Q2 2021 AGNC Investment Corp Earnings Call
After today's presentation there'll be an opportunity to ask questions to ask a question you May Press Star then.
On you touched on the phone to withdraw your question. Please press Star then 2 please note. This event is being recorded I would now like to turn the conference over to Katie Wisecarver of Investor Relations. Please go ahead.
Thank you all for joining E. G. M C investment Corp, second quarter of 2021 earnings call before we begin I'd like.
Like to review the Safe Harbor statement.
This conference call and corresponding slide presentation.
Statements that to the extent they are not recitations of historical fact funds.
Forward looking statements within the meaning of the private Securities Litigation Reform Act of 1995.
Okay.
All such forward looking statements are intended to be subject to the safe Harbor protection provided by the Reform Act.
Actual outcomes and results could differ materially from.
From those forecasts due to the impact of many factors beyond the control of agency.
All forward looking statements.
Put it 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 AGM sees periodic reports filed.
Filed with the Securities and Exchange Commission.
Copies are available on the SEC's website at SEC Gov, we disclaim any obligation to update our forward looking statements unless required by law.
Participants on the call include Peter Federico President and Chief Executive Officer.
Bernie Bell Senior Vice President and Chief Financial Officer, Christian All Executive Vice President and Chief Investment Officer.
Aaron Pas senior Vice President of non agency portfolio management, and Gary Kain Executive chair with that I'll turn the call over to Peter Federico.
Thanks, Katie and thank you to everyone on the call today.
The positive trends that drove the strong performance of agency MBS in the first quarter largely reversed in the second quarter M.
MBS spreads to swap and treasury hedges, particularly longer term hedges.
Widened meaningfully in May and June.
Interest rates rallied and the yield curve flattened.
The spread widening coincided with the shift in investor sentiment following strong economic data, which in turn pushed the fed to begin asset tapering discussions.
The market now expects the fed to communicate its plan for asset.
The tapering sometime later this year.
In addition.
Despite the first quarter increase in mortgage rates prepayment speeds in the second quarter slowed by less than expected.
These faster prepayment speeds pressured higher coupon MBS valuations and reverse the significant.
<unk> outperformance that these coupons experienced in the first quarter.
Given the shift in sentiment regarding asset tapering and faster than expected prepayments speeds spreads of course across the coupon stack widened with lower coupons spreads widening 5 to 10 basis points.
And higher coupon spreads widening 15 to 20 basis points.
As a result, our economic return for the quarter was negative 5.5%.
While this result is disappointing it is also easier to understand when viewed in the context of the first 2 quarters together.
To recap.
In the first quarter 10 year treasury rates increased by more than 80 basis points the.
The yield curve 3 years to 10 years steepened by more than 60 basis points and swap spreads widened.
Against this backdrop agency MBS performed very well, Moreover, higher coupon MBS.
S meaningfully outperformed as investors price in more benign prepayment expectations given the recent increase in mortgage rates.
With our portfolio of being well balanced between lower coupon TBA and higher coupons specified pools are economic return in the first quarter.
There was positive 8.2%.
In the second quarter. However, we experienced a reversal of these conditions, specifically 10 year treasury rates rallied close to 30 basis points, the yield curve flattened by almost 40 basis points and longer term swap spreads tightened.
Against this backdrop and given the shift in fed sentiment following stronger economic data.
<unk> spreads widened meaningfully and in contrast to the first quarter of the underperformance was most pronounced in higher coupon MBS.
The key takeaway here is that the first 2 quarters largely.
We offset each other and more importantly for the year the results are positive.
Through the second quarter, we experienced a 55 basis point increase in 10 year treasury rates and only a modest steepening of the yield curve beyond 3 years.
Over that time period, the performance of lower.
Lower coupon MBS was largely as expected with these coupons modestly outperforming hedges.
In addition, very attractive TBA financing levels further benefited these positions and provided a positive boost to earnings.
Higher coupon MBS. Meanwhile.
Underperformed hedges somewhat year to date due to elevated prepayment speeds.
Putting the 2 quarters together, a gnc's year to date economic return was positive 2.4%.
Importantly, we generated this positive return despite the increase in longer term interest rates.
Prepayment speeds remaining stubbornly fast and the fed the beginning to condition the market foreign of eventual tapering.
The re pricing of both fed and prepayment expectations that occurred in the second quarter is healthy for the agency MBS market at.
At current valuation levels.
The investment backdrop is now more balanced that said as the fed in the market move closer to asset tapering, some further spread widening and volatility as possible.
And while this could pressure our book value in the short run wider spreads are a welcome development over the long run.
As they improve the expected return on new investments and enhance the earnings profile of our portfolio.
With that I'll turn the call over the 2 Bernie to review the financial results for the quarter.
Thank you Peter tangible net book value declined 7.5 per cent for the quarter as.
Wider spreads and the underperformance of our higher coupon specified pools in particular drove a comprehensive loss of 97 cents per share for the second quarter.
Including dividends of 36 cents per share our economic return on tangible common equity was the loss of $5.5 per cent for the quarter.
So far this.
Month as of last Friday, with MBS spreads against somewhat wider we estimate our tangible net book value to be down about 1%.
Net spread and dollar roll income excluding catch up am remained very strong at 76 cents per share unchanged from the first quarter as improvement in our net interest margin.
Offset the fact that we operated with the smaller asset base.
Our net interest margin totaled 209 basis points up from 200 basis points of the prior quarter the.
This improvement was largely driven by attractive dollar all opportunities and lot of repo funding cost, which average 13 basis points for the quarter.
Our total at risk leverage increased only modestly during the quarter to 7.9 times tangible equity as of June 30th compared to 7.7 times as of the first quarter. Despite the decline in our tangible net book value.
Forecasted life speeds increased to 11, 6% as of quarter end as lower.
It's and moderately faster prepayment assumptions were largely offset by changes in portfolio composition.
Actual prepayment speeds on our agency portfolio for the second quarter average 25, 7%.
Our most recent speeds for assets held as of June 30th.
Published in July average 23.5 CPR.
Lastly, our unencumbered cash and agency MBS at quarter end totaled $4.7 billion.
Which excludes both unencumbered credit assets and assets held at our broker dealer subsidiary Bethesda Securities.
Our high quality.
Liquidity position at 47 per cent of our tangible equity remains very strong and largely unchanged from the prior quarter.
I'll now turn the call over to Chris to discuss the agency mortgage market.
Thanks, Bernie as Peter mentioned rates rallied in the curve flattened throughout the second quarter.
<unk> reversing part of the move in Q1 within the agency MBS sector higher coupons were the worst performers in part due to the flattening of the yield curve, but more so as a result of persistently elevated speeds and the little evidence of prepayment burn out more recently, however, with the release of the July of factor report there.
There are indications that burn out may be accumulating with speeds coming in slower than day, count and seasonal factors alone would suggest.
During the second quarter, we continued to gradually reduce the size of the investment portfolio in anticipation of wider spreads as we approach an eventual fed taper announcement at quarter end our investment.
Portfolio totaled to 87.5 billion down 3 billion from the prior quarter due mostly to pay downs.
The most notable shift in composition was in her 15 year of position. Despite the flattening of the yield curve 15 year MBS outperformed thirties and given this relative performance we reduced.
Tenure of holdings by a little over $6.5 billion.
Some of the sales were replaced with the production coupon 30 year MBS.
Residential credit continued to trade well during the second quarter on strong fundamentals materially outperforming agency MBS, but before turning the call over to Aaron to discuss the non agency sector.
Our fifth I'd, an overview of our hedge position and interest rate sensitivity <unk>.
During the second quarter, the duration of our assets shortened by approximately 8 tenths of a year.
As we discussed on the call last quarter with 10 year rates in the 170 area of duration risk profile was more symmetrical than at the start of the year. This combined with.
All of that MBS would trade to relatively short durations led to a decision to maintain a positive duration gap throughout the quarter.
As interest rates rallied in the yield curve flattened wed.
We took steps to rebalance our hedge portfolio by reducing longer term treasury hedge positions as a result, our hedge portfolio totaled 7.
The view of 1 billion at quarter end down 5 billion from the prior quarter, our hedge ratio. However remained almost unchanged at 97% with our duration gap slightly positive at point of 3 years I'll now turn the call over to Aaron to discuss the non agency markets.
Thanks, Chris I'll quickly recap the quarter and provide.
74 update on our current positioning the.
The second quarter was generally characterized by a risk on mode in both the equity and structured product markets.
The NASDAQ and S&P, both through price meaningfully higher in the quarter and credit spreads moved tighter core.
Currently spreads for a large part of the structured products market are at or near their post great.
A brief of crisis tights.
But this in perspective, the high yield CTX index closed Q2 at a spread of 271 basis points.
34 basis points tighter than Q1.
This also represented the lowest month end close over the prior 10 years on.
On the investment grade side, the I G C. Dx index is right.
About at the types of the last 10 years.
After heavy credit risk transfer issuance in Q1 and early Q2.
GSE issuance took a pause.
With the favorable supply backdrop, and the continued push tighter and other risk assets CRT performed well in May and June the.
The credit curve ball flattened with demand outstripping.
Supply at the bottom of the capital structure.
Housing gains of continued to accelerate more recently, causing affordability the affordability levels to deteriorate somewhat weaker.
We continue to believe that declining affordability levels. At this time are not a threat to the housing market more broadly.
Turning to our holdings, our non agency portfolio.
The unchanged in size over the quarter.
And the credit risk transfer space, we continue to shift a bit further down in credit.
The net sold M twos over the quarter, where we saw limited total return potential remaining and added B, 1 and B b 2 risk.
Within our C. M. B S holdings, we continue to sell higher rated double a and <unk>.
AAA cash flows as the spreads are close to their tights in favor of adding some lower rated tranches and SaaS deals.
On the arm B S side, our holdings were basically unchanged as we found limited opportunities to make attractive investments.
Finally, we continue to see favorable tailwind on the repo side for non agency securities.
He is with repo rates continuing to tick lower with that I'll turn the call back over to Peter.
Thanks, Aaron before opening the call up for questions, Gary will share a few thoughts on our outlook for the inflation and the fed.
Thanks, Peter and it is a pleasure to speak with all of you again.
And in light of my new role as executive Chairman My focus when I participate on these calls will generally be on macro themes, while Peter and the rest of the team discussed the specifics of the AGM <unk> positioning and performance today.
Today, given the shifting economic and monetary policy in land.
I wanted to give my thoughts surrounding the inflation debate and its implications for a potential fed actions.
There is now no doubt that the U S is experiencing a significant spike in inflation. So the real debate centers on whether or not it is transitory.
<unk> pad in many market observers believed the spike in inflation is temporary and the fed has communicated its willingness to remain patient in an effort to facilitate substantial further progress on the employment front.
Other market participants believe the inflation pressures will.
The first and that the fed should immediately begin to taper bond purchases and may need to raise rates more quickly than the path that they have communicated.
While both outcomes are certainly possible our view is that the fed will ultimately be correct and that most of the current.
Current inflationary pressures will prove to be transitory.
We believe technological advances and the other deflationary force forces witnessed over the past several decades will dominate over fiscal and monetary stimulus supply chain disruptions short term demands.
Man spikes and increases in labor costs in some sectors of the economy.
But all of that said, we also believe that today's higher inflation readings may not dissipate quickly and sufficiently enough to satisfy either of the market or some members of.
Of the F O M C.
As such the fed may feel like they have to respond to these elevated inflation readings only to have the moderate relatively quickly thereafter.
The this scenario is actually consistent with the performance of the back end of the Treasury curve, we've seen over the past month.
More specifically, we expect of the fed to communicate of taper plan later this year and to begin tapering by early 2022.
This scenario will likely create some MBS spread and rate volatility, which in turn should improve <unk> investment opportunities, particularly.
<unk>, given our low leverage and strong liquidity position.
In addition, further declines in interest rates at this point are likely to be limited and without a longer term inflation issue interest rates should remain relatively range bound.
Together this expected rate.
But the environment should ultimately create an attractive investment backdrop for agency and with that I'll ask the operator to open up the call to questions.
Thank you we will now begin the question and answer session.
To ask a question you May Press Star then 1 on your Touchtone phone.
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At this time, we will pause momentarily to assemble the roster.
Our first question comes from Rick Shane from Jpmorgan. Please go ahead.
Good morning, Peter and Gary.
Pick the congratulations on your respective new roles.
It would actually triggers.
The first question, which is just as we think about.
This quarter's results the results through the remainder of the year.
Is there anything from an expense perspective that we should be aware of.
Related to Gary's retirement.
In terms of the acceleration of any options or expenses associated with that.
Thanks for the question, Rick and good morning.
There is no expense issues that you should be worried about or Cogs.
And of if you look at our expense ratio and actually improve considerably from I think 84 basis points of 7 to 9 basis points. So I would say you can continue to expect our expense ratio to stay right around that range going forward over the short run per.
Perfect I appreciate that and then.
Secondly.
And more to the business when we when you think about the decisions that you were faced with tactically given the <unk>.
Volatility in the second quarter.
What do you think the decisions that you made in terms of rotating the portfolio. What do you look back and say that was a good decision.
Back and say, Hey, we wish we hadn't done that.
Well yeah. It's a good question, what I would say is that and as in my prepared remarks, I really talked about the fact that you really have to look at the the first 2 quarters together and I think we are going to continue to see you.
Quarter to court of volatility given the nature of the.
What do you look economic backdrop and given the fact that the essentially now the fed is in transition and Thats just the nature of the of of transition means that we're going to have more volatility on the asset side I still believe we had and have the right asset balanced a good mix between lower coupon TBA and higher.
The coupons specified pools, the lower coupons, obviously give us a lot of value in terms of the carry the higher coupons of underperformed some.
But quarter to quarter of the volatility was pretty significant but underperformed this last quarter because of the prepayment outlook, but that outlook is going to improve there is no doubt about that is just really a matter.
The win so we feel very comfortable on the on the asset side on the hedging side.
What you saw us do.
Was really positioned for the up moving rates at the end of last year by increasing our hedge ratio of putting on a lot of longer term hedges from really being prepared for a rise in rates.
And the Steepening of the yield curve.
We did that along with the rest of the market and I think what you saw in the second quarter is that the market was essentially off sides in terms of being short and so we had a lot of the pain trade. If you will in the market for lower rates and a flattening of the yield curve.
So in that environment I am not.
Not at all unhappy with our hedge position its just that youre going to have to be patient with it. We actually took some hedges off and tried to position ourselves for the rally in the flattening a little bit more in this environment, you're just going to have to be active I think youre going to have to be a little bit more active on our asset side and we are certainly going to be have to be.
The active on the on the hedging side, but this is going to take another quarter or 2 and then we're going to have a lot more clarity on both the outlook for prepayments and the outlook for the fed and at that point I think we're gonna be in a very strong position, particularly because we've positioned the portfolio with a lot of flexibility today.
Great. It's a very helpful answer.
It was very much.
<unk>.
The next question comes from Bose George from K B W. Please go ahead.
Hey, everyone. Good morning, good morning.
First I just wanted to ask about where you see incremental returns on both on pools and TBA is.
Sure I'll have I'll have Chris the answer that.
Thank you Hey, Bose good morning, so the the gross Roy on production coupon 30 eases.
Very high single digits without roll Specialness, and convexity costs Rose continue to trade very very well the 2 roles around the negative 40 basis points of the 2 and a half roll around negative 15 basis points and so.
The 55, and 30 basis points through repo of respectively, and as we've said in the past while there's no certainty how long. This degree of Specialness will persist, we do expect that rolls in Oregon.
The continued to be a material contributor to returns and for context here as a reminder, each 25 basis points of advantage versus repo was roughly 2%.
Incremental return on an annualized basis.
Higher coupons Baxter generally high single digits area Fifteens mid single digits, and we've materially reduced our positions there as I mentioned earlier.
Okay, great. Thanks, and then just in terms of of where.
Sent an ink spreads could tell you noted there could be volatility.
We've already seen a fair amount of widening is there a way to kind of think about how close we are to normal.
Yes, it's a great question and let me just start with you know putting the context of what Christian said give some context around that if you think about spreads were probably the close to the.
Types of just at the end of the first quarter. So the ROE improvement that Chris referred to particularly on the TBA side is meaningful. So we are in the repricing process and obviously the market now does expect to fed to announce its tapering later this year, there's a chance.
They're all probably that of pulls forward buy of meeting, but again, it's going to be data dependent and actually the risk may or may even be that they push it back given the fact that the you know the delta Varian is causing some issues, but we could still see spreads widen a little further I don't think.
<unk> going to be dramatic.
And so what.
The market has largely reflected the feds defense likely path right now, but there still could be some potential volatility the issue that the market is going to face is that the fed is really going to be focused on the employment reports over the next 2 or 3 months so in each.
Think of it so as employment reports were likely going to have some volatility because of the market will either push forward of pullback on the fed, but we could see a little bit more spread widening but as Chris said, we're already in the end.
Assuming some conservative imply.
Implied funding assumptions were already in the low double digits on the lower coupon M B.
Each of the we're not far from I think ultimately where we settle out.
Okay, great. Thanks very much.
Thank you both.
The next question comes from Brock Vandervliet from UBS. Please go ahead.
Oh great.
Uh huh.
Hi.
So just.
Wonder in terms of looking at the the higher prepay speeds whether.
This is.
Example of kind of a structural change in the market that is driven by originators for example, having the technology of them too.
Hi, Brian sort of.
<unk> books, much more aggressively in prison refi opportunities to borrowers in ways that they haven't.
Before and I guess the question is.
1 do you agree with that too.
Does it change or potentially change how you look at the data and look at it modeling.
Mommy pay speeds yeah.
Let me, let me make of high level comment and then I'll have Chris talk about that there is no doubt that the the pandemic has increased the negative convexity. If you will of the mortgage market. There are structural changes now that have made it much easier to refinance and we're seeing that in the in the in the refinance market.
And those structural changes of Crystal talk about really arent going to go away anytime soon so it is something that we have to build into our into our investment strategy going forward.
Yeah. So the the way that I would characterize the story on speeds is not that they've massively surprised to the upside over the last 6 months.
Market, Oh, where that peak speeds are hitting.
The new highs for a given amount of incentive but rather the disappointment has been more with the lack of burn out in higher coupons and just the persistence of elevated speeds even on season cohorts we had of.
A couple of reports around year end that showed some signs of of.
Our sales and that combined with the so often rates created a lot of optimism going into Q1, the burn out would really start to show up in the higher coupons as the media of fact shut down and the higher rate levels would reduce prepayment risk more generally speaking, but the early indications of burn out last year. It didn't really trend in even lower coupons.
Speeds came in a bit faster given how quickly primary secondary spreads tightened.
As lenders traded profitability for market share and so you know in Q2 all of this optimism repriced and reversed the outperformance in Q1.
You know, there's there's no question that refi efficiency.
It has certainly taken a couple of steps forward over the last year and a half in large part of as Peter mentioned due to the the technological changes the flexibility offered by the <unk>, which.
Had the effect of reducing cost and shortening timelines I think the working from home dynamic has certainly been a factor.
After over the last year or so I mean, the bottom line is it's easier to refinance and it's easier for lenders to reach borrowers today than it was in the past and Covid effectively pulled forward efficiencies and developments that otherwise would have taken many years to get to where we are today and so I do think going forward.
While the trend will be the same the rate of change should be much slower.
I think the takeaway is that active asset management will continue to be critical to generate an.
The attractive returns it's important.
To understand the areas of the market that are most impacted by these changes and be able to incorporate.
Forward into into the asset selection decisions and just to make a final comment on that Youre absolutely right. All of the all of the competition. We're seeing out there that has had an impact but as Chris mentioned just the work from home environment has had a big impact and as everybody goes back to the office in the fall and kids go back.
Back to school, we do believe that we're probably at the leading edge of the improvement in the <unk> and the prepayment outlook. So we're optimistic as we look forward for the next 6 months.
Okay great.
Just as a follow up to clarify the performance on the among the higher coupon <unk>.
Yes.
Was that simply of price.
Adjustments or was it the real.
The real underperformance in the paint.
Payment profile of those of those.
Yeah. That's that's a very good question and as I mentioned on higher coupons and lot of people have different.
Different numbers, but most people I think agree that higher coupons widen 15 to 20.
Some models there are wider than that and that didn't necessarily translate into better or reasons why Chris said they are.
On higher coupons are still in the higher single digits, because you had essentially repriced 2 of faster prepay.
Prepayment assumption over time, that's going to improve but that's why you didn't see the you know a meaningful improvement it was really the price being offset by prepayment outlook.
Got it.
Yeah, I would just I mean, just to add to that I mean valuations and higher coupons backs look much better now their price the faster speeds of 1.
Beyond tens they don't have a lot of duration, they should trade pretty short plus or -50 basis points and as Peter mentioned earlier, they really complement our lower coupon holdings well given that the benefit in a lot of the scenarios that are more difficult for lower coupons.
Okay. Thank you.
Thank you.
The next question comes from Doug Harter from Credit Suisse. Please go ahead.
Thanks, Doug.
Doug Peter Hi, Good morning, I guess can you just talk about kind of where you see leverage today in the context of of the of the long term.
Of the long term of expectations sure.
Let me start with just looking back over the last 4 quarters and what you've seen US do really every corner of very very methodically is reduce our leverage profile. If you look at our average leverage we went from 9.2 on average about a half a turn of leverage each quarter. This last quarter excuse me.
<unk> average was 7.6 and today as we sit here, we're right at around 7.5 times.
Leverage so what I would the way I would describe that is you'll see us putting ourselves in a position as spreads widened through the through the first quarter.
Tightened through the first quarter and then subsequently why do what.
I guess just put ourselves in a position from the leverage perspective, where we have a lot of flexibility what I would say today as we're sort of in the leverage sweet spot at around 7.5 times, meaning that if we do see some disruptions in the market and we feel like there's a lot of uncertainty around the fed and.
And there's a lot of.
You're still the we could we could take our leverage a little bit lower and put ourselves in a position to even have more capacity.
On the flip side of that at 7 and a half times, we have a lot of capacity to take our leverage up if we see spreads.
Improve and widen and we feel like we have adequate clarity.
Valid from the Fed then we have a lot of a lot of flexibility to take our leverage up so I would say we're right in the sweet spot. We can move either direction right now we have a lot of flexibility on the leverage side on our liquidity side and on our hedging side.
So we're positioned opportunistically.
I guess just on the.
All of that last point.
I guess what would be is it.
It kind of a return hurdle is it kind of a spread level that.
Just how you think about what would kind of trigger that to be more opportunistic and take leverage up.
I mean, it's both right at the end of the.
The I E.
1 when if you look back of where mortgages were at the end of the first quarter I think everybody agreed that they were at or near the historical types and we did not think that that was sustainable it's certainly not sustainable in the context of the fed gradually exiting the mortgage market. So there.
The day Theres going to be a repricing and that Fortunately that repricing is now underway.
I can't tell you exactly what the threshold will be or what the.
Return target will be because it will have to be viewed in the context of the market, we have to wait and see exactly how the fed is going to taper.
There's over what time period, they're going to taper and importantly, we need to get a little bit more of an understanding of what it looks like from a reinvestment perspective with the fed we don't know exactly how that's going to go so.
As the fed normalizes monetary policy, we're all going to get a lot more comfortable with that outlook and then we'll be able to evaluate the spread level.
ROE in that context, and make a determination at that point that we think it's the right entry point and were probably not that far from that.
Great. That's helpful. Thank you.
The next question comes from Trevor Cranston from JMP Securities. Please go ahead.
Alright, thanks, good morning.
And the Orange.
The follow up question on that.
Of the prepay outlook and.
Refinancing of efficiency.
When you look at the tenure continuing to drop and the in July.
If we were to see 30 year mortgage rates drop.
Essentially below 3% again can you guys comment on how you think.
Her response of speeds would be to that.
The move back down towards kind of the level, we're 30 year mortgage rates had previously.
Chris you want the yeah, I guess, the best way to frame that is just to think about the the percentage of the universe. That's that's currently in the money today.
Today, so at a 2 and 3 quarters mortgage rate were a little higher than that today, certainly with points paid but roughly 55% of the universe. As you know is CS of 50 basis point or better incentive to refinance for perspective.
<unk>. If you went back to the beginning of the year that number at the same rate would have been probably closer to 75%, maybe a little higher than that so the the outstanding. The note rate on the universe has come down probably around like 30 basis points year to day, probably closer to 80.
Pre COVID-19 and so you know the aggregate speeds that we'll see at these rate levels will be lower for that reason.
Okay got it that's helpful.
And then can you guys comment on how.
How book value has performed so far the door.
Sure.
As.
Bernie mentioned in her prepared remarks, our book value is down.
Very close to 1% just a little a little less than 1% right now and that was as of as of last Friday. So we've had just a little bit of movement in lower coupons spreads, but nothing nothing meaningful our portfolio is pretty well positioned.
Okay perfect. Thank you.
The next question comes from Eric Hagen from BTG. Please go ahead.
Hey, Thanks, Good morning, a couple of questions on the general backdrop for Levered investors right now I guess, the big 1 being just what level of tapering of you think is embedded in the mortgage basis at this point and then on the short end of the curve. How do you think about hedging of your cost of funds at the fed the tax.
1 of the influx of inflationary pressure isn't necessarily transitory.
Sure Good morning, Erik Thanks for the question and the and <unk> and the.
The fed what I would say is that I think the market is adequately priced in the fed making an announcement either at the in November.
That's the December meeting the fed said, it's going to give us advance notice we don't know exactly what advance notice means it's likely of meeting so it seems.
Convenient for them to taper beginning in January I think the uncertainty.
That we have along with the timing give or take.
The meeting is whether or not they're going to taper MBS at a speed different than treasuries, if they followed the.
Playbook day use last time, they would taper them both together over 8 meetings, which essentially is over the 12 months of next year.
There is some discussion as we all know coming out of the fed that may.
<unk> or the taper mortgages faster if they did and I'm not sure what the marginal value of that is but if they did I think it would be over 4 or 5 meetings.
So that would still be tapering over something like 6 or 7 months. So those of US I think the 2 bookends that could have some impact on.
From an on the agency MBS market and then of course, we also want to get some color when the fed announces its tapering what that implies for the reinvestment because don't forget importantly, theyre going to continue to reinvest cash flows for an extended period of time after likely syncing up with the first rate.
Rate increase now Theres some variability there now as well so those are going to be the 2 things that drive the.
The agency MBS market on the funding side.
What I would say is it you're absolutely right, there's going to be some variability right. Now short term funding is is very stable, but what you've seen us do is not really.
Have any rollover risk inside 3 years, if you look at our swap portfolio and our hedge portfolio. We don't have hardly any swaps I think maybe maybe maybe of $1 billion or so less than 3 years. So we don't really have any repricing risk right now.
For the next 3 years with regard to our short term debt youre going to see us continue.
To maintain a high height of high hedge ratio.
For the reasons that you'd point out.
Got it that's helpful. And then separately can you just talk about any adjustments you've made on the hedging side and the asset side of the since quarter end and then tacking on to that would be good.
Get a sense for how much of extension of risk do you guys see in the specified pool portfolio.
In response to the potential interest steepening.
What I would say is that we obviously have had more of a rally with the tenure down to 125.
We have done a little bit more rebalancing this quarter as Chris mentioned, our desire was to maintain a positive duration gap.
Last quarter, and we still have a slight bias for of positive duration gap because mortgages are trading week into a rally. So all other things equal we would like to maintain.
Might likely maintain a positive duration gap now all of that said, we think we're closer as Gary mentioned in his prepared.
Prepared remarks, we think we're closer to the lower end of the range as opposed to the upper end of the range, but there is still some some some down rate risk that we have to be cognizant of from a from the sort of extension perspective, what I would say is the mortgage market and our portfolio is pretty close right now the peak convexity of meaning.
Meaning you have almost equal extension of contraction contraction ratio. We are cognizant of that we were going to continue to maintain with with respect to extension risk or option portfolio. That's moved a lot in value.
If you looked at the value of that portfolio.
So from the time, we put it on at the end of last year.
Net portfolio had a had a cost basis of around $300 million. It doubled in the first quarter and then again halved in the second quarter went right back to its cost basis. So that portfolio is a good example of the volatility but that port <unk> port.
Portfolio also has a lot of protection left in it for us.
It's almost 2 years.
10 years at a 175 strike rate, which is very close to obviously, where the market. Just was so theres a lot of protection that we have in our portfolio and we're going to continue to be very cognizant about the up rate scenario.
As well as the.
The bias from mortgages to widen in a rally.
That's really helpful. Thank you sure.
The next question comes from Ryan Carr from Jefferies. Please go ahead.
Hi, Good morning, Thanks for taking my question and congrats guys on the promotions.
Thank you very much.
The quick question on the dividend level now you're seeing tangible book value largely recover closer to the pre COVID-19 levels.
How are you thinking about dividend in the context.
<unk> spread in dollar roll levels in winter when would you consider.
Consider.
The second point when you consider of potential adjustment to the current level of of the dividend.
Sure. Thank you. Thank you for the question and it's the question that I expect the first of all I. Appreciate you asking for source as opposed to an outlook, but I did expect.
Expect the question, particularly because of our net spread and dollar roll income continues to be so strong at 76.
Since this quarter unchanged from the previous quarter, what I would share of some some high level observations from thoughts on the dividend first.
We're not trying to and we've communicated this in the past we're not trying to achieve a particular dividend outcome at the end of the day. Our goal is very simple which is to generate the.
Or at worst economic return, we can for our shareholders and further and ideally we want that economic return to consist of a very attractive dividend and to the extent possible. Some book value accretion. We think that combination is appealing to the broadest cross section of investors, but make.
Make no mistake, we are very cognizant of the fact that our dividend is the very important component to a significant portion of our shareholders in.
In today's market, if you look at our dividend level against our stock price of our book value. We do think we have a very attractive dividend our dividend yield on either of those measures as close to 9%.
Particularly when you view that 9% in the context of asset valuations.
Across any asset class, we think 9% is a really attractive.
Dividend, but there are a couple of all the things that we pay close attention to I think what you're alluding to is we certainly look at what the current investment environment.
Environment is if you think about that as the mark to market return on our portfolio, which would also be equivalent to the marginal ROE on new investments. That's an important consideration when you think about the durability and sustainability of your dividend, we don't want to ever have to pay our dividend out of.
Out of book value so.
What our marginal return opportunities are is an important consideration.
As we said if you look back to the end of the first quarter. The marginal returns on new investments was actually very close to our dividend level and as Chris pointed out they are starting to improve and that spread is starting to widen.
Somewhat right now also important in that consideration because we want that margin should be as strong as possible is our operating efficiency, which we've already already talked about so that's an important consideration of the final point I would make is that to the extent that we out earn our dividend we want to make sure that we can.
Utilize that excess in a way that is accretive to our shareholders last year. For example, when we out earned it we were able to buy back stock at a meaningful discount which was accretive to both book value and earnings per share for our existing shareholders. Today that trade is not available to us, but as we said we are positioning the portfolio of.
Opportunistically right now in anticipation of better.
Investment opportunities so that the investment outlook in the investment environment that we're in particularly over the relatively short term is also an important factor. So those are just some of the things that we think about gives you some context around how we.
Think about our dividend we are going to continue to evaluate it we are coming out our dividend from a position of strength, which is really great. We have a lot of flexibility as I mentioned with our leverage we have a very strong financial position and we're going to continue to evaluate the appropriateness of our dividend.
As market conditions dictate.
Thanks, very much that was helpful color and then last question from me how are you thinking about opportunities in the credit portfolio within with the prevailing environment.
Sure I'll I'll have Eric talk about that because obviously credit performed very well in the second quarter.
Sure. Thanks for the question. So I mean on the on the credit front I touched on it in the prepared remarks.
I mean residential credit and commercial credit everything performed quite well.
In the second quarter as it has for the last several quarters.
But also to put that in perspective spreads are relatively tight.
So the the go forward landscape for you know for returns is challenging.
I'd peg a lot of our opportunities in the 5 to 7.5% to 8% Roe.
The return range, which you know for some of the risk on the residential credit side, we think.
Risk is relatively low so the risk return is probably fine, but the level of returns is just isn't all of that compelling.
Yes.
Adjusted just the final point on that when you put that those comments together with what Chris said, what it what it basically of showing that the relative value.
Equation has sort of shifted even more toward agency MBS right now I'm in credit obviously is very very difficult to meet our hurdle. There will certainly have the flexibility on the credit.
[laughter] side, but the marginal dollars of likely going to go to the agency side of our business.
Got it thanks very much guidance sure. Thank you for the question.
And our last question comes from.
Mark Devries from Barclays. Please go ahead.
Yeah. Thank you.
Gary I was hoping.
And to get some more detailed thoughts on why do you think.
Ultimately the longer term deflationary pressures ultimately of Trump kind of the the transitory inflationary pressures were saying and then Peter you know how you look the portfolio or position of the portfolio of an environment, where that kind of push and pull keeps rates range bound but we're.
Were you know you think the fed may overreact to the transitory, which should theoretically really kind of increased volatility within the those ranges.
Thanks, Mark and look I think the bottom line is we've seen over the past you know 10 years really then.
In 20, or 30 years, it's much cheaper overtime to produce goods and services and we've seen that in many ways earlier of pulled forward with technology, even with the pandemic, but I think once we get past.
Yes.
The short term.
Kind of supply issues, which have actually temporarily reversed.
That kind of cheapening to produce things shipping costs all of those kind of things I think you know it's hard for us not.
<unk> to revert back to the World we were in.
The 3.4 of 5 years ago.
So look for the next year for the next maybe it's 2 years.
Things like the <unk> the shortage of chips right I mean, that's a big deal but.
It's a big deal temporarily.
Shortage of shipping containers.
Which are which are another factor on the cost front, obviously on the employment front right now.
Where we're seeing wage pressures and lower priced kind of jobs and those things.
We are likely not to dissipate in the next 6 months, but over the next 2 years, they they really should dissipate.
And you know and then if you look at some of the other arguments for inflation kind of being here to stay.
Our relate to money supply in the.
Things the fads.
The the.
Some of the actions on the part of the fed and government spending a lot of those are also temporary right and and should be you know and I think most people would expect even if we see a little we see more over the next year. It's also not.
It doesn't seem to have a lot of staying power. So look when you take a couple of steps back.
What is driving what are the things that has changed the that have really changed and how long have they changed for.
And I think when you look at the things pushing inflation higher.
The vast majority of them seem temporary okay.
On the other hand technology is a real continued force and it is going to affect more and more industries and we've seen that play out throughout this pandemic.
We.
Just had that discussion on this call even with respect to mortgages right.
And that's not kind of 1 of the most impacted areas. So if you take.
When you play that out over the over the next couple of years the lasting impact to me is that it's still cheaper to produce.
<unk> goods and services and a lot more of those goods and services are things like software and handheld electronic devices, which obviously are are cheaper to produce over time. So I think that's the that's the explanation for why.
I'm pretty confident that.
We the long run we don't have an inflation issue again I do think these things are going to play out of take a little longer to play out than the than maybe the fed hopes and so that's why I think you.
You May I think the market may feel like the feds wrong.
For some period.
Overtime, but I think ultimately there'll be right.
Yes.
And Mark what I would say to your question about portfolio positioning is.
I think embedded in your <unk>.
Your question is the fact that.
Understanding that there's going to be considerable volatility in the current environment, we're seeing that right now so I think.
<unk> of top half to position the portfolios you have to position it more from a long term perspective, and just understand that there is going to be quarter to quarter moves.
Just like we had in the first and second quarter.
Where we had considerably different outcomes with respect to mortgage performance in our hedge portfolio, but when you look at the 2.
Core to us together I'm very happy that we had the hedge portfolio that we have it if you look forward 12 months from now.
Likely rates are higher at some point the curve is steeper that's going to be of really good environment for agency likely we're not gonna have to be competing with the fed for assets. That's another.
The way you did.
Benefit for the for the agency MBS market. So.
We're going to continue to approach it from that longer term perspective, we will have to endure the volatility.
Youre going to have to be active in rebalancing, both your asset and hedge side of the portfolio.
The goodness environment and Youll see us continue to do that but over the long run I think we have the right position on you just tend to have to be willing to wait it out.
Ultimately I think it's going to lead to a very strong environment for agency MBS.
Okay. That's really helpful and just 1 follow up then on the.
Kind of the credit investments.
Hey, Mike.
You don't view risk as being high there, but it also doesn't sound like there's much more upside of the returns when do you. When do you consider just kind of selling that down.
Aaron can talk a little bit of Opex, we've done some opportunistic selling already sure. So.
As as the Gse's have been issuing CRT.
It sounds of been rotating the portfolio of little bit further down in credit, where we've been able to.
Kind of little bit more attractive returns and on the flip side, we've been selling.
Selling assets down that we don't think there's much total return potential left so.
So we will look to continue doing that and on that front I mean, we're hopeful that.
Now with some changes at FHFA with director former director Calabria gone in and.
Acting director of Thomson in place that the GSE is will probably be more inclined to issue CRT. Although the timing of that is we will continue to be uncertain, but we're hopeful of that there'll be more supply over the coming year or 2 and that should help.
Marty room of the supply demand issues.
Okay, great. Thank you. Thank you for the question.
We've now completed the question and answer session I would like to turn the call back over to Peter Federico for concluding remarks.
Well again that concludes our second quarter call I, thank everybody for their participation.
Of the patients and we look forward to speaking to you all again at the end of the third quarter.
The conference has now concluded. Thank you for attending today's presentation you may now disconnect.
Okay.
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Yes.
Yeah.
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