AGNC Investment Corp. (NASDAQ:AGNC) Q3 2023 Earnings Call Transcript

AGNC Investment Corp. (NASDAQ:AGNC) Q3 2023 Earnings Call Transcript October 31, 2023

Operator: Good morning and welcome to the AGNC Investment Corp. Third Quarter 2023 Shareholder Call. All participants will be in 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 call over to Katie Turlington, Investor Relations. Please go ahead.

Katie Turlington: Thank you all for joining AGNC Investment Corp’s Third 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 this 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 Federico: Thank you, Katie, and good morning. Despite signs of improvement early in the quarter, the selloff in the bond market intensified in the third quarter as treasury supply concerns and the threat of overly restrictive monetary policy weighed heavily on investor sentiment and drove benchmark interest rates and interest rate volatility materially higher. The treasury market continues to be in the midst of a historic multiyear repricing event. To put the move in context, the increase in the 10-year treasury yield over the last three years is the second largest ever recorded over such a short time period. In percentage terms, the treasury market has never experienced anything like this. The Bloomberg Long Treasury Bond Index which tracks maturities of 10 years or more, has experienced a total return loss of close to 50% over the last 2.5 years, a loss equal to what the S&P 500 experienced following the dot-com bust in 2000.

The move higher in Treasury rates began relatively early in the quarter as supply expectations were revised materially higher due to the growing fiscal deficit. The bearish sentiment accelerated late in the quarter following a hawkish message from the Fed that short-term rates would likely remain higher for longer. In environments like this when treasury prices fall abruptly and the market struggles to find its new equilibrium, Agency MBS typically underperformed. That was indeed the case in the third quarter, as Agency MBS performance relative to benchmark rates lagged meaningfully. In aggregate, Agency MBS spreads to comparable duration treasuries widened 20 to 25 basis points across most of the coupon stack. Since quarter-end, Agency MBS have remained under pressure with spreads widening by a similar amount in October.

At this point, Agency MBS spreads are close to the widest levels reached during the height of the pandemic in March of 2020. The sharp steepening of the yield curve also caused Agency MBS performance to vary significantly across the yield curve. Agency MBS hedged with short and intermediate term instruments perform materially worse than Agency MBS hedged with longer-term instruments. The volatile market conditions that we are now experiencing are a result of a complex set of domestic and global factors. In addition, the Fed is nearing a critical inflection point in monetary policy. During these types of transitions, economic data is highly scrutinized by the market and can have an outsized impact on the trajectory of monetary policy. Once the downward trend in labor and inflation data becomes certain, a more favorable monetary policy stance will undoubtedly emerge.

As challenging as this period has been for all bond market participants, the current investment opportunity in agency MBS on both an unlevered and levered basis is without question. On an unlevered basis, new production par-priced agency MBS provide investors with the opportunity to earn a yield of close to 7% on a security that benefits from the explicit support of the US government. Importantly, this yield is now at least 150 basis points higher than every point on the treasury yield curve and materially above highly rated corporate debt instruments. For levered investors in addition to the very compelling base yield of close to 7%, it is becoming increasingly apparent that a new trading range is developing for Agency MBS which materially improves returns.

Over the last six months, the spread between current coupon Agency MBS and a blend of five and 10-year treasuries has ranged between 150 and 195 basis points. The average has been 170 basis points, and currently, the spread is near the upper end of the trading range. Like all bond market participants, our financial results have been negatively impacted by the unprecedented speed and magnitude of this Fed tightening cycle. The rapid rise in long-term interest rates the increase in interest rate and financial market volatility, heightened geopolitical risk and growing US government dysfunction. As the Fed recently stated, however, this tightening cycle may be nearing its conclusion, and the economic balance of risks is now two sided. Although this process has taken longer and has been considerably more difficult than anticipated, we continue to believe that a durable and very attractive investment environment is still ahead of us once the uncertainties associated with the current environment subside.

With that, I’ll now turn the call over to Bernie Bell to discuss our financial results.

Bernice Bell: Thank you, Peter. For the third quarter, AGNC had a comprehensive loss of $1.02 per share, resulting from the significant rate volatility and spread widening that occurred during the quarter. Economic return on tangible common equity was negative 10.1% for the quarter comprised of $0.36 of dividends declared per common share and a decline in our tangible net book value of $1.31 per share. As of late last week, our tangible net book value was down about 11% for October. Despite the decline in our tangible net book value, leverage at the end of the quarter remained well contained at 7.9 times tangible equity or only moderately higher than 7.2 times as of the end of the second quarter. With our average leverage for the quarter being 7.5 times compared to 7.2 times for the prior quarter.

Our liquidity also remained strong throughout the quarter and in line with our typical operating parameters. As of quarter end, we had unencumbered cash and Agency MBS totaling $3.6 billion or 52% of our tangible equity and $80 million of unencumbered credit securities. During the quarter, we also issued $432 million of common equity through our at-the-market offering program, which at a significant price-to-book premium was accretive to our net book value. Net spread and dollar roll income, excluding catch-up amortization, was $0.65 per share for the quarter, a quarterly decline of $0.02 per share. The decline was largely due to a 23 basis point decrease in our net interest spread to 303 basis points for the quarter, driven by higher funding costs, which more than offset an increase in our average asset yield.

Lastly, the average projected life CPR on our portfolio at the end of the quarter decreased to 8.3% from 9.8% as of the second quarter. Actual CPRs for the quarter averaged 7.1% compared to 6.6% for the prior quarter. I’ll now turn the call over to Chris Kuel to discuss the agency mortgage market.

Christopher Kuehl: Thanks, Bernie. The start of the third quarter was relatively favorable for both US treasuries and Agency MBS as inflation data continued to show a downward trajectory and regional bank sector stress faded into the background. In fact, treasury yields rallied and Agency MBS tightened over the first few weeks of July. This favorable sentiment shifted, however, when the treasury released its borrowing estimate, which was larger than anticipated. Following the September FOMC meeting, the sell-off in treasuries accelerated with five and 10-year treasury yields ultimately increasing 45 and 73 basis points, respectively, as of 9/30 with two-year yields moving only modestly higher, the yield curve steepened significantly during the quarter.

Against this challenging backdrop, Agency MBS underperformed both treasury and swap based hedges with performance varying considerably depending on hedge positioning on the curve. Coupon positioning was also a significant driver of performance as lower and middle coupons materially underperformed production coupons. Our portfolio increased modestly from $58 million to $59 billion as of September 30th. Within our agency holdings, we continue to move up in coupon at more attractive yields and wider spreads. During the quarter, we added approximately $10 billion in 5.5 through 6.5 versus lower coupons. We also converted a material portion of our TBA position to a mix of both high quality and low pay-up specified pools. Our remaining TBA position was largely comprised of Ginnie Mae TBA given attractive valuations and better roll implied financing relative to UMBS.

As of 9/30, our hedge portfolio totaled $63.2 billion, given the duration extension in our assets, we increased the duration of our hedge portfolio primarily by adding treasury-based hedges at the 10-year point of the curve. As a result, our duration gap remained low throughout the quarter and was 0.2 years at quarter end. As of 9/30, approximately 70% of our hedge portfolio duration dollars are at the seven-year or longer points on the yield curve with approximately 50% of our duration in Treasury-based hedges. Looking forward, our outlook for Agency MBS is very favorable. Spreads have decoupled from treasuries and corporates due to supply and demand technical factors that we expect will ease over time. And as Aaron will describe in more detail, spreads and other fixed income sectors are close to post-GFC long-term averages, while spreads on Agency MBS are in the 95-plus percentile area.

This is especially remarkable given that the fundamentals for Agency MBS have rarely looked as compelling as they do today. Organic agency supply is minimal, prepayment risk is deeply out of the money and repo markets for Agency MBS are deep and liquid. With spreads as wide as they are today, we believe investors in Agency MBS are well compensated for elevated rate volatility over the near term. That being said, geopolitical tensions have increased the near-term risk quotient. And while we believe we are in one of the most favorable earnings environments of our history, we will remain disciplined with respect to managing rate risk and leverage. I’ll now turn the call over to Aaron to discuss the non-agency markets.

Aaron Pas: Thanks, Chris. The significant interest rate volatility and the sharp move higher in yields by the end of the quarter had a more material impact on interest rate sensitive products than credit spreads. Credit spreads were mixed in the third quarter and many sectors of the market generated slightly positive excess returns. As a proxy for credit spread moves in Q3, the synthetic IG index was eight basis points wider, while the Bloomberg IG Index representing spreads on cash bonds was actually two basis points tighter over the quarter, both outperformed mortgage spreads. The majority of fixed income credit spreads are currently at valuations far from extreme levels, unlike Agency MBS. Taking a step back, while MBS are near their widest spread since the GFC by almost any measure, CDX IG spreads are roughly at their average over the past 15 years.

A brief overview of several consumer fundamentals suggest that weakening is developing, albeit slowly. Auto loans, credit cards and marketplace lending delinquencies have ticked higher. Additionally, the resumption of student loan payments this month will stretch a relatively broad segment of households even further. While excess savings numbers have been revised higher recently, lower income and renter households have likely drawn down a material amount of savings as a result of increased exposure to inflationary pressures. Taken together, the outlook for the consumer has declined and will contribute to further economic slowdown. That said, we expect a much more muted impact on the mortgage side due to the significant amounts of homeowners’ equity resulting from several years of strong HPA growth.

Turning to our holdings. Our non-agency portfolio is roughly unchanged in size, ending the quarter at just over $1 billion in market value. Within CRT, we turned over roughly 15% of the portfolio and continue to skew holdings to reposition into likely tender candidates or migrating further down the credit stack in seasoned and de-levered profiles. The favorable technicals in the CRT market that we discussed on last quarter’s call remain in place, low issuance volumes, coupled with the GSE desire to extinguish older credit protection via tender offers. This drove further spread tightening on our CRT portfolio during the quarter. The meaningful valuation improvement throughout this year has correspondingly led to lower expected go-forward return expectations.

Nevertheless, the risk side of the equation has declined as we expect lower spread and price volatility for many of our CRT securities as certain segments of the market have become anchored to some degree. With that, I’ll turn the call back over to Peter.

Peter Federico: Thank you, Aaron. Before opening the call up to your questions, I want to briefly discuss our current common stock dividend. We do not provide forward guidance for our dividends, but I do want to share some thoughts on the dividend in the current environment. As I have mentioned many times, one of the primary factors that we evaluate in setting our dividend is the economic return that we expect to earn on our portfolio at current MBS valuation levels. You can think of this return as the mark-to-market return on our portfolio. Given the significant spread widening that has occurred over the last two years in Agency MBS and the subsequent decline in tangible net book value per share and stock price, the dividend yield on our common stock has increased notably.

At the end of the third quarter, the dividend yield on our tangible net book value of our common equity was close to 18%. While this number is informative, it does not include the benefit of our lower cost preferred equity, which is also permanent capital. Including this preferred component, our dividend yield on total equity including both our contractual preferred stock dividends and our current common stock dividend was approximately 15% at the end of the third quarter, including our operating expenses, the required yield on our total capital was just over 16%. Said another way, as of the end of the third quarter, we needed to earn a 16% return on our total tangible equity capital base of $6.9 billion in order to satisfy all of our operating costs and dividend obligations.

At current valuation levels, the expected levered return on Agency MBS depending on coupon is in the mid-teen to low 20% range before convexity and rebalancing costs. The important takeaway from this analysis is that our common stock dividend remains well aligned with the return that we expect to earn on our portfolio at current valuation levels and operating parameters. That said, we continuously evaluate our dividend as market conditions, expected returns and risk management considerations are always changing. With that, we will now open the call up to your questions.

Operator: We will now begin the question-and-answer session. [Operator Instructions] Our first question will come from Crispin Love with Piper Sandler. You may now go ahead.

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Q&A Session

Crispin Love: Thanks. Good morning, everyone. I appreciate you taking my questions. First off, can you just give us your updated thoughts on leverage just based on the preannouncement last week, you were at, I think, about 8.2 times as of October 20th. But what are the ranges that you’re comfortable operating at? And what is the max level that you would operate at before needing to bring it lower?

Peter Federico: Sure. Thank you for the question and good morning, Crispin. You’re right. We reported that our updated leverage was as of about a week ago, 8.2%, up from 7.9% at the end of the quarter. As we sit today, our leverage actually is more in line with where it was at the end of the quarter, right around 7.8%. And we’re comfortable — very comfortable operating in the current leverage range. Obviously, mortgages are extraordinarily cheap. We would love to operate with higher leverage, given how cheap mortgages are, but we also have to be very cognizant of the volatile market conditions that are broadly affecting all fixed income markets, particularly the treasury market. The other thing that I would also point out is, as we disclosed and as Bernie mentioned, from a leverage perspective, and this gets to sort of your maximum leverage question, which is that we continue to operate with a very significant unencumbered cash and security position, as Bernie mentioned, it was 52% at the end of last quarter.

It’s still in the mid-50s, actually as we sit today. So we have a lot of capacity and we are waiting for the right opportunity. And I think that opportunity ultimately will come as the market, all the uncertainties that the market had to contend with in the third quarter subsided. So I can’t give you an answer specifically on the maximum leverage because that’s sort of an environmental question. It will have to — it has to be consistent with the environment that we’re in, the volatility of interest rates, the expectation about spreads, where you are at spread levels. But right now, given how cheap mortgages are Obviously, it is a good investment time. Ultimately, we need some more stability overall in the financial markets, particularly from the Fed and stability in the treasury market.

So I’ll pause there.

Crispin Love: Thanks, Peter. All very helpful there. And then just kind of on your point on how cheap mortgages are. Can you just give an update on your outlook for spreads, they remain very cheap. But curious on your outlook and if it’s changed at all over the last kind of several weeks and months on spreads being range bound in your expectations there?

Peter Federico: Yes. There’s a lot to like about the mortgage market. And in our prepared remarks, I talked about the fact that the current coupon is close to 7%. So what I think is interesting about the mortgage market right now from a return perspective is that it’s highly appealing to a very broad cross-section of investors. From an unlevered perspective, Agency MBS offer extraordinarily value, almost 200 basis points over the treasury curve for security that is — has the guaranteed support of the US government. So and if you look at Agency MBS relative to corporates, high-grade corporates in particular, it’s a significant yield pickup. So I think it’s very attractive on an unlevered basis. And as I mentioned in my prepared remarks, I do think that the Agency MBS market from a spread perspective is starting to establish a new range, which I believe is somewhere — if you think about it versus the five and 10-year treasury current coupon as our starting point.