AGNC Investment Corp. (NASDAQ:AGNC) Q1 2023 Earnings Call Transcript

AGNC Investment Corp. (NASDAQ:AGNC) Q1 2023 Earnings Call Transcript April 25, 2023

AGNC Investment Corp. beats earnings expectations. Reported EPS is $0.7, expectations were $0.65.

Operator: Good morning, and welcome to the AGNC Investment Corporation First Quarter 2023 Shareholder Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. 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 first 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 Federico: Thank you, Katie. The performance of Agency mortgage-backed securities in the first half of the quarter was very strong, continuing the positive momentum that began last November. This led to a notable increase in our net asset value through mid-February. These favorable conditions, however, gave way to a more challenging investment environment in the second half of the quarter, as regional bank instability dramatically altered the macroeconomic and monetary policy outlook, and led to a material increase in interest rate volatility and rapid repositioning of fixed income portfolios. As a result, the strong improvement in our net asset value early in the quarter turned into a modest decline by quarter-end. Following stronger-than-expected economic data in January, the Fed raised the federal funds rate by 25 basis points at the February 1 meeting and indicated more hikes were likely and that short-term rates would remain higher for longer.

By early March, the terminal fed funds rate implied by the futures market approached 6%, indicating that another 100 basis points of tightening was likely. Against this backdrop, the yield curve became meaningfully inverted with the 2-year to 10-year treasury yield differential reaching negative 108 basis points in early March. This sharply inverted yield curve and more aggressive monetary policy outlook raise serious questions about bank earnings and unrealized losses on their asset portfolio. These concerns ultimately led to the abrupt failure of Silicon Valley Bank and drove a dramatic repricing and monetary policy expectations. At the peak of the banking uncertainty, meaningful rate cuts were expected over the remainder of the year rather than rate increases, as previously indicated by the Fed.

In this highly uncertain environment, interest rate volatility increased to crisis levels. As an example, the MOVE index, which measures treasury market volatility, reached a 15-year high. Short-term interest rates experienced the greatest volatility, with the yield on the 2-year treasury dropping 61 basis points in a single day, unmatched by any day during the great financial crisis. Longer-term treasury rates were also volatile with the yield on the 10-year treasury increasing 60 basis points in February and falling by a similar amount in March. Predictably, this volatility adversely impacted Agency MBS. The possibility of bank selling, which became a reality with Silicon Valley Bank, also weighed on Agency MBS performance late in the quarter.

Given these banking issues, the supply and demand outlook for Agency MBS is now more uncertain. Over the near term, it is likely that banks will not be meaningful buyers of MBS and, in some cases, could be sellers. Over the last two years, the fixed income markets experienced a significant repricing as the Fed tightened monetary policy at a historic pace. Agency MBS have been uniquely impacted with the spread between the current coupon MBS and the 10-year treasury, widening 135 basis points since April 2021. Importantly, we believe this repricing is in the late stages and that a new trading range is emerging. More specifically, we think spreads could remain at these compelling levels until this tightening cycle is well behind us. Such spread levels provide investors with meaningful incremental return and are about double the average of the last 10 years.

We also believe agency MBS are attractively priced and adequately compensate investors for the volatility and uncertainty that characterized the U.S. treasury and Agency MBS markets today. In addition for investors seeking the highest credit quality and incremental return, Agency MBS provide a compelling alternative to U.S. treasuries. As we mentioned last quarter, the path to stability is not a straight line and the first quarter is a good reminder of that. But despite the headwinds that we encountered in March, our outlook continues to be very positive. A key driver of this optimism is our belief that our portfolio can generate mid-teen returns at current valuation levels and without spread tightening. For much of the last 15 years, we have competed with the world’s largest and most price and sensitive buyer of Agency MBS.

As the Fed and now banks repositioned their balance sheets, we find ourselves in the favorable position of being one of the few permanent capital vehicles dedicated to Agency MBS at a time when valuations are historically attractive and appear poised to remain that way for some time. Also important, unlike banks, our interest rate exposure is conservatively hedged and our portfolio is fully mark to market. As such, when you invest in AGNC today, you are buying into a levered and hedged portfolio priced at today’s historically attractive valuation levels, making this opportunity very similar to 2009, which was one of AGNC’s most favorable periods. With that, I will now turn the call over to Bernie Bell to discuss our financial results in greater detail.

Bernie Bell: Thank you, Peter. For the first quarter, AGNC had a comprehensive loss of $0.07 per share. Economic return on tangible common equity was negative 0.7% for the quarter, comprised of a decrease in our tangible net book value of $0.43 per share and $0.36 of dividends declared per common share. As of last Friday, tangible net book value was down about 1% for April. Leverage at the end of the quarter was 7.2 times tangible equity, down from 7.4 times as of the fourth quarter, driven by a reduction in our asset balance and the addition of $171 million of common equity raised through our at-the-market offering program. This issuance occurred opportunistically during the quarter at levels that were meaningfully accretive to book value.

Our average leverage for the quarter was 7.7 times tangible equity compared to 7.8 times for the fourth quarter. As of quarter-end, we had cash and unencumbered Agency MBS totaling $4.1 billion or 57% of our tangible equity, and $70 million of unencumbered credit securities. Net spread and dollar roll income excluding catch-up amortization was $0.70 per share for the quarter, a decline of $0.04 per share from the fourth quarter due primarily to somewhat higher funding cost and the addition of new longer-term pay fixed swap hedges. Lastly, the average projected life CPR in our portfolio at the end of the quarter increased to 10% from 7.4% as of the prior quarter-end, consistent with moderately lower forward mortgage rates and a higher average coupon in our portfolio.

Actual CPRs for the quarter declined to 5.2%. I’ll now turn the call over to Chris Kuehl to discuss the Agency mortgage market.

Chris Kuehl: Thanks, Bernie. The first quarter was marked by extreme rate volatility. The tailwind of a growing consensus around the outlook for Fed policy and expectations for lower rate volatility carried over from year-end through the month of January, leading to one of the strongest months on record for Agency MBS performance. But that tailwind abruptly ended in February with the release of much stronger-than-anticipated economic data, and in turn, material repricing of expectations for further Fed policy tightening. Against this more challenging backdrop, Agency MBS materially underperformed hedges in the second half of the quarter. Performance across the coupon stack varied considerably with 3.5% through 4.5%, outperforming production coupons early in the quarter and lower coupons materially underperforming in March as the market priced the impending supply shock following the failures of Silicon Valley Bank and Signature Bank.

Higher coupons widened as well in sympathy with lower coupons, although to a lesser degree. In total, interest rates rallied approximately 40 basis points and 2s through 10s. From this perspective, the quarter appears much more benign than what actually occurred. Given the extreme intra quarter rate volatility and stress in the regional banking system, it is not surprising that mortgages underperformed. Since quarter-end, rate volatility has declined materially as contagion concerns in the banking system have subsided somewhat and economic data appears support of a Fed policy nearing the terminal level for rates. Despite relatively common markets, the overhang of supply from the FDIC and related bank failures has driven Agency par coupon spreads 10 basis points wider since quarter-end to approximately 163 basis points to a blend of 5- and 10-year treasuries.

Our Agency MBS portfolio declined to $56.8 billion as of March 31, down from $59.5 billion at the start of the year as we adjusted leverage lower to enhance flexibility to add Agency MBS as a result of the highly volatile market environment. Despite relatively weak roll implied financing levels during the quarter, specified pool performance generally lagged TBA performance. We took advantage of these weaker specified pool valuations by increasing AGNC’s holdings by a little over $5 billion while reducing our TBA position by approximately $8 billion. With respect to our coupon positioning, we continued to gradually move up in coupon with the weighted average coupon of the portfolio increasing approximately 10 basis points during the quarter.

As of March 31, the hedge portfolio totaled $59.7 billion and our duration gap was 0.2 years. Our hedge ratio declined to 114%, consistent with the expectation that we are nearing the terminal stage of the Fed tightening cycle. And as we have discussed, we expected to gradually shift the composition of our hedge portfolio towards a greater share of longer dated hedges to address the risk of a yield curve steepening. This effort continued in the first quarter and was most pronounced in our treasury holdings where we added intermediate term treasuries while maintaining a short position in longer-term treasury-based hedges. Looking ahead, the combination of wide spreads, low prepayment risk and robust funding markets for Agency MBS creates what we believe to be an extraordinarily attractive and durable earnings environment.

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

Aaron Pas: Thanks, Chris. Considering the significant interest rate volatility, the shifting inflation and economic outlook as well as two large bank failures, credit spreads were, on the whole, fairly well behaved. To put the performance in perspective, in the days following the failure of SVB, the CDX investment grade and high yield indices widen to 91 and 533 basis points, respectively. These (ph) wides were significantly tighter than what occurred during the U.K. liability-driven investment crisis late in the third quarter. In addition, both were tighter at (ph) as compared to year-end. Post SVB, falling rates or rising bond prices for benchmark bonds provided support for the spread product complex. Unlike in September, when spreads and rates both drove bond prices lower, the large rally across the curve towards the end of the first quarter helped dampen credit spread widening.

This likely contributed to better performance with reduced forced selling and deleveraging and bolstering credit spread performance. Consistent with these themes, residential credit spreads performed well in the first quarter. On the run, CRT closed largely unchanged to slightly tighter over the prior quarter, while pockets of seasoned CRT tightened more meaningfully. The residential credit space likely will be a favorite asset class in the near term as credit concerns play out in other asset classes. The residential space as a whole is still supported by low mark-to-market LTVs and conservative underwriting. This results in reduced sensitivity to even moderate housing shocks or a small increase in unemployment. Turning to our holdings, our non-Agency portfolio ended the quarter at $1.3 billion, a decline of approximately $100 million from year-end.

The majority of the decline was driven by sales of AAA CMBS. With wide Agency MBS valuations, and a stronger relative funding outlook, surrogate investments for Agency MBS such as high grade residential and commercial back cash flows have become less attractive for us to hold. Our CRT portfolio was little changed in the first quarter and performed well due to the composition of our holdings. We continue to maintain a high allocation of bonds that provide little to no capital relief to the GSEs. As such, our expectation is for the GSEs to attempt to extinguish this protection over time by tendering the securities at above prevailing market levels. In fact, just yesterday, Fannie Mae announced the tender for seasoned CRT. We expect these tenders to drive favorable total returns for this portion of our whole.

With that, I’ll turn the call back over to Peter.

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

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Q&A Session

Operator: We will now begin the question-and-answer session. And our first question here will come from Rick Shane with J.P. Morgan. Please go ahead with your question.

Rick Shane: Good morning, everybody, and thanks for taking my question. Look, we’re obviously at a really confusing crossroads right now in terms of rates. I suspect a lot easier to manage the portfolio when there’s clear direction. Can you talk a little bit about how you balance levering up in this environment, the hedge strategy and what the signals you will look for to weigh in more aggressively once you see the market taking a direction?

Peter Federico: Sure. Thank you for the question, Rick. It’s a good question to start with. There’s a lot to it and I might leave some things out, so if I miss some of it, ask more. But first let me talk about leverage and sort of the issue that you raised is it is a really challenging environment and that’s sort of to be expected when you think about it. We’re right at sort of the end of the Fed tightening cycle and I think the Fed tightening cycle is going to end at the next meeting whether they raise 25 basis points or pause or just simply pause here, I think it’s likely the last move. So, it’s not surprising that the market is so, if you will, sensitive right now. And really when you go back and you think about the concerns that the market confronted last September, really the issue that destabilized the market was the concern that the Fed would go too far and ultimately cause something in the financial system to break and that in fact happened in March.

And now as we look forward, I think the Fed now understands that and they’ve made it clear that the instability that occurred in the banking system is going to have a material impact on credit availability and ultimately slow the economy down and ultimately act as a tightening of monetary policy. So, I think we’re near the end of that process. I also think that, as Chris mentioned in his prepared remarks, we are starting to see some stabilization in the banking system, which is obviously very good for everybody. But we had to sort of deal with that instability and uncertainty in March and that’s one of the reasons why we maintained a fairly defensive leverage position. We actually sold some assets net during the quarter. As Bernie mentioned, we used our ATM accretively to help manage our desired leverage position.

So, I think that worked out beneficial to our shareholders. And we put ourselves importantly — and this gets to the sort of the outlook, we put ourselves in a position now where we have I think a lot of flexibility. And I think that there’s going to be opportunities that arise in the mortgage market, and given our liquidity position, given our leverage position, I think we’re really well positioned to take advantage of those. Now another key point though, and this is what I think makes this environment so unique and so favorable and I tried to touch on this in my prepared remarks is that we really don’t feel any sense of urgency with respect to meaningfully changing our leverage profile because we think spreads are going to remain fairly stable in this area.

And I think it’s likely going to — spreads will likely remain at these levels, which I think are cheap by anybody’s measure regardless of how you look at them across the curve. They’re going to remain, generally speaking, in this area for the foreseeable near-term future. And that really gives us an opportunity to be patient and to adjust our portfolio over time. But in the meantime, as I said, our portfolio can generate really attractive returns. So, we think we’re sort of at the end of this repricing process. And I think we’re going to stay here for a fairly meaningful period of time and that really gives us a lot of flexibility. A couple of comments with (ph) hedging, because you did bring that up. We did start to change the composition of our hedge portfolio as can be seen in some of our numbers, and as Chris mentioned, consistent with the Fed coming to the end of the tightening cycle.

As the Fed shifted from an easing cycle to a tightening cycle, we talked about this, we wanted to have a greater portion of our hedges in the front part of the curve because we expected yield curve to invert, which it clearly did. And as the Fed comes to the end of the cycle, we would expect the opposite to happen, and that has started to happen. We expect the yield curve to steepen and ultimately the front end of the market to rally more. And so, in that environment, we’ll likely operate with a lower hedge ratio. Chris mentioned it went down to 114%. As we sit today, it’s actually under 100%, and we’ll likely operate with a greater share of longer-term hedges so that we have a little bit more exposure to the yield curve steepening and that would benefit our hedge portfolio.

So, I’ll pause there and let you ask a follow-up, if there is any.

Rick Shane: No, great answer, very helpful, and I will pass the baton.

Peter Federico: All right. Appreciate it, Rick.

Operator: Our next question will come from Trevor Cranston with JMP Securities. Please go ahead with your question.

Trevor Cranston: Hey, thanks. Good morning.

Peter Federico: Good morning, Trevor.

Trevor Cranston: A follow-up on the comments you guys have made already about sales of the failed banks portfolio is coming to market. Can you talk about how much of that you think is priced in versus how much additional widening we might see as those sales actually come to market? And how much — like who you see as the marginal buyer and how much capacity they have to absorb that right now? Thanks.

Peter Federico: Yes, let me just start and then I’ll pass it over to Chris. I think the market has had enough time to digest that information. It’s now pretty well understood what exactly they’re selling and it was a little bit different than the expectations initially, and Chris can talk about the composition that will ultimately come to market. But I think the FDIC essentially has done a good job in working with BlackRock to really make it clear that they are going to tread lightly, if you will, with respect to how they dispose of these assets. It’s important that they maximize value, and doing so, that’s going to take them a long time. I suspect this is going to take the better part of the year. And they’ll adjust according to market conditions and as liquidity and demand shows up. But I think there could be some opportunities in that portfolio, and Chris can talk a little bit about that.

Chris Kuehl: The only thing I’d add, I mean, what we learned last week was the composition and the likely pace for liquidation by asset class. And as Peter said, the pace of sales is a bit longer than maybe what the market feared or at least some had feared. There’s $60 billion in pass-throughs that are expected to be sold at a pace of around $6 billion to $7 billion per month, and so, roughly eight to nine months. $22 billion in CMOs that are expected to be sold at a pace of around $1.6 billion per month. So that’s a little over a year. And then, there’s $14 billion of CMBS and $7 billion in munis. Lower coupons widened materially up to this event. And so, I would say, I would expect the generic sort of 30-year pass-throughs to trade pretty well.

I think there are a few categories within the pass-through position that trade with pay-ups that could trade at very wide spreads. There are few categories within the CMO holdings that could also trade at very wide levels. We’ll have to see. We’ll certainly be engaged on the list as they come out. The first round of list last week traded well. We’ll have to see how things go. But with the disclosure, as Peter said, they also had some market-friendly language that suggested that the FDIC does want to minimize adverse impacts on market functioning and they’re going to consider trading conditions and liquidity on any given day. But there should be some opportunities in some of the less liquid sectors for us.