Q2 2022 AGNC Investment Corp Earnings Call
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Good morning, and welcome to the Aegean Sea Investment Corp Investment Corp, second quarter 2022 earnings conference call.
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Thank you all for joining agency investment Corp, second quarter 2022 earnings call before we begin I'd like to review the Safe Harbor statement.
This conference call and corresponding slide presentation contains statements that to the extent they are not recitations of historical fact constitute forward looking statements within the meaning of the private Securities Litigation Reform Act of 1995.
All such forward looking statements.
Are intended to be subject to the safe Harbor protection provided by the Reform Act.
Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of agency.
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.
It and the risk factors section of agencies 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 Peter Federico Director, President and Chief Executive Officer, Bernie Bell Executive Vice President and Chief Financial Officer, Chris Kuehl, Executive Vice President and Chief Investment Officer, Aaron Pas Senior Vice President non agency portfolio management, and Sean Reid exactly.
Vice President strategy, and corporate development with that I'll turn the call over to Peter Federico.
Good morning, and thank you all for joining a gnc's second quarter earnings call and.
In my prepared remarks today I will discuss the macroeconomic factors that drove the performance of the financial markets during the second quarter.
Importantly, I will also discuss the improvement in our earnings and why we believe a G. N. C is entering a favorable environment that will be conducive to generating strong risk adjusted returns for our shareholders.
Financial markets remained under significant pressure during the second quarter as the fed indicated an accelerated pace of monetary policy tightening following worse than expected inflation data.
The likelihood of materially higher short term rates increase the probability of a recession and led to historically high interest rate volatility.
This challenging monetary policy and macroeconomic environment caused significant and broad based financial market weakness during the quarter, particularly in June .
The S&P index fell 16, 5% in the second quarter, and 26% year to date, making it the worst first half year performance in more than 50 years.
The Bloomberg aggregate bond index, representing more than 25 trillion in bonds fell five 6% in the quarter and 11.2% year to date.
The performance of agency MBS as measured by the Bloomberg Agency MBS Index was in line with the broader fixed income market falling 5.2% in the second quarter and 9% year to date.
Note. These fixed income performance measures represent the percentage change in price on Unlevered bond positions.
The performance of agency MBS on a hedged basis was also weak as the spread or yield differential between agency MBS and swap and treasury rates widen meaningfully in April and again in June .
Over the last 12 months spreads on agency MBS have widened meaningfully by any measure.
One of the simplest measures is the yield differential between the 30 year current coupon MBS and the 10 year Treasury note.
By this measure agency MBS spreads have widened by more than 100 basis points over the last year.
And the second quarter at a spread of about 140 basis points.
This yield differential rarely guess that wide or stays that wide for any meaningful period of time.
Only in 2008 in the midst of the great housing crisis, the dispread trade at or above today's level for an extended period of time.
As we have discussed.
Lighter spreads ultimately lead to enhanced earnings on our existing portfolio.
The second quarter provides a great example of this dynamic as our net spread and dollar roll income increased nearly 15% to 83 cents per common share.
Our net interest margin also improved materially so despite the decline in book value associated with wider spreads are.
Our net spread and dollar roll income improved on a per share basis in the second quarter.
In addition to strong earnings. We are also seeing a number of positive indicators that give us confidence that the performance of agency MBS is poised to improve.
First at current valuation levels.
Agency MBS are attractive by almost any historical measure.
Looking back over history spreads at these levels have consistently proven to be good buying opportunities.
Second we believe the risk of asset sales by the fed is extremely low.
The fed has made it clear through their actions and their words that as their primary monetary policy tool is adjusting the federal funds rate not balance sheet reduction.
Third and most importantly, the supply outlook for agency MBS has improved materially.
At the beginning of the year the net supply of agency MBS to the private sector was expected to be in the $700 billion range, which would have made it the largest issuance year on record.
Today, however, with mortgage rates higher house prices elevated and the economy slowing the net supply of agency MBS is now expected to be closer to 400 billion with most of that supply having already occurred in the first half of the.
A year.
These are significant positive developments for the agency MBS market.
And they give us confidence that this protracted period of weakness is nearing its end.
With mortgage valuations near their historical low.
Levered returns on agency MBS in the current environment or as favorable as they have been at any point during a GNC its existence.
Given this improved outlook.
As this period of volatility subsides.
We will look for opportunities to adjust our conservative positioning, including increasing leverage to further capitalize on this favorable investment environment.
With that I'll now turn the call over to Bernie Bell to review our financial results in greater detail.
Thank you Peter for the second quarter, a GNC had a comprehensive loss of $1 34 per share economic return on tangible common equity was negative 10, 1% for the quarter comprised of the 12.9% decline in tangible net book value and dividends declared a <unk> 36 cents per common share.
As of last Friday, our tangible net book value for July had increased about 3%.
Given the challenging market conditions during the quarter, we continue to operate with lower leverage and minimal interest rate exposure. We took advantage of favorable MBS performance in may to further reduce our leverage position mid quarter and doing so we ended the quarter at 7.4 times tangible equity down slightly from 7.5.
Times as of the end of the prior quarter. Despite the decline in stockholders' equity.
Our liquidity position also remains strong with unencumbered cash and agency MBS at the end of the quarter totaling 2.8 billion, which notably excludes unencumbered credit assets and high quality assets held at our captive broker dealer subsidiary.
Our net interest spread.
The second quarter increased.
Over 50 basis points to 270 basis points, our highest level in well over a decade, thus despite our smaller asset base, our net spread and dollar roll income excluding catch up am increased 11 cents to 83 cents per share for the quarter. This.
This significant outperformance was due to three primary drivers extreme.
Extremely strong dollar oil performance in the second quarter higher asset yields as we shifted the portfolio up in coupon and our large pay fixed interest rate swap position, which as expected largely offset the increase in funding cost.
Although dollar roll Specialness has moderated considerably since the second quarter, our net spread and dollar roll income should remain well protected against higher short term rates that are expected over the remainder of the year as a result of our large hedge position.
Consistent with higher mortgage rates, our average projected life C. P r's decreased to 7.2% as of the end of the second quarter. Our actual CPR has also continued to slow averaging 12.4% for the quarter.
Lastly, early in the quarter, we issued $50 million of common equity at an average price of $12 19 per share through our aftermarket offering program at levels that were accretive to our net book value late in the quarter. However in response to broad equity market weakness, we opportunistically repurchased 51.
Dollars of common equity at an average price of $10 70, 878 cents per share, which represented a significant discount to book value.
I'll now turn the call over to Chris <unk> to discuss the agency mortgage market.
Thanks, Bernie while the supply technicals for agency MBS are improving as mortgage rates hit 10 year highs in housing activity begins to slow interest rate volatility remains the primary headwind to agency spreads over the near term during.
During the second quarter, five and 10 year Treasury yields increased 50 868 basis points respectively.
Smaller period over period change than what we experienced in Q1, but this comparison understates the extreme daily rate volatility observed during the second quarter.
In the first two weeks of June for example, five year Treasury yields sold off 77 basis points only to then retraced 71 basis points of the move in the subsequent two weeks realized interest rate volatility on many parts of the yield curve reached the highest levels in more than 10 years as disappointing inflation data led to increasingly hawk.
As fed sentiment and called benchmark rates to fluctuate materially.
This volatility led to further agency MBS weakness during the second quarter with lower coupon MBS underperforming higher coupons reversing much of the Q1 outperformance of twos, and two and a half versus higher coupons.
During the second quarter, we continued to shift our holdings into production coupons at wider spreads reducing holdings of two and a half threes and three and a half's versus increasing our holdings in fours and four in a house.
Over time this repositioning should benefit the earnings profile of our portfolio. We saw some of this earnings benefit in the second quarter as production coupon rolls traded extremely well with average roll implied financing more than 60 basis points through the average sulfur overnight rate roll.
Roll Specialness over the last few weeks, however has moderated to levels more in line with historical norms since.
Since the start of the year park coupon mortgage spreads versus a blend of five and 10 year hedges have widened nearly 70 basis points or approximately 40 basis points wide of their 10 year average at current valuations agency MBS should be appealing to both levered and Unlevered investors.
The credit quality of agency MBS is becoming increasingly valuable relative to other credit sensitive sectors of the fixed income market is the prospect of a recession increases in funding conditions for Levered agency MBS investors have never been stronger given the actions taken by the fed over the last several years lastly.
At this point is often misunderstood the fed's presence in the agency MBS market will remain a significant positive factor even as its portfolio runs down to this point the fed will likely still own more than 25% of the outstanding agency market at the end of 2023, assuming current rate levels and balance.
She'd expectations as such the percentage of the agency mortgage market held by private investors is likely to remain lower over the next several years than it has been for most of the past 30 years.
Turning to risk management, our hedge portfolio totaled 72.5 billion at quarter end down 5 billion from the previous quarter consistent with the decline in our asset portfolio, our duration gap at quarter end with 0.4 years, a slight increase from the prior quarter.
Given the move higher in interest rates since the start of the year mortgage durations have extended meaningfully and should rates continue to rise further duration extension should be limited said another way at current rate levels, the mortgage market and our portfolio face more contraction risk then extension risk and for this reason, we will likely continue to operate with a positive.
<unk> GAAP.
Lastly, while we proactively reduced our portfolio during the first and second quarter to manage risk, we're likely to add MBS and increased leverage during the second half as the risk return trade offs have improved I'll now turn the call over to Aaron to discuss the non agency markets.
Thanks, Chris structure products had another difficult quarter as the challenges that we're faced in the agency MBS and equity markets rippled through credit markets.
After a significant widening in Q1 credit spreads widen further across the board in the second quarter.
Using CTX I G in high yield as a proxy after widening 18, and 82 basis points, respectively. In Q1, the widening accelerated in Q2.
G widened another 34 basis points, while high yield underperformed investment grade credit and widen roughly 200 basis points.
As we noted on last quarter's call. We expected housing affordability levels to continue to deteriorate at both national and regional levels. At this point housing is the least affordable it's been since heading into the great financial crisis.
Our expectation is that the persistent housing shortage will continue to support housing prices importantly, while affordability remains a major issue credit quality has remained fairly stable and unlike the period preceding the great financial crisis few loans currently will have any sort of payment shock never.
Nevertheless, certain regions could see a price correction if mortgage rates stay at these levels or increase further for a sustained period.
Turning to our portfolio, our non agency holdings increased over the quarter from 1.7 billion at 331 to 1.8 billion at 630.
We added roughly $350 million of securities in the quarter that was partially offset by deliveries of bonds into CRT tender offers as well as higher than typical paydowns on our C. N B S holdings.
Given the widening in credit spreads we were able to redeploy this capital at more attractive levels.
Importantly, this improved the credit quality of our non agency holdings.
AAA rated securities represented 22% of our non agency portfolio at June 30th up from 12% at 331 with a corresponding decrease in below investment grade securities.
While total residential and commercial backed securities issuance declined in Q2 relative to Q1 issuance remained relatively high.
With few alternatives to securitization, many issuers have had little choice, but to securitize and accept market clearing levels to finance their loans.
This has created opportunities for us to selectively add triple A's and some new issue CRT at quite attractive levels.
Looking forward the supply technicals are expected to improve for both residential and CRE markets.
Mortgage origination volume has declined and transaction volume is falling on the commercial side.
This dynamic should be supportive of spreads later in the year our securities issuance declines.
Similarly, as a result of the decline in mortgage originations, we expect a reduction in the gse's need to purchase credit protection in the CRT market.
Despite the improving supply technicals for the second half of the year fundamental challenges and spread risk have increased.
In light of that even with these wider spreads where continued continuing to take a conservative approach to our non agency portfolio as recession concerns will likely lead to continued spread volatility and potential potentially better entry points with that I'll turn the call back over to Peter.
Thank you Aaron with that we'll now open the call up to your questions.
Well now begin the question and answer session.
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At this time, well pause momentarily to assemble our roster.
Okay.
The first question comes with Kathleen Barker with <unk>.
Piper Sandler. Please go ahead Sir.
Good morning, Kevin.
Just given the macro outlook, obviously spreads are very wide.
See margin expansion in TBA dollar rolls are holding up pretty well.
Yet you are still taking a conservative approach here.
Like Youre fairly bullish on the investment outlook why not push a little harder here on leverage.
In order to take advantage of that.
Given these are some of the best investment returns with you for quite some time.
Well thank you for the question.
Yeah, obviously, it's a it's a good question and what we tried to communicate today I think as you rightly described is.
A significant improvement in our outlook for the agency MBS market essentially that we are at or nearing an inflection point in our peer and are in our opinion and ultimately are and what we are more constructive on the outlook for agency MBS and more constructive on our on our view.
Toward <unk>.
The leverage you know our mindset to date appropriately so given all of the uncertainty in the market has been to err on the side of being more conservative given the challenges that the market faced and what we described today.
Is significant improvement in some of the key indicators for the agency MBS market, whether it be supply or where the credit outlook or the stability of the fed or the stock effect of the fed or as you point out absolute returns, so and as Chris pointed out in his prepared remarks.
Our mindset going forward will be more constructive on the market. We are more likely to operate with somewhat higher leverage going forward than we have in the past, but we also have to be cognizant that this environment is not yet played out fully right. We are still seeing extreme interest rate volatility.
Which as Chris said is a headwind to agency MBS performance, we are still seeing some bonds one bond front fund outflows, although that is abating somewhat which would be a positive signal and then theres just overall macroeconomic uncertainty.
So I think we have another month or two or three to get through this period, but ultimately I think it's fair to say that we're fairly optimistic on the performance of agency MBS and we're more likely to be moving back toward our normal operating position over time.
Given the incremental returns right here it seems like you could generate.
Returns on investment that far exceed or or at least in line with where.
The dividend is can you give any update or your thoughts on.
Your yield relative to the peers and maybe just your ability to continue to.
Seed the dividend run rate just given the outlook today.
Well Youre, absolutely right I mean, I think what this shows.
When you're thinking about our dividend is we always try to set our dividend at a level that is consistent with the economic earnings of our portfolio. We tried to be forward thinking in that.
Because doing so ultimately will lead to we believe the most sustainable dividends. So I think what it shows today as we sit here that the dividend level that we came into this period with was appropriate we were in a position of strength with respect to the earnings on our portfolio and then importantly, as our results show this quarter or.
Our economic earnings and our net spread and dollar roll earnings are all improved in today's environment, given the rate environment, given the prepayment environment.
Given the spread environment, we are generating more money today on a net spread and dollar roll income basis than we were and that's all supportive of the dividend level that we currently have the economic return on our portfolio today is better than it was at the beginning of the year. So we.
We feel like we're in a real position of strength.
And that's a position that we'd like to have particularly in an environment, where we can redeploy proceeds and as you point out will return levels that are significantly above our current dividend yield we think that ultimately will lead to a strong position in and better sustainability of our dividend and we will certainly.
We always take into account the environment that we're in but right now we feel real good about the position that we're in.
Okay. Thank you Peter.
Sure. Thank you for the question good questions.
Thank you.
The next question comes with.
Doug Harter with credit Suisse. Please go ahead.
Thanks, Ken can you talk about your outlook for for economic return.
In the coming 12 months or so and how you think that should trend versus.
The dividend level versus kind of the the earnings levels and just what how you think about that.
Sure. Thank you. Thank you for the question, Doug So it sort of dovetails to some extent. The question. We just had I can I can expound on that a little bit and I think when you when you're talking about your sort of forward expectations of economic return for your portfolio. You could really just think about that is what is the mark to market return.
I know your existing portfolio, if we sold our portfolio and bought it all back today, what would the economic earnings beyond that portfolio. It's really the same calculation that we do for marginal returns right. Today for example, with asset yields mark to market asset yields at around 4.4% or four and a half per se.
<unk> you take into account your hedging costs.
The net interest margin. If you will is something in the neighborhood of around 150 basis points, you're leveraged at a times you know, we'll give you a gross or we have 12, our operating costs still below 1% add back the economic return on your.
On your Unlevered equity position and you would get a mark to market returns somewhere for example in the call it 14% to 16% range.
So that would be a reasonable estimate assuming nothing changes over the next year that that would be a reasonable expectation about what your portfolio should earn economically said another way at say, 15% times. The book value that we just reported at 11, 43, which say that the economic earnings on our poor.
Folio should be something in the neighborhood of around $1.75. A share you know 28 or 30 cents above.
Our current dividend level. So that's that's the way I would think about it from that perspective I hope that's helpful.
It is in and I guess, just I don't know if you have that Andy is kind of how that changed.
Over the course of the second quarter, you know factoring in the lower book value, but with wider spreads and therefore water returns.
I'm, sorry could you say the first part of that question again.
Just trying to sort of how does that change over the course of the second quarter factoring in the lower book value for wider spreads.
If we were to look at that similar time.
That's it.
That's exactly right I mean, if you think about where we were at the end of the second quarter versus the end of the first quarter. You know spreads are probably on average 20 basis points wider over the quarter.
So that's you know an incremental call it 1.5% Roe.
You know that you get with you would be using in that calculation. So that's that's the way you would think about that.
Okay, but that makes center alright. Thank you. Thank you for the question Doug.
Thank you.
The next question comes with Rick Shane with J P. Morgan. Please go ahead.
Morning, Rick Thanks, taking my question. This morning, Hey, what do we think about the changes in the forward curve.
And we think about the negative convexity of agency MBS.
And then factor in how deeply discounted the lower coupons are trading.
Can you talk about your investment strategy, where you wanted to deploy capital because I'm thinking if you take a short term view you want to play up in the stack, but if you look out a little bit further you probably want to go down in the stack and so would love to get your views on this and again from the perspective I'm asking the question.
And from that perspective, I'm, an equity investor, but would love to get the perspective of bond investors.
Sure. It's a good question so.
Obviously, we've talked about this for the last couple of quarters. In this last quarter was another example of more movement in our portfolio from a composition perspective.
Toward higher coupon.
M. B S. So we have a significant reduction in our lower coupon positions, our two and two and a half position are much greater position now and call it forced through fives it.
Because those instruments those current coupons, if you will of those production coupons give us.
A significantly better return profile in the current environment and typically for a levered investor like how you're going to migrate toward those coupons that have in a sense. The most negative convexity because they have the most return it does change the way, we think about hedging those positions no doubt.
But in exchange for the higher earnings we have to we have a little bit more two sided rate risk one of the things that Chris mentioned in his prepared remarks was the fact that because of that portfolio composition, you're more likely to see US for example operate with a more significant positive duration gap to give us protection on the prepayment.
The ability of those coupons over time that composition can shift, but but generally speaking it just changed the hedging dynamic for us, but also the the return environment for those coupons is particularly attractive and of course those coupons also offer the incremental.
Return of of favorable dollar roll funding.
Chris do you want to add.
I would just add to at current spreads you are paid a lot in additional carry for taking relatively little incremental convexity risk the convexity profile of.
Our portfolio and for the market as a whole has improved dramatically over the last two quarters as the strike on.
Our mortgage holdings has moved further and further out of the money as rates have sold off and so even across a pretty wide range of rate scenarios.
You know theres less need for optional rate protection, you saw that we reduced our swaption position by about $3 5 billion.
During the second quarter.
This relates you know.
Two the fact that the convexity profile of the portfolio is much better now and much more benign duration risk is less symmetrical now than it was at the start of the year and then the other consideration was that implied volatility is at record levels and so it was a good time to monetize some of that long haul exposure, but you know that.
The coupon stack getting back to your question is still very upward sloping it's flattened a bit since the since the Q1 levels.
And so I'd say for diversification reasons, we're still likely to continue to maintain some exposure to lower coupons as there are scenarios where those.
Coupons given that Theres still.
A large portion of the float.
We'll perform well on a total return basis in certain scenarios.
But generally speaking you know marginal capital is going to continue to be allocated towards production coupons.
Which offer the best return potential.
Got it.
It's interesting look when you look at the at the premium on the current coupon it's not extravagant by any means but if we look a little bit further down the road, given where rates have been over the last decade.
It does strike me that there is if we enter a slowdown more refinance risk in the current coupon and so I'm just curious why not.
Again, I understand what you did in the first half of the year given the rate environment, we faced but as we look forward with the forward curve starting to come down why not start moving down the stack again.
Well I think what Chris described is.
The reasons why you want to be in those coupons from a return perspective, and I think you get to your question and your issue not so much by moving down in coupon book by adjusting your hedge position and I think that's really the key.
Right.
You can look at that.
You can you can you can have the better earnings and an account for that risk that you're talking about by essentially for example, operating with a positive duration gap.
You also potentially be valuable and where you have your hedges on the curve will also be materially important as you pointed out the forward curve is right and ultimately the yield curve flattens.
Even more have.
Even fewer 10 year hedges for example would be meaningful in that in that scenario.
Great very very helpful and as always you appreciate the insight. Thank you Matt.
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Your next question comes with.
Trevor Cranston with JMP Securities. Please go ahead, hi, Trevor.
Hey, good morning.
Listening to your comments so far you know it sounds like you guys are staying a little bit cautious near term because of the high levels of volatility in particular.
So I guess I'm trying to think through the benefits of sort of waiting a little bit to get more aggressive on increasing leverage.
And so I'm wondering if as you see them sort of some normalization of volatility over the next couple of months maybe.
Would you expect that to also result in tightening of MBS over the period and maybe slightly lower returns that are available today.
And is there some near term risk of additional widening that you guys are.
Maybe concerned about that keeps you from taking leverage up more aggressively right now.
That's a good question, let me make a couple of points on that.
What I would say in the current environment is I think as you're pointing out is there essentially is more today as we sit given our more positive outlook. We believe there is a little bit more two way spread risk in the market. There's clearly reasons why spreads could widen further.
As the fed finally adjust to the maximum run off which you will get the first full month will be October volatility is still really high the market is highly dependent on every inflation report we got the fed tomorrow, there's still variability in what the fed may do so there's there's reasons why spreads can be wider but theres also.
I think somewhat more risk in the market today that spreads could be tighter similarly from our perspective, there's more two way rate risk in the market. We're obviously seeing that it does appear that longer term rates may have topped out over the near term it at their peak in mid June So we're cognizant of both.
Those two things, but that said.
One of the unique benefits that may come out of this environment for a GNC is that these attractive returns may be much more durable.
Than previous cycles.
And the reason why that's the case is because ultimately if the fed is successful at curtailing inflation and slow and the economy and not having to deviate from its balance sheet runoff plan. Then ultimately they can gradually step out of the market and that would be supportive of spreads staying in the vicinity.
<unk> of where they are so that could be a really longer term durable favorable investment environment from our perspective, so, but but we are cognizant as you point out of the of the potential of a rally in S and for the potential.
Of spreads tightened, particularly because the supply dynamic has changed so dramatically in.
In favor of lower supply so that's something that we're watching carefully.
Yeah.
Got it okay that makes sense.
And then can you either or an update on how it trended so far in July .
Yeah, I'm, sorry, I meant to mention that in Bernie's prepared remarks. She said it was up about 3% through last Friday actually as we sit here this morning.
Probably up closer to 4% for July as of as of yesterday evening.
Okay. Thank you.
Thank you for the follow up.
Thank you. The next question comes with the list after her with Serbia.
Please go ahead.
Hey, everyone.
Good morning, a very <unk> morning, Peter.
Very nimble during Q2, specifically with capital management can you just describe your mindset, there and how it may be different than past less volatile environments.
Yeah, well certainly we look at our capital markets activity always opportunistically and always from the lens of how how can we.
Execute transactions that are accretive to our existing shareholders. This last quarter was a good example, early in the quarter.
We had the opportunity and not a significant amount, but two to issue equity through our ATM program that we're at levels that were accretive to book value. But then importantly, we also saw a dramatic shift in the equity markets and in the tone of the overall financial markets later in the corner.
In the quarter, we were trading at a significant discount to book value late in the quarter and so we use that as an opportunity to again buy back stock, which would have been accretive to book value and of course accretive to earnings. So we will continue to do those.
Those sorts of activities, we'll look at our capital markets activities very Opportunistically, obviously, one of the key inputs.
And our decision to buy back stock or issuing stock is what are the use of proceeds how how accretive as the investment environment to our existing dividend level. For example in today's market as we just already discussed this morning, there's a reasonably wide margin between those two things which is positive. So we'll continue to.
Look at our capital markets activity are very opportunistically and use that as a way to generate incremental returns for our shareholders.
Okay.
And how do you factor that in.
But in the context of the leverage conversation you are as you weigh those.
Two two ways to either to make incremental investments here.
Yeah.
Great point if for example.
Clearly.
Dad always factors into our are our decisions and where we are where we want to be with respect to our leverage we will certainly have an impact on what we do with respect to our capital market transactions. For example, you were alluding to if we were in an environment, where we wanted to take leverage up and we were.
We're trading at a discount to book value then the best transaction from a shareholder's perspective would be to buy back stock as opposed to adding investments it would be essentially a cheaper way to to increase leverage it would be a way to increase leverage that was most accretive to our existing shareholders. So it's it has to depend.
What has happened in an environment, where our stock is trading relative to our book value and how how we feel about the investment environment and those two things interact with one another but we certainly will use that as a as a lever.
And that calculation.
Okay, Great and then if you could just talk about the prepay speed for a moment just showing there where do you see that going near term and maybe you could put some historical.
Historical context in there for us.
How do you know how low they can potentially go.
Mortgage rates do backup for example.
Sure I'll have Chris speak to speak to that yeah. No. It's a great question I would say given the move higher in rates.
Housing activity is certainly going to continue to slow.
But I'd say, it's difficult to envision an environment, where turnover isn't at least consistent with historical norms even for.
The deepest out of the money cohorts. The labor market is strong that of course helps with mobility Theres a lot of accumulated house price appreciation and I think that the behavioral changes post pandemic as people continue to reevaluate where they live and work I think will continue to contribute to relatively.
Turnover that said.
You know I think turnovers, absolutely slowing but from very elevated levels cash out refi activity is certainly going to drop off for the deeper out of the money cohorts there are.
Better smarter and more efficient ways to extract equity without refinancing you know a very low cost first lien, but I do think the demographic and behavioral shifts post pandemic combined with a relatively strong jobs market will continue to support reasonable turnover we've had.
200, plus basis point rate shocks in the past and late Ninety's, the mid nineties and turnover floored out at around six CPR and I don't think that's an unreasonable expectation this time around but it's a great question and it's often not well appreciated just how important.
A CPR or even a half a CPR is to the convexity of a third of our cash flow and if I could just add one thing to that because I think this is an important discussion with respect to the outlook for the fed and prepayment expectations for the feds portfolio.
You know as we've talked about the fed will ramp up to its full run off in October and its peak run off based on todays economy. If you will is probably going to occur right around September October November period at something less than 30 billion of months, though still below the cap, but as we go through next year given the deep.
The description that Chris just gave with respect to prepayments defense portfolio by the end of next year. For example, we'll probably be running off in the low twenties.
Per month, so a material difference where they are relative to their cap, which I think also also constructive to the overall agency MBS market.
Okay.
Great. Thank you.
Sure.
Thank you. The next question comes with Eric Hagen with <unk>.
Please go ahead.
Hey, Thanks, Good morning, guys I think another one on good morning. Another one on leverage here you know running an agency portfolio around call. It seven five times leverage.
It has historically not been considered very high and the model can easily support more as you guys have talked about.
And you also have call it $2 $8 billion in excess liquidity.
Which comes out to you know call it around 4.5% of your agency portfolio.
And that again looks very supportive like a supportive cushion to support your leverage here.
At the same time you guys have also carried more excess margin in the portfolio when you.
Your leverage has been higher.
So what is the margin level that you kind of talk about or think about maybe being the most comfortable with going forward as a percentage of your agency portfolio and how does the.
The current environment.
Especially with respect to liquidity in the broader market drive that threshold.
Thank you for the question. So what I would start with is that you know are our sort of view on liquidity is obviously very dynamic and very market dependent and portfolio dependent and so.
I understand that the sort of comparison of where we are today from a liquidity perspective on a percentage basis versus where we were but I think it's also really important to look at today's liquidity in the context of today's market and where we have moved so the first point I would make is that.
From a liquidity perspective, we've already absorbed a massive negative shock.
So I don't think that the comparison is necessarily apples to apples anymore. Because we've already incurred for example over the last 12 months 100 basis point move in spreads tremendous interest rate volatility that's had implications to the book value, but as we sit today, we still have a very strong liquidity position.
That's really that's really critical the other is the portfolio composition today and what is it what.
What is its impact on our liquidity position said another way we are operating with lower leverage as you point out, but also a much more defensive portfolio position, which actually has the effect of using up more liquidity in particular, our hedge ratio being so high.
At close to 125% has given us tremendous protection against short term rate increases as evidenced in our earnings we've kept our duration gap limited essentially kept our risk profile low there'll be able to absorb all of the spread shock.
That hedge ratio and that derivative position also has a very high liquidity usage. So those are not positions that we will have over the long run. So when you think about our liquidity position going forward I would I would say all other things equal we're probably at near the low point in terms.
Of the portfolios usage and in what it what it does to our liquidity position.
So when we think about our leverage going forward and as you pointed out I think we can operate very comfortably at higher leverage all of these things have to go into that that liquidity position. So it's a dynamic decision. It's based on the environment. It's based on the shock. That's already occurred it's based on the portfolio, we have and I expect over time, we will not be up.
We are waiting with his defensive portfolio, particularly from our hedge ratio perspective, So I hope that helps to some to some extent.
Yeah. That's helpful. Thank you.
Sure.
Thank you.
Next question comes with Bose, George with K B W.
Christine.
Hey, everyone. Good morning, just a couple of follow up questions for me actually just when you talked about the available spreads in the market.
Should we think about just the cost of convexity hedging.
Versus the nominal spreads given the elevated volatility now you know what.
It's sort of the costs that we have to that's kind of embedded in there.
Yeah.
Well in the current environment, obviously that is a significant punish them. When we talk about you know incremental return opportunities, which are as attractive as they've ever been mid teens high teens in and in some cases, you do have to take into account the convexity rebalancing or hedging.
If you if the assumption is that the volatility in the marketplace is going to stay where it is then you would have to assume that that ongoing rebalancing will be a sort of a meaningful cost to the position.
But we don't believe that's the case as Chris pointed out realized volatility increased 20 or 30% in the second quarter.
While it may it may it may continue to be volatile for the next quarter or two we certainly don't believe that realized volatility will stay as high as it is it will return to more normal levels, four or five or six basis point moves today, not 10, or 11 or 12 basis point moves.
Today, So when you think about the position you're right. There is an incremental cost, but we expect that cost to move back in line with more historical averages over time. So it's it's just something we're going to have to deal with over the short run in our opinion.
Okay that makes sense. Thanks, and then just one different question you series F preferred shares they go floating in mid October .
Is that market open to call and reissue that or just curious what youre thinking there.
That that would that would be we haven't obviously made a decision on that nor would we make a decision on that until we get into that into that call period.
But those those those issues are potentially called.
Okay and that market is yeah. It was series C that you were referring to yeah.
And that market is open.
Okay, Great, Yes, Oh, I know Oh.
From a new issuance perspective, yeah sure yeah, Yeah, yes.
Okay, great. Thanks.
Okay.
Yeah.
Thank you.
Next question comes with a lot different.
With Barclays. Please go ahead.
Hum.
Hey, just had one more question for you on leverage.
Is there any color you can give us on kind of the cadence at which we should expect you to total to lever up.
Are you waiting for for rate volatility to die down. Some are you starting to leg into that any kind of sense for for where you might take that.
Well I don't want to get into where we may take it or precision with respect to when we may take it there because again, it's really a dynamic environment, where we haven't got a fed meeting tomorrow, which is gonna be really significant we got a couple of really important inflation trends.
That over the next couple of months that will have a lot of impact on the short term volatility in the market, but generally speaking I.
Would expect it just to trend somewhat higher we have added some mortgages.
In the month of July not significantly, but we have added some given the investment returns that we were seeing.
But we're going to continue to approach just very opportunistically approach it very disciplined and again I think that this period of attractive returns is going to be with us for some period of time, which actually makes that decision in that equation a little bit easier.
Okay, great. Thank you.
Thank you.
This concludes our question and answer session.
Like now to turn the call back over to Peter Federico for any closing remarks, Chris.
Crystal again.
Well again, thank you all for your participation on our second quarter earnings call and we certainly look forward to speaking with you again at the end of the third quarter.
Okay.
Thank you. The conference has now concluded. Thank you for attending today's presentation you may now disconnect.
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