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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning, everyone, and welcome to the AGNC Investment Corp First Quarter 2018 Shareholder Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please also note today’s event is being recorded.
And at this time, I would like to turn the conference call over to Katie Wisecarver in Investor Relations. ma’am, please go ahead.
Thank you, Jamie, and thank you all for joining AGNC Investment Corp.’s first quarter 2018 earnings call. Before we begin, I would like to review the Safe Harbor statement. This conference call and corresponding slide presentation contain statements that to the extent they are not recitations of historical 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. An archive of this presentation will be available on the website and the telephone recording can be accessed through May 10th by dialing 877-344-7529 or 412-317-0088, and the conference ID number is 10118544.
To view the slide presentation, turn to our website, agnc.com, and click on the Q1 2018 Earnings Presentation link in the lower right corner. Select the webcast option for both slides and audio, or click on the link in the conference call section to view the streaming slide presentation during the call. Participants on the call today include Gary Kain, Chief Executive Officer; Peter Federico, President and Chief Operating Officer; Chris Kuehl, Executive Vice President; Aaron Pas, Senior Vice President; and Bernie Bell, Senior Vice President and Chief Financial Officer.
With that, I’ll turn the call over to Gary Kain.
Thanks, Katie, and thanks to all of you for your interest in AGNC. On our fourth quarter call, we highlighted the unprecedented lack of volatility witnessed in longer term interest rates and equities throughout 2017. Clearly, things changed in late January and early February as interest rates increased around 40 basis points, equity markets weekend, and volatility spiked. This backdrop coupled with reduced fed mortgage purchases drove agency MBS spreads wider by 5 to 10 basis points during the quarter. MBS performance was logical though in light of the increase in volatility and the associated uptick in risk premiums across most asset classes.
To this point, credit spreads widened materially mid-quarter and high yield and IG indices industries at one point had reversed all of the spread tightening experienced during 2017, before recovering majority of the weakness by quarter-end. The wider MBS spreads and to a lesser degree, the increase in interest rates during Q1, led to the decline in AGNC’s book value and the negative economic return for the quarter. That said, our performance in Q1 was aided by our decision in Q4 to materially increase our hedge ratio and reduce our duration gap to almost zero. We will continue to benefit from these actions should rates continue to rise as they have so far in Q2.
Now, let’s turn to slide four and quickly review our results for the quarter. Comprehensive income was a loss of $0.53 per share, net spread and dollar roll income excluding catch-up am was $0.60 per share for the quarter. The slight decline from the prior quarter was a function of our higher hedge ratio, the increase in short-term rates and our slightly smaller portfolio. Looking ahead, as Peter will discuss in a few minutes, we anticipate that this measure should improve in Q1 -- Q2, in light of the significant widening we have seen in the spread between LIBOR and agency repo.
Tangible book value per share decline to $18.63 per share during the quarter, largely as a function of the wider agency MBS spreads. As a result, economic return was negative 2.6% in Q1. Additionally, despite the further sell-off in April, our current estimate of tangible book value for Q2 is down less than 2%.
At this point, I would like to turn the call over to Chris.
Thanks, Gary. Let’s turn to slide six.
In addition, the overall increase in interest rates, the yield curve continued to flatten during the third quarter. Swap spreads also widened across the curve. As you can see on the table on slide six, the two-year treasury yield increased 38 basis points and the 10-year rose 33 basis points, while two-year swap rates increased 50 basis points and 10-year swap rates increased 38 basis points. In the charts on the lower half of slide six, you can see the option adjusted spreads on agency MBS were wider buy a few basis points. However, this understates the underperformance of agency MBS versus treasury or swap hedges, given the sharp re-pricing of implied volatility which pushed nominal spreads on 30-year MBS 5 to 10 basis points wider during the quarter. As a reminder, the difference between nominal spread and option adjusted spread is option cost. And is implied volatility rises, the value of the prepayment option embedded in fixed rate MBS increases.
Let’s turn to slide seven. At risk leverage increased slightly from 8.1 to 8.2, despite a small decline in the size of our portfolio, given a lower net asset value as of March 31st. However, given the recent backup in rates and somewhat wider spreads, we’ve started to slowly increase our MBS holdings. On the top right of slide seven, you can see that prepayment fees on our specified pools are well contained, given the combination of asset selection interest rate levels and slower seasonal factors. Our average CPR for the first quarter was 8.6%, down 1.5% from 10.1% last quarter. The average balance of our TBA position was $15.6 billion during the first quarter. However, the period ending balance as of March 31st, was slightly lower at $13.6 billion. TBA roll implied financing specialness stabilized during the first quarter at levels generally consistent with long-run historical averages.
As we discussed on the call last quarter, the fundamental backdrop for levered investors in agency MBS is strong relative to other fixed income products. Prepayment risk is low and the funding markets are very healthy. Valuations on agency MBS are reasonable, but not cheap and at current levels we wouldn’t expect significant changes in leverage. That said, if agency MBS spreads widen materially, due to an overreaction to either the reduction in fed purchases or to further increases in interest rate or credit spread volatility, we would welcome the opportunity to increase leverage.
I will now turn the call over to Peter to discuss funding and risk management.
Thanks, Chris. I’ll start with a brief review of our financing summary on slide eight.
Our average repo cost at quarter-end was 182 basis points, an increase of 25 basis points from the prior quarter, consistent with the fed’s rate increase in March. A portion of this increase was offset by a modest reduction in the cost of our swap hedges. This improvement in swap cost however was muted by the incremental cost of new swap hedges that we added late in the fourth quarter and early in the first quarter to provide us with a greater level of interest rate protection.
Our average aggregate cost of funds which includes our off-balance sheet TBA funding as well as our cost of swap hedges, increased to 168 basis points from 152 basis points the prior quarter. Despite the increase in our cost of funds, a very favorable funding dynamic emerged in the first quarter.
As we show on slide nine, there was a dramatic shift in the relationship between our repo cost and three-month LIBOR, particularly in March. This relationship is a key variable in our overall cost of funds equation because we hedge our repo funding with pay-fixed swaps whereby we pay a fixed rate and receive three-month LIBOR every quarter.
As we show in the graph on the bottom left of the page, due to a number of factors including tax reform and Treasury bill supply, three-month LIBOR increased 61 basis points during the quarter to peak at 2.31%. Importantly, the increase in three-month LIBOR significantly outpaced the 25 basis-point increase in our repo cost. As a result, the spread between three-month LIBOR in our repo funding moved significantly in our favor during the quarter and ended at a positive differential of 49 basis points. We show a history of the spread relationship on the graph on the bottom right of the page. For comparison, that spread was negative 3 basis points at the end of the third quarter of 2017 and positive 12 basis points in our favor at the end of the year. The level today remains extremely favorable at about 40 basis points.
Due to the timing of our swap reset, the full benefit of the spread movement was not realized in the first quarter. You can see the timing effect on the graph on the bottom left. At quarter-end, our average receive rate on our swap portfolio was 1.9%, significantly below the then prevailing 3-month LIBOR rate. As our swap book resets over the next 90 days, the average receive rate will converge to the current 3-month LIBOR level. This increase will materially improve the carry on our swap portfolio and in the absence of other factors, provide a meaningful tailwind to our cost of funds and net spread income over the next couple of quarters.
Turning to slide 10 and 11, I’ll quickly review our hedging activity and interest rate risk position. In summary, we increased our hedge portfolio to $65 billion and increased our hedge allocation toward a greater share of swap hedges. In the current environment, we believe it is appropriate to operate with less interest rate risk.
On slide 11, we show our duration gap and duration gap sensitivity. Despite the nearly 40 basis-point increase in 10-year swap rates, our duration gap at quarter-end increased only modestly to a half a year. Additionally, our duration gap in the up 100 basis-point scenario increases to just 1.3 years, comparable to the 1.2 years that we reported at the end of December. The stability in this measure shows the minimal un-hedged expansion risk that remains in our portfolio.
With that, I’ll turn the call back over to Gary.
Thanks. And at this point, we’ll open up the lines to questions.
[Operator Instructions] And our first question today comes from Douglas Harter from Credit Suisse. Please go ahead with your question.
Peter, could you help us understand kind of what the timeframe is for that your receive rate to catch-up with LIBOR and how often your swaps reset?
Sure, Doug. It is great question. And we actually added the key number that I think you need in that calculation on page nine. Let me just give you sort of the history of the reset that the average receive rate on our swap portfolio for the last couple of quarters. And the key number for the fourth quarter, our average rate was 1.63%. At the end of the quarter, as we show on slide nine, the average rate as of quarter-end was 1.9%. So, over the quarter, the entire swap portfolio will reset at the higher level of around to 2, 2.35. So, on average, I would expect the average receive rate in the second quarter to be around 2.15%.
And Gary, just a big picture. If you could just talk about your thoughts on consolidation and M&A in the mortgage REIT space, kind of where we are today?
Sure. I mean, I’m really just going to repeat kind of what I’ve said in the past, which is just big picture from our perspective. We owe it to shareholders to look at these, to look at any potential transactions and to see if you can essentially by assets at levels that are favorable to other alternatives or if you can raise equity kind of at more advantageous levels, and that’s kind of the perspective we have been looking at. I think big picture with respect to M&A in the space, it’s I think more one-off in terms of these transactions. If you look backwards in time, there aren’t that many of them. I mean, I’m sure there will be others over time, but they tend to be more one-off, and that’s really all I would say on the subject.
Our next question comes from Bose George from KBW. Please go ahead with your question.
Actually follow-up on the LIBOR repo benefit. So, just to -- when we look at the quarter over quarter difference, just based on the numbers you gave, so is that about 25 basis-point kind of improvement quarter over quarter from that?
Yes. Actually, on the receive rate, I think it’s going to ultimately prove to be higher than that. Now, there will be some other factors that you have to take into account. But, as I said, we ended the quarter on average receive rate of 1.9. It will ultimately reset to 2.35. So, the average will be around 2.15%. But, there will be some other factors that you have to take into account. And obviously repo rate will be a little bit higher. There could be some changes in our swap portfolio. But, it will be around 2 point -- if you just look at what I said the average of quarter over quarter, it’ll be about 35 basis-point increase in our average receive rate. So, in other way, we will end up improving materially. Our portfolio, the average receive rate will be in our favor by 35 basis points in the second quarter.
Okay, great. Thanks it helps. And then, just in terms of the incremental sort of ROE right now on capital that you’re investing, like, where does that stand?
It really depends on how long you price in this benefit realistically. I mean, I think, ROEs, remember, there sort of the equation is, you look at your spread to funding and leverage is important and borrowing costs is important. But, this is a significant increase in the net spread on the levered investments, if your funding is this much better than LIBOR. And so, I mean, to some degree, it depends on how long you want to price that in. But, in the short run, it’s pretty significant. If you kind of phase it out over time, you’re still looking at a percent or two improvement. So, you get into the year in the low double digits.
Okay. But, in the near-term it’s whatever, more like 3% just.
If you price in 40 basis points, it’s a big number.
Okay, great. Thanks. And then just on the duration gap, if you had done no rebalancing, what would have happened to the duration gap.
Yes. It would have moved probably about two-tenths of a year higher. I mean, obviously, we really benefited from having a higher mix of swaptions in our hedge mix. And you can see the expansion in the protection that those hedges are giving us. But, if we had done nothing, it probably would’ve been around three quarters of a year, something in that neighborhood.
What I think is interesting is that what Peter mentioned in terms of the extension from here, doing absolutely nothing over another 100 basis points from where we ended the quarter. So, which would be like mid -- 375isyh, 378 on tens, and our duration gap doing nothing would be 1.3 years, which is well within the tolerance of where we’d be willing to run. It just -- I think it shows kind of the lack of extension kind of at this point in our portfolio and really the lack of a need to do much rebalancing. And a lot of that’s because of the actions we have taken prior to the quarter before rates have gone up, back in the end of last year. We’re already running pretty well-hedged and then took the duration gap down even more.
And our next question comes from Rick Shane from JP Morgan. Please go ahead with your question.
Just want to double check our back of the envelope math. $45 billion swap portfolio, 30 basis points. That implies with that convergence about $0.09 per quarter of earnings. Is that where you’re coming out as well?
Rick, good question. I’m glad you asked for clarification there. You’re right on that component of it. If you just look at just the swap benefit quarter-over-quarter, that calculation would be about right. But there will be some other factors that you have to take into account. For example, our average repo rate for the quarter, last quarter was 1.69%. But, as we showed our ending repo rate was 1.82%. So, our repo -- said another way, our repo rate, our average repo rate is going to increase. So, you’d have to take that into account as well. So, that’s going to offset some of that benefit. Yes. And there could be other changes obviously as well. But, go ahead, sorry.
But, net-net, the benefit is significant. Sorry.
Fair enough. And when we look at that chart on page nine, I think the way that we would interpret this is that this is a non-permanent; it’s real economic benefit that you will enjoy for a period of time. But ultimately, we should see convergence back to that sort of flat between the spread differential?
Yes. Great question. You’re right. It’s hard to say, obviously. But right now, I mean there were some technical factors in the first quarter, and the first half of the year, particularly treasury bill supply, which will subside in the second half of the year and that will put some downward pressure on this. But, the tax reform obviously could be a more lasting change. And there are other fundamental factors going on with LIBOR, which are very difficult to quantify. Obviously, LIBOR is going to go away over the next couple of years. And the way LIBOR is being reset, I think now more accurately reflects the underlying funding that the banks are actually incurring, particularly in the CP markets. So, that, I would say maybe a more long-term technical that will keep that LIBOR rate elevated relative to repo. But, you’re right. This is hard to gauge how long this benefit is going to last, but just the way our portfolio resets, it’s going to have an impact, at least for the next couple of quarters.
Yes. The one thing I would add is if you just look at the chart on the bottom right on page nine, I mean, even assuming that this -- a peak comes back down and we get some mean reversion, there is still a trend here, which we’ve been talking about for a while. And the trend is one where agency repo is improving relative to LIBOR. And that does make sense from a secular perspective. So, we saw a peak, an improvement in this a little over a year-ago, or year and half ago when money market reform was put in place. And then, it came back down and now we’ve seen this dramatic improvement in the relationship over the last few months. And yes, it would be very logical to assume that that’s going to come back down. But when you look at this chart, there is still a trend. And I think that relates to, as Peter mentioned how LIBOR is being looked at, but it also relates to the changes in the agency repo market or the government repo market in terms of the broadening of counterparties, the change in borrower profile and other factors, which are improving spreads there or pricing there. So, I think there’s clearly a cyclical component that’s going to be limited. But, I think you look at that line and it also like jumps out, but there is a secular component as well.
It is somewhat ironic that three or four years ago while the calls were getting -- calls we did were about the potential decline in supply of repo.
Right.
Our next question comes from Trevor Cranston from JMP Securities. Please go ahead with your question.
Thanks. Most of my questions were asked already, but one final follow-up on the LIBOR versus repo spread. If we were to see some mean reversion in that relationship and three-month LIBOR front since declined somewhat, how do we think about throughout the quarter what the resets on your swap looks like? For example, if three-month LIBOR went down to 2% over the next couple of weeks, how much your swaps would actually benefit from the higher rate this quarter?
Yes. Thanks for the question, Trevor. The way I would say, probably the best way to do it is just assume, for purposes of your calculation of what the average receive rate would be, just assume that the portfolio reset evenly over the course of the quarter. So, a third of the portfolio is going to reset each month of the quarter and over the full 90 days because all of our swaps are 90-day receive, it will reset. So if you do that, you’ll have half of the effect of the LIBOR change will be reflected each quarter. So, with LIBOR being at for example at 2.35 right now or even a little higher and I said that I expect our average receive rate to be around 2 to 2.15 in the second quarter, if LIBOR doesn’t change, I would expect our receive rate in the third quarter to be at 2.35. So, just to give you a sense on how we would expect it to change over the next two quarters.
And our next question comes from Fred Small from Compass Point. Please go ahead with your question.
Can you quantify the actual EPS benefit that you saw from the favorable funding dynamic that we’ve been discussing in the first quarter?
Well, in the first quarter, it was pretty small. I would say it was -- I don’t want to use the term negligible, but it’s a fraction of what we would see in the second quarter and to Peter’s point, the third quarter as we get out. Like, if things don’t change or relationships hold that where you get all that, but it was not that material in the first quarter.
To quantify the impact in the first quarter, our average receive rate in the fourth quarter was 1.42% and it increased to 1.63%. So, our average receive rate only increased 21 basis points. To Gary’s point, that change in our receive rate was consistent with the change in the fed funds rate and our funding. So, there was essentially and equal offset in the first quarter. The incremental benefit will show up in the following quarters.
And just, so I understand, I always have trouble trying to recreate it. But, the difference that you see between sort of what you report as your weighted average repo and general collateral MBS repo unlike an index [indiscernible]?
Yes. Well, it depends on where you’re looking. Our two-party repo, I think would be consistent with wherever you look for just general MBS repo levels. I think, there would be a relatively good indication of our funding costs. When we fund through our broker dealer, I would expect that that benefit would be about 10 basis points lower than what you might observe for just generic two-party agency repo.
And how much of repo is currently funded through the fed fund? [Ph]
At the end of the first quarter, we had close to 40% of our funding, it was a little over $18 billion -- around 38% of our funding was going through our broker dealer. I would expect that number to increase gradually over the course of the remainder of the year, but maybe peaking somewhere in the high-40s.
And then, just thoughts right now, if I look at AGNC’s dividend coverage, it’s certainly among the best, if not the best. And then, you’ve got another, sounds like earnings tailwind kicking in here; thoughts on the current dividend level or any potential uptake to increase that?
We don’t tend to -- we don’t really like to give guidance around the dividend. What I would say is I think your opening -- your conclusions were accurate around the coverage and the tailwind behind net spread income at this point. But, there is a lot that goes into the dividend equation. And I think stability is something that investors value. And always keep in mind that irrespective of the dividend, our goal is to maximize earnings potential. And in that environment, if we continue to -- if we can out-earn our dividend, then investors will see that benefit in terms of total returns and improvements and book value and then hopefully in the stock price.
Our next question comes from Ken Bruce from Bank of America Merrill Lynch. Please go ahead with your question.
I guess the question relates also to funding costs, maybe in a slightly different matter. I guess, my experience with these situations where you’ve got a little bit of a wind fall, it tends to essence get bone out in the pricing of other financial instruments. And I’m wondering, if you’re seeing any impact on I guess the pricing of MBS, either due to others being able to capture this tailwind to potential economics of this transaction.
So very, very good question. And I think the answer to that is no. And the reason for that is that the levered investor nowadays is not the marginal bid for agency MBS. And so, for that reason, obviously you still do have a fed bid, but you have an overseas bid, which there’s some leverage associated in that borrowing. But, the reality is, look at the REIT space or even levered investors and the hedge fund space that are going to have large swap positions, just are not the marginal bid, right now. So, I don’t -- the short answer is, if you look at agency MBS relative to other fixed income products, you are not seeing outperformance because of this. So, we’re pretty confident that while yes, in theory, it should be priced into the asset price, it really does depend on what percentage of the buyers of MBS are levered, hedged investors. And the bottom line is that number is pretty small. And for that reason, we’re not seeing it. And I think we’re sort of uniquely positioned to benefit from it. And I think the other piece of that is, we talked a lot about levered returns in agency MBS versus levered returns and other products. And I do think it is -- this is another incremental kind of advantage to that equation. I think the levered returns in agency MBS are going to be -- continue to be superior to that of other products, especially again in light of the fed continuing to reduce our purchases.
And I guess, as a follow-up. There’s been -- concern tends to come and go in the market just about the flattening of the yield curve. So, I guess, at the moment with the 10-year having moved, probably less concerned about that. But do you have a view as to whether you think the curve either flattens out from here or what’s your broader view of how that plays out in the next year or so?
Look, I think, the curve stays flat. The curve has flattened dramatically. There’s very little value to let’s say, running a duration gap. And we’re -- the reality is when you run a position as hedged ours is, you don’t get that much incremental spread from the shape of the curve. So, what I would say is kind of our take on interest rates or our view has been one where we’re bearish in the short run, but only to the tune of maybe another 25 basis points on the long end, and maybe a little more on the short end. And so, I think there is some room for a little bit more flattening. But then, I think then that bias is probably lower, kind of in rates across the curve. So, the big picture I think we’ve seen the bulk of the backup in rates although we expect a little bit more. But from there, I think eventually that will -- eventually meaning maybe a year or two, I think we could easily move toward a steeper curve to the extent that global growth sort of slows down again.
And lastly, I’m sorry to get technical, but just in terms of -- there is basis widening that eroded book value in the quarter. Are you seeing any potential for that to change from here, either wider or tighter? And I assume that if the spreads tightened, then you would see, maybe some, if you will, give back on book value -- that book value reduction in the quarter?
Let me -- what I want to first reiterate what I mentioned earlier, obviously, we hit 3% yesterday on 10s. What I said, it was -- at this point, what we see is that our book value up until yesterday, was down less than 2%. There was really very little kind of net mortgage spread movement on the quarter, but pretty sizeable interest rate movement. So, from here, you do have continued reduction of fed purchases. But, as we said before, we think that’s something that the market knows about has priced in. But, we’re seeing pretty strong performance in other fixed income products and spreads. And at this point, most of the extension in the mortgage market has occurred.
So, we wouldn’t be surprised to see if there is incremental volatility, some periods of wider spreads in the mortgage market. And we’re actually looking for it to in a way taking advantage of those opportunities to increase leverage over time. I mean, again, I think, given the reduction in the fed’s purchases, it would be logical for the bias, but it’s not a big bias to be toward slightly wider spreads. But big picture, we view that as an opportunity.
[Operator Instructions] Our next question is a follow-up from Douglas Harter from Credit Suisse. Please go ahead with your follow-up.
With the funding benefit you have, is there any change in your appetite between TBAs and owning pools today?
Not really. It flows through in both. I mean, I think there is maybe -- there is the ways in that relationship. And what I would say is it’s not a big picture kind of differentiator at this point. I mean, generally, our TBA position has been dropping, but it’s not that much of a function of this.
I’d say, I’d just add to that. I mean, rolls traded somewhat weaker late in the fourth quarter that carried over into the first couple of weeks of January. But generally speaking, roll-implied financing rates traded pretty well throughout the first quarter. Currently, just to give you an idea, lower coupon, 30s [ph] are trading somewhat weaker, call it flat to maybe 5 basis points through mortgage repo. But higher coupons are trading very well in the 20 to 40 basis-point area through repo. And then, 15 is currently in the, call it 10 to 20 basis-point area for repo, just to give you a sense for where things are today.
So, the short answer is, it’s more of a LIBOR effect than it is a repo or agency mortgage funding effect. And so, again, that’s why, it’s not a big factor in that decision.
And then, I guess in your prepared remarks, you said, you kind of weren’t looking to materially change leverage at this point. Is there an opportunity to or way to benefit from this funding advantage you have now, at least in the short-term and sort of take-up leverage just for the short-term to take advantage of the funding, or is that -- or kind of how do you think about that?
I think, the reality is that we look at the overall ROE equation and you know Chris did mention we get we had been recently adding to the mortgage portfolio. But you have to look at this is as a kind of a long -- you have to look at a purchase as over a long-term ROE. And yes, there is short-term benefit. But, what we’ve said in the past is that we are looking for opportunities to increase leverage. And practically speaking, those opportunities can either come from spread widening or they could come from improved funding. But going back to a prior question, I still think there aren’t that many investors in the mortgage market that benefit from this equation. So, it is still possible to get better opportunities on the spread side, even with the improvement in funding. So, that’s something we have to balance over time, but it’s certainly a consideration.
And ladies and gentlemen, at this time, we’ve completed the question-and-answer session. I would like to turn the call back over to Gary Kain for any concluding remarks.
I would like to thank everyone for their interest in AGNC and we look forward to talking to you on the next quarter.
Ladies and gentlemen, that does conclude today’s conference call. We do thank you for attending. You may now disconnect your lines.