AGNC Investment Corp. Q3 FY2025 Earnings Call

Thank you all for joining AGNC Investment Corp.'s Third Quarter 2025 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 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 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, President, Chief Executive Officer and Chief Investment Officer; Bernie Bell, Executive Vice President and Chief Financial Officer; and Sean Reid, Executive Vice President, Strategy and Corporate Development. With that, I'll turn the call over to Peter Federico.

Good morning, and thank you all for joining our conference call. In the third quarter, the Federal Reserve's pivot to a less restrictive monetary policy stance and the easing of fiscal policy concerns drove robust financial market performance and a significant improvement in investor sentiment. Agency mortgage-backed securities were one of the best-performing fixed income asset classes during the quarter and have now outperformed U.S. treasuries for five consecutive months, a sequence of outperformance that has not happened since 2013. In this favorable investment environment, AGNC generated a very strong economic return of 10.6%, comprised of our attractive monthly dividend and book value appreciation. At its September meeting, the Fed lowered the federal funds rate as expected and signaled further monetary policy accommodation with the possibility of rate cuts at the October and December meetings. On the fiscal policy side, the passage of the tax bill early in the quarter and several positive tariff developments eased some of the concerns that dampened the investment outlook in the second quarter. These investor-friendly developments led to a material decline in interest rate volatility and contributed to the outperformance of Agency MBS. As we have discussed, a number of emerging factors support our constructive outlook for agency mortgage-backed securities. The first relates to the improved spread environment for Agency MBS. Over the last four years, the spread range between agency securities and benchmark rates has become increasingly well defined with incremental investor demand consistently emerging when spreads trade near the upper end of the range. In addition, the administration has begun to focus on mortgage spreads as a means of improving housing affordability. In an interview in late September, the Treasury Secretary reinforced this view when he said, 'The really important thing is that we either maintain mortgage spreads or narrow them further to help the American people.' This focus on spreads by the administration is good for Agency MBS and good for our business. Second, the supply and demand dynamic for agency mortgage-backed securities continues to be well balanced. With the primary mortgage rate persistently above 6%, the net new supply of Agency MBS this year will be about $200 billion, the lower end of initial expectations. At the same time, the demand outlook has improved. Bank demand for Agency MBS has been relatively muted this year, but should increase as regulatory reforms get implemented. The money manager community is another important source of demand for Agency MBS. Demand from this sector increased meaningfully in the third quarter, as the favorable shift in monetary policy led to $180 billion of bond fund inflows, which are now running slightly ahead of last year's pace. Third, the financing market for Agency MBS remains strong. With bank reserves just under $3 trillion, the Fed will likely end balance sheet runoff within the next few months. Importantly, the Fed is also considering joining the FICC for purposes of the standing repo facility and using a repo-based measure as its primary target rate. If adopted, these changes would be highly beneficial to the repo market for U.S. treasuries and Agency MBS, particularly during times of stress. Fourth and finally, the potential path of GSE reform continues to move in a favorable direction. The Treasury Department has taken a leadership role in the reform process, holding a series of roundtable discussions with a wide range of housing and mortgage market participants to gain insight into potential reform actions. This careful approach demonstrates the Treasury's commitment to maintaining mortgage market stability. To that end, the Treasury has emphasized three important guiding principles for GSE reform: maximize taxpayer value, lower the mortgage rate through stable or tighter mortgage spreads, and do no harm to the housing finance system. The mortgage market has responded well to this approach. Collectively, the four factors that I mentioned are currently pointing in a favorable direction for Agency MBS. Moreover, given the Treasury's thoughtful approach, it is possible the agency market emerges from this reform process with a stronger and more durable structure. In this evolving investment environment, we believe AGNC as the largest pure-play levered agency investment vehicle is well positioned to generate attractive risk-adjusted returns for our shareholders. With that, I'll now turn the call over to Bernie Bell, our Chief Financial Officer, to discuss our financial results in greater detail.

Thank you, Peter. For the third quarter, AGNC reported comprehensive income of $0.78 per common share. Our economic return on tangible common equity was 10.6%, consisting of $0.36 of dividends declared per common share and a $0.47 increase in tangible net book value per common share, driven by a significant decline in interest rate volatility and tighter mortgage spreads to benchmark rates. As of late last week, our tangible net book value per common share was unchanged to slightly up for October. We ended the third quarter with leverage of 7.6x tangible equity and average leverage of 7.5x, both unchanged from the prior quarter. Our liquidity position remained very strong with $7.2 billion in cash and unencumbered Agency MBS at the end of the quarter, representing 66% of tangible equity. Net spread and dollar roll income declined $0.03 to $0.35 per common share for the quarter, driven by lower swap income due to the maturity of $4 billion of legacy swaps and a timing mismatch between the issuance and deployment of new preferred and common equity capital. Another important driver of our net spread and dollar roll income is the amount of unhedged short-term debt in our funding mix as measured by our hedge ratio. As of the end of the third quarter, our hedge ratio was 77%, representing the amount of swap and treasury-based hedges, excluding option-based hedges relative to our total funding liabilities. This hedge portfolio positioning reflects our expectations for an accommodative monetary policy environment and positions our net spread and dollar roll income to benefit from rate cuts as they occur. Looking ahead, we expect that lower funding costs from the September rate cut and widely anticipated future rate cuts, along with the full deployment of recently raised capital and a shift in our hedge mix toward a greater share of swap-based hedges, will collectively provide a moderate tailwind to net spread and dollar roll income. The average projected life CPR of our portfolio increased 80 basis points to 8.6% at quarter end from 7.8% the prior quarter on lower mortgage rates. Actual CPRs averaged 8.3% for the quarter compared to 8.7% in the prior quarter. Lastly, during the third quarter, we issued $345 million of fixed-rate preferred equity, the largest mortgage REIT preferred stock offering since 2021, and $309 million of common equity through our At-the-Market Offering program at a significant premium to our tangible net book value per share. Notably, the preferred issuance carries a cost significantly below the levered returns available on deployed capital, which is expected to further enhance future earnings available to common shareholders. And with that, I will now turn the call back over to Peter for his concluding remarks.

Thank you, Bernie. Before opening the call up to your questions, I want to provide a brief review of our portfolio activity. Agency spreads to both treasury and swap rates tightened meaningfully across the coupon stack in the third quarter as interest rate volatility declined sharply. Intermediate coupons performed the best driven by strong index-based buying from money managers. Higher coupons also generated positive excess returns, but to a lesser extent, as the sizable inter-quarter rally in long-term interest rates increased prepayment concerns associated with these coupons. Hedge composition was also a driver of performance in the third quarter as swap spreads widened two to five basis points across the curve. Our asset portfolio totaled $91 billion at quarter end, up meaningfully from the prior quarter as we fully deployed the capital that we raised in the second and third quarters. As is often the case when we deploy new capital, the mortgages that we added were largely newly originated production coupon MBS. Over time, however, we optimized our asset composition by rotating into pools with favorable prepayment characteristics as opportunities arise. Consistent with the growth in our asset portfolio, our TBA position increased to $14 billion at quarter end. As a result, the percentage of our assets with favorable prepayment attributes declined to 76% in the third quarter. The weighted average coupon of our portfolio increased slightly to 5.14%. The notional balance of our swap and treasury-based hedges remained relatively stable during the quarter, but the composition of our portfolio shifted to a greater share of longer-dated swap-based hedges. In duration dollar terms, our swap-based hedges increased to 59% of our overall portfolio. Lastly, given the convexity profile of our assets and the large decline in interest rate volatility, we opportunistically added $7 billion of receiver swaptions during the quarter as an additional source of downgrade protection. With that, I'll now open the call up to your questions.

And the first question will come from Crispin Love with Piper Sandler.

Spreads have tightened materially over the last few months and just looking at your results, core earnings were $0.01 below the dividend. Can you just discuss expected ROEs? Have they shifted at all just given the spread tightening and then just touching on the sustainability of the current EBITDA?

Sure, I appreciate your question. You're correct that we've seen a significant movement in spreads recently. As I mentioned earlier, over the last four years, the spread between current coupon and the blended swap curve has generally been between 160 to 200 basis points, and we are currently closer to the lower end of that range at around 170 basis points. In terms of mortgages compared to swaps and treasuries, I would say that current coupons have an expected return on equity between 16% and 18%, which aligns well with our total cost of capital. When considering dividend sustainability, I focus on that measure since it's crucial for covering all of our common and preferred stock dividends as well as our operating costs over our equity base. This measure decreased by approximately 1% from the previous quarter due to an increase in our equity base, bringing it to around 17%. This aligns with the current trading conditions of mortgages. There has been some fluctuation in our net spread and dollar roll income, which has fallen to $0.35, and there are several temporary factors behind that, including the expiration of some short swaps and a lower swap hedge ratio this quarter. Many minor factors contributed to that drop, but we believe we are currently at or near the low point for that measure, with reasons to expect improvement in the future. Overall, while spreads have indeed tightened significantly, the fundamentals regarding dividend sustainability and returns remain well aligned at this time. I'll pause now for your follow-up questions.

All really helpful. You mentioned in your prepared remarks that you significantly decreased the hedge ratio in the quarter. Can you elaborate on that? What prompted this decision? Are you adopting a more short-term rate outlook, particularly regarding decreased rate expectations? Additionally, what do you perceive as the main risks associated with the lower ratio, particularly in relation to the receiver swaptions you referred to?

There are a couple of important developments regarding the hedge ratio. As previously mentioned, we included receiver swaptions, which is significant to this discussion. Additionally, Bernie referenced our overall hedge ratio. With the addition of receiver swaptions, we provided two hedge ratios this time. If you examine our overall hedge portfolio, it fell to roughly 68%. However, I believe a more crucial number to consider in relation to our net spread and dollar roll income is our hedge ratio pertaining to swap-based and treasury-based hedges, which we use to transform our short-term debt into synthetic long-term debt. That hedge ratio was 77% at the end of the quarter, as noted by Bernie. This indicates that 23% of our funding mix comprises short-term debt. When considering the costs associated with short-term debt compared to others, it's important to note that the average repo cost for short-term debt last quarter was 4.43%, representing the highest cost segment of our funding liabilities. This cost is expected to decrease over time as the Federal Reserve eases monetary policy, a trend that has already begun post the first easing, with expectations for more easing ahead. To put this into perspective, the current short-term debt financed at 4.43% incurs about 100 basis points in additional costs compared to swap rates in the three- to five-year sector, translating to approximately a $0.05 improvement as short-term rates decline. We structured our portfolio with this hedge ratio in mind, anticipating benefits from the Fed's shift toward a more accommodating monetary stance, which seems to be gaining momentum for rate cuts. I expect these benefits to materialize over the next few quarters. Additionally, we adjusted the composition of our portfolio in light of the current rate environment and the administration's focus on long-term rates. We must be more vigilant about the risks associated with declining long-term rates and increasing prepayments on mortgages compared to a quarter or two ago. To mitigate this risk, we have selected assets carefully and have also utilized options. In the last quarter, we added $7 billion of receiver swaptions to enhance our down-rate protection. However, since this is a receiver position, it affects the hedge ratio calculation. I wanted to clarify this aspect, as it illustrates the two significant factors in our hedge composition that are vital for understanding our net spread, dollar roll income, and the additional drag we're currently observing, which we believe will reverse over time, coupled with the need for more down-rate protection.

Your next question will come from Terry Ma with Barclays.

Maybe just touch on your comments around incremental demand for MBS from money managers in the quarter. Was that kind of episodic or do you think that appetite will be sustained going forward?

It's truly fascinating and also expected that the shift in monetary policy should not be underestimated. It was a significant change, especially within fixed income, and we certainly witnessed that. The fixed income market has been anticipating a move from the Fed amidst uncertainty around tariffs, and now, with the pivot happening, it appears to be gaining momentum. In terms of bond fund flows, there were $100 billion in inflows during the first quarter and $50 billion in the second quarter, totaling $150 billion in the first half of the year, followed by a substantial increase to $180 billion in the third quarter. Currently, the inflows are averaging over $8.5 billion per day. We are on track for approximately $450 billion in bond fund inflows this year, and I expect this trend to continue based on what we've seen this month. With the Fed anticipated to ease rates in the next two meetings and a less optimistic outlook for equities, a lot of capital remains in money market funds. There may also be a shift out of the equity market, given its current peak. Therefore, I anticipate that bond fund inflows will continue to be strong, particularly supporting the lower and middle coupons as we approach year-end. Another significant factor influencing demand, which remains uncertain but seems to be leaning positively, is the activity from banks. While banks have added around $50 billion in mortgages this year, they've also increased their treasury holdings by $200 billion. The key question is how these potential bank reforms will evolve, and I believe they will materialize with the new Basel Endgame, likely in the first quarter. Everything points to this being beneficial for bank capital, especially regarding mortgage credit. Thus, I foresee potential increases in bank demand for mortgages and possibly some shifts from treasuries to mortgages once the regulatory landscape becomes clearer. Overall, I think the demand outlook remains stable, if not improving.

Got it. That's helpful. And then just a follow-up. I appreciate all the color on net spread and the dynamics around that. But I guess, to the extent that Fed easing gets delayed or pushed out or maybe doesn't even materialize. Do you still expect a near-term tailwind to the net spread when you kind of factor in just, I guess, capital deployment and then also just swaps rolling off?

Yes, I do. There are a few factors that have caused it to drop by about $0.01 or $0.02 more than expected. Bernie mentioned timing mismatches in our capital raising, which we discussed at the end of the second quarter. During that time, we were slow to deploy the proceeds intentionally, leaving us with some excess capital at the end of the quarter, which we eventually used. This can negatively impact our earnings, and we saw that effect. However, as both Bernie and I noted, all those proceeds have now been fully deployed, which removes that headwind, and that's significant. Regarding short-term debt, what's crucial now is the pricing of short-term swaps and rates in relation to the neutral Fed funds rate or target rate. Recently, as the Fed has adjusted, we've seen a first easing, which is important. Additionally, two- and three-year swap rates now align closely with the neutral Fed funds rate of around 3.25%. You can manage this by waiting for actual eases to reflect in our repo balance or by adjusting in the swap market at the long-run neutral rate. I expect this to positively impact us over the next three or four quarters.

Next question will come from Rick Shane with JPMorgan.

In my office, I have a note reminding me that it’s never different this time. However, the current refinancing environment and the distribution of outstanding mortgages appear unlike anything we've previously encountered. Instead of a bell curve, it resembles a barbell. Over the past three years, many borrowers have likely been given mortgages with the expectation that they would refinance them. After predicting this for two decades, we might finally be on the verge of a technological transformation in the mortgage origination process. Are you observing any changes in behavior regarding speeds, and is this a risk we should consider at this point?

Yes to all of the above. That's why I mentioned earlier the need for more down-rate protection, especially considering the administration's focus on mortgage rates and housing affordability, which are very important factors. Let me provide some perspective on the refinance outlook from a mortgage standpoint, specifically from a traditional perspective. When we discuss the refinanceability of the mortgage universe, we refer to situations where mortgages are approximately 50 basis points in the money. Currently, with a mortgage rate around 6%, only 20% of the market benefits from a 50 basis point incentive. This mortgage rate has consistently remained at 6% or higher, and it's unlikely to drop significantly, especially since the 10-year Treasury yield is stuck above 4%. As it stands, only 20% of borrowers are in a position to refinance. If we see a full 100 basis point decrease in mortgage rates to 5%, that percentage would rise to 30%. In order for 40% of borrowers to be able to refinance, we'd need mortgage rates to fall by a full 200 basis points to 4%. Thus, achieving a significant prepayment event requires substantial movement in mortgage rates. However, there is currently a lot of capacity within the system for refinance activity. Technology is playing a vital role in this, as we’ve witnessed over the past quarters. For instance, in September, when mortgage rates briefly dipped below 6.15%, we observed a quick surge in refinancing. This indicates pent-up demand and the capacity of mortgage originators to process these loans significantly faster than in previous times. These observations highlight the importance of having more down-rate protection. We plan to maintain a positive duration gap and continuously work on optimizing our portfolio's asset composition to improve our prepayment protection characteristics. I mentioned that the current prepayment protection is around 75% to 76%, but we've been managing to operate above 80%. For higher coupon rates, we aim to keep that percentage very high. Additionally, our portfolio is increasingly focused on the production coupon, which falls in the 5% to 5.5% range. We've shifted slightly, concentrating more on loans in the 4.5% to 5.5% coupon range, which further bolsters our prepayment protection.

Got it, Peter, this is why I love this job. That's such an interesting answer. I do appreciate it. If I can ask one follow-up, which is that as policymakers are looking for ways to improve affordability, do you see levers out there that are available to reduce the incentive that borrowers need to narrow that 50 basis points in a way that could increase speeds as well?

I'll respond to that in two parts because it's quite intriguing. First, there's currently a lot of capacity in the mortgage origination business, and there seems to be some anecdotal evidence that borrowers are refinancing with incentives lower than 50 basis points. It's possible that some are refinancing with as little as a 25 basis point incentive, particularly if the technology is user-friendly and costs are low. However, the geography plays a significant role in refinance costs, with variations depending on state and local factors like title, taxes, and recording fees. There are potential measures to simplify the process further. The GSEs have occasionally taken steps like waiving appraisals or other types of insurance. There's ongoing discussion regarding waiving title insurance for refinances, which is a notable topic, though it's uncertain if it will proceed due to associated risks. This illustrates the GSEs and regulators attempting to enhance refinance opportunities. They could also adjust their g-fees. From an administrative perspective, the administration's emphasis on mortgage spreads is unprecedented. The Treasury Secretary has clearly articulated the importance of the spread between mortgage rates and the risk-free rate. This indicates a belief that actions taken through potential reforms may stabilize or lower that spread, which could subsequently affect mortgage rates and refinancing. The Treasury is paying close attention to the 10-year yield, raising questions about whether they will alter the balance between short-term and long-term issuances. Regarding GSE reform, how MBS are treated from a capital standpoint in new bank regulations is crucial and could foster greater refinance activity, possibly even lead to changes in capital requirements for Agency MBS based on reform developments. There's a lot of scope for action, and the current environment is quite fascinating.

Next question will come from Trevor Cranston with Citizens JMP.

Peter, you painted a pretty positive picture in terms of the supply-demand outlook for MBS. I guess the other thing that could have a major impact on spreads would be implied volatility and how that's being priced. So can you maybe share your outlook on volatility if you think there's room for that to continue coming down or if there are things you guys are thinking about that could cause that to move back to a higher level?

Yes, that's a great question. It's really important because as we discussed earlier, the current spreads are closer to the lower end of their range. At this point, many are wondering if we will see a rebound into the range. Is there a reason for spreads to rise from these lows and move back towards the middle of the range, which has been the trend? Or how are the underlying factors evolving that will influence spreads' direction? Regarding our outlook on spreads from a macro perspective, over the past few years, there have been numerous uncertainties—monetary policy, fiscal policy, and geopolitical risks—that made it difficult to determine the upper end of the range. With the Fed tightening its monetary policy and the unique balance sheet runoff, we questioned where the upper boundary for spreads was. However, I now feel quite confident about the upper end, though I have some concerns about the lower end. There are various factors that might cause spreads to fall below this lower boundary. The administration is focused on spreads, and while demand is improving, supply remains relatively stable. The funding market is particularly interesting because the Fed is at a turning point concerning its balance sheet. With current funding rates, I anticipate that the Fed will soon conclude its balance sheet actions, likely announcing this in November or December, but certainly by year-end, considering the behavior of funding markets. Additionally, the Fed is contemplating changes that could benefit the repo market, which is a positive sign. Treasury leadership on GSE reform indicates they are exploring potential actions to enhance spread outlook. From a volatility standpoint, we have a favorable monetary policy developing, which should also be beneficial for volatility. If we receive clearer information concerning tariffs over the next month or two, we could experience a relatively stable environment for interest rate volatility. When putting all this together, it suggests that there are reasons for mortgages to potentially break below the lower end of their range. I believe there are fewer concerns about mortgages widening or surpassing the upper limit and stronger indications that they could breach the lower limit.

Yes. Okay. That makes sense. And then you guys recently announced the creation of these current coupon indices. Can you maybe just briefly talk about kind of what the economics are for AGNC and if there's kind of any other things you guys are sort of exploring on the like third-party asset management side of things?

Yes. We did this not for economic reasons but because we believed it would benefit the market. The mortgage market is often misunderstood and lacks transparency. While it is a significant fixed income market, retail investors find it challenging to access and gather information about it. Without platforms like Bloomberg, it's tough to track mortgage behavior. Currently, the only benchmark available is the Bloomberg Mortgage Index, which covers the entire $9 trillion market but has different characteristics compared to other segments. For instance, the average coupon of the Bloomberg Aggregate Index is approximately 3.5%. When an investor enters a bond fund that invests in mortgages, they receive this average coupon. However, there isn't an index that indicates the characteristics of newly originated mortgages. So we established an index that rebalances monthly to provide the right balance of coupons centered around the par coupon, which is currently about 5%. This gives investors better insights. We have posted the historical performance on our website, making it accessible without a Bloomberg terminal. Our goal is to enhance transparency and provide investors with better information, which may help attract more investors to this fixed income asset class.

Next question will come from Doug Harter with UBS.

It's actually Marissa Lobo on for Doug today. If you could talk to us about your view of optimal leverage in the current spread and ball environment?

Yes. Yes. Well, I would say right now, you look at our leverage, we're sort of operating right where we have normally been. It was a little higher at times when mortgages were cheaper; we're back to around 7.5x leverage, as Bernie mentioned; I think that's a good place to be. We think we're at that unencumbered cash, which is 66% of our equity. So we have a lot of flexibility. And what I would just say is that given all that flexibility and given all the considerations and the factors that we are looking at, as they evolve, over the next couple of months, those factors will inform whether or not we want to continue to operate with this leverage or higher leverage or lower leverage. But certainly at this level, we have a lot of capacity, a lot of flexibility, and we're able to generate really attractive returns.

And I know you touched on this with Trevor's question. But what do you see as the biggest near-term risk to your constructive view on spreads?

Yes, I would say the major risks are related to macroeconomic factors. For instance, if there were significant changes in fiscal policy that impacted the inflation outlook, those changes would not yet be reflected in the market. Additionally, if something were to drive inflation and volatility up, leading the Fed to pause its actions again, that would generally apply pressure on fixed income markets and specifically on Agency MBS. At this point, these factors are the primary macroeconomic influences. A notable shift in the tariff outlook or a dramatic change in the Fed's perception of the inflation outlook could necessitate a change in strategy. However, any notable change in the inflation outlook would need to be substantial—likely not related to tariffs, as the Fed currently views them as a one-time price adjustment rather than an ongoing source of inflationary pressure. Therefore, the inflationary factors would need to outweigh the evident weakening in the labor market, which the Fed must address.

The next question will come from Kenneth Lee with RBC Capital Markets.

Just one from me. And I think you've touched upon this briefly. In terms of the hedges, net duration gap didn't change that much. Is the thinking here that it could potentially be more positive over the near term as you look to get more down rate protection, but I just wanted to get your thoughts around that?

We would prefer to work with a slightly larger duration gap than what we currently have. Right now, it's around 0.2, which isn't very significant. Additionally, the 10-year rate is at approximately 4% or just below that. From a rate standpoint, I believe the near-term risk for the 10-year rate is that it might increase rather than decrease. Therefore, there may come a time when we would like to have a higher duration gap, but given that the rate is currently just below 4%, that may not be the right moment.

Your next question will come from Harsh Hemnani with Green Street.

You touched on this in the prepared remarks a little bit, but there's two ways to manage that down rate risk. The first is asset selection, as you mentioned, and the second would be the path you took this quarter was maybe expanding TBAs and getting outright convexity hedges. Given that you've deployed all the capital you raised in, call it, the second quarter and third quarter, was this sort of a decision driven by sizing at all in the sense that it might be harder for you to source those specified pools in the market at this time or at the speed you would like to? Anything on that front in terms of sizing?

Yes. No, it's a really good question, Harsh. Thank you. You're right. So quite often, as I mentioned, when we raise capital, we want to deploy it sort of immediately. And so we do that by buying generic kind of mortgages, TBAs or production coupons that have the most negative convexity, if you will. But what's important is that over time, we continue to refine and upgrade, if you will, our asset composition. And there's lots of opportunities and capacity to do that. In the third quarter, for example, what you don't see in our overall numbers is that we actively rotate out of certain specified pools into new specified pools as those opportunities arise as the GSEs, for example, sell new specified pools. Just to put a number on that in the third quarter, about $8 billion of our specified pools rotated and changed into different specified pools that had slightly different characteristics that we preferred more than our existing holdings. So that optimization happens all the time in our portfolio, and that is an important source of alpha generation for us. And I think that there's lots of capacity to do that. It does take some time months and quarters, but you can do that in significant size on a regular basis. And so what you'll likely see us because we are always trying to give ourselves greater down-rate protection, particularly in the current environment. You'll see us rotate out of those generic pools as opportunities arise into specified pools with certain characteristics that we think are beneficial in the current environment. It could relate to credit, it could relate to LTV, it could relate to HPA in certain areas, lots of little factors can have a big impact on the refinanceability of a mortgage.

Next question will come from Bose George with KBW.

Actually, a couple of little things for me. Peter, you mentioned the $0.05 tailwind. What's the time frame for that? Is that sort of looking at the forward curve and by the time the Fed is done? Or just any color on that?

The $0.05 I calculated represents the impact if short-term rates, currently at 4.43, reflected a roughly 100 basis point difference as they move toward the neutral rate. If this were to occur, say, over the next six months, that $0.05 would materialize during that period. It ultimately depends on how quickly the Fed reduces short-term rates or how swiftly we convert that short-term debt into swaps at the equivalent rate.

Okay, that makes sense. In terms of whether further tightening of spreads is beneficial or not, it clearly impacts your book value. Does it also complicate covering the dividend? Or does the calculation still hold since you receive a lower return on equity based on a higher dollar amount of equity?

Well, you're right in that if the entire change of our book value is due to spreads, then from an investor perspective, they get the benefit, the same economics of the benefit. So if spreads stay where they are, for example, then there's no change in our book value and the future earnings stay strong. Conversely, if the only thing that changes is that spreads tighten, then our book value goes up by the present value of those earnings that you give up. So from an investor perspective, you're sort of indifferent from a return perspective, you're going to get the same economics of the return whether it's in the form of future earnings or in book value appreciation. From that point forward, then the dividend yield on our book value would be lower. The return on our portfolio would be lower, but they would still be aligned. And from an investor perspective, they would have gotten the same economic benefit all in.

Okay. That makes sense. I have one more question regarding spreads. You mentioned that if quantitative tightening is likely coming to an end soon. However, if the Fed continues to reduce its holdings in Agency MBS and reinvest in treasuries, could that lead to potential spread risk due to widening spreads compared to treasuries?

Yes. Chairman Powell recently mentioned that we are at a turning point for the balance sheet and will end the runoff. It is now clear that this is indeed the case. He continues to refer to the guidance that they plan to primarily hold treasury securities. However, the term "primarily" remains undefined, which is significant for the mortgage outlook. It could mean holding 95% or possibly 60%. This distinction is important, but he stated that they would study and clarify this further. They have a clear obligation to manage the runoff in a way that avoids market instability, which he acknowledged. Therefore, I do not anticipate any actions regarding the mortgage portfolio that would disrupt the market. Currently, the Fed's balance sheet is reducing at a rate of about $200 billion a year, which the private sector can manage. These mortgages will be redirected into treasury securities. There is still room for discussion about how the balance sheet might change in terms of its composition. Ultimately, this could be a lever that the government sees as crucial for enhancing mortgage affordability by including more mortgages in that composition. If that happens, it could lead to lower mortgage spreads and rates.

Your next question will come from Eric Hagen with BTIG.

Can you walk through the approach behind raising the preferred stock and how much leverage in the capital structure you feel like you're comfortable taking both maybe in the near and longer term? And just generally, I mean, what are the variables that you consider when raising preferred stock as like a substitute for common stock?

Sure. It was great to access that market again. When was the last time we were active there? I think we were out for about five years. That market has been inactive for a solid four years, so reopening it was important. We were the second transaction to occur in that market, and from our view, it had a higher coupon than what we had issued before, aligning well with our floating rate breakevens. The coupon for that transaction was 8.75%, and it performed really well in the aftermarket, which makes us quite pleased. The 8.5% coupon is significant for our common shareholders' economics; if we reinvest the proceeds from the preferred in the way we leverage it, we could generate a return of about 16%. This means an additional 9% of return will benefit our common shareholders. We aimed to push the issuance and increased our preferred percentage to around 18% of our total capital mix after that transaction. This feels like a solid balance in our capital structure, though it could be slightly higher. In the past, it has reached between 22% and 25% at its peak, giving us some flexibility. We wanted to seize the opportunity of this market reopening because we believe it will lead to more earnings for our common shareholders due to that preferred stock.

Our last question for today will come from Jason Weaver with Jones Trading.

Peter, can you talk a little bit about how you see the prepay risk in those higher coupon 30s in the 6% and 6.5% range? I think a bit under half are spec, but what specific type of collateral protection are you focusing on there?

Yes. It's an important point. That's one of the reasons we provide a table showing what we call high-quality prepayment characteristics. There are other characteristics we look for beyond just low loan balance that also offer prepayment protection. As mentioned in our presentation, 76% of our portfolio includes these additional characteristics. Regarding higher coupons, we clarify that 39% have high-quality prepayment characteristics and 37% possess other valuable traits. These other traits can include factors like loan age, credit scores, FICO, geography, and specific areas, all of which play a significant role. For our higher coupons, almost all, in the high 90s percentage, have embedded prepayment features that we prefer. Even with some higher coupons exposed to prepayment risk in the current environment, we remain aware of the characteristics of those pools. We aim to source pools that we believe will provide more stability in cash flows. We have reduced our exposure to higher coupons, so the ones still in our portfolio have desirable characteristics.

That's helpful. And then maybe one more for Bernie. I know you gave an unchanged book value estimate to date, but can you give me any sense of the level of liquidity into October and whether it's substantially different from your cash on hand at quarter end?

Sure. Yes, our liquidity is largely unchanged since quarter end.

We have now completed the question-and-answer session. I would like to turn the conference back over to Peter Federico for concluding remarks. Please go ahead.

I appreciate everyone joining our call today. We are happy to report the results from the third quarter, which may be one of our fourth best quarters in the last ten years. We are pleased to deliver this for our shareholders. We remain optimistic about the outlook for the agency market and for our business. We look forward to speaking with you again at the end of the fourth quarter, sometime in January.

Thank you for joining the call. You may now disconnect.