AGNC Investment Corp. (AGNC) Earnings Call Transcript & Summary

All right. Good afternoon, everyone. Thank you for joining me. I'm Carter Smith with Barclays, and I'm pleased to be joined here by Peter Federico, CEO of AGNC Investment Corporation. Today's presentation will be a fireside chat. I have a prepared list of questions here in front of me, but feel free to raise your hand and asking questions throughout. I'll take a couple of points here to make sure any audience questions are being answered. But first, Peter, again, thank you for being with us today. Can you please just discuss are how the agency MBS market has performed quarter-to-date so far?

[Technical Difficulty] interest rate volatility was coming down. That was a really good environment for agency mortgages, and they performed very well and spreads tightened fairly meaningfully July and into early August. But then if you recall, the sentiment started to shift mid-August in anticipation of the Jackson Hole Conference, Fed becoming more hawkish, a little more concern about the inflation data. Interest rates rose significantly. Interest rate volatility went materially higher, and that was a much more negative environment for Agency MBS. So when you put those 2 periods together, mortgages are flat to maybe a little weaker as we sit here today, particularly after this morning's economic print and the weakness that the market is experiencing right now.

Okay. Can you talk about maybe the differences in performance from lower coupons, the higher coupons than spec pools compared to generics?

Well, again, it depends on the environment at the time period. But overall, lower coupons have generally speaking, done a little bit better this quarter than higher coupons. The production coupons are back to levels of spreads that we experienced in the second quarter. Up until this morning, lower coupons actually had outperformed and were a little bit stronger. But with this morning's inflation trend and the concerns about the Fed being more aggressive on their balance sheet, lower coupons have underperformed some. So it's probably closer to flat now, but lower coupons had outperformed and higher coupons have been the most attractive, if you will, from a return perspective.

Okay. And I guess going off of that, how do you view the forward relative attractiveness of lower-coupon, the high coupons? And again, I think the breakdown between 4 [indiscernible].

Well, I think the value in the agency space is in the higher coupons, in the production coupons. If you look at where those spreads are today, if you look at them on an OAS basis, current coupon spreads are probably above 40 basis points, again, where they were at the end of the second quarter after tightening early in the quarter. Nominal spreads are also just a very simple way of looking at the richness or cheapness of mortgages. If you look at current coupon to the 10-year, that spread at one point this quarter had gotten out to 155 basis points. It's probably around 150 basis points today. At that level, that's a level that typically represents a really attractive entry point for Agency MBS. So from our perspective, the return profile of higher coupon MBS continues to be really attractive. On a levered basis, returns for us are probably in the mid-teens range on those coupons. Lower coupons have a lower yield and a lower return profile and from a total return perspective, had the potential to perform fairly well. But those coupons in today's environment are much more exposed to the risk of the Fed's balance sheet. And so those coupons don't look as attractive to us for that reason. To the extent that the Fed wants to get rid of mortgages more rapidly than the current plan, which I don't think they will, but ultimately, that's the concern in the market is that the Fed owns 2% and 2.5% coupon. So those would be the coupons that would come under pressure. So that's an area that we would likely stay away from. You also mentioned TBA versus pool, another big shift during the quarter. TBA funding specialness, particularly in the second quarter, was really attractive, meaning that you could pick up significant incremental return by owning mortgages in TBA form and on-balance sheet one. That specialness has compressed like we expected in the third quarter. So there's not much of a funding benefit between owning a pool on balance sheet and off balance sheet. So putting that together, it's more likely that we would own mortgages and pool form than in TBA form going forward.

Okay. Given those pretty favorable return outlook, you've been hesitant to take up leverage so far. So how do you think that return outlook can hold to a point where you can increase that leverage after its higher return profile?

Well, a couple of things on that. If you look back at the -- at our second quarter earnings call, what I described at that time was what we believed was the beginnings of a shift in the outlook for Agency MBS. And the environment that we've been in, obviously, has been a significantly defensive environment because Agency MBS have been under such pressure now for about 4 quarters. But the outlook began to change in the second quarter and now still in the third quarter to be much more positive for Agency MBS. The big shift in dynamic that has occurred from where we were at the beginning of the year to now, is that the mortgage supply outlook is materially better. We expected $700-plus billion of supply at the beginning of the year, which would have made it the largest single issuance year in the agency market history. The outlook of supply today is much closer to $400 billion, and we've already gotten about $390 billion of that supply. So the supply of mortgages for the remainder of the year is going to be materially lower. So our outlook for mortgages is materially better today, the technicals are better. We still have the overhang of the Fed, but that led us to the view that we're more likely to take leverage up going forward as opposed to maintaining the more defensive position that we have for the last several quarters. So directionally, I think that still holds today, is it over time, we would return to more normal leverage levels, but we still have some uncertainty, obviously, to get through over the next couple of months with the Fed's final moves to pushing the Fed funds right up to its terminal rate.

Okay. And I guess based on the interest rate environment today, how long do you think that supply outlook could remain favorable for agency mortgage-backed securities.

I think it's only getting more favorable. I mean that's the thing. When you look at where the mortgage rate is earlier this week, it was at 6.25%. It's probably closer to 6.5% today. Think about that in comparison to where we were 1.5 years ago when it was [ 280 ]. That is a very significant meaningful increase that is really going to dampen the supply of new mortgages. It's not only going to dampen people's ability to purchase new homes and to move, but it's also going to significantly reduce the amount of cash refinance activity, cash out refis. And so there's another significant slowing of supply that we would have otherwise have gotten this year because there is significant equity buildup in people's homes. But that supply is not going to be able to come into the market with mortgage rates where they are. So I think the supply outlook is going to remain favorable for the foreseeable future well into 2023.

Okay. Got it. Turning to capital for a second. Earlier this week, you announced -- maybe last week, you announced the preferred issuance. Can you just talk about the move there and what your plans are with that issuance.

Sure. We did issue $150 million of fixed floating rate reset structure, which is [ interest ] 5-year fixed, and then it resets every 5 years thereafter, we think that's a really attractive investment option for investors. 7.75% coupon rate also, we think, was attractive. It was a well-placed deal, and we were happy with the deal. And you could think about that as giving us the additional capital flexibility for a number of things. One is just for -- to support new mortgage investments. If the return on new mortgage investments is in the mid-teens, and we can issue that preferred at below an 8% coupon, that there's meaningful potential additional accretion value for our common shareholders. We also have another preferred stock outstanding that will become callable. So it could be used for those proceeds as well. So we have a lot of flexibility with it, but we thought it was a really attractive issue for investors, and it gives us the ability to lever that capital or use it for other business purposes. So additional capital flexibility is always beneficial.

Got it. Turning back to spreads. What risk do you see in the near term of further spread widening, particularly given events like today where you get a little bit of a surprise.

Well, I think today is an example of that. I mean so we're seeing the impact of additional interest rate volatility, which is always harmful, if you will, to the agency mortgage market. We would all other things equal, we'd like to see less interest rate volatility. But really the risk is uncertainty associated with how the Fed is going to manage its balance sheet reduction. I think the Fed has been really, really clear that they have a plan to reduce its balance sheet, both in treasuries and Agency MBS up to $35 billion a month in Agency MBS. And I think the Fed is going to stick with that plan for the foreseeable future, multiple years. But there is a risk of mortgage sales, and that's going to be what people will talk about when you have an inflation print like today that was a little bit above expectations. I think people will say, might the Fed increase its pace of balance sheet reduction. I don't believe they will. I think the Fed has been very clear that its primary tool for tightening financial conditions is through the Fed funds rate. They've also been very explicit, and they mentioned it in their minutes that they understand that balance sheet actions carry with it unintended consequences. And they are also keenly aware that market conditions today are not that great in terms of the overall liquidity in the bond market, both in the treasury and in the mortgage market. So I think they're going to be cautious with their actions not to destabilize the financial markets such that they can get the Fed funds rate to the intended restrictive level that they want to get it to as quickly as possible. So I think -- that bodes well for the Fed continuing to just allow the mortgage portfolio to run off at the natural runoff pace, which, by the way, will be materially lower than the $35 billion a month. They're probably running off at about $25 billion a month right now.

So I guess what then is keeping you up at night for the chance for the Fed reducing the holding -- the MBS holdings in a material way. What signs do you think that they would have to take that action into more meaningful consideration?

Well, when you look at, for example, forward inflation expectations, they have moved down very meaningfully. And I think that, that is due to the Fed's rhetoric and to the Fed's credit. And that's really important to the Fed is they want to make sure that inflation expectations don't become entrenched in the market. If they feel like that's not the case, then they would likely be inclined to behave differently with respect to both monetary policy and the balance sheet. And that, I think, is the risk in the marketplace today. I think the market was hopeful that the trend in inflation was going to continue to be lower as it has been from June till now. We had an uptick in a couple of the measures which disappointed the markets. I don't believe it's an uptick that's going to continue, but that's the risk from the Fed's perspective is will they have to deviate from the plan that they've laid out today? And what implications would that have for the market. So that, I think, is the risk that everybody faces in all fixed income markets and frankly, for equity markets as well.

Okay. I'll pause there for just a second and see if we have any questions from the audience. Yes. One up here at front. Right up there.

For a nonexpert in kind of your business and your company. Can you explain why an inverted yield curve, which is happening today and everything mainly happening more and more, why that isn't just terrible for your business because you're borrowing short kind of lending off, I mean explain completely how you're not more negatively impacted by that?

Yes. That's a great question. I appreciate that question. And I think it's one that is often misunderstood, but it's a really important question. So you mentioned the inversion, the borrowing short and lending long in terms of our long-term assets. You're right that our funding is short term. Our repo rolls over about every 90 days. But we don't have that exposure if you have that short-term debt hedged out synthetically with a longer-term interest rate derivatives. So for example, if I enrolling my 90-day repo and I have a pay fixed swap of 5 years, then essentially, I've synthetically converted that rate -- that funding rate to that 5-year swap rate. The receive leg on my swap offsets the 90-day repo rate. Those 2 things are well correlated. It leaves you with locked-in essentially locked in 5-year funding. So you don't have that exposure. The inverted yield curve can have significant earnings impact typically negative. But what's important in today's environment is that even though the yield curve is inverted, what really matters is where is our underlying asset relative to that 10-year part of the curve where that is most inverted. Typically, that spread is not as wide as it is today, which would mean that it would be a more challenging earnings environment. But that spread today is at 150 basis points, as I mentioned. If you lever that 7x or 8x, you can generate a very significant return on that investment even though it is inverted. So think about it this way, if you buy a new mortgage today and you synthetically hedge it with 10-year debt assumed you did that perfectly, you would be able to lock in about 150 basis points. And if you levered that multiple times, you can generate mid-teens earnings in this environment. So it's really important that the margin -- the nominal spread today is as wide as it is in this environment. So there's still really good earnings opportunities here. Go ahead. I'll give you.

[Technical Difficulty].

Well, if it narrows and you put that on, then that would be a really significant positive for book value because that would mean our underlying asset is outperforming our hedges. So you would have an increase in the market value of your portfolio in that scenario. So your spot value, if you will, would go up. But you're right, your future earnings would go down in that scenario. That's really one of the key reasons why when you look at the -- our business model, the mortgage REIT business model in environments when spreads are widening, it hurts your book value presently, like it has this last year. The spreads have widened to historically wide levels and our book value has dropped accordingly. It's bad for your book value in the short run, but if your cash flows aren't affected, ultimately, you'll get that money back, just like if a credit bond spread widens, but they're still money good. What it means, though, is in the future, our new investments are much more profitable, right? We can put new investments on at much better returns. So overall, our franchise value should go up in an environment where spreads are widening, and that's the environment we're in today. So with spreads widening, actually, we can generate more return on our portfolio as we go through time than we would have prior to spreads widening. Thank you for the question. Good question. Any other -- Yes.

Your core earnings or earnings available for distribution have exceeded the dividend by a wide margin in the last several quarters. So the current dividend yield is still around 12%. Can you just talk about how you're thinking about the dividend given those competing dynamics?

Sure. You're absolutely right. And this gets back to the question about the hedging. In today's market, we've been operating with a hedge ratio essentially at 100% or more, which means that our short-term debt is essentially locked in. It doesn't have much exposure to the short-term rate increases. And so our cost of funds is very stable, and therefore, our net interest margin is very stable. In fact, our net interest margin this last quarter was 270 basis points, and our net spread and dollar roll income was $0.83 a share, which is the highest it's been in 7 years. So by that measure, we're generating significant earnings on our portfolio. And that's helpful in your dividend analysis, but it doesn't always give you the complete picture. If you think about it, there are accounting nuances in that number that creates distortions. Assets aren't at market yields, their historical cost yields or amortized costs, your hedges are at historical cost yield. So you can get sometimes misleading picture of earnings through that measure. It doesn't include all of the hedges. But it is a helpful measure. It's sometimes better, I think, to look at the mark-to-market return, if you will, or the economic return on your portfolio. If you ask yourself a simple question, if you had to sell your portfolio and buy it all back today, what would the return on that portfolio be? It would be different than what that net spread and dollar roll income measure would tell you. So in today's market because mortgages have widened so much, the return, let's say, is around 14%. So the economic return going forward of our portfolio is around 14%, which is very much in line with our 12-ish percent dividend. So that gives you meaningful information about the appropriateness of the dividend level and the stability of your dividend. And so I always like to look at a number of factors. Net spread and dollar roll income is one, but I also like to look at that sort of the economic return on our portfolio and say what do we think we're going to earn going forward based on market prices today?

Okay. So I guess, does that give us a pretty good sense of some of the longer-term earnings outlook for not only 2023 but maybe 2024 as that starts to flow through the portfolio.

Absolutely. I mean so this is what's so challenging about today's market is that we have a lot of uncertainty, and we're moving through this tightening process. But the return profile of Agency MBS going forward is as attractive as it's ever been in our history. So if you look back to 2009, we've been through several periods where the return outlook has been good, but not this good. And ultimately, I think once the Fed gets through this final move that I think people will look at the Agency MBS market on both an absolute basis and on a levered basis and say returns are attractive. If I can buy an Agency MBS at 150 basis points spread to the 10-year, that's good for a real money investor. And if I can do that on a levered way and generate mid-teens returns, that also historically is really attractive. And if the Fed is able to get through this process and sort of stabilize markets and allow its balance sheet to run off like at once gradually over a 3-year period, I think spreads can remain attractive for an extended period of time, which would be great for our business model.

We were talking about this earlier a bit. It's been a while since we've had a normalized environment -- in a normalized environment, I do naturally want to see a little bit of natural book value tailwind through earnings, excluding the dividend?

Ideally, Look, at the end of the day, we're trying not to achieve a particular dividend target, although we're well aware that our dividend level is really important to a significant portion of our investors. We're trying to generate the best economic return we can for our investors, right, which is the combination of the dividend we pay and the book value change in our portfolio. At the end of the day, that's what investors are going to get back from AGNC is that economic return. The form of that return can take mostly dividend like it is today and some book value accretion, hopefully, down the road. We think a combination of those 2 things is most appealing to the widest cross-section of investors, but we are very understand very well that the dividend level is really important. But from our perspective, what we're trying to do is generate the best economic return we can for our shareholders. And we think we're entering an environment in our business where those returns would be really attractive.

Okay. And I guess going back to the leverage, can you just talk about what a normalized leverage ratio looks like for the agency portfolio?

Sure. So for the last several quarters now, maybe 1.5 years, we've been operating with what we would call characterizes lower-than-normal leverage. We've been operating with leverage in the 7x to 7.5x. And there have been times when we've been slightly lower, but not many. But most of our time in a "normal operating environment", our business model can easily operate at 8, 9 or 10x leverage. So that sort of gives you some bookends as where we could operate. And directionally, I think we're going to start to see slightly higher leverage as we go through time because I expect markets to stabilize and the investment opportunities to be really attractive.

All right. Got it.

Moving to a much different topic. Can you just talk about the relative attractiveness of opportunities in the credit portfolio?

Yes. Well, all assets have sort of got fallen in value. So return opportunities are better across really all asset classes. And that's the case for the credit part of our business. That part of our business remains relatively small and is typically less than 10% of our capital is allocated to our credit business. I wouldn't expect much change in that going forward, not because the credit assets aren't attractive. But from a relative perspective, Agency MBS have widened more and returns are even better in that space. So when you look at the agency market and in particular, the value from a levered investor perspective of the agency market is the ability to finance that collateral in a really liquid transparent market. right? That's what's unique about Agency MBS. Everybody knows the price. It's very easy to use that as collateral and funding. It's not as easy to use a non-agency collateral in funding markets. And so you have to sort of weigh not only the return, but also the financing. Both markets are really strong right now. But at the margin, I wouldn't expect much shift in our capital allocation because the agency market is so strong.

Okay. How big would you be willing to take that credit portfolio once we kind of play through the cycle and the return profile is more than what your [ profits ] now?

I think it could go higher in a percent of capital, but not that meaningfully higher. I think at the end of the day, when you invest in AGNC, you're going to get predominantly an agency market. And we think that that's what's value to shareholders. Shareholders have the ability to diversify their own portfolio, their own way. And sometimes, investors can diversify in a more liquid way than if we did that on their behalf. You know what I mean, if you wanted to invest in CMBS and we have some, it may be better from a liquidity perspective to have the investor buy a CMBS exposure and an AGNC exposure. So AGNC is going to be predominantly an agency portfolio, an agency MBS portfolio I think investors understand that. I think they know how we operate. They know the risk parameters, and we do that in a really transparent way. They know that we're going to be very thoughtful in the way we manage our capital from a shareholder perspective. So we want to preserve that, but we also want to use opportunities to diversify and to generate outsized returns. We'll continue to do that in space as we see appropriate. But I don't expect it to be that material of an increase in our capital allocation.

Okay. And maybe if I could sneak in one more on the credit portfolio. How has the underlying credit quality performed, especially as we're starting to see some markets start to actually experience negative home price [ depreciation ]?

Very well. I mean the housing market has been really strong, right? And even though we've seen slowing and even though we're starting to see some pressure on the consumer debt-to-income ratios are coming under a little bit of pressure, given the affordability issues. The housing market is really strong, and there is a tremendous amount of built up equity, and that's really strong. And the underwriting was done in a really strong way. So the market that we're entering, even though it's going to be a significant housing slowdown is not going to be very problematic from a credit perspective. So I don't expect any significant impact negatively in the credit the portfolio.

Okay. Going back to the agency portfolio then. How have prepayment speeds performed in the quarter? And do you think we're approaching kind of the lower bound of where prepayments speeds to go?

We are. And prepayment speeds have behaved sort of predictably. If you think back where we were at the end of the first quarter, generically, the mortgage market -- the agency mortgage market was probably prepaying at around 14% CPR. It dropped to around 10% CPR in June. And today, our last reported prepayment speed for the market was around 8%. And that's just because of where the mortgage rate is today. If you think about the average note rate of the mortgage universe is around 3.5%. And the primary mortgage rate today is at 6.5%. So you can expect prepayment speeds to be near their slowest for the foreseeable future. I would expect, for example, the market to prepay next year at something like 6% or 7%, 8% CPR at the most, which is really just essentially the natural turnover in the mortgage market. No discretionary refinance activity.

We've already covered the Fed pretty well, but as it relates to Fed actions, what impact do future Fed actions have on your hedging strategy and positioning?

Well, the challenge that you have on the hedging side is that each incremental Fed action has an impact predominantly on the short end of the curve. But as we're seeing, it has a significant impact on the back end of the curve to the question we had earlier in the flattening of the yield curve, right? The back end of the yield curve is anticipating an economic slowdown. And to the extent the Fed speeds up or slows down, it's creating a lot of curve volatility. That's challenging from a hedging perspective because if you have your hedges in a particular part of the curve, like the back end of the curve that is not moving a lot or actually even going down, then those hedges are relatively ineffective. So what we've done in this market is that we've moved a greater share of our hedges to the [Technical Difficulty] intermediate part of the curve, from 2 years to say, 7-year part of the curve, because there, the interest rate movements are a little bit more predictable than on the back end of the [ macro ]. So it's challenging from a hedging perspective because you're constantly having to rebalance your hedge portfolio and trying to get the best mix of hedges that replicates the market value movements in the assets. And when the yield curve is volatile, that's particularly challenging.

Okay. I guess one last one for me. One of the topics that people were worried about is the Fed stepped out of the market was that there wouldn't be enough incremental buyers of the Agency mortgage-backed securities. Market is much smaller now than kind of the initial thinking was at the time of that. But can you just talk about who the incremental buyers are for production Agency MBS, now the Fed has really stepped away from that market?

Well, you touched on the right point, which is that all other things equal, the Fed backing away today at these rate levels is not nearly as problematic because there's not going to be very much supply at all. The other key point, though, is that the market is much better positioned today for this Fed move in this environment than it has been in times past. This was well telegraphed to the Fed's credit. And if they maintain this predictable pace of just allowing their balance sheet to run off naturally, the runoff that they're going to experience next year is probably in the low $20 billion-ish range per month, not that significant. Money managers, bond fund inflows, overseas investors, bank demand, REIT demand. Generally speaking, I would say that the mortgage investors away from the Fed are underweight mortgages, neutral to underweight. So there's capacity to absorb them, particularly at these more attractive return levels. So I don't think it will be problematic. As long as the Fed sort of stays the course and allows this portfolio to run off naturally, I think at these rate levels, I think the market will do very well.

[ Okay ]. We have time for some more audience questions if there are any do we have?

Yes, sir.

Sorry, 2 questions for me. First, what would cause you to cut your dividend? And then second, what are the -- again, more from a general standpoint, what are the largest risks, I guess, that keep you -- that make you worried about the portfolio, the mix, the hedges, the duration. Like what are the things that could go wrong that we should be aware of?

Sure. Good questions. On the dividend question, what I would say, it sort of goes back to the point that I was trying to make earlier, which is when you're thinking about your dividend from our perspective, you're trying to set your dividend at a level that you think is consistent with the earnings power of your portfolio. Right? If you don't do that, what you'll essentially be doing is paying dividend out of book value, and that's in a situation that we would not want to have. So if we felt like we couldn't sustain our dividend, it would lead one to conclude you need to lower your dividend so that you don't erode book value, right? And that's why, for example, if you just compare 2 environments real quickly because I think it's an important point. If you look at where the agency mortgage market was in May of last year, when the Fed was actively buying mortgages at a pace of $40 billion a month, they put so much pressure on the mortgage prices that the return was in the high single-digit range on a levered basis. Let's say it was 7% or 8% return at that point in time. Against the 12% dividend, that would be an unsustainable situation. Spreads have since widened, prices have fallen, spreads have widened, and now the return profile is in the mid-teens, 12%, 13%, 14%, 15%. That's much more sustainable, and that's really good for our business and that's why we're excited about this, [ Michael ]. But that's the way I think you have to look at those markets and say, if you can't sustain your dividend and you have to pay it out of your book value, that would be a situation that you would think is unsustainable. The challenge for our business, generally speaking, is that in a sense, when we buy mortgages, when we buy Agency MBS, we are selling an interest rate option to the homeowner. They can prepay it at any time. That's what makes it so powerful or they can extend it to its life if they want, right? So we're short an option to the homeowner, right? And that interest rate option gains value when interest rate volatility goes up. So the homeowner's option becomes more valuable. It's negative for us and beneficial to the homeowner. So when you think about our business, one of the things that's most challenging is extreme interest rate volatility, extreme interest rate moves. That makes it much more challenging to keep our portfolio in balance. And it's -- from our perspective, we want environments of relatively low interest rate volatility so that we're able to generate that return that carry on our portfolio consistently. When you have outsized interest rate moves, you have to rebalance your portfolio and there's a cost of doing that. And so from our perspective, that's what's most challenging. In today's market, we're in an environment where that interest rate volatility is really high. The good news is, though, I think it's going to subside relatively quickly. The Fed is sort of on a fast track to getting that Fed funds rate to its restrictive level, and then I think it will pause. I think that will all happen by the December meeting. And I expect interest rate volatility to come down at that point, and that would be a really favorable environment. But that's the challenging thing about today's market.

Any other questions? All right. Well, we will stop there. I want to thank Peter again for his time. And yes, we'll be heading off to lunch after [indiscernible].

Thank you so much. Appreciate it. Thank you for the questions.