Dynex Capital Inc

NYSE:DX

Earnings Call Transcript 2023-Q1

[Operator]

Good morning. My name is David, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Dynex Capital First Quarter 2023 Earnings Conference Call. Today's conference is being recorded. [Operator Instructions]

Thank you. Alison Griffin, Vice President, Investor Relations, you may begin your conference.

[Alison Griffin, VP, IR]

Good morning, and thank you for joining us today for Dynex Capital's first quarter 2023 earnings call. The press release associated with today's call was issued and filed with SEC this morning April 24, 2023. You may view the press release on the homepage of the Dynex website at dynexcapital.com as well as on the SEC website at sec.gov.com.

Before we begin, we wish to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan, and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. The company's actual results and timing of certain events could differ considerably from those projected and/or contemplated by those forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, please refer to our disclosures filed with the SEC, which may be found on the Dynex website under Investor Center as well as on the SEC website.

This conference call is being broadcast live over the Internet with a streaming slide presentation, which can be found through our webcast link on the homepage of our website. The slide presentation may also be referenced under Quarterly Reports on the Investor Center page.

Joining me on the call is Byron Boston, Chief Executive Officer and Co-Chief Investment Officer; Smriti Popenoe, President and Co-Chief Investment Officer; and Rob Colligan, Executive Vice President, Chief Financial Officer.

And with that, it is now my pleasure to turn the call over to Byron.

[Byron Boston, CEO and Co-Chief Investment Officer]

Thank you, Alison and good morning everyone.

Let me start with a few key points. As I mentioned in the past this is an incredible moment in history, global risk may have increased, but most important, we're adding historical opportunity in the mortgage-backed securities market. Spreads are at a generational-wide level with an opportunity for private investors to step in and make accretive long-term investments.

Second, this decade is a massive period of change. The globe has been jolted by multiple crises that is creating changes for social, political, economic, and geopolitical arrangements. Enormous amounts of change mean higher volatility and unknown consequences. Nonetheless, our team is experienced and disciplined. We've proven the value we experienced in the past and we have responded to other market events in a very thoughtful manner as shown in our long-term results. We've managed our business for the long-term and just as we've done in the past, we are determined to guide you, our shareholders through this disruptive market environment.

Third our strategy is built for this environment. For some time now Dynex has been preparing for a high probability of unanticipated events and surprises. In fact you've even heard me say surprises are highly probable. We've also characterized the environment as evolving and to us, that means we must be very careful about drawing strong conclusions as many factors remain in a state of flux. We've now experienced two turbulent market events in the last six months.

First, the LDI crisis originating in U.K. and now the banking crisis in the U.S. Both events represent exactly the kind of surprises that are liquid balance sheet, flexible mindset, and preparation is designed for and we continue to manage our capital with this disciplined approach.

As many of you know, I started my career in the financial markets in 1981. The current period has a lot of similarities to when I began in the business. Multiple financial crisis raged throughout the 1980s. Ultimately the FDIC and RTC were past, we're selling billions in assets and private investors stepped in to take advantage of generationally-wide mortgage-backed securities spreads. There were no GSE portfolios or fair to take down any of the risks, while today we are not witnessing the same scale of disruption in the 1980s, however we are as generationally-wide mortgage-backed securities spreads and private investors now have the chance to step-in and take on the risk just as they did in the 1980s.

With my long history in the markets, I see compelling investment opportunity here while spreads go wider. We consider the bulk of the widening behind us. In the medium-term to-long-term, we see a very real possibility of tighter spreads that will eventually allow the recovery of book-value. We believe the capital we've invested and the dry powder we retained to deploy will generate strong returns for our shareholders creating value for years to come.

Smriti, will provide further details on all of this in her comments. I want to emphasize how Dynex Capital is uniquely situated to this opportunity. I'll also talk about experience and discipline in our management team. Managing the duration and convexity of 30-year agency mortgage-backed assets truly requires an exceptional set of skills to do it on a levered basis, required a complete understanding of the risks, thorough disciplined processes, and a very flexible mindset. We have demonstrated our ability to do this well, particularly during the first three years of this volatile decade.

I'll turn now to Rob, who'll discuss our financial results and Smriti, who will take you through our strategy for the environment.

[Rob Colligan, EVP and CFO]

Thanks Byron, and good morning.

For the quarter, the company reported book-value of $13.80 per share and a comprehensive loss of $0.54 per share. The book-value performance, plus the dividend delivered an economic loss of 3.7% for the quarter. The portfolio was positioned for spread tightening, which occurred for the first half of the quarter, resulting in a mid-quarter book-value of approximately $15.30.

Going into the end of the quarter, spreads widened and the 10-year treasury fell particularly after the failure of several banks. This combination resulted in asset losses and hedge losses going into the quarter-end. We continue to believe that our portfolio will recover a significant amount of value when volatility lessens, investor demand for mortgage-backed securities improve or simply as paydowns occur overtime.

We added TBAs and pools to our portfolio this quarter, as spreads wide which added 1.4 turns of leverage and represents the majority of our leverage increase from 6.1 turns to 7.8 turns during the quarter. Earnings available for distribution or EAD was negative this quarter. Our EAD does not include the benefit of our hedging activities. We continue to use features as their primary hedging instrument, due to the depth and liquidity of the futures market, as well as lower capital requirements compared to the comparable swap instrument.

In the first quarter, Dynex realized $89 million of hedge gains bringing our unamortized hedge gains of $766 million at the end of the quarter. This is a material number that has inflated the company from rising rates and it's clearly protected book-value from a dramatic rise in rates over the last year.

As mentioned last quarter, these hedge gains are amortized into REIT taxable income over the hedge period of approximately 10 years. The earnings release provides our estimate of hedge gains by quarter for 2023 for the full year '24 and then years thereafter. For the first quarter, we recognized $18 million or approximately $0.34 per share-related to our hedge book.

The total amount of gain to amortize into REIT taxable income can go up or down depending on the company's hedge position and move-in rates in subsequent quarters. We have experienced some value degradation in our hedge book, since we rolled our features in February as long-term rates have dropped, although they are up in value since quarter-end, as rates have once again reversed direction.

Since our hedge gains are a component of REIT taxable income, they will be part of our distribution requirement along with other ordinary gains and losses. As we discussed last quarter, we expect the hedge gains will be supportive of the dividends in 2023 and beyond even if net interest income and EAD decline due to higher financing costs.

Page 6, on our earnings presentation highlights the components of portfolio returns and recent trends in net interest income and hedge gains. Finally, I wanted to mention that we eliminated the utilization of our ATM program this quarter as we felt this was a period for capital deployment and market pricing was less favorable.

With that, I'll now turn the call over to Smriti for her comments on the quarter.

[Smriti Popenoe, President and Co-Chief Investment Officer]

Thank you, Rob and good morning everyone.

At a high-level, I'm very excited about the opportunity we're seeing to invest in agency residential mortgage-backed securities. This excitement is tempered with a deep respect for the complexity of the global macroeconomic environment.

Let me explain. From a macro perspective, we still frame the environment as evolving and we are seeing a series of transitions occurring in the global economy. Specifically, transitions from pandemic to post-pandemic, disinflation-to-inflation, peacetime-to-wartime, globalization-to de-globalization, dollarization to de-dollarization, non-renewable energy to renewable energy, quantitative easing to quantitative tightening, zero and negative interest rates to positive interest rates, geopolitical or unipolarity to multipolarity and regionalization, automation to artificial intelligence, and many more.

This led us to characterize the investing landscape as having a flat scale distribution as we discussed during last quarter's earnings call. Our risk and investment strategy continue to be set in this context. Against this backdrop, we are now seeing the evolution of a historic even generational investment opportunity in the Agency RMBS market. We already believe spreads were attractive last year when they widened in November and then tightened quite substantially in January, but due to the banking turmoil in March, we now have an even more extended opportunity to make investments.

As many of you know, the FDIC has engaged BlackRock to sell the assets held by SVB and Signature Bank. These assets totaling $98 billion are in the control of BlackRock's market advisory group and will be sold over the next 9 months. I'll discuss this development alongside my other comments today.

So why are we calling this a generational opportunity. Please turn to Page 10 of the earnings deck. This slide shows the history going back to 1985 of current coupon agency MBS nominal spreads hedged assuming an equal mix of five and 10-year treasuries. I want to highlight five periods.

The early 1980s, 1998 to 2003, 2007-2008, 2020, and then 2022 through today. These periods represent a major deviation from the average level of MBS spreads and are usually followed by periods of much tighter spreads, even if it takes two to three years. In our view, these are periods during which capital deployment and investment result in outside forward returns and we are right in the middle of one such great opportunity.

On the very left-side of the chart, you can see MBS spread spiking as the liquidations rose from the savings and loan crisis. In many ways, we are in a similar situation. Banks are net sellers of mortgages, home prices are falling moderately and private capital dominates the bid for agency MBS.

But we are different in two important aspects. First, we don't believe we are in the same scale of crisis atmosphere with continuous large-scale liquidation of the same magnitude. And second, the stock effect of the Fed's MBS holdings, even with quantitative tightening is a powerful stabilizing agent for mortgage spread. You can see that in the post GFC spreads spikes, they're much lower than 2008 or the 1980s because of how big the Fed's balance sheet is.

On the very right-hand side of the chart, you can see the dramatic move wider since late 2021 in mortgage spreads, representing a tripling from the levels at lows. We believe that most of the transition to wider spreads in Agency RMBS is now behind us and while spreads may fluctuate and gap wider on occasion spreads today broadly reflect the risk premium that's demanded by private capital and net supply picture from quantitative tightening, seasonal supply, and some but not all of the risk premium for the sales from the FDIC takeover of the failed bank.

We expect spreads will remain at wider levels until the bulk of the sales are complete and hence we view this period as extremely beneficial to remain invested and to continue investing. This is not to say that we think no further bank failures can occur or that more sales are unlikely that's still possible. We're simply pointing out that a significant amount of repricing has already occurred.

We are of course always contemplating what could take spreads out in 2008 levels. We believe substantial stress in the banking system with forced asset sales could get us there but there are mitigating factors today with bank's ability to tap the discount window and the BTFP, bank term funding program. These things would cushion or slow any type of disruption resulting from such stresses.

As I mentioned previously, the stock effect of the Fed's balance sheet is also a stabilizing factor. So the irony of the current situation is that while there does seem to be an immediate opportunity, we are tempering that enthusiasm with a deep respect of the many ways and this situation can actually develop.

A final point to note on this slide, is that we have preserved a significant portion of our book value through the bulk of the transition to wider spreads. Book-value was in the $17 range in August of last year and as Rob mentioned, as high as $15.50 in early February. So book-value can arise even with a modest tightening in the spreads.

Let me now turn to our positioning and outlook. We remain focused on liquidity and flexibility and the opportunistic deployment of capital. On that, we've been moving our position up in coupon, while also adding assets on weakness, we added a little over $1.1 billion in assets for the quarter at wider spreads in February and March. This took leverage to total and common capital about 1.4x up from year end. We have largely maintained our position and lower coupons 2s and 2.5. They currently make up 20% of assets by fair-value, these remain positively convex assets offering positive spreads to treasuries with prepayment upside relative to both market and model expectations and remain supported by the demand for housing.

We are managing our hedge position with a medium-term outlook for rates on the curve. Because of the medium-to-long term inflationary forces we describe on Page 7. We believe that Fed is focused on inflation and in the absence of a significant economic downturn, can continue to look past any moderate economic weakness to maintain the restrictive financial condition needed for inflation to decisively turn towards their 2% target.

These factors result in range-bound yields at the long-end of the yield curve, which also provides solid fundamental support for tightening of the mortgage basis once the supply shock of the FDIC sales go through the system. At today's level of mortgage spreads were more focused on the mortgage basis as the major source of alpha generation, as opposed to curve and rates positioning on hedges. We see opportunity to add assets across the coupon stack and would favor adding both current coupons and discounts based on relative value at the time, preserving some flexibility with TBA and selectively investing in pools.

I'll briefly cover what we know about the FDIC sales and our expectations for how conditions may evolve. The total amount of securities to be sold is $98 billion, $55 of which are Agency and Ginnie Mae securities and 43 billion CMOs. The first sales happened last week, about $1 billion. Mortgage spreads did widen in response and the sales are expected to ramp-up to $1.5 billion to $2 billion per week. This should last about 25 weeks if they keep up the current pace. So we expect this to-end sometime in October.

We also expect concurrent sales of the CMOs to begin in about two weeks. These are expected to bring duration and hedging flows into the market that will further impact rates and spreads. All told, we estimate the duration equivalent of 69 billion tenures will be sold, over half of which is in the path through bucket. Over the course of these sales, we expect to find opportunities to deploy capital at attractive levels.

So what can shareholders expect from us. As I've said, this is a very accretive investment environment, by which I mean, the return on capital, exceeds our dividend yield. We expect to be active and opportunistic and better. We can reallocate existing capital, raise and deploy capital as well as raise leverage, all three remain very powerful options and comprise significant upside over the long-term as we outlined on Slide 12.

In the medium-term as Rob mentioned, we expect bullish support for Agency MBS spreads to come from any decline in delivered volatility, the relative attractiveness of the agency guaranteed cash-flow offering significantly turns over treasuries, as well as on a risk-adjusted basis versus credit-sensitive investments. We remain highly respectful of the global macro situation when looking ahead to the debt ceiling, which we believe can be a major risk flash point and we are planning accordingly.

A final point, going back to the spread slide on Page 10. I wanted to highlight Dynex's performance. We began our existence in current form in January 2008 at the beginning of the great financial crisis. Between 2008 and 2019, we generated a cumulative total economic return of 106%. From 2020 to 2022 this decade Dynex has delivered industry-leading performance outpacing our peer group of Agency and hybrid rates by an average of 28% and 52% respectively on a cumulative basis.

We're excited about the prospect of a target-rich investment landscape to put the power of the Dynex team to work, our demonstrated performance in managing transitions is the direct result of having the experience, skill-set, mindset, and expertise to navigate exactly this type of environment.

With that, I will turn it back to Byron.

[Byron Boston, CEO and Co-Chief Investment Officer]

Thank you Smriti.

Let me reiterate, first, we are seeing a compelling generational opportunity to invest in agency residential mortgage-backed securities. Our stock trades at a discount to book, we pay an attractive and consistent monthly dividend that we believe is sustainable. We have ample dry powder to take advantage of attractive investment opportunities as they develop. We think the stock offers strong value at these levels and the Dynex team is personally invested alongside our existing shareholders, and we will continue to invest as we see value.

Second, it is important now more than ever to be able to rely on our team has a clear strategy and deep experience in navigating complex environments, it's also important to have transparency in your investments. The Dynex balance sheet can be clearly and cleanly valued. We use mark-to-market valuations to calculate our book-value daily. All of our assets are marked and reflected in earnings and book-value. We do not have any held-to-maturity investments or other unrealized losses that are hidden from site. These are central aspects and assess not only manages your capital, but where your capital is invested.

We take responsibility as managers and stewards of your savings very seriously. We thank you for your trust and look-forward to updating you on our performance and the environment next quarter.

With that operator, we will now open the call for questions.

[Operator]

Thank you. [Operator Instructions] We'll take our first question from Trevor Cranston with JMP Securities. Your line is now open.

[Trevor Cranston, JMP Securities]

Hi thanks, good morning. Smriti, you mentioned that with the beginning of the bank portfolio sales last week, you saw some spread widening. Can you talk a little bit more about kind of who you see is the marginal buyer of MBS in the market and how confident you are that there won't be a material additional spread widening as those portfolios continue to be sold over the coming weeks? Thanks.

[Smriti Popenoe, President and Co-Chief Investment Officer]

Yes, hi Trevor. Thank you for the question. Yes, so one thing I want to say is, there are different ways in which mortgage spreads can widen, right? So in 2020 to 2021, you had a transition in interest rates. Same in '21 to '22. Mortgage spreads widened at that time really because the underlying cash flows of the instruments themselves was affected. You went from an interest-rate regime of like 1.5% tenure notes or 0.5% tenure notes to 4%, 5% levels of rates.

So that's where extension risk or the actual mortgages change their cash-flow and can therefore widen if you will. Those types of spread widening events are ones that we believe are controllable and you can think through the way the duration of an instrument changes and you can hedge for that, okay?

What we're seeing, what we saw in November of last year and what we're seeing now in March of this year and even here going-forward with the FDIC sales is different because the underlying cash was the instruments on actually changing much at all. Interest rates have been super range-bound right. So you're seeing an imbalance between the supply and demand of mortgages. It's very technical in nature.

And that gives us some confidence because you can actually hedge the instruments better and so to answer your question directly on the FDIC sales, we did see some mortgage spread widening. It's not to say that we won't see more spread widening out, we actually expect to see a fair amount of spread widening the marginal bid at this point really is money managers. And that's we're seeing stepping in to take some of this product down from what I understand, they're still relatively underweight.

Lower coupon securities mortgages are starting to look attractive relative to corporates. So those would be rationale for money managers to allocate money into the sector, but we do expect as time goes on. That we're going to see periodic bouts of widening from here. Is it going to be the 60, 70, 80 basis point type widening that we've seen? I don't think. We are already here at 170 basis points nominal spread to treasuries, they look very cheap to corporate bonds here on a risk-adjusted basis. So that's where we see the demand coming from.

[Byron Boston, CEO and Co-Chief Investment Officer]

And I'll add one other thing, Trevor - one question is, how far will a government-backed bond widen versus other non-government-backed assets and the one - as seen a couple of times in history, where they widened suddenly in time and then capital accumulates in really chases after the asset to bring spreads back-end. So describing situation where spreads were move around, but you've got to ask yourself, how far will the government-backed asset widen versus other assets that don't carry a similar guarantee.

[Trevor Cranston, JMP Securities]

Sure, makes sense. Then I guess - so to the extent that there is some incremental widening that occurs as these sales happen and you know that - potentially have some impact on-book value. Can you talk about how high you'd be willing to let your leverage drift in that scenario, given that there potentially be a more attractive investment opportunity to take advantage of on the flip side of that.

[Smriti Popenoe, President and Co-Chief Investment Officer]

Yes, I think, look, this is why we've emphasized cash and unencumbered assets of a really high amount relative to our - the amount of repo that we hold. I would say there are two major factors on leverage here. You heard me say, we like the investment opportunity but we're tempering it because we see the global macro-environment evolving. So the number one consideration for us always in terms of increasing leverage or adding assets is going to be what is the macro-environment. If that happens to be something where we expect to have a fair amount of degree of caution, then I would say our appetite to increase the leverage will be lower, right?

But in the large scheme of things, this period is actually a period in which you should be okay taking leverage up over and above sort of what you think your normal operating leverage numbers are because of the long-term investment opportunity. So in reality, I feel like if we see that investment opportunity when spreads widens, our willingness to do that while it will be tempered by the macro risks that's in the environment, it's going to be higher than when - if spreads we're seeing 30 or 40 basis-points tighter. So on average, our inclination would be to run higher levels of leverage.

[Trevor Cranston, JMP Securities]

Okay. I appreciate the color. Thank you.

[Smriti Popenoe, President and Co-Chief Investment Officer]

Sure.

[Operator]

Next we'll go to Doug Harter with Credit Suisse. Your line is now open.

[Doug Harter, Credit Suisse]

Thanks. Can you just talk about the repo market and, how you're dealing with maturities, around the time of the potential debt ceiling and just how that influences your last comments around this being an environment where you should be comfortable taking higher levels of leverage.

[Smriti Popenoe, President and Co-Chief Investment Officer]

Yes, I think that's a great question. Doug, it's great to hear from you. Look, we think this is a major risk flashpoint. We believe our financing should be adjusted to reflect the risk of potential issues leading up to it and even including a potential default by the U.S. even if it's for a short period of time, right. You're already seeing sort of some dislocations in the bond market.

We have not actually seen a ton of activity in the repo market that would suggest that the availability of financing is impaired, right now. It's actually quite flushed with cash. All the money that's moved into the money funds is out in the repo markets right now. You can see that in bill rates, short-term bill rates are super-low right now like, below 4%. So some of that is starting to bleed through into the agency repo market in terms of availability of funding, okay?

So, just in terms of the way we typically manage around quarter ends and events like this, our strategy has been to term things out past certain dates. We continue to employ that strategy. We haven't had any issues with the ability to term finance debt at all, but we do think having this upcoming risk is one of the other reasons that we're tempering our willingness if you will to take leverage up without consideration of that very important factor.

So. Can I say, one more thing - one other piece, which is happening the TBA on our balance sheet makes it really easy for us to take the leverage off. So if you think about, I think our leverage ratio, Rob, can you talk about the difference between the repo leverage versus the total?

[Rob Colligan, EVP and CFO]

Sure, yes, our repo leverage alone is only about 3.4 turns. So the rest of our leverage is TBA and other. So to Smriti's point, so give you some more color on that much faster for us to adjust as need is.

[Doug Harter, Credit Suisse]

Got it. And how would you think about if we got a successful resolution of the debt ceiling or - and spreads remained attractive. What would be kind of the higher-end of the range you might be comfortable with and this type of widespread environment.

[Smriti Popenoe, President and Co-Chief Investment Officer]

So look, in the past, right, you might think of different types of leverage levels. If you go back to that chart on page, Page 10. When spreads are wide, we've started of leverage levels in the low-teens I would say, right? When spreads are wide, you want to be able to run higher levels of leverage. When spreads are sort of in the middle of the range, maybe you bring that down . So sort of like the 8x, 9x level and when they're at the tighter end-of-the range, you actually want to run lower leverage, because you're taking advantage of tighter spreads.

So, at the higher-end of things you're running in - I'm going to say 10 to 12, don't hold me to that, but that's kind of the idea, right, is just - they're higher levels of leverage. All of this I would say, you just can't sit there and believe that you can run it as sort of a rule-of-thumb without considering the risks environment, right? So, if all else were equal we felt comfortable, yes the leverage can rise to the low double-digits. And those would be massively accretive investments that we're going to be made over-time because we expect those spreads to come back-in.

[Doug Harter, Credit Suisse]

Great, thank you.

[Smriti Popenoe, President and Co-Chief Investment Officer]

Sure.

[Operator]

Next we'll go to Bose George with KBW. Your line is now open.

[Bose George, KBW]

Hi ma'am, good morning. Actually could we get an update on-book value quarter-to-date?

[Smriti Popenoe, President and Co-Chief Investment Officer]

Yes. We - right now, I guess through Friday I think we're down between 1% and 2%.

[Bose George, KBW]

Okay, great, thanks . And then just wanted to switch an accounting question. Can you remind me, is there a way to disaggregate how much of the treasury futures mark. Would have corresponded to like a periodic payment on the swap side?

[Rob Colligan, EVP and CFO]

To your questions Bose, there is when you get into nuances and assumptions around cheapest to deliver in that. So very few people do it do a disaggregation between carry and mark-to-market. So that's why we put the total amount out there, so people can see what we've earned. And what's been supportive or what's buffered higher repo costs. But good question, I haven't seen many like stall that answer very well.

[Bose George, KBW]

Okay. And but the $0.34 is the amortization of previous marks, right, so.

[Rob Colligan, EVP and CFO]

Yes, that is correct. Yes - and as we go into a more of a technical answer, but we've put our total gain out there. We've used the straight-line approach being a REIT. And the tax impact is important. So that's why we're putting out that disclosure. If we were in swap form we'd probably have more gain upfront given the move-in rates and the shape of the curve. But in order to give a simple answer, we're just giving a total gain and how it will actually impact REIT [indiscernible].

[Bose George, KBW]

Yes, okay. No, that makes sense. Thanks a lot.

[Operator]

[Operator Instructions] Next we'll go to Eric Hagan with BTIG. Your line is open.

[Eric Hagan, BTIG]

Hi, thanks, good morning. Couple of questions here. When you think about the - how the hedges are allocated and maybe masked with the asset side of the balance sheet, how much is hedging is current coupon TBA versus the pools in the portfolio. And how do you see that hedge ratio evolving for TBA's versus pools going-forward? And then following-up on the question around leverage, just how does the slow prepayment environment - I would just factor-in itself kind of drive the amount of leverage you're willing to tolerate. Like, how does that triangulate with the amount of liquidity you carry, how much liquidity do you envision carrying if you're leverage would even go up a little bit more. Thanks.

[Smriti Popenoe, President and Co-Chief Investment Officer]

Okay, I'll take the second question first, which is the prepay environment which is an interesting thing. I think we've gone through probably the slowest period of prepays in the last three to four months. And from here on out, I think prepays will start to rise due to seasonal factors and just existing home sales, ramping-up off the bottom.

So in terms of the slow prepay, so yes, we do carry leverage, we do carry liquidity right to be able to manage the way the yield of an instrument changes over time as that pull-to-par comes back and that's an important factor-in thinking through having cash-on-hand to pay the dividend and so on and so forth, but it's not a - it's not a-- it's not a big material consideration, Eric. We're carrying sufficient amounts of cash and unencumbered assets to be able to cover all of that. So on the margin, it does not actually make a lot of difference in terms of our ability or willingness to take leverage up or down.

The main driver of whether or not we're going to make a marginal investment, is going to be, does the marginal investments make our return that exceeds the cost-of-capital. And in this environment that is also tempered with the macro question. Should we take up that risk? So, leverage is more a function of that demand at levels of liquidity we carry, a function of the macro volatility we expect and the strategy is to carry enough liquidity and unencumbered assets to be able to make the margin calls when spreads widen, so that you have excess capacity to put that extra capital to work when the spreads have widened and book-value has declined, right?

So we're anticipating book-value to decline as spreads widen, we want to be prepared for that with the extra liquidity. And then we want to be able to deploy that dry powder at that time to make that marginal investment and when spreads tighten in, you will get the benefit of that. So that's the second question. Your first question - remind me what that was again, look like.

[Eric Hagan, BTIG]

Yes, we're looking at the hedge ratio between TBA pools and how you guys think about that Thank you.

[Smriti Popenoe, President and Co-Chief Investment Officer]

Yes, I would say, look, we - the instruments that we hold many of them in fact not almost all of them trade at par or below par, right. So these are instruments that in general that even at these level of interest rates are going to be longer durated securities. Some of them, the current coupons have sensitivity to the five-year part of the curve. Some of them have more sensitivity to the seven and 10-year part of the curve.

So in general, we on a blended basis, we think our sensitivity somewhere between that five and seven-year part of the curve, and that's how we're thinking about that hedge ratio. When the hedge ratio changes and I think you're right on that, it's really when the underlying cash flows start to start to shift.

For the cash flows to shift, we think mortgage rates have to really start to fall much below 6%. Approximately 5.5% or so for cash flows to change and then or go the other direction, 7% or above. So you're now sitting sort of in the sweet-spot where your range-bound in treasuries, your mortgage durations aren't changing that much. So we're not really feeling a great need to mess around with the hedge ratio. But that's kind of how we think no matter it's mostly on an aggregated basis. The current coupons are more sensitive to the five-year part of the curve and below. But many - most of our assets are actually sitting much below par and that's why we have the longer curated hedges.

[Doug Harter, Credit Suisse]

Yes. Really helpful. Thank you guys very much.

[Smriti Popenoe, President and Co-Chief Investment Officer]

Sure.

[Operator]

There are no further questions at this time. I'll now turn the call back over to Byron Boston, CEO, for any additional or closing remarks.

[Byron Boston, CEO and Co-Chief Investment Officer]

Thank you very much all, and as I said earlier - I just want to make sure, I was not muted. Thank you again for joining our call this quarter and we look forward to chatting with you again next quarter. Thank you very much.

[Operator]

And this does conclude today's conference call. You may now disconnect.