AGNC Investment Corp

NASDAQ:AGNC

Earnings Call Transcript 2022-Q2

[Operator]

Good morning and welcome to the AGNC Investment Corp. Second Quarter 2022 Earnings Conference Call. [Operator Instructions] Please note that this event is being recorded.

[Katie Wisecarver, Investor Relations]

Thank you all for joining AGNC Investment Corp.’s second 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; Bernie Bell, Executive Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President and Chief Investment Officer; Aaron Pas, Senior Vice President, Non-Agency Portfolio Management; and Sean Reid, Executive Vice President, Strategy and Corporate Development.

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

[Peter Federico, Director, President and Chief Executive Officer]

Good morning and thank you all for joining AGNC second quarter earnings call. In my prepared remarks today, I will discuss the macroeconomic factors that drove the performance of the financial markets during the second quarter. Importantly, I will also discuss the improvement in our earnings and why we believe AGNC is entering a favorable environment that will be conducive to generating strong risk-adjusted returns for our shareholders.

Financial markets remained under significant pressure during the second quarter as the Fed indicated an accelerated pace of monetary policy tightening, following worse-than-expected inflation data. The likelihood of materially higher short-term rates increased the probability of a recession and led to historically high interest rate volatility. This challenging monetary policy and macroeconomic environment caused significant and broad-based financial market weakness during the quarter, particularly in June.

The S&P Index fell 16.5% in the second quarter and 20.6% year-to-date, making it the worst first half year performance in more than 50 years. The Bloomberg Aggregate Bond Index representing more than $25 trillion in bonds fell 5.6% in the quarter and 11.2% year-to-date. The performance of Agency MBS as measured by the Bloomberg Agency MBS Index was in line with the broader fixed income market, falling 5.2% in the second quarter and 9% year-to-date. Note, these fixed income performance measures represent the percentage change in price on unlevered bond positions. The performance of Agency MBS on a hedged basis was also weak as the spread or yield differential between Agency MBS and swap and treasury rates widened meaningfully in April and again in June.

Over the last 12 months, spreads on Agency MBS have widened meaningfully by any measure. One of the simplest measures is the yield differential between the 30-year current coupon MBS and the 10-year treasury note. By this measure, Agency MBS spreads have widened by more than 100 basis points over the last year to end the second quarter at a spread of about 140 basis points. This yield differential rarely gets that wide or stays that wide for any meaningful period of time. Only in 2008, in the midst of the Great Housing Crisis, did this spread trade at or above today’s level for an extended period of time.

As we have discussed, wider spreads ultimately lead to enhanced earnings on our existing portfolio. The second quarter provides a great example of this dynamic as our net spread and dollar roll income increased nearly 15% to $0.83 per common share. Our net interest margin also improved materially. So despite the decline in book value associated with wider spreads, our net spread and dollar roll income improved on a per share basis in the second quarter.

In addition to strong earnings, we are also seeing a number of positive indicators that give us confidence that the performance of Agency MBS is poised to improve. First, at current valuation levels, Agency MBS are attractive by almost any historical measure. Looking back over history, spreads at these levels have consistently proven to be good buy-in opportunities. Second, we believe the risk of asset sales by the Fed is extremely low. The Fed has made it clear through their actions and their words that their primary monetary policy tool is adjusting the federal funds rate, not balance sheet reduction. Third, and most importantly, the supply outlook for Agency MBS has improved materially. At the beginning of the year, the net supply of Agency MBS to the private sector was expected to be in the $700 billion range, which would have made it the largest issuance year on record.

Today, however, with mortgage rates higher, house prices elevated and the economy slowing, the net supply of Agency MBS is now expected to be closer to $400 billion, with most of that supply having already occurred in the first half of the year. These are significant positive developments for the Agency MBS market. And they give us confidence that this protracted period of weakness is nearing its end. With mortgage valuations near their historical low, levered returns on Agency MBS in the current environment are as favorable as they have been at any point during AGNC’s existence. Given this improved outlook, as this period of volatility subsides, we will look for opportunities to adjust our conservative positioning, including increasing leverage to further capitalize on this favorable investment environment.

With that, I will now turn the call over to Bernie Bell to review our financial results in greater detail.

[Bernie Bell]

Thank you, Peter. For the second quarter, AGNC had a comprehensive loss of $1.34 per share. Economic return on tangible common equity was negative 10.1% for the quarter comprised of the 12.9% decline in tangible net book value and dividends declared of $0.36 per common share. As of last Friday, our tangible net book value for July had increased about 3%. Given the challenging market conditions during the quarter, we continued to operate with lower leverage and minimal interest rate exposure. We took advantage of favorable MBS performance in May to further reduce our leverage position mid-quarter.

In doing so, we ended the quarter at 7.4x tangible equity, down slightly from 7.5x as of the end of the prior quarter despite the decline in stockholders’ equity. Our liquidity position also remained strong with unencumbered cash and Agency MBS at the end of the quarter totaling $2.8 billion, which notably excludes unencumbered credit assets and high-quality assets held at our captive broker-dealer subsidiary.

Our net interest spread for the second quarter increased over 50 basis points to 270 basis points, our highest level in well over a decade. Thus, despite our smaller asset base, our net spread and dollar roll income, excluding catch-up, increased $0.11 to $0.83 per share for the quarter. This significant outperformance was due to three primary drivers: extremely strong dollar roll performance in the second quarter, higher asset yields as we shifted the portfolio up in coupon and our large pay fixed interest rate swap position, which as expected largely offset the increase in funding cost. Although dollar roll specialness has moderated considerably since the second quarter, our net spread and dollar roll income should remain well protected against higher short-term rates that are expected over the remainder of the year as a result of our large hedge position.

Consistent with higher mortgage rate, our average projected life CPRs decreased to 7.2% as of the end of the second quarter. Our actual CPRs also continued to slow, averaging 12.4% for the quarter. Lastly, early in the quarter, we issued $50 million of common equity at an average price of $12.19 per share through our at-the-market offering program at levels that were accretive to our net book value. Late in the quarter, however, in response to broad equity market weakness, we opportunistically repurchased $51 million of common equity at an average price of $10.78 per share, which represented a significant discount to book value.

I will now turn the call over to Chris Kuehl to discuss the agency mortgage market.

[Chris Kuehl]

Thanks, Bernie. While the supply technicals for Agency MBS are improving as mortgage rates hit 10-year highs and housing activity begins to slow, interest rate volatility remains the primary headwind to agency spreads over the near-term. During the second quarter, 5 and 10-year treasury yields increased 58 and 68 basis points respectively. The smaller period-over-period change than what we experienced in Q1, but this comparison understates the extreme daily rate volatility observed during the second quarter.

In the first 2 weeks of June, for example, 5-year treasury yields sold off 77 basis points only to then retrace 71 basis points of the move in the subsequent two weeks. Realized interest rate volatility on many parts of the yield curve reached the highest levels in more than 10 years as disappointing inflation data led to increasingly hawkish Fed sentiment and caused benchmark rates to fluctuate materially. This volatility led to further Agency MBS weakness during the second quarter with lower coupon MBS underperforming higher coupons, reversing much of the Q1 outperformance of 2s and 2.5s versus higher coupons.

During the second quarter, we continued to shift our holdings into production coupons at wider spreads, reducing holdings of 2.5s, 3s, and 3.5s versus increasing our holdings in 4s and 4.5s. Over time, this repositioning should benefit the earnings profile of our portfolio. We saw some of this earnings benefit in the second quarter as production coupon rolls traded extremely well with average roll implied financing more than 60 basis points through the average SOFR overnight rate. Roll specialness over the last few weeks, however, has moderated to levels more in line with historical norms. Since the start of the year, par coupon mortgage spreads versus a blend of 5 and 10-year hedges have widened nearly 70 basis points and are approximately 40 basis points wide of their 10-year average.

At current valuations, Agency MBS should be appealing to both levered and unlevered investors. The credit quality of Agency MBS is becoming increasingly valuable relative to other credit-sensitive sectors of the fixed income market as the prospect of a recession increases and funding conditions for levered Agency MBS investors have never been stronger, given the actions taken by the Fed over the last several years.

Lastly, and this point is often misunderstood, the Fed’s presence in the agency MBS market will remain a significant positive factor even as its portfolio runs down. To this point, the Fed will likely still own more than 25% of the outstanding agency market at the end of 2023, assuming current rate levels and balance sheet expectations. As such, the percentage of the agency mortgage market held by private investors is likely to remain lower over the next several years than it has been for most of the past 30 years.

Turning to risk management, our hedge portfolio totaled $72.5 billion at quarter end, down $5 billion from the previous quarter, consistent with the decline in our asset portfolio. Our duration gap at quarter end was 0.4 years, a slight increase from the prior quarter. Given the move higher in interest rates since the start of the year, mortgage durations have extended meaningfully. And should rates continue to rise, further duration extension should be limited. Said another way, at current rate levels, the mortgage market and our portfolio face more contraction risk than extension risk. And for this reason, we will likely continue to operate with a positive duration gap. Lastly, while we proactively reduced our portfolio during the first and second quarter to manage risk, we are likely to add MBS and increased leverage during the second half as the risk return trade-offs have improved.

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

[Aaron Pas]

Thanks, Chris. Structured products had another difficult quarter as the challenges that were faced in the Agency MBS and equity markets rippled through credit markets. After a significant widening in Q1, credit spreads widened further across the board in the second quarter. Using CDX IG and high yield as a proxy after widening 18 and 82 basis points respectively, in Q1, the widening accelerated in Q2. IG widened another 34 basis points, while high-yield underperformed investment grade credit and widened roughly 200 basis points.

As we noted on last quarter’s call, we expected housing affordability levels to continue to deteriorate at both national and regional levels. At this point, housing is the least affordable it’s been since heading into the great financial crisis. Our expectation is that the persistent housing shortage will continue to support housing prices. Importantly, while affordability remains a major issue, credit quality has remained fairly stable and unlike the period preceding the Great Financial Crisis, few loans currently will have any sort of payment shock. Nevertheless, certain regions could see a price correction if mortgage rates stay at these levels or increase further for a sustained period.

Turning to our portfolio, our non-agency holdings increased over the quarter from $1.7 billion at 3/31 to $1.8 billion at 6/30. We added roughly $350 million in securities in the quarter that was partially offset by deliveries of bonds into CRT tender offers as well as higher than typical pay-downs on our CMBS holdings. Given the widening in credit spreads, we were able to redeploy this capital at more attractive levels. Importantly, this improved the credit quality of our non-agency holdings. AAA-rated securities represented 22% of our non-agency portfolio at June 30, up from 12% at 3/31 with a corresponding decrease in below investment grade securities. While total residential and commercial backed securities issuance declined in Q2 relative to Q1, issuance remained relatively high.

With few alternatives to securitization, many issuers have had little choice but to securitize and accept market clearing levels to finance their loans. Additionally, CRT supply was extremely elevated with first half 2022 issuance exceeding all of 2021, which was a large driver of the significantly wider spreads. This has created opportunities for us to selectively add AAAs and some new issue CRT at quite attractive levels. Looking forward, the supply technicals are expected to improve for both residential and CRE markets, Mortgage origination volume has declined and transaction volume is falling on the commercial side. This dynamic should be supportive of spreads later in the year as securities issuance declines. Similarly, as a result of the decline in mortgage originations, we expect a reduction in the GSE’s need to purchase credit protection in the CRT market.

Despite the improving supply technicals for the second half of the year, fundamental challenges and spread risks have increased. In light of that, even with these wider spreads, we are continuing to take a conservative approach to our non-agency portfolio. As recession concerns will likely lead to continued spread volatility and potential – potentially better entry points.

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

[Peter Federico, Director, President and Chief Executive Officer]

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

[Operator]

[Operator Instructions] The first question comes with Kevin Barker with Piper Sandler. Please go ahead, sir.

[Peter Federico, Director, President and Chief Executive Officer]

Good morning, Kevin.

[Kevin Barker, Piper Sandler]

Just given the macro outlook, obviously, spreads are very wide you are seeing margin expansion TBA dollar rolls are holding up pretty well. Yet you are still taking a conservative approach here. It seems like you are fairly bullish on the investment outlook. Why not push a little harder here on leverage in order to take advantage of that given these are some of the best investment returns we’ve seen for quite some time?

[Peter Federico, Director, President and Chief Executive Officer]

Yes. Thank you for the question. Yes, obviously, it’s a good question. And what we tried to communicate today, I think, as you rightly described is a significant improvement in our outlook for the Agency MBS market essentially that we are at or nearing an inflection point in our opinion. And ultimately we are more constructive on the outlook for Agency MBS and more constructive on our view towards leverage. Our mindset to date, appropriately so, given all of the uncertainty in the market has been to err on the side of being more conservative given the challenges that the market faced and what we described today, is significant improvement in some of the key indicators for the Agency MBS market, whether it be supply or the credit outlook or the stability of the Fed or the stock effect of the Fed or, as you point out, absolute returns. So – and as Chris pointed out in his prepared remarks, our mindset going forward will be more constructive on the market. We are more likely to operate with somewhat higher leverage going forward than we have in the past. But we also have to be cognizant that this environment is not yet played out fully, right? We are still seeing extreme interest rate volatility, which, as Chris said, is a headwind to Agency MBS performance. We are still seeing some bond fund outflows, although that is abating somewhat, which would be a positive signal. And then there is just overall macroeconomic uncertainty. So I think we have another month or 2 or 3 to get through this period. But ultimately, I think it’s fair to say that we’re fairly optimistic on the performance of Agency MBS, and we’re more likely to be moving back toward our normal operating position over time.

[Kevin Barker, Piper Sandler]

Given the incremental returns right here, it seems like you could generate returns on investment that faxed or at least in line with where the demand is. Can you give any update or your thoughts on your yield relative to the peers and maybe just your ability to continue to exceed the dividend run rate, just given the outlook today?

[Peter Federico, Director, President and Chief Executive Officer]

Well, you’re absolutely right. I mean I think what this shows when you’re thinking about our dividend is we always try to set our dividend at a level that is consistent with the economic earnings of our portfolio. We try to be forward thinking in that because doing so ultimately will lead to, we believe, the most sustainable dividend. So I think what it shows today, as we sit here, that the dividend level that we came into this period was appropriate, we were in a position of strength with respect to the earnings on our portfolio. And then importantly, as our results show this quarter, our economic earnings and our net spread in dollar roll earnings are all improved in today’s environment given the rate environment, given the prepayment environment. Given the spread environment, we are generating more money today on a net spread and dollar roll income basis than we were, and that’s all supportive of the dividend level that we currently have. The economic return on our portfolio today is better than it was at the beginning of the year. So we feel like we’re in a real position of strength. And that’s a position that we’d like to have, particularly in an environment where we can redeploy proceeds as you point out, return levels that are significantly above our current dividend yield, we think that ultimately will lead to a strong position and better sustainability of our dividend. And we will certainly always take into account the environment that we’re in. But right now, we feel really good about the position that we’re in.

[Kevin Barker, Piper Sandler]

Okay, thank you, Peter.

[Peter Federico, Director, President and Chief Executive Officer]

Sure. Thank you for the question – good questions.

[Operator]

Thank you. The next question comes with Doug Harter with Credit Suisse. Please go ahead.

[Doug Harter, Credit Suisse]

Thanks. Can you talk about your outlook for economic return in the coming 12 months or so? And how you think that should trend versus the dividend level versus kind of the earnings levels and just what – how do you think about that?

[Peter Federico, Director, President and Chief Executive Officer]

Sure. Thank you for the question, Doug. It’s sort of dovetails to some extent, the question we just had. So I can expound on that a little bit. I think when you’re talking about your sort of forward expectations of economic return for your portfolio, you could really just think about that as what is the mark-to-market return on your existing portfolio. If we sold our portfolio and bought it all back today, what would the economic earnings be on that portfolio? It’s really the same calculation that we do for marginal returns, right? Today, for example, with asset yields, mark-to-market asset yields at around 4.4% or 4.5%, you take into account your hedging costs. The net interest margin, if you will, is something in the neighborhood of around 150 basis points. You leverage that 8x, it would give you a gross ROE of 12%. Our operating costs still below 1%, add-back economic return on your unlevered equity position, and you would get a mark-to-market return somewhere, for example, in, call it, 14% to 16% range. So that would be a reasonable estimate assuming nothing changes over the next year that, that would be a reasonable expectation about what your portfolio should earn economically. Said another way, at, say, 15% times the book value that we just reported at $11.43 would say that the economic earnings on our portfolio should be something in the neighborhood of around $1.75 a share, $0.28 or $0.30 above our current dividend level. So that’s the way I would think about it from that perspective. I hope that’s helpful.

[Doug Harter, Credit Suisse]

It is. And I guess, just – I don’t know if you have that, handy, kind of how that changed over the course of the second quarter, factoring in the lower book value but wider spreads and therefore, wider returns.

[Peter Federico, Director, President and Chief Executive Officer]

I’m sorry, could you say the first part of that question again? How did that change…

[Doug Harter, Credit Suisse]

How did that change over the course of the second quarter, factoring in the lower book value but wider spreads, just if we were to look at that similar type mark-to-market…

[Peter Federico, Director, President and Chief Executive Officer]

That’s exactly right. I mean, if you think about where we were at the end of the second quarter, versus the end of the first quarter, spreads are probably, on average, 20 basis points wider over the quarter. So that’s an incremental, call it, 1.5% ROE that you would be using the calculation. So that’s the way you think about that.

[Doug Harter, Credit Suisse]

Okay. That makes sense. Alright. Thank you.

[Peter Federico, Director, President and Chief Executive Officer]

Thank you for the questions, Doug.

[Operator]

Thank you. The next question comes with Rick Shane with JPMorgan. Please go ahead.

[Peter Federico, Director, President and Chief Executive Officer]

Good morning, Rick.

[Rick Shane, JPMorgan]

Thanks for taking my questions. Good morning. Hey, when we think about the changes in the forward curve and we think about the negative convexity of Agency MBS and then factor in how deeply discounted the lower coupons are trading. Can you talk about your investment strategy, where you want to deploy capital? Because I’m thinking, if you take a short-term view you want to play up a stack. But if you look out a little bit further, you probably want to go down to the stack. And so I’d love to get your views on this. And again, from the perspective – I’m asking the question from the perspective of an equity investor but would love to get the perspective of bond investors.

[Peter Federico, Director, President and Chief Executive Officer]

Sure. It’s a good question. So obviously, we’ve talked about this for the last couple of quarters, and this last quarter was another example of more movement in our portfolio from a composition perspective toward higher coupon MBS. So we have a significant reduction in our lower coupon positions, our 2 and 2.5 position, a much greater position now in, call it, 4s through 5s. It’s because those instruments, those current coupons, if you will, of those production coupons, give us a significantly better return profile in the current environment. And typically, for a levered investor like you’re going to migrate toward those coupons to have, in a sense, the most negative convexity because they have the most return. It does change the way we think about hedging those positions, no doubt.

But in exchange for the higher earnings, we have to – we have a little bit more two-sided rate risk. One of the things that Chris mentioned in his prepared remarks was the fact that because of that portfolio composition, you’re more likely to see us, for example, operate with a more significant positive duration gap to give us protection on the prepayment variability of those coupons. Over time, that composition can shift. But generally speaking, it does change the hedging dynamic for us, but also the return environment for those coupons is particularly attractive. And of course, those coupons also offer the incremental return of favorable dollar roll funding. Chris, do you want to add to that?

[Chris Kuehl]

Yes, I would just add to – at current spreads, you are paid a lot in additional carry for taking relatively little incremental convexity risk. The convexity profile of our portfolio and for the market as a whole has improved dramatically over the last two quarters as the strike on our mortgage holdings has moved further and further out of the money as rates have sold off. And so even across a pretty wide range of rate scenarios, there is less need for optional rate protection. You saw that we reduced our swaption position by about $3.5 billion during the second quarter. And this relates to the fact that the convexity profile of the portfolio is much better now, much more benign. Duration risk is less symmetrical now than it was at the start of the year. And then the other consideration was that implied volatility is at record levels and so it was a good time to monetize some of that long-haul exposure. But the coupon stack getting back to your question is still very upwards sloping. It’s flattened a bit since the Q1 levels. And so I would say for diversification reasons we are still likely to continue to maintain some exposure to lower coupons as there are scenarios where those coupons given that there is still large portion of the float will perform well on a total return basis in certain scenarios. But generally speaking, marginal capital is going to continue to be allocated towards production coupons, which offer the best return potential.

[Rick Shane, JPMorgan]

Got it. And it’s interesting, look when you look at the premium on the current coupon it’s not extravagant by any means, but if we look a little bit further down the road given where rates have been over the last decade, it does strike me that there is – if we enter a slowdown, more refinance risk in the current coupon. And so I’m just curious why not – and again, I understand what you did in the first half of the year given the rate environment we faced. But as we look forward with the forward curve starting to come down, why not start moving down the stack again?

[Peter Federico, Director, President and Chief Executive Officer]

Well, I think what Chris described is the reasons why you want to be in those coupons from a return perspective. And I think you get to your question and your issue, not so much by moving down a coupon, but by adjusting your hedge position. And I think that’s really the key, right? You can have the better earnings and account for that risk that you’re talking about by essentially, for example, operating with a positive duration gap, which also potentially be available and where you have your hedges on the curve will also be materially important. As you point out, forward curve is right and, ultimately, the yield curve flattens even more having fewer 10-year hedges, for example, would be meaningful in that scenario.

[Rick Shane, JPMorgan]

Great. It’s very helpful. I appreciate it.

[Peter Federico, Director, President and Chief Executive Officer]

Thank you, Rick.

[Operator]

[Operator Instructions] Your next question comes with Trevor Cranston with JMP Securities. Please go ahead.

[Peter Federico, Director, President and Chief Executive Officer]

Hi, Trevor.

[Trevor Cranston, JMP Securities]

Hi, thanks. Good morning. Listening to your comments so far, it sounds like you guys are staying a little bit cautious near-term because of the high levels of rate volatility, in particular. I guess I’m trying to think through the benefits of sort of waiting a little bit to get more aggressive on increasing leverage. And so I am wondering if – as you see sort of some normalization of volatility over the next couple of months, maybe – would you expect that to also result in tightening of MBS over that period and maybe slightly lower returns that are available today? And is there some near-term risk of additional widening that you guys are maybe concerned about that keeps you from taking leverage up more aggressively right now?

[Peter Federico, Director, President and Chief Executive Officer]

Yes. It’s a good question. Let me make a couple of points on that. What I would say in the current environment is, I think, as you’re pointing out, is there essentially is more today as we sit, given our more positive outlook. We believe there is a little bit more two-way spread risk in the market. There is clearly reasons why spreads could widen further as the Fed finally adjust to the maximum runoff, which the first full month will be October volatility is still really high. The market is highly dependent on every inflation report. We got the Fed tomorrow. There is still variability in what the Fed may do. So, there is reasons why spreads can be wider, but there is also, I think somewhat more risk in the market today, the spreads could be tied to. Similarly, from our perspective, there is more two-way rate risk in the market. We are obviously seeing that, it does appear that longer term rates may have topped out over the near-term at their peak in mid-June. So, we are cognizant of both those two things. But that said, one of the unique benefits that may come out of this environment for AGNC is that these attractive returns may be much more durable than previous cycles. And the reason why that’s the case is because ultimately, if the Fed is successful at curtailing inflation and slowing the economy and not having to deviate from its balance sheet runoff plan, then ultimately, they can gradually step out of the market, and that would be supportive of spreads staying in the vicinity of where they are. So, that could be a really longer term durable favorable investment environment from our perspective. So – but we are cognizant, as you point out, of the potential of a rallying and for the potential of spreads tightened, particularly because the supply dynamic has changed so dramatically in favor of lower supply. So, that’s something that we are watching carefully.

[Trevor Cranston, JMP Securities]

Got it. Okay. That makes sense. And then can you give us an update on how book value has trended so far in July?

[Peter Federico, Director, President and Chief Executive Officer]

Yes. I am sorry, I meant to mention that. In Bernie’s prepared remarks, she said it was up about 3% through last Friday. Actually, as we sit here this morning, it’s probably up closer to 4% for July as of yesterday evening.

[Trevor Cranston, JMP Securities]

Okay. Thank you.

[Peter Federico, Director, President and Chief Executive Officer]

Yes. Thank you for that follow-up.

[Operator]

Thank you. The next question comes with Vilas Abraham with UBS. Please go ahead.

[Vilas Abraham, UBS]

Hey everyone.

[Peter Federico, Director, President and Chief Executive Officer]

Good morning.

[Vilas Abraham, UBS]

One very – good morning Peter. You have been very nimble in Q2 specifically with capital management. Can you just describe your mindset there? And how it may be different than past less volatile environments?

[Peter Federico, Director, President and Chief Executive Officer]

Yes. Well, certainly, we look at our capital markets activity, always opportunistically and always from the lens of how can we execute transactions that are accretive to our existing shareholders. This last quarter was a good example. Early in the quarter, we had the opportunity, not a significant amount, but to issue equity through our ATM program that were at levels that were accretive to book value. But then importantly, we also saw a dramatic shift in the equity markets and in the tone of the overall financial markets later in the quarter. We were trading at a significant discount to book value late in the quarter. And so we use that as an opportunity to, again, buyback stock, which would have been accretive to book value and of course, accretive to earnings. So, we will continue to do those sorts of activities. We will look at our capital markets activities very opportunistically. Obviously, one of the key inputs in our decision to buy back stock or issue in stock is what are the use of proceeds, how accretive is the investment environment to our existing dividend level, for example, in today’s market. As we just already discussed this morning, there is a reasonably wide margin between those two things, which is positive. So, we will continue to look at our capital markets activity very opportunistically and use that as a way to generate incremental return for our shareholders.

[Vilas Abraham, UBS]

And how do you factor that in, in the context of the leverage conversation as you weigh those two ways to make incremental investments here?

[Peter Federico, Director, President and Chief Executive Officer]

Yes, great point. If for example – clearly, that always factors into our decisions where we are or where we want to be with respect to our leverage will certainly have an impact on what we do with respect to our capital markets transactions. For example, you are alluding to – if we were in an environment where we wanted to take leverage up, and we were trading at a discount to book value than the best transaction from a shareholder’s perspective would be to buy back stock as opposed to adding investments. It would be essentially a cheaper way to increase leverage. It would be a way to increase leverage that was most accretive to our existing shareholders. So, it has to depend on what’s happening in an environment where our stock is trading relative to our book value and how we feel about the investment environment. And those two things interact with one another. But we certainly will use that as a lever in that calculation.

[Vilas Abraham, UBS]

Okay, great. And then if you could just talk about the prepaid fees for a moment. Just where do you see that going near-term? And maybe you could put some historical context in there for us on how low they can potentially go if mortgage rates do back up, for example?

[Peter Federico, Director, President and Chief Executive Officer]

Sure. I will have Chris speak to that.

[Chris Kuehl]

Yes. No, it’s a great question. I would say given the move higher in rates, housing activity is certainly going to continue to slow. But I would say it’s difficult to envision an environment where turnover isn’t at least consistent with historical norms even for the deepest out-of-the-money cohorts. The labor market is strong. That of course, helps with mobility. There is a lot of accumulated house price appreciation. And I think the behavioral changes post-pandemic as people continue to reevaluate where they live and work, I think will continue to contribute to relatively robust turnover. That said, I think turnover is absolutely slowing, but from very elevated levels, cash out refi activity is certainly going to drop off for the deeper out-of-the-money cohorts. There are better, smarter, more efficient ways to extract equity without refinancing a very low-cost first lien. But I do think the demographic and behavioral shifts post-pandemic, combined with a relatively strong jobs market, will continue to support reasonable turnover. We have had a 200-plus basis point rate shocks in the past in the late ‘90s, the mid-90s. And turnover floored out at around 6% CPR. And I don’t think that’s an unreasonable expectation this time around. But it’s a great question, and it’s often not well appreciated just how important a CPR or even half a CPR is to the convexity of a third [ph] year cash flow.

[Peter Federico, Director, President and Chief Executive Officer]

And if I could just add one thing to that, I think this is an important discussion with respect to the outlook for the Fed and prepayment expectations for the Fed’s portfolio. As we have talked about the Fed will ramp up to its full runoff in October and its peak runoff based on today’s economy, if you will, is probably going to occur right around the September, October, November period at something less than $30 billion a month, so still below the cap. But as we go through next year, given the description that Chris just gave with respect to prepayments, the Fed’s portfolio by the end of next year for example, we will probably be running off in the low-20s per month. So, a material difference where they are relative to their cap, which I think is also constructive to the overall Agency MBS market.

[Vilas Abraham, UBS]

Great. Thank you.

[Peter Federico, Director, President and Chief Executive Officer]

Sure.

[Operator]

Thank you. The next question comes with Eric Hagen with BTIG. Please go ahead.

[Eric Hagen, BTIG]

Hey. Thanks. Good morning guys. I think another one on – good morning. Another one on leverage here, running an agency portfolio around, call it, 7.5x leverage has historically not been considered very high and the model can easily support more as you guys have talked about. And you also have, call it, $2.8 billion in excess liquidity which comes out to call it around 4.5% of your agency portfolio. And that, again, looks very supportive, like a supportive cushion to support your leverage here. At the same time, you guys have also carried more excess margin in the portfolio when your leverage has been higher. So, what is the margin level that you kind of talk about or think about maybe being the most comfortable with going forward as a percentage of your agency portfolio? And how does the current environment, especially with respect to liquidity in the broader market, drive that threshold?

[Peter Federico, Director, President and Chief Executive Officer]

Thank you for the question. So, what I would start with is that our sort of view on liquidity is obviously very dynamic and very market dependent and portfolio dependent. And so, I understand the sort of comparison of where we are today from a liquidity perspective, on a percentage basis versus where we were. But I think it’s also really important to look at today’s liquidity in the context of today’s market and where we have moved. So, the first point I would make is that – from a liquidity perspective, we have already absorbed a massive negative shock, right. So, I don’t think that the comparison is necessarily apples-to-apples anymore because we have already incurred, for example, over the last 12 months, a 100 basis point move in spreads, tremendous interest rate volatility that’s had implications to the book value. But as we sit today, we still have a very strong liquidity position. So, that’s really critical. The other is the portfolio composition today and what is it, what is its impact on our liquidity position. Said another way, we are operating with lower leverage as you pointed out, but also a much more defensive portfolio position, which actually has the effect of using up more liquidity, in particular, our hedge ratio being so high at close to 125% has given us tremendous protection against short-term rate increases as evidenced in our earnings. We have kept our duration gap limited, essentially kept our risk profile low. They will be able to absorb all of the spread shock. That hedge ratio in that derivative position also has a very high liquidity usage. So, those are not positions that we will have over the long run. So, when you think about our liquidity position going forward, I would say all other things equal, we are probably at near the low point in terms of the portfolio’s usage and what it does to our liquidity position. So, when we think about our leverage going forward, and as you pointed out, I think we can operate very comfortably at higher leverage. All of these things have to go into that liquidity position. So, it’s a dynamic decision. It’s based on the environment. It’s based on the shock that’s already occurred – it’s based on the portfolio we have. And I expect over time, we will not be operating with as defensive portfolio, particularly from a hedge ratio perspective. So, I hope that helps to some extent.

[Eric Hagen, BTIG]

Yes, that was helpful. Thank you.

[Peter Federico, Director, President and Chief Executive Officer]

Sure.

[Operator]

Thank you. The next question comes with Bose George with KBW. You may proceed.

[Bose George, KBW]

Yes. Hey everyone. Good morning. Just a couple of follow-up questions for me. Actually, when you talked about the available spreads in the market, how should we think about just the cost of convexity hedging versus the nominal spreads? So, given the elevated volatility now, what was sort of the cost that we have to – that’s kind of embedded in there?

[Peter Federico, Director, President and Chief Executive Officer]

Yes. Well, in the current environment, obviously, that is a significant part. So, when we talk about incremental return opportunities, which are as attractive as they have ever been mid-teens, high-teens and in some cases, you do have to take into account the convexity, rebalancing or hedging requirement associated with those positions. We have already talked about the fact that the current coupon or production coupons are going to have sort of that most negatively convex profile and requires the most rebalancing. If the assumption is that the volatility in the marketplace is going to stay where it is, then you would have to assume that, that ongoing rebalancing will be sort of a meaningful cost to the position. But we don’t believe that’s the case. As Chris pointed out, realized volatility increased 20% or 30% in the second quarter. While it may continue to be volatile for the next quarter or two quarters, we certainly don’t believe that realized volatility will stay as high as it is. It will return to more normal levels, 4 basis point, 5 basis point or 6 basis point moves a day, not 10 basis point or 11 basis point or 12 basis point moves a day. So, when you think about the position, you are right, there is an incremental cost, but we expect that cost to move back in line with more historical averages over time. So, it’s just something we are going to have to deal with over the short run in our opinion.

[Bose George, KBW]

Okay. No, that makes sense. Thanks. And then just one sort of different question. Your Series F preferred shares, they go floating in mid-October. Is that market open to call and reissue that? I am just curious what you are thinking there.

[Peter Federico, Director, President and Chief Executive Officer]

That would be. We haven’t obviously made a decision on that nor would we make a decision on that until we get into that call period, but those issuers are potentially callable.

[Bose George, KBW]

Okay. And that market is…

[Peter Federico, Director, President and Chief Executive Officer]

Yes, I think that was Series C that you were referring to. Yes.

[Bose George, KBW]

Sorry, yes. And that market is open. Okay. Good. Thank you.

[Peter Federico, Director, President and Chief Executive Officer]

Yes. I know – from a new issuance perspective?

[Bose George, KBW]

Yes.

[Peter Federico, Director, President and Chief Executive Officer]

Yes.

[Bose George, KBW]

Okay, great. Thank you.

[Operator]

Thank you. The next question comes with Mark DeVries with Barclays. Please go ahead.

[Peter Federico, Director, President and Chief Executive Officer]

Hi Mark.

[Mark DeVries, Barclays]

Thanks. Hey. I just had one more question for you on leverage. Is there any color you can give us on kind of the cadence at which we should expect you to lever up? Are you waiting for rate volatility to die down some? Are you starting to leg into that? And any kind of sense for where you may take that?

[Peter Federico, Director, President and Chief Executive Officer]

Well, I don’t want to get into where we may take it or – precision with respect to when we may take it there because, again, it’s really a dynamic environment where we got a Fed meeting tomorrow, which is going to be really significant. We have got a couple of really important inflation print that over the next couple of months that will have a lot of impact on the short-term volatility in the market. But generally speaking, I would expect it just to trend somewhat higher. We have added some mortgages in the month of July, not significantly, but we have added some given the investment returns that we were seeing. But we are going to continue to approach this very opportunistically, approach it very disciplined. And again, I think that this period of attractive returns is going to be with us for some period of time, which actually makes that decision in that equation a little bit easier.

[Mark DeVries, Barclays]

Okay. Great. Thank you.

[Operator]

Thank you. This concludes our question-and-answer session. I would like now to turn the conference back over to Peter Federico for any closing remarks. You may proceed.

[Peter Federico, Director, President and Chief Executive Officer]

Well, again, thank you all for your participation on our second quarter earnings call, and we certainly look forward to speaking with you again at the end of the third quarter.

[Operator]

Thank you. The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.