AGNC Investment Corp. (NASDAQ:AGNC) Q4 2022 Earnings Call Transcript

AGNC Investment Corp. (NASDAQ:AGNC) Q4 2022 Earnings Call Transcript January 31, 2023

Operator: Good morning and welcome to the AGNC Investment Corp. Fourth Quarter 2022 Shareholder Call. Please note 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 fourth quarter 2022 earnings call. Before I 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 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 will turn the call over to Peter Federico.

Peter Federico: Thank you, Katie. Throughout our 15-year history, we have noted that rapid and sizable interest rate changes are the most challenging environments for levered fixed income investors. Importantly, however, these transitions have generally preceded our most favorable investment environments. As I will discuss in greater detail, the investment opportunity ahead could be one of the most favorable and durable in AGNC’s history. For the fixed income markets, 2022 was among the worst years ever experienced. Interest rates across the yield curve moved materially higher as the Fed increased the federal funds rate 425 basis points in just 9 months, the yield on the 10-year treasury increased by close to 250 basis points.

To put that move in historical context, the total return on the 10-year treasury in 2022 was the worst annual performance in over 100 years. The sharp increase in treasury rates pushed mortgage rates to their highest level in more than two decades. Agency MBS often underperformed other fixed income asset classes during significant market downturns. This was indeed the case last year as spreads across the mortgage coupon stack widened to levels rarely seen before. Similar to the 10-year treasury, the total return on the Agency MBS index in 2022 at negative 12% was the worst year on record dating back to 1980. These challenging conditions peaked in September and October when monetary policy and macroeconomic uncertainty was at its highest point.

On our third quarter earnings call, we highlighted the tension between extraordinarily attractive investment returns and highly uncertain financial market conditions. We also noted our expectation that a uniquely favorable investment environment would eventually emerge. Since that time, bond market sentiment has improved materially. This positive shift coincided with investors recognizing the unique investment opportunity available in Agency MBS on both a levered and unlevered basis. At the same time, weaker inflation data allowed the Fed to slow the pace of monetary policy tightening, which in turn led to a decline in interest rate volatility. These positive developments attracted investors back to the fixed income markets. The key question for investors today, of course, is not what happened, but rather where do we go from here?

Will the Agency MBS market revert back to the challenging conditions to characterize 2022 or is the outlook for 2023 more favorable? We strongly believe it is the latter. We believe the positive shift in bond market sentiment that occurred in November likely marks the beginning of the recovery for Agency MBS. Market shifts like this evolve over time and are not linear. But that said we do believe the recovery is underway. This favorable outlook for Agency MBS is supported by several positive dynamics. First, even though Agency MBS spreads tightened in the fourth quarter, they remain wide by historical standards and continue to represent a compelling investment opportunity. This is especially true for levered investors such as AGNC given the significant improvement in funding that has occurred over the last several years.

Moreover, while biased tighter, we believe spreads will remain wider than previous historical averages. This would be a welcome development for AGNC and supportive of our ability to generate attractive returns for shareholders over time. Second, the demand for Agency MBS will likely outpace the supply even without Fed purchases. Ongoing affordability challenges and a slower housing market will limit the organic supply of Agency MBS this year. In addition, runoff on the Fed’s portfolio will be extremely slow given minimal refinance activity. Third, interest rate volatility is poised to decline. The Fed has already slowed the pace of rate increases and is nearing the inflection point in monetary policy. If inflation data continues to moderate and the Fed pauses, interest rate volatility should fall materially.

Greater interest rate stability and a more stable economic outlook could reignite bank demand for Agency MBS and increase the demand for fixed income securities more broadly from a wider range of investors. So to summarize, we believe strong investor demand, manageable supply and improving interest rate stability together strengthen the outlook for Agency MBS. Importantly, with the Fed expected to gradually unwind its mortgage portfolio over the next several years, this environment could also prove to be more durable than previous episodes. With spreads above historical norms and funding conditions favorable, AGNC is well positioned to generate attractive returns for shareholders without compromising our long-standing risk management discipline.

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

Bernie Bell: Thank you, Peter. For the fourth quarter, AGNC had total comprehensive income of $1.17 per share. Economic return on tangible common equity was 12.3% for the quarter comprised of $0.36 of dividends declared per common share and an increase in our tangible net book value of $0.76 per share. The strong increase in our tangible net book value of 8.4% for the quarter was driven by a tightening of spreads between our mortgage assets in swap and treasury-based hedges. As of last Friday, tangible net book value was up approximately 10% for January. Leverage at year-end was 7.4x tangible equity, down from 8.7x as of the third quarter, primarily due to the improvement in our tangible net book value and a lower asset balance.

Average leverage for the quarter was 7.8x tangible equity compared to 8.1x for the third quarter. During the fourth quarter, we also opportunistically issued approximately $187 million of common equity through our at-the-market offering program. As of quarter end, we had cash and unencumbered Agency MBS totaling $4.3 billion or 59% of our tangible equity and $100 million of unencumbered credit securities. Net spread and dollar roll income, excluding catch-up amortization, was $0.74 per share for the quarter. The decline from $0.84 per share for the third quarter was primarily a function of our smaller asset base, higher repo funding cost and lower dollar roll income, which offset higher asset yields and higher interest rate swap income for the quarter.

Lastly, our average projected life CPRs as of the end of the quarter increased modestly to 7.4%, while actual CPRs continue to slow meaningfully averaging 6.8% for the quarter. I will now turn the call over to Chris Kuehl to discuss the agency mortgage market.

Chris Kuehl: Thanks, Bernie. As Peter discussed, Q4 marked a decisive turn for fixed income markets. Interest rates peaked in October with 5-year treasury yields reaching nearly 4.5% before retracing the move as the outlook for Fed policy solidified on evidence that inflation is beginning to slow. The par coupon agency spread to a blend of 5 and 10-year treasury hedges widened to 180 basis points in October before GAAP being tighter as sentiment turned and investors took advantage of the highest yield levels and wider spreads on production coupon Agency MBS in more than 10 years. Early in the quarter, lower coupon MBS materially underperformed higher coupons. However, as index-based fixed income bond fund flows improved, lower coupons made up for much of the early underperformance to end the quarter only marginally behind production coupons with the entire coupon stack outperforming treasury and swap-based hedges.

During the fourth quarter, we continued to optimize our holdings with a bias towards 30-year production coupon MBS. As of December 30, our asset portfolio totaled $59.5 billion. Our hedging activity during the quarter was relatively minimal, although we did opportunistically move a portion of our hedges to points further out the curve. At quarter end, the hedge portfolio totaled $67.6 billion and our duration gap was 0.4 years. Over time, as the Fed reaches its desired short-term rate level, our hedge ratio will gradually decline and our hedge composition will likely shift towards a greater share of longer term hedges. As Peter mentioned, the outlook for returns this year is favorable. Despite the outperformance in the fourth quarter, spreads on production coupon MBS are still materially wider than the average levels during 2018 and 2019 when the Fed was last reducing its balance sheet.

From current levels, we are not expecting significant tightening, but we do expect to extract the economic value from wider spreads for strong earnings over time. The combination of wide spreads, low prepayment risk, and robust funding markets for Agency MBS has created an attractive in what we believe will be a durable investment environment. I will now turn the call over to Aaron to discuss the non-agency markets.

Aaron Pas: Thanks, Chris. Credit spreads in the fourth quarter tightened for most sectors and across the capital structure as inflation data eased and the economic outlook improved. In response to the strong performance, we opportunistically sold about $300 million in non-agency securities over the quarter, ending the year with a total portfolio of $1.4 billion. While we did reduce our portfolio allocation and credit, we remain very comfortable from a credit perspective with our current composition of our non-agency portfolio and our specific holdings. The majority of our residential credit holdings are backed by or reference seasoned loans and as such, now benefit from a significant amount of house price appreciation. On the commercial side, the vast majority of our securities are supported by significant levels of credit enhancement.

Looking forward, issuance in both residential and commercial mortgage sectors is expected to remain relatively low. The supply dynamic has contributed to spread tightening year-to-date, particularly against the backdrop of inflows into fixed income. As a result, we expect most spread product to trade directionally with rates barring a material repricing associated with a more severe recession than currently anticipated. Should bond fund inflows accelerate, we expect this would be favorable for spreads against the lower supply backdrop. With that, I will turn the call back over to Peter.

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

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Q&A Session

Operator: Excuse me. I apologize for the inconvenience. The first question comes from Vilas Abraham with UBS. Please go ahead.

Vilas Abraham: Hi, everybody. Thanks for the question. Can you guys talk a little bit more about the hedge book at this stage in the tightening cycle? And what are the different scenarios you’re thinking about there? And then just also, I know just the net duration did drop a bit quarter-over-quarter. So if you could touch on that, too. Thanks.

Peter Federico: Sure, good morning, Vilas. And again, we apologize for the technical difficulties this morning. But with respect to the hedge portfolio, Vilas, I think you’re sort of alluding to it correctly at a high level. What you’ve seen us do with our hedge portfolio is shift our hedge portfolio to the sort of monetary policy and economic environment that we’re in. In an environment, for example, where the Fed is tightening aggressively like it has been, the yield curve tends to invert. And so what you saw us do is operate with a very high hedge ratio to give us a lot of protection against for our short-term debt repricing and then also front-end load our hedges more to the 1 to sort of 5-year part of the curve because that’s the part of the curve that tends to underperform.

And that has certainly been the case as the Fed has aggressively tightened monetary policy over time. In fact, Chris alluded a little bit to this. As the monetary policy position from the Fed evolves and ultimately, they are getting close to the point where they are going to pause and then looking further down the road, there will eventually be a point where the market will repricing and even more aggressive easing than the market is currently pricing in. You could expect us to evolve our hedge position again to that environment. And in that scenario, if you look back in history, what we tend to do is operate with a less than 100% hedge ratio over time and fewer shorter-term hedges because obviously, the front end of the curve is going to be the part of the curve that will ultimately outperform.

And ultimately, with the yield curve being as inverted as it’s now, I think it’s unsustainably obviously, inverted, there’ll be a time when the yield curve will be more positively. So we would benefit from having a hedge position that has a greater share of longer-term hedges in a smaller portion of shorter-term hedges. On the duration gap, Chris can talk a little bit about that. But you’re right, we are operating with a slightly smaller duration gap in this environment.

Chris Kuehl: I’ll just add. I mean, our duration gap shortened about 0.8 of a year during the quarter, and the majority of that was driven by repositioning into higher coupons within the 30-year MBS portfolio. The par coupon mortgage rate also declined about 30 basis points during the quarter. And so that, too, had the effect of shortening the duration of our asset portfolio. And as Peter mentioned, we shifted a portion of our treasury based hedges to longer key rate buckets and our activity there shortened the duration of the aggregate hedge portfolio by about 0.2 of a year. I just €“ there is a great obvious curve rate or duration trade. The best trade is only mortgages without making a lot of bets on rates, which is why we don’t have much of a duration gap.

And just to echo Peter’s comments, given the correlation between spreads, rates and Fed policy, we’ve maintained a relatively high hedge ratio on the front end of the curve as that’s the biggest risk to spreads as aggressive Fed policy.