AGNC Investment Corp (AGNCO) 2018 Q2 法說會逐字稿

Good morning, and welcome to the AGNC Investment Corp.'s Second Quarter 2018 Shareholder Call.

(Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Katie Wisecarver, Investor Relations.

Please go ahead.

Thank you, Austin, and thank you all for joining AGNC Investment Corp.'s Second Quarter 2018 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 August 9, by dialing (877) 344-7529 or (412) 317-0088, and the conference ID number is 10122211.

To view the slide presentation, turn to our website, agnc.com, and click on the Q2 2018 earnings presentation link in the lower right corner.

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

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

With that, I'll turn the call over to Gary Kain

Thanks, Katie, and thanks to all of you for your interest in AGNC.

Volatility in rates and equities returned to more normal levels in the second quarter following the spike we experienced early in the year.

During the second quarter, the U.S. economy continue to show significant strength, especially on the employment front, despite the escalation of trade tensions.

We did, however, see a modest decline of momentum internationally, casting some doubt on the sustainability of the global synchronous growth narrative.

The decline in volatility witnessed in rates and equities during the second quarter was also apparent in both Agency MBS and credit spreads, with both largely unchanged quarter-over-quarter.

Interest rates rose modestly and the yield curve continued its flattening trend.

The spread between 2-year and 10-year swap rates closed the quarter at only 14 basis points.

For comparison, the spread was around 90 basis points at the end of 2016, following the presidential election.

The flat yield curve can be a headwind to earnings because it eliminates a levered investors' ability to boost net interest income by merely running a larger duration gap.

That said, our current quarter's net spread income of $0.63 was within $0.01 of the $0.64, we reported in both Q4 2016 and Q1 2017, when the yield curve was considerably steeper.

A key driver of this result is the fact that AGNC generally runs a relatively small duration gap and hedges across the curve, which reduces our alliance on the shape of the curve for the bulk of our income.

We also benefited from the improvement in the spread between our repo rates and 3-month LIBOR during this time period.

Looking ahead, we remain somewhat bearish on interest rates in the near term, but continue to believe that longer term inflation expectations will remain well anchored, making it difficult for rates to increase significantly.

Additionally, while it seems a little too early to call for the end of this long-running expansion, there appear to be more headwinds building on the horizon, including escalating trade tensions, renewed challenges facing the EU, slowing growth in China, along with higher short-term rates and a flat yield curve.

At this point, I'd like to turn the call over to our CFO, Bernie Bell, to review the highlights for the quarter.

Thank you, Gary.

Turning to Slide 4. Comprehensive income was $0.34 per share for the quarter.

Net spread and dollar roll income, excluding catch-up am was $0.63 per share, representing $0.03 increase over the prior quarter.

As Gary mentioned, our net funding cost benefited during the second quarter from the favorable spread differential between our repo funding rate and 3-month LIBOR received on our pay-fixed swaps.

As Peter will discuss in a few minutes, this positive funding dynamic subsided somewhat during the second quarter, but remains favorable, especially compared to historical levels.

Tangible net book value declined to $18.41 per share during the quarter or about 1%, while our economic return, which includes $0.54 of dividends paid for the quarter was a positive 1.7%.

Thus far for the third quarter, our current estimate of tangible book value is largely unchanged despite the recent increase in interest rates.

Moving to Slide 5. Our investment portfolio increased to $77 billion during the second quarter.

Our at-risk leverage increased slightly to 8.3x tangible equity as of the end of the quarter, while our average leverage for the quarter was down slightly at 8x tangible equity as a function of the timing difference between equity issuances and asset acquisitions.

During the quarter, we successfully raised close to $800 million in new capital through a $633 million follow-on equity offering and a $155 million from At-the-Market equity offering.

This new equity was slightly accretive to book value, but more importantly as an internally managed REIT, this capital lowered our operating expense ratio as a percent of stockholders' equity by approximately 6 basis points.

And brings our expense ratio to just under 80 basis points of our ending equity, which is less than half of our peer group average.

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

Thanks, Bernie.

Let's turn to Slide 6. Yield curve continued to flatten during the second quarter with 2-year and 10-year swap rates increasing 15 and 21 basis points, respectively.

Swap spreads on the intermediate to long end of the curve were a few basis points wider during the quarter.

And as a result, mortgage performance versus swaps and treasuries was mixed with most coupons within a few basis points of unchanged as of June 30.

Thus far into the third quarter, Agency MBS have performed well tightening a few basis points, along with other risk assets.

Turning to Slide 7. You can see in the top left chart that the investment portfolio increased to $77.1 billion in market value as we fully deployed the capital raised during the second quarter.

On a net basis, we added approximately $8 billion in MBS with purchases predominantly in production coupon, 30-year TBA and specified pools.

On the top right of Slide 7, you can see that prepayment speeds on our specified pool holdings continue to perform well given the combination of asset selection and the overall interest rate environment.

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

Thanks, Chris.

I will start with a brief review of our financing activity.

Our average funding cost, which includes the cost of our repo funding and the implied financing rate in our TBA assets increased 30 basis points in the second quarter to 192 basis points.

Over the same period, the cost of our pay-fixed swap portfolio improved 31 basis points and shifted to a positive carry position.

As a result of this offset, our aggregate cost of funds, which includes our repo and TBA funding as well as the cost of our swaps improved a basis point to 167 basis points for the second quarter.

On Slide 9, we show the funding dynamic between our repo funding and 3-month LIBOR.

As expected, the spread differential moderated during the quarter from the extreme level that we saw at the end of the first quarter.

Despite this decline, the differential today continues to be very favorable.

Over the near term, we expect our repo funding rate to remain on average in the LIBOR minus 10 to 20 basis point range.

Turning to Slide 10.

I'll quickly review our hedging activity.

Consistent with the increase in our capital base and corresponding growth in our asset portfolio, we increased our hedge portfolio to $68.4 billion.

The most significant change came in our swap portfolio, where we added new pay-fixed swaps as well as took delivery of $1.2 billion of new swaps associated with the expiration of in the money swaptions.

Finally, on Slide 11, we provide a summary of our interest rate risk position.

Given the modest uptick in rates during the quarter, our duration gap widened slightly to 0.8 years, but our extension risk continues to remain limited.

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

Thanks, Peter.

And at this point, I'd like to open up the call to questions.

(Operator Instructions) And our first question will come from Doug Harter with Crédit Suisse.

Gary, just hoping to talk a little bit about your comments about the flatter curve and not needing to run kind of as or not getting paid to run a duration gap.

I guess, just in that context, can you talk about kind of the decision to have your duration gap expand a little bit during the quarter?

First off, the expansion in the duration gap was really a function of just a move in interest rate.

So essentially, it wasn't us actively trying to increase the duration gap.

So that was just to quickly address that issue.

But the other thing to keep in mind is while you are not paid for a duration gap, the challenge in managing a levered mortgage portfolio is understanding that you always have two-sided interest rate risk.

And if you look at Page 11 in our earnings presentation, what you'll see is that we have in an up 100 basis point rate move, we have 0.9 years of extension.

On the other hand, we have 1.6 years of contraction in a down 100 basis point scenario.

So one of the things that we really try to think about in the risk management of the portfolio is, look, we know there are risks that interest rates can move.

And if you look at our portfolio, essentially it has more exposure to call risk or shortening of duration than it does to extension.

And for that reason, the lowest risk position is actually to have a positive duration gap.

Now I mean, we could argue about whether that should be 0.5 years or something like that, but something north of 0 in duration gap is actually the lowest risk position.

And you know, we obviously don't only position -- there's obviously other factors that go into it.

But I think that's really the most important thing for you to think about is that it is important for us to use the base duration gap to help manage kind of the range of different scenarios that are possible, even with our positioning here, again, the exposure to a down rates scenario is significant.

That's helpful.

And then, in prior calls, you had talked about the appetite or willingness to let leverage increase.

Can you just talk about kind of your views on that today and the relative attractiveness of Agency MBS in order to add to the portfolio?

Sure, so nothing has changed.

Big picture, we believe our leverage right now is lower than kind of a steady state level where we would like it to be kind of in an -- whatever, call it, over the next few years.

But we're waiting for a catalyst and that catalyst will likely be wider spreads, could be a change in the interest rate environment, but more likely will be a move toward wider spreads, which we do think, again, that mortgage spreads are probably biased a little bit wider.

And we do expect a little bit more spread volatility now that the Fed's purchases are pretty small, so we're going to look to be opportunistic about that.

But I do want to be clear nothing has changed.

I mean, we -- from what I've been saying over the last year, I think the steady state for leverage in the future is going to be noticeably higher, maybe closer to 10x, but we do want to have a catalyst.

We want to see spreads a little wider before we start moving in that direction.

Your next question comes from Rick Shane with JPMorgan.

Gary, when we think about the sort of contour of the quarter, one of the things that we observed was that there was a slight downtick in terms of book value between your second-month mark and your final mark for the quarter.

And what we saw was essentially rates flat and spreads tightened a little bit during that time so that surprised us modestly.

Just curious what you're seeing and if we're interpreting things correctly?

So first off, I want to -- in looking at the position, there are lot of things that, that factor in.

I mean, one of the factors is kind of how treasuries perform versus swaps versus mortgages and specified mortgages.

And so I think, look, when you look at the quarter and the changes, you're talking about moving 0.5% or 1% here or there.

I think it's hard to fine tune and say exactly what the drivers are.

And I think from our perspective, the portfolio performed over the course of the quarter and for that matter individually kind of as expected.

But I do think that you have to be careful especially with curve moments and all of these different factors trying to fine tune book value to such small increments.

No question about it and again we're at the disadvantage of, we're working off a balance sheet that's 3 months old at any given point as well.

I was just curious that usually, directionally even on a month-by-month basis, we're pretty close and just curious if there was anything that shifted in your portfolio on the last month as you deployed new capital?

No, nothing material there.

Again, I think the noise probably came from relationship between treasuries and swap spreads, swaps and that was probably what created the noise there.

Got it.

And if you'd indulge us one last question.

Again, it sort of in the margin of error, but did see the CPRs pick up a tad, which just given the direction interest rates contradicts what we would expect, and again, going from 8 to 10 sort of a rounding error, but curious what's -- what you're seeing there?

Yes, sure.

So you're talking about actual CPRs.

I mean it's just housing activity in peak summer seasonals, which should start to turn as we move into the fall.

Okay.

So you would expect to see back into single-digit CPRs as we move through the year?

Yes, more or less.

Your next question comes from Bose George with KBW.

This is Eric on for Bose.

Just a follow-up on prepayment speeds.

Actually just turning to your forecast of 7% CPR for the lifetime forecast.

Is there an assumption for the passive interest rates in there that's different from the forward curve?

Or is there something that's more specific to the collateral that you're buying that's moving that forecast lower?

So I mean, basically our forecast on prepayment speeds is tied to the forward curve.

And so it is -- it does look at the specifics of our collateral and that absolutely factors into the forecast.

But the forecast relates again to the forward curve and while the curve is flat and it doesn't build in that much of a rise to interest rates that increase is sufficient.

And again, keep in mind, the seasonal factors that Chris mentioned.

We are in kind of peak seasonal factors now, which are elevating prepayment speeds as well over kind of even a yearly average.

Yes, that makes sense.

And then can you just give us a sense for levered returns that you're currently sitting on 30-year specified pools, and if you can include in your answer, what the level is on 1-month repo that would be helpful.

Look, I think, returns are still in the neighborhood of, we'll call it, very low double digits.

And I think that's helped by our very low expense ratio.

So again for AGNC, there is very little difference between -- it's very little difference between our, kind of, gross ROE and our net ROE, when our expense ratio, as Bernie mentioned, is sub-80 basis points.

And again, that's without even factoring in the MTGE management income or the termination fee income.

So big picture, we're still comfortable with where those returns are.

And again, that's on new money and that's inclusive of the yield curve where it is.

The second part of your question was on repo rates and about 2.15% I think is kind of where repo is.

Yes.

As I said before, I think a reasonable estimate would be of using 3-month LIBOR as a benchmark.

We've been seeing our funding rates at LIBOR minus 10 to 20 basis points.

So if you want to do it off 1 month, that's probably plus 5 or 10 basis points to 1 month LIBOR.

But they have improved a little bit since quarter-end, but I think that's a reasonable estimate to use going forward.

Got it.

One more from me, if you don't mind.

Just on your comments from the shape of the yield curve from your opening comments.

If it really does look like the yield curve is going to invert?

Can you just comment on what you think mortgage spreads will do in that kind of environment and what they'll be relative to swaps and treasuries?

Sure.

I mean, the trend is such that in fruition certainly isn't out of the question at this point.

And look, we do think that mortgage spreads are -- will likely widen in a -- in an inverting yield curve.

And so I think that will be an offset in a way towards the negative impacts of a -- of the inverted yield curve.

But an inverted yield curve is something that's obviously not only a -- will not only be a challenge for someone like a REIT, but it's a challenge for our bank, it's a challenge for all investors in spread product and in mortgages.

And so I think, along those lines, it is logical to expect that mortgage pricing to adjust and spreads to be wider.

And so that's partially -- and that's a factor in our decision not to take leverage up at this point in time.

And our next question comes from Trevor Cranston with JMP Securities.

I got a follow-up on your comments, Gary, about the two-sided rate risk you're always managing with the portfolio.

I was looking at the performance OAS charts on Slide 6 and 15s have obviously underperformed, 30 is quite a bit since beginning of '17, which I would guess is partially at least related to the flattening of the curve.

So I was just curious if you could talk about how you guys think about the role of 15s in the portfolio particularly when we're in a flattening curve environment?

Yes, sure.

This is Chris.

So we've reduced our 15-year waiting over the last year or so quite a bit from around the low 30 -- just below 30% to 16% as of June 30.

15s, as you mentioned, have had a number of headwinds of the flatter yield curve, low prepayment risk and just general low levels of volatility.

And so we've been willing to reduce that position.

With that said, I think, at current valuations, we think 15s will be reasonably well supported just given pretty favorable tacticals with net negative supply.

And there are very few short spread duration alternatives for investors with reasonable liquidity.

And so for those reasons and diversification reasons, we're not likely to take it down materially from where it currently is.

But hopefully, that helps answer your question.

Just what I would add is, keep in mind, that -- I mean one of the things that the reason mortgages remain profitable for us to invest in even with a flat yield curve is basically it relates to option costs and the prepayment option.

And that's really what we are working with and that's what drives our levered returns.

And in the case of 15-year, and in particular, seasoned 15-year, there's so little option cost that the spreads are lower and the ROEs on a levered position are a lot lower.

You would have to run considerably higher leverage on 15s and not to the tune of 1 or 2 turns to get close to the ROEs, which we don't -- so we don't like that trade-off.

And the trade-off gets harder in an environment where the entire spread or a big chunk of the spread comes from option cost.

So that's a key driver of the mindset.

And it's more, I would say, secular than it is market timing related to what we think of 15 years this month versus next.

The next question is from Mark DeVries with Barclays.

So we obviously had a lot of M&A in the mortgage REIT space this year.

Gary, I'm interested at your comments on what you view as some of the relative advantages or even disadvantages of getting larger and also comment on your appetite for M&A here?

Sure.

And thank you for the question.

I think it is very relevant.

So look, I think it's important to recognize that, that generally speaking, size does help when you're talking about how companies in the space trade.

And in terms of things like price-to-book ratio and those are relevant and they affect your flexibility, your ability to raise capital, your ability to do other things.

So size is an important factor, but really more important is in our case, as a internally managed company, as we grow or if we grow, our expense ratio drops.

And if you look at expense ratios and other kind of financial asset managers, these things are really important in today's day and age, I mean, the days of people ignoring fees and ignoring kind of expense ratios, I think outside of this space are over.

And so big picture, we look at our expense ratio and view it as something that is very relevant to the long run kind of value proposition that AGNC kind of gives investors.

So that's really the bigger of the two benefits if you grow.

But on the other hand, you have to be disciplined.

And you should grow when you feel like the investment opportunities are there and when you're talking about raising capital accretively or certainly not dilutively.

Now when we get to the M&A activity, honestly, we struggle with understanding how buying other mortgage REIT vehicles are really realistically buying their assets above book value is competitive versus just raising equity.

And so practically speaking, we are very willing to participate in M&A activity, but I mean where transactions have occurred, the levels are absolutely not justified relative to -- honestly, relative to doing nothing, but also relative to just accessing the capital markets more generically as we have done.

And our last question today will come from Jim Young with West Family Investments.

Gary, you had mentioned that you expect the long-term inflation expectations to remain well anchored.

And as you think about how the economy develops and how said policy evolves, can you give us a sense and some insights into your thinking about leverage and how you are thinking about leverage at 8.3x for this quarter?

At what point in time or what factors are you looking for to determine when you would want to increase leverage?

And how high of leverage would you feel comfortable in going over the next couple of years?

Sure.

And it's a very good question.

Thanks, Jim.

What I would say first off is, when you go to the interest rate environment, it absolutely is relevant from the perspective of leverage.

First and foremost, AGNC puts a huge amount of value on its overall risk management strategy.

We are conservative with how we look at our liquidity.

And in that regard, we have to add up essentially 2 main risks that, that can affect the portfolio and where you obviously have to then manage your kind of leverage position.

The first is interest rate risk.

So to the extent that we expect a lot of volatility in interest rates or to the extent that we're running a large duration gap, then that does limit or should limit kind of how much risk we're willing to take with respect to leverage or exposure to spread risk -- mortgage spread risk, which obviously can affect valuations and wider mortgage spreads require you to post more margin and so forth.

So there is a trade-off between interest rate risk management and then let's just say increased leverage.

That said, I think in most interest rate environments, our interest rate risk is going to remain within a reasonable band.

And so the bigger moving part in the future around this total aggregate risk will probably be the leverage level.

But keep in mind, first of all, that -- the space so to speak use to run at like 14x leverage give or take before 2008.

And then just sort of magically ended up at 8x after -- in 2009 kind of through where we are is that being give or take the average.

But during that period, clearly, the markets have evolved quite a bit.

Haircuts have come back down.

We've seen stability in agency funding.

And for that matter, stability in funding and other -- in even outside of the agency space over the past 10 years.

And the lower haircuts alone would account -- would allow us to raise leverage more than 2 or 3x and be in a similar position.

So I think, big picture that's kind of a starting point for how we look at the interplay between interest rate risk and the interest rate environment versus leverage.

To be more specific, I think that if we were sitting here in 2 years, I think that the average leverage on, let's say, on agency mortgage positions will probably be a little north of 10, we'll say in the 10 to 11 area, is probably -- is a very reasonable place for it to be.

And I would say that that's sort of consistent with the risk we are taking at 8x leverage, let's say in 2010 or '11, given the changes in the financial markets.

So does that cover all your questions.

We have now completed the question-and-answer session, I would like to turn the call back over to Gary Kain for any concluding -- excuse me, concluding remarks.

I want to thank everyone for your interest in AGNC and we look forward to speaking to you next quarter.

Thank you.

The conference has now concluded.

Thank you for attending today's presentation.

You may now disconnect.