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Edited Transcript of AGNC earnings conference call or presentation 31-Jan-19 1:30pm GMT

Q4 2018 AGNC Investment Corp Earnings Call

BETHESDA Feb 4, 2019 (Thomson StreetEvents) -- Edited Transcript of AGNC Investment Corp earnings conference call or presentation Thursday, January 31, 2019 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Aaron J. Pas

AGNC Investment Corp. - SVP

* Bernice E. Bell

AGNC Investment Corp. - SVP & CFO

* Christopher J. Kuehl

AGNC Investment Corp. - EVP of Agency Portfolio Investments

* Gary D. Kain

AGNC Investment Corp. - CEO, CIO & Director

* Katie R. Wisecarver

AGNC Investment Corp. - VP of IR

* Peter J. Federico

American Capital Agency Management, Llc - Chief Risk Officer and SVP

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Conference Call Participants

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* Bose Thomas George

Keefe, Bruyette, & Woods, Inc., Research Division - MD

* Douglas Michael Harter

Crédit Suisse AG, Research Division - Director

* Mark C. DeVries

Barclays Bank PLC, Research Division - Director & Senior Research Analyst

* Richard Barry Shane

JP Morgan Chase & Co, Research Division - Senior Equity Analyst

* Trevor John Cranston

JMP Securities LLC, Research Division - Director and Senior Research Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the AGNC Investment Corp. Fourth Quarter 2018 Shareholder Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.

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Katie R. Wisecarver, AGNC Investment Corp. - VP of IR [2]

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Thank you, Keith, and thank you all for joining AGNC Investment Corp.'s Fourth Quarter 2018 Earnings Call.

Before we begin, I'd like to review the safe harbor statement. This conference call and corresponding slide presentation contains statements that, to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of 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 the Risk Factors section of AGNC's periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law.

An archive of this presentation will be available on our website and the telephone recording can be accessed through February 14, by dialing (877) 344-7529 or (412) 317-0088, and the conference ID number is 10127312. To view this slide presentation, turn to our website, agnc.com, and click on the Q4 2018 earnings presentation link in the lower right corner. Select the webcast option for both slides and audio or click on the link in the conference call section to view the streaming slide presentation during the call.

Participants on today's call include Gary Kain, Chief Executive Officer; Bernie Bell, Senior Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President; Peter Federico, President and Chief Operating Officer; and Aaron Pas, Senior Vice President.

With that, I'll turn the call over to Gary Kain.

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [3]

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Thanks, Katie, and thanks to all of you for your interest in AGNC. Volatility increased significantly during the fourth quarter as concerns around trade, weaker global growth, Fed policy and growing political dysfunction in many regions of the world fueled the dramatic risk-off move in global financial markets. U.S. equities suffered their worst quarter since 2009 and credit spreads widened materially. Interest rates initially rose during the first half of the fourth quarter before dropping significantly in December. The 10-year treasury hit an intra-quarter high of 3.24% in early November before rallying 55 basis points to close the year at 2.69%.

The risk off sentiment in financial markets and the substantial pickup in interest rate volatility pushed Agency MBS spread significantly wider during the quarter. Nominal spreads to the swap curve widened between 20 and 30 basis points on 30-year 3.5s through 4.5s.

As Chris will discuss in a few minutes, some of the spread widening was expected, given the decline in interest rates. However, the bulk of it was due to a combination of larger risk premiums and the increase in applied volatility, which elevated the prices of all options, including those embedded in MBS.

This spread widening more than offset the modest benefit we realized from the decline in rates and led to the 8% reduction in book value for the quarter. Although the wider spreads on Agency MBS hurt our book value in the short run, it also significantly enhances the expected returns on our MBS investments. Against this backdrop, we raised approximately $1 billion of new capital during the quarter that we patiently deployed at very attractive valuations.

Since quarter-end, the S&P 500 has recovered more than half of the losses experienced during Q4 and yet interest rates are largely unchanged. Implied volatility and credit spreads have also retraced a good portion of the moves from the fourth quarter.

Given the modest recovery in Agency MBS spreads since year-end, in our estimation, book value may have recovered almost half of the Q4 decline when we include our projection of the improvement in spreads and rates following yesterday's FOMC meeting.

Looking ahead, we would not be surprised to see the recent rebound in risk assets continue in the short run, especially given a more dovish Fed. But we continue to believe that the global economic slowdown is real and will ultimately take its toll on the U.S. economy.

Our interpretation of yesterday's FOMC meeting is that the Fed abandoned its hiking bias and has shifted to a much more symmetric policy stance. Moreover, given our view that inflation will remain anchored and that U.S. growth is likely to slow, this hiking cycle is potentially over. This is a pretty big deal and something that few would have expected just a few months ago. This more favorable interest rate environment coupled with materially wider MBS spreads should support attractive returns for AGNC as we begin 2019.

At this point, I would like to turn the call over to Bernie to review the results for the quarter.

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Bernice E. Bell, AGNC Investment Corp. - SVP & CFO [4]

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Thank you, Gary. Turning to Slide 4, we had a comprehensive loss of $0.90 per share for the quarter. Net spread and dollar roll income excluding catch-up am was $0.53 per share. The quarter-over-quarter decline of $0.08 per share and net spread in dollar roll income was attributable to several factors. First, our decision to delay deployment of capital during the fourth quarter acted as a temporary drag on net spread income.

As we commented on our last earnings call, we proactively sold Agency MBS and reduced our leverage at the end of September because we believe spreads were bias wider. In October, we allowed our portfolio to contract further.

During November, we began to gradually redeploy capital, including the $1 billion of new capital we raised during the quarter with the majority of our purchases occurring later in the quarter. As a result, our average asset balance relative to our capital base was noticeably low in the fourth quarter.

When comparing our average leverage quarter-over-quarter, this lower asset balance is difficult to see because our leverage calculation is also impacted by the decline in net book value. Normalizing for this decline, our average leverage of 8.4x tangible equity for the fourth quarter would have been just under 8x or notably lower than 8.5x for the prior quarter.

Second, as Peter will discuss in greater detail, another significant factor impacting the decline in our net spread income was higher funding costs and timing differences associated with our interest rate swap hedges.

Lastly, the loss of quarterly management fee income from MTGE following the termination of management agreement in the third quarter contributed a small portion of the quarter-over-quarter decline. Although we received a termination fee in the third quarter that compensated AGNC for the equivalent of 3 years of fee income, we have not included any portion of the termination fee in our net spread and dollar roll income.

As Gary discussed, tangible net book value declined 8% to $16.56 per share as of the end of the quarter due to wider mortgage spreads. But I also want to highlight that spread movements do not alter the cash flow generating capability of our existing portfolio and consequently, the impact on net spread -- or net book value due to spread movements should largely reverse over time as the portfolio matures.

Moving to Slide 5. With our new capital effectively deployed, we ended the year at 9x leverage versus our average at-risk leverage of 8.4x for the quarter.

Turning to Slide 6. For the year, we had a total comprehensive loss of $1.14 and $2.35 of net spread and dollar roll income. Our total economic return for the year was negative 4.9%, including $2.16 of dividends.

During the year, we raised a total of $2.6 billion of new equity capital, which was accretive to both net book value and earnings. As an internally managed mortgage REIT, the new capital significantly enhanced our operating efficiency, further benefiting AGNC's low cost advantage.

With that, I will turn the call over to Chris to discuss the market.

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Christopher J. Kuehl, AGNC Investment Corp. - EVP of Agency Portfolio Investments [5]

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Thanks, Bernie. Let's turn to Slide 7. Volatility in both interest rates and asset spreads increased materially during the fourth quarter, given elevated concerns related to global growth and a reset of expectations for the path of future Fed policy. In the tables on Slide 7, you can see that rates moved sharply lower with 5- and 10-year swap rates rallying 49 and 40 basis points, respectively.

As Gary mentioned, Agency MBS spreads were materially wider with static spreads on 30-year MBS ending the fourth quarter approximately 20 to 30 basis points wider.

In contrast, option-adjusted spreads on 30-year MBS were around 5 basis points wider as the increase in market implied volatility and lower rate levels materially increased the option costs embedded in MBS rather than the OAS itself. This divergence and the change in static spread versus option adjusted spread was particularly large in the month of December with static spreads widening 10 to 15 basis points, while option adjusted spreads were largely unchanged on average.

Some of the static spread widening associated with the sharp move lower in rates is anticipated in our hedging assumptions and therefore, static spread changes can overstate the impact of NAV in a period with large declines in interest rates. Simply put, both OAS and nominal spread metrics are important in quantifying MBS performance. And in a quarter like this, the right answer lies in between the 2 measures. Thus far, into the first quarter, rates have stabilized and Agency MBS spreads have tightened approximately 5 basis points.

Turning to Slide 8, you can see in the top left chart that the investment portfolio increased by approximately $10 billion as we fully deploy the equity raise during the fourth quarter. In the charts on the lower half of Slide 8, you'll notice that our TBA position declined to $7.3 billion, driven by generally weak roll implied financing rates relative to mortgage repo.

Over the near term, weaker roll implied financing rates will likely continue to bias our holdings in favor of specified pools versus TBA.

Over the last 2 quarters, we've added a little more than $11 billion in high-quality specified pools on a net basis, while reducing our TBA position and growing the total investment portfolio by approximately $13.5 billion.

Given the move lower in rates, combined with the deteriorating quality of TBA float and relatively weak roll levels, specified pools have outperformed in the first quarter after lagging the rate move in December, and we expect that these tailwinds will continue to be supportive of higher quality pool valuations.

I'll now turn the call over to Peter to discuss funding and risk management.

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Peter J. Federico, American Capital Agency Management, Llc - Chief Risk Officer and SVP [6]

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Thanks, Chris. I'll start with a brief review of our financing activity. Our financing costs were materially higher in the fourth quarter, particularly in December as the Fed raised short-term rates another 25 basis points.

In addition to the Fed, year-end funding markets were unusually tight and drove a surge in repo rates late in the year. Repo rates began to move materially higher in mid-December when we saw a nearly $50 billion outflow of money from government money market funds just ahead of the national day of mourning in honor of President Bush. Repo rates remained elevated throughout the rest of the year and peaked over the time with the trading range of 3% to 7%. As a result, our average repo rate increased to 2.79% at year-end, up from 2.3% at the end of September and 2.4% at the end of November. Since year-end, repo rates have returned to more normal levels with our average funding cost today being approximately 2.6%.

Our aggregate cost of funds also increased during the quarter with only a portion of the higher repo cost being offset by improvement on the received leg of our pay fixed swaps. The average receive rate on our swap book was 2.48%, up just 11 basis points from the prior quarter despite 3-month LIBOR being materially higher. This divergence is normal as it takes time for our swaps to reset. Over the next couple of quarters, the average receive rate on our swap book will gradually converge with the prevailing 3-month LIBOR rate.

Turning to slides 11 and 12, we provide a summary of our hedging activity and interest rate risk position. Consistent with the growth in our assets, our hedge portfolio increased to $78.5 billion during the quarter with increases in both our swap and treasury positions. Our hedge ratio remained high at 94% of our funding liabilities. As expected, given the rally in interest rates, our duration gap declined to 0.2 years from 0.9 years in the previous quarter.

As we mentioned last quarter, despite the yield curve being flat and minimal earnings benefit, there are still important risk management benefits to operating with the positive duration gap, given the negative convexity of the portfolio and the risk to MBS spreads in a sharp rally.

With that, I'll turn the call back over to Gary.

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [7]

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Thanks, Peter. And at this point, we'll open up the call to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And the first question comes from Bose George of KBW.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [2]

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First, I just wanted to ask about spreads. You gave the number about spread widening and then some improvement. Can you just help quantify where spreads are right now relative to the end of 3Q and what that implies in terms of ROEs?

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [3]

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Well, I guess, relative to the end of the quarter, let's say we're about 5 basis points give or take tighter in static spreads, which is still obviously materially wider than where we were at the end of Q3. So we still view it -- I mean, obviously, I mentioned in my introductory remarks that book value may have recovered almost half of the loss last quarter, but we still see the investment environment as being very favorable both on the spread side and I think from a big picture perspective also on the rate side kind of given the change in the Fed's mindset and obviously, the change in the global economy.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [4]

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And if you just compare it to the ROE that you guys generated on a core basis this quarter -- is whatever 12.5-ish, are incremental returns better than that?

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [5]

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Yes. So if you just do a rough calculation of ROEs, let's say TBA 4% coupon as an example, spreads are pretty close to 100, still static spreads assume over time 10 to 15 basis point funding advantage repo versus 3-month LIBOR, so that gives you a margin of 110 to 115. And with 9x leverage and a 3.5% base yield on mortgages, you're pretty close to 14% on a gross ROE basis. And then, again, given AGNC's very low operating expenses that still can yield you a net ROE expectation of pretty close to 13 and that's a big differentiator versus the space where expense ratios are much higher. So importantly, that -- the 13 is better than what things look like -- materially better than what things looked like a quarter ago.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [6]

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Okay. Great. That's helpful. And then just given the views or the expectations in the market in terms of rates going forward, what are your thoughts on hedging the portfolio? Any potential changes on how you look at that?

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [7]

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It's a great question in this environment, and I remember we got the question on the last call, given how inexpensive it was to hedge duration, why don't you -- why do you run with any duration gap at all? And our response was that when you manage a negatively convex mortgage portfolio where durations drift, 0 is not -- 0 duration gap is not necessarily the best risk management position and we commented that a positive duration gap made sense. Now, the -- kind of the duration drift in our portfolio is much more symmetrical in the 2 directions. So a quarter ago when rates were higher, almost all of the risk to duration was that it was going to contract if there was a rally like what we saw, whereas today the difference between extension risk and contraction risk is much closer. That said, I think our view is that spreads are more likely to widen into a further rally and will tend to perform better into a selloff. So I think given that, we'll still like to maintain a positive duration gap in the near term, maybe increase it a little from where it is now especially if we backup in rates, but that's how we're looking at the rates picture right now.

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Peter J. Federico, American Capital Agency Management, Llc - Chief Risk Officer and SVP [8]

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Bose, this is Peter. One thing I would add sort of beyond the higher level view that Gary just gave you with respect to the composition of the hedge portfolio, I wouldn't expect a big change in the mix between our swap and treasury hedges, but one thing I do want to point out that I think is often overlooked and it had an impact this last quarter when you're looking at our overall cost of funds is that each quarter some of our swap portfolio matures and rolls off and we often ultimately have to replace it. For example, in the fourth quarter about $2 billion of the portfolio matured and we added $4.5 billion worth of new swaps in the fourth quarter and yet our portfolio increased by $3 billion. I point that out because when we enter into new aftermarket swaps, they typically have a negative carry profile. For example, swaps from 3 years out to 10 years on average in the fourth quarter, if you entered into a new swap, had a negative carry profile of 40 or more basis points. So the point is, as you roll your portfolio into new swaps, if you do them aftermarket, then it's going to have a negative cost to us and that actually in cost to pay rate on our portfolio by 6 basis points in the fourth quarter. And as we look out over 2019, as I said, we typically have about $2 billion mature in the quarter. That's just an incremental cost that it will mute somewhat the benefit that we expect to get and will continue to get from rising 3-month LIBOR leg on our swaps, so I just wanted to add that.

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Operator [9]

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And the next question comes from Doug Harter with Crédit Suisse.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [10]

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Gary, can you talk about your leverage expectations? Obviously, the recovery in book value would push that down, kind of thoughts as to take advantage of the wider return opportunity. Do you increase leverage, look to raise more capital? How are you thinking about that dynamic?

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [11]

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Sure. Well, first off, what I would say on the leverage issue is we've spoken on this call and at other presentations about our view on leverage, which is haircuts have improved dramatically. The markets are much more stable than they were post crisis and that it was just a matter of time that we wanted to be running higher leverage, and we thought it made a lot of sense to do so. But as we stressed even on the last call, it wasn't the right opportunity, given the spread environment. Well -- I mean, the environment has changed, both from the rates perspective and the spread perspective as we've discussed. And so we're very comfortable with higher leverage at this point and think it's prudent. So to your question, yes, book value is improved. But even with the improvement in book value, our leverage still has not come down at all from its -- from the 9 that we've -- that we disclosed at year-end. So on the margin, in this environment, our expectation is to leverage higher, not lower. And again, I mean, we feel good about the investment environment. We think it's an attractive spread environment. And I can't stress enough, I mean, the change in kind of the perspective on the interest rate environment with the Fed that's -- kind of has a much more balanced stance for the first time in years, basically. So hopefully, that answers the question. I think you also asked about equity. And obviously, the investment environment I described is favorable for the equity equation. The other factors that we always talk about that we look at and that are very important price-to-book ratio is obviously a key factor. Another one that we've discussed often is the fact that as an internally managed company, as we grow, our operating expenses drop as our equity base increases. Given how low our operating expenses are at this point, both in absolute terms and relative to the space, I think that's a much smaller factor for us in the equity equation. There is one other factor that is -- that has become relevant at least in us thinking about this equation, and that is as TBA specialness has gotten weaker and our preference on the investment side right now is for specified pools versus TBAs, that does serve as some headwind to how much or how often you can raise equity. TBAs are obviously much more liquid. You can buy them in very large quantities very quickly. And if you're comfortable running a big TBA position, that's certainly -- it certainly helps in terms of quickly deploying capital in the end state that you want it in. On the other hand, specified pools, while they're available in ample size for AGNC, they take longer to acquire and we are very careful about optimizing that mix. So in an environment where specified pools are more attractive than TBAs, that has to be factored into this equation. I want to be clear, it doesn't in any way preclude raising equity. It just -- in the current environment and this may reverse at some point in the not-too-distant future, it is something that we added to the equation.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [12]

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I guess, following up on that last point, Gary, the -- kind of the lower average leverage for the quarter, I guess, how much of that was kind of intentional kind of trying to protect yourself a little bit from the spread widening you saw coming versus kind of that factor of kind of specified pools taking -- that the end state taking longer to acquire?

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [13]

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It's a great follow-up question. And 100% of that was intentional and unrelated to the specified pools. In Q4, given the volatility, our mindset was related around an entry point for TBAs and when we wanted to buy the mortgage basis. Essentially, the way we address specified pools is we're consistently looking for good pools all the time whether we "need them for this week or not." And so we are very active in that market. And I think, Chris can give you a couple of numbers. I think the numbers like we -- over the last 2 quarters, we've probably bought $11 billion...

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Christopher J. Kuehl, AGNC Investment Corp. - EVP of Agency Portfolio Investments [14]

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On a net basis.

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [15]

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On a net basis relative to runoff, $11 billion in high-quality specified pools. And we'll do that whether we're raising equity or not, but the -- so that -- the timing issues were unrelated to the specified pool issue. But in the end, if your end state investment is TBAs, then you can get into that in a day or 2, if you want, okay? If your end state investment is specified pools, if we continue -- if we raise capital over and over again in a bigger and bigger size, we're going to have a deficit that's going to take us a while to overcome in terms of acquiring specified pools. It doesn't really affect the timing of deployment into TBAs, which will be the first step of the process, no matter what.

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Operator [16]

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And the next question comes from Rick Shane with JP Morgan.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [17]

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You guys are highlighting what I would describe as a strategic shift in response to a more symmetric rate outlook. You mentioned higher leverage. Also, there's commentary about the costs of adding additional swaps. When we think about the rate outlook softening and volatility declining, does it make sense at this point to increase the swaption exposure to sort of mitigate tail risk if that less -- that more symmetric outlook proves to be wrong?

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Peter J. Federico, American Capital Agency Management, Llc - Chief Risk Officer and SVP [18]

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Yes. Rick, it's a good question. This is Peter. Obviously, the answer is it could. We obviously have not increased our swaption portfolio. In fact, you could see our swaption portfolio shrinking. And actually, when we have exercised our swaptions in the last couple of quarters, we've taken delivery of swaps that were randomized. So those options gave us the protection we wanted and proved to be valuable. The way we would look at it and the way we look at those options in general is that we often look at those options as protection against really tail risk events, which are important and we look to get into them when the level is right and when the cost from the implied volatility used to price the options is right. We've seen implied volatility coming down. If it comes down further, we may find it -- even though our rate view may not be for materially higher rates, there are times when we like to put on that out of the money protection because it's particularly cheap, but it's a balance between the level of rates, the cost of the option and obviously, our overall view on the interest rate environment. And as Gary described, our view of the interest rate environment is much more benign today, and our expectation is that it will become more evident that rates will be more stable going forward over the next 6 to 12 months. But obviously, we'll have to wait and see how the market plays out.

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [19]

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But given the decline in volatility helps, but volatility is still elevated over where it was from most of last year. And so I don't think we see this as a great entry point yet to buying options.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [20]

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Got it. But again, my assumption is that if your rate outlook is correct in the near term, the cost of that hedge will go down and the improvements in an environment where you've taken leverage of protecting yourself against that tail risk actually increases as well.

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [21]

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No. We would like the opportunity evolve. I think it's an excellent point. If all comes down materially, higher leverage against a bigger option portfolio would be something we'd be very interested in. So excellent point.

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Peter J. Federico, American Capital Agency Management, Llc - Chief Risk Officer and SVP [22]

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And again, it's going to take the market some time here to sort of digest what the Fed did just yesterday. And obviously, the next couple of meetings will be important to hear what the Fed says about its posture. But you're right. Our expectation is that they'll get cheaper.

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Operator [23]

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And the next question comes from Mark DeVries of Barclays.

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Mark C. DeVries, Barclays Bank PLC, Research Division - Director & Senior Research Analyst [24]

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Something you could quantify for us, the impacts -- the per share impact on spread income from some of the issues you highlighted that kind of weighed on that, the delay in deployment of some of the capital and some of the issues around repo cost?

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Peter J. Federico, American Capital Agency Management, Llc - Chief Risk Officer and SVP [25]

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Yes. This is Peter. I'll start and Gary can chime in. As Bernie mentioned, obviously, about a $0.01 was due to the MTGE fee. But in general, the difference beyond that was about half-and-half between the deployment of capital and the higher funding cost. The higher funding cost, the year-end pressure was probably of a little bit greater magnitude than the deployment of capital, so -- but those were the 2 big factors that sort of were about half-and-half of the difference in the quarter-over-quarter change in net spread income. Funding costs were a little bit larger than the deployment of capital probably.

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Mark C. DeVries, Barclays Bank PLC, Research Division - Director & Senior Research Analyst [26]

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Okay. Got it. And then Chris, I was hoping you could elaborate more on the point you made about the reality being somewhere between the impact on OAS and static spreads?

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Christopher J. Kuehl, AGNC Investment Corp. - EVP of Agency Portfolio Investments [27]

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Sure. So a lot of the movement or the disconnect between the move in static spreads versus OAS was the increase in implied volatility or the increase in option cost, which to the extent that realized vol is lower than the move in implied volatility or you don't go out and purchase rate options immediately after they move higher in implied volatility. You can expect to earn back that option cost in a sense. And so we've seen so far quarter-to-date implied volatility has declined. And so some of that disconnect and spread differential between static spreads and OAS has reversed so far this quarter. The other thing to point out is the static spread metrics are simply spreads to an average life point on the curve and our durations, our hedge ratios are shorter than that point on the curve, which effectively incorporates or anticipates mortgage underperformance versus that metric into a move lower into rates. And so that's a big part of it.

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [28]

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Just theoretically what I'd add is if you just take a step back from this quarter, if you just say what is OAS "good for?" OAS will capture kind of -- assuming volatility stays the same is better for capturing the expected spread move given a change in rates. So we expect mortgage spreads to widen into a rally as the option -- the prepayment option gets more on the money. OAS captures that. On the other hand, OAS ignores essentially in the number changes to implied volatility and -- whereas static spreads will widen if volatility goes up. And so the OAS component is better for normalizing -- or kind of excluding the rate move and the static spread number is better for capturing changes to volatility, which do impact both ours and most other investors' P&Ls.

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Operator [29]

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And our last question comes from Trevor Cranston with JMP Securities.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [30]

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Just 2 quick ones. First, you guys have talked about the impact of the funding costs going up around the end of the year. Can you comment on where you're seeing repo rates today versus sort of where they were at 12/31?

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Peter J. Federico, American Capital Agency Management, Llc - Chief Risk Officer and SVP [31]

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Sure. Trevor, this is Peter. As I said, we've seen some pretty substantial improvement from where we were at the end of the year. And in the last 2 weeks of the year in particular, we really just -- I would say on average, our December funding rates were probably 15 basis points higher than we would have expected just based on the fact that really in the fourth quarter, we had the effective 2 Fed tightenings, not just one, because the previous tightening occurred at the end of September right at the end of the month, so the full effect of that tightening as well as the tightening in December. We have seen some improvement. As I said, we're -- our average repo rates today are around 2.60%. I think over the near term -- meaning the next couple of quarters, if 3-month LIBOR stays about where it is, I think that our funding should be in the less 10 to 15 basis points relative to that level. But again, I think we're going to see the funding markets, the liquidity, the levels all change pretty quickly here. We've also seen more money coming into the repo markets. We've seen the term market start to actually invert relative to shorter repo rates. So I think there's a lot of people now pricing out of the Fed, that will change the outlook going forward. But in that LIBOR minus 10 range, 10 to 15 basis points is probably a reasonable proxy for the near term.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [32]

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Okay. That's helpful. And then second question, obviously, most of the focus has been on the agency book for a good reason, but I was curious if -- with all the credit spread widening and volatility we've seen, if you guys have found any opportunities to add to the credit book over the fourth quarter or in the first quarter?

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Aaron J. Pas, AGNC Investment Corp. - SVP [33]

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This is Aaron. So we took up risk a little bit in Q4 as you can see by our balance increasing by about $100 million. We've added a little bit more risk over the last few weeks in January. Having said that, as Gary mentioned in his prepared remarks, I mean, we aren't kind of -- our outlook on the U.S. economy and credit risk isn't very favorable at this point. And while credit spreads were wider, so were agency mortgage spreads. So risk-adjusted returns, the whole space increased in our investable assets. We do see opportunities in the credit risk transfer market. We have added some risk there and continue to like the underlying fundamentals, but don't see the portfolio growing materially at these levels.

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Operator [34]

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And we have now completed the question-and-answer session. I'd like to turn the call back to Gary Kain for concluding remarks.

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [35]

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I think there may have been -- is there one more question in the queue?

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Operator [36]

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Yes. There is a follow-up question from Bose George from KBW.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [37]

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Just -- I don't know if you've said this already, but where are the spreads -- effective spreads on TBA versus specified pools?

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [38]

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So you're talking about just -- like the static spreads versus -- there's -- again, on the OAS front, you're going to have an OAS pickup. So they are more favorable like -- generally, 5 plus basis points better on an OAS basis. And Chris, on a static basis?

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Christopher J. Kuehl, AGNC Investment Corp. - EVP of Agency Portfolio Investments [39]

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Yes. I mean, generally speaking -- I mean, it depends on the coupon that you're looking at and its respective moneyness versus current mortgage rates. So 30-year 4s, for example, let's just take typical loan balance bucket, say 150k max pools or HLB pools as they're referred to, trade with the pay up of around 20 to 24 ticks. So a spread give of, call it, 10 -- 5 to 10 basis points. Again, it varies depending on the moneyness of the spec story or strategy. But generally speaking, to Gary's point, specified pools are a far cheaper way to source back some of the negative convexity embedded in a mortgage position because the options that you're effectively buying back traded a significant discount to fair full theoretical value or your alternative options on interest rates that you can buy to cover a similar risk. So generally speaking, they trade and that's where the OAS pickup comes from. 30-year 4s currently trade at a theoretical discount to fair value of probably around 50% to 60%.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [40]

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Okay. That makes sense, but just -- so back of the envelope, it's sort of 5 to 10 basis points?

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [41]

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Yes. One thing is that's for what we call high-quality specs, but a big component of our specified pool strategy is not just high-quality specs, and so it's kind of a mix. It can be as simple as new production pools where you only pay up a tick or something with reasonable characteristics. And so there's no real spread give up and you just end up with a pool that you're putting on repo where you're starting in the same place, so you should think of a mix -- there's still a mix. Today, it's a small component as TBA. There's is a pretty sizable component kind of in a theoretical new portfolio that's kind of these more cheaper specified pools are better than average pools, and then there's the high-quality pools that Chris talked about.

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Christopher J. Kuehl, AGNC Investment Corp. - EVP of Agency Portfolio Investments [42]

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The last thing I'd add with respect to sort of the net spreads on specs versus TBA is that with roll specialness having come off and basically trading flattish to repo rates in the case of 30-year MBS, the carry profile on specs versus TBA has improved a fair amount over the last quarter or 2. And so that contributes to some of -- it's part of the reason why we're optimistic on valuations going forward as well.

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [43]

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Right. So you have -- prepayment speeds obviously are a key components and they're slower.

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Operator [44]

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And I would like to return the floor back to Gary Kain for concluding remarks.

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Gary D. Kain, AGNC Investment Corp. - CEO, CIO & Director [45]

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Great, and thanks to everyone for your participation on the Q4 2018 call, and we look forward to speaking with you next quarter.

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Operator [46]

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Thank you. The presentation has now concluded. Thank you for attending today's call, and you may now disconnect your lines.