AGNC Investment Corp. (AGNCL) Q2 2021 Earnings Report, Transcript and Summary

Good morning, and welcome to the AGNC Investment Corp. Second Quarter 2021 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’d now like to turn the conference over to Katie Wisecarver of Investor Relations. Please go ahead.

Thank you all for joining AGNC Investment Corp.'s second quarter 2021 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 facts, 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 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. Participants on the call includes; Peter Federico, President and Chief Executive Officer; Bernie Bell, Senior Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President and Chief Investment Officer; Aaron Pas, Senior Vice President of Non-Agency Portfolio Management; and Gary Kain, Executive Chair. With that, I'll turn the call over to Peter Federico.

Thanks, Katie, and thank you to everyone on the call today. The positive trends that drove the strong performance of Agency MBS in the first quarter, largely reversed in the second quarter. MBS spreads to swap and treasury hedges, particularly longer-term hedges widened meaningfully in May and June, as interest rates rallied and the yield curve flattened. The spread widening coincided with the shift in investor sentiment following strong economic data, which in turn pushed the Fed to begin asset tapering discussions. The market now expects the Fed to communicate its plan for asset tapering sometime later this year. In addition, despite the first quarter increase in mortgage rates, prepayment speeds in the second quarter slowed by less than expected. These faster prepayment speeds pressured higher coupon MBS valuations and reversed the significant outperformance that these coupons experienced in the first quarter. Given the shift in sentiment regarding asset tapering and faster-than-expected prepayment speeds, spreads across the coupon stack widened with lower coupon spreads widening five to 10 basis points and higher coupon spreads widening 15 to 20 basis points. As a result, our economic return for the quarter was negative 5.5%. While this result is disappointing, it is also easier to understand when viewed in the context of the first two quarters together. To recap in the first quarter, 10-year treasury rates increased by more than 80 basis points. The yield curve three years to 10 years steepened by more than 60 basis points and swap spreads widened. Against this backdrop Agency MBS performed very well. Moreover, higher coupon MBS, meaningfully outperformed as investors priced in more benign prepayment expectations given the recent increase in mortgage rates. With our portfolio being well balanced between lower coupon TBAs and higher coupon specified pools, our economic return in the first quarter was positive 8.2%. In the second quarter however, we experienced a reversal of these conditions. Specifically, 10-year treasury rates rallied close to 30 basis points, the yield curve flattened by almost 40 basis points and longer-term swap spreads tightened. Against this backdrop and given the shift in Fed sentiment following stronger economic data, MBS spreads widened meaningfully. And in contrast to the first quarter, the underperformance was most pronounced in higher coupon MBS. The key takeaway here is that the first two quarters largely offset each other and more importantly for the year the results are positive. Through the second quarter, we experienced a 55 basis point increase in 10-year treasury rates and only a modest steepening of the yield curve beyond three years. Over that time period, the performance of lower coupon MBS was largely as expected with these coupons modestly outperforming hedges. In addition, very attractive TBA financing levels further benefited these positions and provided a positive boost to earnings. Higher coupon MBS, meanwhile underperformed hedges somewhat year-to-date due to elevated prepayment speeds. Putting the two quarters together AGNC's year-to-date economic return was positive 2.4%. Importantly, we generated this positive return despite the increase in longer-term interest rates prepayment speeds remaining stubbornly fast and the Fed beginning to condition the market for an eventual tapering. The repricing of both Fed and prepayment expectations that occurred in the second quarter is healthy for the Agency MBS market. At current valuation levels, the investment backdrop is now more balanced. That said, as the Fed and the market moved closer to asset tapering, some further spread widening and volatility is possible. And while this could pressure our book value in the short run, wider spreads are a welcome development over the long run, as they improve the expected return on new investments and enhance the earnings profile of our portfolio. With that I'll turn the call over to Bernie to review the financial results for the quarter.

Thank you, Peter. Tangible net book value declined 7.5% for the quarter as wider spreads and the underperformance of our higher coupon specified pools in particular drove a comprehensive loss of $0.97 per share for the second quarter. Including dividends of $0.36 per share our economic return on tangible common equity was a loss of 5.5% for the quarter. So far this month as of last Friday with MBS spreads again somewhat wider, we estimate our tangible net book value to be down about 1%. Net spread and dollar roll income excluding catch-up AM, remained very strong at $0.76 per share unchanged from the first quarter, as improvement in our net interest margin offset the fact that we operated with a smaller asset base. Our net interest margin totaled 209 basis points, up from 200 basis points the prior quarter. This improvement was largely driven by attractive dollar roll opportunities and lower repo funding costs which averaged 13 basis points for the quarter. Our total at-risk leverage increased only modestly during the quarter to 7.9 times tangible equity as of June 30, compared to 7.7 times as of the first quarter, despite the decline in our tangible net book value. Forecasted life speeds increased to 11.6% as of quarter end as lower rates and moderately faster prepayment assumptions were largely offset by changes in portfolio composition. Actual prepayment speeds on our agency portfolio for the second quarter, averaged 25.7%. Our most recent speeds for assets held as of June 30, published in July averaged 23.5 CPR. Lastly, our unencumbered cash and Agency MBS at quarter end totaled $4.7 billion, which excludes both unencumbered credit assets and assets held at our broker-dealer subsidiary Bethesda Securities. Our high-quality liquidity position at 47% of our tangible equity remains very strong and largely unchanged from the prior quarter. I'll now turn the call over to Chris to discuss the Agency mortgage market.

Thanks, Bernie. As Peter, mentioned, rates rallied and the curve flattened throughout the second quarter reversing part of the move in Q1. Within the Agency MBS sector, higher coupons were the worst performers in part due to the flattening of the yield curve but more so as a result of persistently elevated speeds and little evidence of prepayment burnout. More recently however, with the release of the July factor report, there are indications that burnout may be accumulating with speeds coming in slower than day count and seasonal factors alone would suggest. During the second quarter, we continued to gradually reduce the size of the investment portfolio in anticipation of wider spreads as we approach an eventual Fed taper announcement. At quarter end, our investment portfolio totaled $87.5 billion, down $3 billion from the prior quarter due mostly to paydowns. The most notable shift in composition was in our 15-year position. Despite the flattening of the yield curve, 15-year MBS outperformed 30s and given this relative performance we reduced our 15-year holdings by a little over $6.5 billion. Some of these sales were replaced with production coupon 30-year MBS. Residential credit continued to trade well during the second quarter on strong fundamentals materially outperforming agency MBS. But before turning the call over to Aaron to discuss the non-Agency sector, I'll provide an overview of our hedge position and interest rate sensitivity. During the second quarter, the duration of our assets shortened by approximately eight tenths of a year. As we discussed on the call last quarter with 10-year rates in the 170 area, our duration risk profile was more symmetrical than at the start of the year. This combined with a view that MBS would trade to relatively short durations led to a decision to maintain a positive duration gap throughout the quarter. As interest rates rallied and the yield curve flattened, we took steps to rebalance our hedge portfolio by reducing longer-term treasury hedge positions. As a result, our hedge portfolio totaled $74 billion at quarter end, down $5 billion from the prior quarter. Our hedge ratio however remained almost unchanged at 97% with our duration gap slightly positive at 0.3 years. I'll now turn the call over to Aaron to discuss the non-Agency markets.

Thanks Chris. I'll quickly recap the quarter and provide a brief update on our current positioning. The second quarter was generally characterized by a risk-on mode in both the equity and structured product markets. The NASDAQ and S&P both repriced meaningfully higher in the quarter and credit spreads moved tighter. Currently, spreads for a large part of the structured products market are at or near their post great financial crisis tights. Put this in perspective, the high-yield CDX Index closed Q2 at a spread of 271 basis points, 34 basis points tighter than Q1. This also represented the lowest month end close over the prior 10 years. On the investment grade side, the IG CDX Index is right about at the tights of the last 10 years. After heavy credit risk transfer issuance in Q1 and early Q2, GSE issuance took a pause. With a favorable supply backdrop and the continued push tighter and other risk assets, CRT performed well in May and June. The credit curve both flattened with demand outstripping supply at the bottom of the capital structure. Housing gains have continued to accelerate more recently causing affordability levels to deteriorate somewhat. We continue to believe that declining affordability levels at this time are not a threat to the housing market more broadly. Turning to our holdings, our non-agency portfolio was roughly unchanged in size over the quarter. In the credit risk transfer space, we continue to shift a bit further down in credit. We net sold M2s over the quarter where we saw limited total return potential remaining in added B1 and B2 risk. Within our CMBS holdings, we continue to sell higher rated AA and AAA cash flows as these spreads are close to their tights in favor of adding some lower-rated tranches in SASB deals. On the RMBS side, our holdings were basically unchanged as we found limited opportunities to make attractive investments. Finally, we continue to see favorable tailwinds on the repo side for non-agency securities with repo rates continuing to tick lower. With that, I'll turn the call back over to Peter.

Thanks Aaron. Before opening the call up for questions, Gary will share a few thoughts on our outlook for inflation and the Fed.

Thanks Peter, and it is a pleasure to speak with all of you again. And in light of my new role as Executive Chairman, my focus when I participate on these calls will generally be on macro themes, while Peter and the rest of the team discuss the specifics of AGNC positioning and performance. Today given the shift in economic and monetary policy landscape, I wanted to give my thoughts surrounding the inflation debate and its implications for potential Fed actions. There is now no doubt that the US is experiencing a significant spike in inflation. So the real debate centers on whether or not it is transitory. The Fed and many market observers believe the spike in inflation is temporary and the Fed has communicated its willingness to remain patient in an effort to facilitate substantial further progress on the employment front. Other market participants believe the inflation pressures will persist and that the Fed should immediately begin to taper bond purchases and may need to raise rates more quickly than the path that they have communicated. While both outcomes are certainly possible, our view is that the Fed will ultimately be correct and that most of the current inflationary pressures will prove to be transitory. We believe technological advances and the other deflationary forces witnessed over the past several decades will dominate over fiscal and monetary stimulus, supply chain disruptions, short-term demand spikes and increases in labor costs in some sectors of the economy. But all of that said, we also believe that today's higher inflation readings may not dissipate quickly and sufficiently enough to satisfy either the market or some members of the FOMC. As such, the Fed may feel like they have to respond to these elevated inflation readings only to have them moderate relatively quickly thereafter. This scenario is actually consistent with the performance of the back end of the treasury curve, we've seen over the past month. More specifically, we expect the Fed to communicate a taper plan later this year and to begin tapering by early 2022. This scenario will likely create some MBS spread and rate volatility, which in turn should improve AGNC's investment opportunities, particularly given our low leverage and strong liquidity position. In addition, further declines in interest rates, at this point, are likely to be limited and without a longer-term inflation issue, interest rates should remain relatively range bound. Together, this expected rate and spread environment should ultimately create an attractive investment backdrop for AGNC. And with that, I'll ask the operator to open up the call to questions.

Thank you. We’ll now begin the question-and-answer session. [Operator Instructions] Our first question comes from Rick Shane from JPMorgan. Please go ahead.

Good morning, and Peter and Gary congratulations both on your respective new roles.

Thank you, Rick.

It actually triggers my first question, which is just as we think about this quarter's results or results through the remainder of the year, is there anything from an expense perspective that we should be aware of related to Gary's retirement in terms of acceleration of any options or expenses associated with that?

Thanks for the question, Rick, and good morning. No, there's no expense issues that you should be worried about or cognizant of. If you look at our expense ratio, it actually improved considerably from I think, 84 basis points to 79 basis points. So I would say, you can continue to expect our expense ratio to stay right around that range going forward over the short run.

Sure. Perfect. I appreciate that. And then, secondly and more to the business when we -- when you think about the decisions that you were faced with tactically given the volatility in the second quarter, what do you think the decisions that you made in terms of rotating the portfolio? What do you look back and say that was a good decision? And what do you look back and say, hey, we wish we hadn't done that.

Well, yes, it's a good question. What I would say is that, and in my prepared remarks I really talked about the fact that you really have to look at the first two quarters together. And I think we are going to continue to see quarter-to-quarter volatility given the nature of the economic backdrop and given the fact that essentially now the Fed is in transition and that's just the nature of a transition means that we're going to have more volatility. On the asset side, I still believe we had and have the right asset balance a good mix between lower coupon, TBAs and higher coupon specified pools. The lower coupons, obviously, give us a lot of value in terms of the carry. The higher coupons have underperformed some. But quarter-to-quarter, the volatility was pretty significant but underperformed this last quarter because of the prepayment outlook. But that outlook is going to improve. There's no doubt about that. It's just really a matter of when. So we feel very comfortable on the asset side. On the hedging side, what you saw us do was really positioned for the up move in rates at the end of last year by increasing our hedge ratio, putting on a lot of longer-term hedges and really being prepared for a rise in rates and the steepening of the yield curve. We did that along with the rest of the market. And I think what you saw in the second quarter is that the market was essentially off side in terms of being short. And so we had a lot of the pain trade if you will in the market was for lower rates and a flattening of the yield curve. So in that environment, I'm not at all unhappy with our hedge position. It's just that you're going to have to be patient with it. We actually took some hedges off and tried to position ourselves for the rally and the flattening a little bit more. In this environment you're just going to have to be active. I think you're going to have to be a little bit more active on our asset side and we're certainly going to be -- have to be active on the hedging side. But this is going to take another quarter or two and then we're going to have a lot more clarity on both the outlook for prepayments and the outlook for the Fed. And at that point I think we're going to be in a very strong position particularly because we positioned the portfolio with a lot of flexibility today.

Great. It’s a very helpful answer. Thank you guys very much.

Thank you.

The next question comes from Bose George from KBW. Please go ahead.

Hi, everyone. Good morning.

Good morning Bose.

So, first I just wanted to ask about where you see incremental returns on -- both on pools and TBAs?

Sure. I'll have Chris answer that.

Hi, Bose. Good morning. So the gross ROE on production coupon 30s is very high single digits without roll specialness and convexity costs. Rolls continue to trade very, very well. The two rolls around negative 40 basis points, the 2.5 roll around negative 15 basis points, and so 55 and 30 basis points through repo respectively. And as we've said in the past while there's no certainty how long this degree of specialness will persist, we do expect that rolls are going to continue to be a material contributor to returns. And for context as a reminder each 25 basis points of advantage versus repo was roughly 2% and incremental return on an annualized basis. Higher coupon specs are generally high single digits area, 15s mid-single digits, and we've materially reduced our positions there as I mentioned earlier.

All right. Thanks. And then just in terms of where you think spreads could go, you noted there could be volatility. We've already seen a fair amount of widening. Is there a way to think about how close we are to normal?

Yeah. Yeah, it's a great question. And let me just start with put into context what Chris just said, give some context around that. If you think about spreads were probably close to their all-time tights just at the end of the first quarter. So the ROE improvement that Chris referred to particularly on the TBA side is meaningful. So we are in the repricing process. And, obviously, the market now does expect the Fed to announce its tapering later this year. There's a chance probably that it pulls forward by a meeting. But again it's going to be data-dependent. And actually the risk may even be that they push it back given the fact that the delta variant is causing some issues. But we could still see spreads widen a little further. I don't think it's going to be dramatic. And so we -- I think the market has largely reflected the Fed's likely path right now, but there still could be some potential volatility. The issue that the market is going to face is that the Fed is really going to be focused on the employment reports over the next two or three months. So -- and each of those employment reports were likely going to have some volatility because the market will either push forward or pull back on the Fed. But we could see a little bit more spread widening. But as Chris said, we're already in the -- assuming some conservative implied funding assumptions. We're already in the low double digits on lower coupon MBS. So we're not far from I think ultimately where we settle out.

Okay, great. Thanks very much.

Thank you Bose.

The next question comes from Brock Vandervliet from UBS. Please go ahead.

Great.

Hi, Brock

Hi. I just wonder in terms of looking at the higher prepay speeds whether this is an example of kind of a structural change in the market that is driven by originators for example having the technology to mine servicing books much more aggressively and present refi opportunities to borrowers in ways that they haven't before. And I guess the question is one do you agree with that? Two does it change or potentially change how you look at the data and look at modeling prepay speeds?

Yes. Let me make a high-level comment and then I'll have Chris talk about that. There is no doubt that the pandemic has increased the negative convexity if you will of the mortgage market. There are structural changes now that have made it much easier to refinance and we're seeing that in the refinance market. And those structural changes that Chris will talk about really aren't going to go away anytime soon. So it is something that we have to build into our investment strategy going forward.

Yes. So the way that I would characterize the story on speeds is not that they've massively surprised to the upside over the last six months or so where that peak speeds are hitting new highs for a given amount of incentive, but rather the disappointment has been more with a lack of burnout in higher coupons and just the persistence of elevated speeds even on seasoned cohorts. We had a couple of reports around year end that showed some signs of burnout and that combined with the sell-off in rates created a lot of optimism going into Q1 that burnout would really start to show up in higher coupons as the media effect shutdown and that higher rate levels would reduce prepayment risk more generally speaking. But the early indications of burnout last year didn't really trend and even lower coupon speeds came in a bit faster given how quickly primary/secondary spreads tightened as lenders traded profitability for market share. And so in Q2 all this optimism repriced and reversed the outperformance in Q1. There's no question that refi efficiency has certainly taken a couple of steps forward over the last 1.5 years. In large part as Peter mentioned due to the technological changes, the flexibilities offered by the GSEs which have had the effect of reducing cost and shortening time lines I think the working from home dynamic has certainly been a factor over the last year or so. I mean the bottom line is it's easier to refinance and it's easier for lenders to reach borrowers today than it was in the past. And COVID effectively pulled forward efficiencies and developments that otherwise would have taken many years to get to where we are today. And so I do think going forward while the trend will be the same the rate of change should be much slower. I think the takeaway is that active asset management will continue to be critical to generating attractive returns. It's important to understand the areas of the market that are most impacted by these changes and be able to incorporate that into asset selection decisions.

And just to make a final comment on that. You're absolutely right all of the competition we're seeing out there that has had an impact. But as Chris mentioned just the work-from-home environment has had a big impact. And as everybody goes back to the office in the fall and kids go back to school we do believe that we're probably at the leading edge of the improvement in the prepayment outlook. So we're optimistic as we look forward for the next six months.

Okay. Great. And just as a follow-up to clarify the performance on the -- among the higher coupon TBAs. Was that simply a price adjustment, or was there a real underperformance in the payment profile of those securities?

Yes. That's a very good question. And as I mentioned on higher coupons and a lot of people have different numbers but most people I think agree that higher coupons widen 15 to 20. In some models they're wider than that. And that didn't necessarily translate into better ROEs. That's why Chris said the ROEs on higher coupons are still in the higher single-digits because you had to essentially reprice to a faster prepayment assumption. Overtime that's going to improve, but that's why you didn't see a meaningful improvement. It was really the price being offset by prepayment outlook.

Got it. Okay. Thank you.

Chris do you want to add to that?

Yes. I would just -- I mean just to add to that I mean valuations and higher coupon specs look much better now. They're priced to faster speeds at 130 on 10s. Yes, they don't have a lot of duration. They should trade pretty short, plus or minus 50 basis points. And as Peter mentioned earlier, they really complement our lower coupon holdings well, given that they'll benefit in a lot of the scenarios that are more difficult for lower coupons.

Okay. Thank you.

Sure. Thank you.

The next question comes from Doug Harter from Crédit Suisse. Please go ahead.

Thanks.

Good morning, Doug.

Peter. Hi. Good morning. I guess can you just talk about kind of where you see leverage today in the context of the long-term expectations?

Sure. Let me start with just looking back over the last four quarters. And what you've seen us do really every quarter very methodically is, reduce our leverage profile. If you look at our average leverage, we went from 9 to on average about 0.5 turn of leverage each quarter. This last quarter, our leverage was 7.6%. And today as we sit here, we're right at around 7.5 times leverage. So what I would -- the way I would describe that is, you see us putting ourselves in a position as spreads widen through the first quarter -- tightened through the first quarter and then subsequently widen what you see us is, put ourselves in a position from a leverage perspective where we have a lot of flexibility. What I would say today is, we're sort of in the leverage sweet spot at around 7.5 times, meaning that if we do see some disruptions in the market and we feel like there's a lot of uncertainty around the Fed and there's a lot of volatility, we could take our leverage a little bit lower and put ourselves in a position to even have more capacity. On the flip side of that, at 7.5 times, we have a lot of capacity to take our leverage up. If we see spreads improve and widen and we feel like we have adequate clarity on the Fed, then we have a lot of flexibility to take our leverage up. So I would say we're right in the sweet spot. We can move either direction right now. We have a lot of flexibility on the leverage side, on our liquidity side and on our hedging side. So we're positioned opportunistically.

I guess, just on that last point, I guess, what would be -- is it kind of a return hurdle? Is it kind of a spread level that -- or just how you think about what would kind of trigger that to be more opportunistic and take leverage up?

Yes. I mean, it's both, right? At the end of the day, when -- if you look back at where mortgages were at the end of the first quarter, I think, everybody agreed that they were at or near their historical tights and we did not think that that was sustainable. It's certainly not sustainable in the context of the Fed gradually exiting the mortgage market. So there's going to be a repricing and that – fortunately, that repricing is now underway. I can't tell you exactly what the threshold will be or what the return target will be, because it will have to be viewed in the context of the market. We’d have to wait and see exactly how the Fed is going to taper, over what time period they're going to taper. And importantly, we need to get a little bit more of an understanding of what it looks like from a reinvestment perspective with the Fed. We don't know exactly how that's going to go. So as the Fed normalizes monetary policy, we're all going to get a lot more comfortable with that outlook. And then, we'll be able to evaluate the spread level in the ROE in that context and make a determination at that point, that we think it's the right entry point. And we're probably not that far from that.

Great. That’s helpful. Thank you.

The next question comes from Trevor Cranston from JMP Securities. Please, go ahead.

Hey. Thanks. Good morning.

Good morning.

Follow-up question on the prepay outlook and refinancing efficiency. When you look at the 10-year continuing to drop in July, if we were to see 30-year mortgage rates dropped substantially below 3% again, can you guys comment on how you think how responsive speeds would be to that, if we move back down towards kind of a level where 30-year mortgage rates hit previously?

Sure. Chris, do you want to take that?

Yes. I guess, the best way to frame that is, just to think about the percentage of the universe that's currently in the money today. So at a 2.75% mortgage rate, we're a little higher than that today, certainly with points paid. But roughly 55% of the universe is -- sees a 50 basis point or better incentive to refinance. For perspective, if you went back to the beginning of the year, that number at the same rate would have been probably closer to 75%, maybe a little higher than that. So the outstanding -- the note rate on the universe has come down probably around, like, 30 basis points year-to-date probably closer to 80 pre-COVID. And so, the aggregate speeds that we'll see at these rate levels will be lower, for that reason.

Okay, got it. That's helpful. And then can you guys comment on, how book value has performed so far in July?

Sure. As Bernie mentioned in her prepared remarks, our book value is down very close to 1%, just a little less than 1% right now. That was as of last Friday. So we've had just a little bit of movement in lower coupon spreads, but nothing meaningful. Our portfolio is pretty well positioned right now.

Okay. Perfect. Thank you.

Sure.

The next question comes from Eric Hagen from BTIG. Please go ahead.

Hi. Thanks. Good morning. A couple of questions on the general backdrop for levered investors right now, I guess the big one being, just what level of tapering you think is embedded in the mortgage basis at this point? And then, on the short end of the curve, how do you think about hedging your cost of funds if the Fed detects that some of the inflationary pressure, isn't necessarily transitory?

Sure. Good morning Eric. Thanks for the question. On the Fed, what I would say is that, I think the market has adequately priced in the Fed making an announcement, either at the November or December meeting. The Fed said it's going to give us advanced notice. We don't know exactly what advanced notice means. It's likely a meeting. So it seems, convenient for them to taper beginning in January. I think the uncertainty that we have along with the timing give or take a meeting is whether or not they're going to taper MBS at a speed different than treasuries. If they follow the playbook they used last time, they would taper them both together over eight meetings, which essentially is over the 12 months of next year. There is some discussion as we all know coming out of the Fed, that maybe they should taper mortgages faster. If they did and I'm not sure what the marginal value of that is, but if they did I think it would be over four or five meetings. So that would still be tapering over something like six or seven months. So those are I think the two bookends that could have some impact on the Agency MBS market. And then, of course, we also want to get some color, when the Fed announces it's tapering. What that implies for the reinvestments because, don't forget, importantly, they're going to continue to reinvest cash flows. For an extended period of time, after, likely syncing up with the first rate increase now there's some variability there now as well. So those are going to be the two things that drive the Agency MBS market. On the funding side, what I would say is that, you're absolutely right, there's going to be some variability. Right now short-term funding is very stable. But what you've seen us do is not really have any rollover risk inside three years. If you look at our swap portfolio and our hedge portfolio, we don't have hardly any swaps I think maybe $1 billion or so, less than three years. So we don't really have any repricing risk right now, for the next three years with regard to our short-term debt. You're going to see us continue to maintain a high hedge ratio for the reasons that you'd point out.

Got it, that's helpful. And then, separately, can you just talk about any adjustments you've made on the hedging side and the asset side since quarter end? And then, tacking on to that, it would be good to get a sense for how much extension risk you guys see in the specified pool portfolio, in response to …

Yeah.

… potential re-steeping?

Yeah. What I would say is that we obviously have had more of a rally with the 10-year down to 1.25%. We have done a little bit more rebalancing this quarter. As Chris mentioned, our desire was to maintain a positive duration gap last quarter. And we still have a slight bias for a positive duration gap, because mortgages are trading weak into a rally. So all other things equal we would like to maintain, or might likely maintain a positive duration gap. Now all that said, we think we're closer -- as Gary mentioned in his prepared remarks, we think we're closer to the lower end of the range, as opposed to the upper end of the range. But there is still some down rate risk that we have to be cognizant of. From a sort of extension perspective, what I would say is, the mortgage market and our portfolio is pretty close right now to peak convexity meaning you have almost equal extension and contraction risk. So, we are cognizant of that. We're going to continue to maintain with respect to extension risk our option portfolio. That's moved a lot in value. If you looked at the value of that portfolio, from the time we put it on at the end of last year, that portfolio had a cost basis of around $300 million. It doubled in the first quarter and then again halved in the second quarter went right back to its cost basis. So, that portfolio is a good example of the volatility, but that portfolio also has a lot of protection left in it for us. It's almost two years on 10 years at a 1.75% strike rate, which is very close to obviously where the market just was. So, there's a lot of protection that we have in our portfolio and we're going to continue to be very cognizant about the uprate scenario as well as the bias for mortgages to widen in a rally.

That’s very helpful. Thank you.

Sure.

The next question comes from Ryan Carr from Jefferies. Please go ahead.

Hi, good morning. Thanks for taking my question and congrats guys on the promotions.

Thank you very much.

So, a quick question on the dividend level. Now, you've seen tangible book value largely recover closer to the pre-COVID levels. How are you thinking about dividends in the context of current spread and dollar roll levels? And when would you consider -- or at what point would you consider a potential adjustment to the current level of the dividend?

Sure. Thank you for the question and it's a question that I expected. First off, I appreciate you asking for thoughts as opposed to an outlook. But I did expect that question particularly because our net spread and dollar roll income continues to be so strong at $0.76 this quarter unchanged from the previous quarter. What I would share some high-level observations and thoughts on the dividend. First, we're not trying to -- and we've communicated this in the past, we're not trying to achieve a particular dividend outcome. At the end of the day, our goal is very simple which is to generate the absolute best economic return we can for our shareholders. And further and ideally, we want that economic return to consist of a very attractive dividend and to the extent possible some book value accretion we think that combination is appealing to the broadest cross-section of investors. But make no mistake, we are very cognizant of the fact that our dividend is a very important component to a significant portion of our shareholders. In today's market, if you look at our dividend level against our stock price or our book value, we do think we have a very attractive dividend. Our dividend yield on either of those measures is close to 9%, particularly when you view that 9% in the context of asset valuations across any asset class, we think 9% is a really attractive dividend. But there are a couple of other things that we pay close attention to. I think what you're alluding to is we certainly look at what the current investment environment is. If you think about that as the mark-to-market return on our portfolio which would also be equivalent to the marginal ROE on new investments, that's an important consideration when you think about the durability and sustainability of your dividend, we don't want to ever have to pay our dividend out, out of book value. So, what our marginal return opportunities are is an important consideration. As we said if you look back to the end of the first quarter, the marginal returns on new investments was actually very close to our dividend level. And as Chris pointed out, they are starting to improve and that spread is starting to widen somewhat right now. Also important in that consideration, because we want that margin to be as strong as possible, is our operating efficiency which we've already talked about. So, that's an important consideration. And the final point I would make is that to the extent that we out-earn our dividend, we want to make sure that we can utilize that excess in a way that is accretive to our shareholders. Last year for example when we out-earned it, we were able to buy back stock at a meaningful discount which was accretive to both book value and earnings per share for our existing shareholders. Today that trade is not available to us. But as we said, we are positioning the portfolio very opportunistically right now in anticipation of better investment opportunities. So that the investment outlook and the investment environment that we're in, particularly, over the relatively short-term, is also an important factor. So, those are just some of the things that we think about gives you some context around how we think about our dividend. We are going to continue to evaluate it. We are coming at our dividend from a position of strength, which is really great. We have a lot of flexibility, as I mentioned, with our leverage. We have a very strong financial position and we're going to continue to evaluate the appropriateness of our dividend as market conditions dictate.

Thanks very much. That was helpful color. And then, last question from me. How are you thinking about opportunities in the credit portfolio within -- with the prevailing environment?

Sure. I'll have Aaron talk about that, because obviously credit performed very well in the second quarter.

Sure. Thanks for the question. So, I mean on the credit front, I touched on it in the prepared remarks. I mean residential credit, commercial credit, everything performed quite well in the second quarter as it has for the last several quarters. But, also to put that in perspective, spreads are relatively tight. So, the go-forward landscape for returns is challenging. I'd peg a lot of our opportunities in the 5% to 7%, 5% to 8% return range, which for some of the risk on the residential credit side we think risk is relatively low. So, risk return is probably fine, but the level of returns is just isn't all that compelling.

Yes. Just a final point on that. When you put those comments together with what Chris said, what it basically is showing that the relative value equation has sort of shifted even more toward Agency MBS right now. I mean credit obviously is very, very difficult to meet our hurdle there. We'll certainly have the flexibility on the credit side, but the marginal dollars are likely going to go to the Agency side of our business.

Got it. Thanks very much, guys.

Sure. Thank you for the question.

And our last question comes from Mark DeVries from Barclays. Please go ahead.

Yes. Thank you. Gary, I was hoping to get some more detailed thoughts on why you think ultimately the longer-term deflationary pressures, ultimately Trump kind of the transitory inflationary pressures we're seeing? And then, Peter, how you look at portfolio or position the portfolio in an environment where that kind of push and pull keeps rates range bound, but where you think the Fed may overreact to the transitory, which should theoretically really kind of increase volatility within those ranges?

Sure. Thanks Mark. And look, I think the bottom line is, we've seen over the past 10 years really even 20 or 30 years, it's much cheaper over time to produce goods and services. And we've seen that in many ways earlier pulled forward with technology even with the pandemic. But, I think once we get past the short-term kind of supply issues, which have actually temporarily reversed that kind of cheapening to produce things, shipping costs, all of those kind of things. I think it's hard for us not to revert back to the world we were in three, four or five years ago. So look, for the next year, for the next maybe it's two years things like, the shortage of chips right, I mean that's a big deal, but it's a big deal temporarily, shortage of shipping containers, which are another factor on the cost front. Obviously on the employment front right now, we're seeing wage pressures and lower-priced kind of jobs. And those things are likely not to dissipate in the next six months. But over the next two years, they really should dissipate. And then, if you look at some of the other arguments for inflation kind of being here to stay are -- related to money supply and the Feds, some of the actions on the part of the Fed and government spending, a lot of those are also temporary, right, and should be -- and I think most people would expect even if we see a little -- we see more over the next year it's also not -- doesn't seem to have a lot of staying power. So look, when you take a couple of steps back, what is driving -- what are the things that's changed that have really changed and how long have they changed for. And I think when you think – look at the things pushing inflation higher, the vast majority of them seem temporary, okay? On the other hand, technology is a real continued force and is going to affect more and more industries and we've seen that play out throughout this pandemic. We just had that discussion on this call even with respect to mortgages, right? And that's not kind of one of the most impacted areas. So if you take – so when you play that out over the next couple of years, the lasting impact to me is that it's still cheaper to produce goods and services and a lot more of those goods and services are things like software and handheld electronic devices, which obviously are cheaper to produce over time. So I think that's the explanation for why I'm pretty confident that over the long run, we don't have an inflation issue. Again, I do think these things are going to play out, take a little longer to play out than maybe the Fed hopes. And so that's why I think you may – I think the market may feel like the Fed is wrong for some period of time. But I think ultimately, they'll be right.

Yes. And Mark, what I would say to your question about portfolio positioning is I think embedded in your question is the fact that, understanding that there's going to be considerable volatility in the current environment, we're seeing that right now. So I think the way you have to position the portfolio is you have to position it more from a long-term perspective and just understand that there is going to be quarter-to-quarter moves just like we had in the first and second quarter, where we had considerably different outcomes with respect to mortgage performance in our hedge portfolio. But when you look at the two quarters together, I'm very happy that we had the hedge portfolio that we have. If you look forward 12 months from now, likely rates are higher. At some point the curve is steeper. That's going to be a really good environment for Agency. Likely we're not going to have to be competing with the Fed for assets. That's another good benefit for the Agency MBS market. So we're going to continue to approach it from that longer-term perspective. We'll have to endure the volatility. You're going to have to be active in rebalancing both your asset and hedge side of the portfolio. In this environment, you'll see us continue to do that. But over the long run I think we have the right position on. You just going to have to be willing to wait it out and ultimately I think it's going to lead to a very strong environment for Agency MBS.

Okay. That's really helpful. And just one follow-up then on kind of the credit investments. It sounds like, you don't view risk is being high there but it also doesn't sound like there's much more upside to returns. When do you consider just kind of selling that down?

Aaron, can talk a little bit about that. We've done some opportunistic selling already.

Sure. So as the GSEs have been issuing CRT, we've been rotating the portfolio a little bit further down in credit, where we've been able to find a little bit more attractive returns. And on the flip side, we've been selling assets down that – where we don't think there's much total return potential left. So we'll look to continue doing that. And on that front, I mean we're hopeful that with some changes at FHFA with director – former director, Calabria gone and acting director Thompson in place that the GSEs will probably be more inclined to issue CRT. Although, the timing of that is – will continue to be uncertain but we're hopeful that there'll be more supply over the coming year or two and that should help balance some of the supply-demand issues.

Okay. Great. Thank you.

Thank you for the questions.

We've now completed the question-and-answer session. I'd like to turn the call back over to Peter Federico for concluding remarks.

Well, again, that concludes our second quarter call. I thank everybody for their participation and we look forward to speaking to you all again at the end of the third quarter.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.