply-demand imbalance remains in place. However, higher mortgage rates, combined with goods and service inflation outpacing wage inflation will likely slow HPA. We expect affordability levels to continue to deteriorate somewhat. But at this point, we don't expect this to cause a correction in house prices at a national level. Looking forward, returns across the residential and commercial non-agency opportunity set have continued to improve. In the near term, we would like to see additional clarity with respect to the Fed, rate stabilization and the trajectory for bond fund redemptions to become more constructive on credit. With that, I'll turn the call back over to Peter.

Thank you, Aaron. And with that, we will now open the call up to your questions.

First question comes from Bose George with KBW.

Can you discuss the differences in spreads between agencies and credit? What do you consider to be the best option for deploying capital right now?

Sure. Thank you for the question, Bose. So thinking back to the comments that we made in our prepared remarks, I think it's clear that we've seen significant improvement in expected returns in the non-agency space given the amount of spread widening that has occurred, and we like the valuation levels there, generally speaking. And as Aaron mentioned, there has been some spread movement in the non-agencies but not nearly to the extent that we've seen in the agency market. So just generally speaking, I would say that from a capital allocation perspective, I would expect the marginal capital to be allocated more towards the agency space.

Okay. Great. You mentioned that the returns are attractive, but you didn't specify a number. Could you provide a range of returns?

Sure. Let me start by providing an outlook that will lead into that discussion. It's important to reiterate the messages we are trying to convey today. Generally speaking, we’re becoming increasingly optimistic that a significant portion of the repricing has already occurred, and there is certainly a risk of an overshoot. These are the types of markets where overshoots often happen, which is why we made the decisions we did regarding our portfolio in the first quarter. With that in mind, returns in the agency space look appealing, both in absolute terms and relative to your specific question about absolute returns. The production coupons currently represent the most attractive segment of the agency market. Right now, those returns are in the low to mid-teen range, although interest rate volatility is high and the cost of hedging is unusually elevated in this market, which will eventually settle down. However, relative returns also appear very promising. Looking back at historical periods, for instance, during 2019 when the Fed was cutting its balance sheet, spreads are significantly wider than they were at that time. To illustrate, nominal spreads today to the 10-year are approximately 125 basis points compared to 80 basis points back then. Additionally, as Chris noted, OASs are about 35 basis points wider, indicating attractive relative returns. We are entering a challenging period, as Chris pointed out, with the seasonal supply of mortgages expected to be high for the coming months. We will find out tomorrow how the Fed plans to ramp up its balance sheet runoff. Therefore, the technicals may be a bit challenging, and we want to monitor market trading closely. If there is a time for an overshoot, it is likely now. The decline we observed in April might be a part of that overshoot process. However, we are well positioned for this. We took proactive measures in advance, and as Bernie mentioned, our leverage remains low as of last week. Thus, we are well positioned, and spreads and returns are becoming increasingly attractive to us. I'll pause there.

The next question comes from Rick Shane from JPMorgan.

I'm not sure if you provided it, I'm not sure if you provided it, but can you give us a quick update on where you think book value is as of last week?

Yes. Bernie mentioned that in her prepared remarks, and I mentioned that spreads were about 10 basis points wider. And Bernie mentioned that as of last Friday, we estimated our book value down around 6%, which would be consistent with the spread widening event of about 10 basis points.

Got it. And that's pretty consistent with how we're looking at it as well. Look, you talked a little bit about the return opportunity in response to Bose's question. And if we think about it in order to sustain the dividend, you probably need a low double-digit type ROE to maintain the dividend. Given the low leverage, given the widening of spreads and the opportunities that you see ahead, how do you feel about that sustainability?

Thank you for your question. I understand that many people are thinking about this. First, it's important to provide some historical context regarding our dividend. We are starting from a very strong position. For instance, last year we had a $1.44 dividend compared to a net spread in dollar income of $3.02. This demonstrates our strong standing at the beginning of this period. A key point to consider is that due to the recent changes in rates and spreads, the return opportunities on our future investments are significantly improved. Furthermore, the mark-to-market return on our portfolio is now better as well. In other words, our existing portfolio, reflecting the changes in spreads and rates over the past four months, is yielding a higher rate of return, aligning with the increased dividend yield on our portfolio. Currently, we have substantial flexibility and do not feel pressured to increase leverage to maintain earnings consistent with our dividend, thanks to the enhanced return on our portfolio. The main takeaway is that we are positioned to be patient and disciplined, waiting for the right opportunity that Chris mentioned, which we believe will be rare, as it hasn't occurred frequently since the financial crisis. We just need to exercise patience, as our portfolio is generating a much better rate of return than it was four or five months ago.

For sure. And look, I think the dividend policy over the last 2 years is basically a reflection of understanding that you were over-earning given the opportunity the market presented and that you didn't want to get ahead of yourself because investors value the stability of the dividend. I guess I would say, when you think about and certainly understand that the ROE is a function of the mark-to-market. So that is a really important consideration but when you look at the opportunity ahead in the context of sort of what your concerns were, it feels like it's still within those dimensions.

I definitely believe it's within those dimensions. You could use a simple calculation on the expected return of our portfolio. If you were to assess the market value of our portfolio and sell it only to buy it back today, considering the asset yield—which would likely be around 4% on a fully hedged basis—you would arrive at a return on equity in the range of 12% to 14%, given our cost structure. This aligns closely with the dividend we are distributing.

In terms of the investment position you talked about remaining defensive and looking for some additional clarity before you could take up leverage and take advantage of the situation. But just wondering if you could just further flesh out any specific milestones or signs that you're looking for before you could start taking advantage of the attractive investment opportunities.

Yes, that's a great question, Ken. What I would emphasize is that there are specific indicators that would be helpful. Mortgages showed weakness again in April, and we're on the brink of the Fed's announcement regarding the balance sheet tomorrow. I believe there are four things that would support the market, and we should gain clarity on these over the next one to three months, which is a relatively short timeframe. First, we need to see more stability in interest rates. With interest rates from three to ten years hovering around 3%, we are likely close to a complete repricing of expectations. Of course, there's still a possibility that the terminal Fed funds rate could end up being higher than what the Fed originally suggested, which will need to unfold. Overall, the market would benefit from more interest rate stability, and we hope we're nearing that juncture. Secondly, building on Chris' point, the market understands that valuations should generally reflect that the current technicals for the mortgage market will be quite challenging in the next one to three months. While this is already known, we want to observe the market trading more steadily during this time, which would be another indicator we're looking for. The third aspect, which I'm unsure about in terms of timing, is that the market would benefit from a clearer understanding of the Fed's long-term runoff plans. If you remember, when the market weakened in April, it coincided with the Chairman discussing front-loading interest rate hikes, which led the market to believe that they might be more aggressive regarding the balance sheet. We don't anticipate that happening; we expect the Fed will take a measured approach to its balance sheet while pursuing a more aggressive interest rate strategy. Additional insights from the Fed on its long-term runoff plan would be beneficial. Lastly, as Aaron pointed out, we will be monitoring bond flows. Over the past several months, due to pressure across the fixed income market, bond flows have seen significant outflows. However, this trend has started to slow in the last few weeks. We expect it to eventually stop and anticipate bond inflows given the favorable return levels resulting from the repricing. This will be a crucial indicator of market strength. Additionally, we know many index investors are still underweight MBS. These are the indicators we are watching for, and we expect to gain significant clarity on these points in the coming months. I hope this answers your question.

That's great color there. That's great color there. One follow-up, you talked about adjusting some of your hedges and your hedge positioning. Wondering if you could just talk a little bit about that and any kind of potential implications to how you expect book value could move over the near term, just given all the various dynamics there.

One of the key points about the current environment is that we are experiencing a spread event, specifically the underperformance of Agency MBS compared to hedges. In my prepared remarks, I identified the spread component as approximately 13.5% of our overall book value. Our approach has been to minimize interest rate risk due to the volatility in the environment. We aimed to maintain a neutral duration position, starting the quarter with a 0.1 year duration gap and ending with a 0.3 year gap. Currently, our duration gap is about half a year. This neutral stance is important because the first quarter was challenging for the agency market, particularly due to the significant two-way rate risk that emerged in February with the onset of the Ukraine war. The 10-year yield fluctuated sharply, rising from 150 at the beginning of the quarter to 2% and then dropping back to 1.65 after a significant rally. Given this volatility, we preferred not to be significantly long or short and wanted to keep our duration risk neutral. We continue to maintain a high hedge ratio, as we believe substantial intermediate hedges are necessary due to the underperformance in the 3-year to 7-year part of the curve. Our goal is to protect our book value, particularly in light of the spread widening event we experienced in April.

Yes. I would like to add that much of our rebalancing occurred on the asset side of the balance sheet, driven by several factors. As the Fed indicated tighter policy rates, the market experienced a sell-off and increased volatility. During this period, lower coupon mortgage-backed securities performed significantly better than higher coupons. Given this strong relative performance, it was logical for us to focus our delta hedging in these coupons instead of rates in order to maintain tight spreads and duration. I also mentioned the coupon swap trades. Overall, our agency portfolio decreased by about $9 billion in net terms, and we executed an additional $18 billion in coupon swaps, which were also influenced by relative value duration rebalancing and liquidity considerations. Generally, low dollar-priced mortgages with minimal option costs tend to attract a narrower investor base, which factored into our decision to adjust our coupon positioning. Recently, lower coupons have notably lagged behind production coupons, reversing much of the progress seen in the first quarter. While the relationships are now more balanced, we still lean towards higher coupons for the time being. However, lower coupons can also perform positively and generate good total returns in certain situations if fixed income outflows turn into inflows, as mentioned by Peter. Index passive and light index-based fund flows will likely support these positions, given that they still account for a significant share of the float. Nonetheless, we must adjust our positions for liquidity and the negative carry they present compared to higher coupons. We will remain opportunistic in our coupon positioning as market conditions evolve, while still favoring higher coupons.

Given the large move you've already seen, can you just update us kind of how you're thinking about the risk and the potential for tightening in agency spreads over kind of the coming months?

Thank you for the question, Doug. I believe this potential investment opportunity is unique for AGNC, making it quite compelling. In the current environment, spreads have significantly widened, which has improved returns. While further weakness is likely as the Fed reduces its balance sheet, what stands out is the absence of clear catalysts for spreads to tighten quickly. This perspective is positive for us, as we expect to experience a period of consistently attractive return opportunities. There are investors, particularly in the money manager sector, who are underexposed to the mortgage index, which could drive demand. At the same time, we anticipate a substantial net supply of mortgages. Therefore, we foresee an environment where attractive returns will be accessible for an extended time, which is beneficial for our business. That's how we are assessing the current landscape.

Looking at the spec pool portfolio and the premium over TBAs, would you expect some pay up to more or less always exist? Or is there a floor, if you will, for where those securities might trade in a higher mortgage rate environment?

Yes, Chris. It depends on the category, but there is a minimum level. The quality of the TBA float is declining with less Fed involvement. With the reduction in pay-ups this year, there have been some excellent opportunities to enhance convexity affordably through pool selection. Call protection is a good example; it's often seen as valuable only when prepayments are rapid, but it's really about cash flow stability. Being sure that a pool will maintain its duration during a rally allows for better hedging of spot duration. It ultimately comes down to cash flow stability. For that reason, there is a minimum for pay-ups, typically above TBA, with TBA being the absolute minimum for deliverable securities. Additionally, there are certain pool characteristics to avoid in this environment to find better turnover performance, which is also important for the convexity profile of the mortgage portfolio.

Well, I wouldn't say that on the latter part of that, I don't think that affects it directly. I think just generally speaking, for our on-balance sheet portfolio, we typically fund that somewhere in the neighborhood of around 50% bilateral and 50% Bethesda. And while we could take the Bethesda percent up, we're comfortable operating in that sort of 40% to 50% range because we do want to always maintain as diversified as possible of funding base. So we want to have really healthy, active relationships with our bilateral counterparties as well. They're important source of liquidity for us. So I don't expect any material change in the composition between bilateral and Bethesda and I don't expect any material to drive any material change in our TBA position; what you'll see drive our TBA position is our view on relative value. The TBA specialness obviously is a very significant factor there. So those would be the sort of fundamentals that drive the TBA position. Well, thank you for your participation on the call today and for your interest in AGNC, and we look forward to speaking with you again at the end of next quarter. Thank you again for your participation.

Thank you.