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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 and welcome to the AGNC Investment Corp. Third 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.
At this time, I would like to turn the conference call over to Katie Wisecarver in Investor Relations. Please go ahead.
Thank you, Jamie, and thank you all for joining AGNC Investment Corp.'s third quarter 2018 earnings call. Before we begin, I'd 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 our website and the telephone recording can be accessed through November 8th by dialing 877-344-7529 or 412-317-0088, and the conference ID number is 10124456.
To view the slide presentation, turn to our website, agnc.com, and click on the Q3 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; Bernie Bell, Senior Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President; Peter Federico, President and Chief Operating Officer; and Aaron Pas, Senior Vice President.
With that, I'll turn the call over to Gary Kain.
Thanks, Katie. And thanks to all of you for your interest in AGNC. 10-year treasury rates closed the quarter north of 3% for the first time since 2013, rising around 20 basis points in Q3. Investor confidence in the strength of the US economy, coupled with somewhat more hawkish Fed commentary finally took its toll on the bond market. US equities continued their march higher during the quarter, while fixed income credit spreads tightened further.
On the negative side, international growth was unable to regain any positive momentum and emerging markets were hard-hit. Against the backdrop of higher rates, and mixed Agency MBS spreads, AGNC's economic return was slightly positive at 0.7% for the quarter as book value declined around 2%. Since quarter end, we have seen a spike in both equity and fixed income volatility, while rates continued to head higher with 10-year rates peaking around 3.25% earlier in the month before declining with the recent risk off move.
Equities, both in the US and globally have struggled throughout October, while credit spreads have given back most of the tightening experienced in Q3. We continue to believe that the deteriorating international picture, coupled with higher interest rates, greater political uncertainty and a growing fiscal deficit will eventually take its toll on growth in the US. That said, it is difficult to ascertain the timing in light of the positive momentum currently enjoyed by the US economy.
We also believe that longer term inflation expectations will remain well anchored. As such, further increases in intermediate and longer term rates should be relatively muted with 10-year rates unlikely to exceed 3.5% for any extended period of time. On the Agency MBS front, the bias remains toward further widening as the bulk of the demand has come from money managers and other relative value players, while banks have added fewer MBS than previously anticipated. This is unlikely to change as we head into the end of the year.
Additionally, volatility probably will not return to recent lows in the near term, which will also keep some pressure on Agency MBS. With this in mind, we have maintained our conservative leverage position but would be very comfortable opportunistically increasing our MBS exposure if spreads were to widen materially.
At this point, I'd like to turn the call over to Bernie to review the highlights for the quarter.
Thank you, Gary. Turning to Slide 4, comprehensive income was $0.03 per share for the quarter. Net spread and dollar roll income, excluding catch-up am was $0.61 per share. As Chris and Peter will discuss shortly, weaker TBA funding levels and a decline in the favorable spread differential between our repo funding and three month LIBOR received on our interest rate swaps contributed to the $0.02 decline in our net spread income from the second to third quarter.
As Gary mentioned, tangible net book family declined a little over 2% to $18 per share as of the end of the quarter, while our economic return, which include $0.54 dividends paid for the quarter was slightly positive at 0.7%.
Moving to Slide 5, our investment portfolio increased to $82 billion as a function of our capital raise during the quarter. Our at risk leverage averaged approximately 8.5 times tangible equity for the quarter. We ended the quarter slightly lower at 8.2 times as we proactively sold some MBS late in the quarter in anticipation of an increase in volatility going into year-end.
During the quarter, we raised a little over $800 million in new equity capital to a follow-on offering. This new equity was both accretive to book value and further enhances our operating efficiency. As the largest internally managed mortgage REIT, our cost structure as a percent of total equity is less than half that of our Agency peer group average.
Last week, during the third quarter we received $42 million of termination fee income in connection with the sale of MTGE and corresponding termination of the MTGE management agreement. The $42 million cash termination fee received more than exceeded the write-off of our remaining intangible asset associated with the management agreement of $23 million during the quarter.
And with that, I'll turn the call over to Chris to discuss the market.
Thanks, Bernie. Let's turn to Slide 6. Rates across the curve continued to move higher during the third quarter with 5-year and 10-year swap rates increasing 19 basis points. Swap spreads were a few basis points tighter with yields on 10-year treasuries increasing 21 basis points. 30-year Agency MBS spreads were more or less unchanged to slightly wider during the third quarter, while credit spreads were notably tighter with AAA CMBS and investment grade corporate debt approximately 13 basis points tighter and residential credit spreads approximately 20 basis points tighter quarter-over-quarter. Thus far into the fourth quarter, rates have continued to sell off and spreads on both Agency MBS and credit are noticeably wider.
Turning to Slide 7, you can see in the top left chart that the investment portfolio increased to $81.8 billion in market value, as of September 30th. Consistent with our equity raise, on a net basis, we added approximately $4.7 billion in MBS. In the charts on the lower half of Slide 7, you'll notice that our TBA position declined to $9.4 billion, driven by weaker roll implied financing rates, and relatively attractive specified pool valuations. Low loan balance and other specified pool valuations languished for much of this year given a combination of higher rate levels, a benign prepayment environments and a marginal bid for mortgages coming from money managers and investor base predominantly focused on TBA. These factors combined with a reduced Fed presence in the Agency MBS market also pressured roll implied financing rates lower, while at the same time allowed for specified pools to trade at attractive levels relative to both nominal carry metrics and option adjusted valuations.
Over the last two quarters, we've net added approximately $14 billion in 30-year specified pools backed by loans with either lower loan balances or other favorable convexity characteristics. Given the increase in specified pool holdings, I want to highlight a couple of points. First is that the absolute pay-up risk on our portfolio versus TBA is just over half of one point. Additionally, given the average seasoning of our holdings, the aggregate downside to pay-ups on the portfolio into higher rate environments is low.
Going forward, we will continue to be opportunistic and weigh TBA roll financing against alternative funding options, specified pool valuations in the overall prepayment environments. Importantly, we do expect that over the longer-term, we will continue to have favorable opportunities to finance TBA positions at levels consistent with long-run historical averages of around 10 to 15 basis points below repo. But it's important to recognize that there will be times when supply and demand technicals are less favorable. We just happen to be in one of those periods.
I'll 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 activity. Consistent with the Fed's decision to raise short-term rates another 25 basis points in September, our average funding cost, which includes the cost of our repo funding and the implied financing rate on our TBA assets, increased by a similar amount in the third quarter to 2.18%. Our total cost of funds which includes the benefit we receive from our pay fixed swaps increased 21 basis points to 1.88% in the third quarter. Our aggregate cost of funds was negatively impacted in the third quarter by some deterioration in the spread between repo funding and three month LIBOR as well as the weakening in TBA funding levels that Chris mentioned. Both of these funding variables have been relatively stable thus far in the fourth quarter.
Turning to Slide 10, I'll quickly review our hedging activity. Consistent with the increase in our capital base and corresponding growth in our asset portfolio, we increased our hedge portfolio to $71.7 billion. At that level, our hedge portfolio 95% of our funding liabilities.
Finally, on Slide 11, we provided summary of our interest rate risk position. Despite the increase in interest rates during the quarter, our duration gap remained relatively stable at 0.9 years.
Lastly, extension risk in our portfolio continues to be limited with our estimated duration gap in the up 100 basis points scenario, being less than two years.
With that, I'll turn the call back over to Gary.
Thanks, Peter. And at this point, I'd like to open up the call to questions.
[Operator Instructions] Our first question today comes from Bose George from KBW. Please go ahead with your question.
Just given your commentary on spreads, et cetera, can you give us an update on just quarter-to-date book value?
Sure, I mean obviously the things have been relatively volatile on both the rate front and on the spread front. But let’s say down 4% or so is a good ballpark number.
Okay, great. Thanks. And then the -- given that as well, can you just talk about where incremental returns are, what’s that done to the opportunity for you guys?
I mean spread widening is noticeable on the quarter but we will call it maybe just over 5 basis points. So I mean there's a little bit of a benefit there in terms of ROEs. But at this stage of the game, I wouldn’t say that spread widening is creating kind of a massive change in the outlook. I mean it’s for that reason that we kind of proactively kind of kept our leverage unchanged. We’ve talked for a while about increasing leverage and we still fully intend to do that at some point. But as I mentioned earlier, we still remain somewhat bearish on mortgage spreads in the near term. But again, if spreads were to move more materially, then we view that as a very good opportunity.
Okay, thanks. And then actually one small one just on your repo maturities. It came down to 67 days from 101, just curious what drove that?
Yes. Hi, Bose. This is Peter. Yes, that’s one of the benefits we get from having our own broker dealer and we’re able to through that broker-dealer I think access shorter-term funds which we think in the current environment is a benefit given the fact that you know when you move out to three months, four months and six months out in that range you start to price in materially more Fed activity. So keeping our book a little shorter has given us a benefit in our overall funding. But I don’t expect it to change much from where it is today.
Our next question comes from Rick Shane from JP Morgan. Please go ahead with your question.
Hey, guys. Thanks for taking my questions this morning. Gary, when we sort of laid out your macro -- or your outlook, you were pointing to higher volatility, greater risk of spread widening and potentially sort of limited near-term risk on higher rates. That suggests a couple of things, primarily that hedge costs will probably go up a little bit, but at the same time, you have less interest potentially in swapping out that book. Should we expect the duration in the portfolio is going to go up modestly and should that lead to marginally better returns?
I guess what I would say, let me characterize it a little differently. What I would say is in the short-run I think we still remain a little bearish on interest rates but we again don’t think that rates are likely to move that much higher against. That backdrop, our duration gap, as Peter mentioned today, is not very different from what it was at the end of the quarter. I think if you were to get to that higher end of the range that I mentioned, if we would get up near let's say 3.5 on rates, let's say this current risk-off bout that we’re dealing with ends and rates pick-up a little bit. I think it is logical to assume that we would increase our duration gap, since in that environment it would still be a positive slope to the yield curve. That would help earnings a little bit, as we would reduce our kind of overall hedging activity as a percentage of the book. So I think there is upside assuming we get that kind of scenario.
With respect to kind of current positioning, yes, hedges are cheaper now given the shape of the yield curve. But on the other hand, we know we have to be cognizant that with mortgage negative convexity, we have two-sided interest rate risk and that's kind of dictated the interest rate position that we have now. I think I got most of your question, but let me know if there's something you want me to follow-up on?
No, that’s exactly what I was looking for. Thank you very much.
Our next question comes from Doug Harter from Credit Suisse. Please go ahead with your question.
Hi, Gary. Have you seen any change in credit pricing, kind of given this risk-off move we've seen here? And just in general, what's your appetite on credit today?
So yes, I mean credit spreads have clearly widened noticeably on the quarter. They're pretty close to -- basically having given back the performance in Q3, the tightening in Q3. That said, I mean ROEs are still -- even for us with a really low expense ratio, net ROEs are still mid single-digits, maybe a little better than that. So big picture, we haven't seen enough of a change to get us more interested in increasing our credit positions. But I do think it's important to stress that look we’re obviously kind of going through, this is what we call at this point a mini credit event, where volatility has picked up. We’ve seen a few of these over the last three or four years. At some of point, one of these is going to propagate into something bigger than that. And we're very focused on being well positioned for that type of scenario. I'm not predicting that this -- what we’ve seen over the last month is going to translate into that opportunity but there is going to be a credit event, probably in the not-too-distant future and the liquidity of our Agency portfolio, coupled with the capabilities that we've developed over the years, partially in managing MTGE, but also in just making direct investments for AGNC are such that if that scenario unfolds we intend to be very active in looking at a range of credit products. So again, at this stage, the move is not -- has not been anywhere near material enough to change the relative value landscape but that would be a very good scenario for us if that were to -- if this were to continue down that path.
Our next question comes from Trevor Cranston from JMP Securities. Please go ahead with your question.
Hi, thanks. A question on prepay speeds. Looking at the projected lifetime speed for the book and I guess the speed you guys saw for October, the numbers are pretty low. I was wondering if you guys could comment on sort of where you see sort of the baseline turnover speeds for your portfolio and incrementally if we did see the 10-year sort of move up to the 3.50 level, how much more room there is for speeds to continue to decline? Thank you.
Sure, so over the very near-term speeds are likely to decline. Next month speeds will actually be up slightly, just given increase in day count. But seasonals into the winter months speeds will likely decline a bit from here. But with respect to turnover, I would say it's pretty close to this area call it 6, 7 CPR on the 30-year book is kind of a reasonable long-term projection. I think over the near-term, turnover -- baseline turnover has been coming in quite a bit faster than that due to just general relatively fast housing turnover and cash-out refis. I think that’s likely to start to slow, just given the move in rates. The cost of doing the cash out refinance has gone up materially. So I think it’s reasonable to expect that the long-term sort of forecasted CPRs will start to become more in line with sort of actual turnover going forward.
Got it. Okay. That’s helpful. And then a question on the financing side. The repo coming through, Bethesda is up to about $26 billion now. Can you remind us how to think about sort of how you guys view the optimal size of that and what the capacity for borrowing through Bethesda as a percentage of the total borrowings? Thanks.
Hi, Trevor. It is Peter. Yes, it's up to that level. On a percentage basis, it was actually down a little bit quarter-over-quarter. But I would expect it to be in let's say for a longer run target somewhere in the 40% to 50% of our funding level. And obviously it's really attractive funding as it's hugely beneficial from a margin perspective. It makes us much more efficient from a capital perspective. And obviously, gives us access to a lower cost funding. But at the same time, we're also cognizant that we want to maintain maximum liquidity with all of our counterparties. We have 46 counterparties in addition to Bethesda Securities that we want to be active with so that we have ample liquidity with everybody. And so I think in that 40% to 50% range would be a comfortable target for the foreseeable future.
Our next question comes from Mark DeVries from Barclays. Please go ahead with your question.
Yes, thanks. Gary, you mentioned the expectation that spreads widen here on agencies in the intermediate term and when you see that happen, maybe there will be a more attractive opportunity to lever up. But how do you think about the idea of de-levering some in advance of that widening to kind of dampen some of the book value volatility and protect a little bit more equity that you have to re-lever when the spreads get more attractive?
Look, that's a good question and I mean I guess we did a little of that in September. Our average leverage was higher. We felt spreads had gone too far. We thought there would be some year end volatility. So, we took our leverage back down let's say in mid-September. But I think one of the things that we are very cognizant of in terms of the AGNC’s value proposition is to be a little more transparent and somewhat a little more consistent. And trying to move leverage around and make big timing trades has a cost in terms of obviously earnings and kind of -- and we are harder to predict and obviously less transparent. In big picture, I think we take very seriously the transparency for shareholders, consistency of returns and so forth. And so, we intend to actively manage the portfolio, be proactive, but we have to balance that against a backdrop of being consistent and transparent. And so, that's kind of the mindset that we take in that process.
Ladies and gentlemen, at this time, I'm showing no additional questions. We will complete today's question-and-answer session. I’d like to turn the conference call back over to Gary Kain for any concluding remarks.
Well, I would like to thank everyone for their participation on the call and we look forward to talking to you next quarter.
And ladies and gentlemen, that does conclude today's conference call. We thank you for joining today's presentation. You may now disconnect your lines.