AGNC Investment Corp. (AGNC) Q2 2015 Earnings Report, Transcript and Summary

Good morning, and welcome to the American Capital Agency Second Quarter 2015 Shareholder Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.

Thank you, Keith, and thank you all for joining American Capital Agency’s second quarter 2015 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 forecasts 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 the 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 August 11 by dialing 877-344-7529 or 412-317-0088 and the conference ID number is 10068975. To view the slide presentation turn to our website, agnc.com and click on the Q2 2015 Earnings Presentation link in the upper 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 Malon Wilkus, Chair and Chief Executive Officer; Sam Flax, Director, Executive Vice President and Secretary; John Erickson, Director, Chief Financial Officer and Executive Vice President; Gary Kain, President and Chief Investment Officer; Chris Kuehl, Senior Vice President in Mortgage Investments; Peter Federico, Senior Vice President and Chief Risk Officer; and Bernie Bell, Vice President and Controller. With that I’ll turn the call over to Gary Kain.

Thanks, Katie, and thanks to all of you for your interest in AGNC. The second quarter was a difficult one for fixed income and for agency MBS. More specifically, generic agency MBS indices posted their second worst quarterly returns over the past seven years, as higher rates and wider spreads combined to pressure returns. But we were not pleased with this quarter’s results, we do feel good about adopting a more conservative stance earlier in the year and entering the quarter with our lowest leverage since 2008. On our last two earnings calls, we stress that global risk factors were driving excessive volatility in interest rates. These forces coupled with historically full valuations and the growing probability of a near-term Fed hike warranted a defensive approach. While we have stressed the importance of economic returns over time, it is critical not to put too much emphasis on quarter-over-quarter numbers in light of the significant volatility we are witnessing in the fixed income markets right now. Short-term changes in rates, curves, and MBS spreads have been significant, but they’ve also tended to be mean reverting. As such, when you look at things over a 6 to 12 months period, many of these moves wash out. If we just look at Q2, the decline in our book value was in part driven by a widening in spreads relative to swaps and Treasuries. The underperformance was especially pronounced versus intermediate-term rates, given the steepening of the yield curve. It is important to remember that while wider MBS spreads lead to temporary declines in book value, actual cash flows are not affected. When MBS spreads widen, the only thing that changes is that the discount rate applied to the cash flows increases. The higher discount rate leads to a temporary drop in price, but if the security is held to maturity, actual returns are unchanged and mark-to-market losses are essentially reversed. Contrary to this short-term negative, wider spreads provide the opportunity to invest in higher returns, which could support a materially better earnings stream over the longer-term. Now, this assumes that you’re in a position to make incremental investments, and as importantly, do not feel like it is necessary to sell positions to reduce leverage. It is for these reasons that we have chosen to operate with lower leverage over the last several quarters, as it gives us the capacity and flexibility to opportunistically add MBS at wider spreads. As we look forward, mortgage valuations are more reasonable and there is the potential for interest rate volatility to return to more normal levels. If these favorable trends continue, we will opportunistically reposition the portfolio toward more normal risk levels, which would likely mean, increasing leverage and/or being willing to take on more duration risk. Either of these actions could favorably impact our expected ROEs. That said, there are some near-term risk factors that give us pause, including continued uncertainty in China and Europe, renewed weakness in oil and other commodities and volatility surrounding both the timing and the market impact of Fed rate hikes. Against this backdrop, we are still bias toward prioritizing risk management in the near-term, but are much closer to viewing either further increases in interest rates or incremental spread widening as opportunities to become more aggressive. With that as the introduction, let me briefly review some of the results for the quarter, before turning the call over to team to discuss the portfolio. First, given the combination of wider mortgage spreads, higher rates in the steeper curve, second quarter comprehensive income equated to a loss of $0.97 per share, and economic returns were negative 3.6%. Net spread income inclusive of dollar roll income totaled $0.60 per share. During the quarter, we repurchased approximately $80 million of our common stock, or approximately 1% of our outstanding shares. As I have discussed in the past, our framework for evaluating stock buybacks includes a number of variables, including, but not limited to a daily estimate of our price-to-book ratio and assessment of the overall mortgage market landscape, our views on interest rates, and our expectations about the drivers and sustainability of share price weakness. Like all public companies, we’re also bound by other parameters, such as, window periods and daily volume guidelines. If we turn to Slide 6, I will briefly review what happened in the market during Q2. During the second quarter, longer term swap rates rose and the yield curves steepened significantly. I’ve shown in the table on the top right, 10-year swap rates increased 41 basis points, while three-year rates increased only 13 basis points. While a steeper yield curve is generally a positive for MBS performance that was clearly not the case this quarter, as mortgages underperform both Treasury and swap benchmarks. As you can see in the table, significant price declines were experienced across all coupons in both 15-year and 30-year MBS. For example, 30-year 3.5% dropped just over two points in price, while five-year Treasuries dropped less than 1.25 points. In aggregate, as I mentioned at the outset of the call, the Barclays mortgage index posted its second worst quarterly total return over the last seven years, with only the second quarter of 2013 being worse. As you can see on the table at the bottom right side of the page, option-adjusted spreads on 30-year mortgage pass-throughs widened close to 20 basis points when averaged across a range of coupons. 15-year MBS fared better on this basis, but we’re still almost 10 basis points wider. At this point, I will turn the call over to Chris to discuss our portfolio.

Thanks, Gary. Let’s turn to Slide 7. As we discussed on last quarter’s earnings call, we believe that agency MBS were fully valued, given significant global risk factors and elevated interest rate volatility. Against this backdrop, we entered the second quarter with low leverage and a willingness to bring leverage down further. As of June 30, our investment portfolio was $59.2 billion, down from $66.2 billion at the start of the second quarter. Our sales were more heavily concentrated in 15-year MBS, given the combination of lower ROEs and the potential for greater volatility in the front end of the yield curve. Additionally, given our relatively low leverage levels, the shorter spread duration of a larger 15-year position is less valuable. At this point, I want to take a minute to discuss some additional details regarding the specified pools that comprise the majority of our portfolio. As there are some interesting characteristics that the market may not fully appreciate, while the majority of our holdings are in prepayment-protected specified pools, it’s important to note that these pools are also seasoned on average more than three years. And given the combination of seasoning and prepayment protection, we can expect these positions to perform well in both higher and lower rate environments relative to newer production pools. Seasoned pools have shorter maturities and also prepay faster in higher rate environments. And, therefore, can command significant pay-ups, if rates were to move higher. This is especially true with respect to 15-year MBS, where three-year to five-year seasoned pools at a discount to par can be expected to trade at a premium of 1 to 2 points above TBA and higher rate environments. Obviously, as we’ve highlighted over the last five years, the prepayment-protected aspects of these pools also provide enhanced performance, if rates fall, as prepayment speeds on these pools will remain contain versus more generic MBS. By concentrating the portfolio in pools with the combination of seasoning and prepayment protection, we have the desired benefit of two-sided performance, or as it’s called in the mortgage market a better convexity profile. Again, these types of pools comprise the majority of our specified pool holdings with more than 80% of our lower loan balance and higher LTV pools seasoned on average more than 30 months. I’ll now turn the call over to Peter to discuss funding and risk management.

Thanks, Chris. I’ll begin with our financing summary on Slide 8. Our repo portfolio balance fell to $45 billion at quarter end, consistent with the reduction in assets that Chris mentioned. Our funding cost increased to 45 basis points during the quarter, due to the addition of some longer-term funding and due to generally higher repo cost observed during the quarter. More recently, repo costs have declined slightly through the first month of this quarter. On Slide 9, we provided summary of our hedge portfolio. In aggregate, the notional balance of our hedge has declined slightly to $48.4 billion during the quarter. Given the decrease in our asset and debt balances, our hedge ratio as measured by the notional balance of our hedges relative to our debt and TBA position increased to 84% in the second quarter, up from 78% in the first quarter. Said in another way, 84% of our repo funding has been synthetically converted to longer-term fixed rate debt to our hedges. As a result, our all-in cost of funds should remain relatively stable even in a scenario where the Fed raises short-term rates. As Gary mentioned, the significant steepening of the yield curve in the second quarter contributed to the decline in our book value. We manage our sensitivity to yield curve fluctuations primarily through hedge selection. In that process, we consider the overall sensitivity of our business to changes in the shape of the yield curve. In the current environment, we have positioned our hedge portfolio in a way that allows our net asset value to benefit when the yield curve flattens. Obviously, if the yield curve were to steepen, the opposite would occur and our net asset value would be adversely impacted. Changes in the shape of the yield curve affect our overall business in two primary ways. First, when the yield curve steepens, our future earnings outlook generally improves. This is the case, because we like most investors do not hedge out all of the duration exposure in our mortgage purchases. As such, net interest margin tends to improve when longer-term rates are materially higher than shorter-term rates. Second, we believe option-adjusted spreads will be increasingly correlated with the shape of the yield curve. More specifically, if the yield curve were to steepen, we would expect option-adjusted spreads to tighten given the enhanced income characteristics of MBS in this environment. Conversely, in a scenario where the yield curve flattens materially, we would expect option-adjusted spreads to widen as investors demand incremental return to offset the deterioration in net interest margin that occurs in a flat yield curve environment. Our view on the correlation of option-adjusted spreads in this scenario is further supported by the reduced participation of highly levered OAS buyers in the market today. In the past, steady demand for MBS from highly levered buyers like the GSEs dampened OAS widening even in very flat yield curve environments. So to recap, a flattening of the yield curve tends to negatively impact our overall business through lower net interest margin and through wider option-adjusted spreads. As such, we tend to position our hedges in a way that allows our book value to benefit when the yield curve flattens, thereby mitigating some of this negative impact on our overall business. As we discussed, option-adjusted spreads widened last quarter despite the yield curve steepening. This was due in part to the fact that spreads began the quarter at historically tight levels. We do not believe this recent correlation is indicative of the way spreads will move if the yield curve continues to steepen. Finally, on Slide 10 we provide a summary of our duration gap and duration gap sensitivity. Given the increase in interest rates, the duration of our assets increased by about a year to 4.6 years. At the same time, the duration of our hedge portfolio increased only slightly to 3.6 years. As a result, our net duration gap at quarter-end was positive one year. With that, I’ll turn the call back over to Gary.

Thanks, Peter. And at this point, I’d like to ask the operator to open up the lines to questions.

Yes, thank you. We will now begin the question-and-answer session. [Operator Instructions] At this time, we will pause momentarily to assemble our roster. And the first question come Steve DeLaney with JMP Securities.

Good morning, everyone, and thanks for taking my question. Some good comments, good color in the presentation, especially from Chris’ comments about the lower spread duration on the 15-year MBS. And I was just curious, guys, that looking at the quarter, 15-years certainly outperformed on an OAS widening basis, only about 10 versus 20 as you pointed out. But we noticed a decline, I guess, in your 15-year composition downed about 35% from something in the 39% to 40% about a year ago. So, as we look forward in the possibility with flatter curve, could we expect to see an increase in the percentage of the 15-year segment of the portfolio just on the basis that we know we have lower spread duration there? So, help me understand how you think about the mix between 15s and 30s. Thanks.

Hey Steve, it’s Gary.

Hi, Gary.

Thanks for the question. I’ll start it, and maybe Chris will add a little bit. But, look, first off, obviously, as we think about the potential for Fed hike, so one of the things that you have to keep in mind with respect to 15-year is they are more sensitive to the frontend of the yield curve than 30-year mortgages are. And that’s generally, if anything, somewhat favorable. They also as you mentioned have shorter spread duration. So, if spread movements – if there is spread widening they’re less affected by that. Both of those again are generally favorable. However, if you do think that the volatility in the frontend of the curve could be higher than the volatility in the backend of the curve, then all of the sudden some of the shorter duration benefits of 15-years actually get weaker. So, that’s one thing that we do think about. The other thing is, as we operate with kind of much lower leverage than normal for us, then the shorter spread duration is less of an advantage with respect to 15-year. And so, as leverage in a sense comes down, there is much less incentive just generally speaking to own 15-year. And so, to Chris’s discussion earlier, I think our focus in the case of 15-year has really to stay in real value-added position such as the very seasoned pools and especially very seasoned loan balance pools that will perform in both directions. And we have much less interest so to speak in TBA or generic 15s.

Got it, got it. And, Gary, just a follow-up to that, so if we’re to believe the Fed and that we’re looking at the first tightening maybe just a couple of months away, I know that you’ve taken up your total hedge position to 84%, but that, of course, includes your swaptions. If we’re actually into a modest tightening here in a couple months, should we expect any change in the mix of your hedges maybe between fixed pay swaps versus swaptions or do you kind of like where you’re positioned right now? Have you already positioned for the tightening, I guess, is what I’m asking.

Yes. Hi, Steve. This is Peter. I’ll take that.

Hello, Peter. Thank you.

I would say, that generally speaking in the current environment, we like the mix that we have, a little higher percent of swaps relative to our swaps and positions that we had in the past. Now, if obviously, if rates start moving we could just take our overall hedge ratio up even higher if we felt like there was significant moment in interest rate. But in the current environment, we sort of downplayed the use of options in part, because options really give us a lot of benefit for outsized interest rate moves. And in the current environment, while there could be movements of 50 basis points like we’ve seen. We don’t have the same view on really big 100 basis point or 150 basis point move. So, out of that money options we don’t believe right now are necessarily appropriate for our portfolio. So, we’re relying more Treasuries and swap hedges.

Great. Okay, thanks for the color guys.

Sure. Thanks, Steve.

Thank you. And the next question comes from Doug Harter with Credit Suisse.

Thanks, Gary. If you could just talk about how you are viewing kind of the volatility in the book value. Obviously, and kind of in what we saw in June was an outsized move relative to any of the other months that we’ve kind of seen since you’ve reported monthly. So, just how you’re thinking about risk tolerances and book value sensitivities in this environment?

Doug, thanks for the question. And it’s an important topic. I mean, as you said, since we released book value on a monthly basis beginning in October of last year, we really only had one month with a decent size move and that was June. As we sit here today, though, the moves in July are minimal, at this point. So we’re not expecting any big move there, but we obviously still have a few days left. But what I think is important is that, to your point about the volatility in the bond markets, I mean, despite a very volatile period, again, we’ve had this, we’ve had one-month with a big move. And again, that that really informs a lot of the reason why we’ve operated this year with very low leverage, because if you operate with low leverage, if rates and spreads are moving around at some point when you feel better about things, you have the capacity to take advantage of it. And so, you have the capacity to add mortgages and so forth. So while we would not generally say, I want to be clear about this, we don’t generally like to see book value go down. But there are times when, I mean, the reality is wider spreads, we will get back the negative impact from wider spreads if we hold positions over the long-term. And more importantly, they will increase our ROEs over time, especially if we can grow our portfolio at that point. And so now that we’ve seen a widening in a sense to kind of more reasonable levels. In mortgages, future widening really, any material future widening will get us to the point, where most likely, where we view things as an opportunity. And so what I think you have to do is, you have to balance kind of the impact of book value changes in the near-term versus the impacts on kind of go-forward returns. And when you operate at lower leverage, I think, it’s a little easier to view our spread widening as kind of being two-sided as opposed to adjust the negatives.

Great. And then in the – in late 2013, you, in addition to buying back your own stock, you bought back – you bought equity investments and peers when they are trading at large discounts. How are you thinking about that potential investment in this environment?

At this point it’s not something, we still have a small position that’s kind of left over from that. However, it’s not something we’ve been engaged in. It’s always a consideration. But, again, even at that point, we view buying back our stock as kind of the first order of business in scenarios, where we’re doing a lot of that than we – there are times where we will consider purchasing other REIT stocks. But it’s not something that we’ve done recently.

Great. Thank you, Gary.

Thank you. The next question comes from Mike Widner with KBW.

Hey, good Morning, guys. I guess, my first one is pretty simple and kind of just in the details. But I was looking at your lifetime speed assumptions, and those came down a fair bit, Q-over-Q, particularly for the higher coupon 30-year. I just wonder, I mean, obviously, rates are higher, but that – if I look just mostly at the 30-year 4%s and 4.5%s, I guess, I was just surprised that CPRs are up, actuals are up; and then Q-over-Q, you just took the assumption down quite a bit. I ask because, even if I back out the catch-up adjustment, your premium amortization was quite a bit lower than we were looking for, and I’m just trying to think about how to model that going forward?

Well, I think it’s pretty straightforward in that. The lifetime assumptions aren’t going to – are going to be more correlated with the change in interest rates, and for that matter that, the change in mortgage rates and the shape of the yield curve. So a steeper yield curve implies higher forward rates or higher rates in the future. When you combine that with just the backup in rates and wider mortgage spreads, it’s extremely logical that almost necessary to assume slower prepayments kind of going forward. And so to your point, yes, we did see the peak in prepayments speeds in Q2. But I think everyone’s assuming that, they’re headed lower, both in the short run. But then, again, if you believe any of the information embedded in the yield curve, then they’re headed even lower from there. So that’s a good driver of the slowdown in the kind of go-forward prepayment estimates. To your point, we do back that out the catch-up am component in current periods with respect to kind of the net spread income number I gave you. But, again, we think that’s the logical way to look at it.

Yes, I mean, that certainly makes sense to me. I mean, I guess, philosophically what I’m wrestling with is, talking about how much duration, I mean, it’s a fair amount of duration extension implicit in assuming that much extension in the life of them. And so, I mean, I just hear a lot of talk about, oh, well, the changes in value were all about OAS widening and spreads widening, but at the time, I mean, duration is extended by quite a bit, I mean some of this stuff, a full two years of extension. And so I’m just having a hard time reconciling some of the discussion I hear about, how much the OAS move out versus just, the fact that it was even by your own measures and by your own tables, quite a bit of duration extension. I mean, I think your 30-year portfolio overall was 1.3 years longer Q-over-Q, so I don’t know, I mean, I know, it just seems like there’s a little bit of contradiction there, and I don’t want to overstate, because I think the durations – the OAS has probably widened a little bit, but doesn’t seem like it explains really all the book value change?

So, first off, I mean, we were very clear in the opening remarks that it was a combination of spread widening, higher interest rates, and, Peter, spent quite a bit of time talking about the shape of the yield curve and the fact that that was a factor as well for us. So I do want to be clear that there was a range of impacts there. And we were very clear about the fact that our duration gap got longer as a function of the extension. And that’s something we not only address kind of quarterly, but we’re very careful in our disclosures to show you and talk about the – how our portfolio performs up a 100 and what happens to the duration gap, and what happens with extension. So, I mean, the reality is extension in the mortgage portfolio is par for the course, and that’s something we deal with quarter-over-quarter.

Yes. And that’s fair. I mean, I think to be clear your disclosure is great and it’s helpful, and it helps put all that in perspective. Yes, I’m just reacting to a lot of kind of a consistent theme we’ve heard from mortgage REITs, a lot of, it was very OAS, or very spread widening driven, the book value declines that we’ve seen across the group. And, I mean, to some degree it just – well, the book values are down, and I think, it was clearly a combination of both. Let me – I’ll move on from there and just ask a simple one. On the balance sheet, you show $5.1 billion of Treasuries, and then, on your hedge portfolio, you showed $2.9 billion, so there’s another $2.2 billion somewhere. Is that just short duration, cash sort of stuff, or I’m just thinking about how to model that from both the book value and the earnings standpoint, the extra 2.2…?

Yes, Mike. This is Peter. In the back of our presentation, we give you a breakdown, a little bit more detail of our Treasury position, it’s on page 25. And you can see that there’s some long and short positions, so net-net that’s what you’re picking up there is our net long position in Treasuries. And that move around, obviously, quarter-to-quarter. And as we rebalance the portfolio, we often use Treasuries for short-term [Technical Difficulty].

I got you, yes. So the $900 million that you’ve short – net short year-over-year, is that shown on the other side basically is a derivative presumably on the liability side?

Yes.

Okay, great. Thanks. That’s all for me guys.

Thanks, Mike.

All right. Thank you.

Thank you. And the next question comes from Charles Nabhan with Wells Fargo.

Hey, guys. Thanks for taking my question. I was wondering if you could comment on FHLB advances. As you incorporate that in your funding mix over time, how large do you see that component being? And also could you talk about some of the advantages that might represent both on the hedging side and on the funding costs side?

Sure. Charles, this is Peter. I’ll give you some insight into that. And I’ll talk you about why we’re a little bit slow in our use of those advances right now. We have begun to use some advances, but our position has been very small. And to your point, the advances of Federal Home Loan – we’re at Federal Home Loan Bank, Des Moines, the advance rates can be very attractive relative to what we see in the regular repo marketplace. Just to give you an order magnitude, short-term one-month advances are about 10 basis points more attractive. If you go out as far as a year, that spread might widen to 15 basis points to 20 basis points of incremental pick-up in terms of having lower costs. Now, there are some additional costs that you have to consider when you’re looking at your advances. One is that, you obviously have to post the haircut, which is generally consistent with standard market haircuts, but on top of that you also have to make an equity investment. So you can think about that as an incremental haircut. And so the all-in cost could be a little bit more than regular repo when you factor in the higher haircut in the equity cost. Second, there are funding opportunities out in the term that the Federal Home Loan Banks can offer. And we would certainly look at that. They can be fixed rate, floating rate and callable, and that could be a meaningful source of hedge for us and replace some swaps. Now, there are two negatives that we sort of have to get over before we start using those more significantly. One is that, just as a consideration, the Federal Home Loan Bank through their advance program has the ability to change the margin on those longer-term advances at their discretion. That’s unlike what we see in term-repo. Today, for example, we have five-year term repo out where the haircut is fixed. So, that’s a real benefit of having a fixed margin and a consideration when we use longer-term Federal Home Loan advances. The other key to our reluctance to over rely on it right now is that we’re obviously still waiting for some clarity from FHFA as to whether or not captive insurance companies are going to be allowed to remain as eligible members of the Federal Home Loan Bank system. We believe we should be. We believe our mission is absolutely consistent with the mission of the Federal Home Loan Bank system. We’re hopeful that we’re allowed to stay members. But until we get clarity, we’re reluctant to use the term advances in any significant way. What you can expect to see in this quarter is probably increased use of advances, but they’re likely to be only around 30 days until we get that clarity from FHFA.

Great, and as a follow-up, could you touch on your dollar roll performance this quarter? And maybe also comment on what you are seeing thus far in the third quarter in terms of specialness?

Sure, so roll is generally traded sideways to slightly weaker during the second quarter. That said, I expect we’ll continue to have opportunities to roll positions at levels better than on balance sheet repo, but not likely with the same consistency or degree of specialness that we had over the last, say, 12 to 18 months. But just to give you a spot, I mean, the Fannie three-roll [ph], for example, is trading great right now at around negative 25 basis points, which is about 60 basis points through one month repo. But other rolls are trading considerably weaker. And the size of our roll position going forward is going to continue to be a function of both specialness and the overall refi environment. And even in periods when rolls are only trading 20 basis points through one month repo, we’ll still likely have a sizable roll position if the overall refi environment is benign. 20 basis points is still a fair amount of low-risk incremental return.

Okay, great. Thanks for the color, guys.

Thank you.

Thank you.

Thank you. And the next question comes from Chris Gamaitoni from Autonomous Research.

Good morning. Thanks for taking my call. Could you give us a sense of – you mentioned spreads widening and the curve shifts, there is more opportunistic investment opportunities, maybe a sense of the delta between the current in-place returns and what you may see on new investments when you do take up leverage?

So when you think about, I mean, it’s sort of hard to quantify. I mean, when you look at the existing portfolio, if you look at it on mark-to-market basis, it obviously benefits from the wider spreads, but you have to mark it down first. But realistically, if you just think of an environment where spreads widen 10 basis points, 20 basis points, that incremental spread levered seven – or seven times, can get you an extra 1%-ish, 15 basis points gets you right around 1% higher ROE. And so, incremental spread widening can be very helpful in terms of kind of longer-term returns. The other thing is as you see spreads widening, if they get to kind of a wider-end of the range that you would expect in the given environment, I mean, the bigger picture issue is that it really allows you to run a bigger position. And so, not only do you get kind of the better new money returns, it’s a percent or two better in ROE under some cases, but you are also willing to run higher leverage and that’s obviously important as well from an earnings perspective. So, when we look going forward and we say look given that what we’ve seen over the past quarter if we see spreads continue to widen, they will get to the point where we feel they are at the wider end of kind of a go-forward range, and be willing to take leverage up in addition to kind of be looking at higher ROEs. And so, that’s really the driver of saying that these types of moves can set up good ROE opportunities in the future.

Sure. And then, can you clarify or just give me a sense, you mentioned that the more seasoned spec pools; as rates rise this will prepay faster; maybe just why that would occur and how that kind of floats with decreasing the lifetime CPR, relatively significantly on your 30-years that are predominantly spec pools?

Yeah, sure, I mean, first off, so we’ll start with why that we think they will kind of prepay faster in a rising rate environment. I want to be clear, they will still slow down versus where they have been. The difference is a brand new pool generally takes a couple of years. I mean, if you think about in a rising rate environment where people are not refinancing, because they can lower their rate. They are typically kind of prepaying or leaving the pool mainly because they move. And so, a new loan where someone has just taken out a new loan either at again a decent percentage of recent originations are purchase, they’re obviously – again, that percentage is going to go up now that rates have gone up especially. But even so, even people that have newly refi-ed they typically don’t do that if they think they’re going to move right away. So, from that perspective, new pools take awhile to season or to get to the point where they’re going to have reasonable turnover so to speak. Or as a seasoned pool that’s three-years-old or something, three-, four-, or five-years-old is in a very different position, again both from the perspective that it’s much further out on a ramp so to speak. And so, that means that if rates are much higher, instead of getting two, three, four CPR like you might get on a newer pool; you’re likely to get seven, eight, nine CPR on the more seasoned pool. In today’s environment, there is another benefit which is the three-, four-, five-year-old pools also have built-in house price appreciation, which also means that from a credit perspective they’re in a better position to refinance. They actually could consider some level of cash out refi, even though that’s not going to be as big an issue. But they are certainly not going to be locked into their home, and so they’re in a better position to move. So, there are a couple of different factors that get to that. And again, when you go to, well, we lowered our expectation for longer-term prepayments; I mean, the only thing that relates to is we’re just taking out in a sense a component of refi expectations. And that’s the component that is kind of correlated with interest rates. So, hopefully that…

Sure, that makes sense. That makes perfect sense. Thank you.

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

Thanks, guys, for taking my questions. Hey, Gary, in the past when you talked about repurchases. One of the things that – one of the ways you framed it is it’s not just a function of stock price but actually how you feel about the potential value of the underlying securities. And you’ve just given some really interesting commentary about the idea that the opportunity to, as spreads widen, is with low leverage, is to start buying securities, attractively priced securities, and levering up the balance sheet. It kind of looks to me like, if you take both of those things in combination, you are already starting to leg into that trade. You are buying back shares; that’s leveraging up the balance sheet. You are suggesting based on your, at least, previous commentary, that you do like the pricing at these levels. So are we looking at a little bit of, at least, near-term tactical shift, given what’s happened with spreads?

What I would say is, I just want to talk a – clarify a little bit about what we’re saying around spreads and rate levels. I mean, we feel much better about them. We think mortgage spreads have gotten back to a point, where they’re reasonable now, as opposed to kind of full, which they were late last year, or early this year. We still feel that the – we still think that they are biased, where that there are number of scenarios that could lead to better opportunities, let’s say, over the next three to six months. So, I mean, as you can see, our leverage didn’t go up intra-quarter and obviously went down a little bit. And currently, it’s not materially different from kind of where I closed the quarter. So, but to your point about kind of how do you express, as we get more confident around things. To your point depending on kind of price-to-book ratios and those and the other factors I’ve laid out, one method of taking leverage up, certainly can be share repurchases, obviously, another method is, you just go out and buy mortgages. And we certainly will consider both options under the assumption that we are looking to increase leverage.

Got it. Great. Thank you very much.

Thank you.

Thank you. And the next question comes from Daniel Hyman with PIMCO.

Gary, how are you doing?

Good. How are you doing, Dan?

Good. Well, first, we like to see you buying back the stock here, so that was a nice thing to see in the report. And I just wanted to ask a little bit more about that in terms of how much room do you potentially have to add the equity – to add more equity, assuming it stays at current levels?

Well, first off, we have, I think it’s around $900 million in kind of authorized share repurchases currently. So, there is a fair amount of capacity on that front. I think, again, how much capacity we end up using is a function of how the stock trades and what kind of discounts and some of the other factors that I’ve laid out.

So where would you think about, let’s being max, using all that? Where would you think about, do you have a range where you would say, we just got to buy all of it; it’s just way too cheap, or do you have a way to think about that, that you could…?

Well, yes generally, let me just generally kind of outline the process that we tend to use when we look at share repurchases. Again, I got to overlay into this that window periods that are the only times that we can operate with respect to share repurchases. Second of all, on a daily basis, there are guidelines as to how much that you can buy and what percent of your trading volume, so that those are factors. Now, other kind of outside of those two, the way we tend to execute share repurchases with is that, we have a schedule, where at a certain threshold, we start to buy shares. And the short-term trigger tends to be at a price-to-book ratio based on a current estimate. And then if that thresholds drop, or if the price-to-book ratio drops, then the speed of the amount that we will purchase on a daily basis tends to increase. So that’s the general process that we use with respect to share buybacks. And, obviously, those thresholds can change and there – and then there are other variables, but that is – that’s the way that we kind of operationally execute.

And then, one more follow-up. It looks like you’ve added a little bit of duration to the portfolio as of June 30, and you’ve add a bit of spread duration with the portfolio. So given that and what’s going on so far in July, rates are a fair amount lower and spreads are a fair amount tighter. July has been a pretty good month? Can you comment on that or?

Well, actually, I’d say, spreads are largely a wash, maybe even a basis point or two wider like from the beginning of the quarter. They widened a fair amount a early in July, and then they’ve come back up until the last couple – last day or so. But – so they’ve kind of bounce around, but not a huge change there. We have had a little bit of a rally. But, again, going just back to what I said earlier about book value, which is it’s pretty much changes this quarter or this month are minimal and we’ll put the number out in a couple of days. I mean, I don’t know what’s going to happen over the next few days. But there has not been a big change in book value. With respect to your earlier comment about like adding duration to the portfolio, it’s more a matter of the extension embedded in the mortgage portfolio. We had both an increase in rates, but more importantly, this is steepening in the yield curve. So our durations extended a fair amount. We offset a little of that extension, but obviously not all of that and that’s the reason for the larger duration gap.

Thanks.

Thank you, Dan.

Thank you. And the next question comes from Mark DeVries with Barclays.

Yes, thanks. Sorry, if I missed this. But what type of levered ROEs, do you think are available now given the OAS widening we’ve seen at the levels of leverage that you are comfort with?

So, I mean, just to give you a little color on where sort of yields and spreads are, I mean, 30-year yields are in the 3% area, 15% is around, 2.25% with nominal spreads around a 100 basis points to 150 basis points without much of a duration gap on 15s and 30s. Obviously, ROEs are going to be a function of leverage and hedge curve position and duration gap. But those are reasonable spots on where sort of current spreads are given the widening.

Got it. And then on the issue of OAS widening in a steeper curve, I think you commented that you don’t expect to see that happen the way it did in this quarter. Could you talk a little bit about what caused that in this quarter? I know you mentioned that you felt like spreads were just at historically tight levels, and that was part of it. Where there any other drivers, and what would cause it to be different, particularly when you think about the fact that a flattening curve probably means the Fed is now tightening, and that they’re now no longer reinvesting the principal and interest into MBS, and the kind of technical pressure that may put on spreads?

Well, to your point, again, first off, just with respect to this quarter, as we had talked about beforehand, we felt that the risk return kind of profile for MBS was weaker than it had been. Valuations were relatively full and volatility was high. So it’s not surprising, I mean, the amount was maybe a little surprising, but it wasn’t surprising that you saw wider spreads or underperformance in mortgages, in that they had held up very well, and they don’t necessarily react great – volatility in the short run. So I think, again, this quarter we think is more of – they were fully valued and it was logical to have them pull back so to speak. But if you go forward, and it’s goes back to exactly what you just outlined. If you think about a flatter yield curve environment for a second, what ends up happening is in this environment, it is probably created by the Fed actually raising rates potentially in September, and expectations of them continuing to raise rates at a relatively moderate pace. An then the next thing that people will think about, which is an additional factor is that at some point, they will stop reinvesting in mortgages, that obviously is likely to push spreads wider. But even outside of that factor that if the yield curve is steep, I mean, is flat, one source of spread for investors such as us is the yield curve spread and that’s true for a bank. It’s true for hedge funds. It’s true for most levered investors in particular. But a source of spread, which is kind of a yield curve spread, if you’re not a 100% hedged, drops off. And so it is logical therefore for investors to kind of demand more kind of option-adjusted or kind of intrinsic spread from the product. And so for that reason as well, we think that for bigger moves over time a flattening yield curve is probably more of a threat to mortgage spreads. Conversely, if the yield curve were to continue to steepen from here, it gets to reasonably steep, kind of historically steeper kind of – it’s an environment where banks, REITs, hedge funds, people that are willing to buy mortgages and take a year or two of duration risk are going to see significant incremental spreads associated with that and returns associated with kind of that carry position. And so for that reason, it’s logical to believe that you won’t see kind of that being or it’s not as logical to assume that that’s going to be a pressure point or a tough situation for the mortgage market with respect to option-adjusted spreads. So look, that doesn’t mean month-by-month or week-by-week you’re going to see that pattern. But when we look at the world going forward over the next year or whatever that is kind of the way we think about the likely correlation between yield curve and spreads.

Okay. It’s really helpful. And then just one last clarification, Peter’s commented that your position for NAV may actually benefit in a flattener, does that assume that you’re not seeing OAS widening that they may tighten some?

Well, no, I think that is in a sense, assuming the hedges will perform better in that environment. But that – again, if spreads widen materially, then the spread widening could very easily dwarf the hedge bias so to speak and vice versa. So, I mean, I think his point is that all things being equal, we will benefit; the hedges are better suited to more of a flattener.

Okay. Got it. Thank you.

Thank you. And the next question comes from Brock Vandervliet from Nomura.

Thanks very much. Most of everything’s been asked and answered. But when you speak of curve flattening, so the 2%s-10%s [ph] right now are 155, 160. After the Fed starts moving, where do you think that goes? Thanks.

Look, I mean, I think that there is a number of difference. There are number of different scenarios. Look, we do think – look, our core view on the current landscape is we think the Fed really wants to go. We think it’s more likely than not they go in September. However, we also think that the global economy in particular is not very strong. And we think that the U.S. economy is somewhat overrated as well. And against the backdrop of a Fed tightening, we think the dollar improves. That makes it even – that creates another headwind for the U.S. economy. You couple that with weakness again in China and other places, which we don’t think go away anytime soon. We just don’t see inflation being a real issue. And the bottom line is, while a central –while the Fed has to think about both – obviously, both employment and inflation, and right now – and employment is obviously moving in the right direction and had moved a lot in the right direction. I think the Fed is somewhat hoping on the inflation side and I think that the act of tightening will make it even more difficult for the Fed to hit their target on the inflation side. And so, if you play all that through, I think the larger goal scenario a year from now is we’re probably 25 to 50 flatter. But in the short-run a lot of things can happen.

Got it. That’s very helpful. Thank you very much.

All right. Well, thank you guys for your interest in AGNC and we’ll talk to you again next quarter.

Thank you. The conference is now concluded. An archive of this presentation will be available on AGNC’s website. A telephone recording of this call can be accessed through August 11 by dialing 877-344-7529 using the conference ID 10068975. Thank you for joining today’s call. You may now disconnect.