AGNC Investment Corp (AGNCO) 2017 Q1 法說會逐字稿

Good morning, and welcome to the AGNC Investment Corp.

First Quarter 2017 Shareholder Call.

(Operator Instructions) Please note that 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, Chad, and thank you all for joining AGNC Investment Corp.'s first quarter 2017 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.

An archive of this presentation will be available on our website, and the telephone recording can be accessed through May 11, by dialing (877) 344-7529 or (412) 317-0088, and the conference ID number is 10105255.

To view the slide presentation, turn to our website, agnc.com, and click on the Q1 2017 Earnings Presentation link in the lower-right corner.

Select the Webcast option for both slides and audio, or click on the link in the conference call section to view the streaming slide presentation during the call.

Participants on the call today include: Gary Kain, Chief Executive Officer; Peter Federico, Executive Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President; Aaron Pas, Senior Vice President; and Bernie Bell, Senior Vice President and Chief Accounting 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.

We were pleased with AGNC's performance during the first quarter, and more importantly, we believe that the current outlook for our business looks increasingly favorable.

In sharp contrast to the fourth quarter of 2016, interest rate volatility was limited during Q1, with rates generally staying within a 20-basis-point range, and ending the quarter largely unchanged.

As we stressed on last quarter's call, the tug-of-war between a healthier U.S. and global economy and greater geopolitical risk was likely to keep interest rates within a reasonably tight band over the near-term.

Against this backdrop, the risk of a significant selloff in rates in which the 10-year rises above 3% seems considerably more remote than it did 3 months ago, especially given the challenges the administration has had trying to implement significant portions of their agenda.

Agency MBS spreads were also relatively stable during the quarter and ended Q1 slightly wider.

That said, mortgages continue to meaningfully underperform other credit-centric fixed income assets during the quarter as market participants became increasingly focused on the potential for the Fed to begin shrinking its balance sheet, which could begin as soon as the end of this year.

Given the importance of this issue, I will address the implications of the potential and of Fed reinvestments on the mortgage market in further detail later in my prepared remarks.

Separately, the funding landscape continues to strengthen, and as Peter will discuss in a few minutes, there are other developments that could further improve the funding environment over the short to intermediate term.

With that introduction, let me turn to Slide 4, and quickly review our results for the quarter.

Comprehensive income totaled $0.35 per share.

Net spread income, which includes dollar roll income, remained at $0.64 per share during the quarter when we exclude the $0.03 expense from catch-up amortization.

Tangible book value per share decreased marginally by 1% to $19.31 during the quarter.

Total book value, which includes goodwill and other intangible assets, was $20.98.

Economic return on tangible book value was positive 1.8% for the quarter as our $0.54 dividend significantly exceeded the $0.19 decline in tangible book value.

Turning to Slide 5. At-risk leverage increased to 8x tangible book, and our portfolio increased to almost $60 billion as of March 31.

Before I turn the call over to Chris, I also want to briefly mention that our Board of Directors recently gave management the authority to acquire MTGE common stock when we believe the purchases are attractive based on the combination of both price-to-book discounts and relative pricing versus the mortgage REIT space.

Following our expansion into credit assets, we are now comfortable owning the stock of a hybrid REIT such as MTG, especially given our complete confidence in its portfolio and its business model.

To date, we have not purchased any MTGE shares, though we have been in a closed trading window period since the authority was given.

AGNC's evaluation of MTGE stock acquisitions will be, like any other investment decision, based on the expected total return relative to other opportunities.

We may also consider the fact that such purchases could further support our management relationship with MTGE.

Any purchases, to the extent that they occur, would be either open market or private block purchases and would be consistent with applicable restrictions on trading and in accordance with federal securities laws, given our status as the manager of MTGE.

Additionally, any share repurchases MTGE wants to execute will always have priority over AGNC purchases of MTGE stock.

That said, we currently anticipate that AGNC and MTGE will have different price thresholds for their respective purchase or repurchase activity.

As a management team, we are excited about both AGNC's and MTGE's long-run outlook and believe any purchases, potential AGNC Investment in MTGE stock to the extent valuations are sufficiently attractive could generate incremental value for AGNC shareholders.

At this point, I would like to turn the call over to Chris to discuss the market and our Agency portfolio.

Thanks, Gary.

Turning to Slide 6, I'll start with a review of the markets.

As Gary mentioned, the rates market was relatively stable during the first quarter in comparison to the volatility that we experienced in Q4.

As of March 31, the yields on treasuries were within a few basis points of where we ended 2016.

Swap rates moved a bit more with yields on 10-year swaps increasing 7 basis points to end the quarter at 2.39%.

MBS spread volatility was also low during the quarter with LIBOR option adjusted spreads trading at a narrow range and ending the quarter just slightly wider versus rates.

Relative to other fixed income risk assets however, the underperformance of Agency MBS was more dramatic considering the strong performance in CRT, TMBS, high yield and IG, with each of these asset classes continuing to benefit from a risk-on mindset, whereas the Agency MBS market had to contend with the Fed beginning to set expectations around the timing and nature of ending reinvestments in both MBS and treasuries.

Gary will talk more about this in a few minutes.

Let's turn to Slide 7. Consistent with a small increase in at-risk leverage during the quarter, the investment portfolio increased to $59.5 billion as of March 31, up from $57.7 billion at the end of last year.

The TBA position was $14.5 billion as of March 31, which was an increase from $11.2 billion as of year-end.

TBA dollar roll financing improved throughout the quarter versus both repo and short-term rates, with roll-implied financing rates for production coupons trading approximately 20 to 30 basis points through short-term repo as of quarter end.

Given the combination of a relatively benign prepayment environment, higher Fed funds rates and generally an improving TBA deliverable assumption, it's reasonable to expect the roles can continue to trade well.

Moving to the chart on the top right of the page, you can see that prepayment speeds on the portfolio remain very well contained, and despite the move lower end rates since the end of the first quarter, prepayment risk is still benign given the low percentage of borrowers that have a compelling incentive to refinance.

I'll now turn the call over to Peter to discuss funding and risk management.

Thanks, Chris.

I'll begin with our financing summary on Slide 8. Our repo funding cost at quarter end was 105 basis points, up from 98 basis points last quarter.

Repo cost were higher throughout the quarter as the market increasingly anticipated the Fed's rate increase on March 15.

The increase in repo cost was offset to a significant degree by a corresponding reduction in our swap cost.

For the quarter, our average net swap cost was 50 basis points, down from 57 basis points last quarter.

In aggregate, our overall cost of funds, including the implied funding on our TBA position, increased during the quarter to 126 basis points from 115 basis points last quarter.

The increase was driven primarily by our larger average pay fixed swap position, which increased $3 billion to $35.7 billion as well as by higher implied funding cost on our TBA position.

The offset to the higher TBA financing cost was a sizable increase in the yield on our TBA assets, which was the primary driver of the 6-basis-point improvement in our net interest margin over the quarter.

We continued to expand our funding at our broker-dealer Bethesda Securities.

At quarter end, our repo position at Bethesda Securities totaled $7.6 billion or approximately 20% of our funding.

Given the attractiveness of this funding, we expect to increase this position further this quarter.

As we have discussed for several quarters now, our funding position has improved over the last year or two.

To summarize, we continue to see the benefits of money market reform as evidenced by improved funding levels relative to LIBOR.

This improvement directly lowers the cost of our repo funding hedged with pay fixed swaps.

The expansion of our use of Bethesda Securities gives us greater access to attractive funding at very favorable margin terms.

Despite our greater emphasis on Bethesda Securities, we continue to maintain our long-standing relationships with a diverse set of funding counterparties which serves as a net increase in our repo capacity.

Additionally, dollar roll financing continues to be attractive and helps us mitigate the impact of higher short-term rates on our aggregate funding.

And lastly, the FICC continues to explore opportunities to expand its membership base.

Recently, it expanded membership guidelines to include certain noninvestment companies.

We are hopeful and optimistic that the FICC will, at some point, expand its membership further to include registered investment companies which would be a very favorable development for our funding source through Bethesda Securities.

Turning to Slide 9, I'll quickly summarize our hedge position.

The notional amount of our hedges increased slightly to $49 billion, consistent with the increase in our asset portfolio.

In aggregate, our hedge ratio remained relatively constant at 90% of our funding liabilities.

Given the likelihood that the Fed will continue to raise short-term rates, it is important that we maintain a high hedge ratio.

Accordingly, we will likely maintain or even marginally increase our current hedge position relative to our funding liabilities.

The composition of our hedge portfolio may also change as market conditions warrant.

Since quarter end, for example, we adjusted somewhat our hedge mix by increasing our use of pay fixed swaps and decreasing our use of short treasury hedges.

We continuously adjust the composition of our hedge portfolio with the goal of finding the mix of hedges that best offsets the market value sensitivity of our assets.

Our hedge mix also impacts our net spread income as only the cost associated with currently accruing pay fixed swaps is included in that calculation.

Lastly, on Page 10, we provide a summary of our interest rate risk position.

As shown on the table, our duration gap at quarter end was 1.1 years, down slightly from 1.3 years the prior quarter.

Given the slight rally in rates thus far this quarter, and rebalancing actions that we took, our duration gap today is just above 0.5 year long.

And with that, I'll turn the call back over to Gary.

Thanks, Peter.

If we turn to Slide 11, I want to take a few minutes to discuss the elephant in the Agency MBS room, which is of course, the potential for the Fed to reduce the size of its portfolio of treasuries and Agency MBS.

Recent Fed communications indicate this process could begin at the end of 2017 or early in 2018.

The reduction in the size of the central bank's portfolio is generally expected to occur as the Fed gradually reduces the purchases it currently executes to replace the ongoing runoff of its existing portfolio.

Importantly, recent statements indicate that the Fed is not presently contemplating outright sales of MBS or treasuries, and most market participants anticipate that they will taper or gradually reduce their purchases before ending them completely some time thereafter.

The tapering process implies that the Fed will continue to purchase a material amount of Agency MBS in 2018.

Once the Fed does end its purchases, its Agency MBS portfolio will shrink naturally based on -- upon prepayments on the underlying loans, backing the securities in their portfolio.

Assuming the runoff occurs with 10-year rates near or above 2.5%, the prepayment rate on the Fed's portfolio will likely remain relatively muted and not much higher than 10% CPR which translates to around $150 billion per year.

On Slide 11, we provide a summary of the size of the Fed's MBS portfolio going back to 2008, and our estimate of the balance under a couple of scenarios for the next several years on the graph at the bottom of the page.

As you can see from the gray line, the Fed's MBS holdings reached its current position of just under $1.8 trillion during 2014 after it completed 3 rounds of quantitative easing.

The far right portion of the graph shows projections of the portfolio using our tapering assumptions and at 10% and 15% CPR.

As you can see, the MBS portfolio will likely remain larger through 2019 than where it was at any point prior to the latter half of 2013.

As such, investors shouldn't lose sight of the fact that years after the eventual end of reinvestments, the Fed will still maintain substantial holdings of Agency MBS.

Now let's look at spreads in the MBS market against the backdrop of the Fed's balance sheet.

The blue line shows option adjusted spreads on 30-year 3.5% coupon MBS since 2010.

As you can see, Agency MBS are currently priced toward the wider end of the spectrum, and are in line with where they were before QE3.

More importantly, spreads are now consistent with the levels they were at, following the Taper Tantrum in 2013.

In fact, the only time during this period in which spreads were noticeably wider, around 10 to 15 basis points, was during the mid- to latter half of 2011, when the Fed's portfolio was only around $800 billion versus our projection of approximately $1.6 trillion toward the end of 2019.

I would also like to point out that the latter half of 2011 was characterized by a very different market backdrop.

There was a substantial decline in interest rates, uncertainty surrounding the U.S. debt downgrade and the debt ceiling and substantially wider spreads on -- of other competing fixed income products.

As such, it would be straight -- shortsighted to assume a base case scenario where MBS spreads reverted back to the 2011 levels.

To better understand this last point, let's turn to Slide 12.

As these graphs clearly show, spreads on other fixed income assets were considerably wider back in 2011 and have tightened substantially since then.

What is most important to understand from the graphs on this page is a significant divergence of valuations that has occurred over the past several years between Agency MBS and other competing sectors, including investment-grade corporates, high yield debt and credit risk transfer securities.

As you can see, mortgage spreads have widened over the last year or so, while the other 3 sectors tightened significantly.

To this point, IG, high-yield and CRT are essentially at their narrowest spread levels since before the Great Recession.

While Agency MBS spreads have moved toward the wider end of the range.

While some of this divergence can certainly be explained by the market's risk-on mindset following President Trump's election and a stronger environment for credit, a meaningful amount of this divergence is likely attributable to the market setting up for the end of the Fed's purchases.

In summary, it seems to us that a significant portion of the widening in Agency MBS that would likely result from the Fed shrinking its balance sheet has already occurred.

This widening, coupled with the improvement in agency repo, which is very important for levered investors, further explains why projected ROEs on Agency MBS investments are very compelling relative to similar strategies on the credit side.

That said, it is certainly very possible that hawkish headlines from the Fed related to its balance sheet could cause spreads to widen further over the next year and overshoots their value, especially given the reduction in the willingness of Wall Street to warehouse risk.

If this occurs, we would view it as an excellent buying opportunity and would consider increasing leverage to take advantage of such a scenario.

The last page, Slide 13, summarizes a lot of what we have discussed today and reiterates why we are increasingly optimistic about our business as we look ahead.

On this slide, we break down our business into 3 primary drivers: asset valuations and returns; the funding landscape; and the hedging and risk management environment.

For the reasons we have discussed today, Agency MBS are attractively priced and they will likely stay that way given the Fed's desire to gradually shrink the balance sheet.

Leverage and funding are, of course, critical to our business model, and as Peter discussed, the funding environment continues to improve.

Lastly, while we don't believe this is the best environment to take significant interest rate risk, we do feel like a significant increase in interest rates is now a lower probability event for the reasons we discussed earlier.

Against this backdrop, Agencies should be very well positioned to generate attractive risk-adjusted investment income over the intermediate term.

With that, let me open up the line to questions.

(Operator Instructions) The first question will come from Bose George with KBW.

It's Eric on for Bose.

Just wanted to expand on the MTGE comments.

What prompted the announcement in connection with MTGE last night?

And Gary, I think you mentioned different valuation thresholds for AGNC and MTGE, I'm hoping you can expand on that, too.

Does that mean you don't really expect MTGE's evaluation to ever really catch up to the average in the mortgage REIT sector?

I'll start with your last point.

No, not at all.

The statement related to the thresholds or AGNC and MTGE, just merely stated that MTGE's buyback, share repurchase decisions are going to be like AGNC share repurchase decisions, a function of a lot of other issues.

When you buy back shares, you're extinguishing those shares, and you're shrinking your company, it reduces your flexibility to execute different business strategies, it increases your operating cost over time.

And so they're a sort of -- there are other factors that have to be considered besides just either price-to-book discount and accretion.

On the other hand, for AGNC, they can look at purchases of MTGE shares, more from a total return perspective and can actually factor in things like relative pricing versus the space and things like that in their decisioning, or in our decisioning.

So what I would say is, the focus you should give, we are very confident about MTGE's business model over time.

As a matter of fact, we actually think that MTGE's kind of relative weakness in pricing versus a space that we've seen over the last few months is likely to be very temporary and that's a key driver of the decision.

Got it.

It also looks like you're continuing to rotate more of your longer duration hedges into Treasuries versus swaps.

Is that your way of taking a position that swap spreads versus Treasuries will continue to be particularly tight?

And I want to get a sense for the advantage you think you capture from using Treasuries over swaps at the longer end of the curve.

Good morning.

This is Peter.

We did increase the position in the first quarter.

And as you point out, really we're trying to find a hedge mix that we think is the best mix for our assets.

And given the volatility in swaps versus what we've seen over the last several quarters, and it's been the tightness in swap spreads, it was beneficial to us over the course of the last year to have a higher percent of our hedges in Treasuries.

I did mention though in my prepared remarks that we've actually rotated out of some of those positions and into a higher percent of longer-term hedges in the swap area.

So that will likely continue what we've done, a fairly significant amount of that rotation already this quarter.

The next question will come from Douglas Harter with Credit Suisse.

I was just wondering if you could talk about, in this environment, the cost of tightening up the duration gap and how you're thinking about that with rates having come down off of their -- towards the lower end of the recent range?

Sure.

We put a slide together for the last earnings call, it was Slide 7 again.

And we're -- with the curve flatter, considerably flatter than where it's been kind of over the last few years, or really last 5 or 6 years, the cost of running a smaller duration gap is not as prohibitive as it used to be.

I mean, realistically, you don't get paid a lot for running a larger duration gap given the -- relative -- the flat nature of the curve.

That said, what you have to be careful about is that if you look at Slide 10, which shows what -- how our duration gap moves up and down 100 basis points, you have to be careful not shortening your duration gap too much from a risk management perspective.

And what I'm trying to get to is, if you look, our duration gap is centered at 1.1 years as you mentioned.

But down 100, it would shorten quite a bit to negative 0.7 years, so that's a move of 1.8 years for the 100-basis-point decline, whereas up 100, it only expands by 0.8 years.

So there is some asymmetry with respect to kind of from a risk management perspective, and that would get worse to the extent that you kind of brought the base duration gap down too much.

So I think the important thing is, yes, you're not paid a lot to run a huge duration gap, but you have to keep in mind that the risk management aspects of the asymmetry.

And I guess, in a low volatility environment, to help manage that I mean, how do you think about the price of swaptions or other optional hedges?

Right now, we -- the price of swaptions have come down, options in the rates market have recently declined, they were higher, kind of toward the beginning of the year and they've come down.

And I think they're certainly reasonable.

On the other hand, I think the benefit of today's environment is one that I think interest rate volatility seems like it's more contained.

And so we don't have as big of a need for options.

To the extent that we increase leverage or kind of our position changed, I think we certainly would consider adding more swaptions.

Next question will come from Joel Houck with Wells Fargo.

If we could just kind of revisit Slide 11, which is very helpful, but I'm wondering if you could maybe, to the best of your ability, handicap.

We see the line and the point is well made, that if MBS spreads are returning to pre-QE3 levels, if you go back even further, you can see that the line has been higher.

How would you handicap where this line goes, out through say the end of '19?

Or said differently, under what scenarios would you see it, MBS, OES, widening versus narrowing from this point forward?

Excellent question, Joel.

And what I would say, the thing that stands out -- based on our kind of prepared remarks, what I would say is, we don't think that under all circumstances, Agency MBS spreads need to widen as the Fed's portfolio starts to shrink.

We think we've priced in a fair amount of that.

On the other hand, I don't think you're going to see substantial tightening.

Now there is 1 scenario where we would -- where we could see mortgage spreads kind of widening materially over time and that would be one where the Fed ends reinvestments and interest rates fall significantly.

And the reason that scenario could lead to wider spreads is just that the Fed's portfolio would be running down at a much faster rate than the 10% to 15% that you see there, if again, if rates fell to let's say 150 on 10s or below, you might be looking at 30%, 35%, 40% CPRs on the Fed portfolio.

And I think that would be -- that would put a fair amount of stress on the mortgage market, to have in a very short period of time, the private sector have to absorb kind of all of those finances.

And at the same time, you would also have an impact of the outstanding, the Fed wouldn't be cleaning up kind of the outstanding float in a high prepayment environment.

So I think this scenario, where mortgage spreads are most at risk is one where interest rates kind of stay at these levels or maybe higher over the next year, the Fed does end their reinvest -- starts the process of ending their reinvestments, but then you get a large rally in interest rates.

That's probably the 1 scenario where we see mortgage spreads materially wider.

I think that, where you could see mortgage spreads materially tighter is a simple one, which is one where the Fed -- something derails the Fed, and they don't end up ending reinvestments, kind of -- and that's also -- that's a probably more realistic scenario than the first one I described.

But I hope that helps.

No, that's extremely helpful.

If I could just ask a question.

With respect to the Fed perhaps, not the latter scenario or spread scenario, in your mind, was that more driven by the overall general economic activity, in other words, as long as things are bumping along okay, the Fed will continue.

You're at a measured pace, but if we hit a speedbump in the economy, that will cause them to back off?

Are there other factors you're thinking about?

Yes.

I think that's probably accurate.

But I would focus on what [Terry Allen] said in her press conference, which is one of the things that she thinks a lot about, with respect to the ending of reinvestments is they don't want to start the process and have to stop it.

They want that to go in the background.

And so what I would say is that, it's a little less about the baseline strength of the economy, and more about how big are the risks over let's say the next year or 2, that you're going to have to change that posture.

Because I think when you listen to the Fed, they really want that to go on sort of autopilot.

And so I think they will be more reticent to start that process to the extent that there's significant risk around the economy, let's say from either global forces or there's substantial uncertainty around the political environment, when there's downside risk.

So I think that yes, the baseline of the strength of the economy is important, but I think the uncertainty around the next year would probably be more important as they -- for them, when they actually pull the trigger.

And our last question will come from Rick Shane with JPMorgan.

It's interesting, almost all the conversation this morning's been about the right side of your balance sheet, not necessarily the left, from the analysts.

And I had one question there as well.

You guys have been historically pretty, very thoughtful in terms of managing risk and making some strong tactical decisions.

One tool that you have not used, that seems to be cropping in the market is MSR hedging.

I'd like to get your thoughts on that and perhaps why that's not a tool you used.

That's a good question, and we've certainly, over the years, looked at MSR.

And I think it is helpful in the fact that it has, obviously has negative duration such -- which, that's a good starting point from the perspective of our hedges.

On the other hand, it has kind of 1 very significant kind of weakness as a hedge, and that relates to its liquidity.

So when you think about AGNC's hedges, where they're just absolutely critical is, if interest rates were to go up 100 basis points, we have a quick move higher.

And what ends up happening, obviously, is the price of our mortgages, our Agency MBS, drop in price, and we get margin calls from our lenders.

And on the other hand, our hedges increase in value in that scenario, and we can transfer the margin that's posted to us on our hedges to the margin calls essentially on our assets.

Even if MSR is increasing in value, it's not pledgeable and it's not something that you can realize and manage your kind of liquidity over a reasonable amount of time.

And so that doesn't rule it out as hedge, but it really limits how much of it you would be willing to use as a hedge.

And that's a big picture issue for us.

I mean, and we understand that these, we'll call it kind of liquidity situations, where you have big enough price moves to worry, but it don't occur all that often.

But when you run a levered portfolio, you have to pay a lot of attention to something that might occur once every 3 or 4 years.

And we feel that's the prudent thing to do.

The other thing I would add is, when you run a levered mortgage portfolio, you take on a lot of negative convexity in and of itself, and that's inherent in the agency business model to begin with.

And then when you layer in a negatively convex hedge, such as IO or MSR, even outside of the liquidity issue I raised, that takes management to -- portfolio management to another level.

And I mean, you can probably use -- you can see that easiest in the fact that, think about if interest rates did go, the 10-year did go to 3%, there's almost no negative duration in your MSR or IO hedge at that point.

And so basically have to go on and rehedge your portfolio at that point, that gives you an idea, I mean, of one kind of straightforward example of the negative convexity.

But I'd say those 2 are the biggest issues we see, in kind of using MSR in a, kind of a big way as a hedge.

We have now completed the question-and-answer session.

I'd like to turn the conference back over to Gary Kain for concluding remarks.

I'd like to thank everyone for your interest in AGNC, and we look forward to talking to you next quarter.

Thank you.

The conference is now concluded.

An archive of this presentation will be available on AGNC's website and the telephone recording of this call can be accessed through May 11 by dialing (877) 344-7529 or (412) 317-0088, and the conference ID number is 10105255.

Thank you for joining today's call.

You may now disconnect.