Good afternoon. I'm Derek Hewett from Bank of America Securities. I cover the specialty finance sector, including mortgage REITs. With us today is Peter Federico, CEO of AGNC Investment Corp. So thanks for joining us today.
Thank you for having us. Appreciate it.
So Peter, could you start off by maybe providing a brief history of AGNC Investment, plus maybe discuss the investment strategy and competitive advantages that you believe that the company has? And then also, I believe the company's coming up on 16 years as a public entity, so congrats on the longevity and the strong total return over that period of time since inception in 2008.
Sure. Appreciate that. Yeah, in May of this year, we rang the morning bell at Nasdaq and commemorated our 15th-year anniversary. And when you look back over that environment, it's been a remarkable sort of environment of both good environments and bad environments for a levered investor like we are in predominantly agency mortgage-backed securities. But over that time, from our IPO in 2008, and really we began to grow in 2009 through our 15-year anniversary, we generated a total stock return of close to 350%, 349%, I think exactly. Or on an annual basis, that's a 10% total stock return, which is very, very similar to the S&P 500.
So over a long period of time, I think that demonstrates the longevity and durability of our business model because over that environment, we've had some tremendously different investment environments following the Great Financial Crisis where mortgages were extremely cheap and the Fed started to get involved in the Agency mortgage-backed security market. QE1, QE3, QE4 were all episodes where the Fed was participating in the mortgage-backed security market. But over that timeframe, we've been able to generate really attractive returns for our shareholders. And we're looking forward to the environment that we're starting on right now because if you think about the last couple of years in the fixed income markets, it's been an extraordinarily challenging time for fixed income investors.
Agency mortgage-backed securities have been negatively impacted by the environment over the last two years with the Fed so aggressively tightening monetary policy, raising short-term rates 525 basis points. And at the same time, for the first time ever, they reduced their balance sheet by $1.3 trillion. So we've never had to experience that sort of aggressive monetary policy tightening. But yet we've been able to navigate that. Our disciplined approach to risk management, asset selection, making sure our portfolio is adequately hedged at all times is really critical to our business model. And if we take that approach over the long run, we think we can generate really attractive returns for our shareholders. And we may be at the forefront right now of a particularly attractive investment environment following this difficult fixed income environment that we've had to navigate.
Okay, thank you. And then last year and the year prior was a very volatile year for the mortgage market and spreads. Seems like the markets started to stabilize in late last year. So what is your current outlook for the mortgage market and then spreads in general for the remainder of this year? And then what is the biggest risk to your baseline assumption in terms of either on the positive or the negative side?
So when you invest in it, it's really actually an interesting sort of market. You think about the Agency mortgage-backed security market; it's an $8.5 trillion market, but it's extremely difficult for investors to access remarkably. And it's difficult, particularly for retail investors. If you want to invest in mortgage-backed securities, you really have to do it through an institution, do it through a bond fund. So when you invest in AGNC stock, it gives you investors sort of an easy way to access this very unique asset class. But when you invest in us, you're taking a levered position, if you will, in mortgage-backed securities. So the primary risk, the primary driver of changes in our book value are changes in mortgage spreads, mortgage spreads relative to swap and treasury rates, which those are the instruments we use to hedge our portfolio.
I point that out because as the Fed went through the Great Financial Crisis and continued to buy mortgages and grow its balance sheet to a total of $2.7 trillion in mortgage-backed securities or 30% of the market, they got to the point after QE4, which was at the end of 2021, where they had driven mortgage spreads to essentially the all-time tightest level that we've ever experienced relative to the 10-year Treasury, for example, a par-priced mortgage was trading at about a 40 basis point spread. That was half of the average spread over the previous 12 years. So it was sort of unsustainably at a tight level. At that point, there was an inflection where the Fed said we're going to actually start to tighten monetary policy and reduce our balance sheet.
That caused mortgage spreads to widen to sort of an all-time wide level of close to 200 basis points over the last two years. That has been an environment that's been difficult from a book value perspective for us because we have a negative impact to our book value. But what that does alternatively is it puts us in an environment today where we have really attractive go-forward investment opportunities. A levered investment in mortgage-backed securities today at these wide spread levels can generate mid-teens returns, which are levels of returns that we haven't really seen at only a few occasions over our 15-year history. We're excited about the environment that we're in today. It's certainly been a challenging path to get there. But the outlook from an earnings perspective is improving as we've gotten more stability into the fixed income outlook.
Okay. And then just given that volatility with the Agency product, where are you seeing kind of the best investment opportunities? And I know the credit portfolio in terms of capital allocation and then also the size of the credit portfolio is still relatively small. But just given the volatility that you've seen with the Agency product over the last 15+ years, what are your thoughts in terms of allocating additional incremental capital towards credit at this point in AGNC's lifecycle?
Well, I think we're at a point right now in the Agency mortgage-backed security market where you can look at Agency mortgages on a levered or unlevered basis. And I think you can make a credible case that they are the cheapest fixed income asset class across any asset, certainly cheaper than credit. If you look at agency mortgage-backed securities today on a spread to U.S. Treasuries and post-Great Financial Crisis, agency MBS securities enjoy the full backing of the U.S. government's support. They're not full faith and credit, but they have a government guarantee of support. So you can look at them as comparable to a U.S. Treasury, I believe, from a credit perspective. And you can earn a return over U.S. Treasuries of 150 basis points-200 basis points. So I think that's an incredible amount of incremental return for a comparable credit.
Remarkably, Agency mortgage-backed securities also trade cheap to investment-grade debt, which is a highly unusual scenario, but that's the environment that we're in today. So relative to single-A corporates, Agency MBS are trading at a wider spread and a better yield. So they look attractive to credit. They look attractive to U.S. governments. I think there's going to be a rotation out of both Treasuries and credit securities into Agency MBS. So from our perspective, we think that's the cheapest asset. I would not look for our portfolio to increase its capital allocation, only about 3% or 4% of our portfolio of our capital is allocated to credit. I expect us to remain predominantly 30-year Agency MBS because they are so cheap on both a levered and unlevered basis. I expect that to be the case going forward in this environment.
Okay. And then currently, where are Agency MBS spreads relative to the historic average you had discussed earlier? They got as tight as 40 basis points, wide as 200. But where are they right now? And do you think there's additional opportunity to tighten over the next 12 months?
Yeah, I think you got to look at the market. And looking at that history is really important. So if you look at the period following the Great Financial Crisis, 2010 really to 2022, that 12-year period, we saw mortgage spreads, generally speaking, be more stable during that environment because the Fed was participating in that market, in our market, in really about 11 out of the 14 years, whether they were growing their balance sheet or maintaining their balance sheet. So that was highly impacted by the Fed's presence. And over that time period, mortgages, as I said, just a simple benchmark, the par-priced mortgage to a 10-year Treasury averaged about 75 basis points, 80 basis points.
When the Fed started to tighten monetary policy and reduce its balance sheet, we moved up in spread to now sort of the new range that we've been trading in for the last five quarters has been somewhere in the neighborhood of 150 basis points-190 basis points. So call it double the historical average. That spread level, importantly, has held over the last five quarters. And importantly, we've hit the upper end of that range on five separate occasions over the last five quarters. And when mortgages get to around that 190 basis point range, what we see is new money flow into that market on an unlevered basis. And spreads, importantly, have held the upper end of the range, which I think is a positive development. But I do believe in the environment that we're in that this spread range may be the new norm.
If you think about the world ahead of us the next 10 years where the Fed is reducing its footprint in the Agency mortgage market, whether they're letting their balance sheet run off slowly over time in terms of their mortgage position, as they've indicated, I think when you see mortgage spreads 150 basis points or more to the 10-year Treasury, I think that's a level that is a lot of incremental compensation for investors. I think it's a comfortable level for them to trade in. And that spread environment would be very positive for our business. What we want, ideally, as a levered investor in fixed income is we want our asset to trade at a wide spread and stay there, trade there on a sort of a stable basis. And the other challenge for our business is interest rate volatility, right? Because mortgages move with interest rates.
They extend as interest rates go up and their duration shortens when interest rates go down. So that requires constant interest rate rebalancing. That has a cost. The ideal environment for a levered investment in mortgage-backed securities for any investor is one where spreads are wide and interest rates are stable. That gives you the environment that allows you to generate the best return for your shareholders. We may be entering that period. I think mortgage spreads will stay wide and attractive. And I believe that the volatility of spreads is starting to compress, which is important, stay in that range. And hopefully, as the Fed transitions from monetary policy tightening to the pause, which is where we are now, to ultimately easing, that should coincide with interest rate volatility coming down.
Interest rate volatility coming down is always positive for a mortgage-backed security position, whether it's levered, unlevered, whether it's hedged or unhedged. It'll generally result in a price improvement of a mortgage-backed security because the duration, the variability of that mortgage starts to get reduced.
Okay, wonderful. And then the yield curve has been inverted for quite a while now. Could you explain to an investor why an inverted yield curve isn't necessarily a negative for the overall business model?
Yeah. The shape of the yield curve and the inversion of the yield curve would be challenging for the business model if we bought long-term mortgages, which we do, and hedged and funded them with short-term debt and had no hedges, in which case we would have a huge exposure to our short-term funding costs going up 525 basis points. There would be massive compression. That would be a very negative environment. But that's not the way we hedge our portfolio. We do fund our portfolio with essentially 30-day or even less than 30-day repo. There's no question about that.
But we also operate, particularly in the most recent environment, with a hedge ratio of over 100%, which what that means is we've taken all of our short-term debt and we've essentially put hedges against it so that we've synthetically converted our short-term debt to longer-term debt that matches the duration of our asset portfolio. So even though, for example, the yield curve is inverted and short-term rates have gone up, our cost of funds over the last two years has remained relatively stable. It's gone up some, but relatively stable. And you can see that in our net interest margin, which is the spread between our debt and our hedges versus our asset yield. And as of last quarter, that spread was still 308 basis points. It was actually the widest spread, close to the widest spread we've ever printed.
So the shape of the yield curve, if you're fully funded and the amount of hedges you have and you hedge across the yield curve with your hedges from short-term hedges all the way out to 10- and 15-year hedges, then the shape of the yield curve is not going to drive your long-term profitability. What drives the profitability is where our mortgage spreads relative to the yield curve. With mortgage spreads at 150 basis points, if the yield curve is perfectly flat, no benefit or cost of the shape of the yield curve, and mortgages are trading 150 basis points over the curve, then we can generate 150 basis points levered, essentially 7x or 8x. That's the power of our business. That's the environment that we've been operating in.
Okay, great. And then just in terms of leverage, leverage ended this or last year at 7x . You have sitting on over $5 billion of unencumbered assets. Leverage has been low in this period of volatility relative to kind of pre-COVID. Could you talk about expectations for when would you be willing to increase leverage to increase returns further, or are spreads just so wide and attractive that you don't really need to increase leverage to generate an attractive risk-adjusted return?
It's a little bit of both. I'll start with the last part of what you just said, because that is definitively the case. The good thing about the environment today is that we, like you said, we've operated in the sevens for our leverage for the last several quarters. At the end of last quarter, it was 7x in our unencumbered cash and mortgage-backed security position, meaning that the amount of cash we have available to meet our margin requirements and our funding was at really an all-time high of a little over $5 billion or about 65% of our capital base. So we have a lot of capacity to withstand adverse moves in the mortgage market. Our leverage shows that we still have capacity to take leverage up once the environment changes.
But the benefit of today's environment really is that you don't have to stretch that hard. You don't have to take undue risk to generate really attractive returns. On a mark-to-market basis today, if you look at our portfolio levered the way we levered it and risk manage it the way we manage it, we can generate really attractive mid-teens returns. There will come an environment, I think, over time where we have greater visibility into the Fed, greater confidence in monetary policy, better clarity on how the Fed's going to manage the tapering of its balance sheet and ultimately stop running its balance sheet off. You know, we're going to get that information really over the next several months. So over time, I expect greater clarity, less uncertainty in the fixed income market, less uncertainty with regard to interest rates.
That could be an environment where we would be willing to operate with a little higher risk if we felt like we had greater clarity on the outlook. We're generating attractive returns. We've got a really strong liquidity position, gives us lots of capacity to withstand volatile and unstable markets, which we've all experienced in the fixed income market over the last couple of years.
Okay. And then kind of a key topic for investors is the dividends. So could you talk about just the general AGNC's dividend policy, especially since you've been significantly over-earning the dividends for quite a while now? And just thoughts in terms of willingness to, in terms of do you want to kind of keep the dividend as is? Would you be willing to pay some special dividends just given the significant rise in core earnings that you've been generating over the last few years?
Yeah, I think we're going on three years of the dividend being at the current level. So I think that that's a really positive statement about the sort of forward approach we take to setting our dividend. What's imperative is that if you look at some of the accounting results and our results and others and the way our business works and the way the accounting works, if you look at current period earnings for us, for example, if you look at that net interest margin I mentioned of 308 basis points, or if you look at what we describe as our net spread and dollar roll income, an earnings measure that's influenced by the way accounting works for both your assets and in particular your hedges, it is indicative of the current earnings on our portfolio, but it's not a valuable projection of the go-forward earnings.
So, for example, last quarter, our net spread and dollar roll income was $0.60 and our dividend was $0.36. It looks like we're out-earning it substantially. But that is not the projected return of our portfolio. If you think about that net spread and dollar roll income annualized over our capital base, our ROE, if you will, on that measure would be about 30%. In fact, in 2023, it was very close to 30%. But mortgages today don't generate a 30% return. They generate a return that mortgage spreads today, current coupon spreads to a combination of Treasury hedges and swap hedges generates about 175 basis points of incremental return. That 175 basis points levered, for example, seven times would generate an ROE after you include the equity component of around 17% after the cost of running our business.
So that number is indicative of sort of the mark-to-market return on our portfolio. That number is a number that I'd look at and say, on a go-forward basis, based on today's mortgage prices and today's hedge costs and today's short-term debt cost, I think our portfolio said another way, if you sold the whole portfolio, all your hedges, bought everything back, I think the go-forward return on our portfolio would be mid-teens. From a dividend perspective, that's the key number, not the net spread and dollar roll income number, not that 30% return on equity. It's that mid-teens number. The question is, what do you compare that to?
Well, if you look at our total cost of capital, you take the amount of dividends we pay on our common stock, you take the amount of dividends in dollars on our preferred stock, you take the cost for us to run our business, our compensation and our general administrative costs. That's the cost that we need to run our business divided by our capital base. That's the total cost of capital. If you think about that as a break-even ROE, at the end of last quarter, that number was around 15.5%. So you need to generate around 15.5% to cover all those costs that are sort of baked into your business, your fixed costs, if you will. The return on our portfolio on a mark-to-market basis is very much aligned with that. That, I think, is the key comparison.
Now, there's lots of factors that can change over time. The environment, the cost of hedging, the amount of leverage we're willing to operate, those are all variables that could change. So we're constantly evaluating that. But when you think about it from that perspective, you can see the alignment from an economic perspective of our dividend and our earnings. And I think that's really critical because you can get confused by the accounting numbers.
Okay, that makes a lot of sense. And then what would you need to see to raise incremental capital, like do overnight deals versus what you've been doing currently with just issuing under your ATM program?
Yeah, it's been a lot of years since we've done a bought deal. I can't actually recall the last time we did a bought deal, but raising money through the at-the-market program can be really attractive and beneficial to our existing shareholders. First, from a capital management perspective, I always look at capital management activities from the perspective of our existing shareholders. Can I raise capital today that I believe is beneficial to our existing shareholders? Raising capital through the ATM program, the at-the-market program, has a very low cost to it. And if you're trading at a meaningful premium to your book value, like we have over the last 12 months, we've been able to raise capital at a very low cost in a way that's definitively beneficial to our book value for our existing shareholders.
Now, it's also important that we take that capital ultimately and deploy that and lever it the same way I want the existing portfolio levered. If you do that, then you should be neutral from an earnings perspective, and it should be beneficial from a book value perspective. We approach it from the lens of our existing shareholders, want to make sure that it's accretive to them from a book value perspective. Ultimately, if you can raise it accretive from a book value and redeploy that at really wide spreads, it can be beneficial to an earnings. It can be very helpful to your existing shareholders, but you have to do that in a very disciplined way. It also has to be done in sort of concert with where our existing shareholder and our existing portfolio is levered. Are the returns consistent?
So we've approached it that way, and the ATM program has given us that flexibility. There's really no need from our perspective right now to look at bought transactions because the issuance cost is materially different and higher than the ATM program. So it would be inferior to our existing shareholders' perspectives.
Okay. And then what is your target mix in terms of common versus preferred? At what level do you think is most advantageous? And you have a couple of preferred deals that are callable at this point in time. So kind of how do you think about it from that perspective?
Currently, we've been operating with an amount of preferred, which is a little at the higher end of our range, call it in the 22%-23% range of our capital mix. In today's environment, with mortgage spreads being as wide as they are, the average cost of our preferred stock is around 7%, even though some of it is floating rate and has a materially higher coupon. The average of it all is around 7%. Think about that. If you're paying 7% on that preferred stock and redeploying that on a levered basis because it's permanent capital at a return of, say, 17%, there's 10% incremental return that accrues to the benefit of our common shareholders. That's why looking at our break-even ROE from a total cost of capital, it's imperative that you include that 7% preferred because a lot of investors don't do that in that calculation.
That's why I pointed that calculation out. So in today's environment, that cost of preferred at 7% versus the return opportunity is extremely beneficial, which is why we want a high percent of it in our portfolio. Over time, that may change, and we may reduce that percent. As you point out, a couple of our transactions, one is callable today, one or a couple of transactions will be callable in 2024, and we'll have to make that decision at the time. The one that's callable today actually is floating rate, and it's actually at a materially higher coupon. But over time, that also gives us a lot of optionality. That could be very attractive funding, for example, in a couple of years. So we have to evaluate that over time.
Okay. And then could you talk about Bethesda Securities? I don't think it's talked about all that much, just the benefits of having an internal broker-dealer and maybe the benefits that you get from a funding perspective.
Yeah. And I'm glad you brought that up because I'll first talk a little bit about the funding market because I think this is really important. If you look back to the Agency MBS funding market, back to 2019 and prior, it had much greater volatility in it. And it was in 2019 when the Fed was last reducing its balance sheet, where it ran into problems when it reduced its balance sheet too far. What the Fed essentially does when it reduces its balance sheet is they take reserves out of the banking system. And they took too many reserves out of the banking system, and it caused a huge dislocation in the repo market for U.S. Treasuries and Agency MBS securities at quarter ends in that year, month ends, year ends. We traded up to, I think, 10% versus a Fed funds target that was materially lower.
What that did is that awakened the Fed to the importance of making sure that those markets stayed tied to the Fed funds rate. Otherwise, they lose control of monetary policy. The transfer mechanism stops working. So what the Fed did at that time is they reintroduced open market operations, started to put $1 trillion of liquidity into the system immediately available every day. And then they created two repo facilities. They created the reverse repo facility and the standing repo facility, which puts a lower and upper bound on the repo market. Essentially, the Fed is willing to borrow money and lend money at the upper and lower bound. And essentially, what that does is that ties the repo market for Agency MBS collateral and U.S. Treasuries to the Fed funds target. That's hugely important for us.
That's why Agency MBS Securities are uniquely suited for a levered investment strategy because it is such a deep liquid market, and now it has the benefit of this liquidity that the Fed is sort of guaranteed. So that's really a significant positive development over the last several years. Bethesda Securities were unique. Another one, one or two other REITs have it, but you have to be of a certain scale. But we have our own captive broker-dealer. And what that does is that gives us access to wholesale funding that is cleared through the Fixed Income Clearing Corp, FICC, the same clearing corp that every dealer and major participant uses, broker-dealer uses. So it gives us access to wholesale quality funding from a cost perspective. Importantly, you have better margin terms through the FICC, so it makes you more capital efficient.
It allows us to clear TBA securities in a very cost-effective capital way. It allows us to custody our own bonds. So there's lots of benefits that we've been able to garner from that captive broker-dealer. About 50% of our funding runs through there. It makes us more profitable from a funding cost perspective and certainly much more efficient from a capital perspective, which is one of the reasons why when we talked about the $5 billion of excess cash and liquidity, part of that is because we're so efficient because of our captive broker-dealer.
Okay. And then how is AGNC approaching hedging coming out of the extreme volatility that we've seen over the last couple of years?
It's evolving. So when you think about AGNC takes an approach, as I mentioned, where interest rate risk is certainly a risk to our shareholders, but we do everything we can to keep that risk as low as possible. For us, what that means is that we keep our duration gap or the interest rate sensitivity differential between our assets and our hedges. We keep that relatively low. It's usually in the neighborhood of zero to about a half year positive duration gap. It's not significant from that perspective. Importantly, when you think about our hedging objective, we're trying to achieve two things. We're trying to achieve the right amount of hedges to keep our short-term debt stable.
For that reason, we've operated with a hedge ratio of more than 100% for the last several years, meaning all of our short-term debt was essentially synthetically converted. We also are trying to find the right mix of hedges that best replicates the market value change of our assets. For us, that means two things. It means hedging across the yield curve because mortgages are sensitive to short-term interest rates and intermediate interest rates and long-term interest rates. We hedge a mix of hedges from one year out to 15 years, as I mentioned. We also hedge with a mix of Treasuries and swap-based hedges because we feel like the combination of those gives us the best market value offset.
In an environment where the Fed is raising short-term rates like they did, we concentrated our hedges more toward the short and intermediate part of the curve because the yield curve was inverting. Hedges perform better in the intermediate part of the curve. Over time, we've begun to shift that composition toward a greater amount of long-term hedges. In fact, 70% of our hedge duration today comes from hedges beyond seven years because we expect the yield curve to re-steepen. We expect the long end of interest rates to stay stable or rise and shorter-term interest rates to fall. So we don't want hedges in that part of the curve. We want more long-term hedges in our mix. And ultimately, as the Fed transitions to easing, we'll likely operate with a hedge ratio less than 100%, in a sense, having more short-term debt in our funding mix.
That's the way it'll evolve over time.
Okay. Well, we're running a little short on time. Are there any questions from the audience? Now, well, maybe I'll ask one additional question. Just in terms of the stock, it tends to trade around tangible book value. But what do you think is like the single catalyst that could cause the shares to rerate higher?
You mean to trade it?
At a premium to book.
At a premium. If you look at our price-to-book ratio, I think this is an important development in the market. I think in terms of investors understanding, it certainly has changed over the last several years. In times past, when spreads have widened and our book value has gone down, we've traded at a discount. There are several REITs trading at a discount today. But when you think about the business on a go-forward basis, the time that investors should be willing to pay a premium for the stock is when your go-forward earnings are improving. That's the environment that we're in today. Investors, I think, are looking at our stock, and we're actually trading—we have traded at the last reported book value. It was trading at a—our last reported book value was $8.70 a share.
One could conclude that the stock is trading at a premium today because investors are looking at it and saying, "This is the best earnings environment that AGNC has maybe ever had." On a go-forward basis, they should be able to generate mid-teens returns. If all of these variables start to calm down and there's certainty in the market, interest rate volatility comes down, and mortgage spreads stay wide, that's a great earnings environment. It's worth a premium because in that scenario, mortgage spreads being wide, if you think about it, there's sort of three outcomes always for investors. One is that spreads stay wide and don't change, and we generate really attractive returns on a go-forward basis. The other is spreads tighten, in which case go-forward earnings aren't going to be quite as high, but the stock price or the book value is going to go up.
And then the third scenario is mortgage spreads widen again. And in that scenario, I think what we're starting to observe is the likelihood of that is starting to be diminished relative to the last two years. And there's greater probability now, I believe, on the two positive outcomes and a little lower probability on mortgage spreads breaking through the upper end of the range. So that's, I think, the environment that's starting to emerge. We're not there yet, but I think the certainty that we get over the next three to six months, I think, will inform that a lot.
Okay. Great. So I think we are out of time. So unless there is a last-minute question from the audience... Well, thank you very much, Peter.
Thank you for having us. Appreciate it.