Earnings Call Transcript - AGNC Q4 2020

Operator, Operator

Good day and welcome to the AGNC Investment Corp. Fourth Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note today's event is being recorded. I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please, go ahead.

Katie Wisecarver, Investor Relations

Thank you all for joining AGNC Investment Corp.'s fourth quarter 2020 earnings call. Before we begin, I'd like to review the safe harbor statement. This conference call and corresponding slide presentation contain 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.

Gary Kain, CEO

Thanks Katie and thanks to all of you for your interest in AGNC. Our portfolio continued to perform extremely well in Q4, supported by very attractive funding and ongoing large-scale Fed MBS purchases. Most importantly, the positive 7.5% economic return in Q4 lifted our full year 2020 total economic return to positive 3.5%. As a reminder, economic return is the combination of dividends paid plus the change in our book value. In 2020, the $1.56 in cash dividends paid during the year more than offset the $0.95 per share decline in our book value. This is a very favorable result, given the 23% book value decline in Q1 and the significant full year losses experienced by many of our peers. During the fourth quarter equity markets continued to show substantial strength, and credit spreads tightened, as optimism around additional fiscal stimulus and vaccine efficacy boosted the prospects for a second half 2021 recovery. Consistent with this stronger economic outlook, the yield curve began to steepen, with longer-term rates rising modestly, a trend that has continued in January. Agency MBS performance was strong during the quarter across the board, with lower coupons outperforming. MBS continued to benefit from ongoing Fed support, limited interest rate volatility, and strong dollar roll funding levels. Looking ahead, the improvement in the valuation of all financial assets, including agency MBS over the last several quarters does reduce the expected return profile on new investments. That said, agency MBS are still attractive on a relative basis for levered investors, given the dual benefits of low funding costs and continued Fed purchases. Importantly, the near-zero interest rate environment is likely to be with us through at least 2023, and it is unlikely we will see any tapering of MBS purchases before early 2022. Even after the Fed stops growing their balance sheet, they will likely remain very active in the mortgage market, replacing the runoff in their portfolio, until they begin to raise short-term interest rates. At this point, I will turn the call over to Bernie to review our financial results for the quarter.

Bernie Bell, CFO

Thank you, Gary. Turning to slide 4. We had total comprehensive income of $1.16 per share for the fourth quarter. Net spread and dollar roll income excluding catch-up AM was $0.75 per share. The $0.06 decline from our recent third quarter peak of $0.81 per share was largely attributable to lower prevailing yields on new asset purchases and the funding advantage of our TBA dollar roll position moderating somewhat during the fourth quarter. As I mentioned on our last call, looking ahead over the next several quarters, we expect this general trend to continue. That being said, we still expect our net spread and dollar roll income to remain well above early 2020 levels. Tangible net book value increased 5.2% for the quarter, largely due to the strong performance of our lower coupon assets. Including dividends of $0.36 per share, our economic return on tangible common equity was 7.5% for the fourth quarter. So far this month, as of last Friday, we estimate that our tangible net book value is up about 3%. Turning to slide 5. Our investment portfolio at quarter end totaled $97.9 billion largely unchanged from the third quarter. Our ending leverage was 8.5 times tangible equity, down from 8.8 times as of last quarter end, largely due to book value appreciation. Our liquidity position remained very strong in the fourth quarter with cash and unencumbered agency assets totaling $5.4 billion at quarter end, which excludes both unencumbered credit assets and assets held at our broker-dealer subsidiary Bethesda Securities. Actual prepayment speeds on our portfolio increased to 27.6% for the quarter. But importantly, this does not include the lower coupon component of our holdings held in TBA form. Our forecasted life CPRs increased to 17.6% as of quarter end from 15.9% the prior quarter, largely due to a 20 basis point decline in primary mortgage rates during the quarter. Also notable during the fourth quarter, we completed an additional $101 million of accretive common stock repurchases at an average repurchase price of $15.32 per share. Moving to slide 6. For the year, we had total comprehensive income of $0.47 per share and $2.70 of net spread and dollar roll income excluding catch-up AM. And as Gary mentioned, despite the extremely challenging market conditions earlier in the year, we generated a 3.5% positive economic return for the year. Lastly, demonstrating our commitment to shareholder-friendly capital markets activities, we completed $1.4 billion of accretive capital transactions during the year, including $402 million of common stock repurchases or 5% of our outstanding common stock. With that, I'll turn the call over to Chris to discuss the agency mortgage market.

Chris Kuehl, Executive Vice President

Thanks, Bernie. Let's turn to slide 7. Following the election and vaccine news, interest rate volatility continued its downward trend with rates gradually moving higher on the longer end of the yield curve. A steeper curve, lower interest rate volatility, and the steadfast commitment from the Fed to maintain its current policy until substantial further economic progress is made provided a strong tailwind for risk assets and in particular agency MBS. As you can see agency MBS prices were higher across the coupon stack, despite 10-year notes selling off 23 basis points in yield or a little more than two points in price, even longer duration lower coupon MBS ended the quarter higher in price. Specified pool performance, while generally positive versus hedges, underperformed the tightening in lower coupons during the quarter. Let's turn to slide 8. As you can see in the top left chart the investment portfolio at $98 billion was little changed as of December 31st. Given attractive spreads and favorable demand technicals for lower coupon 30-year MBS, we incrementally trimmed higher coupon holdings during the fourth quarter in favor of production coupon MBS. However, with the outperformance of lower coupons in the fourth quarter and since year-end, the relative value equation between higher coupon specified pools and production coupons is balanced now and unlikely to drive further compositional changes outside of the natural replacement of runoff. Importantly, we maintained a large TBA net roll position of $33.8 billion during the fourth quarter as roll implied financing continued to trade exceptionally well particularly during the first half of the quarter. Roll implied financing cheapened noticeably into year-end, but remains attractive in some coupons. Looking ahead, while agency mortgage spreads have tightened considerably over the last six months, this performance is not unique to the sector. Corporate debt, residential credit, CMBS have all performed well and some relative value relationships still suggest that agency MBS have further room for spreads to tighten, particularly given the backdrop of ongoing Fed purchases, attractive funding, and a prepayment environment that is likely to improve during 2021. I'll now turn the call over to Aaron to discuss the non-agency market.

Aaron Pas, Senior Vice President

Thanks Chris. I'll quickly recap the quarter our current positioning and then provide an update on our outlook for housing and credit. Please turn to Slide 9. After risk assets widened briefly in October, the rally was back on track for the rest of the quarter. Event risk associated with the election dissipated and the market received several rounds of positive news on the vaccine front. The combination of expectations for additional stimulus coupled with a light at the end of the tunnel due to the vaccine allowed credit investors to look through any near-term adverse data and COVID concerns. With that as a backdrop, structured products continued to perform well with both highly rated cash flows, as well as credit-sensitive assets resetting to much tighter levels. With respect to our holdings, our credit portfolio grew over the quarter through incremental CRT investments and price appreciation of our holdings. We found some value in certain lower credit CRT which largely drove our position increase in Q4. And over the quarter spreads tightened across virtually all our holdings, and in some cases have now retraced to much tighter levels than pre-COVID. Fortunately, some of the retracement in asset spreads has filtered through into repo rates with borrowing rates relative to LIBOR now approaching levels of early last year. Turning to the housing backdrop. As we said last quarter housing fundamentals in the aggregate remained strong and we see little risk to this changing in the near term. This should remain a tailwind and provide support to residential credit performance, a view held by many market participants, which has been a large driver of where spreads are today. With that said, there is increased risk in some higher-priced areas of the country that may face negative headwinds on the migration front. This can be attributed to several factors such as state tax policy, high cost of living, and related to that the significant increase in work from home or work from anywhere trends. If this trend continues it will likely take years to play out but could have a material impact. While we do not see this being an issue for our current positioning in mortgage credit we cannot ignore this risk when evaluating incremental investments with certain exposures. With that I'll turn the call over to Peter to discuss funding and risk management.

Peter Federico, President and Chief Operating Officer

Thanks Aaron. I'll start with our financing summary on Slide 10. Our average repo funding cost for the fourth quarter was 38 basis points, down two basis points from the prior quarter. Our funding cost at quarter end, however was materially lower at only 24 basis points as some of our higher cost longer-term funding matured late in the quarter. Importantly, the funding curve also flattened materially during the quarter, driven by a decline in the cost of longer-term repo. Today, for example, longer-term repo in the 12- to 18-month area costs around 20 basis points depending on whether it is sourced through our captive broker-dealer or direct with a counterparty. Given this favorable funding environment, I expect our average repo cost to remain relatively stable at around 20 basis points over the next several quarters. Our aggregate cost of funds which includes the costs associated with our TBA position, as well as the cost of our swap hedges, declined more sharply in the fourth quarter to 5 basis points from 15 basis points the prior quarter. This improvement was due to the combination of lower repo cost, continued very attractive dollar roll funding levels and somewhat lower swap costs. The improvement in our cost of funds, however, did not fully offset the decline in our asset yield. As a result, our net interest margin decreased modestly to 202 basis points in the fourth quarter, down 13 basis points from the prior quarter. Looking ahead, I expect our net interest margin to be biased somewhat lower as asset pay downs are replaced with new purchases at current yield levels. On slide 11, we provide a summary of our hedge portfolio, which increased significantly from the prior quarter. In aggregate, our hedge portfolio totaled $67 billion, up from $60 billion the prior quarter as we added meaningfully to both our swaption and short treasury positions. These positions were concentrated in the 10-year part of the curve and as such provided us incremental protection against the steepening of the yield curve similar to what occurred in the fourth quarter. Given this increase, our hedge ratio at quarter end increased to 80%, up from 71% the prior quarter. This increase reflects a continuation of the theme that we discussed on our last couple of earnings calls, which is that the macroeconomic risk is shifting more toward higher rates. Lastly, on slide 12, we show our duration gap and duration gap sensitivity. Our duration gap at the end of the quarter was negative half a year. This negative duration gap is consistent with the increase in our hedge portfolio, the shortening of our asset durations and our bias in the current environment to operate with incrementally more uprate protection. With that I'll turn the call back over to Gary.

Gary Kain, CEO

Thanks, Peter. Before I open up the call for questions, I wanted to highlight a few new slides we added to the appendix this quarter that provide a longer-term perspective on AGNC's absolute and relative performance. Like the rest of the public equity space, we tend to focus our earnings calls on quarterly performance and near-term outlooks. And in the process, we're probably doing AGNC investors a disservice, if we don't periodically address the longer term. As slide 28 illustrates, AGNC has outperformed both the S&P 500 and our peer group average from a total stock return perspective since our May 2008 IPO. In fact, we are one of only two residential mortgage REITs in existence at the time of our IPO that has outperformed the S&P 500 since that date, and we are the top-performing mortgage REIT over this 12-plus year time frame. On slide 29, we show our total stock return comparison over time versus some relevant benchmarks. The key takeaway is that AGNC's outperformance of the S&P 500 and other benchmarks has occurred over an extended period that has included a wide range of interest rate environments and despite some very challenging episodes including the great financial crisis, the Taper Tantrum, Brexit and the global COVID-19 pandemic. While some of these events adversely impacted AGNC's short-term performance, the long-term trend line is unmistakable. On slide 30, we compare AGNC's yield to traditional yield vehicles. And again, the result is noteworthy. As you can see AGNC's 9.2% dividend yield is not only a multiple of traditional yield vehicles, but it is particularly noteworthy given the low yield levels available across the broader financial markets. Over time, these dividends really do add up. And to this point, AGNC has paid a total of $42.88 per share in dividends since its IPO back in 2008. Finally, expense structure is always a critical consideration for investment vehicles. On the last slide, we show AGNC's operating cost structure, which as a percentage of stockholders' equity is the lowest in the industry at 87 basis points. On a per asset basis, this translates to under 10 basis points, which is in line with lower cost bond ETFs. Expense structure for an internally managed REIT is analogous to the fees charged by a mutual fund or other asset manager and so having lower expenses directly translates to higher realized returns for an investor. It is a unique opportunity to be able to combine industry-leading returns with the lowest cost vehicle available in the mortgage REIT space. Collectively these slides illustrate why we believe AGNC is a great long-term fit for virtually any portfolio. This is especially true when you consider that the lack of credit risk in our portfolio reduces AGNC's correlation with a typical pro-cyclical stock portfolio. So, with that let me open up the call to questions.

Operator, Operator

Thank you. We will now begin the question-and-answer session. Today's first question comes from Doug Harter with Credit Suisse. Please go ahead.

Doug Harter, Analyst

Thanks. Gary following up on kind of the power of the dividend. Can you just talk about your dividend outlook for this year and whether now that we've flipped into 2021 whether that changes the need for distributions from a taxable standpoint?

Gary Kain, CEO

From a taxable perspective, we have significant flexibility regarding our dividend decisions. Historically, in the mortgage REIT sector, the requirements for taxable distributions forced us to pay out nearly all our income in taxes. However, our current approach with dollar rolls and the distinctions between taxable income, accounting income, and true economic income have alleviated that constraint. This shift allows us greater freedom in our dividend policies compared to five or ten years ago, enabling us to function more like a typical company. When we examine the mortgage REIT sector, particularly AGNC, it's clear that we are not restricted by tax-related issues. The current yield of around 9% for AGNC stands out as very appealing when comparing other income options in the market. We're pleased with our position, seeing positive outcomes for investors. Over the past few quarters, we've maintained a dividend of 9% or more, repurchased stock, increased our book value, and witnessed a rise in stock prices. Our main aim is to achieve the best risk-adjusted total returns for our shareholders, balancing dividends with stock price and book value growth. We're optimistic about this trend over the last three quarters, and indications show that book value has gone up by 3% in January. We will continually assess the dividend moving forward, as it's an essential aspect of how AGNC supports its shareholders. However, it's not the sole focus; the synergy between dividends and book value, reflected in stock prices, is crucial. We remain committed to buying back stock judiciously, believing it offers the best long-term benefits for our shareholders.

Doug Harter, Analyst

Great. Thank you, Gary.

Gary Kain, CEO

You’re welcome. Thank you.

Operator, Operator

And our next question today comes from Eric Hagen with BTIG. Please go ahead.

Eric Hagen, Analyst

Hey, good morning guys. First question just thinking about the backdrop of spreads being tight. Where do you see AGNC adding the most alpha in the portfolio over the near term? Do you see it coming more from the asset selection side, or maybe actively managing the hedging side with duration positioning? And maybe you can talk about the general approach given your outlook for spread volatility and such. And then the second question, can you talk about what you like in the portfolio of higher coupon specified pools specifically the 3.5s and 4s. Maybe you can go into some detail around how you think about owning them relative to lower coupon TBA? Thank you.

Gary Kain, CEO

Yes. I will start briefly and then pass it over to Chris. To provide some overarching context, I want to revisit points Chris and I made earlier in our prepared remarks. First, it's important to note that agency MBS have become more expensive, and we've observed three quarters of solid spread performance. The initial one to two quarters were largely about recapturing prior widening. However, recent movements have certainly made mortgages pricier than long-term averages. It's crucial to view AGNC and the mortgage market within the broader context; we must acknowledge the strength in financial assets overall. Viewed from this perspective, agency MBS appear relatively attractive. They benefit from present bond market conditions, characterized by very low funding costs and Federal Reserve support through MBS purchases. This makes us unique beneficiaries, particularly as a leveraged investor who depends on favorable funding conditions. With that in mind, we've held the view in recent quarters that lower coupon MBS and dollar roll opportunities were more appealing compared to higher coupons. However, this has now started to normalize. So, in terms of how we create value, I believe it lies in strategically adjusting our leverage and capital deployment, as well as on the hedging side. We have introduced options to shield the portfolio from rising rates, and we implemented these measures before the recent uptick in rates. These strategies will continue to enhance AGNC's profitability and safeguard the portfolio from possible shocks. Now I'll let Chris elaborate on specifics regarding higher coupons and related opportunities.

Chris Kuehl, Executive Vice President

I want to highlight that the gross return on equity before convexity costs for both higher coupon specifications and production coupon TBA is currently in the high single digits without any roll specialness. In the fourth quarter, we transitioned some of our 15-year TBA positions to spec pools, and within the 30s, we moved out of several spec positions into lower coupon TBA. Over the past few quarters, we've been actively trimming positions in higher coupon specs in favor of production coupon TBA due to the significant recovery in pay-ups that primarily occurred in the second quarter, all while production coupons remain very cheap and rolls have been exceptionally strong. As Gary pointed out, this strategy has yielded positive results, with lower coupons significantly outperforming recently. However, considering the performance of lower coupons, the relative value has now reached a balanced state. Nevertheless, I believe that due to strong technical factors and still reasonable absolute valuations, production coupons are unlikely to widen in the near future. On balance, our reinvestments will likely target both production coupons and some pools.

Eric Hagen, Analyst

Thank you guys for the very good answer, appreciate it.

Gary Kain, CEO

You’re welcome.

Operator, Operator

And our next question today comes from Bose George with KBW. Please go ahead.

Bose George, Analyst

Hey, guys, good morning. Just to follow-up on Eric's question. So you said the gross ROEs in the high single digits. Can you just go into the contribution from the TBAs? You said, I guess, a 10 to 15 basis point benefit? Is that like another whatever 1% - 1.5% of ROE?

Chris Kuehl, Executive Vice President

Yes, rolls have traded in a wide range recently, between 10 basis points and 100 basis points through repo. For context, 25 basis points of specialness roughly adds 2% to the gross ROE. As I mentioned earlier, the implied financing rates on production coupons are currently on the lower end, around 10 to 15 basis points to repo. I believe there is potential for rolls to perform better from this point. The positioning in the latter half of the fourth quarter has started to feel a bit heavy after the extreme levels we've experienced over the past six months. Considering the current levels, which are generally in line with long-term historical norms, some temporary positions may exit or convert to pools, which could be beneficial. However, I do not expect us to return to the Q3 levels, but I do think rolls will improve and trade better than just the long-term averages due to the current Fed policy.

Gary Kain, CEO

For every 25 basis points of specialness, it adds approximately 2% to ROE. So if rolls are 25 basis points special, you add 2; if they are 50 basis points special, you add 4. At the peak of 100 basis points special, you add 8 to ROE. This is a quick way to estimate the impact.

Bose George, Analyst

Okay, great. That's very helpful. And then, actually you noted also obviously the other variable in the return is leverage. Can you just talk about the backdrop you need to see for leverage to go up from here?

Gary Kain, CEO

Sure. I think the short answer is again we're very comfortable with the risk-return profile of Agency MBS. But again they've clearly appreciated. And so, in light of that in this kind of environment, we're operating toward the lower end of kind of our leverage range that we would normally operate in. But we do expect volatility. We do expect there may be some false alarms around the taper tantrum. We do expect at some point down the road a real tapering obviously, but we think that's a fair amount further out. So, as the opportunities present themselves, we have plenty of dry powder. We're operating with more liquidity than we probably ever have in the history of the company, given the composition of our portfolio between pools and TBA, given Bethesda Securities and the advantages that presents. So we've got a lot of dry powder. We'll look at opportunities within the Agency sector should they arise, and are certainly willing to dedicate more capital outside of the agency space. But as we've said, the tightening has kind of filtered through everywhere. But hopefully that helps.

Bose George, Analyst

Yes. No, that's very helpful. Let me just sneak in one more just on prepay expectations.

Gary Kain, CEO

Sure.

Bose George, Analyst

I'm curious about your thoughts on the many originators going public with strong growth expectations. How do you think that will impact prepayments this year?

Gary Kain, CEO

I’ll be brief, and maybe Chris will want to add something later. We’ve noticed a significant tightening of the primary and secondary spread, particularly in the fourth quarter and so far this year, and there’s still some room for that trend to continue. Essentially, even if interest rates rise, mortgage rates may not have to follow suit. On the flip side, we've experienced a period of rapid prepayments affecting many segments of the mortgage market, with a large portion still being refinanceable. However, we anticipate some burnout; if individuals haven't refinanced when given a great opportunity for nine months, it raises the question of why they would wait until the 11th month to act. It is still too soon to conclude that we are beyond the refinancing wave; that's definitely not the case. However, there is reason to believe that especially if the yield curve continues to steepen, or even if we remain at these mortgage rates, prepayments may begin to slow down. For the first time in a while, I believe there is more potential upside than downside regarding prepayments. Chris, do you want to add anything?

Chris Kuehl, Executive Vice President

Certainly. To address your first question, banks have certainly lost market share to more efficient nonbank lenders over the past few years, and I believe this trend will likely continue to some extent. As Gary mentioned, we are starting to notice encouraging signs regarding prepayments, particularly with the recent January Factor reports showing an increase of about two CPR, or roughly 6%, in the 30-year universe. Although the day count indicated speeds should have risen by approximately 15%, everything else being equal, driving rates were slightly lower during that period, which is a positive sign. Moreover, the primary-secondary spread contraction of around 20 basis points in the fourth quarter implies that capacity constraints are beginning to ease, compelling lenders to compete more on pricing to sustain their volume. This suggests that we may have reached peak levels. With primary and secondary spreads moving closer to normalized levels, as treasury rates and secondary mortgage rates rise, most of that increase should be passed on to borrowers. However, with 80% of the market still motivated to refinance, prepayment risk remains quite high. Overall, there are indeed some positive signs emerging.

Bose George, Analyst

Okay, clear. Thanks a lot.

Operator, Operator

Our next question comes from Charlie Arestia with JPMorgan. Please go ahead.

Charlie Arestia, Analyst

Hi, good morning everybody. I'm on for Rick today. I was wondering if you could talk a bit more about your interest rate sensitivity table. I think it's on slide 26. Where it looks like portfolio values remain pretty stable within a rate shock of 50 bps up or down, but that impact becomes more severe the next 25 bps in either direction. Given the increased hedge ratio and particularly growth in that swaption book that presumably mitigates some tail risk. Can you help me understand the impacts of these rate shifts on the portfolio and why they are nonlinear as the shocks get more severe?

Peter Federico, President and Chief Operating Officer

Hey, hi, Charlie. This is Peter. Well, you're exactly right. I mean, what you're seeing there is the negative convexity profile of the mortgage universe. And you reach a certain point where that convexity profile starts to change. Right now we happen to be at a point both in the mortgage universe and in our portfolio where we're pretty close to peak convexity. So as you get to the further ends of the distribution, you're exactly right that the market value sensitivity will start to change with that. What you're also seeing in this table is how our portfolio rebalancing is interacting with that convexity profile. For example, we have less up rate exposure in this table this quarter than we had last quarter because of the options that we had. Those options are going to give us a lot of protection up 50 and 100, but they'll have incrementally more protection because of their convexity profile once we get 100 or 150 or 200 basis points up. So you can't see that here. We're also starting with a negative duration gap in this table, which is one of the reasons why we have a little bit more exposure to the down rate scenario. So you're right. This table interacts with the overall convexity profile of the market and our portfolio it's going to change with that. And that's one of the reasons why we have to be dynamic in managing our exposure as the interest rate environment changes, and we alluded to the fact that we do think that you're starting to see the risk of more up rate paths right now versus down rate, obviously, rates can move in both directions, but we think with the economy starting to show some signs of recovery, the vaccine starting to be rolled out, that incrementally there's a little more upside to rates as opposed to downside. And so, we're going to continue to manage it that way.

Gary Kain, CEO

The other thing just to keep in mind in the down 100 case, which is kind of the biggest change from the prior quarter is, the simulation floors rates at zero. And so, there is actually down 100 for the 10-year, whereas the last time around the 10-year was below 1%. So there was no sort of down 100. But just understand what that environment relates to that would basically be all rates 10 years and in under 10 basis points, right? And it now brings the mortgage rate under 2% in the base part of that shock. We would clearly rebalance in that scenario. But look, if the circumstances that would lead to that would definitely challenge a lot of different investments across the board. And to Peter's point, look, right now, we feel that it is better to protect against an increase in the back end of the curve and take a little more exposure into a rally and that you're actually seeing that in those tables.

Peter Federico, President and Chief Operating Officer

Yes. To elaborate, one of the reasons we introduced options in the fourth quarter was due to the attractive pricing resulting from low interest rate volatility. We added approximately $5 billion in purchases during the quarter, though the net change was only $3.5 billion. We saw this as a significant opportunity to enhance our portfolio with options.

Charlie Arestia, Analyst

That's very helpful color. Thank you, both. And if I could squeeze in one follow-up based on just some comments in the prepared remarks. I think Chris mentioned, you could still see room for spreads to tighten from here. I'm just wondering what scenarios are you guys envisioning where spreads could possibly move materially wider from where they are here?

Chris Kuehl, Executive Vice President

Yes. I would just say the relative value picture across fixed income is still a positive for Agency MBS. Whereas I'd say, if you compare that to QE3, it was a headwind. Other sectors have tightened along with Agency MBS, and so relative valuations still look attractive whereas in prior periods of QE this wasn't the case. Production coupon nominal spreads are still around 15 to 20 basis points wide to sort of two-month average tights during QE3 or more like probably 35 to 40 basis points wide to the absolute tights. And then you look at other sectors like Agency DUS, IG, high yield, where current spreads are much, much tighter than prior periods of QE. And as Peter mentioned, implied volatility being lower today than that period that also benefits Agency MBS much more than other sectors. So, given the backdrop of the support from the Fed, it wouldn't surprise me to see spreads have a little more room to tighten.

Gary Kain, CEO

Yes. The widening you mentioned is likely to occur significantly when the Fed decides to taper. However, I believe that this widening will be distributed across all financial assets, and I wouldn't anticipate that MBS will be the most adversely affected. While this is still some time away, it’s important to keep it in mind.

Operator, Operator

Thank you. Our next question today comes from Brock Vandervliet with UBS. Please go ahead.

Vilas Abraham, Analyst

Hey guys. This is Vilas in for Brock. Just on the tapering, I heard your comment on early 2022 and it's unlikely that before that tapering happens, where do you think the market is at in terms of expectations there? And what would be like a downside surprise? And I guess in terms of the portfolio, is there an appropriate way that you're thinking of positioning into that event even though it's a while out potentially?

Peter Federico, President and Chief Operating Officer

Vilas, hi, it's Peter. Let me start with that and then I'll have Gary talk a little bit about the specifics to the portfolio. But I think you're raising an important point about the market's concern about tapering. And I think the important thing for everyone to understand is how different the environment is today versus 2013. Obviously, 2013, it was a dramatic move in the market. But you have to think about how different the environment is today versus then. Just first with respect to the Fed in their current position, they're much more transparent, much more deliberate; their inflation target is different. They're using forward guidance. So we have much more stability from a rate perspective with respect to the Fed's monetary policy. Second, we have a much, much different view today about the Fed holding mortgages and treasuries on their balance sheet. If you recall, they had grown their balance sheet from $0 to $3 trillion-ish in 2013. And all of the discussion was how quickly can they get back to zero. Today they have $7-plus trillion, and the discussion is not at all about whether they can continue to hold that. So we have a very different position from a balance sheet perspective. And then lastly, we now have sort of a playbook for what tapering looks like. And in fact, the Fed's already indicated that they'll likely do what they did last time which is like Gary said, once they start to shift monetary policy, perhaps late this year or early next year, we sort of know that they're going to taper over eight, nine, 10 month period. And then really importantly, they'll continue to reinvest after that until they ultimately raise rates. So it's a much more predictable framework today, which I think ultimately leads to lower volatility response. But clearly, as Gary pointed out, there will be some response in the mortgage market.

Gary Kain, CEO

I would like to add two points to the discussion. Firstly, the earliest we might see tapering is likely in the fourth quarter, assuming everything goes right—the vaccines have a strong impact in the latter half of the year, employment trends are positive, and inflation rises rapidly. However, this is a very optimistic scenario. A more realistic baseline would be the first half of 2022, where employment improves and the economy rebounds. Additionally, as Peter mentioned, there is a possibility that they might increase quantitative easing if those positive outcomes do not materialize. While it's not our current expectation, it remains a possibility. Furthermore, it’s important to emphasize that this Fed has committed not to preemptively react to inflation increases, unlike previous instances. They raised rates in 2017 but later reversed that decision. This current Fed is taking a different approach and will not act preemptively, which is significant. When they do begin tapering, the effects on the mortgage market will depend on prevailing pricing and prepayment speeds at that time, which will specifically influence our portfolio. We have strategies in place to handle this, including leverage and hedges. Historically, the agency mortgage market experienced a significant impact last time, but currently, the Fed's liquidity is being spread throughout the markets, which should lessen the effect on the agency sector. Additionally, the prepayment situation is more challenging now than it was in 2012 and 2013. Back then, many specified pools were yielding low double digits, which did not benefit from rising rates. Today, even strong specified pools are yielding in the 20s, with many at 30 or more. Therefore, in the event of rising rates and wider mortgage spreads, there will be some offset to these negatives due to prepayment dynamics. Although this may sound technical, there are valid reasons to be optimistic. As Chris pointed out, we are currently seeing wider levels for mortgages too. We've gained valuable insights from past experiences in the mortgage market, which should lead to improved positions moving forward. There are numerous factors to consider, and while we are preparing defensively for higher rates, we also recognize that such changes are still some time away, and we possess the tools needed to manage these situations effectively.

Vilas Abraham, Analyst

If I could, I'd like to ask one more question about the uniqueness of the situation as we approach that event. Is it reasonable to assume that some adjustments will be necessary as the Fed is anticipated to step back? I know you've discussed this previously, and there are additional factors to consider as well. Any comments on this would be appreciated.

Chris Kuehl, Executive Vice President

I think the Fed's presence will continue to be significant even after they begin tapering and cease expanding their balance sheet. As Peter mentioned, if we look at previous periods of quantitative easing as a reference, they are likely to reinvest paydowns, which are currently about $85 billion per month. This figure is expected to decrease when the Fed starts tightening policy. However, they will probably keep reinvesting paydowns long after they stop growing the balance sheet, likely until at least the first rate hike. Therefore, the Fed's technical stance will remain very supportive in terms of managing the monthly float and facilitating roll financing. It is anticipated that the Fed's mortgage position could increase by another $400 billion to $500 billion this year, leading to a total mortgage position of around $2.5 trillion, where reinvestments are happening back into the market to manage the float.

Operator, Operator

Thank you. Our next question today comes from Trevor Cranston with JMP Securities. Please go ahead.

Trevor Cranston, Analyst

Hi. Thanks. Most of my questions have been asked, so maybe one more follow-up on the decline in roll specialness. Looking at slide 10, it looks like the average cost of funds on TBAs was negative 54 bps in 4Q. And I think Chris said, you guys currently see rolls around 10 basis points special versus repo. Can you just sort of talk about how you guys are thinking about the cost of funds side heading into 1Q? And sort of how much that differential between kind of where the rolls were in 4Q and where you see them today is likely to impact cost of funds? Thanks.

Peter Federico, President and Chief Operating Officer

Sure Trevor, thank you for the question. Another helpful resource is Table 17, which outlines the cost of funds in two parts. You're asking a great question regarding the key factors in our cost of funds. The first is the repo cost, which was 38 basis points last quarter and ended at 24 basis points. Given the current prevailing rates, I expect that repo cost will decrease from 38 basis points to a stable range in the 20s and low 20s. The TBA component was negative 58 in the third quarter and then 54, which is a variable that we can't fully predict. It will change throughout the quarter, complicating our forecast. As Chris noted earlier, that range has fluctuated from 10 basis points to 100, currently around 15 basis points, with the expectation of improvement. However, we will have to wait to see where it lands in the first quarter; we believe it is improving, but it may end up lower than the fourth quarter. Regarding the swap cost, I expect it to remain stable but to rise slightly, as adding hedges will increase costs. However, I don't foresee significant changes in our cost of funds, which is close to zero and likely to remain in the range of zero to 10 basis points over the next quarter or two. We can't provide more precision as we need to observe how roll specialness develops, but we believe it will improve from the 10 to 15 basis points range that Chris mentioned.

Gary Kain, CEO

But you should expect the dollar roll – you should expect the funding levels on TBAs to be higher, noticeably higher this quarter than last quarter at this point.

Trevor Cranston, Analyst

Okay. That's helpful.

Peter Federico, President and Chief Operating Officer

Thank you, Trevor.

Operator, Operator

Ladies and gentlemen, today's final question comes from Kevin Barker with Piper Sandler. Please go ahead.

Kevin Barker, Analyst

Thank you. Just a follow-up on your comments off the dividend yield and the outlook for the dividend, the point that you made about how you have a lot of flexibility there. Do you feel that just generally that the market is prepared to accept lower dividend yields for lower risk just given all of the volatility that we saw in the past year? Do you feel like that could be start to be accepted by the market and maybe a lower risk portfolio will be appropriately priced in the market compared to what it has been in years past?

Gary Kain, CEO

It's interesting, the way you worded that question. I'm not sure in a sense, the market's pricing of different positions. And I don't mean just the mortgage REIT space. I could say, the broader equity markets, is sort of in a different category today than it's been in a long time, and long time probably since the late 1990s. And so what I would say is, we have confidence in the markets over time. And from a management perspective, it's our responsibility to make those trade-offs in terms of leverage, in terms of risk management, and to evaluate those, and do what we think is best for our investors over the long run and not obsess necessarily about how that's going to be received in the very short run. I mean, like to your question, I'll just say, like it would have been – it's very easy. Given our net spread and dollar income, given the category it will be in, all right? It would be very simple and it would be well received to raise the dividend here. It's – I mean, and yeah, we think the stock would like that in the short run, but we think that we should be prudent about where interest rates are, where yields are on other vehicles forgetting just the mortgage REIT space. We're not obsessed with where a couple of our peers are or stuff like that. We think that it's – this is why people trust management over time is to make those kind of trade-offs and to understand that sometimes they won't necessarily be well received for a quarter or two. But over the long run and we talked about our long-term track record, you generate those – that kind of track record by making good prudent risk management decisions over time, and we value stability and we think investors do. So, now I'll come back to – look, we'll – our leverage decisions, our hedging decisions will be made with preserving and enhancing the long-term net present value of the company. And we know that over time that will be received – will be rewarded by shareholders, and it will reward shareholders. But especially in today's market, but even in other markets, you try not to – you can't help but think about it, but you try not to obsess about the short-term reaction in the stock market.

Kevin Barker, Analyst

Thank you. That's very helpful. All my other questions have been answered. Thanks.

Gary Kain, CEO

Thank you. Appreciate the question.

Operator, Operator

Ladies and gentlemen, this concludes the question-and-answer session. I'd like to turn the conference back over to Gary Kain for closing remarks.

Gary Kain, CEO

I'd like to thank everyone for their interest in AGNC, and we look forward to talking to you again next quarter.

Operator, Operator

Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.