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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
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 2021 Shareholder Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.
Thank you for joining AGNC Investment Corp.’s fourth quarter 2021 earnings call. Before we begin, I’d like to review the Safe Harbor statement. This conference call and corresponding slide presentation contains statements that to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act.
Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of AGNC. All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of AGNC’s periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC’s website at sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law.
Participants on the call include Peter Federico, Director, President and Chief Executive Officer; Bernie Bell, Executive Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President and Chief Investment Officer; Aaron Pas, Senior Vice President of Non-Agency Portfolio Management; and Sean Reid, Executive Vice President of Strategy and Corporate Development.
With that, I’ll turn the call over to Peter Federico.
Thank you, Katie and welcome to everyone on the call today. Investor sentiment turned negative in the fourth quarter as the Fed signaled a significant shift in monetary policy. With inflation running well above its long-run target and the labor market nearing full employment, the Fed accelerated the pace of asset tapering, signaled an aggressive series of short-term interest rate increases and discussed more rapid balance sheet runoff. This abrupt shift by the Fed led to an uptick in interest rate volatility amid greater monetary policy uncertainty. The risk of materially higher short-term rates caused the yield curve to flatten significantly with short-term rates increasing meaningfully and longer term rates remaining relatively unchanged.
Against this backdrop, Agency MBS underperformed in the fourth quarter as spreads to benchmark rates widened. Most of that spread widening occurred in November and led to our negative economic return for the quarter. Our economic return for the year, however, was positive 2.9% and represents the combination of our 9.6% annual dividend yield and a decline in book value due to wider Agency MBS spreads.
We will likely continue to face some challenging market conditions as the Fed pivots from near zero short-term rates and quantitative easing to higher rates and quantitative tightening in 2022. The Fed also communicated the possibility of starting the balance sheet reduction sooner and more rapidly than previously anticipated. The amount and timing of this balance sheet reduction will be an important driver of Agency MBS spreads going forward. Accordingly, we will continue to operate with a more defensive position, characterized by lower leverage and significant hedge protection. We will also continue to be patient and opportunistic in our investment decisions.
In 2021, wider spreads led to a decline in our book value. This trend continued in January with current coupon MBS spreads widening an additional 20 basis points. As a result, our book value was down about 6% in January through last Friday. Importantly, despite the significant move in January, our leverage today is at 7.5x and our duration gap is at half a year. This positioning gives us the capacity and flexibility to take advantage of attractive investment opportunities as they arise. Today, the expected return on the production coupon 30-year MBS is in the 10% to 12% range before including the incremental benefit associated with favorable TBA dollar roll funding.
Wider mortgage spreads adversely impact our book value in the short run, but benefit our business over the longer run. The net present value of our business can be thought of as the expected return on our existing portfolio, combined with the expected return on the new investments that we add over time. If an Agency MBS investor is well-positioned and enters a period of spread widening with lower leverage as we have, our business benefits in two ways. First, with respect to our existing portfolio, wider mortgage spreads can improve the flows on higher coupon specified pools through slower prepayment speeds and reduced premium amortization expense. Second, with respect to our future portfolio, wider spreads obviously improved the return on new investments. For example, a 25 basis point widening in spreads levered 8x, improves the ROE on new investments by 2.25%.
So to summarize, we are well-positioned for the current environment. And while challenging in the short run, wider spreads are good for our business over the long run as they lead to stronger earnings and greater franchise value. Looking at AGNC’s performance over a multiyear period, illustrates the value of being a long-term investor and the durability of our business model across a wide range of market conditions. Over the last 3 years, AGNC generated a total economic return of 25%. During that period, we had to navigate unprecedented volatility and broad financial market dislocations due to the pandemic. The growth of the Fed’s balance sheet to close to $9 trillion and now uncertainty as the Fed tightens monetary policy. Yet despite these challenges, over that time period, AGNC paid shareholders an average annual dividend of over 10% per year, while experiencing a relatively small decline in book value.
With that, I will now turn the call over to Bernie to discuss our financial results.
Thank you, Peter. AGNC had a comprehensive loss of $0.31 per share for the fourth quarter. Economic return on tangible common equity was negative 1.8% for the quarter, reducing our total economic return for the year to positive 2.9%, comprised of $1.44 in dividends per common share and a $0.96 decline in tangible net book value per share. Our at-risk leverage increased modestly during the quarter to 7.7x our tangible equity as of year end as the reduction in our asset base was offset by the decline in our tangible net book value.
Importantly, our leverage is still meaningfully below our normal operating levels. Our unencumbered cash and Agency MBS at quarter end totaled $4.9 billion, which excludes unencumbered credit assets and assets held at our captive broker-dealer subsidiary. At 50% of our tangible equity, we believe this positions us well to increase leverage to take advantage of attractive investment opportunities once market conditions stabilize.
Our net spread and dollar roll income continued to benefit from a favorable funding environment, stable hedge cost, and advantageous dollar roll opportunities. Thus despite our smaller asset base, net spread and dollar roll income remained very strong at $0.75 per share for the fourth quarter. Our net interest spread for the quarter declined modestly to 2.15% from 2.19% for the third quarter, but remained above our average for the year of 2.11%.
Our average forecasted life CPR was largely unchanged at 10.9% as of quarter end, while our actual CPR continued to trend lower, averaging 18.6% for the quarter compared to 22.5% for the prior quarter. And this trend appears poised to continue into the new year as evidenced by our most recent CPR print published in January for assets held as of December 31, which declined to a 22-month low to 16.8%.
Lastly, demonstrating our commitment to shareholder-friendly capital markets activities, during the fourth quarter, we completed $42 million of accretive common stock repurchases increasing total accretive repurchases for the year to $257 million or 3% of common shares outstanding.
I will now turn the call over to Chris to discuss the agency mortgage market.
Thanks, Bernie. As Peter described, the markets have re-priced considerably over the last 2 months following the shift in Fed policy guidance. During the fourth quarter, the yield curve flattened dramatically with 2-year treasury rates increasing 45 basis points, while 10-year rates were a little changed as of 12/31. Given heightened uncertainty surrounding Fed policy, Agency MBS underperformed interest rate hedges in Q4. However, performance was heavily influenced by hedge positioning on the curve with longer term hedges providing little benefit.
30-year current coupon MBS spreads ended the year approximately 20 basis points wider than the tightest levels observed midway through the second quarter of last year. In contrast, investment grade CDX and other highly rated structured product spreads ended the year near the tightest valuations observed during 2021. With the end of QE approaching an increased uncertainty surrounding the pace and structure of balance sheet normalization, it is logical for Agency MBS spreads to have underperformed. This underperformance intensified in January as the market re-priced to the possibility of a more aggressive start to balance sheet normalization. Given the widening that has occurred to-date, spreads are within 10 basis points of average levels observed in 2018 when the Fed was reducing its balance sheet following the end of QE3. As a result, current valuations are attractive, both on an absolute basis and relative to other asset classes.
The fundamentals for the Agency MBS markets are also strong. Funding markets remain deep and liquid, prepayment risk is lower given the move higher in interest rates and cross-sector relative value was supportive of Agency MBS. However, as Peter described, given the likely headwinds on the supply and demand front, we have remained defensively positioned and we will be patient in taking leverage higher. The technical challenges for MBS stem from the combination of the uncertainty around the Fed’s path towards balance sheet normalization and expectations for relatively heavy organic supply and new originations of GSE eligible mortgages in 2022. However, I want to stress that these dynamics should create an excellent investment environment for AGNC once the market fully reflects these factors.
As of quarter end, our investment portfolio totaled $82 billion, down $2 billion from the prior quarter. TBA dollar roll financing remained strong during the quarter and continues to provide a substantial benefit with 30-year production coupon rolls trading approximately 35 basis points through repo. TBA specialness, however, will likely trend lower over the course of the year as the Fed begins to reduce its MBS holdings.
Our hedge portfolio totaled $75.4 billion at quarter end, up $2.5 billion from the previous quarter. Our hedge ratio or the notional balance of our hedges relative to our funding liabilities increased to 101%. Given the volatility and uncertainty associated with the current environment, we continue to favor a hedge portfolio that is well diversified by hedge type and by maturity. We will also continue to operate with a high hedge ratio as doing so minimizes short-term debt repricing risk.
I will now turn the call over to Aaron to discuss the non-agency markets.
Thanks, Chris. I will quickly recap the quarter and provide a brief update on our current positioning. As I will describe in just a minute, we were able to find some opportunities on the non-agency front due to increased volatility in spreads in the fourth quarter. Having said that, as Chris mentioned, the credit complex generally performed quite well overall in the quarter, considering the rapidly changing landscape with respect to the Fed and future policy changes.
Turning to our holdings, the non-agency portfolio increased modestly in the fourth quarter to $2.3 billion from $2.1 billion as of September 30, 2021. This increase was primarily driven by additions of highly rated private label RMBS and shorter spread duration commercial credit assets. Within the residential private label market, spreads widened meaningfully on AAA securities backed by agency-eligible investor loans in the quarter. Price spread levels in November were at significant concessions to where the agency equivalent security traded. We viewed this as an attractive entry point and we increased our AAA position further. Additionally, on the CMBS front, certain short spread duration assets widened as investors made room for heavy new issue supply. We took advantage of this widening and made incremental investments. With the end of QE on the horizon, these shorter spread duration profiles were a good fit.
Finally, with increased clarity around the CRT supply outlook, we decreased the size of our portfolio in Q4 by roughly 10%. As we look forward, we see solid fundamentals supporting the credit risk backing both our residential and commercial credit holdings. Housing continues to perform well. Commercial real estate assets posted strong price gains in 2021 and certain segments of the commercial sector are poised to continue to benefit from inflationary tailwinds. That said potential impacts of Fed policy will leave us positioning a bit more cautiously in the near term.
With that, I will turn the call back over to Peter.
Thank you, Aaron. And with that, we will now open the call up to your questions.
[Operator Instructions] And the first question today comes from Rick Shane with JPMorgan. Please go ahead.
Good morning, guys and thanks for taking my questions.
Good morning, Rick.
Peter, you had provided an update on book value through January and you’d also put that in the context of 20 basis points of spread widening that you have seen. If we look at the rate sensitivity or the basis sensitivity chart, your book value versus the move has outperformed expectations, what’s driving that divergence? And is that something that we should continue to expect? Is there something you have done to mitigate the basis risk in the short-term?
Yes, thank you for the question, Rick. It’s a good question. Yes, if you look at our sensitivity table, if my memory serves me correctly, 10 basis points is worth about 5.5%, 10 basis points of widening is about 5.5%. And what I mentioned in the January is that the current coupon had widened about 20 basis points all the lower coupons generally underperformed and higher coupons outperformed a little bit on a relative basis. They were still wider by 5 to 10 basis points. But on average, if you looked at our portfolio, spreads widened somewhere in the neighborhood of 11 or 12 basis points probably on average, which still would point to a little bit of outperformance relative to that. And really, one of the key drivers of performance in this environment is not only the composition of your portfolio, but it’s also the spread duration of your portfolio. One of the reasons why we like having higher coupon in our portfolio as it gives us a lower spread duration a little bit less sensitivity. So those are two drivers. And the other is hedge composition and hedge position. That’s really, really important in this last – in the last quarter, we had 2-year rates increase by about 50 basis points and 10-year rates remain relatively unchanged. As Chris pointed out in his prepared remarks, if you had overweight in the longer end of the curve from a hedge perspective, you really would have gotten no benefit from those hedges. So it’s a combination of the assets part of our portfolio, having a mix – having the higher coupons that give us less spread duration. And then it’s the overall hedge composition that’s going to have an impact on our overall performance. But you’re right, on average, given just looking at spreads, I would say, our book value outperformed what that spread table would tell you. I hope that helps.
Great. Very helpful. And then one other question, you talked about the buyback and you mentioned several times that the repurchases during the fourth quarter were accretive. When we think about accretion, we can think about it in the context of GAAP book value, tangible book value or earnings. And I’m curious when you reference accretion which of those metrics are you referencing specifically right now? And when you think about your repurchase policy was the one that drives the behavior?
Well, at the end of the day, we think that our capital management activities can be a real source of value for our shareholders. So we’re always looking at the market conditions, whether it’s to issue stock that we believe is accretive or the buy back stock that is accretive. And we look at it from an accretion perspective, on a daily basis, and I’ll give you an example. In the fourth quarter, we were looking at our book value every day relative to the current stock price. That’s our tangible book value as we see it in real time relative to the current stock price and when we see that at a meaningful discount that’s accretive to our shareholders from a book value perspective. And clearly, when we’re buying back our shares that is also can be accretive from an earnings perspective. But our primary measure is looking at it and making sure that those capital market activities are accretive to our tangible book value.
And worth mentioning, again, you’re doing that on a real-time basis. So you’re looking at the updates, what the NAV is or what the book value is based on your marks and making that decision on a real-time basis.
That is correct.
Okay, great. Very helpful, I will drop back into the queue and thank you, guys.
Alright. Thank you, Rick.
The next question comes from Douglas Harter with Credit Suisse. Please go ahead.
Good morning, Doug.
Thank you. Good morning. You talked about continuing to kind of keep the more defensive positioning right now. What are the conditions that you would be looking for to start to kind of go on a little bit of more offense? Is it time? Is it a spread level? Just kind of what are your thought processes?
Sure. Thank you for that question. And you’re right. We continue to be really positioned fairly defensively. I mentioned in my prepared remarks, even though that our leverage was, I think, 7.7 at the end of last quarter, it was still currently around 7.5. So we’re operating really pretty significantly below where we have operated in the past from a leverage perspective, which gives us a lot of flexibility. But the outlook, obviously, given the certainty that we face with the Fed and the supply outlook in the mortgage market, our bias is that spreads are going to continue or biased to go wider, maybe not meaningfully wider, but we still believe they can go wider from here, just to put a number on it somewhere in the 5 to 15 basis point range is probably possible. So we want to see some clarity from the Fed. We want to see some stability in the overall market.
And if you just step back and you look at the agency market, one of the messages that we’re trying to communicate is that the Agency MBS market actually is not really good footing from a fundamental perspective right now. If you look at it from just the fundamentals, the funding is really good, the liquidity is good, absolute returns, as I mentioned, have improved quite a bit from where they were, for example, May of last year. So your ROEs have improved 2% or 3% from that point. The relative value of Agency MBS continues to look really strong. The stock effect of what Fed and banks own is really significant. They own about 70% of the overall market. So the tradable supply is not that great. And generally speaking, investors are underway. Those are all really positive forces and prepayments are starting to improve. The headwind is a technical one that we have to sort of endure over the short run is we want to get through this 2022 supply overhang that we’re likely going to see. We want clarity from the Fed. We want to sort of understand where rates settle out in this macroeconomic environment. But when we get that clarity, and I think it’s not that far away, I think we have a real opportunity to add mortgages at very attractive levels. So we are looking at it from that perspective is, we need to get through the next several meetings. We’re going to get a lot of clarity from the Fed. Our guess is that mortgage spreads widen some, they’ll be even more attractive on probably both an absolute and relative basis. And once we get that sort of clarity, we will look to take our leverage up. But we need a little more time, I think, to get to that point. So I’ll pause there and let you follow on.
No. That’s incredibly helpful, Peter. So I appreciate the insights there.
Sure. Thank you.
The next question comes from Bose George with KBW. Please go ahead.
Hey, everyone, good morning.
Good morning.
Actually, Peter, can you just elaborate a little more. You mentioned we could see a little more spread widening. I mean you guys noted earlier spreads are, I think, 10 basis points from what we saw in 2018. So just yes, what are your expectations? Could we see ‘18 levels, could we see worse or what’s your thoughts there?
Sure. Let me start with that, and then I’ll pass it off to Chris, who will talk a little bit about it from sort of a more historical perspective. But like I mentioned, spreads could certainly widen 5 to 15 basis points from here. It’s also important to look at how much spreads have widened over the last 13 months. If you look at just sort of collectively on average, I’d say somewhere in the neighborhood of 25 basis points of widening. And importantly, as I mentioned already, from where they were at the beginning of May of last year, they are probably close to 40 basis points, 35 or 40 basis points. So we’ve seen material widening. But if mortgages were too widen say 5, 10, 15, 20 basis points for I think it would put it back in some historical ranges. Chris can talk about that?
Yes. No. As Peter mentioned, I mean, we’re within about 10 basis points of average levels from 2018 when the Fed was last running off its balance sheet. I think the thing to keep in mind is we had a 20 basis point widening in spreads in January. It’s logical given how abrupt the shift in policy guidance was that the initial adjustment is going to be centered in the agency mortgage market. It’s a deep, liquid, very shortable market where hedges can easily be set against other sectors that have also benefited from QE. But given the sharp underperformance, they should enjoy a fair amount of support on a relative basis versus other sectors. The balance sheet impacts from Q2 will take time. I mean, its impact is cumulative. It shouldn’t be 100% on day 1 or even 5 months in advance for that matter. And so on a relative basis, we think mortgages probably will be reasonably well supported. That’s not to say that they couldn’t widen another 5 to 15 basis points. But it really depends on the ultimate structure of balance sheet normalization. We’re in a period of high uncertainty with respect to Fed policy, the economic outlook. And so we do expect elevated spread volatility. And for valuations to possibly overshoot fair value at times, and that will provide us a good opportunity to increase leverage given our starting position. Especially if rates are settling in a bit higher against the backdrop of low prepayment risk, it will be a very attractive earnings environment.
Okay, great. Yes, makes a lot of sense, thanks. And then I just wanted to ask about – I just wanted to ask about specialness as well, how you expect that to trend in the back half of the year with the Fed?
Yes. Go ahead, Chris.
So roll specialness should gradually weaken this year. But given the amount of float, as Peter mentioned, that’s tied up with the Fed and banks, it could certainly persist a good deal longer than the last time the Fed was reducing its balance sheet. The speed with which specialness comes off will depend on a lot of factors that are unknown. Where the caps are set relative to the level of rates on the long end will determine how quickly the quality of the float deteriorates. If rates are near current levels and trending higher, and the caps are set at reasonable levels, the float is going to stay clean for a long time. If on the other hand, long-end rates rally back to sub-150 on 10s and the caps are set at very high levels, the float is going to deteriorate a lot faster. I would say base case roll specialness trends towards 15 basis points through repo this year, which would be fine. Longer term average levels of roll specialness, is around 10 basis points. And even 10 basis points is compelling prepayment risk is low. And so it’s difficult to project. But it depends on a lot of different factors, but hopefully, that gives you some guidance.
Yes, that’s very helpful. Thanks a lot, guys.
Sure. Thank you.
The next question comes from Kevin Barker with Piper Sandler. Please go ahead.
Thank you. I appreciate all the comments around spread widening and the potential opportunity out there. The Fed obviously was a little more aggressive than I think the market expected. I mean do you feel like the maybe from just your own personal perspective, do you feel like the Fed is getting a little too aggressive given what we’ve seen out there from an inflationary perspective? And you feel like there is probably an opportunity that’s going to emerge as we move through this year, where the Fed is playing catch up, and it creates a much bigger opportunity to redeploy capital?
Well, yes, thank you for the question, Kevin. And it’s obviously a challenging question in the current environment. I can’t say whether or not the Fed is behind or not behind. I think the Fed believes that they are behind right now, which was why they made such an abrupt shift in its – in their monetary policy stance. I think though you sort of have to separate what the Fed’s actions are into two pass. And I think what the Fed did at this last meeting was make it very clear that their primary tool for tightening monetary policy conditions is through the Fed funds rate. So on that front, I think they are going to begin raising rates in March, and I think they are going to do that very steadily. In fact, there were some comments from Fed members just yesterday about sort of steady increases. So having four or five rate increases in 2022, does not seem sort of out of expectations at this point. I think the Fed is going to be fairly aggressive on that front. I don’t believe that the terminal rate has changed much from what the Fed themselves have said it would be in the 2% to 2.5% range. But I think they are going to be more aggressive on the short-term rate front, which is one of the reasons why having a high hedge ratio is so important in the current environment.
On the balance sheet, I think it’s much more difficult to predict at this point what the Fed is going to do. In fact, the Chairman himself said at the last meeting that the Fed still needs a couple of meetings to discuss. But what he did communicate, which I take some comfort in is how he described how he wants the runoff to work. And the words that he used several times were predictable orderly and run in the background. And if the Fed does that, then I think they will set the caps at sort of reasonably comfortable levels. And if they do that, then I think ultimately, they’ll allow their balance sheet runoff to happen sort of durably over the next couple of years, which would give them the opportunity to get the $9 trillion down to something like $6 trillion without destabilizing the market – the financial markets. And I think the Fed is very focused on making sure that this program operate, like he said, in the background, maintain orderly markets, keep prices relatively stable. So I think they are going to lean that way a little bit more cautious on the balance sheet tool. They themselves say they don’t really know exactly how the balance sheet sort of works with monetary policy, whereas they know exactly what the impact from a monetary policy perspective will be of short-term rates. So I think they are going to focus on that and try to get the balance sheet running off in a predictable and durable way, which would be fine for us. And ultimately, I think that could lead, as you say, to an environment at the back end of that period of maybe 6 months where we actually have a pretty attractive opportunity in Agency MBS. So I’ll pause there.
Okay, thanks. Those comments are very helpful. In your view, where do you see the greatest tail risk given the current economic environment and the uncertainty that we see out there today? Is it inflation? Is it a Fed? I don’t want to say a mistake but overly aggressive Fed? What are the two main thing that you’re paying attention to a significant tail risk?
What I would say is that certainly, the inflation outlook in current situation with CPI at 7% is becoming really problematic for the Fed. And obviously, they are going to adjust short-term rates quickly. If it were to persist, even in the face of that, there could be incremental pressure on the Fed to adjust its balance sheet more aggressively. The Fed has – there are members within the Fed who believe that balance sheet adjustment could be a more significant monetary policy tool. It could have an impact on the shape of the yield curve if you were to sell assets more quickly or run off your balance sheet more quickly. So, that’s the area that I think there will be a lot of debate even within the Fed as to how quickly they can run off their balance sheet. The Fed themselves looks at the reverse repo facility, for example, and the fact that there is $1.5 trillion plus in that as an indication that they can reduce their balance sheet relatively quickly without disrupting the market. So, that’s the area that I think there is the greatest uncertainty because we don’t exactly know how the Fed is going to use that tool with respect to its balance sheet for monetary policy adjustment.
Okay. Thank you for taking my question.
The next question comes from Kenneth Lee with RBC Capital Markets. Please go ahead.
Hi. Good morning. Thanks for taking my question.
Good morning. Hi Ken.
Wondering if you could just talk a little bit more about how you think expected returns on new money investments could change, especially as the Fed starts tightening and the dollar roll specialness starts to dissipate? Thanks.
Sure. Yes, I will start and then I will have Chris talk a little bit about. But as I mentioned, we have seen quite a bit of improvement just in sort of the base ROEs into the low-double digit ROE range. So, we have seen some meaningful improvement. And obviously, if spreads widen further, there could be some opportunities there for us. And as Chris mentioned, specialness is going to remain positive. Chris, go ahead.
Yes. No. As Peter said, gross returns on production coupons are in the 10% to 12% area. Currently, it spreads widening, will obviously help that to some degree. But roll specialness will offset – and those returns, by the way, I mean or without roll specialness. But within the production coupons, we have 3s are towards the higher end of that range, 2.5s towards the lower end of that range. But in higher – production coupon specs are currently in the high-single digits.
Great. Very helpful. And just one follow-up, if I may, just on prepayment speeds, I wonder if you just could give any updated thoughts around how fast they could continue to decline as rates potentially rise? Thanks.
Sure. So, over the next couple of months, speeds should drop off pretty materially, primary rates are almost 50 basis points higher since year-end. We are also entering a seasonal low period for housing turnover. Speeds that will be released in a couple of days should be down around 15% or so for the Fed factors down another 10% to 15% for the Fed, March period. Prepayment risk is – has dropped considerably. Current mortgage rates around $3.65, $3.70, average note rates on the float somewhere around $3.40 to $3.50, with only around 15% of the universe exposed to a 50 basis point incentive to refinance. And so lender focus is going to shift more towards purchase related transactions and cash out refis. Early indications suggest that this could also be a pretty big uptick in burnouts or signs of burnout for higher coupons. Yes. So, we expect to see speeds come down considerably.
Great. Very helpful. Thanks again.
Sure.
The next question comes from Eric Hagen with BTIG. Please go ahead.
Hi. Thanks. Good morning. A couple from me. Just one follow-up on funding costs and specialness, would you say there is a difference in how you hedge lower coupon TBAs versus the pools, or does the decision to move between those purely boiled down to specialness and funding costs? And then the second one is lots of focus from this administration on affordable housing, access to credit and such. And a lot of your specified pools are mostly backed by loans to lower-income borrowers probably fit into the cohort of folks that the administration is at least trying to help. Curious if that plays any impact into the value you see in the spec pool portfolio going forward?
Chris, do you want to take…?
Yes. I guess I mean, on specialness on repo-funded positions versus TBA positions. It’s really comes down to just funding arbitrage between the two and what the overall backdrop is for the prepayment environment. And there is really no difference in how we think about hedging those two assets necessarily apart from the convexity differences between, say, a high-quality specified pool and a TBA. With respect to the direction from that FHFA is heading towards, there is clearly a focus on affordable lending. We weren’t surprised to see the increase in pricing on second homes and high balance loans. We expect that they are going to continue to look for ways to subsidize more affordable lending type products or borrowers. And – but I do expect that the changes will be on the margin. I don’t expect that there will be any dramatic shifts. The areas that are most likely to be affected are some of the lower pay-up less call protected areas like weaker credits, low FICO, higher LTV. But the call protection on those products was marginal to begin with and pay-ups were already very, very low. With respect to the higher-quality holdings in our portfolio, I would describe them not as much – I mean there is certainly a correlation between loan balance and income, but our holdings are heavily concentrated in other sectors as well like certain geographies like New York and certain other geographies that tend to have a better convexity profile. And so again, I think the impacts are going to be marginal. I don’t – the direction is clear towards affordable lending and weaker credits. But I don’t expect them to – I don’t expect there to be dramatic changes there that materially change the prepayment profile on higher quality specs.
That’s helpful. Thank you.
The next question comes from Trevor Cranston with JMP Securities. Please go ahead.
Hi. Thanks.
Good morning Trevor.
Good morning. Question on the hedge side, can you talk a little bit about how you are thinking about the shape of the yield curve evolving as the Fed begins tightening this year? And also maybe provide some commentary on how a curve flattener would impact the portfolio as opposed to the parallel shift that’s shown in the standard duration tables? Thanks.
Sure. Yes. Thank you for the question. And I think it’s an important one, as I mentioned, in the current environment, I talked about this on the last call, and I think this is going to continue to be the case. I think we are going to continue to see a lot of yield curve volatility as the market sort of re-prices the long end against what the Fed is doing in terms of tightening monetary policy. And obviously, we don’t know to the extent that they pull forward and move more aggressively, that would sort of indicate that there would be a bias toward a flattening. But we also have to see what happens with respect to the macroeconomic environment and what inflation is doing and whether or not the market believes that the Fed is in front of it and going to control it or actually behind it, in which case to curve could move in back end rates could go higher. So, from a hedge perspective, that creates a lot of challenge for us. What we have done is we have continued to sort of concentrate our hedges in the intermediate part of the curve, which I think is really important in this environment. What tends to happen is from 2 years to say, 7 years, that part of the curve will tend to lead the rate increase that certainly was the case so far with now 10-year rates going up and then sort of stabilizing at 180. Our portfolio has about 45% of our hedges, our hedge portfolio. About 45% of our hedges are in the intermediate part of the curve, only about 20% in the 2-year to 3-year range and about 30% in the back end. So, we are going to continue to move our hedges around as we see this playing out, but it’s going to be a challenge, and it’s going to be also a driver of overall performance. But what we are trying to do with our hedge portfolio is stay really well diversified across the curve, have a concentration in the intermediate part of the curve, have our hedge ratio be close to 100% and now keep our duration gap fairly contained. Our bias is that rates are going to go higher, but the curve movements could be significant, and that’s just something that we are going to have to work through over the next few quarters.
Got it. Okay. That’s helpful. Thank you.
Sure.
And our last question today comes from Mark DeVries with Barclays. Please go ahead.
Yes. Thanks. Just one question for me. Could you talk about where you could see leverage going once you get to this more stable environment where spreads have widened that and you have got less rate volatility?
Sure. Well, we have a lot of capacity. I mean we have talked about this in the past. If you just look at our current leverage versus historical leverage, we can certainly comfortably operate 8.5x, 9x, 9.5x leverage. One of the real benefits that we have from a capital perspective is our Bethesda Securities subsidiary that gives us tremendous amount of capital flexibility and has freed up a lot of excess capital. Bernie mentioned in her prepared remarks today, we are still operating with at $5 billion ish of unencumbered equity. So, we have a lot of capacity and a lot of room to be able to operate easily in the 8.5x to 9.5x range, which would really be significant from an earnings perspective from the jump-off point here at 7.5x. You think about where we are operating, I mean now we have been operating here for multiple quarters, we are still able to generate really attractive earnings. Our existing portfolio is really strong. Our hedge position is really strong. So, we are able to have great earnings in the current environment and still be operating with a relatively low leverage point. So, we have the opportunity, and I think we will over the next couple of quarters to be able to take advantage of this environment once the market sort of finishes its re-pricing to the current Fed environment. So – but we have – I think we have significant capacity to move up and leverage.
Okay. And then one more question, if I may. And this may be a tough one to answer. But how do you think about what normalized ROEs are for the agency business? It’s hard to answer because the Fed, obviously, for most of the last decade has been artificially depressing returns because it feels like we have been in QE for as long as I can remember. But how do you think once they remove themselves from the market, where we eventually settle out in terms of what levered returns can be?
Yes, it’s a great question. If you look back over the last 13 years, the Fed has basically been involved in the market in about 9 years of the 13 years. So, we really come to have a market that the Fed has basically, in a lot of ways, taken ownership of whether it’s on the funding side, they have done some dramatic things there that are beneficial to our business. And the Fed has clearly demonstrated a willingness to step in and stabilize both the treasury and Agency MBS market in times of distress as a levered investor, that is a very significant positive for us. But because the Fed has participated so long, you are right that all other things equal, that sort of would put downward pressure on spreads. But I still believe that the Agency MBS market from a levered investor perspective, can consistently generate low-double digit ROEs, even taking into account the Fed’s participation. And if you look back at spreads over the last 13 years or 14 years and returns over that time period. At the tightest, they have been in the high-single digit range, maybe 7%, 8%, 9% ROEs, and at the widest they have been in the mid to high teens. So, I think they settle out in the low teens, which is very supportive of our business model, meaning if you can operate with 8x or 9x leverage, taking into account the cost of your business, that should translate into supporting the dividend that obviously is lower than that, but still very, very attractive. And if you look at our dividend today, based on the current stock price at around 9.5%, I think that the Agency MBS market can be very supportive of a dividend and that level.
Okay, great. Thank you.
Alright.
This concludes our question-and-answer session. I would like to turn the conference back over to Peter Federico for any closing remarks.
Thank you, operator, and thank you for everybody for your participation on the call today. We look forward to talking to you again at the end of the first quarter.
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.