AGNC Investment Corp

NASDAQ:AGNC

Earnings Call Transcript 2022-Q1

[Operator]

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

[Katie Wisecarver, VP, IR]

Thank you all for joining AGNC Investment Corp.'s First Quarter 2022 Earnings Call. Before we begin, I'd like to review the safe harbor statement. This conference call and corresponding slide presentation contains statements that, to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the safe harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of AGNC.

All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of AGNC's periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law.

Participants on the call include Peter Federico, Director, President and Chief Executive Officer; Bernice Bell, Executive Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President and Chief Investment Officer; Aaron Pas, Senior Vice President of Non-Agency portfolio management; and Sean Reid, Executive Vice President, Strategy and Corporate Development.

With that, I'll turn the call over to Peter Federico.

[Peter Federico, President, CEO & Director]

Thank you, Katie, and thanks to everyone for joining the call today. The investment environment was very challenging in the first quarter as the market faced increased geopolitical risk, growing inflation concerns and the expectation of significantly tighter monetary policy. Interest rates ended the quarter materially higher with the yield on the 2-year treasury increasing over 160 basis points. A rate move of that magnitude hasn't occurred in more than 30 years. This challenging environment led to a risk-off sentiment, pressured equity markets and caused fixed income prices to decline.

The Bloomberg Aggregate Bond Index posted its worst quarterly performance in more than 40 years with a price decline of almost 6 points. That index is now down 9 points for the year. These extreme moves highlight how difficult market conditions were for all fixed income instruments. The Agency MBS market was also adversely impacted by uncertainty associated with the Fed's balance sheet. As a result, Agency MBS significantly underperformed swap and treasury hedges. The performance was weak across the coupon stack with higher coupon MBS experiencing the greatest underperformance in spread widening.

Over the last 12 months, the Agency MBS market has experienced a dramatic repricing as the Fed abruptly shifted monetary policy. We began the year with short-term rates near 0 and the Fed growing its balance sheet. In contrast today, the market now expects a very aggressive series of short-term rate increases and balance sheet runoff to begin later this month. At the March meeting, the Fed indicated that the initial runoff plan will include an Agency MBS cap of $35 billion per month. Importantly, however, with the primary mortgage rate now nearing 5.5%, paydowns on the Fed portfolio will likely be well below the cap for the foreseeable future.

Major monetary policy transitions are always challenging for the fixed income market. This is especially true for the Agency MBS market given the unique role it plays in monetary policy and in the economy. Agency MBS have remained under pressure in April with spreads widening about 10 basis points. as the Fed's balance sheet reduction phases in over the next several months and with the long-term runoff plans still not fully understood, further spread widening is possible. This difficult environment adversely impacted AGNC in the first quarter. On average, spreads on our portfolio widened about 25 basis points during the quarter, which was the primary driver of our negative economic return.

Based on our fourth quarter disclosures, a 25 basis point spread widening event was expected to generate a book value loss of 13.5%. The remainder of our book value decline can be attributed to the increase in interest rates, which as the numbers show was a relatively small given the hedge position and intra-quarter rebalancing. As we discussed last quarter, we expected spreads between Agency MBS and other benchmark rates to widen given the uncertainty associated with the Fed's monetary policy position. But the spread widening that occurred in the first quarter was materially faster and larger than anticipated.

We started the quarter with a defensive position characterized by lower leverage and a high hedge ratio. We also took meaningful steps during the quarter to further reduce our aggregate risk profile. These steps included reducing our asset position, adjusting our coupon profile and increasing our hedge portfolio. As the Fed aggressively raises short-term rates and ramps up its balance sheet runoff, we will likely remain defensive in our portfolio positioning. Despite this defensive positioning, we believe today's valuation levels reasonably compensate investors for the risks associated with the current environment.

Levered returns on production coupon MBS are very attractive on both an absolute basis and relative to past cycles. As such, we believe further MBS weakness, if it occurs, will likely be characterized as an overreaction and will likely represent a compelling investment opportunity for AGNC. The mortgage market also benefits from a self-correcting mechanism in that higher mortgage rates will eventually lead to slower prepayment speeds, lower mortgage origination volume and less runoff on the Fed's portfolio. In addition, structural changes to the repo market since 2019 have meaningfully improved Agency MBS funding conditions, which is particularly beneficial to levered investors like AGNC.

So in conclusion, with asset valuations considerably more attractive now and funding conditions strong, we remain very optimistic about the outlook for our business. With that, I'll now turn the call over to Bernie to discuss our financial results in greater detail.

[Bernice Bell, EVP & CFO]

Thank you, Peter. AGNC had a comprehensive loss of $2.23 per share for the first quarter. Economic return on tangible common equity was negative 14.4% for the quarter comprised of the decline in tangible net book value and dividends declared of $0.36 per common share. Notably, despite the decline in our tangible net book value, our at-risk leverage remained below our normal operating levels throughout the quarter. Leverage as of the end of the first quarter was 7.5x tangible equity, slightly lower than the fourth quarter, while our unencumbered cash and Agency MBS also remained strong at $3.5 billion at quarter end, which excludes both unencumbered credit assets and assets held at our captive broker-dealer subsidiary. Our average projected life CPRs decreased to 7.9% from 10.9% as of Q4. Actual CPRs also continued to trend lower, averaging 14.5% for the quarter, compared to 18.6% for the prior quarter.

Our net interest spread for the first quarter increased to 219 basis points from 215 basis points for the fourth quarter as the improvement in asset yields due to declining prepayment speeds and portfolio repositioning more than offset a modest increase in our cost of funds. Thus, despite a smaller asset base, our net spread and dollar roll income remained very strong at $0.72 per share for the quarter, down only $0.03 from the prior quarter.

Additionally, given the size of our swap position relative to our repo funding, our net spread and dollar roll income is well protected against a significant increase in short-term rates that is expected to occur over the remainder of the year.

As Peter mentioned, agency spreads widened further in April. As of last Friday, we estimate that our tangible net book value is down approximately 6% from quarter end, while our leverage remained largely unchanged. Looking ahead, although our asset balance is somewhat smaller, higher rates and wider spreads improved both the earnings profile in our existing portfolio and the expected return on new investments that we add over time.

With that, I'll now turn the call over to Chris to discuss the agency mortgage market.

[Christopher Kuehl, EVP & CIO]

Thanks, Bernie. As Peter described, the fixed income markets had an extraordinarily difficult start to the year. 2-year and 10-year treasury yields increased 161 and 83 basis points, respectively, through March 31 and while agency MBS initially led the move wider in spread, most all fixed income sectors underperformed the move higher in treasury yields. 30-year production coupon MBS spreads widened more than 40 basis points during the first quarter. As the Fed guided the markets to price in 6 additional 25 basis point rate hikes for 2022, an accelerated time line for tapering of net purchases and perhaps most surprisingly, a materially accelerated time line for balance sheet normalization.

Given the dramatic increase in mortgage rates, supply shifted to higher coupons and led to substantial underperformance versus rate hedges, lower coupon MBS on the other hand, continued to benefit from Fed purchases and a sharp decline in origination. We took advantage of the relative outperformance in lower coupons by repositioning the agency portfolio into production coupon MBS at much wider spreads with improved roll carry and improved liquidity. Over time, we believe this repositioning will benefit our portfolio through favorable earnings.

During the quarter, we reduced holdings in 2.5% coupons and below by approximately $27 billion. It increased our higher coupon position by $18 billion. Dollar roll specialness for production coupon MBS continued to trade extremely well as rates moved sharply higher and production shifted, redefining the TBA deliverable. Currently, production coupon rolls are trading very special. However, we do anticipate that this will moderate in coming months to levels more in line with historical norms. Since quarter end, markets have continued to reprice. Spreads on 30-year current coupon MBS have widened an additional 10 basis points, bringing the cumulative year-to-date widening to just over 50 basis points.

Coupon stack performance, however, has shifted over the last few weeks with lower coupon MBS underperforming higher coupons, the opposite of what was observed during the first quarter. 30-year production coupon nominal spreads are now approximately 35 basis points wide of average levels observed when the Fed was last reducing its balance sheet in 2018 and 2019. Historically, some of the best investing environments occur when interest rate volatility is high and nominal spreads are wide. The technical headwinds for the MBS market, however, are challenging with heavy anticipated organic supply, at least in the short run, combined with the incremental supply from Fed balance sheet runoff. As such, we expect spreads to remain at historically wide levels for some time. And as Peter mentioned, there is a risk of a temporary overshoot over the near term.

I want to stress though that given our relatively low leverage, these dynamics will likely create an excellent long-term investment environment for AGNC. Our hedge portfolio totaled $77.5 billion at quarter end, up $2 billion from the previous quarter, while the asset portfolio declined by just under $10 billion. Given the volatility and uncertainty associated with the current environment, we continue to favor a hedge portfolio that is well diversified by hedge type and by maturity.

I'll now turn the call over to Aaron to discuss the non-agency markets.

[Aaron Pas, SVP]

Thanks, Chris. As Chris mentioned, the volatility in equity and fixed income markets was also felt in structured products. While credit spreads were not immune, they generally outperformed high-grade and high-quality assets. Spreads on AAA-rated assets moved meaningfully wider in Q1. To put the moves in perspective on the residential side, the price spread between private label RMBS and Agency MBS widened about 1 point through March and further in April, while non-QM AAA spreads widen roughly 70 basis points. AAA conduit spreads were about 30 basis points wider over the quarter and other commercial real estate backed AAAs cheapened up significantly as well. Turning to residential credit. The entire capital structure in on-the-run CRT saw significant repricing and very poor price action for most of the quarter. Heavy supply, macro weakness and structural changes put in place in the fourth quarter contributed to this underperformance.

RMBS and CMBS issuance levels remained elevated with near record volume in many sectors. Exacerbating this impact was the change in the prepayment landscape. In 2021, RMBS issuance was at a similar level. However, this issuance was coupled with faster prepayment rates and thus manageable net supply. Today, issuance has remained high, while paydowns have declined, leading to a large increase in net supply and further pressure on spreads. Consistent with the actions we took in our agency portfolio, we were generally defensive on the non-agency side.

Our non-Agency holdings declined from $2.3 billion at year-end to $1.7 billion at 3/31. This was driven primarily by reducing our AAA RMBS exposure in January and February by about $400 million. Additionally, we reduced our CRT position early in the quarter and subsequently added a portion of that risk back as spreads continue to widen.

Turning quickly to the housing landscape. The strong underlying fundamentals, mainly the supply-demand imbalance remains in place. However, higher mortgage rates, combined with goods and service inflation outpacing wage inflation will likely slow HPA. We expect affordability levels to continue to deteriorate somewhat. But at this point, we don't expect this to cause the correction in house prices at a national level. Looking forward, returns across the residential and commercial non-agency opportunity set have continued to improve. In the near term, we would like to see additional clarity with respect to the Fed, rate stabilization and the trajectory for bond fund redemptions to become more constructive on credit.

With that, I'll turn the call back over to Peter.

[Peter Federico, President, CEO & Director]

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

[Operator]

[Operator Instructions]. First question comes from Bose George with KBW.

[Bose George, KBW]

Can you just talk about spreads in agencies versus credit? Like where do you -- what do you see as the preferred place to deploy capital currently?

[Peter Federico, President, CEO & Director]

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

[Bose George, KBW]

Okay. Great. And then -- and you noted the returns are attractive. You didn't really sort of put a number in there. Can you give us kind of a range of returns?

[Peter Federico, President, CEO & Director]

Sure. And let me start by sort of maybe just giving you more sort of an outlook that will lead into that because I think it's important to sort of reiterate the messages that we were trying to communicate today, which is just generally speaking, we're increasingly optimistic that a significant portion of the repricing has already taken place, and there's certainly a risk of an overshoot. These are the kinds of markets that overshoots tend to occur, which is essentially why we took the actions that we did with respect to our portfolio in the first quarter.

All that said, returns in the agency space do look attractive, both on an absolute and relative basis to your -- specifically to your question on an absolute basis. And Chris mentioned the production coupons being the most attractive part of the agency market right now. Those returns to us right now are sort of in the low to mid-teen range, although interest rate volatility is very high and there's a cost of hedging that is unusually high in this market that will eventually abate, but relative returns also look really attractive. If you look back at the historical periods, returns in that area looking back, for example, the 2019 period, which is sort of a comparable period where the Fed was reducing its balance sheet, spreads are meaningfully wider than they were in 2019. Nominal spreads, for example, to the 10-year today are like 125 basis points versus 80 basis points. And I think Chris mentioned OASs are about 35 basis points wider.

So the relative returns are attractive. We are entering a period though, as Chris mentioned, where the technicals are challenging, the seasonal supply of mortgages will be high for the next few months. And of course, we're going to find out tomorrow exactly the ramp that the Fed is going to use to ramp up its runoff of its balance sheet. So the technicals will be a little challenging, and we want to see how the market trades. And if there was a time for an overshoot, it's probably right around now. In fact, the weakening that we saw in April may be part of that overshoot process.

But again, we're well positioned for this. We took actions ahead of it. And as Bernie mentioned, our leverage remains low at the -- as of the point that you mentioned, which was last week. So we're well positioned for it and spreads are and returns are starting to look very attractive to us. I'll pause there.

[Operator]

The next question comes from Rick Shane from JPMorgan.

[Richard Shane, JPMorgan Chase & Co]

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

[Peter Federico, President, CEO & Director]

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

[Richard Shane, JPMorgan Chase & Co]

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

[Peter Federico, President, CEO & Director]

Well, thank you for that question. I know that's on a lot of people's minds. The first point with respect to our dividend and dividend position is that I think it's important to put the right historical context around it, which is that again, we are starting from a really strong position, if you think back to where we were, for example, a year ago with our $1.44 dividend versus our net spread in dollar income, for example, last year of $3.02. So we were in a really strong position to begin this period. But I think one of the really key messages is that given the rate move that has occurred and given the spread move that has occurred, you also can think about not only the return opportunity on our future investments as being materially better, which it is on the marginal investments that we will make over time. But you also have to consider that the mark-to-market return, if you will, on our portfolio is now materially better.

So if said another way, our existing portfolio, given the move in spreads and rates that has occurred in the last 4 months is now generating a higher rate of return, consistent with the increase, if you will, in the dividend yield on our portfolio. So we are in a position right now where we continue to have a lot of flexibility. We don't feel any pressure to have to take leverage up in order to continue to generate earnings consistent with our dividend given the improvement in the return on our portfolio. And I think that's really -- the key point is that we are in a position where we can be patient and disciplined and wait for the right opportunity that sort of Chris described, which we believe is going to be an opportunity that really hasn't occurred very often really since the great financial crisis. So we just need to be patient. But our portfolio today is generating a much better rate of return than it was 4 or 5 months ago.

[Richard Shane, JPMorgan Chase & Co]

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

[Peter Federico, President, CEO & Director]

I definitely do. I think it's within those dimensions. -- again, you could just use a sort of simple back of the envelope calculation on the expected return on our portfolio. If you do sort of a mark-to-market return on our portfolio, if you sold it and bought it back today, you take the asset yield, which would probably be close to 4% on a fully hedged basis, you're going to get a number given our cost structure that is in the, call it, 12% to 14% ROE range. So very consistent with the dividend that we're paying.

[Operator]

Next question comes from Kenneth Lee, RBC Capital Markets.

[Kenneth Lee, RBC Capital Markets]

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

[Peter Federico, President, CEO & Director]

Yes. Great question, Ken. Thank you. What I would say is that there are sort of some specific signals that would be beneficial. So obviously, mortgages were weaker again in April. And we're right sort of at the edge now with the Fed making its announcement on the balance sheet tomorrow. But I would say there's probably 4 things that would benefit the market. And I think we're going to get clarity on these 4 elements over the next, call it, 1 to 3 months. So it's a relatively short-term thing.

But first, I think we need to see greater interest rate stability. And now with interest rates from 3 years to 10 years essentially at 3%, we're probably pretty close to the sort of a full repricing of the interest rate expectation. Of course, there's still some risk that the terminal Fed funds rate is going to be higher than what the Fed initially indicated. So that's going to have to play out a little bit. But I think we -- the market just generally speaking, would benefit from greater interest rate stability. And hopefully, we're getting near that point. The second, and this sort of builds on Chris' point, we understand and the market understands importantly, which is why we think valuations should generally have reflected this. The technicals for the mortgage market are sort of most challenging over the next, call it, 1 to 3 months.

So while the market knows this, we want to see the market start to trade stably during that time period. So that would be another signal that we would be looking for. The third, which I'm not sure when we'll get this information, but I think the market would benefit from greater understanding of the Fed's long-term runoff plans. If you think back to when the market sort of got pretty weak in April, it was right around the time period where the agency market that is when the Chairman was talking about front-loading interest rate hikes and sort of the market interpreted that as maybe a signal that they might front-load or be more aggressive on the balance sheet. We don't think that's going to be the case. We think the Fed is going to be very measured on its balance sheet in order to facilitate a much more aggressive interest rate approach, but some additional information and thinking from the Fed on the long-term runoff plan will be helpful.

And then lastly, this is a point that Aaron mentioned, which is really important, is we're going to be looking at bond flows and for the last several months, of course, given all the pressure in the fixed income market broadly, bond flows have been experiencing significant outflows. That has started to slow in the last couple of weeks. And eventually, we expect it to stop, and we expect actually bond inflows given the absolute level of returns that are available in that repricing. So that will be a significant indicator of strength in the market. And then, of course, we know that there's lots of index investors, as Chris has mentioned, that are still underweight MBS. So those would be the signals, if you will, that we're looking for, and we think we're going to get a lot of clarity on those points over the next few months. I hope that answers your question.

[Kenneth Lee, RBC Capital Markets]

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

[Peter Federico, President, CEO & Director]

Well, I think one of the key points about the current environment, this is really important is that what we're experiencing is essentially a spread event, right? It's the underperformance of Agency MBS relative to hedges. And if you look -- and this is why in my prepared remarks, I sort of identified the spread component as around 13.5% of the book value that we overall experienced. And the point of that is that we have approached this environment from an interest rate perspective as having as little interest rate risk as possible because of the volatility of the environment. So we did not want to have a significant long position or a significant short position from an interest rate risk position. We wanted to keep our duration, if you will, as neutral as possible. And you can see that in the fact that we started the quarter with a 0.1 year duration gap, and we ended the quarter with a 0.3-year duration gap. And today, our duration gap is only about half a year. right?

And we wanted to have that sort of as neutral of a position as possible because during the first quarter, one of the things that made the agency market so difficult was there was tremendous 2-way rate risk that emerged in February when the thought of the Ukraine war became a reality. And if you think back to what happened to the 10-year, the 10-year went from 150 at the beginning of the quarter to 2%, 2.05 before the war and we actually had a significant rally at that point back down to 1.65, right? So there was significant 2-way rate risk. We were uncomfortable being meaningfully short or meaningfully long. We just wanted to keep our duration risk as neutral as possible.

And that's the way we are continuing to approach our hedging today. We're operating with a really high hedge ratio because we want to have a lot of intermediate hedges because the 3-year to 7-year part of the curve is underperformed, but we also want to keep our duration risk as neutral as possible over the short run so that we sort of have protected that part of our book value and the biggest driver like we experienced in April was really just a spread widening event.

[Christopher Kuehl, EVP & CIO]

Yes. The one thing I'd add is just a lot of our rebalancing was done on the asset side of the balance sheet, and that repositioning was motivated by a few factors. I'd say as the Fed guided the markets to price in materially tighter policy rates obviously sold off, volatility spiked. And yet lower coupon MBS performed very well relative to higher coupons. And so given this strong relative performance, it made sense for us to do a lot of our delta hedging in these coupons rather than rates in order to sell both basis at relatively tight spreads and duration. I mentioned the coupon swap trades as well. We did about -- on a net basis, our portfolio declined by about $9 billion on the agency side and par value. We also did an incremental $18 billion in coupon swaps that were also motivated by relative value duration rebalancing, but also liquidity. Generally speaking, very low dollar-priced mortgages with very little option costs and carry have a less diverse investor base.

And so that was another consideration in rightsizing our coupon positioning. And over the last few weeks, as I mentioned, lower coupons have materially underperformed production coupons, reversing a lot of that move that we saw in Q1. And so the relationships are a little more balanced now, but I'd say we're still biased towards up in coupon at this point. But the position is -- the one thing on lower coupons, I mean, they can get tactical in a positive way as well and perform well on a total return basis in certain scenarios when fixed income outflows eventually turn and become inflows, as Peter just discussed, index passive and active light index-based fund flows will certainly benefit these positions because they comprise still a large percentage of the float but the position needs to be rightsized for liquidity and the negative carry that they have versus higher coupons, and we'll be -- we'll continue to be opportunistic with respect to our coupon positioning as the environment changes, but still with a bias towards up in coupon.

[Operator]

Our next question comes from Doug Harter, Credit Suisse.

[Douglas Harter, Crédit Suisse]

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

[Peter Federico, President, CEO & Director]

Yes. Well, thank you for the question, Doug. I think this is one of the things that is going to make this potential investment opportunity really unique for AGNC and why I think it's so compelling is that -- if you think about the environment that we're in, spreads have obviously cheapened up a lot and returns are better. And further weakness is certainly possible as the Fed balance sheet runoff goes underway. But I think what's going to be perhaps more unique about the environment that we're going to be in is that there doesn't appear to be an obvious catalyst for spreads to tighten a lot in a really short period of time, which is really good from our perspective and from an overall business perspective is that we think we're going to be in a period that is going to offer durably very attractive return opportunities.

Now there are some sets of investors who are underweight specifically the sort of money manager community is materially underweight the mortgage index, and that could be a significant source of demand. But at the same time, we are going to have a meaningful net supply of mortgages. So we think we're going to be in an environment where really attractive returns are going to be available to us for a reasonably long period of time. And that's really good from a business perspective. So that's the way we're looking at the current environment.

[Operator]

Our final question comes from Eric Hagen, BTIG.

[Eric Hagen, BTIG]

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

[Peter Federico, President, CEO & Director]

Yes. Sure, Chris.

[Christopher Kuehl, EVP & CIO]

Yes. No, that's a good question. I mean, they're generally -- it depends on the category, but there is a floor. I mean the quality of the TBA float is getting worse with less of a Fed presence. And given how much pay-ups have come off year-to-date, there have been some great opportunities to add convexity cheaply through pool selection. Call protection is a great example where it's often thought of as only adding value when prepayments are really fast, but it's really about the cash flow stability and knowing that you can count on a pool maintaining its duration into a rally allows you to more fully hedge the spot duration. And so it really comes down to cash flow stability. And so for that reason, pay ups -- there is a floor, it's typically above TBA, the absolute floor is TBA, obviously, for deliverable securities.

And of course, I mean, there are also pool attributes avoid in this environment and source for better turnover performance as well, which is equally impactful to the convexity profile of the mortgage portfolio.

[Eric Hagen, BTIG]

That's helpful answer. Second, what are some of the variables you think that drive the amount of funding you source at Bethesda Securities versus bilaterally? And how does that also factor into the amount of TBA you carry and how much funding you do off balance sheet?

[Peter Federico, President, CEO & Director]

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

[Eric Hagen, BTIG]

That's helpful. And is the funding at Bethesda mostly overnight repo or is it term repo?

[Peter Federico, President, CEO & Director]

Oh, no. We obviously do both. It tends to be -- we obviously do run our overnight position through Bethesda Securities, which is a really valuable source of funding for us. It's obviously the cheapest funding. It's really in markets like this where the Fed is raising short-term rates where the expectation of higher rates is really meaningful. Having the overnight balance is really helpful. So we run our overnight position through there, but we also do a significant amount of funding out to 30, 60 and sometimes even 90 days to there, but most of the term funding is done through bilateral counter parties.

[Operator]

We now completed the question-and-answer session. Now I'd like to turn the call back over to Peter Federico for concluding remarks.

[Peter Federico, President, CEO & Director]

Well, thank you for your participation on the call today and for your interest in AGNC, and we look forward to speaking with you again at the end of next quarter. Thank you again for your participation.

[Operator]

Thank you.