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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 day and welcome to the AGNC Investment Corp. Fourth Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note today's event is being recorded.
I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please, go ahead.
Thank you all for joining AGNC Investment Corp.'s fourth quarter 2020 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 facts, 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 forecasts 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 includes Gary Kain, Chief Executive Officer; Bernie Bell, Senior Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President; Aaron Pas, Senior Vice President; and Peter Federico, President and Chief Operating 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. Our portfolio continued to perform extremely well in Q4, supported by very attractive funding and ongoing large-scale fed MBS purchases. Most importantly, the positive 7.5% economic return in Q4 lifted our full year 2020 total economic return to positive 3.5%.
As a reminder, economic return is the combination of dividends paid, plus the change in our book value. In 2020, the $1.56 in cash dividends paid during the year more than offset the $0.95 per share decline in our book value. This is a very favorable result, given the 23% book value decline in Q1 and the significant full year losses experienced by many of our peers.
During the fourth quarter equity markets continued to show substantial strength and credit spreads tightened, as optimism around additional fiscal stimulus and vaccine efficacy boosted the prospects for a second half 2021 recovery. Consistent with this stronger economic outlook, the yield curve began to steepen, with longer-term rates rising modestly, a trend that has continued in January.
Agency MBS performance was strong during the quarter across the board, with lower coupons outperforming. MBS continued to benefit from ongoing fed support, limited interest rate volatility and strong dollar roll funding levels.
Looking ahead, the improvement in the valuation of all financial assets, including agency MBS over the last several quarters does reduce the expected return profile on new investments. That said, agency MBS are still attractive on a relative basis for levered investors, given the dual benefits of low funding costs and continued fed purchases.
Importantly, the near zero interest rate environment is likely to be with us through at least 2023 and it is unlikely we will see any tapering of MBS purchases before early 2022. Even after the fed stops growing their balance sheet, they will likely remain very active in the mortgage market, replacing the runoff in their portfolio, until they begin to raise short-term interest rates.
At this point, I will turn the call over to Bernie to review our financial results for the quarter.
Thank you, Gary. Turning to slide 4. We had total comprehensive income of $1.16 per share for the fourth quarter. Net spread and dollar roll income excluding catch up AM was $0.75 per share. The $0.06 decline from our recent third quarter peak of $0.81 per share was largely attributable to lower prevailing yields on new asset purchases and the funding advantage of our TBA dollar roll position moderating somewhat during the fourth quarter.
As I mentioned on our last call, looking ahead over the next several quarters, we expect this general trend to continue. That being said, we still expect our net spread and dollar roll income to remain well above early 2020 levels. Tangible net book value increased 5.2% for the quarter, largely due to the strong performance of our lower coupon assets. Including dividends of $0.36 per share, our economic return on tangible common equity was 7.5% for the fourth quarter. So far this month, as of last Friday, we estimate that our tangible net book value is up about 3%.
Turning to slide 5. Our investment portfolio at quarter end totaled $97.9 billion largely unchanged from the third quarter. Our ending leverage was 8.5 times tangible equity, down from 8.8 times as of last quarter end, largely due to book value appreciation. Our liquidity position remained very strong in the fourth quarter with cash and unencumbered agency assets totaling $5.4 billion at quarter end, which excludes both unencumbered credit assets and assets held at our broker-dealer subsidiary Bethesda Securities.
Actual prepayment speeds on our portfolio increased to 27.6% for the quarter. But importantly, this does not include the lower coupon component of our holdings held in TBA form. Our forecasted life CPRs increased to 17.6% as of quarter end from 15.9% the prior quarter, largely due to a 20 basis point decline in primary mortgage rates during the quarter. Also notable during the fourth quarter, we completed an additional $101 million of accretive common stock repurchases at an average repurchase price of $15.32 per share.
Moving to slide 6. For the year we had total comprehensive income of $0.47 per share and $2.70 of net spread and dollar roll income excluding catch-up AM. And as Gary mentioned, despite the extremely challenging market conditions earlier in the year, we generated a 3.5% positive economic return for the year. Lastly, demonstrating our commitment to shareholder-friendly capital markets activities, we completed $1.4 billion of accretive capital transactions during the year, including $402 million of common stock repurchases or 5% of our outstanding common stock.
With that, I'll turn the call over to Chris to discuss the agency mortgage market.
Thanks, Bernie. Let's turn to slide 7. Following the election and vaccine news, interest rate volatility continued its downward trend with rates gradually moving higher on the longer end of the yield curve. A steeper curve, lower interest rate volatility and the steadfast commitment from the Fed to maintain its current policy until substantial further economic progress is made provided a strong tailwind for risk assets and in particular agency MBS.
As you can see agency MBS prices were higher across the coupon stack, despite 10-year notes selling off 23 basis points in yield or a little more than two points in price, even longer duration lower coupon MBS ended the quarter higher in price. Specified pool performance, while generally positive versus hedges, underperformed the tightening in lower coupons during the quarter.
Let's turn to slide 8. As you can see in the top left chart the investment portfolio at $98 billion was little changed as of December 31st. Given attractive spreads and favorable demand technicals for lower coupon 30-year MBS, we incrementally trimmed higher coupon holdings during the fourth quarter in favor of production coupon MBS. However, with the outperformance of lower coupons in the fourth quarter and since year-end, the relative value equation between higher coupon specified pools and production coupons is balanced now and unlikely to drive further compositional changes outside of the natural replacement of runoff.
Importantly, we maintained a large TBA net roll position of $33.8 billion during the fourth quarter as roll implied financing continued to trade exceptionally well particularly during the first half of the quarter.
Roll implied financing cheapened noticeably into year-end, but remains attractive in some coupons. Currently 30-year production coupon implied financing rates are roughly 10 to 15 basis points special relative to repo.
Looking ahead, while agency mortgage spreads have tightened considerably over the last six months this performance is not unique to the sector. Corporate debt, residential credit, CMBS have all performed well and some relative value relationships still suggest that agency MBS have further room for spreads to tighten, particularly given the backdrop of ongoing Fed purchases, attractive funding, and a prepayment environment that is likely to improve during 2021.
I'll now turn the call over to Aaron to discuss the non-agency market.
Thanks Chris. I'll quickly recap the quarter our current positioning and then provide an update on our outlook for housing and credit. Please turn to Slide 9. After risk assets widened briefly in October the rally was back on track for the rest of the quarter. Event risk associated with the election dissipated and the market received several rounds of positive news on the vaccine front.
The combination of expectations for additional stimulus coupled with a light at the end of the tunnel due to the vaccine allowed credit investors to look through any near-term adverse data and COVID concerns. With that as a backdrop, structured products continued to perform well with both highly rated cash flows, as well as credit-sensitive assets resetting to much tighter levels.
With respect to our holdings, our credit portfolio grew over the quarter through incremental CRT investments and price appreciation of our holdings. We found some value in certain lower credit CRT which largely drove our position increase in Q4. And over the quarter spreads tightened across virtually all our holdings and in some cases have now retraced two, as well as through pre-COVID levels. Fortunately, some of the retracement in asset spreads has filtered through into repo rates with borrowing rates relative to LIBOR now approaching levels of early last year.
Turning to the housing backdrop. As we said last quarter housing fundamentals in the aggregate remained strong and we see little risk to this changing in the near term. This should remain a tailwind and provide support to residential credit performance, a view held by many market participants, which has been a large driver of where spreads are today.
With that said, there is increased risk in some higher-priced areas of the country that may face negative headwinds on the migration front. This can be attributed to several factors such as; state tax policy, high cost of living and related to that the significant increase in work from home or work from anywhere trends.
If this trend continues it will likely take years to play out but could have a material impact. While, we do not see this being an issue for our current positioning in mortgage credit we cannot ignore this risk when evaluating incremental investments with certain exposures.
With that I'll turn the call over to Peter to discuss funding and risk management.
Thanks Aaron. I'll start with our financing summary on Slide 10. Our average repo funding cost for the fourth quarter was 38 basis points, down two basis points from the prior quarter. Our funding cost at quarter end, however was materially lower at only 24 basis points as some of our higher cost longer-term funding matured late in the quarter.
Importantly, the funding curve also flattened materially during the quarter driven by a decline in the cost of longer-term repo. Today for example, longer-term repo in the 12- to 18-month area costs around 20 basis points depending on whether it is sourced through our captive broker-dealer or direct with a counterparty.
Given this favorable funding environment, I expect our average repo cost to remain relatively stable at around 20 basis points over the next several quarters. Our aggregate cost of funds which includes the costs associated with our TBA position, as well as the cost of our swap hedges declined more sharply in the fourth quarter to 5 basis points from 15 basis points the prior quarter.
This improvement was due to the combination of lower repo cost, continued very attractive dollar roll funding levels and somewhat lower swap costs. The improvement in our cost of funds however did not fully offset the decline in our asset yield. As a result, our net interest margin decreased modestly to 202 basis points in the fourth quarter, down 13 basis points from the prior quarter.
Looking ahead, I expect our net interest margin to be biased somewhat lower as asset pay downs are replaced with new purchases at current yield levels, gradually pushing our overall asset yield lower.
On slide 11, we provide a summary of our hedge portfolio, which increased significantly from the prior quarter. In aggregate, our hedge portfolio totaled $67 billion up from $60 billion the prior quarter as we added meaningfully to both our swaption and short treasury positions. These positions were concentrated in the 10-year part of the curve and as such provided us incremental protection against the steepening of the yield curve similar to what occurred in the fourth quarter.
Given this increase, our hedge ratio at quarter end increased to 80% up from 71% the prior quarter. This increase reflects a continuation of the theme that we discussed on our last couple of earnings calls, which is that the macroeconomic risk is shifting more toward higher rates.
Lastly, on slide 12, we show our duration gap and duration gap sensitivity. Our duration gap at the end of the quarter was negative a half a year. This negative duration gap is consistent with the increase in our hedge portfolio, the shortening of our asset durations and our bias in the current environment to operate with incrementally more uprate protection.
With that I'll turn the call back over to Gary.
Thanks, Peter. Before I open up the call for questions, I wanted to highlight a few new slides we added to the appendix this quarter that provide a longer-term perspective on AGNC's absolute and relative performance.
Like the rest of the public equity space, we tend to focus our earnings calls on quarterly performance and near-term outlooks. And in the process, we're probably doing AGNC investors a disservice, if we don't periodically address the longer term.
As slide 28 illustrates, AGNC has outperformed both the S&P 500 and our peer group average from a total stock return perspective since our May 2008 IPO. In fact, we are one of only two residential mortgage REITs in existence at the time of our IPO that has outperformed the S&P 500 since that date and we are the top-performing mortgage REIT over this 12-plus year time frame.
On slide 29, we show our total stock return comparison over time versus some relevant benchmarks. The key takeaway is that AGNC's outperformance of the S&P 500 and other benchmarks has occurred over an extended period that has included a wide range of interest rate environments and despite some very challenging episodes including the great financial crisis, the Taper Tantrum, Brexit and the global COVID-19 pandemic. While some of these events adversely impacted AGNC's short-term performance, the long-term trend line is unmistakable.
On slide 30, we compare AGNC's yield to traditional yield vehicles. And again, the result is noteworthy. As you can see AGNC's 9.2% dividend yield is not only a multiple of traditional yield vehicles, but it is particularly noteworthy given the low yield levels available across the broader financial markets. Over time, these dividends really do add up. And to this point, AGNC has paid a total of $42.88 per share in dividends since its IPO back in 2008.
Finally, expense structure is always a critical consideration for investment vehicles. On the last slide, we show AGNC's operating cost structure, which as a percentage of stockholders' equity is the lowest in the industry at 87 basis points. On a per asset basis, this translates to under 10 basis points, which is in line with lower cost bond ETFs.
Expense structure for an internally managed REIT is analogous to the fees charged by a mutual fund or other asset manager and so having lower expenses directly translates to higher realized returns for an investor. It is a unique opportunity to be able to combine industry-leading returns with the lowest cost vehicle available in the mortgage REIT space. Collectively these slides illustrate why we believe AGNC is a great long-term fit for virtually any portfolio. This is especially true when you consider that the lack of credit risk in our portfolio reduces AGNC's correlation with a typical pro-cyclical stock portfolio.
So, with that let me open up the call to questions.
Thank you. We will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Doug Harter with Credit Suisse. Please go ahead.
Thanks. Gary following up on kind of the power of the dividend. Can you just talk about your dividend outlook for this year and whether now that we've flipped into 2021 whether that changes the need for distributions from a taxable standpoint?
From a taxable standpoint, we continue to have quite a bit of flexibility with respect to where we set the dividend. And actually, that's a key. I'm glad you asked the question that way. Because I think historically what's happened in the mortgage REIT space is the taxable distribution requirements have led us to pay basically all of our income or potential income out in taxes as you go back in time.
But given the way we use dollar rolls and the differences between taxable income and both accounting income and kind of true economic income. Really that's no longer a binding constraint for us. So, it gives us more flexibility with respect to our dividend policy and practices than maybe what we had five or 10 years ago and it kind of -- and that in a sense a way to look at that is that we can act more like a normal company without that if that constraint is not binding.
And so what's important is then you look at the mortgage REIT space and you look at AGNC. And in particular and you say okay we don't have a binding constraint around the tax side. And if you look at our current dividend relative to any other dividend vehicle in this environment or really your alternatives around income, the 9% or so yield for AGNC is very, very attractive kind of from a big picture perspective.
Another thing just to keep in mind and that we certainly think about is we really like the position that we're in and we think it's really worked out well for investors. So, look at the last several quarters, we're paying a nine or-more going back a few quarters percent dividend. We are able to buy back stock. We're growing book value, the stock price is going up. And this again is a strong position and something that we're comfortable with.
And as we've discussed on prior calls look our priority for shareholders is to generate the best risk-adjusted total returns that we can. That in other words make as much money for our shareholders as possible. The dividend is part of that equation and then the stock price or book value is the other part.
And again our bigger priority is the combination of those two. And we're very happy with that trend certainly over the last three quarters. But again Bernie mentioned the book value looks to be up 3% in January at this point. So, things continue to go in the right direction.
Look, we're going to continue to evaluate the dividend on a go-forward basis. And it is an important component of how AGNC takes care of shareholders. But it again isn't the only piece. And it's the combination of the dividend, book value, which then translates to stock price, we'll continue to be active in buying back stock when it makes sense. And we think in the long run that's the best overall equation for shareholders.
Great. Thank you, Gary.
You’re welcome. Thank you.
And our next question today comes from Eric Hagen with BTIG. Please go ahead.
Hey, good morning guys. First question just thinking about the backdrop of spreads being tight. Where do you see AGNC adding the most alpha in the portfolio over the near term? Do you see it coming more from the asset selection side, or maybe actively managing the hedging side with duration positioning? And maybe you can talk about the general approach given your outlook for spread volatility and such.
And then the second question, can you talk about what you like in the portfolio of higher coupon specified pools specifically the 3.5s and 4s. Maybe you can go into some detail around how you think about owning them relative to lower coupon TBA? Thank you.
Yes. I'll quickly start and then hand it over to Chris. But what I would say just big picture is, I want to go back to comments that both Chris and I made earlier in our prepared remarks. First off, look, we -- and what -- and again, what you mentioned in the question about, mortgages, agency MBS are more expensive now. And we've seen three quarters of strong spread performance.
The first, let's say quarter and a half or two quarters of that was recouping kind of widening. And -- but the -- some of the move of late is certainly making mortgages more expensive than longer-term averages. But you can't look at this -- you can't look at AGNC or the mortgage market in a vacuum.
We need to be and everyone needs to be practical about the strength that we're seeing in financial assets across the board. And from that lens, agency MBS don't look bad. And they more so are a direct -- absolute direct beneficiary of the current kind of bond market dynamics, which are incredibly low funding cost and a Fed backstop via MBS purchases. So we're unique beneficiaries and that's especially true of a levered investor, who relies obviously on the funding equation.
So, with that being said, look, we used to think that the -- we've believed over the last several quarters that lower coupon MBS and the dollar roll kind of opportunities clearly were stood out versus higher coupons. But that has sort of -- that has more normalized at this point. And so big picture how do we add value? I think we add value by opportunistically moving around our leverage and our capital deployment and absolutely on the hedge side.
We've added options. We've protected the portfolio against higher rates. And we did that before this recent move higher. And those are definitely things that over time will continue to add to AGNC's bottom line and protect the portfolio against potential shocks. And I'll let Chris follow-up on your kind of the specifics of higher coupons and those opportunities.
So, I'd just add, the gross ROE before convexity cost on both higher coupon specs and production coupon TBA is very high single-digits without roll specialness currently. During the fourth quarter, we converted some of our 15-year TBA positions to spec pools, and within 30s we shifted out of a few spec positions into lower coupon TBA.
But -- and over the last few quarters, we've -- that's a trade that we've done a fair amount of, trimming positions in higher coupon specs versus production coupon TBA given sort of the sharp recovery in pay-ups that occurred mostly in the second quarter against the backdrop of still very, very cheap valuations on production coupons and exceptionally strong rolls.
And as Gary mentioned, this positioning has worked out really well, with lower coupons significantly outperforming of late. But as we mentioned, given the performance of lower coupons the relative value equation has shifted to a point where it's balanced now.
That said, I think given strong technicals and still reasonable absolute valuations, I think production coupons aren't likely to widen anytime soon. But I'd say on the margin, our reinvestments will likely go into both production coupons as well as some pools.
Thank you guys for the very good answer, appreciate it.
You’re welcome.
And our next question today comes from Bose George with KBW. Please go ahead.
Hey, guys, good morning. Just to follow-up on Eric's question. So you said the gross ROEs in the high-single-digits. Can you just go into the contribution from the TBAs? You said, I guess, a 10 to 15 basis point benefit? Is that like another whatever 1% - 1.5% of ROE?
Yes, sure. So, rolls have traded in a wide range over the last few months call it, 10 basis points to as much as 100 basis points through repo. For context 25 basis points of specialness adds roughly 2% to the gross ROE. But as I mentioned in my earlier remarks, rolls implied financing rates on production coupons are currently towards the cheaper end of that range, around 10 to 15 basis points to repo.
Yes. I do think it's -- I do think there's upside for rolls to trade better from here. I think the positioning in the second half of the fourth quarter started to get a little heavy given extreme levels that we enjoyed for the better part of the last six months.
And so I do think given current levels, which are more or less in line with long run historical norms some of the more transient positions will exit or be converted the pools which could help. That said, I don't think we get back to the Q3 type levels, but I do think rolls improve a bit from here and trade better than just long-term averages given current fed policy.
And just a quick rule of thumb on that is for every 25 basis points of specialness, it's about 2% per ROE. So, if it's -- if rolls are 25 basis points special that's you're adding 2, if it's 50 basis points special you're adding 4. At the absolute peak where it was 100 basis points, special you're adding eight ROE. So that's just a quick way to approximate it.
Okay, great. That's very helpful. And then, actually you noted also obviously the other variable in the return is leverage. Can you just talk about the backdrop you need to see for leverage to go up from here?
Sure. I think the short answer is again we're very comfortable with the risk return profile of Agency MBS. But again they've clearly appreciated. And so, in light of that in this kind of environment, we're operating toward the lower end of kind of our leverage range so that we would normally operate in. But we do expect volatility. We do expect there maybe to be some false alarms around the taper tantrum.
We do expect at some point down the road of real tapering obviously, but we think that's a fair amount further out. So, as the opportunities present themselves, we have plenty of dry powder. We're operating with more liquidity than we probably ever have in the history of the company, given the composition of our portfolio between pools and TBA, given Bethesda Securities and the advantages that presents.
So we've got a lot of dry powder. We'll look at opportunities within the Agency sector should they arise, and are certainly willing to dedicate more capital outside of the agency space. But as we've said, the tightening has kind of filtered through everywhere. But hopefully that helps.
Yes. No that's very helpful. Let me just sneak in one more just on prepay expectations.
Sure.
Also just curious what your thoughts are. Obviously, there's a lot of new -- not new originators, but a lot of originators going public with a lot of strong growth expectations. How do you think that sort of feeds into what happens with prepays this year?
Look, and maybe Chris will want to add something, I'll be brief. Look, I think we've seen a lot of tightening of the primary / secondary spread in particular in the fourth quarter and so far this year. There's a little more room for that to continue. In other words, more even if interest rates go up, mortgage rates don't necessarily have to.
But on the other hand, we have had a decent period of fast prepayments, right? And they've permeated to lots of segments of the mortgage market, a huge percentage has been refinanceable and still is. And we do expect to see burnout, which is where if someone hasn't refinanced and had a great opportunity for nine months why in the 11th month are they actually going to finally pull the trigger.
So what I would say is look it's too early to say that we are -- we're past the refi wave. That's clearly not the case. But on the other hand there is reason to believe especially if we see the yield curve continue to steepen from here. But even if we just stay at these mortgage rates that prepayments will start to burn out. So I think for the first time in awhile there is more upside I think on the prepayment equation than downside.
I don't know Chris if you want to add anything to that.
Yeah. No, I just -- I guess to your first question, I mean, banks for sure have lost share quite a lot over the last few years to more efficient nonbank lenders. And I think that will probably continue to some degree.
As Gary mentioned, we are beginning to see some positive indications on the prepay side of burnout for the most recent Jan Factor reports CPRs on the 30-year universe increased about two CPR or about 6%. Despite day count suggesting that speed should have increased by about 15% everything else equal. And driving rates were actually even slightly lower for that period. So that was a positive sign.
And as we mentioned the primary secondary spread contraction of around 20 basis points in the fourth quarter suggest that capacity constraints have started to ease and lenders are having to compete more on price to maintain volume. And so that too is an indication that we may have seen the peaks.
And so with primary / secondary spreads closer to more normalized levels of treasury rates and secondary mortgage rates drift higher from here, most of that should be passed through to borrowers. But again with 80% of the market still exposed to an incentive to refinance, prepayment risk is still very elevated. But net-net some positive signs for sure.
Okay, clear. Thanks a lot.
Our next question comes from Charlie Arestia with JPMorgan. Please go ahead.
Hi, good morning everybody. I'm on for Rick today. I was wondering if you could talk a bit more about your interest rate sensitivity table. I think it's on slide 26. Where it looks like portfolio values remain pretty stable within a rate shock of 50 bps up or down, but that impact becomes more severe the next 25 bps in either direction. Given the increased hedge ratio and particularly growth in that swaption book that presumably mitigates some tail risk. Can you help me understand the impacts of these rate shifts on the portfolio and why they are nonlinear as the shocks get more severe?
Hey, hi, Charlie. This is Peter. Well, you're exactly right. I mean, what you're seeing there is the negative convexity profile of the mortgage universe. And you reach a certain point where that convexity profile starts to change. Right now we happen to be at a point both in the mortgage universe and in our portfolio where we're pretty close to peak convexity. So as you get to the further ends of the distribution, you're exactly right that the market value sensitivity will start to change with that.
What you're also seeing in this table is how our portfolio rebalancing is interacting with that convexity profile. For example, we have less up rate exposure in this table this quarter than we had last quarter because of the options that we had. Those options are going to give us a lot of protection up 50 and 100, but they'll have incrementally more protection because of their convexity profile once we get 100 or 150 or 200 basis points up.
So you can't see that here. We're also starting with a negative duration gap in this table, which is one of the reasons why we have a little bit more exposure to the down rate scenario.
So you're right. This table interacts with the overall convexity profile of the market and our portfolio it's going to change with that. And that's one of the reasons why we have to be dynamic in managing our exposure as the interest rate environment changes, and we alluded to the fact that we do think that you're starting to see the risk of more up rate paths right now versus down rate, obviously, rates can move in both directions, but we think with the economy starting to show some signs of recovery, the vaccine starting to be rolled out, that incrementally there's a little more upside to rates as opposed to downside. And so, we're going to continue to manage it that way.
The other thing just to keep in mind in the down 100 case, which is kind of the biggest change from the prior quarter is, the simulation floors rates at zero. And so, there is actually down 100 for the 10-year, whereas the last time around the 10-year was below 1%. So there was no sort of down 100. But just understand what that environment relates to that would basically be all rates 10 years and in under 10 basis points, right? And it now brings the mortgage rate under 2% in the base part of that shock.
We would clearly rebalance in that scenario. But look, if the circumstances that would lead to that would definitely challenge a lot of different investments across the board. And to Peter's point, look, right now, we feel that it is better to protect against an increase in the back end of the curve and take a little more exposure into a rally and that you're actually seeing that in those tables.
Yes. And just to round that out, one of the reasons why we added options in the fourth quarter was the combination of the -- the low interest rate volatility, made those prices very attractive, the absolute level. And we actually added about $5 billion of purchases during the quarter. The net change was only $3.5. But we did find it to be an opportunity a real attractive opportunity to add options to our portfolio.
That's very helpful color. Thank you, both. And if I could squeeze in one follow-up based on just some comments in the prepared remarks. I think, Chris mentioned, you could still see room for spreads to tighten from here. I'm just wondering what scenarios are you guys envisioning where spreads could possibly move materially wider from where they are here?
Yes. I would just say the relative value picture across fixed income is still a positive for Agency MBS. Whereas I'd say, if you compare that to QE3, it was a headwind. Other sectors have tightened along with Agency MBS, and so relative valuations still look attractive whereas in prior periods of QE this wasn't the case. Production coupon nominal spreads are still around 15 to 20 basis points wide to sort of two-month average tights during QE3 or more like probably 35 to 40 basis points wide to the absolute tights.
And then you look at other sectors like Agency DUS, IG, high yield, where current spreads are much, much tighter than prior periods of QE. And as Peter mentioned, implied volatility being lower today than that period that also benefits Agency MBS much more than other sectors. So, given the backdrop of the support from the Fed, it wouldn't surprise me to see spreads have a little more room to tighten.
Yes. The widening that you referred to is any significant widening occurs probably when the Fed tapers. But I would -- I think that widening will be spread out this time across all financial assets and I actually wouldn't even expect MBS to be like the hardest hit. That's a ways off, but probably a ways off, but keep that in mind as well.
Thank you. Our next question today comes from Brock Vandervliet with UBS. Please go ahead.
Hey guys. This is Vilas in for Brock. Just on the tapering, I heard your comment on early 2022 and it's unlikely that before that tapering happens, where do you think the market is at in terms of expectations there? And what would be like a downside surprise? And I guess in terms of the portfolio, is there an appropriate way that you're thinking of positioning into that event even though it's a while out potentially?
Vilas, hi, it's Peter. Let me start with that and then I'll have Gary talk a little bit about the specifics to the portfolio. But I think you're raising an important point about the market's concern about tapering. And I think, the important thing for everyone to understand is how different the environment is today versus 2013. Obviously, 2013, it was a dramatic move in the market. But you have to think about how different the environment is today versus then.
Just first with respect to the Fed in their current position, they're much more transparent, much more deliberate, their inflation target is different. They're using forward guidance. So we have much more stability from a rate perspective with respect to the Fed's monetary policy.
Second, we have a much, much different view today about the Fed holding mortgages and treasuries on their balance sheet. If you recall, they had grown their balance sheet from $0 to $3 billion-ish – $3 trillion-ish in 2013. And all of the discussion was how quickly can they get back to zero.
Today they have $7-plus trillion and the discussion is not at all about whether they can continue to hold that. So we have a very different position from a balance sheet perspective.
And then lastly we now have sort of a playbook for what tapering looks like. And in fact the Fed's already indicated that they'll likely do what they did last time which is like Gary said, once they start to shift monetary policy, perhaps late this year or early next year, we sort of know that they're going to taper over eight, nine, 10 month period.
And then really importantly they'll continue to reinvest after that until they ultimately raise rates. So it's a much more predictable framework today, which I think ultimately leads to lower volatility response. But clearly as Gary pointed out, there will be some response in the mortgage market.
So two things I'd add and I think that was a good discussion. I'll just give you specifics look what's the earliest that any – they could taper, probably fourth quarter. And that would require everything to go right. The vaccines to create a roaring back half of the year, employment to be going in the right direction, inflation to be picking up very quickly. I mean that's a very, very optimistic case.
But that's the earliest it's possible kind of a baseline as early 2020 – first half of 2022, which is still a very good scenario where employments improving. The economy is back. And – but – and as Peter mentioned, I just want to – and talking about this there is a chance that they increase QE if some of those things don't happen. It's not where we are and it's not an expectation but it is a possibility.
And the other thing is just to reiterate what Peter said, this is a Fed that has promised they're not going to anticipate a pickup in inflation, which is what happened the last time around, okay? They were preemptive, okay? We've been doing this enough. We're – and they were – they anticipated in raising rates in 2017 and so forth and then reverse course. This is a different Fed. They're not going to be preemptive and that has – makes a big difference.
So when they do start tapering, it depends – and the impact on the mortgage market - it's going to depend on where pricing is at the time and where prepayment speeds are at the time in terms of the specific impact to our portfolio. But what I would say is we have tools to manage that. We have our leverage. We have hedges and again, I don't – the last time there was an outsized impact on the agency mortgage market. It was sort of the center of the storm. And all you need to look at is what's going on in everything: equities, credit spreads, just all of the cash on hand. The reality is the Fed's liquidity this time is being distributed across the markets as a whole. So by definition the impact on the agency space is lower.
The other reason why it will be lower this time on the agency side is because of the fact that the prepayment equation is worse than it was in 2012 and 2013. There were a lot of specified pools that were paying low double-digits, 12, 14 CPR, and those didn't benefit from a backup in rates because they were already slow.
In today's environment even good specified pools are paying in the 20s. And many specified pools are paying at 30 or a little higher. So in a backup in rates and a widening mortgage spreads there is a prepayment offset to some of those negatives.
So I know that's a technical discussion, but there are reasons to believe. And as Chris mentioned, right now we're not -- we're at wider levels for mortgages as well. There are reasons to believe that this is a much more manageable scenario.
The other thing is, we've all learned a little bit in the mortgage market and seen one of these. And so I think positions will be better this time around. So, there are a lot of reasons. It's something that's on our mind. You can see our positioning is defensive toward higher rates, but it has to be balanced with the fact that this is further off. And we have tools to manage.
And then, -- and then, if I could, just sneak in one more on -- just on specialness specifically heading into that kind of event, is it fair to think that it has to come off a little bit as the Fed is expected to step away. And I know you've talked about this before. And there are some other factors in play as well. But just some comments on that would be great.
I think the -- I mean the Fed's presence, even after they start tapering and complete tapering, so they're no longer growing their balance sheet. It's -- as Peter mentioned, the -- if prior periods of QE, can serve as a guide, they're likely going to be reinvesting paydowns which are currently running around the $85 billion per month, that number will likely go down, when the Fed starts to get active or tighten policy.
But, it's -- they're likely going to continue to be reinvesting paydowns long after they stop growing the balance sheet, likely through at least the first rate hike. And so, the Fed technical is still going to be incredibly supportive with respect to cleaning out the float on a monthly basis and supporting roll financing.
I mean, it's likely that the Fed mortgage position will probably grow by another $400 billion to $500 billion this year. So it's -- you're talking about a $2.5 trillion mortgage position that's where reinvestments are being made back into the market cleaning the float.
Great. Thank you.
Our next question today comes from Trevor Cranston with JMP Securities. Please go ahead.
Hi. Thanks. Most of my questions have been asked, so maybe one more follow-up on the decline in roll specialness. Looking at slide 10, it looks like the average cost of funds on TBAs was negative 54 bps in 4Q. And I think Chris said, you guys currently see rolls around 10 basis points special versus repo.
Can you just sort of talk about how you guys are thinking about the cost of funds side heading into 1Q? And sort of how much that differential between kind of where the rolls were in 4Q and where you see them today is likely to impact cost of funds? Thanks.
Sure Trevor. Thanks for the question. Another table that's helpful to look at is, Table 17 where we break out the cost of funds into two components. And you're raising a good question, and so the two key inputs in our -- well three key inputs in our cost of funds.
First is the repo cost which last quarter was 38 basis points ended the quarter at 24 basis points. And as I said, given where prevailing rates are right now repo rates whether it's overnight out to 18 months, I expect that repo cost in that 38 basis points to come down fairly reliably into the 20s and low 20s, and stabilized there.
The TBA component which was negative 58 in the third quarter and then 54 , obviously that's a variable that we can't fully predict. It's going to evolve over the quarter and that makes that forecast a challenge. What Chris described earlier is that that range has been from 10 to 100. It was currently in the 15-ish range and expectation is that it was going to improve. Where exactly it improves to in the first quarter, we'll have to wait and play that out. But directionally, we think it is improving. But that doesn't mean that, it's going to be better than where it was in the fourth quarter. In fact, likely it will be a little bit lower.
And with respect to the last component, the swap cost, I expect it to be fairly stable, but directionally a little bit higher because – clearly, if we continue to add hedges, it's going to add some costs there. But I don't expect a whole lot of movement in our cost of funds. It's close to zero. I think it's going to be zero to 10 basis points over the next quarter or two. So I know, we can't give you any more precision there, because obviously, we have to wait and see how the role specialness plays out. But directionally, we think it's going to improve from what Chris said from the 10 to 15 basis point range.
Okay. That's helpful.
But you should expect the dollar roll – you should expect the funding levels on TBAs to be higher, noticeably higher this quarter than last quarter at this point.
Okay. Thanks for the comments.
Thank you, Trevor.
Ladies and gentlemen, today's final question comes from Kevin Barker with Piper Sandler. Please go ahead.
Thank you. Just a follow-up on your comments off the dividend yield and the outlook for the dividend, the point that you made about, how you have a lot of flexibility there. Do you feel that just generally that the market is prepared to accept lower dividend yields for lower risk just given all of the volatility that we saw in the past year? Do you feel like that could be start to be accepted by the market and maybe a lower risk portfolio will be appropriately priced in the market compared to what it has been in years past?
It's interesting, the way you worded that question. I'm not sure in a sense, the market's pricing of different positions. And I don't mean just the mortgage REIT space. I could say, the broader equity markets, is sort of in a different category today than it's been in a long time, and long time probably since the late 1990s. And so what I would say is, we have confidence in the markets over time. And from a management perspective, it's our responsibility to make those trade-offs in terms of leverage, in terms of risk management, and to evaluate those, and do what we think is best for our investors over the long run and not obsess necessarily about how that's going to be received in the very short run.
I mean, like to your question, I'll just say, like it would have been – it's very easy. Given our net spread and dollar income, given the category it will be in, all right? It would be very simple and it would be well received to raise the dividend here. It's – I mean, and yeah, we think the stock would like that in the short run, but we think that we should be prudent about where interest rates are, where yields are on other vehicles forgetting just the mortgage REIT space. We're not obsessed with where a couple of our peers are or stuff like that.
We think that it's – this is why people trust management over time is to make those kind of trade-offs and to understand that sometimes they won't necessarily be well received for a quarter or two. But over the long run and we talked about our long-term track record, you generate those – that kind of track record by making good prudent risk management decisions over time, and we value stability and we think investors do.
So, now I'll come back to – look, we'll – our leverage decisions, our hedging decisions will be made with preserving and enhancing the long-term net present value of the company. And we know that over time that will be received – will be rewarded by shareholders, and it will reward shareholders. But especially in today's market, but even in other markets, you try not to – you can't help but think about it, but you try not to obsess about the short-term reaction in the stock market.
Thank you. That's very helpful. All my other questions have been answered. Thanks.
Thank you. Appreciate the question.
Ladies and gentlemen, this concludes the question-and-answer session. I'd like to turn the conference back over to Gary Kain for closing remarks.
I'd like to thank everyone for their interest in AGNC, and we look forward to talking to you again next quarter.
Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.