AGNC Investment Corp. (AGNC) Q4 2015 Earnings Report, Transcript and Summary

Katie Wisecarver - Director of Investor Relations Malon Wilkus - Chair and Chief Executive Officer, American Capital Agency Corp. and Chief Executive Officer, American Capital AGNC Management, LLC Samuel Flax - Executive Vice President and Secretary, American Capital Agency Corp. and Executive Vice President, Chief Compliance Officer and Secretary, American Capital AGNC Management, LLC John Erickson - Chief Financial Officer and Executive Vice President, American Capital Agency Corp. and Executive Vice President and Treasurer, American Capital AGNC Management, LLC Gary Kain - President and Chief Investment Officer, American Capital Agency Corp. and President, American Capital AGNC Management, LLC Christopher Kuehl - Senior Vice President, Agency Portfolio Investments, American Capital Agency Corp. and Senior Vice President, American Capital AGNC Management, LLC Peter Federico - Senior Vice President and Chief Risk Officer, American Capital Agency Corp. and Senior Vice President and Chief Risk Officer, American Capital AGNC Management, LLC Bernice Bell - Senior Vice President and Chief Accounting Officer, American Capital Agency Corp. and Vice President and Chief Financial Officer, American Capital AGNC Management, LLC

Douglas Harter - Credit Suisse Rick Shane - JPMorgan Jason Weaver - Sterne Agee Joel Houck - Wells Fargo Securities Bose George - Keefe, Bruyette & Woods Stefano Risa - PIMCO Brock Vandervliet - Nomura Securities Kenneth Bruce - Merrill Lynch Deepak Narula - Mehta Partners

Good morning and welcome to the American Capital Agency Fourth Quarter 2015 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.

Thank you, Austin, and thank you all for joining American Capital Agency’s fourth quarter 2015 earnings call. Before we begin, I’d like to review the Safe Harbor statement. This conference call and corresponding slide presentation contain 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 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 16 by dialing 877-344-7529 or 412-317-0088 and the conference ID number is 10078446. To view the slide presentation, turn to our website, AGNC.com, and click on the Q4 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 the call today 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 of Mortgage Investments; Peter Federico, Senior Vice President and Chief Risk Officer; and Bernie Bell, Senior Vice President and Chief Accounting Officer. With that I will turn the call over to Gary Kain.

Thanks, Katie, and thanks to all of you for your interest in AGNC. We finally got the first Fed rate hike in almost 10 years in mid-December and quarter-over-quarter changes in interest rates were largely consistent with expectations. Both the Treasury and swap curve flattened with shorter-term rates increasing close to 40 basis points and longer-term rates only rising around 20 basis points. The performance of spreads across the fixed income spectrum was mixed, with some asset classes such as agency MBS widening and some improvement in other sectors like high yields that had underperformed the most in Q3. However, the beginning of 2016 has been a very different story. Interest rates have fallen sharply, credit spreads have widened, and global equity and commodity prices have been under significant pressure. For this reason, at the end of my prepared remarks, I will directly address the 2016 landscape and what I think it means for AGNC shareholders. With that said, let me turn to slide 4 and quickly review our results for the quarter. Comprehensive income totaled $0.06 per share. Net spread income, which includes dollar roll income, but excludes catch-up am improved to $0.54 per share from $0.51 last quarter. Economic return was positive 0.8% for the quarter or 3.3% on an annualized basis. This was a result of a $0.41 drop in book value being more than offset by our $0.60 per share dividend. The small drop in our book value was in part driven by a modest widening in agency mortgage spreads during the quarter. However, agency MBS spreads are now materially wider than they were when we began 2015. For example, option-adjusted spreads on 30-year 3.5s widened on the order of 30 basis points over the course of 2015. Wider spreads improved the carry in our portfolio and therefore bolster the outlook for future economic returns. Accretion from share repurchases also positively impacted our economic return. During the quarter, we repurchased $161 million, or 2.6% of our common stock. On slide 5, I just want to highlight that our leverage was unchanged at 6.8 times. Given this conservative position, we have ample capacity to take advantage of attractive opportunities when we think the time is right. Turning to slide 6, economic return for the year was negative 2.6%. This result was comprised of a combination of $2.48 per share of dividends, and a $3.15 decline in book value. Fortunately, AGNC operated with its lowest ever leverage during 2015. This decision was driven by our view, which we communicated to investors at the beginning of 2015 that agency MBS were fully valued and we were concerned that the risk-return equation had deteriorated. I don’t want to ignore the fact that AGNC’s total stock return was materially worse than our economic returns as our price-to-book ratio declined significantly during 2015. As I will discuss shortly, we now believe that our current price-to-book ratio is inconsistent with the improving fundamentals of our business. At this point, I will turn the call over to Chris to discuss the changes in the markets during Q4 and our portfolio.

Thanks Gary. Turning to slide 7, I’ll start with a review of what happened in the market during the fourth quarter. The yield curve continued to flatten with the 10-year swap rates increasing 18 basis points in yield while 5-year swap rates were higher in yield by 33 basis points. Swap spreads also continued to tighten in large part driven by [indiscernible] supply of US treasuries sold by foreign currency reserve accounts. Agency MBS generally underperformed the move in swap rate hedges during the quarter. At the bottom of slide 7, we have a time series of average daily option-adjusted spreads for both 15-year 3s and 30-years 3.5% MBS, which were both wider on average during the quarter by approximately 10 basis points and 8 basis points, respectively. Turning to slide 8, we have our performance summary for 2015 of the major fixed income risk asset categories. As you can clearly see, 2015 was a difficult year across each of these asset classes. Unlike the taper tantrum of 2013, however, where agency MBS were in the spotlight, the spread widening throughout 2015 was broad-based with the most dramatic underperformance in CMBS and high yield markets. As Gary mentioned earlier, spreads on most asset classes so far in 2016 have widened materially with the exception of agency MBS, which are more or less unchanged year-to-date. For example, investment grade corporates and CMBS are wider by approximately 18 basis points and 11 basis points respectively, while 30-year 3.5% Fannie Mae MBS are unchanged to slightly tighter. Agency MBS are benefiting from the status of the most liquid zero credit risk spread product. Their outperformance can also be attributed to the growing consensus that the Fed’s reinvestment program will likely remain in place for the foreseeable future. Let’s turn to slide 9, and I’ll quickly review our investment portfolio composition. At risk leverage was unchanged as of quarter end, however, the investment portfolio declined to $59.9 billion, given the combination of share repurchases, higher interest rates, and MBS underperformance. At a high level, our portfolio composition was largely unchanged quarter-over-quarter as we believe the combination of both seasoned pools and call protection position us well for the current environment. And lastly, with respect to prepayments, as you can see in the table on the top right of slide 9, the portfolio continues to perform well. 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 10. Our repo funding cost was 61 basis points at the end of the fourth quarter, up from 52 basis points the previous quarter. This increase was due to the Fed’s December rate hike as well as typical year-end balance sheet pressure. In response to the higher cost over year-end, we shortened the average maturity of our repo funding to 173 days from 201 days the previous quarter. As I’m sure most of you are aware, the FHFA recently published its final rule on Federal Home Loan Bank membership. We, like the rest of the mortgage REIT industry, are very disappointed in the final rule which prohibits our captive insurance company from remaining a member of the Federal Home Loan Bank of Des Moines. FHFA’s position is based on their interpretation of the Federal Home Loan Bank Act of 1932, which explicitly allows insurance companies to be Federal Home Loan Bank members. FHFA, however, has defined the term insurance company to exclude captive insurance companies. This decision reverses a long-standing practice among Federal Home Loan Banks of allowing captive insurance companies as members. Mortgage REITs like AGNC play an important role in the US housing finance system and our business model is one of the few business models that has successfully brought private capital to the US housing finance system and importantly has done so on a permanent basis. Our mission and the mission of the Federal Home Loan Bank system are squarely aligned and we disagree with FHFA’s position. As such, we are hopeful that Congress will ultimately preserve our access to the Federal Home Loan Bank system. Until that time, however, FHFA’s final rule mandates that our advances be terminated at the earlier of their contractual maturity or February 2017, one year after the effective date of the final rule. Many of our advances have contractual maturities greater than one year. Thus, the outstanding balance of our advances will remain relatively steady at about $3 billion through February 2017. There has been a lot of discussion recently about the repo market in response to new regulatory requirements. For that reason, we added slide 11 to the presentation this quarter to provide some additional color on our funding outlook. It has been our experience that many of our largest counterparties have already made changes to their repo books stemming from new regulatory requirements. In general, these changes have reduced market capacity and increased somewhat the cost of mortgage repo. Despite the reduction in market capacity, we have been able to add new counterparties and maintain a significant amount of excess repo capacity. This capacity gives us the flexibility to increase leverage at the appropriate time. Equally important, our repo funding is well diversified across 36 active counterparties. Although our repo funding position is strong, we recently took an important step to further enhance our future funding capability. Specifically about six months ago, we began the process of forming a wholly-owned broker dealer. This entity is now fully formed and staffed and the regulatory application process is underway and we are hopeful that the entity will be operational by mid-year. Once our broker dealer is up and running, we will pursue membership with the Fixed Income Clearing Corporation, thereby giving us access to direct repo and the ability to clear our own TBA trades. Further, we are optimistic that the funding conditions will gradually improve. This optimism stems from the fact that the issues in the repo market are not a function of poor liquidity, but rather a result of higher capital requirements and balance sheet constraints introduced over the past several years that affect the largest financial intermediaries. Over time, we believe new forms of funding will emerge that will allow end users like ourselves to bypass to some extent the balance sheet constraints associated with these large financial intermediaries. Cleared repo, direct repo, and repo with small to midsize financial institutions are all likely to be part of the ultimate solution. Money market reform is another positive for the agency MBS market. Money market fund balances are at record levels and new SEC regulation greatly incents these institutions to own or lend against government collaterals such as agency MBS. Over time, we believe this liquidity will ultimately make its way into our market. Finally, on slide 13, we provide a summary of our interest rate risk position. At quarter end, our duration position was 0.8 years long, a slight increase from the previous quarter. Additionally, given the level of interest rates and the composition of our portfolio, our exposure to extension risk and prepayment risk was relatively even. With that, I’ll turn the call back over to Gary.

Thanks, Peter. At this point, please turn to slide 14 and I want to conclude today’s prepared remarks with a discussion of the current environment and our outlook for 2016. As most of you or probably all too aware of, 2016 has gotten off to a very rough start for most risk assets. US equity markets are down close to 10%, posting one of the worst Januarys on record. Many foreign equity markets are doing even worse, with the Chinese stock market, for example, down around 25%. In response, treasury and swap rates have rallied materially given the risk off mindset with yields on most maturities down 30 basis points to 40 basis points and that’s before today. Interestingly, yields on treasuries and swaps longer than 4 years are now lower than they were at the end of the third quarter, despite the Fed’s rate hike. Additionally, spreads on credit-sensitive fixed income assets have underperformed materially, with the widening in a number of sectors exceeding 50% of the aggregate move we experienced in all of 2015. Agency MBS on the other hand have performed relatively well year-to-date and are roughly unchanged. Against this challenging backdrop, we’re pleased that our preliminary estimate for AGNC’s January book value is largely unchanged. Now, I want to discuss our take on the global economic landscape. We believe the market is beginning to recognize that the global economic headwinds are real and that the US will not be entirely immune to what is going on elsewhere in the world. Unlike previous tightening cycles where the US economy was typically accelerating at a robust pace, today we are experiencing moderate growth and we’re not on an upward trajectory. The shallow nature of the current expansion makes the US economy in our opinion much more susceptible to external shocks like falling oil prices, weaker global demand, unfavorable exchange rate movements or decreased foreign investment in the US. Today’s global headwinds are indeed significant and we have listed a few of them on the top of the slide. Importantly, we believe many of these headwinds are more structural than cyclical. Yes, oil and other commodity prices will eventually stop declining, but absent a major shift in the supply and demand equation, the dramatic re-pricing over the past year will likely continue to create significant challenges for commodity-producing countries. As a result, we expect continued selling from sovereign wealth funds, central banks and other large overseas entities. When you couple this with currency-related selling from other emerging market countries, it is logical to assume that these factors will continue to negatively impact financial conditions in the US, even if the Fed were to be on hold. This dynamic is an important component of the feedback loop to the US. If overseas entities remain net sellers of US fixed income assets, equities or commercial real estate, the US economy will obviously face incremental headwinds. We all know too well that these same entities had been massive buyers of US assets over the last decade. So this is a major reversal in the flow of these funds. One should assume that the Fed is keenly aware of this dynamic and I would guess this was a major reason why they guided the markets to a much longer horizon for ending reinvestments on their existing treasury and MBS portfolio. We also think it is just a matter of time before the Fed also has to abandon its tightening bias. It is never easy to pinpoint the timing of inflection points, so we would not be surprised to see another one or two tightenings before this shift occurs. That said, the probability of the Fed getting stopped out sooner rather than later has clearly increased. To this point, the global interest rate picture is already fully pricing in the slower growth and deflationary pressures we just described. If you look at slide 15, it is amazing that 5-year rates in Germany, Switzerland and Japan were all negative as of last Friday. 10-year rates in these countries form a reasonably tight band around zero. The key take away from this slide is that US rates and to a lesser extent yields in the UK still stand out on the high side despite the significant year-to-date rally. The obvious driver of the rate differences is the divergent pass of the various Central Banks. If the Fed does change its tune, there is clearly room for US rates to move even lower. Now, if we look at slide 16, I want to conclude with what all this means for AGNC. If our assessment of the global landscape is correct, then the phrase “lower for longer” should again become the operating philosophy with respect to interest rates. Needless to say, this has not been the predominant mindset of investors over the last several years. In this “lower for longer” environment, we believe levered investments in agency MBS could be very compelling, especially given the material spread widening that has already occurred. The funding landscape is important to this conclusion and I wholeheartedly agree with Peter’s earlier comments that the worst should be behind us. Without further deterioration in funding levels, wider spreads will translate to higher returns over time. So that leaves one remaining topic, our outlook for the agency mortgage REIT space. To us, current price to book ratios do not make sense against the backdrop of an improving operating environment. A key distinction from the beginning of last year when we were less bullish on share repurchases is the cheapening of our underlying assets. A significant discount to book is more understandable environments where investors believe that risk-adjusted levered returns on an agency MBS portfolio are not compelling, and the underlying assets are poised to weaken. However, as valuations cheapen and returns become more attractive, this discount should contract. During 2015, with regard to AGNC and the rest of the mortgage REIT space, the opposite has occurred. Against the backdrop of significant price to book discounts, cheaper MBS, stable funding, and a view that we are not in a multi-year interest rate hiking cycle, common stock repurchases are compelling. We were active last quarter, as I mentioned earlier and in the absence of a noticeable improvement in our stock valuation, we will be active again this quarter. My guess is that one of you may ask me a related question along the lines of would AGNC be willing to buy other REIT stocks like it did in the past? The answer is a qualified yes. It is a consideration, but it has a materially higher hurdle than share repurchases and a number of conditions would need to be met. First, we would need to be repurchasing as much of our own stock as possible, given SEC volume constraints and window period limitations. Additionally, we have no intentions of purchasing the shares of any other company that is not actively involved in repurchasing its own shares. The equation right now is just too compelling and the accretion too material for an investor-focused management team to ignore. And with that, let me open up the call to questions.

[Operator Instructions] Our first question comes from Doug Harter with Credit Suisse.

The first question on the relative attractiveness of MBS today, how much of that do you think is due to the volatility in the market versus the underlying zero volatility attractiveness of MBS?

I guess what I would say is, if you went back to last year and I used the example on 30-year 3.5s option-adjusted spreads on mortgages are like 30 basis points wider and that’s adjusted for changes in implied volatility in the market or new option prices. So that’s kind of, we’ll say from a purely theoretical perspective, it’s 30 basis points adjusting for any change in market volatilities. But what I think is more important is if you went back to that period, we felt that mortgage valuations were not that compelling going back a year ago and that we were in a pretty volatile environment, and it was very unclear how things were going to evolve on the rate front, and for that matter on the economic front and let’s face it, most people were not expecting interest rates to be anywhere near where they are today. And so when you look at the world today, it is very possible not only are mortgages considerably wider, but I think there is a growing possibility that interest rate movements from here are more bounded than what people might have thought a little over a year ago. And so big picture, I mean what we are saying is from a risk adjusted perspective, things are a lot wider. We understand that there is volatility in spread products. We understand that corporates are widening, and materially we understand that CMBS is dramatically wider. But keep in mind, agency MBS don’t really have a credit component. And so to some extent, to the extent that they keep widening because other products that do have credit components are widening, then that is incremental return and it’s incremental risk premium that we are going to be willing to take advantage of.

And then on the broker dealer, is that something – is the benefit there going to be on the availability of repo or on the cost or both?

It really will be on both. What we’re hopeful for, when we get the broker dealer up and running hopefully mid-year is that, one, it’s going to give us access to repo that you enter into directly with the FICC with the exchange, so we bypass the conflict and, if you will, the friction that we’re experiencing with the intermediaries. And also from a cost perspective, both in terms of the margin requirement and the actual cost, we expect it to be a little bit lower. So we really are hopeful that it’s a very effective form of our financing.

How long would that take to scale up once the broker dealer is running to become a meaningful contributor?

We’re hopeful that by the end of this year that it will be a meaningful part of our funding. Of course, we’re going to continue. As I mentioned, we have 36 counterparties, and it’s important for us to strike a balance here with all of our funding. We want to maintain active and strong relationship with all of our existing counterparties where we do two-party repo with. So we will simply diversify our funding, but we expect it to be a meaningful component of our funding hopefully by the end of this year.

Our next question comes from Rick Shane with JPMorgan.

Really helpful context around relative performance of option-adjusted spreads. I’m curious as we think about the opportunity and the risks going forward, do you see potential risk spread widening related to sovereigns backing away from that market? I guess what I’m trying to ask is how important a participant are sovereign funds in your market?

They are a relevant or an important participant. However, they haven’t been driving things recently or really over the last year or two. So some sovereigns have been, or rumors have it that some sovereigns have been selling a small amount of some mortgages, but others have been buying them that are in a different position. So I think that from a big picture perspective, we don’t really see selling of MBS from sovereign, from let’s say foreign Central Banks as being a driving force in the market. Most of those Central Banks have a much, much more significant treasury position than they have a mortgage position. And they would likely, and it certainly seems like they tend to sell treasuries first. But again, you have to keep in mind that the biggest holders and really the biggest participants on the margin in the MBS market are domestic banks and they certainly have been adding mortgages and remain in a position to add mortgages. But one thing I just want to reiterate is that as long as it’s within reason, widening spreads for technical reasons are an opportunity over the long run and the key being as long as your leverages are reasonable and the widening is within reason, and given the lack of credit component and given the fact that really since 2013 most investor positions of the product are much more conservative, it’s really hard to see an environment where agency MBS spreads widen to the point where they create liquidity issues or quick rebalancing needs and so forth.

Our next question comes from Jason Weaver with Sterne Agee.

The first one, given the wider spreads we’ve observed especially since the end of the year, can you maybe ballpark the estimate of available ROE on incremental dollars of investment, assuming similar leverage and mix as your current portfolio?

Yields on 30-year 3.5%, for example, this morning are around 275, 280-ish using a reasonable CPR assumption and with seven times leverage and a one-year duration gap, you’re looking at growth spots, marginal ROEs solidly into the double digits.

Along with that question, given the incremental better opportunities we’re seeing going forward, at what level of benchmark rates you internally more concerned about a real pick up in refi-driven prepayments?

Look, I think you have to keep in mind that when we had these discussions three years ago around what rate levels does it take to create incremental prepayments, mortgages were a lot tighter or even a year ago. Given the widening we’ve seen in mortgage spreads, that gives a further cushion relative to swap rates and to a lesser extent relative to treasury rates where you don’t really have to worry about prepayments that much. So I think we still have a decent cushion there. And remember, our portfolio has a fair amount of seasoned specified product. And so we feel we have obviously the protection that that affords and we have a smaller TBA position than we’ve had in the past. So what I would say is this is that we view the prepayment picture even if this rally were to continue as very manageable.

Our next question comes from Joel Houck with Wells Fargo.

Kudos for the significant share buybacks last quarter. The question is the formation of the broker dealer related or I guess to the closing of the DTCC, they’re not going to process repo agreements as of July 15. And if that’s the case, what happens if the approval for that extends beyond that date or are they not related?

It was not related to that at all. We actually started the broker dealer process at least six months ago and that is an issue, the issue with DTCC between the two major clearing banks, Bank of New York and JP. We don’t actually think that that’s going to be a real meaningful problem for the marketplace. Today, at least 85% of the collateral is cleared through Bank of New York. Our agent will be Bank of New York for our banker dealer. So we don’t expect that to be an issue for us. We don’t really expect it to be an issue for the market. I think over time the market will work its way through the issues that it’s experiencing right now. And I think ultimately in the best interest of all the participants, both the regulatory bodies and the key clearing banks to make sure that that doesn’t become an issue for the market.

And maybe a broader question related to the potential sale of a manager, can you talk about the logistics of the management contract and does it get renegotiated with a new buyer? How does the Board work, the management team, all that related to a potential sale of American Capital?

Joel, that’s just not a topic we’re going to be able to cover. What I will say is I don’t think there will be any disruption to AGNC or the team with respect to any kind of transaction that may occur at American Capital or the management.

No, I appreciate that you can’t comment on a potential sale. I’m just asking about the logistics of the contract automatically get assumed by a buyer or is there renegotiation by a buyer?

It’s again just not a topic that we’re going to be prepared to discuss on this call.

Our next question comes from Bose George with KBW.

First just on your leverage, it remains low relative to what you see as normalized. Can you discuss what you’d need to see before you could take up leverage?

Look, what I would say is you got to take a step back and we have viewed the environment, the key factor in the environment being the macro landscape. And in 2015, we had in our minds a difficult macro environment where we expected spread widening just from a technical perspective and because risk-adjusted returns weren’t where we felt they should have been. We think that again in the case of agency MBS, the bulk of that has played out. Now that’s not to say that risk premiums couldn’t go up if we continue to see widening in other products, which is a very, very real possibility. So I think from our perspective at this point, it is more about looking for the appropriate timing to, in a sense, take leverage back up closer to historical norms versus needing further widening or looking for a particular trigger. I think it is more now about just being opportunistic again. And also maybe a little bit more of seeing if the economic landscape is sort of evolving the way we anticipate over time. So I would say that we feel that 2016 is going to be a favorable macro environment. That doesn’t mean we’re not going to have some strong kind of risk-on periods where rates could back up pretty quickly. But we see those as being more temporary. So against the backdrop of a favorable, much more favorable macro environment, I think we want to be opportunistic with respect to leverage. And there are multiple ways to get there. We can get there by buying mortgages; we can get there by repurchasing shares. And we will find the way that we think is in the best interest of the company.

Actually just on repo cost, can you just give an update where they stand relative to year end, any changes there?

They’ve come down a little bit. I would say, on average, they may have come down 3 basis points to 5 basis points since year-end and it’s really – that improvement is really across the curve from one month out to 12 months. So there’s been a little bit of improvement. We expect them to maybe improve a little bit more, but then stabilize here.

Actually just one last one, the FHLB funding, the loss of that, does that change in any way the plan that you talked about earlier about AAA investments, or is that not a factor how you fund them?

What I would say is that it is not irrelevant to what our future investments in the space. I think one of the benefits of AAAs and for that matter AAA non-agencies, including CMBS, would be that you could fund them with the flubs at more attractive levels than where you could fund them in the wholesale market. And that difference was much bigger than the difference on the agency side. So with the flub funding having a reasonable or a maturity for us that’s about a year off, I think non-agencies become – AAA non-agencies are on the margin less attractive. Now, the other reason we would use those positions is given that we are not running anywhere near full leverage and even if we were at eight times leverage, this would be true. If you have unencumbered positions that you’re not currently borrowing against, then the incremental yield is still relevant. So what I would say is look we can still get value out of that position, but the value would be more limited given the change at the flubs.

Our next question comes from Stefano Risa with PIMCO.

I have a question [indiscernible] I have a question that’s kind of similar to – evolves some from that were already asked. I was wondering what do you think is a good benchmark for funded that you guys should be referring to? Something that in the long run will generate the kind of 10% yield that the REIT is supposed to generate, both in terms of leverage which I think has been discussed quite a bit, but also in terms of what duration exposure, how much curve exposure you’re keeping. And within that context then, how do you look at your position versus that benchmark? I know you can obviously depart from it quite a bit, but how do you look at it now?

Yeah, let me attempt to give you an answer to that. Look, I think when we think about kind of our generic operating position, we think of it around we’ll call it 7.5 to 8 times leverage. We think of around a year-ish duration gap. And those are sort of starting points around that for a generic position. When you look at kind of benchmarking that, you can certainly take let’s say the Barclay’s mortgage index. You can look at things like, you can then hedge that out to let’s say one year and come up with a benchmark set of hedges across the curve. And then that you can back into let’s say we’ll call it a benchmark levered return. So there are ways to do that and we obviously can benchmark us versus our peers, which we do in the earnings materials and so forth. So I don’t know if that gets to what you’re looking for.

Yes, absolutely. So then relative – I don’t know if that benchmark would get you to 10% kind of yields. Maybe if you get on the NAV, you will get eight years of duration, right, because of the one-year duration from the portfolio. But how do you look at your position now versus that? You definitely have less turns of leverage and you definitely have less duration than that benchmark.

Absolutely and I think you’re getting to – and the point of – in 2015, we ran positions that were considerably more conservative than what we would consider the norm. And that really was from almost day one of 2015 and the driver of that was concerns around the market environment and in particular with respect to leverage. And so what we are communicating today is that we feel that the macro environment is getting more interesting and I think that will be more conducive to running kind of risks, a portfolio that’s more consistent with that long run. Clearly we’ve rallied a fair amount and I’m not saying that today is the perfect time to add a fair amount of duration. But from a big picture and a macro perspective, we feel that the conditions that were prevalent in 2015 to incent us to be very conservative are hopefully waning pretty quickly.

I would just add to get to your point about the market benchmark, Barclay’s actually puts out two indexes that I think might be helpful to you. One is the total return of the agency mortgage market. The other though is they also put out a yield curve and duration neutral swap index that mirrors the agency index. So you in a sense have a fully hedged swap index performance and then you can adjust that based on the leverage or your duration gap and get a passive benchmark performance.

Our next question comes from Brock Vandervliet with Nomura Securities.

So I’m surprised you haven’t gotten this question earlier, but given the move in swap spreads, and I guess we were thinking that, starting into the new year, these things would widen and they actually went back to at or near tights. Has this changed at all your perspective of them as a hedge tool? And what may else you be investigating as a tool for hedging?

Brock, I’ll start, and then Gary might want to add. But if you notice this quarter, we actually did increase the amount of treasuries in our hedge mix. Our treasury position went from about $1.5 billion to about $4 billion, and we did it both in cash treasuries but also increased our use of treasury futures. So I would expect, going forward, us to have a higher share of treasuries in our mix because I think the sort of persistent issues in the swap markets dictate that we have a more diversified hedge position. And the other thing that I would say is that there is a new 10-year futures that has been introduced to the market. The existing 10-year future operates like an underlying seven-year security. The new treasury future is actually going to have a very tight delivery basket around the on the run 10-year, so it’s going to have a duration and a risk characteristic much more like a 10-year security. And once that market I think develops and once the liquidity develops in that new instrument, I think that could be another interesting and useful tool for us over the long run.

Just one thing to add to Peter’s point, there are other options and there will be more options. But I think it’s important while swaps may have re-priced, they still are though a useful tool for hedging. And again, I think what’s really important just from a theoretical perspective to think about is as long as agency repo rates can basically relative to LIBOR are bounded or kind of don’t continue to get worse, then to the extent that swap hedges still work very well in terms of hedging our kind of exposure and doing what we want them to do, which is basically to lock in our funding costs over a longer period of time. And so again, I think that’s a key component of why we spent a fair amount of time on the funding situation. The funding situation did deteriorate in 2015, but again we feel that that process is for the most part played itself out. And then when you look forward beyond the next six months or something like that, we actually feel that there are a number of things as Peter laid out that could improve that situation over time. And so big picture, it’s important to not have all your hedges in exactly one place given the realities of where things are today. But on the other hand, I don’t think people should be writing off swaps as an effective hedge going forward and we absolutely still believe they will be.

Our next question comes from Ken Bruce of Banc of America Merrill Lynch.

There’s been a lot of discussion around obviously the value of the stock or at least the valuations applied to the sector. And I think looking at – and this is kind of somewhat bigger picture, but if you look at what the concerns are, part of the concerns are in the market, it’s around essentially an institutional bias towards lower leverage. It started with banks and financial institutions at large. It looks like it’s basically migrating to non-banks. And there’s a lot of concern that that’s going to include mortgages. I guess do you think that concern is misplaced or how should we be thinking about these institutional biases? I think the FHLB situation plays to that narrative. And you’ve been very close to Washington, so any thoughts around that would be very helpful.

Sure, look, I think what you have to keep in mind is that we have chosen just, I’m going to first go back to just a small piece of that question, which is the leverage piece. Obviously capital requirements for other financial institutions have gone up dramatically. That doesn’t apply to us. Agency MBS haircuts have not gone up, we don’t expect them to go up materially. We’re operating even where we were three or four years ago, even 9 or 10 times leverage is not a problem given haircuts and kind of the availability or having enough excess capacity at that point. So in our world, for us, we have just chosen proactively to take leverage down in response to a less favorable environment from our perspective. I think that was the right decision. But for us, there aren’t increased capital requirements that are going to force us to operate with lower leverage for an extended or for over the foreseeable future. As Peter discussed, we have ample capacity with or without the flubs and the market is going through a process of just reallocating repo essentially to the lowest cost providers which is away from the largest banks and that will take a little bit of time, but we think that process is underway.

Ken, I would just add to that and go back to what I said in my prepared remarks, and I think it is building out on what Gary just mentioned, there has been an overall reduction in the ability to finance leverage positions over the course of last year because all these regulatory rules have taken place. But we’re optimistic that the underlying issues are not going to be permanent. The liquidity is in the system. The money funds, for example, at close to $2.8 trillion is a good example, the money fund money will make its way into our market. It’s just that the traditional mechanisms have been impeded by these regulatory rules. Money funds, for example, the money fund rules related to government securities, there’s about $1.2 trillion in government money funds and there’s about $1.2 trillion or $1.3 trillion in prime. And just the daily NAV reporting rules we think will push the prime money at least a significant portion of the prime money to the government sector. So there’s another form of liquidity. Again, these things take time to evolve, but we think over the course of the next 12 months or so that some of these frictions will be eased.

And then just going back to the kind of bigger picture question of price to book ratios, I think you really have to think about the mortgage REIT space and even in particular the agency REIT space a little differently which is, look, our assets are very straightforward to value. They’re very liquid and they can be sold basically within a minute. We can sell a decent percentage of them, obviously not the whole portfolio, but that’s a completely different landscape than kind of the typical type of financial institutions, some of those that you mentioned. And so this is, the REIT space is a little different in terms of the transparency and liquidity of our assets. Additionally, for larger REITs, the expense ratios are very low. And so you’re not – if you look at the fees, total fees for agency around 150 basis points, but that’s basically on eight times leverage and assets of our equity, that’s under 20 basis points per asset, which is lower than the typical index fund. So when you piece together some of the drivers for significant discounts in other areas, they really don’t apply very well to this space. Now that being said, if the underlying asset, as I said earlier, is fully valued or something, it’s much more logical for someone to say if I’m going to take a levered position, I need a bigger cushion. But again, as that asset, underlying asset adjusts and cheapens up, then that driver drops off pretty quickly. So I think that’s where we’re today.

And I hope you’re right in terms of the way that the market is evolving in terms of funding for the sector. I guess one of the ways, even though you don’t have a specific prudential regulator for mortgage rates, one of the ways that leverage does get, potentially regulated just through the market mechanism and I think valuation is one of those ways. If valuations remain like they are, how long are you willing to allow that, essentially the status quo if you will to take place or would that in any way begin to change the strategy in terms of how you utilize capital?

Look, I think the reality is we will, the valuation of the stock will not be a key or kind of major driver of how we run our business. I think as we’ve talked about it as a major factor in our share repurchase decisions and how we invest incremental capital. But big picture, look, we do understand that equity markets that at times some things are in favor and some things are not in favor and you know what we’re actually just optimistic about is we actually believe that we’re probably in the eighth inning of this sector being maybe in the unfavorable category. And I think that if we’re having this conversation next year, it is a lot more likely than not that it will go very differently.

The last question comes from Deepak Narula with Mehta Capital.

Gary, you mentioned that you might potentially look to buy other REIT stocks. And in the last quarter, you did buy $9 million of your own shares, and that’s good. But is that the maximum that you could have bought of your own stock specifically like in the last quarter?

Very good question. That was not the maximum that we could have bought. The price-to-book ratio of AGNC varied pretty substantially, I’d say, during the course of the quarter. And the overall landscape, in our view on the landscape also varied. But what I would say is that was a significant increase over where we had been before. And I think the message is that if it’s dependent on price-to-book ratios, but to the extent that AGNC was on the lower end of the price-to-book range where we traded at some points last quarter, we would be very active. And in a sense purchasing what people call the SEC max or the maximum amount that you can buy on a daily basis is absolutely a potential in an environment if the stock trades poorly.

Given the discounts currently, which are fairly wide, and it certainly makes sense for you to be buying back stock when the discounts are wide and obviously not when they are low, I mean recently you’re what, in your own numbers, about a 23% discount to book. There is nothing that could be more attractive in the marketplace than buying that, right, buying back your own stock, unless you can buy it at a bigger discount relative to that. But other than that, no mortgage investment could potentially compete with a 22% discount, right?

Look, we’ve been clear in the past about how we think about discounts and how you can translate that back based on leverage and so forth. Look, we understand the compelling nature of discounts. And look, if you just play back what we’ve talked about today, at a high level, we view share repurchases as an attractive opportunity. And we actually don’t feel that in this environment that these discounts are that sustainable. Now that being said, I’m not going to go into anything specific about what our thresholds are and how active we’ll be at a particular level of price to book and there are other factors that are thought about.

Could you potentially tender for stock and buy back bigger chunks, because like you said, these discounts probably will not stay for a long period of time, and while they are there, it’s probably one of the better investments you could make.

I think we’ve talked enough about the share repurchase landscape. And that’s all I’m really comfortable talking about at this point.

We have now completed the question-and-answer session. I’d like to turn the call back over to Gary Kain for concluding remarks.

I would like to thank everyone for joining us on the Q4 2015 earnings call and we look forward to talking to you again next quarter.

The conference has now concluded. An archive of this presentation will be available on AGNC’s website and a telephone recording of this call can be accessed through February 16 by dialing 877-344-7529 using the conference ID 10078446. Thank you for joining today’s call. You may now disconnect.