Q2 2020 Annaly Capital Management Inc Earnings Call

[music].

Good morning, and welcome to the Annaly Capital Management second quarter 2020 earnings Conference call. All participants will be in listen only mode should you need assistance. Please signal a conference specialist by Christmas Starkey followed by zero.

After today's presentation, there will be opportunity to ask questions to ask a question May put star then one when you're Touchtone phone.

To withdraw your question. Please press Star then too.

Please note this event is being recorded.

I'd now like turn the conference over to Porphyry kept our please go ahead.

Thanks, Good morning, and welcome to the second quarter 2020 earnings call family Capital management.

Any forward looking statements made during today's call subject to certain risks and uncertainties, including with respect to cover at 19 impacts, which I outlined in the which Dr. section most recent annual I'm quoting <unk>.

Actual events or results may differ materially from these forward looking statement.

We encourage you to read the disclaimer <unk> earnings release in addition to our quarterly filings.

Additionally, the content of this conference call may contain time sensitive information that is accurate only as of today.

We do not indicate and specifically disclaim any obligation to update or revise or something.

During this call we make present, both GAAP and non-GAAP financial measures.

<unk> GAAP non-GAAP measures is included in our Chile.

As a reminder, annaly routinely most important information for investors on the company's website at Www Dot Annaly dotcom.

I think referenced in todays call can be found in our second quarter 2020, investor presentation, and second quarter 2020 financial supplement.

Okay and into the presentation section of our website.

Oh intends to use their web page that need to decode material nonpublic information are complying with the company disclosure obligations under regulation FD.

To pose an uptake that you couldn't patients it's not material on a regular basis.

We encourage investors analyst and media.

Im interested party to monitor the company's website. In addition to song and always press releases FCC filing public conference calls presentations and Webcasts and other information to post from time to time on its website.

Please note today's event is being appointed participants on today's call include David Finkelstein, Chief Executive Officer, and Chief Investment Officer, Serena Wu Chief Financial Officer.

Like Sandia had a presidential credits.

And Gallagher head of commercial real estate in coffee, Chief Credit Officer, and ochre task had a secured I thought it.

And with that I tend to call it the today.

Thank you Bobby and good morning, everyone. Thanks for joining us on our second quarter earnings call.

Jay I'd like to highlight the number of course corporate initiatives provide an update on the market you discuss portfolio activity across all four businesses during the quarter and finally provider outlooks for the balance of the year middle handed off to shrink it did discuss financials, but no well last quarter each of our credit meters, providing it does look it.

Their respective markets and portfolios to be fishing, Oh provide those updates today, but as poor be noted each of our business hedges years, well to join in Q1 day.

How to begin with I wanted to touch on its your strategic corporate actions, we've taken as of late quarter end, we closed our previously announced internalization transaction, which marks a significant step in a series of measures, Italy is implemented as an industry leader somewhat governance standpoint.

An internally managed REIT, we look forward to demonstrating increased transparency in alignment with our shareholders, who benefit from our ability to be more nimble in the way, we do business in order to generate long term value.

We also announced two leadership changes, Steve Campbell was appointed as Chief operating Officer, and Glenn Votek will retire from his role as senior advisor at the end of August while remaining a director on all board.

As COO, Steve will expand on the work he's been doing just head of business operations and work closely with the executive team to help oversee and always overall operations and risk management functions. When it's been an invaluable part of our leadership team and we thank him for his numerous contributions over the years and look forward to is continuing service or.

Sure.

Additionally, during the second quarter, we utilize our share buyback program now repurchased 175 million in common stock year to date.

Underscores our belief that Soc is undervalued relative to our book value and affirms our support of the value of our stock to the various capital allocation tools, we have on hand.

These initiatives are testament to our focus on driving shareholder value, ensuring that the firm as a whole or structure as well as our portfolio is positioned to continue outperforming as our second quarter results demonstrate.

Following one of the most challenging unforeseen operating environments nano its history, we were pleased with our performance during the second quarter, we delivered an economic return of nearly 15% to cheat core earnings well in excess of our rightsize dividends.

Measured approach to weathering the crisis served us well, we feel very good about our positioning is the recovery progresses as I'll get into in more detail.

So the economic slowdown brought on by the pandemic is obviously created considerable uncertainty and this is different kind of recession than that which we've experienced in the past given the unprecedented speed and magnitude it's downturn [noise] social distancing mandated shutdowns to damage certain sectors of the economy and the corresponding impact on the.

Labor market has been substantial.

There's been some signs that the worst the economic distress, maybe behind us although with the recent surgeon cases in some areas. The U.S. demonstrates the fragile nature of the recovery.

Nevertheless, financial conditions have improved considerably.

The market dysfunction that occurred amid the initial kogut outbreak in the U.S. has dissipated and we have seen significant improvement in liquidity and asset pricing. This is in large part due to the ongoing decisive actions taken by the federal reserve, which had been successful in the <unk> restoring markets and easy credit strange.

Liquidity tools have sufficiently supported funding markets. The credit facilities have opened channels to credit for businesses households, and local governments temporary adjustments to regulation. Some somewhat encouraged bank lending and most impactful to handle these portfolio you asset purchases have supported the smoothed functioning of Treasury and age.

See markets.

Now turning specifically to the agency market, the feds purchase and upwards of 850 billion M.B.S. and just over four months is dramatically altered the supply and demand picture for the sector.

After a pace of purchases at the height of the volatility the reached nearly 50 billion per day to help stabilize the sector that is transition to steady run rate of 40 billion per month net of portfolio run off which on a gross basis equates to roughly 40% current agency issuance.

That is largely taken delivery of the most negatively convex MBS, which has resulted in the shifted the TV a deliverable across production coupons to more newly originated pools and as a result nominal Terry on production coupon TB ASE has improved dramatically, thereby adding to returns for TV a holders.

Given this dynamic we increased our TV a position in the quarter and gravitated further down in coupon.

Lower coupon holdings are predominantly in TV ace and higher coupons are concentrated in specified pools in light of the meaningful elevation in prepayment speeds in this environment.

While our portfolio speech did experience an increase on the quarter Prepays on our overall portfolio were notably lower than the GRC universe, which paid roughly h. CPR faster. Despite the higher average coupon of our portfolio relative to the universe.

With respect to our hedges, we added to our swap portfolio primarily in the front in the short term swaps would pay rates close to zero present, providing attractive heads to our financing.

This reduced our pay rate as well as shortened the maturity of our swap portfolio.

We further reduced the LIBOR broke through none of our hedge portfolio with our swap book now, 80% No I guess and we re initiated our treasury futures short position that was unwound in first quarter.

We also continue to take advantage of the attractive low levels of volatility to hedge the tail risk of the sharp rise in rates in the long into the yield curve and as such we replaced much of our legacy swaption position with additional out of the money payer swaptions.

Shifting to residential credit the sector saw significantly more activity as market dynamics began to improve following the crisis. The housing market remained strong given long term positive fundamentals, which we believe will help to the ultimate recovery.

We're experiencing a meaningful imbalance between supply and demand as a cyclical low number of housing units meets continued strong household formations and anecdotal evidence suggests that pandemic disruptions that limited impact on the whole buying and refinancing processes.

Non agency securities across legacy CRT, Jumbo 2.0, and Nonqm have seen substantial recovery.

Improvement signals that the market currently believes that the majority of for Barents cases, which have stabilized over the past couple of months will ultimately be resolved. However, non agency lending has been somewhat slow to redevelop as credit standards have tightened the relative to pre pandemic underwriting and mortgage originators tend to be focused more on age.

See originations in light of fewer frictions in a wide primary secondary spread.

Residential portfolio was roughly unchanged quarter over quarter, a 2.6 billion as modest purchases and mark to market increases largely offset sales and portfolio run off.

Securitization market started to show signs of life in mid May come we issued nearly 500 million of expanded Prime securities earlier. This month subsequent to quarter end.

Aggregate issuance under our OPX shell has now reached four and a half billion across 11 transactions since 2018 as I mentioned last quarter, we expect to see more growth in this segment as markets continued to normalize when we are encouraged by the steady pace securitization activity to support our asset generation strategy.

In the commercial sector, we're slowly beginning to see activity pick up but volumes do remain somewhat muted.

June however, did bring about an increase in new refinancing requests with some new acquisition activity at post Cogan purchase prices and simultaneously we've seen a significant number of warehouse providers begin to close new loans, although pricing levels had been reset higher.

Cross sectors within commercial the operating fundamentals remain challenged in hospitality as the average national occupancy rate hovers around 40%.

And in retail to prolong shutdown and increasing number of retailer bankruptcies is continuing to weigh on that sector.

More positive note multifamily remained strong throughout the quarter is the latest data indicates over 90% of renters made a full or partial rent payment as of June and in the office sector. Although new leasing has slowed significantly office reach of reported strong rent collections above 90% throughout the back end of this.

Second quarter.

With respect to our CRM portfolio, specifically total assets at quarter end, two and a half billion represented a slight decrease while economic interest remained essentially flat.

The decline in portfolio size was driven by approximately 53 million and loan pay offs as well as security sales.

Financing side, a weighted average cost of borrowing decreased by roughly 60 basis points to 2.7% driven largely by a reduction in whiteboard given that cops overall, we feel good about the conservative positioning of the portfolio across sectors and the strength of our relationships with best in class sponsors and operating partners to mitigate.

Great and further disruption.

Shifting to middle market lending activity is also picked up as of late spreads tightened and sponsors have refinanced transactions that have exhibited improving underlying leveraged profiles.

New deal activities, primarily relegated to more broadly syndicated loans. However for context first lien executions on larger transactions and tightened 75 to 100 basis points over the past quarter, while traditional middle market has shown less movement in pricing.

Unitranches and second lien loans within middle market are experiencing more notable price discovery than its larger market Brethren and we expect these gaps to remain is traditional middle market participants grapple with their portfolios.

Consistent with our communication last quarter, we continue to speak actively with sponsors borrowers and agents to closely monitor performance. Despite the challenging environment. We're pleased with how the portfolios performed during the period ending the quarter essentially unchanged at 2.2 billion in assets as we getting further clarity around the law.

Long term implications of Cogan, we're reassured by the stable in defensive nature of our portfolio and remain confident and its ability to withstand prolong bouts of market volatility. We believe our focused industry specific positioning within nondiscretionary defensive in mission critical names will generate the outperformance versus peers.

That will further differentiate our brand in the sector back some of our industry concentrations have materially benefited from the current environment. For example, government mandates at all levels have created an even greater dependency on technology, while also driving demand and behavior in ways that it's me once boring annuity businesses into growth sectors.

Portfolio construct has been protected against broader sectors that have witnessed demand destruction, and we maintain meaningful exposure where pockets of spend remain resilient.

No additional no with respect to our direct lending portfolios. We have taken what we believed to be a very conservative approach regarding reserves and seasonal adjustments, which threed or will discuss in further detail.

Finally shifting to our outlook as we think about our capital allocation out the horizon, we've been focused on preserving flexibility given uncertainty in the greater economy related to covert shutdowns, we maintain the view that the agency sector represents the most attractive investment opportunities currently while also providing strong liquidity we have.

Entered a more normalized environment with fed action, serving as a key driver MBS spreads have retrace much the widening experienced in March we do remain positive on the sector given ample funding availability at low rates dude rate volatility and a complete reversal of an inferior technical backdrop the characterized.

Sector at the outset at this year.

Well our allocation agency may increase modestly we do continue to evaluate opportunities to deploy capital across our three credit businesses and we are beginning to vote to develop a better lens into how each credit sector is evolving and we expect to shift to a more offensive posture in the coming months as we gain more clarity on the economic in real estate landscape.

Yes, we were certainly careful to take prudent steps during the early phase of the market recovery to ensure we are well positioned to capitalize on the opportunities that are sure to arise.

And as part of our preparation we've chosen to be conservative with our leverage as well as our dividends. Our goal has been to maintain optimal liquidity thresholds and to manage the portfolio within conservative risk parameters produced the highest level of quality earnings in this market environment.

Consequently, we reduce leverage during the quarter from 6.8 to 6.4 times and made the prudent decision to set our quarterly dividend at 22 cents dividend represents a 10 at 10.5% yield on our book values, which is in line with our historical average while being competitive relative to our peers in berries fixed income.

Benchmarks as I mentioned, we out earn the dividend by five cents this quarter and absent another market dislocation or other unforeseen developments, we expect Q3 core earnings to also exceeded dividends.

Overall, we maintain a more constructive view of the operating environment and our ability to deliver compelling returns as each of our businesses respective sectors begins to emerge from the initial volatility and disruption caused by the pandemic.

And now with that I'll hand, it over to screen to discuss the financials.

Thank you David and good morning, everyone I will provide brief financial highlights for the quarter ended June 32020, and while earnings release discloses the GAAP and non-GAAP core results I will be focusing this morning, primarily on our core results and related metrics all excluding pay <unk>.

As David mentioned earlier, the stabilizing actions of the fed coupled with our active portfolio management resulted in improved fair value without agency assets and significant improvement in financial performance.

Book value per share with $8.59. The Q2, a 12% increase from Q1, and we generated core earnings per share excluding T. I a of 27 cents, a 30% increase from the prior quarter.

Book value increased our GAAP net income of 856 million of 58 cents per share, which includes five cents related to see so and specific or that and higher other comprehensive income of $721 million.51 to staff unimproved valuations on agency MBS, resulting from lower market rates.

GAAP net income improved this quarter as a result off hire GAAP net interest income of 399 million, primarily due to low interest expense from reduced repo rates imbalances and we also experienced lower losses on asphalt portfolio of $92 million.

Last quarter, I noted that most about assets and liabilities or asset value and that our book value decline was not a function of both asset sale.

Rather unrealized mark to market losses with potential for recruitment.

Good point with evidence of course with improvement in fair value measures and resulting in print book value.

While financial conditions have stabilized there is still significant uncertainty around the long term economic pickup.

This makes analysis regarding Cecil where the particularly challenging.

As a result, we ran numerous scenario in excess of 20 to determine the appropriate amount of fees over that to the quota and ultimately booked reserves that were considerably more conservative than our base case scenario.

In comparison, our base case scenario resulted in a modest release ever that which we felt inappropriate given the continued economic uncertainty sensitive around the evolving pandemic.

We recorded reserves associated with our credit businesses, the 68.8 million unfunded commitments during the second quarter.

Consisting of 22 million of additional reserves during the quarter, primarily resulting from the impact the credit 19 or how borrow it.

More general reserves related to pull cost for a deterioration in economic condition of the market values of 46.8 million.

Total reserves now comprise 5.32% about acreage in M.L. line for probably as of June 32020.

I'd remind that the impairment model introduced by the new Cecil standard is based on expected losses, rather than incurred losses, which was the previous management there was that historically.

I understand it and entity recognizes it estimate of life time expected credit losses, as an allowance, which that that'd be believes will result in more timely recognition of such losses.

And while changes in economic scenarios and asset performance in the future will impact before that and subsequent quoted.

How is that levels should not be considered as a pervasive credit issue within that portfolio or an indication of what was as may be recorded in the future.

We have previously discussed our methodology and now sadara and thoughtful approach to season where that.

As always we spent time analyzing the results of there was that calculation and ensuring our expectations aligned with the quality of the portfolio and the performance of the borrowers.

We continue to think it critical in the current environment to consider the adverse economic scenario is available in this process and to err on the side of conservatism, given the significant uncertainty and the economic and market values in our it.

We remain comfortable without existing credit portfolios and the associated piece or is that and we'll continue to monitor specific asset performance and economic projections as its attendant feature at that.

Turning to enter the largest fact that quarter over quarter to quarter earnings X P. A low interest expense of 196 million. This is 503 million in the prior quarter due to lower average repo rates and balances as well at higher TV a dollar roll income at 96 million best at 44 million in the prior quarter.

Hi, average balances, partially offset by higher expense from the net interest component of interest rate swaps at 65 million. That's a 14 million in APAC were on high average national balances.

As David touched on our economic leverage declined to 6.4 times from 6.8 times quarter over quarter, which is mainly due to a decrease in repo balances of 5.4 billion and an increase now equity base of 1.1 billion that was partially offset by an increase in today contracts, a 5.8 billion an increase net pebbles indefinite touches a 1.5 billion.

Our treasury function at the best in the business and their expertise an exemplary market timing was a key component that helped us whether the market dislocation last quarter and our ability to deliver strong core earnings this quarter.

Additionally, as noted about call it did benefit from a reduction in financing costs with low average, we put right down to 79 basis points from 1.77.

Event combined with low average repo balances down to 68.5 billion from 96.8 billion and we achieved these results while opportunistically extending out what type of time, increasing our weighted average day to maturity by 50% from 48 to 74 days.

Signaling from the fed on continued low rates combined with considerable injection of additional reserves in the financial system through retail operations and asset purchases have led to very stable funding conditions with replay markets experiencing no signs of stress to the quarter, even on pivotal month end and quota and reporting.

And access to repo financing remains ample.

With improved stability in financial markets, we've seen an improvement in lenders appetite to finance credit assets, particularly in the residential space.

In anticipation of the expiration of our FHLB membership in February of 2021, we're executing an outfit financing strategy involved in committed funding facilities for our residential credit business and as David mentioned, we we maintained a strong presence in residential securitization market.

Consistent with that strategy since the beginning of the second quarter. We added 1.1 to 5 billion of capacity across two new credit facilities for our residential credit credit the permanent nonrecourse financing.

The portfolio generated 198 basis points of NIM from Q1 of 118 basis points driven primarily by the decrease in classified that I mentioned a moment ago.

Well I Koreatown average equity, excluding PAA with 12.82% for the quota in comparison to 9.27% for Q1.

Our efficiency metrics tens modestly relative to Q1 thing to point out a 1% of equity for the second quarter in comparison to 1.98 to 10 also as David mentioned, our cannibalization transaction closed at the end of the quota and we anticipate generating cost savings at the long time as we embark on being an internally managed company.

And we ended the quarter with excellent liquidity profile was 7.9 billion of unencumbered assets and increase of 1 billion from prior quarter, including cash and unencumbered agency MBS, a 5.3 billion.

And finally, the company had performed exceptionally well given the challenges faced from remote work and market uncertainty. We continue to be impressed by the resiliency of our workforce an exemplary service that IP infrastructure team has provided to every one of us during this time of room night, where.

Everyone at Annaly contributes to access and we are proud of the result that we have reported for the second quota and expect to continue providing best in class results for our shareholders.

With that I'll turn it over to the operator a question.

Thank you we will now begin the question and answer session.

To ask a question you May press Star then one under Touchtone phone.

You are using a speakerphone please pick up your handset before pressing the keys to withdraw your question. Please press Star then too.

At this time, we will pause momentarily to assemble roster.

Our first question comes from Air Cages with KBW. Please go ahead.

Hey, Thanks, good morning, and nice quarter guys.

Hey, how much did TV is add to your your net interest margin for the quarter is is the special unless reflected in both the asset yield and the cost of funds.

And then how big is it TB balance now.

First is going to Jim.

So.

Good morning, everyone. Thanks for your comments with respect to the incremental benefit of the TV a position for the second quarter I'll say, they see the actual dollar contribution or or in pennies was about seven cents and.

With respect to the NIM contributions and.

Yes.

Stellarone provided about 97.5 million keyboards NIM for the Florida.

And then our TV a balance is roughly unchanged for the quarter and with respect to what we expect for the third quarter.

It is likely to be in the product in the proximity of where we were at a for Q2, maybe a touch higher.

Right. Okay. Thanks for that just on the TV is again, just every mortgage rate I feel like kind of accounts for.

Dollar roll Specialness, a little differently in there and they're NIM is it picked up in your asset yield or your funding costs or both.

Good.

In terms of how it's actually reflected in the yield.

And then on the NIM right. Okay. So it's reflected in your funding costs.

No. It is not reflected in the funding costs, we add the incremental dollar roll income to core income.

And then the outcome.

Okay. So the NIM itself is not reflective of TV is at all.

[noise] <unk> dollar roll at all.

No no. It does and then they definitely TV AD dollar roll income correct.

Okay.

Sorry, I think you're thinking about it a little differently, but yes, that's correct.

Sure Okay.

Total before it used to Dubai.

Sure.

Yeah, Yeah, and I think I understand.

For the agency derivatives portfolio I realize you guys, maybe Duncan asset this very often but how much of your cost basis was amortized through core earnings.

That portfolio last quarter and.

Then with rates haven't coming down.

Quite a bit I mean, as presumably some of those assets in keeping how are you guys thinking about your footprint.

In that portfolio.

Well look first of all talk about the footprint agency derivatives for example in what we're talking about here Eric is the difference between the balance sheet leverage in structural leverage so right now balance sheet leverage.

Tools are financed through the repo market is more attractive than structural leverage meaning derivatives, who you know when I say structural leverage I mean and asset cruise outcome is dependent on a larger asset like derivatives are so balance sheet leverage is incredibly expensive right now.

Abundantly available because the the.

Reserves in the system and in the agency space, it's more favorable than.

Structural leverage through derivatives, so that could change, but derivatives would have to cheapen, a little bit as well as MSR or for it to be more attractive MSR has different structural aspects to it that make it very cheap, but nonetheless structural leverage is little bit inferior right now to balance sheet.

Leverage now in terms of amortization of the.

Because you know given the MSR for example, which mimics the the derivatives portfolio.

There was it.

Appreciation in the amount on the balance sheet of MSR passive which was amortization in the other half of which was was a.

The multiple compression. So I think we had 25 billion in the 277 million. The MSR that started the quarter with actual amortization and derivatives you might say wood on the Io side would mimic that.

But okay.

And did you guys say what your book value was July.

I didnt in the prepared comments, we've it's been relatively calm weve oscillated around where we then where we ended the quarter in right now as of last night, it's up roughly 1%.

Got it great. Thank you guys. So much you.

You bet.

Our next question comes from Rick Shane with JP Morgan. Please go ahead.

Hey, guys. Thanks for taking my question and good morning.

I wanted to talk a little bit about dividend policy, David you would ER in your comments suggested that Q3 earnings core earnings are on track.

Exceed the dividend again and I'm curious when you guys think about dividend policy.

Currently you're always are very high I suspect that one of the things that influences. The the outlook is reinvestment risk is speeds pick up [noise] I'm curious how you guys are looking at this and especially in light of having cut the dividend earlier in the year.

Thanks, Rick and that's exactly right reinvestment as a key criteria here. So we set the dividend at 22 cents, because we believe that to be the sustainable level for the foreseeable future as long as we had Atlanta into the horizon now core earnings in Q2 were above that dividend and we expect them to be so in Q3.

<unk>.

A lot of that is driven by the tailwind from the fed and specialists NPV is where where our rolling come up doubled over the quarter and it is currently exist in today and if we look at past episodes Acumedia persisted for some time, but when we think about reinvestment into for.

Example, pools, where we see the Levered returns on agency MBS is in the context of.

11% to 12%, maybe a little bit higher and so as we look at the dividend right now at a tenant at 5% yield on book value. The reinvestment of agency run off is perfectly consistent with that longer term.

More steady state level, assuming race in this context, but keep in mind. We do have this near term tailwind of specialists and some other factors that are beneficial to the portfolio, where we're out earning the dividend. This quarter. We can say how long that will persist for but we do think about this.

For are much more than just.

The quarter or to where we do have the specialists and we're trying to get the appropriate level, where we know it's sustainable and that's how we feel about it if we continue downturn. It that's perfectly okay because were given the shareholder at 10%.

Dividend yield on their book value.

Got it and actually is you're answering that question I'm. Realizing there's there's another element to that which is that some of that additional that excess earnings is coming back to shareholders in the form of the repurchase at a discount as well.

Exactly exactly and we'll see where we end the year and Oh, but we feel good about where everything is.

Okay. So is it fair to say that the repurchase will be part of the flex in terms of using odd that excess earnings in the short term.

It's all dependent the rig going on the attractiveness of of the repurchase auction relative to other other options in our capital allocation policy you know in the second quarter and beyond as we mentioned, we bought back $175 million, where the stock.

The average price of those shares was I believe $6.30 or meetings will meaningfully above that level now.

So we're very happy that the market picked up the slack in did did a lot of that work as we look at the buyback policy. It's it's it's not a point in time estimated everything changes on a daily basis, because asset prices changes in the relative attractiveness of buying back stock versus putting that capital to work.

Folio changes and if you just thinking about the the immediate accretion of the stock buyback in terms of book value versus the longer term earnings of the portfolio. There is a there is a trade off there certainly and yeah, we generated 25% accretion from the buyback thus far.

Our but when you look at the portfolio and the economic return of the portfolio on a quarter that was 15% and that persists. We think so it's not it's not an apples to apples comparison, we have to look at how how attractive assets are and then put that in the context aware the stock prices and make a buyback decision based.

On that.

Great that I appreciate that and everything he said the two words that stood out everything changes I think thats, probably the best description of what we've all got through this year. So thank you guys you bet Rick Thank you.

Our next question comes from Kenneth Lee with RBC capital markets. Please go ahead.

Hi, Good morning, Thanks for taking my question I'm wondering if you could just provide a bit more color on your prepared remarks on the on the potential to increase agency allocation do you expect any meaningful shift in terms of equity capital allocation going forward. Thanks.

Oh sure can you bet and what I meant by that is that the increase in agency could could occur over the very short term as credit markets are still read developing and we do have some run off and that capital will be reallocated to agency over the over the very near term and when we say that I mean, you know.

Very small percentage.

We don't anticipate increasing agency meaningfully, but we do recognize that these credit markets are a little bit slow to redevelop we don't have complete clarity on the economy and some of that run off could go into the agency sector now that being said we are starting to get through this phase two.

Who as I mentioned last quarter, where it's really about recalibrating each each portfolio in the business in making sure we're optimizing each of the businesses and we're starting to get a better look at how things are going to unfold and we're seeing opportunities in credit.

And we're very constructive on it it just made it just may take a little bit of time to make sure we have the right approach and.

We have complete clarity on how things are going to play out. So we don't expect a meaningful increase in agency, but over the near term you can see a small uptick.

Great very helpful and one not one quick follow up on if I may.

You mentioned in terms of B the agency funding composition extending out the repo financing terms wondering going forward or would you expect to either further lengthen the repo financing terms or you know maintained you know what what you've been doing thanks.

It depends on on the shape of the curve like a over the last couple of months. The term structure of repo has flattened pretty considerably which has enabled us to.

To extend out the curve it Ed at very attractive rates, so we'd like to see it flattened a little bit a little bit further and we think it should given the posture the fed and when you look at the last set of economic projections, so lift off not likely to occur for the next couple of years.

You could see some further flattening in the term curve, but we're we're we're watching it and we're making incremental steps to to term out our repo.

Great very helpful. Thanks again.

You bet 10.

As a reminder, if you would like to ask a question. Please press Star then one.

Our next question comes from George Bahama does with Deutsche Bank. Please go ahead.

Hi, Good morning, just one congrats on a solid quarter.

So really favorable backdrop.

Coming cost.

Track to specialists TV market.

Just out of curiosity, what are some things that you're you're concerned about array looking closely at you kind of in the near and intermediate term.

Things things to look like I think positive generally, but just wondering how how you're going to think about downside risk from here.

Sure. Thanks, Peoria think yeah, and I think prepays isn't just kind of an obvious one yes, maybe outside the us outside of that.

Sure sure.

So look with respect to the agency market. We are in an environment, where funding is abundantly available and will be for some time given the reserves in the system of volatility is low and the fed is specifically.

Directing volatility lower and they also happen to be a huge tailwind in terms of purchases of agency MBS or the technicals are very favorable and to your point. It does it does appear to be very good backdrop for the foreseeable future for agency and Prepays, obviously being being the uncertain.

During the risk, which we I don't think.

You know you've heard a lot about I'm sure this quarter and I think weve managed prepay risk as well as anybody 96% of the portfolio is in specified pools and weve built that portfolio up over over a number of years and we use the up to the opportunity in March to.

Reduce the pool holdings that we didnt.

Fine as attractive and what we're left with this portfolio that is up.

Very high quality and as a consequence of that portfolio, we did see a fair amount of appreciation in those pools.

In the second quarter as as markets stabilized and that is one of the risks I think going forward.

Beyond just prepays is what happens to pool pricing over over the next quarter to two we feel good about where pools are at the reason why they appreciate it is because they're worth it you know they provide that much better convexity profile profile in lower prepayment.

Characteristics than the market, but generally speaking pool pricing can be a can be variable and so that's probably the risk in agency in credit you know as we've said, we like our our portfolio Weve appropriately conservative we reserved for any idea what we think to be if any.

Venture out the down out the horizon, but theres idiosyncratic risk in in every credit assets and so.

We feel good about it but there could be one off a disruptions and so that's something we're looking at as well. So broadly speaking in agency, it's probably pool pricing in a credit there could be unforeseen events, given the economy that could disrupt individual assets.

Got it is helpful color and my other questions have been asked and answered. Thanks again, you bet. Thanks George.

Our next question comes from Doug Harter with Credit Suisse. Please go ahead.

Hey, guys is actually Josh Bolton on for Doug I was wondering if you could talk a little bit more about the thought process around the hedge repositioning in the quarter, adding more hedges on the short end of the curves.

And then I guess should we expect more options hedging going forward I know you mentioned some of the tail risks and just any more additional comments on the hedge position would be great. Thanks.

Sure you bet Josh.

So first of all with respect to the repositioning we you know what we experienced in the quarter.

Was initially a pretty significant steepening of the curve, which which we anticipate and I think tenure no got to roughly 2025 basis points higher than it was now at the time, we started the quarter with the swap portfolio would have about nine odd years I believe.

Now given how long that portfolio is in duration as we mentioned last quarter. It provides multiples of interest rate protection relative to the assets, which are much shorter in duration. So.

Given the slope of the curve given the.

Significant decrease in front end bill is rates to zero, roughly we took the opportunity.

To add hedges and move down the curve and better balance out the hedge profile to bring the average life to about half what it was at the end of the first quarter and it's still about twice the duration, maybe a little bit more than twice the duration of the asset portfolio currently but 40.

Percent hedge ratio being more than a little bit over twice the duration you get to roughly.

80% to 90%, maybe a little bit more of.

Interest rate protection, assuming a parallel shift in occur with the still slight steepening bias, which we which we think is the appropriate approach, but nonetheless, it's a more balanced hedge profile now with a slight steepening bias and we took advantage of near zero rates at the front end of the curve.

We should we think has very limited downside potential in terms of those hedges, losing money because it's not our it's not our view that we end up in a negative rate scenario negative policy rate scenario that is so we feel good about it now with respect to options.

We did reinvest Oh, a lot of the run off than in our swaption portfolio backing out of the money Swaptions and I'll tell you going forward that we will be a function of the level of implied volatility when I look. This morning, three month tenure swaption ball was about 53 basis point it didnt get below that.

Level in early 2019 to about 49 basis points.

And then last time prior to that was 2017 and before that it was pre crisis. So ball implied volatility is very low and thats by design on the part of the fed into the extended continues to decline it will be a more attractive hedge to our to our agency portfolio.

And I would say that at current levels, you should expect it to be it.

A critical component of the portfolio going forward does that answer your question.

Yep, that's great. Thanks, David appreciate the comments he bed, Josh good to hear them.

This concludes our question and answer session I would like turn the conference back over to David Finkelstein for any closing remarks.

Okay. Thanks, Brendan for your hope and we hope everybody stay safe thanks for joining us today, and we'll talk to you soon.

The conference has now concluded. Thank you for attending today's presentation you may now disconnect.

[music].

Yes.