Q4 2020 AGNC Investment Corp Earnings Call
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For the AG Energy investment Corp.
For 2020 earnings conference call.
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I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.
Thank you all for joining AGM for the investment Corp, fourth quarter 2020 earnings call before we begin I'd like to review the Safe Harbor statement.
The conference call and corresponding slide presentation.
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 with the.
For materially.
From those forecasts due to the impact of many factors beyond the control of the GNC.
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 <unk> periodic reports filed with the Securities and Exchange Commission.
Copies are available on the SEC's website at SEC Gov, we disclaim any obligation to update our forward looking statements unless required by law.
Participants on the call include Gary Kain, Chief Executive Officer, Bernie Bell Senior Vice President and Chief Financial Officer, Chris Kuehl Executive Vice President.
Aaron Pas senior Vice President and Peter Federico President and Chief operating Officer.
With that I'll turn the call over to Gary Kain.
Thanks, Katie and thanks to all of you for your interest in H C. R.
Our portfolio continued to perform extremely well in Q4 supported by very attractive funding and ongoing large scale fed MBS purchases.
Most importantly, the positive seven 5% economic return in Q4 lifted our full year of 2020 total economic return to <unk>.
Positive three 5%.
As a reminder, economic return is the combination of dividends paid plus the change in our book value.
In 2020, the dollar 56 in cash dividends paid during the year more than offset the 95 cents per share decline in our book value.
This is a very favorable result, given the 23% book value decline in Q1, and the significant full year of losses experienced by many of our peers.
During the fourth quarter equity markets continued to show substantial strength and credit spreads tightened as the optimism around additional fiscal stimulus and vaccine efficacy boosted the prospects for a second half 2021 recovery.
Consistent with the stronger economic outlook, the yield curve began to steep and with longer term rates rising modestly a trend that has continued in January.
Agency MBS performance was strong during the quarter across the board with lower coupons outperforming.
<unk> continued to benefit from ongoing fed support limited interest rate volatility and strong dollar roll funding levels.
Looking ahead the improvement in the valuation of all financial assets, including agency MBS over the last several quarters. It does reduce the expected return profile on new investments.
That said agency MBS are still attractive on a relative basis for levered investors given the dual benefits of low funding costs and continued fed purchases.
Importantly, the near zero interest rate environment is likely to be with us through at least 2023 and it is unlikely we will see any tapering of MBS purchases before early 2022.
Even after the fed stops growing their balance sheet. They will likely remain very active in the mortgage market, replacing the run off in their portfolio until they begin to raise short term interest rates at this point I will turn the call over to Bernie to review our financial results for the quarter.
Yeah.
Thank you Gary turning to slide four we had total comprehensive income of $1 16 per share for the fourth quarter net.
Net spread and dollar roll income excluding catch up am was <unk> 75 cents per share the 6% decline from our recent third quarter peak of 81 cents per share. It was largely attributable to lower prevailing yields of new asset purchases and the funding the advantage of our TBA dollar roll position moderating somewhat during the fourth quarter.
As I mentioned on our last call looking ahead over the next several quarters. We expect this general trend to continue that being said, we still expect our net spread and dollar roll income to remain well above early 'twenty 'twenty levels.
Tangible net book value increased five 2% for the quarter largely due to the strong performance of our lower coupon assets.
Including dividends of 36 cents per share our economic return on tangible common equity was seven five per cent for the fourth quarter.
So far this month as of last Friday, we estimate that our tangible net book value is up about 3%.
Turning to slide five of our investment portfolio at quarter end totaled 97.9 billion largely unchanged from the third quarter.
Our ending leverage was 8.5 times tangible equity down from eight eight times as of last quarter and largely due to the book value appreciation.
Our liquidity position remained very strong in the fourth quarter with cash and unencumbered agency assets totaling $5 4 billion at quarter end, which excludes both unencumbered credit assets and assets held at our broker dealer subsidiary Bethesda Securities.
Actual prepayment speeds on our portfolio increased to 27, 6% for the quarter, but importantly, this does not include the lower coupon component of our holdings held in Tpa for them.
Our forecast of life C. P ours increased to 17, 6% as of quarter end from 15, 9% the prior quarter largely due to a 20 basis point decline in primary mortgage rates during the quarter.
Yes.
Also notable during the fourth quarter, we completed an additional $101 million of accretive common stock repurchases.
At an average repurchase price of $15 32 per share.
Moving to slide six for the year, we had total comprehensive income of 47 cents per share and $2.70 of net spread and dollar roll income excluding catch up am and as Gary mentioned, despite the extremely challenging market conditions earlier in the year, we generated 3.5% positive economic.
Return for the year.
Lastly, demonstrating our commitment to shareholder friendly capital markets activities, we completed $1 4 billion of accretive capital transactions during the year, including $402 million of common stock repurchases or 5% of our outstanding common stock.
With that I'll turn the call over to Chris to discuss the agency mortgage market.
Thanks for any let's turn to slide seven.
Following the election in vaccine news interest rate volatility continued its downward trend with rates gradually moving higher on the longer end of the yield curve the.
Steeper curve lower interest rate volatility and the steadfast commitment from the fed to maintain its current policy until substantial further economic progress is made provided a strong tailwind for risk assets and in particular agency MBS.
As you can see agency MBS prices were higher across the coupon stack. Despite 10 year notes selling off 23 basis points in yield or a little more than two points in price even longer duration lower coupon MBS ended the quarter higher in price.
Specified pool performance, while generally positive versus hedges underperformed the tightening in lower coupons during the quarter, let's turn to slide eight.
As you can see in the top left chart. The investment portfolio at 98 billion was little changed as of December 31st given the attractive spreads and favorable demand technicals for lower coupon 30 year MBS, we incrementally trimmed higher coupon holdings during the fourth quarter in favor of production coupon MBS. However.
With the outperformance of lower coupons in the fourth quarter and since year end, the relative value equation between higher coupons specified pools and production coupons as balanced now and unlikely to drive further compositional changes outside of the natural replacement of run off.
Importantly, we maintained a large TBA net roll position of $33 8 billion during the fourth quarter as roll implied financing continued to trade exceptionally well, particularly during the first half of the quarter.
Role implied financing cheapened noticeably into year end, but remains attractive in some coupons currently 30 year of production coupon implied financing rates are roughly 10 to 15 basis points special relative to repo Lucky.
Looking ahead, while agency mortgage spreads have tightened considerably over the last six months. This performance is not unique to the sector corporate debt residential credit see MBS have all performed well and some relative value relationships still suggests that agency MBS have further room for spreads to tighten, particularly given the bag.
Drop of ongoing fed purchases attractive funding and of prepayment environment that is likely to improve during 2021, I'll now turn the call over to Aaron to discuss the non agency market.
Thanks, Chris I'll quickly recap the quarter, our current positioning and then provide an update on our outlook for housing and credit.
Please turn to slide nine.
After risk assets widen briefly in October the rally was back on track for the rest of the quarter.
The event risk associated with the election dissipated and the market received several rounds of positive news on the vaccine front.
The combination of expectations for additional stimulus coupled with a light at the end of the tunnel due to the vaccine allowed for credit investors to look through any near term adverse data and COVID-19 concerns.
With that as the backdrop structured products continued to perform well with both highly rated cash flows as well as credit sensitive assets resetting to much tighter levels.
With respect of our holdings, our credit portfolio grew over the quarter through incremental CRT investments and price appreciation of our holdings, we found some value in certain lower credit CRT, which largely drove our position of increase in Q4.
Over the quarter spreads tightened across virtually all of our holdings in some cases have now retrace too as well as through pre COVID-19 levels.
Fortunately some of the retracement in asset spreads has filtered through into repo rates with borrowing with borrowing rates relative to LIBOR now approach the levels of early last year.
Turning to the housing backdrop, as we said last quarter housing fundamentals in the aggregate remains strong and we see little risk to this changing in the near term the should remain a tailwind and provide support to residential credit performance of view held by many market participants, which has been a large driver of where spreads are today.
With that said there is increased risk and some higher priced areas of the country that may face negative headwinds on the migration front.
This can be attributed to several factors such as state tax policy high cost of living and related to that the significant increase in work from home or work from anywhere trends.
If this trend continues it will likely take years to play out that could have a material impact.
Well, we do not see this being an issue for our current positioning in mortgage credit we cannot ignore this risk when evaluating incremental investments with certain exposures.
With that I'll turn the call over to Peter to discuss funding and risk management.
Thanks, Aaron I'll start with our financing summary on slide 10.
The average repo funding cost for the fourth quarter was 38 basis points down two basis points from the prior quarter.
Our funding cost at quarter end, however was materially lower at only 24 basis points and some of our higher cost longer term funding matured late in the quarter.
Importantly, the funding curve also flattened materially during the quarter.
Driven by a decline in the cost of longer term repo today for example longer term repo in the 12 to 18 months area cost around 20 basis points, depending on whether it is sourced through our captive broker dealer or direct with the counterparty.
Given this favorable funding environment I expect our average repo cost to remain relatively stable at around 20 basis points over the next several quarters.
Our aggregate cost of funds, which includes the cost associated with our TBA position as well as the cost of our swap hedges declined more sharply in the fourth quarter to five basis points from 15 basis points of the prior quarter.
This improvement was due to the combination of lower repo cost continued very attractive dollar roll funding levels and somewhat lower swap costs.
The improvement in our cost of funds, however, did not fully offset the decline in our asset yield as a result, our net interest margin decreased modestly to 202 basis points in the fourth quarter down 13 basis points from the prior quarter looked.
Looking ahead I expect our net interest margin to be by a somewhat lower as asset pay downs are replaced with new purchases at current yield levels gradually pushing our overall asset yield lower.
On slide 11, we provide a summary of our hedge portfolio, which increased significantly from the prior quarter.
In aggregate, our hedge portfolio totaled 67 billion up from 60 billion of the prior quarter.
As we added meaningfully to both our swaption and short treasury positions.
These positions were concentrated in the 10 year part of the curve and as such provided us incremental protection against the Steepening of the yield curve similar to what occurred in the fourth quarter.
Given this increased our hedge ratio at quarter end increased to 80% up from 71% the prior quarter.
This increase reflects the continuation of the themes that we discussed on our last couple earnings calls, which is that the macroeconomic risk is shifting more toward higher rates.
Lastly, on slide 12, we show our duration gap and duration gap sensitivity of our duration gap at the end of the quarter was negative of half of year.
This negative duration GAAP is consistent with the increase in our hedge portfolio the shortening of our asset durations and our bias in the current environment to operate with incrementally more upgrade protection with that I'll turn the call back over to Gary.
Thanks, Peter before I open up the call for questions I wanted to highlight a few new slides, we add it to the appendix this quarter that provide of longer term perspective on a GNC is absolute and relative performance.
Like the rest of the public equity space, we tend to focus our earnings calls on quarterly performance and near term outlooks and then the process, we're probably doing a GNC investors of Dis service, if we don't periodically address the longer term.
As slide 28 illustrates a GNC has outperformed both the S&P 500, and our peer group average from a total stock return perspective, since our May 2008 IPO.
In fact, we are one of only two residential mortgage Reits in existence at the time of our IPO that has outperformed the S&P 500 since that day and we are the top performing mortgage REIT over this 12 plus year timeframe.
On Slide 29, we show our total stock return comparison over time versus some relevant benchmarks.
The key takeaway is that aging and sees the outperformance of the S&P 500, and other benchmarks has occurred over an extended period that has included a wide range of interest rate environments and despite some very challenging episodes, including the great financial crisis, the taper tantrum.
The Brexit and the global all global COVID-19 pandemic.
While some of these events adversely impacted a GNC short term performance.
The long term trend line is unmistakable.
On slide 30, we compare AGM sees yield to traditional yield vehicles and again. The result is noteworthy as you can see a G. N. CS nine 2% dividend yield is not only of multiple of traditional yield vehicles, but it is predict particularly noteworthy.
Given the low yield levels available across the broader financial markets.
Over time, these dividends really do add up and to this point aging Etsy has paid a total of $42.88 per share in dividends since its IPO back in 2000 of name.
Finally expense structure is always a critical consideration for investment vehicles on the last slide we show a gnc's operating cost structure, which as a percentage of stockholders equity is the lowest in the industry at 87 basis points.
On a per asset basis. This translates to under 10 basis points, which is in line with lower cost bond Etfs.
Expense structure for an internally managed REIT is analogous to the fees charged by of mutual fund or other asset manager and so having lower expenses directly translates to higher realized returns for an investor.
It is a unique opportunity to be able to combine industry, leading returns with the lowest cost vehicle available in the mortgage REIT space.
Collectively these slides illustrate why we believe a GNC is of great long term fit for virtually any portfolio.
This is especially true when you consider that the lack of credit risk in our portfolio reduces a gnc's correlation with the typical pro cyclical stock portfolio.
So with that let me open up the call for questions.
Thank you we will now begin the question and answer session.
The question you May Press Star then one on the Touchstone for one.
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Today's first question comes from Doug Harter with Credit Suisse. Please go ahead.
Thanks, Gary following up on kind of of the power of of the dividend.
You just talk about your dividend outlook for this year and weather.
Now that we've flipped into 2021, whether that changes.
The the need for for distributions from of taxable standpoint.
You know.
From a taxable standpoint, we continue to have quite of bit of flexibility with respect, where we set the dividend and actually that's a key.
I'm glad you asked the question that way because I think historically, what's happened in the mortgage REIT space is the taxable distribution requirements have led us to pay basically all of our euro income or potential.
<unk> income out in <unk>.
Taxes is as you go back in time, but given the way we use dollar rolls and the differences between taxable income and both.
Both of accounting income and just kind of true economic income.
Really that's no longer a binding constraint for us so it gives us more flexibility with respect to our dividend policy and practices than maybe what we had five or 10 years ago, and it kind of brick and that in a sense of way to look at that is that we.
We can act more like a normal company without that if that constraint is not binding and.
And so what's important is that as you look at the mortgage REIT space are and you look at AT&T and.
In particular, and you say okay.
We don't have a binding constraint around the tax side and if you look at our current rate.
The dividend relative to any other dividend vehicle in this environment or or really.
Our alternatives around income the 9% or so yield for a GNC.
Is very very attractive kind of from a big picture picture of perspective.
The other thing just to keep in mind that we certainly think about.
As you know, we really like the position that we're in and we think it's really worked out well for our investors. So look at the last several quarters we're paying.
All of nine or more of it going back a few quarters per cent dividend, we are able to buy back stock, we're growing book value of the stock prices going up.
And this again is you know.
Our strong position and something that.
We're comfortable with and you know as we've discussed on prior calls for our priority for shareholders is to generate the best best risk. Adjusted total returns that we can that in other words make as much money for our shareholders as possible the dividend.
Is part of that equation and then the stock price our book value is the other part and again our bigger priority is the combination of those two and we're very happy with that trend certainly over the last three quarters, but again the.
Bernie mentioned the book value of looks to be up 3%.
In January at this point, so things continue to go in the right direction look we're going to continue to evaluate the the dividend on a go forward basis and it is an important.
A component of how Aegean Sea.
No.
<unk> takes care of shareholders, but its again isn't the only piece and it's the combination of the dividend book value, which then translates to stock price will continue to be active in buying back stock when it makes sense and we think in the long run.
It's the best overall equation.
For shareholders.
Yeah.
Great. Thank you Gary.
Youre welcome. Thank you.
And our next question today comes from Eric Hagen with BTG. Please go ahead.
Good morning, guys first question, just thinking about the backdrop of spreads being tight where do you see agency out of the most alpha in the portfolio over the near term do you see it coming more from the asset selection side or maybe actively managing the hedging side with duration of positioning and maybe you can talk about.
The general approach given your your outlook for spread volatility and such and then the second question.
Can you talk about what you like and the portfolio of higher coupons specified pools, specifically, the three and a halves in force.
Maybe you can go into some detail around how you think about owning them relative to lower coupon TBA.
Yeah, I'll quickly start and then hand it over to Chris.
Well, what I would say just big picture is I wanted to go back to.
The comments at both the Chris and I made earlier in our prepared remarks first of all flip.
And and what and again, what you mentioned in the question about mortgages agency MBS are more expensive now.
And we've seen three quarters of of strong spread performance. The first let's say a quarter and a half for two quarters. So that was recouping kind of widening and but you know the some of the move of late is certainly.
Making mortgages more expensive than longer term averages.
But.
Can't look at this.
You can't look at a GNC or the mortgage market in a vacuum we need to be and everyone needs to be practical about the strength that we're seeing in financial assets across the board.
And from that lens agency, MBS don't look bad and they more so.
Or a direct absolute direct beneficiary.
Of the you know the.
Current kind of.
Bond market dynamics, which are incredibly low funding cost and.
The fed backstop the MBS purchases.
So we're unique beneficiaries and that's especially true of of Levered investor who relies obviously on the funding equation, so with that being said.
Look.
We used to think that the we've believed over the last several quarters that lower coupon MBS and the dollar roll kind of opportunities clearly were stood out versus higher coupons, but.
Of that has sort of that has more normalized at this point and so big picture of how do we add value I think we add value by opportunistically moving around our leverage and our capital deployment.
And absolutely on the hedge side.
We've added options.
We've we've protected the portfolio against higher rates and we did that before this recent move higher.
And those are definitely things that over time, we will continue to add to <unk> bottom line and protect the portfolio.
Against the end of potential shocks and I'll, let Chris follow up on your you know kind of the specifics of.
Higher coupons and.
Those opportunities.
I'd just add the gross ROE before of convexity cost on both higher coupon specs and production coupon TBA.
It was very high single digits without roll Specialness currently.
During the fourth quarter, we converted some of our 15 year of TBA positions to spec pools and within <unk>, we shifted out of <unk>.
Few spec positions into lower coupon TBA, but.
And over the last few quarters, we've that's a trade that we've we've done a fair amount of just trimming positions in higher coupon spec versus production coupon TBA given.
Sort of the sharp recovery in pay ups that occurred mostly in the second quarter.
Against the backdrop of still very very cheap valuations on production coupons and exceptionally strong roles in.
As Gary mentioned this positioning has worked out really well with lower coupon significantly outperforming of late.
But as we mentioned given the performance of lower coupons, the relative value equation has shifted to a point, where it's balanced now.
That said I think given strong technicals and still reasonable absolute valuations I think production coupons aren't likely to widen the anytime soon.
But I'd say on the margin our Reinvestments will likely go into both production coupons as well as some pools.
Thank you guys for the very good answer I appreciate it.
Youre welcome.
The next question today comes from Bose George with the VW. Please go ahead.
Hey, guys good morning.
The follow up on the next question. So you said the gross ROE.
The high single digits.
Moving to the contribution from the TBA as you said I guess, the 10 to 15 basis point benefits is that like another whatever 115 per cent, yes sure. So.
Rolls of have traded in a wide range over the last few months call. It.
10 basis points to as much as the 100 basis points through repo for context, 25 basis points of Specialness adds roughly 2% to the gross Roe.
You know, but as I mentioned in my earlier remarks roll implied financing rates on production coupons are currently towards the cheaper end of that range around 10 to 15 basis points through repo.
Yeah, I do think it's I do think there's upside for all of the trade better from here I think the positioning in the second half of the fourth quarter started to get a little heavy given <unk>.
Extreme levels that we enjoyed for the better part of the last six months and so I do think given current levels, which are more or less in line with long run historical norms.
Some of the more transient positions widespread or be converted the pools, which which could help.
That said I don't think we get back to the Q3 type levels, but I do think roles improve a bit from here and trade better than just long term averages given current fed policy.
And just a quick ROI. The a quick rule of thumb on that is for every 25 basis points of Specialness its about 2% per our ROE. So if it's if we're if roes are 25 basis points first of all of its youre, adding two if it's 50 basis points special you're adding for <unk> at the absolute P.
Where it was a 100 basis points of actual you're adding eight are away. So that's just a quick way to.
To approximate it.
Okay, Great. That's very helpful. Thanks, and then actually you know there's also obviously of the other variable and the return of leverage can you just talk about the backdrop you need to see.
For the leverage to go up from here.
Sure.
I think the short answer is again, we're very comfortable with the risk return profile of the agency MBS, but again, they've clearly appreciated.
And so in light of that in this kind of environment.
Where we're operating towards the lower end of kind of our <unk>.
Leverage range that we would normally operate in but we do expect volatility we do expect it.
There maybe to be some false alarms around the taper tantrum, we do expect at some point down the road of real tapering, obviously, but we think that's the.
A fair amount further out so.
So as we as the.
<unk> present themselves, we have plenty of dry powder, we're operating with more liquidity than we probably ever have in the history of the company.
Given the composition of our portfolio between pools and TBA.
Give in Bethesda Securities and the advantages that presents so we've got a lot of dry powder, we will look at opportunities.
Within the agency sector should they arise and you know and and are certainly willing to dedicate more capital outside of the agency space, but as we said the tightening.
Has kind of filtered through everywhere.
Hopefully that helps yes, no. That's very helpful. He let me just sneak in one more just on prepaid orientation also just curious what your thoughts are obviously, there's a lot of new net new originators, but a lot of originators going public with a lot of net.
The growth expectations now how do you think that sort of feeds into what happens with prepays. This year.
Look and maybe Chris will want to add something I'll be brief look I think we've seen a lot of.
We've seen a lot of tightening of the primary secondary spread and particular in the fourth quarter and so far this year, there's a little more room for that to continue in other words more even if interest rates go up mortgage rates don't necessarily have to but on the other half.
And we have had a decent period of fast prepayments right.
And and the they've permeated to lots of segments of the mortgage market of huge percentage has been re financeable and still is.
And we do expect to see burnout.
Which is where if somewhat hasnt refinanced and had a great opportunity for nine months.
Why in the 11th month of the actually going to finally pull the trigger so what I would say is look it's too early to say that we are yes, we're past.
Of the refi wave, that's clearly not the case, but on the other hand, there is reason to believe especially if we see the yield curve continues to steepen from here, but even if we just kind of stay at these kind of mortgage rates that prepayments will start to burn out so I think.
For the first time in a while there is more upside I think on the prepayment of equation than downside I don't know, Chris if you want to add anything to that.
Yes.
I guess to your first question I mean, the banks for sure of loss share quite a lot over the last few years to two more efficient non bank lenders and I think that that will probably continue to some degree.
As Gary mentioned, we are beginning to see some positive indications on the prepay side of burn out for the most recent Jan factor reported CPR on the third of your universe increased about two CPR or about 6%.
Despite day counts, suggesting that speeds should have increased by about 15% of everything else equal in driving rates were actually even slightly lower for that period. So that was that was a positive sign in.
As we as we mentioned the the primary secondary spread contraction of around 20 basis points from the fourth quarter suggests that the capacity constraints of started the ease and lenders are having to compete more on price to maintain volume and so.
That too is an indication that we may have had seen the peaks and so.
With the primary secondary spreads closer to more normalized levels of treasury rates and secondary mortgage rates drift higher from here most of that should be pass through to borrowers.
But again with 80% of the market still exposed to an incentive to refinance prepayment risk is still still very elevated but net net some positive signs for sure.
Okay, great. Thanks, a lot.
Thanks.
So are you on the next question comes from Charlie <unk>.
J P. Morgan. Please go ahead.
Hey, good morning, everybody I'm on for Rick Today, I was wondering if you could talk a bit more about your interest rate sensitivity table I think it's on slide 26.
You.
It looks like portfolio values remained pretty stable within a rate shock of 50 bps up or down.
But that impact becomes more severe the next 25 bps in either direction.
Given the increased hedge ratio and particularly growth in that swaption book that presumably mitigate some tail risk can you help me understand.
The impacts of these rates shifts on the portfolio and why they are non linear as the shocks get more severe.
Hey, Hi, Charlie this is Peter well Youre exactly right I mean, what you're seeing there is the negative convexity profile of the mortgage universe.
And you reach a certain point, where the convexity profile starts to change right now we happen to be at a point both in the mortgage universe in our portfolio, where we're pretty close to peak convexity. So as you get to the further ends of the of the of the distribution you're exactly right that the market for.
Sensitivity, we will start to change with that.
Youre also seeing in this table is how our portfolio.
Rebalancing is interacting with the convexity profile for example, we have less operate exposure in this table this quarter than we had last quarter because of the options that we had at those options are going to give us a lot of protection up 50% of 100, but they'll have incrementally more protection.
Because of their convexity profile once we get 100 of 150 of 200 basis points up. So you can see that here. We're also starting with the a negative duration gap in this table, which is one of the reasons why we have a little bit more exposure to the down rate scenario. So.
You are right. This table interacts with the overall convexity profile of the market and our portfolio of what's going to change with that and Thats. One of the reasons why we have to be dynamic and sort of managing our exposure as the interest rate environment changes and we sort of alluded to the fact that we do think that we're starting.
To see the risk of more up rate path right now versus down rate, obviously rates can move in both directions, but we think with the economy starting to show some signs of recovery of the vaccine starting to be rolled out that incrementally there is a little more upside to rates as opposed to downside and so we're going to.
We're going to continue to manage it that way the other thing just to keep in mind in the down 100 case, which is kind of the biggest change from the prior quarter is the.
The stimulation, Florida rates of zero and so there is actually a down of 100 for the 10 year, whereas the last time around the tenure was below 1%. So there was no sort of down 100, but just understand what that environment of relates to that would basically be all rates 10 years in an under.
10 basis points right.
And it now brings the mortgage rate under 2%.
The base part of that shock, we would clearly rebalancing in that scenario, but look if the end of the circumstances that would lead to that wood wood debt.
Definitely challenge a lot of different investments.
Across the board and to Peter's point look right now we feel that it is better to protect against an.
The increase in the backend of the curve and and take a little more exposure into a rally and the you're actually seeing that in.
And those tables and just the just around that out one of the one of the reasons why we added options in the fourth quarter was the combination of the <unk>.
The low interest rate volatility made those price is very attractive the absolute level, we actually added about $5 billion of.
Of of purchases during the quarter. The net change was only three and a half, but we did find it to be an opportunity.
The real attractive opportunity to add options to our portfolio.
That's very helpful color. Thank you both.
Thank you. Thank you for that and if I could squeeze in one follow up based on just some comments in the prepared remarks, I think Chris mentioned.
You could still see room for spreads the tightened from here I'm just wondering.
What scenarios of you guys, envisioning, where spreads could possibly move materially wider from where they are here.
Yeah.
Just say the relative value picture across the bank fixed income is still a positive for agency MBS.
Whereas I would say if you compare that to Q3. It was it was a headwind.
Other sectors of tightened along with the agency MBS and so relative valuations.
Still look attractive, whereas in prior periods of QE. The this wasn't the case.
Production coupon euro nominal spreads.
For still around 15% to 20 basis points wide to sort of two month average tights.
During Q3 or more like probably 35 to 40 basis point Wides of the absolute types and then you look at the other sectors like agency does IAG high yield were current spreads are much much tighter.
Then the prior periods of QE.
And as Peter mentioned implied volatility being lowered today.
The in that period that also benefits agency MBS much more than other sectors.
So given the backdrop of the.
The the support from the fed.
It wouldn't surprise me to see spreads.
I have a little more room to tighten.
Look thank you very much wide open.
Yes, the widening your look that you referred to is any significant widening occurs probably when the fed.
Papers, but I would honestly I think that widening will be spread out this time across all financial assets and I actually wouldn't even expect the MBS to be like the hardest hit.
You know, that's a ways off but probably a ways off but.
With that in mind as well.
Yes.
Okay.
Thank you. Our next question today comes from Brock Vandervliet with UBS.
UBS. Please go ahead.
Hey, guys. This is the VA lesson for for Brock just on the.
Just on the tapering.
I heard your comment on.
Early 2022.
Unlikely that before that the tapering happens where do you think the market is that in terms of expectations, there and what would be a.
Like the downside surprise and I guess in terms of the portfolio is there an appropriate way that you're thinking of positioning into a into that event, even though it's a you know.
Potentially.
Via the size of Peter Let me start with that and then I'll have Gary talk a little bit about the specifics of the portfolio, but I think youre raising the important point about the market's concern about tapering and I think the.
Important thing for everyone to understand is how different the environment is today versus 2013, obviously 2013, it was dramatic move in the market.
But you have to think about how different the environment is today versus then just first with respect to the fed and their and their current position.
They're much more transparent much more deliberate.
For the inflation target is different they're using forward guidance. So we have much more stability from a rate perspective with respect to the fed's monetary policy.
We have a much much different view today about the the fed holding mortgages in treasuries on their balance sheet. If you recall they had they had growing their balance sheet from zero to 3 billion ish.
The three trillion ish.
In 2013, and all of the discussion was how quickly can they get back to zero today. They have seven plus trillion and the discussion is not at all about whether they can continue to hold that.
So we are of very different position from the from a balance sheet perspective, and then lastly, we now have sort of a playbook for what tapering of it looks like and the fact, the fed's already indicated that the likely do what they did last time, which is as Gary said once they once they start to shift in monetary policy, perhaps late this.
For early next year.
Sort of know that theyre going to taper over eight 910 months period, and then really importantly, they'll continue to reinvest after that until they ultimately raise rates. So it's a much more predictable.
Framework today, which I think ultimately leads to lower volatility response, but clearly the as Gary pointed out there'll be some response in the mortgage market. So two things I'd add and I think that was a good discussion.
I'll just give you specifics of look whats the earliest that any they could taper of probably fourth quarter of.
And in that would require everything to go right the vaccines too.
Create.
You know a roaring back half of the year.
Employment to be going in the right direction inflation to be picking up very quickly I mean, that's a very very optimistic case, but that's the earliest it's possible.
Kind of of baseline as early 'twenty first half of 2022.
Which is still a very good scenario, where employment is improving.
The.
The economy is back.
And.
And as Peter mentioned I, just want to in talking about this there is there is a chance that the increase QE of some of those things don't happen.
Where we are and it's not an expectation, but it is a possibility.
And the other thing is just to reiterate what Peter said. This is of fed that has promise, they're not going to anticipate a pickup in inflation, which is what happened. The last time around okay. They were preemptive. Okay. We've been doing this enough.
Where were and they were they anticipated and raising rates in 2000.
17, and so forth and then reversed course this is a different fed theyre not going to be preemptive and that has a makes a big difference.
So when they do start tapering it depends at the and the impact on the mortgage market, it's going to depend on where pricing is at the time and where prepayments speeds are at the time in terms of the specific impact to our portfolio, but what.
What I would say is we have tools to manage that we have our leverage we.
Of hedges and I again, I don't the last time, there was an outsized impact on the agency mortgage market. It was sort of the center of the storm and all you need to look at is what's going on and everything equities.
Credit spreads just all of the cash on hand, the reality is the fed's liquidity. This time is being distributed across the markets as a whole so by definition the impact on the agency space is lower the other reason why it will be lower this time on the agency side is because of the for.
Fact that.
Net.
The prepayment equation is worse than it was in 2012 and 13, there were a lot of specified pools that were paying.
Low double digits.
<unk> 14, CPR and those didn't benefit from a backup in rates because they were already slow in today's environment. Even good specified pools are paying in the twenty's and many specified pools are paying of 30 or.
For a little higher.
So in a backup in rates and of widening mortgage spreads there is a prepayment offset to the to the some of those negatives. So I know that's of technical discussion, but there are reasons to believe and as Chris mentioned right now we're not.
We're at wider levels for mortgages as well there are reasons to believe that this is of much more manageable scenario of the other thing as you know.
We've all learned a little bit in the mortgage market and seen.
One of these and so I think physicians will.
We will be better.
This time around so there are a lot of reasons, it's something that's on our mind you can see our positioning is.
Defense of toward higher rates, but it has to be balanced with the fact that this is further off and.
And we.
We have tools to manage.
And the.
Thanks for that and then if I can just sneak in one more on the Specialness specifically.
Heading into that kind of event at the fair to think that it has to come off a little bit.
The fed is expected to step away and you know I know.
Talking about the four and there were some other factors in play as well, but just.
Some comments on debt would be great.
I think the I mean, the fed's presence, even after they start tapering and complete tape rain. So they are no longer growing their balance sheet.
As Peter mentioned the.
The.
If prior periods of QE conserve as a guide they're likely going to be reinvesting paydowns, which are currently running around the 85 billion.
Per month.
That number will likely go down.
When it's when the fed starts to get active or tightened policy, but there.
They are likely going to continue to be reinvesting paydowns long after they stopped growing the balance sheet.
Likely through at least the first rate hike.
And so the fed technical is still going to be incredibly supportive with respect to.
Cleaning out the flowed on a regular on a monthly basis and supporting role roll financing I mean, it's likely that the fed mortgage position.
We'll probably.
We grow by another 400 or $400 billion to $500 billion. This year.
So it's you're talking about of two five trillion dollar mortgage.
The mortgage position, that's where reinvestments are being.
Or being made back into the into the market cleaning the float.
Great. Thanks, guys.
And our next question today comes from Sugar Cranston with JMP Securities. Please go ahead.
Alright. Thanks.
Most of my questions have been assets.
Sort of maybe one more follow up on the <unk>.
Decline in roll Specialness.
We're going to slide 10, it looks like the <unk>.
Average cost of funds on TBS was negative 54 bps in <unk>.
And I think Chris said you guys currently see rules around 10 basis points special versus repo.
Can you just sort of talk about how you guys are thinking about the cost of funds side heading into <unk> and sort of how much that differential between.
Kind of where rules or the <unk> and where you see them today.
It is likely the cost of funds for.
Sure Trevor Thanks for the question.
Another another table that is helpful to look at his table 17, where we break out the cost of funds and the two components and youre raising of.
Good question.
The two key inputs into our three key inputs in our cost of funds first is the repo costs, which last quarter was 38 basis points ended the quarter of 24 basis points and as I said, given where prevailing rates are right now of repo rates, whether it's overnight out to 18 months I expect that repo costs.
Net 38 basis points to come down fairly reliably to into the Twenty's.
Low twenty's and stabilize there the.
The TBA component, which was negative 58 in the third quarter and then 54.
Obviously, that's a variable that we.
We cant fully predict it's going to it's going to evolve over the over the quarter and that makes that forecast the challenge what Chris described earlier.
That that range has been from 10 to 100. It was currently in the 15 ish range of an expectation is that it was going to improve where exactly it improves too in the in the first quarter, we'll have to wait and play that out but directionally. We think it is improving.
But that doesn't mean that it's going to be better than where it was in the fourth go into effect likely it'll be a little bit lower and with respect of the last component of the swap cost.
Expect it to be fairly stable, but directionally.
Directionally, a little bit higher because clearly if we continue to add hedges, it's going to add some cost there, but I don't expect a whole lot of movement in our cost of funds.
It's close to zero.
I think it's going to be zero to 10 basis points over the over the next.
Quarter two so.
I know you can't give you any more precision there because obviously, we have to wait and see how the the roll specialness plays out but directionally.
It's going to improve from what Chris said it from the 10 to 15 basis point range.
Okay. That's helpful answer the question.
But you should sort of act. The dollar roll you should expect of the funding levels on TBA has to be higher noticeably higher this quarter than last quarter.
Sure of at this point.
Yes.
Thanks for the comments.
Thank you for.
Ladies and gentlemen, today's final question comes from Kevin Barker with Piper Sandler. Please go ahead of it.
Thank you just to follow up on your comments of the dividend yield.
And the outlook for the dividend point that you made about <unk>.
Now you have a lot of flexibility there.
Do you feel that just generally that the market is prepare to.
Except lower dividend yields for lower risk.
Just given all of the volatility that we saw in the past year.
Do you feel like that could be.
The start to be accepted by the market and maybe.
A lower risk portfolio will be.
Appropriately priced in the market compared to what it has been in years past.
Yeah.
It's interesting the way you worded that question.
I'm not sure in a sense of the market's pricing of of different.
Positions and I don't mean, just the mortgage REIT space I could I could say the broader equity markets.
It's sort of in a different category today than it's been in a long time.
And long time, probably since the late nineties.
And so what I would say is.
We have confidence in the in the markets.
Over time and from a management perspective, it's our responsibility to make those trade offs in terms of our leverage in terms of risk management.
And to evaluate those and do what we think is best for our investors over the long run and and not obsess necessarily about how that's going to be received in the very short run I mean like you know to your question I'll just say like.
It would have been it's very easy.
Our net spread and dollar roll income I mean, given the category it will be in alright be very simple and it would be well received to raise the.
The dividend here and yeah, we think the stock would like that.
In the short run, but we think that we should be prudent about where interest rates are where yields are on other vehicles for getting just the mortgage REIT space, we're not obsessed with where a couple of our peers or stuff like that we think that.
It's this is why people trust management over time.
Is to make those kinds of trade offs and to understand that sometimes.
No the.
I won't necessarily be.
Well receive for for a quarter or two.
But over the long run and we talked about our long term track record.
Generate those track that kind of track record by making good.
Prudent risk management decisions over time, and we when we value stability and we think investors do so now I'll come back to you know look.
Well, our leverage decisions, our hedging decisions will be made the with preserving and enhancing the long term.
Net present value of the company.
And we know that over time that will be received will be rewarded by shareholders and it will reward shareholders, but especially in today's market, but even in other markets you try not to you can't help but think about it but you try not to obsess about short the short term reaction.
And the stock market.
Thank you that's very helpful. All my other questions have been answered thanks.
I appreciate the question.
Ladies and gentlemen, this concludes the question and answer session.
Conference back over to Gary Kain for closing remarks.
I'd like to thank everyone for their interest in a GNC and we looking at look forward to talking to you again next quarter.
Thank you Sir This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.
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