AGNC Investment Corp. (NASDAQ:AGNC) Q2 2023 Earnings Call Transcript

AGNC Investment Corp. (NASDAQ:AGNC) Q2 2023 Earnings Call Transcript July 25, 2023

Operator: Good morning and welcome to the AGNC Investment Corp’s Second Quarter 2023 Shareholder Call. All participants will be in a listen-only mode. [Operator Instructions]. After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note that this event is being recorded. I would now like to turn the conference over to Katie Wisecarver, Investor Relations. Please go ahead.

Katie Wisecarver: Thank you all for joining AGNC Investment Corp.’s second quarter 2023 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 facts, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of AGNC. All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice.

Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in AGNC’s periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC’s website at sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law. 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, Executive Vice President, Strategy and Corporate Development. With that, I’ll turn the call over to Peter Federico.

Peter J. Federico: Thank you, Katie. Market conditions in the second quarter, on balance provided further support for our favorable investment outlook for agency MBS and made us increasingly confident that we are at the forefront of one of the most compelling investment environments that we have experienced in our 15-year history. Historically attractive asset valuations, strong funding markets, and gradually improving hedging conditions as the Fed ends its monetary policy tightening campaign underpin our favorable return expectations. Macroeconomic factors continue to be the primary driver of Agency MBS performance in the second quarter. Debt ceiling uncertainty, and the possibility of a government default weighed heavily on Agency MBS performance and push spreads to the widest level since the great financial crisis.

Fixed income markets were also pressured by hawkish Fed minutes and continued strength in the labor market. At current valuation levels, Agency MBS look extremely attractive on a standalone basis and provide investors a compelling alternative to U.S. Treasuries. At a spread to the 10-year Treasury of about 175 basis points, new production Agency MBS give investors the ability to earn a 5.5% yield on a security that is backed by the explicit support of the U.S. government. This combination of yield and credit quality makes Agency MBS appealing to a wide range of investors on both a levered and unlevered basis. Agency MBS also look compelling relative to investment grade corporate debt, particularly in light of a worsening credit outlook. To illustrate this point on Slide 12 of the presentation, we show the Treasury spread differential between current coupon Agency MBS and the Bloomberg Investment Grade Corporate Bond Index.

From 2010 to 2022, the average spread differential between these two instruments was negative 75 basis points, which is to be expected given the superior credit quality of Agency MBS. Recently however, this long standing spread relationship has reversed with current coupon agency MBS now trading at a wider spread to Treasuries than this investment grade corporate bond index. At today’s spread differential of positive 15 basis points, Agency MBS are about 90 basis points cheap to the historical average. Over time, this spread relationship will likely revert to the norm as investors take advantage of this opportunity and move up in credit quality. Also important, the short-term funding markets for Agency MBS and U.S. treasuries remain strong in the second quarter, despite debt ceiling concerns.

The stability and resiliency of the repo market for these two government backed securities is due to the actions of the Fed in the now well-established reverse repo and standing repo facilities, which together provide a clear, upper and lower bound for short-term repo rates. Following the debt ceiling resolution, the Treasury Department issued a significant amount of short-term debt in an effort to replenish its general account at the Fed. This issuance was readily absorbed and largely offset by a decline in the Fed’s reverse repo facility balance, leaving the funding market for Agency MBS largely unaffected. Finally, the interest rate environment has begun to show signs of improvement, with the Fed nearing an inflection point in monetary policy and interest rates perhaps having already reached their cyclical high point.

Fixed income investments are an increasingly attractive asset class. Consistent with this more favorable interest rate outlook, bond funds have continued to experience substantial inflows. Interest rate volatility has also declined from the highs of last year and will undoubtedly decline further once the Fed reaches its desired short-term rate level. Declining interest rate volatility is beneficial to Agency MBS valuations and over time lowers the cost of interest rate related rebalancing. Looking back over the last couple of years, the U.S. Treasury and Agency MBS markets have undergone a dramatic repricing as the Fed transitioned from an ultra-accommodative monetary policy stance to its current restrictive stance. We believe this transition is largely complete and that one of AGNC’s most favorable investment environments is now emerging.

When an investor buys a share of AGNC stock, they buy into a levered portfolio of Agency MBS and Hedges that is fully mark to market. At current spread levels we believe our portfolio can generate mid to upper teen returns on a go forward basis, either through strong earnings if mortgage spreads remain at these elevated levels or a combination of favorable earnings and net book value appreciation if mortgage spreads tighten somewhat over time. With the macroeconomic and interest rate environment still unsettled, short term deviations from this promising path are possible. Nevertheless, we remain confident that over the longer term, this investment environment will prove to be one of the best for Agency MBS investors. With that, I will now turn the call over to Bernie Bell to discuss our financial results in greater detail.

Bernice E. Bell: Thank you, Peter. For the second quarter, AGNC had comprehensive income of $0.32 per share. Economic return on tangible common equity was 3.6% for the quarter, comprised of a slight decrease in our tangible net book value of $0.02 per share and $0.36 of dividends declared per common share. As of last Friday so far for July, tangible net book value was largely unchanged. In light of the continuing rate volatility we maintained our disciplined risk management strategy throughout the second quarter. Leverage at the end of the quarter was unchanged at 7.2 times tangible equity, while average leverage decreased from 7.7 times for the first quarter to 7.2 times. During the quarter, we opportunistically issued $106 million of common equity through our At The Market offering program at a significant price to book premium.

As of quarter end, we had cash and unencumbered Agency MBS totaling 4.3 billion or 58% of our tangible equity and 80 million of unencumbered credit securities. Net spread roll and dollar income, excluding catch up amortization, was $0.67 per share for the quarter, a decline of $0.30 per share from the first quarter due to a somewhat smaller asset base. Our net interest spread increased to 3.26% for the second quarter compared to 2.88% for the prior quarter. The increase was largely due to a higher ratio of our legacy low fixed pay rate, interest rate swap hedges to our funding liabilities for the quarter. Lastly, the average projected life CPR on our portfolio at the end of the quarter was largely unchanged at 9.8%. Actual CPRs for the quarter averaged 6.6% compared to 5.2% for the prior quarter.

And with that, I’ll now turn the call over to Chris Kuehl to discuss the Agency mortgage market.

Christopher J. Kuehl: Thanks, Bernie. The Agency MBS market faced several major headwinds in the second quarter, including a supply shock following the second largest bank failure in U.S. history, a debt ceiling standoff that risked triggering a U.S. debt default, and a further repricing of market expectations for tighter Fed monetary policy. Agency MBS underperformed Treasury and swap based hedges in April and May, with par coupon spreads reaching post-GSE wides in late May when the debt ceiling uncertainty was at its peak. Spreads recovered somewhat in June following the debt ceiling resolution and a subsequent decline in interest rate volatility. The price performance of Agency MBS varied considerably across the coupon stack with lower coupons meaningfully outperforming higher coupons due to strong index based investor demand throughout the quarter, stemming from fixed income fund inflows.

From a total return perspective however, the performance differences across the coupon stack were much more muted given the significantly higher yield associated with higher coupon MBS. Hedge position was also an important driver of Agency MBS performance during the second quarter as the yield curve flattened 50 basis points with the yield on two-year treasuries increasing 87 basis points and the yield on 10-year treasuries increasing 37 basis points. For AGNC, having a significant amount of short and intermediate hedges was beneficial to our overall performance. Despite the volatility early in the quarter, as Peter mentioned, there are a number of reasons for optimism. First, interest rate volatility is likely to decline, which is a positive for Agency MBS.

Second, the stresses in the regional banking system have largely abated and further forced bank liquidations are unlikely. Third, the SVB liquidation has gone better than most market participants expected and as of today, more than 70% of the combined agency pass through and CMO holdings have been sold. At the current pace, we expect this FDIC liquidation process to be largely complete within the next two months. And lastly, as Aaron will describe further, with primary mortgage rates near 7% and relatively muted housing activity and slowing seasonals, we expect the supply of Agency MBS over the remainder of the year to be very manageable. Given this improving outlook, we added approximately 2 billion in Agency MBS during the quarter, bringing our portfolio to 58 billion as of June 30th.

With respect to portfolio positioning, we continued to move up in coupon, increasing our higher coupon holdings by approximately 5 billion versus reducing lower coupon positions. As a result, the weighted average coupon of the portfolio increased to approximately 19 basis points during the quarter. Since quarter end, we’ve continued to take advantage of attractive valuations, adding MBS and bringing our at risk leverage to 7.5 times as of the end of last week. Our hedge portfolio totaled 61.2 billion as of June 30th, and our duration gap was 0.4 years. Our hedging activity was relatively minimal during the quarter as we modestly increased our hedge position given the move higher in rates and the increase in our MBS holdings. With the debt ceiling standoff behind us, clarity with respect to the supply outlook for Agency MBS and greater confidence that we are near the inflection point of this Fed policy cycle, we expect the second half of the year to be an attractive earnings environment for Agency MBS.

I will now turn the call over to Aaron to discuss the non-Agency markets.

Aaron Pas: Thanks, Chris. During the second quarter, both Triple A and credit spreads generally performed well, tightening modestly by quarter end. Technical factors continue to be very impactful in the residential mortgage credit space. Limited housing supply driven by elevated primary mortgage rates have caused both purchase and refinance origination volumes to remain low. Existing borrowers with deep out of the money mortgages are effectively locked into their current mortgages, reducing housing inventory. This can be seen in the depressed existing home sales data, which have been running well below levels seen over the last decade. Lower overall levels of housing activity drive lower mortgage issuance volume and are also supportive of house prices given limited supply, which together provide a favorable technical backdrop for mortgage credit.

Additionally, the fundamental picture has improved modestly as well. The downside risk associated with a significant credit event has declined as expectations increased for a soft landing in light of encouraging signs seen in recent inflation readings. In addition, firming house prices and a resilient employment landscape provide further reason for optimism. The technical backdrop within the credit risk transfer market has driven strong outperformance in this sector. First, due to a decline in MBS issuance, there are significantly lower credit protection needs from the GSEs as compared to last year. Second, tender offers and pay downs have further reduced CRT flow. Taken together the impact on CRT securities outstanding has been a decline of approximately 8% over the last year.

Turning to our holdings, our non-Agency portfolio ended the quarter at just over 1 billion, a decline of approximately 250 million from March 31st. We continued to reduce our CMBS position over the quarter while also opportunistically selling some CRT securities and rotating further dominant [ph] capital structure. The notional amount of our CRT holdings declined over the quarter as we rotated into a deeper but seasoned credit. Lastly, just a note on the repo market for non-Agency securities, spreads were largely unchanged in the quarter with a bias towards being slightly wider. With that I will turn the call back over to Peter.

Peter J. Federico: Thank you, Aaron. With that, we’ll now open the call up to your questions.

Q&A Session

Operator: Thank you. [Operator Instructions]. Our first question comes from Douglas Harter with Credit Suisse. Please go ahead.

Douglas Harter: Thanks and good morning, hoping you could talk about how you’re viewing the dividend in light of the comments around where you see current returns and then whether you view the coming maturity of a lot of legacy shorter dated swaps as having any impact on the dividend level?

Peter J. Federico: Sure. Thank you for the question, Doug. I know that’s a question on a lot of investor’s minds. I think there’s a couple things to point out in that answer. First, I’ll start with if you look at the net interest margin on our portfolio, this quarter it actually increased to 326 basis points. I think it is probably the all-time high from a net interest margin perspective, which demonstrates the fact that we had such a significant portion of our short-term debt fully hedged out for this rate increasing environment. But that spread is not indicative of the true economic earnings of the portfolio going forward. And similarly, if you look at our net spread and dollar roll come at $0.67 that’s also not reflective of the economics.

I think you’re getting to the correct question is, if you look at the portfolio on a mark to market basis, fully from an asset liability and hedge perspective, the net interest margin is clearly not 326 basis points, it’s much more in today’s environment, probably in the neighborhood of 175 to 180 basis points. If you look at new current coupon mortgages, for example, hedged with a mix of 5 and 10-year swap, and Treasury hedges, you’re probably in the neighborhood of 180 basis points, which is historically very attractive. That’s why we’re so excited about this environment. If you lever that something like 7.5 times, given the current coupon spread, and given our operating expense of a percent, you should come out in the high teens in terms of an economic return on the portfolio on a go forward basis.

That’s what we look at when we think about the playability and durability and sustainability of our dividend. Our dividend yield today on our book value is right in the 15% range, the economic earnings on the portfolio to economic earnings on their portfolio on a go forward basis is as I said, probably in the high to mid-teens. So I think those two things align very well and that’s one of the reasons why we’ve been so disciplined in keeping our dividend where we have kept it over the last couple of years despite our net spread and dollar roll income being more than two times our dividend at time. So that’s the way we think about it going forward. We’re very comfortable with where our dividend is right now, versus the economics of the business.

The other thing that I would also point out is that you talked about the fact that we will have short-term swaps rolling off over the next year, and that will lead to some compression. But again, it should bring that net interest margin down more in line with the economics and our net spread and dollar roll income more in line with our dividend. So we’re comfortable with where it is and we think they aligned well from an economics perspective right now.

Douglas Harter: Right appreciate the answer.

Peter J. Federico: Sure, thank you.

Operator: Next question comes from Trevor Cranston with the JMP Securities. Please go ahead.

Trevor Cranston: Alright, thanks. Good morning.

Peter J. Federico: Good morning Trevor.

Trevor Cranston: You guys laid out pretty well I think the favorable case for MBS. I was wondering if you could talk a little bit more about how impactful you think the end of the FDIC portfolio sales would be on the MBS market, sort of spread volatility in general? Thanks.

Peter J. Federico: Yes. Thank you for the question. We are very optimistic about the outlook, and we think we’re at an important turning point somewhere in the next several months. If you think about it, the market has really struggled, and it’s been multiple quarters now of just an environment where the reasons for concern and uncertainty have clearly outweighed the reasons for optimism. But what’s happened and particularly now, as we got through the second quarter, is a lot of those sources of uncertainty have now fallen away. If you think about it, the Fed is clearly close to being done, whether they’re done tomorrow and even former Chairman Bernanke thinks that tomorrow is the last move. But if it’s not tomorrow, it may be one more move.

We do have to get through some economic data, but the Fed is near the end, and that’s certainly positive. The Fed’s balance sheet runoff is sort of on autopilot, there’s no issues there. The regional banking crisis seems to now be well in the rearview mirror, which is very positive, and the big movement in deposits has been put in the past. As Chris pointed out, there doesn’t seem to be another balance sheet-related banking crisis. And the Silicon Valley Bank is largely done. I don’t expect that to have really any impact on the market that has been absolutely easily absorbed without any disruption. So there’s lots of reasons to be optimistic about the direction of mortgage performance. I think that’s one of the reasons why we’re encouraged by the outlook, is that we still have some uncertainty to contend with the Fed and the way that they talk about the economy and inflation.

But over the next couple of months, really the key to stability is going to be the inflation data. And if the inflation data continues to be in line with expectations or even lower, that is going to lead to an important decline in interest rate volatility, which is an important positive for Agency MBS. Chris, do you want to add to that?

Christopher J. Kuehl: I would just say, look, the FDIC, the failure of Signature Bank and SVB was clearly a supply shock that the market had to deal with and spreads widened into that. More specifically to your question, when this process ends, the liquidation by the FDIC, market technicals should improve materially. The timing will also likely coincide with lower housing seasonals, which means less organic issuance. And so that should be a tailwind for performance in the second half. Of the $82 billion, $83 billion of Agency MBS that had to be liquidated, there’s 13 billion pass-throughs left, 10 billion in CMOs. And as Peter said, the process has gone very well, much better than some had feared. And we can credit yield levels and strong inflows into index-based fixed income managed funds is the reason the liquidation has been so easily absorbed.

Trevor Cranston: Got it, okay. And then you guys mentioned adding to the portfolio since the end of the quarter, can you talk, in general, sort of where you’re adding in the coupon stack, I mean a lot of the comments are focused on current coupon spreads. So I was curious if you guys are generally looking at 6s and higher at this point or where you’re at it?

Christopher J. Kuehl: Sure. So relative value across the stack is still very much upward sloping given current valuations. And our marginal purchases are concentrated in production coupons. And importantly, this — our view on relative value is not unique to us or unique to our models. The steep upward slope in spread curve across the stack exists because the dominant bid for mortgages is coming from index-based investors, driven by fixed income fund inflows that need to buy low coupons or index coupons that aren’t being produced outside of the FDIC liquidation. The low coupon float is locked up outside of what’s been sold through the FDIC. It’s locked up at the Fed and banks that don’t want to sell because they don’t want to take a hit to capital. And so there are very few true arbiters of value currently and all the supply, by definition, is in production coupons.

Trevor Cranston: Okay, appreciate the color. Thank you.

Operator: Our next question comes from Bose George with KBW. Please go ahead.

Bose George: Hey guys, good morning. I wanted to ask about leverage. Can you just remind us how you view kind of normalized longer-term leverage?

Peter J. Federico: Sure. First, I would say, Bose, that our leverage outlook is dependent on the environment. It’s situational, it always is. It depends on the interest rate environment, our expectations about the interest rate volatility. As we look ahead, it depends a lot on where mortgage spreads are, whether they’re at historically wide or historically tight levels. So it obviously changes over time. We’ve obviously been operating with a very defensive position really for eight quarters. If you look back at our asset balances, for example, they’ve been declining or stable for eight quarters in a row. It was actually in the second quarter that marked the first change in that trajectory, where our asset balance actually increased.

And that is consistent with our changing view on the investment outlook being more positive. As Chris said, we added to our portfolio. And importantly, as Chris mentioned in his prepared remarks, our current leverage is now higher than it was at the end of last quarter. We were currently operating at around 7.5 times. So we have a lot of capacity to take leverage higher as the market conditions continue to unfold. And as we get increasingly confident in the outlook, we’re operating, as you know well, with a significant amount of unencumbered cash and mortgage-backed securities at 4.3 billion or 58% of our unencumbered — of our equity. So we have a lot of capacity to be opportunistic. And as Chris mentioned, we’re continuing to add mortgages in this environment, and we’ll likely do so over time.

Bose George: Okay, great, makes sense, thanks. And then just from a capital raising standpoint, just given the efficiency of your ATM issuances, is that likely to be the way you issue capital going forward?

Peter J. Federico: Well, it’s a highly efficient way of raising capital. From a cost perspective, it’s extremely low cost, it gives you a lot of flexibility to do those capital raises at a time when you really believe that they’re accretive to your existing shareholders and at a time when you can deploy that capital very quickly. We did opportunistically raise about another $100 million. We did so at levels that were very accretive to our book value for existing shareholders. But again, we’re going to continue to be opportunistic with that. And we also importantly, believe that we’re operating at a very desirable scale and size. And so as I mentioned before, that is something that we consider with respect to our capital raising.

So I think you can expect us to continue to be very disciplined and very opportunistic with those capital raises, always looking at it from the perspective of our existing shareholders, making sure that we’re operating with the desired leverage level for our existing shareholders first, then looking at the capital markets, can we raise capital accretive from an earnings and from a book value perspective, can we deploy those proceeds in a way that is beneficial to our existing shareholders. So we’ll continue to take that approach. And the ATM program really gives you a lot of flexibility because it is so low cost.

Bose George: Okay, great, thanks.

Operator: Next question comes from Rick Shane with J.P. Morgan. Go ahead.

Richard Shane: Good morning everybody and thanks for taking my questions. I wanted to — first of all, when we look at Page 25, the interest rate sensitivity, I think one of the things that is worth mentioning is, over the last couple of quarters ordinarily when we look at rate sensitivity, it is both symmetric and linear. And when we look right now, it’s pretty linear in a rising rate environment, but you have non-linearity and it is not as asymmetrically favorable as rates fall. Is that a function of the swaptions and also potentially some amortization of premium of higher coupon securities in a falling rate environment, what drives that?

Peter J. Federico: Now what’s happening — that’s a good question and you actually can see that on Page 11 of the investor presentation, but it just shows you the duration gap sensitivity. And what it’s showing is that from a rate perspective, overall, we are above the peak convexity point in the mortgage universe. The mortgage universe is far out of the money right now. In fact, it would take a 200 basis point rally in order for there to only be about 20% of the universe to be refinanced. But what it shows is that we have more down rate risk. In fact, said another way, our duration will move quicker in a down rate scenario than it will in an uprate scenario. That is one of the reasons why we continue to operate with a small positive duration gap.

Our duration gap actually hurt our performance in the second quarter because we did have a small positive duration gap and rates were rising. But in the current environment, where we stand right now, there’s clearly more two-way rate risk in the market. And as you point out, there’s a little bit more sensitivity to our portfolio, to a falling rate scenario. So we’ll likely continue to operate with a small positive duration gap, and you can see that in the sensitivity table that you point out.

Richard Shane: Peter, that’s a great answer. And it actually leads me to my next question, which is that, look, you guys — this is not an easy business, but there are three or four basic decisions that you guys make, where you play in the stack, how much leverage you run, what your hedge ratio is. So those are the big levers within the model. And you’ve indicated that you see an opportunity, at this point, to modestly increase leverage. I don’t think anybody expects you’re going to double leverage or increase leverage to 30% overnight. But I am curious, as you do that, given where we are, is the intention to let the — as we saw the duration extend modestly from the first quarter to the second, should we expect the duration to modestly increase as well given where we are in the rate cycle?

Peter J. Federico: Are you referring to the duration gap?

Richard Shane: Yes, I’m sorry. Yes, I apologize.

Peter J. Federico: Yes. So no, I appreciate your summary, and you point out the three key variables. I’ll actually address two of the variables. We already talked about leverage and from a duration gap perspective, I would say, generally speaking, no. In the current environment, because of the shape of the yield curve, the inverted yield curve, having a positive duration gap actually is negative carry on the portfolio. In today’s market, a one-year duration gap is something equivalent to about a 1% drag in ROE. So we are cognizant in an inverted yield curve environment that there is a cost of doing that. So we’ll keep our duration gap likely low. There will come a time in the future, to your point, once the yield curve is positively sloped again, which it inevitably it will be, operating with a positive duration gap and maybe even a larger positive duration gap may be very profitable, if you will, from an ROE perspective, both in terms of the level of rates and the carry that we’ll generate on that position.

But for the foreseeable future, I don’t expect that to change very much. The other variable that you point out, I want to also address, which is the hedge ratio. So that is, obviously, a key driver of performance. We’ve operated with a very high hedge ratio, meaning all of our short-term debt was essentially termed out into synthetically longer-term debt. Our hedge ratio was still at 119%. As you look forward in our portfolio, we will have swaps rolling off in our portfolio. We actually provide the one-year component of our swap portfolio, which is about $12 billion. Those swaps are not all rolling off in this calendar year. In fact, only about $5 billion of those $12.5 billion are rolling off in the next six months. I point that out because as it sits right now, you could see a scenario where as our short-term swaps roll off over the next 12 months and then particularly throughout 2024, that could also coincide quite nicely with the scenario where the Fed is actually lowering short-term rates.

So in a scenario where the Fed is lowering short-term rates, monetary policy and shifting toward an easing policy, we will likely operate with a lower hedge ratio, perhaps well under 100% at some point, which would be another source potentially of earnings potential on our portfolio. So we’ll look at our hedge ratio. We’ll look at our duration gap. We’ll look at our overall leverage as key drivers. It’s also important to point out since we’re talking about the hedge ratio and the fact that there will be compression coming from short-term hedges rolling off, which have been very beneficial to us. It’s also important to point out that the average yield on our portfolio today is still only 390 versus a mark-to-market yield of well over 5%. It’s probably something like 5.1% or 5.2%.

So said another way, our assets are still 100 to 120 basis points below market yields. That, too, will change over time as we roll out of old assets into new assets. Hedges roll off, that will be a source of compression. As we roll into new assets, that will be a source of benefit. So I just wanted to point that out, but thank you for that question.

Richard Shane: No, it’s a great answer and I think I’m going to have to go over the transcript about 15 times in order to really get everything out of it, but I appreciate it. Thank you so much.

Peter J. Federico: Yes, appreciate the questions.

Operator: Your next question comes from Vilas Abraham with UBS. Please go ahead.

Vilas Abraham: Hey everyone. Some of my questions have been asked and answered. Maybe some commentary, Peter, just on the net supply expectations and the kind of puts and takes around that, that you think could impact spreads over the next couple of quarters?

Peter J. Federico: Sure, and Chris pointed this out in his prepared remarks, from a net supply perspective, I think everybody still expects there to be something in the neighborhood of about $200 billion worth of organic supply, which is very manageable. Add to it what the Fed’s runoff is putting — actually the Fed’s portfolio is running off a little bit faster than it was a quarter ago, but that’s still about another $200 billion. So for the year, I still think the private sector has to absorb about $400 billion worth of mortgages, but I think the private sector can easily absorb that amount of mortgages. And as Chris pointed out, we’ve gone through sort of the — perhaps the peak cyclical point for the seasonals for the mortgage, for the housing market.

And we expect the second half of the year to be some slowing where mortgage rates are, affordability. All those things should keep mortgage supply well contained in the second half of the year, which would be a positive for mortgage performance, particularly as the demand from fixed income remains as robust as it currently is with the inflows. I suspect that, that equation is going to work out well for Agency MBS. And when you look at Agency MBS, not only from — just from a supply perspective, but when you look at Agency MBS in particular, relative to other fixed income investments, we pointed out the performance of Agency MBS versus corporates, I think that rotation is a significant source of demand that takes time to occur, but I think it will occur.

So even though banks may be not quite the buyers of mortgages in the second half of the year that we thought they may be because of the capital issues that they face, the flow of money into fixed income and in particular, the flow of money that should ultimately make its way to the Agency MBS market because it is so cheap relative to Treasuries, for essentially the same credit quality, I know it’s not exactly the same credit quality, but from a government guarantee perspective, they are exceedingly cheap to Treasuries and they are exceedingly cheap to investment-grade debt. And I think that’s going to draw dollars into the Agency MBS market. That takes time. But that, coupled with the positive seasonals, I think, makes for a better second half of the year.

Vilas Abraham: Okay. And then just across the coupon stack, you touched on this earlier. So does that kind of imply that lower coupons continue to outperform a little bit as bond funds on buying or just how do you think about the dispersion and performance across the stack?

Peter J. Federico: Yes, I’ll start with that, and then Chris might add to that. But that’s exactly right. That’s what happened in the second quarter, is that there was steady, very steady. Every week, we saw bond fund inflows. Those bond funds, as Chris pointed out, are buying the index. The index is more than 50%, 2 and 2.5. So they are buying those coupons. So from a price perspective, those coupons performed very well. When you think about the performance of the coupon stack, though, adding in carry, the performance differences were much more muted because the higher coupons offer so much better carry. But there was still outperformance of the lower coupons in the quarter because of the fixed income demand and the lack of supply.

Vilas Abraham: Okay. Great. And did you guys give a quarter-to-date book value update? I don’t know if I missed that?

Peter J. Federico: Bernie mentioned that it was roughly unchanged on the quarter so far.

Vilas Abraham: Okay, thank you very much.

Peter J. Federico: Yup, thank you Vilas.

Operator: Your next question comes from Eric Hagen with BTIG. Please go ahead.

Eric Hagen: Hey, thanks, good morning. I got a couple here. Lots of divergence between swap performance versus treasuries last quarter. Do you have any views on what may have driven that divergence and does it have any bearing on how you hedge going forward? And then second question here, I mean imagine that you guys have seen — have been following the expectation for new bank regulations, which expand the scope of Basel. We could maybe even see some of that later on this week. Do you see that being a source of volatility for MBS, do you see any like broader connectivity between banks, lightening their footprint in mortgage finance and the performance of MBS in the secondary market, maybe more generally?

Peter J. Federico: Sure. I appreciate all those questions. First, with respect to hedge, you’re absolutely right. There’s been some performance differences between using swap hedges and treasury hedges. It’s a very volatile market, and that does make hedging very challenging. We see that in the shape of the yield curve and the fact that the two and five year parts of the curve outperformed so much. The five-year part of the curve, in particular, outperformed. Five year treasuries outperformed so from a hedging perspective last quarter so that would have been one of the sort of the ideal hedge position. But we’ll continue to use a mix of hedges, with swap spreads being as negative as they are. We’ll likely bias towards a little bit more swap hedges in our mix going forward.

But I think it’s important, from an overall performance perspective, over the long run, to have a mix. We’re going to have quarter-to-quarter volatility and performance because of the hedge mix. We saw that this quarter and also because of the coupon mix. But over the longer run, we think the right mix from an asset perspective is in the middle to high coupons, where we’re concentrated right now. They give us the best carry, the best return profile. And from an overall hedge mix, again, using a blend of hedges, 5 and 10 years, in particular, we have increased the weight of those hedges that hurt us in our performance last quarter. About 65% of our portfolio, close to 70% of our hedges now are five years and out, in particular, in the 7 to 10-year part of the curve.

With the yield curve being as inverted as it is, I suspect that, that is going to be a beneficial trade for us to have over time. The yield curve will ultimately invert. So we want less short-term hedges, more long-term hedges. And we’ve positioned for the re-steepening of the yield curve and our hedge position. So I think that’s going to be the biggest driver of hedge-related performance as opposed to the mix between swaps and treasuries. With respect to bank capital, there’s no doubt that the banks face increasing capital requirements. We do not expect this to be a short-term issue in the Agency MBS market. This is much more of a longer-term, probably multiyear issue that banks will face. But I also do believe that ultimately, when the banks face higher capital requirements or increased capital requirements related to interest rate risk, that ultimately, on its face, it sounds like that would be negative from a demand perspective for Agency MBS, but I think you could also look at a scenario where there actually may be benefits to owning Agency MBS over treasuries because of the significant yield and carry differential.

So there could be a substitution effect also over time for banks out of treasuries into the much higher yielding Agency MBS. I think that’s something that’s going to play out over the long run. I don’t expect that to be a 2023 issue.

Eric Hagen: I appreciate the color. Thank you.

Operator: Next question comes from Crispin Love with Piper Sandler. Please go ahead.

Crispin Love: Thanks, and good morning. Appreciate you taking my questions. Just looking at Slide 12 in your presentation, which I think is a new one, you highlight the Agency MBS spread relative to investment-grade corporates, which definitely shows the relative opportunity there, which you’ve hit on a little bit. But what do you think are the key drivers in the kind of the spread relative to corporates, is it all based on agency technical, or just kind of curious other factors that might be…?

Peter J. Federico: It’s a great question and it’s a complicated question. But I think it’s really, really important because the point that we’re trying to make here is that the environment that we’re currently in is actually one that is very rare in terms of agencies being this cheap relative to investment-grade corporates, given the fact that post-Great Financial Crisis, the agency mortgage-backed security essentially has the backing — the explicit — does have the explicit backing of the U.S. government in terms of the support for the GSEs. So you can really make a very clear credit differentiation between these two instruments as to why we chose it. Interest rate volatility is a big driver of it with the amount of interest rate volatility that we’ve had, interest rate volatility is always negative for Agency MBS, and you can see that.

So to some extent, that makes sense that agencies have underperformed. The other point is that when you have rapidly moving markets, particularly in the downturns, we make this point all the time. Agency MBS tend to underperform other asset classes. They lead in the downturn, if you will. And they lead in the downturn because they are a unique security, and that they are short of all their liquid and their spread products. So from a — when investors have to liquidate, particularly in bond funds, when you have to liquidate, you liquidate what you can sell what is liquid, and Agency MBS is that security of choice. So as interest rates were going up and the market was worried about the Fed and the balance sheet runoff, Agency MBS were uniquely negatively impacted.

So when you look at this equation, I think the thing that’s most mispriced in it is probably not corporates, they may actually be sort of neutral, maybe a little bit rich. But it’s Agency MBS that I think are exceedingly cheap in this comparison. The other sort of interesting point is that despite the Agency MBS market being the second most liquid market in the world, relative only to U.S. Treasuries, and being $8.5 trillion, it’s a very difficult asset class for investors to access if you’re not an institutional investor. If you want to put money to work, you can go to Fidelity and you can buy a corporate bond. Corporate bonds are much more liquid from that perspective in terms of retail’s ability to access that market and to understand that market.

Agency MBS is a fixed income asset class that’s dominated by institutional access. Makes it more difficult and so that’s why you could have environments like we have right now where Agency MBS, despite being AAA-rated, are trading at a wider spread to Treasuries than single A-rated corporate bonds.

Crispin Love: Appreciate the answer Peter, and that is all I had for questions.

Peter J. Federico: Thank you.

Operator: We have now completed the question-and-answer session. I’d like to turn the call back over to Peter Federico for concluding remarks.

Peter J. Federico: Thank you, everybody for participating on the call today. Just want to sort of recap that we think that we’ve obviously gone through a long period, a couple of year period where Agency MBS have been challenged by the repricing that has occurred in the fixed income markets, but I do believe that we’re getting close to the end of that process. And as I mentioned, we believe a very favorable investment environment is now starting to emerge. So we look forward to talking to you again at the end of the third quarter. Thank you for listening today.

Operator: Thank you for joining the call. You may now disconnect.