Dynex Capital, Inc. (DX) Q4 2021 Earnings Report, Transcript and Summary

Good morning. My name is Rob and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital, Inc. Fourth Quarter 2021 Earnings Results and Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Alison Griffin, Vice President of Investor Relations. You may begin your conference.

Thank you, operator. Good morning. And thank you all for joining us today for the Dynex Capital fourth quarter and full year 2021 earnings conference call. The press release associated with today's call was issued and filed with the SEC this morning, February 3, 2022. You may view the press release on the homepage of the Dynex website at dynexcapital.com, as well as on the SEC's website at sec.gov. Before we begin, we wish to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words; believe, expect, forecast, assume, anticipate, estimate, project, plan, continue, will and similar expressions identify forward-looking statements. These statements reflects our current beliefs, assumptions, and expectations based on information currently available to us and are applicable only as of the date of this presentation. These statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. The company's actual results and timing of certain events could differ considerably from those projected and/or contemplated by those forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, please refer to our disclosures filed with the SEC, which may be found in the Dynex website under the Investor Center, as well as on the SEC's website. This conference call is being broadcast live over the Internet with a streaming slide presentation which can be found through a webcast link on the homepage of our website. The slide presentation may also be referenced under Quarterly Reports on the Investor Center page. Joining me on the call is Byron Boston, Chief Executive Officer and Co-Chief Investment Officer; Smriti Popenoe, President and Co-Chief Investment Officer; and Steve Benedetti, Executive Vice President, Chief Financial Officer and Chief Operating Officer. And with that, it is my pleasure to turn the call over to Byron Boston.

Thank you, Alison, and thank you everyone for joining our fourth quarter earnings call. Sitting here at the beginning of 2022, I am incredibly excited about the opportunities we see before us to generate strong future long-term returns. Over the past three years, the world has seen some of the most unique market events in history. From the beginning, we have always structured our portfolio to withstand and anticipate unforeseen market events. Over the past three years, we have done just that maintaining our year-end book values at or around $18 per share through periods of spread volatility. We also generated solid returns over the same period with a three-year total economic return of 28%. We entered 2021 with the same discipline portfolio strategy and mindset, the market environment was highly uncertain and experienced fits and starts throughout the year, primarily driven by the pandemic. In that environment, we were able to grow our common equity capital based by over $200 million, protect book value and maintain $1.56 dividend. For the past year, we have believed that better opportunity to invest our capital would evolve. So we have been patient and disciplined in preparing for those opportunities, especially by keeping our leverage low and holding on to dry powder. Now we are seeing the beginning of a more favorable environment as the largest noneconomic buyer or fixed income assets, U.S. Federal Reserve Bank is about to exit the market. Our strategy has continued to enable us to protect book value while maintaining our low leverage profile during the month of January. We're confident in our ability to navigate the complex environment before us, and to continue to deliver an attractive dividend and long-term returns, even if the Fed raises short-term interest rates four to five times this year. At Dynex, we have the unique and enviable combination of a highly experienced management team with a flexible mindset and a very liquid balance sheet. These factors position us extremely well to take advantage of the opportunities we see ahead in this market. As I stated at the beginning, we manage for the long-term and as such, we're making the necessary investments in our people, processes and technology to scale and grow our business and to ensure we have the ability to generate solid returns for our shareholders well into the future. It is our belief that technology will significantly impact the world of asset management. And we are growing our relationships with the right technology partners to keep a competitive edge as the world continues to change and evolve. And with that, I will now turn the call over to Steve to give you more specifics regarding our performance.

Thank you, Byron. The fourth quarter was marked by periods of volatility as mortgage spreads widened and the yield curve flattened while short-term interest rates and funding costs continue to remain low. Given the environment, we held leverage at the lower end of our target range of five to 10 times our equity capital to minimize the impact of this volatility on our results. With this backdrop on a per common share basis, both comprehensive income and total economic return or minus $0.04 per share or minus two-tenths percent for the quarter. For the year on a per common share basis, comprehensive income was $0.53 and total economic return was $0.47 or 2.5%. Earnings available for distribution was $1.97 per common share and we paid a dividend of $1.56, the $0.06 difference between comprehensive income and economic return for the year is largely attributable to net capital raising activities. From a full year perspective, the company raised $237 million in new common equity capital, growing common equity by over 50% at an average net issue price of $18.27, substantially improving the liquidity of our common stock and unlocking operating leverage in the platform. Earnings available for distribution per common shares sequentially declined from $0.54 last quarter to $0.45 this quarter. The decline was principally due to lower leverage on our capital during the quarter resulting in a smaller average balance of interest earning assets coupled with a modest decline in asset yields. The change in net interest spread and adjusted net interest spread of 6 and 7 basis points respectively was due largely to increases in prepayment speeds and agency 2.5 partially offset by income received from early prepayments on call protected CMBS and CMBS IO. Overall, agency RMBS prepayment speeds were 11.2% CPR. As a reminder, the company utilizes the prospective method for amortizing investment premiums on RMBS and as such our results fully reflect the actual realized prepayments during the period and do not include cumulative catch up amortization adjustments that are based on long-term assumptions and could potentially distort near-term results. Finally, the funding cost benefit on dollar rolls versus repo on RMBS was an estimated 77 basis points during the third quarter versus an estimated 64 basis points last quarter. As it relates to book value, the driver of the $0.43 per common share decline during the fourth quarter was spread widening on Agency MBS. We estimate that book value per common share at the end of January is unchanged since the end of the year. From a portfolio perspective, investments inclusive of TBA securities declined by $133 million mainly due to pay downs. Our investment portfolio is approximately $4.7 billion as of December 31 with 90% invested in Agency RMBS and 10% invested in CMBS and CMBS IO. From a hedging perspective, we maintain our notional coverage at $4.3 billion with a minor increase in short U.S. treasury futures during the quarter. Regarding the tax character of dividends for 2021, the $1.56 dividend declared on common stock will be substantially a return of capital. The reason for the return of capital is largely due to timing differences between GAAP and tax income, including deferral of net gains on derivative instruments designated as tax hedges and the higher use of TBA securities, which impact current year tax results versus on balance sheet RMBS. That concludes my prepared remarks. And I’ll turn the call over Smriti.

Thank you, Steve, and good morning, everyone. I’ll start with a comment on our 2021 performance. We believe that it was critical to remain patient and disciplined in our portfolio construction, maintaining liquidity in the position and flexibility in both the position and our mindset that discipline is paying off here in 2022 as book value has remained flat through January. I’m going to focus my comments today on how we view the current investment environment and the Dynex strategy for navigating it as well as our outlook. First off, we believe changes in government policy will continue to have major implications for returns and that we are entering a very favorable period for investing. We heard from the federal reserve last week. They are clearly focused on managing inflation without damaging growth in the economy. They have indicated a willingness to raise rates in March and to continue to raise based on evolving data and that they will begin shrinking their balance sheets sometime in May or June. This near simultaneous removal of monetary stimulus and liquidity support is unprecedented. And it creates the unusual dynamic of asset yields correcting higher, even as financing cost rise, making the return environment quite attractive. This is a key positive factor for Dynex giving us the opportunity to expand our balance sheet and locking in long-term accretive returns. The transition to this favorable investing environment has begun option adjusted spreads on Agency RMBS are 45 basis points wider since the tights in April of 2021 and 20 basis points wider since the end of December. Through January, we have already withstood a 20 basis point wider OAS adjustment and an adjustment to higher yields keeping book value flat, and our capital intact into today’s wider spread environment. Going forward returns for Dynex will be driven by the performance of our existing portfolio plus incremental returns on capital that we invest. Let’s start with the existing portfolio. The main factors determining returns will be a rising repo rates that will impact earnings, wider spreads and greater interest rate volatility those will impact book value. So first rising repo rates, we believe we can adjust the size of the balance sheet to generate the earnings needed to meet the current dividend in the face of rising repo rates. As of now with the market pricing four to five rate hikes in 2022, we estimate that adding one incremental turn of leverage will fully cover our existing dividend. We expect to add that over the coming quarters as we see spreads widen further from today’s levels. Second, the exposure to further spread widening. Dynex’s risk to spread widening is mitigated by three factors. Our low levels of leverage, our coupon positioning and our hedge construction. Our year-end leverage of 5.8 times limited the book value declines from spread widening thus far in 2022, simply because we own fewer assets. Second, the assets that we owned were sheltered from wider spreads. We own low coupons 2%s and 2.5%s that have been and will continue to be protected against the worst of the spread widening. This is because as mortgage rates rise and exceed 3.5% new supply gets pushed into the 3% and 3.5% coupons. These higher coupons will continue to bear the brunt of future widening from quantitative tightening because there won’t be a fed backstop. In the lower coupons 2%s and 2.5%s, the stock effect of the fed and bank balance sheets come into play. They own 75% of the float that plus the lack of new supply and the seasoning in those bonds will all contribute to limiting spread widening further and also provide support for dollar rolls. Finally, we’ve insulated the portfolio from big moves and specified full pay ups by focusing on low pay up stories and limiting the amount of capital at risk to collapses in payups, such as that experienced in March 2020 and thus far in January 2022. So while we do expect spreads to widen, we expect that Dynex’s existing portfolio of assets will experience less volatility and lower return degradation than the rest of the mortgage universe as the fed begins to exit. We also believe that we can adjust our position to mitigate the impact of spread widening. Our hedge ratios for the lower coupons that we own or designed for the extension in a rates up spread widening environment, which is what we’re experiencing. And it’s actually the biggest reason for our book value preservation today. At these rate levels, the 2% coupon is fully extended and convexity in the 2.5% coupon is much lower than before. Our hedge construction was designed to match this extension risk and has functioned as expected in the move up to 1.8% in 10-year yield. We also expect interest rate volatility to be something that all asset managers will contend within 2022, at Dynex, we address this with our scenario planning, preparation and process. All of last year, we had plenty of chances to make tactical decisions at the wrong time that tenure was done at 112, tenure back at 177, but working within the framework of a short, medium and long-term view kept us grounded. Coupon positioning and hedge selection are a big part of how we manage rate volatility, selecting coupons that will be more stable, designing, effective hedges using option strategies. It’s all part of our active management process and this will be a focus for us in 2022. So all in all, we feel very solidly positioned heading into this environment by holding a flexible liquid high credit quality position, even as spreads widen, we believe we’ll be able to manage the balance sheet to position the portfolio for solid long-term return generation. So that covers our existing portfolio. Now let’s talk about incremental returns. As we’ve seen in January, with the market’s realization that the fed will soon begin to exit the mortgage and treasury market, prices have begun to adjust across risk assets. We have already seen this as cryptocurrencies back, certain tech stocks, high yield, municipal bonds, corporate bonds and mortgage spreads have all reacted to the mere mention of quantitative tightening. Most market participants anticipate the quantitative tightening process to begin sometime between May and July of this year. Mortgage desks are calling for 15 to 25 basis points, wider spreads in current coupons. We think lower coupons will widen less. And that at that 15 to 25 basis points wider level, this would bring spreads to near what we would term fair levels for the long-term. We believe this is an attractive entry point at returns in the low to mid-teens ROE. We also believe that we could see even wider spreads during bouts of volatility. Dynex is well positioned for these anticipated widening events, and we view them as opportunities for us to add assets and contribute significant incremental return to our portfolio. So how should investors think about this in the context of our balance sheet? On the existing book, we have cushioned the move wider thus far, and the real power is in the headroom for expansion of the balance sheet. We think we have the room to add two to four turns of incremental leverage, which when invested in the low to mid-teens ROE provides a strong foundation for returns well in excess of the current level of the dividend. As always, we’re approaching this market with discipline, you should see us take up leverage over the coming quarters to take advantage of wider spreads. Our investing in hedging will likely be in the higher coupons as they cheapen and offer additional returns. We’re also open to explore diversification into CMBS as those spreads have already adjusted wider and will continue to do so. We’ve spoken about CRT. That market is about to have more supply in 2022 than in many years. And it remains an alternative that will continue to evaluate. Dynex’s natural portfolio position is to be diversified and we believe the transitioning environment will allow for these types of strategy is to be implemented in the portfolio, again. I will add that all else being equal, our preference will be to generate returns with more liquid and flexible investments. I’ll leave you with the following thoughts. We have successfully managed through the significant widening and spreads thus far. We are experienced at this and we believe we’ve positioned the book to be cushioned against the worst of the widening. We stand ready to deploy capital as we move into this more favorable return environment and we’re looking forward to building a very solid stream of cash flow that will position us to deliver strong performance in the long-term. I’ll now turn it over to Byron.

Thank you, Smriti. Let me point out a couple of things here at the end. We’re entering into a unique transitional period in history. And it is more important now than ever to be able to rely on a team that has a clear strategy and deep experience in navigating complex environments. At Dynex Capital, we have a plan to manage through this evolving environment. We’re patient, discipline and focused on our execution and on driving long-term shareholder returns. We believe that Dynex Capital represents a compelling investment opportunity and income oriented investors should consider diversifying their portfolios with both our common and preferred stock. Come join us on our long-term and continued journey of delivering attractive risk adjusted returns. Thank you. And we’ll open up the call for questions.

[Operator Instructions] And your first question comes from the line of Eric Hagan from BTIG. Your line is open.

Thanks. Good morning. Great job. Last month, managing risk on your balance sheet. A couple from me, I think, you guys are much heavier in the 2% coupon than you are in the 2.5%. Can you guys just maybe walk through and expand on the liquidity you expect for that coupon as the fed begins tightening. And just the reinvestment risk there more generally with prepays being slow. And then I’m looking at Slide 13, I think you guys mentioned there’s an opportunity to increase leverage two to four turns. I assume four turns represents – doesn’t represent really a cap on your leverage. But maybe just reminding us what that cap kind of is in any detail on whether that two to four turns is a short term vision for the balance sheet or just kind of how that fits into the overall outlook. Thanks.

Sure. Good morning, Eric. Thank you for your questions. So I’ll take the second question first, if you don’t mind just discussing the leverage and then we’ll address the more detailed question around the Fannie 2s. So on the leverage, yes. I think we believe there’s room to increase two to four turns. It does not represent a cap. I think the environment as we see it right now with returns in the low to mid teens that is a very reasonable level for us to go up to. And I will say that, in our comments, we talked about the potential during bouts of volatility for spreads to go considerably wider. And you could make an argument in those types of environments to really take it up more than that, two to four turns. In general, you’ve seen us operate somewhere between five and 10 times. We rarely dip below five, it’s usually when there’s really significant risk in the environment. We rarely go above 10, it’s usually when there’s significant return in the environment. So I would say, five to 10 is generally where we operate. And 2 to 4 times is a reasonable expectation, but – and it’s obviously not a cap and in great return environments, we should be taking advantage of those with more assets. So – and then I’ll turn to your question of two. So twos are a very interesting coupon, we were in that coupon before the fed started buying that coupon. We believe that it is going to be a strong foundation for our portfolio. We’ve owned that coupon from the very beginning, and I think it’ll be a core part of our long-term position here in the portfolio. So with respect to the reinvestment risk in that coupon, so again, in – they’re not really producing that many twos at this point, most of the twos that are out there are sitting on bank balance sheets and the fed. In fact, 75% of the float in twos is sitting in those two places. There’s very little float in that coupon that makes it a scarcity bid that will support the price of it. The seasoning in the coupon in general also allows you to take advantage of reinvestment from prepay. So as these bonds season, they have embedded home price appreciation and turnover that can give you a pretty nice return on capital, in terms of reinvestments. And look, over the long-term, there’s going to be very little supply in this coupon. So it’s a very technically sound play for us to keep our portfolio. Did that address both your questions?

That was really helpful. Thank you so much.

Sure.

Your next question comes from the line of Doug Harter from Credit Suisse. Your line is open.

Hey, good morning, everyone. This is Josh Bolton on for Doug. Pleasantly surprised to see book value flat through January, especially given the spread widening and some other book value updates from peers that were down throughout that month. Wondering, if you could walk through some of the factors that you think led to that book value outperformance in 1Q, again in the seemingly tough environment for lever mortgage investors. Thanks.

Sure. Thank you, Josh. Yes, I mean, I would point to this, the three things. Number one ism we came into this with much lower leverage. I think, you guys see our leverage, our total leverage is a function of levels of common and preferred, our leverage to common equity is also lower. That’s something I would look – I would point investors to as something to also take a look at in terms of metrics when you’re evaluating different companies. So our leverage overall was lower coming into this that really helped a lot. The second piece is, our allocation to these lower coupons. They’ve really been absolutely rock solid. We’ve been completely aligned with the fed in terms of the strategy for to buy what they buy and to own what they own and the way to be clever and smart about that strategy is as the fed exits, they’re not selling the two and two and a half coupon. They’re going to own those for forever, right. And they’re going to run off slowly. So that’s been what’s contributing to the outperformance of those two coupons and the underperformance has been coming in the higher coupons threes and three and half, because those are the coupons that are now being produced and they’re not being purchased by the fed. So I think we were just positioned in these technically very sound positions. And I think of it as sort of the safest place to hide in the mortgage market at this point. And then lastly, it’s just our hedge positioning. These assets are longer duration assets. We hedge them to a longer duration hedge ratio. That is how we think about duration in general. Our strategy and you guys have probably heard this from us a long time. We don’t – we think about durations, not just a single point estimate, but we’re looking at durations across a different environments. And quite frankly, that long duration asset hedge with a long duration hedge worked out and it was the right strategy for this scenario. So those are the three things. And look, I can’t emphasize enough liquidity, flexibility, our process, these are all things that contribute to how we position and how we got here.

Yes. And Josh, let me add one other thing that this is – we’ve been consistent. This is the way we’re managing, I think a year ago, you could have listened to our conference calls. We’ve been very consistent in terms of how we’ve approached this. So in reality, we’ve talked about this opportunity. We’ve talked about these potential adjustments and we’ve had the portfolio structured this way and we’ve been very patient and waiting for this environment to evolve.

Great. Thanks for that. And then just following up on the leverage comments you made earlier, you mentioned could take leverage of 2 to 4 times. I’m wondering if we don’t see any meaningful widening from here. Should we still expect leverage to creep higher just given that you mentioned adding one turn of leverage we’ll cover the dividend this year or any thoughts around timing of the leverage increase would be helpful? Thank you.

Yes. I mean that’s the $64 question, right? Like when are you going to do it and how much. It’s really interesting because this environment is really unique. So let me just walk through just what’s – we’ve had a significant amount of widening here and the incredible thing about this market is that returns are in the low to mid teens that between 10% and 12% right now as we measure it and that include the impact of essentially a 200 basis point rate hike in that’s being priced in the markets. So returns are accreted here. They are very strong. So we’re not – we’re cognizant that that is, this is an environment where we could actually put capital to work today. But what we think from here going ahead is that more widening is yet to come, right? And so far we’ve had 20, 25 basis points of widening in January. We think there’s an additional 15 to 20 to go. And we’re going to be patient about when we step into that. So again, if you think about when is the tapering going to end, probably in March, the impact of that really doesn’t flow through into the fed and the mortgage markets until June or July. So because the fed will continue to receive settlements of securities, then they may begin quantitative tightening. That stuff starts to impact in early second quarter, late third quarter. All of those things will contribute to decision making on our part in terms of timing. So again, all else being equal, we actually think spreads will be wider from here. So we’re not in a any great rush to run in and buy bonds. At the moment, although I will say returns are accreted here, we expect them to get more accretive and we’ll be there to put money to work then.

Hey, Smriti let me add one other thing in there, which is Jay Powell doesn’t know yet how they’re going to manage their portfolio, how they’re going to reduce their portfolio, how many rate heights they’re going to have. And every, all the central bankers want to say, we’re flexible. We’re nimble. The Dynex Capital has to be the same. Government policy will drive returns. And if the government policy makers are feeling their way through this, this is an evolving environment, we’re disciplined. We’re not going to try to predict the future, but we’re ready to respond, discipline scenario planning, preparation, preparation, preparation.

Great. Appreciate the comments, guys.

Thanks, Josh.

Your next question comes from a line of Trevor Cranston from JMP Securities. Your line is open.

Hey, thanks. Good morning. Looking at the interest rate exposures on Slide 11, there’ve been some shifts in the numbers from the end of the year through January 31. I was wondering if you could just take us through what drove that if it’s any changes to the portfolio or if that’s more so just the result of some incremental extension of some of the assets. Thanks.

Yes. Hi, Trevor. That is actually some very minor changes in the portfolio. And again, the 2.5% coupon up here at 180 on tens has more convexity to it relative to what it had down below in the 160, 170 area. So you’re just seeing some of that in here. We’ve not made any meaningful changes to the book.

Okay. Got it. In terms of prepay speeds, the portfolio is paying fairly slowly already in the fourth quarter. And you mentioned that 2%s are already fully extended. I was wondering if you could kind of talk about how much room you think there is for your portfolio speeds to decline further this year particularly given to move higher and mortgage rates that we’ve seen in January. Thanks.

Right. I mean so this is really the interesting part, right? So rates have moved higher. And I think one of the biggest factors going forward in terms of impacting prepay speeds is going to be the home price appreciation that we’ve seen in the market. So that 18% to 25% home price appreciation puts a lot of bonds in play for cash out refinancing. So cash out refinancing will be an issue. The other thing I think that will be an issue. And again, this will probably affect the 2.5% coupon more than the 2% coupon is just the structure of the mortgage market right now. You’ve seen a lot of competition with non-bank mortgage originators that will tighten the primary, secondary mortgage spread. So those – we expect the prepay speeds environment to not slowdown as much as people think especially in the higher coupons, right. Staffing at these originators has been actually also an issue, they’ve kept capacity as even as rates have risen. So the landscape’s going to be really competitive. So we feel like the call protection in having those low coupons is important and relative to the rest of the coupon stack will probably be sheltered. And then in terms of room for prepay speeds to slow, I can’t sit here and say that to you that they’re going to slow or not. I can say that we’re positioned for this environment in the lower coupon specifically because we’ve had this fundamental opinion of the option costs of mortgages in general being much, much higher than the models are telling us because of the fundamental structure and the mortgage market is being very much geared towards these assets being very callable. So I hope that answers your question and you know what…

Yes. I think that’s the…

The bottom line is – the book isn’t that sensitive to it, to be honest, that’s what I would say.

Sure. Okay. Yes. That’s very helpful. Appreciate the comment. Thank you.

Sure.

[Operator Instructions] Your next question comes from the line of Bose George from KBW. Your line is open.

Hey everyone. This is actually Mike Smith on for Bose. Congrats on a really strong start of the year. Just a couple for me on the balance sheet. Just wondering if you have a base case estimate for runoff or kind of how you’re thinking about the pace of reduction compared to the prior taper. And then just as a follow-up, where do you think the incremental demand for Agency MBS will come from?

Sure. Hello, Mike? Yes, I mean, it’s – it is actually anybody’s guess at this point in terms of the pace of the balance sheet, but I would say one general comment, first off is I think the fed has more tools in their toolkit this time around relative to the last time we went through this. I think they’ve realized that the balance sheet is a significant tool and the reaction of risk assets to quantitative tightening talk from central banks around the globe is something that, that every investor should be paying attention to at this point. So we generally expect risk assets across the spectrum to respond to a global decline in liquidity that’s coming, and it’s being very well telegraphed by madam Lagarde today, Jay Powell last week. So this is a major factor. The timing and the pace of this balance sheet reduction, really the timing is at least as important as the pace for us. And essentially the adjustment that will need to accompany that is the pricing at which private capital is able to come in and start to take these assets from the Fed, right. So relative to the last time, I think there's a real desire at the Fed to shrink the balance sheet sooner. So we're thinking about it in those terms. I can't give you an exact forecast. I think the market is really got a wide range of things here and the Fed themselves have not really telegraphed that much. I wouldn't be surprised to see a relatively steep decline in the way these, the balance sheet gets run off. And then your second question – can you repeat your second question again? I'm sorry. You talked about the Fed balance sheet and what was your second question?

Yes, no, second part of the question was just where do you think the incremental demand comes for, as the Fed kind of starts to really…

The demand, right. Yes. So that's again, a great question, because look, you have a situation right now where the Fed is reducing its footprint and private capital needs to come in. Who is the private capital? It's money managers, it's banks, it's mortgage REIT, such as ourselves, it's other hedge funds investors that come in and the gap is really pretty massive. Some of the Street analysts have estimated about a $400 billion gap between what the Fed is going to effectively, implicitly sell versus what needs to be bought. And the number one plug for that is money managers and I think that is going to single handedly drive the different – where we end up in terms of how much wider things get. So our belief and our operating assumption is that there's going to be a gap between the supply that comes in as a result of the Fed's balance sheet running off and the demand. And that's why we think spreads are going to go wider. I mean, money managers have sold over $500 billion worth of mortgages in the last two years and they need to get back to neutral, but they – so if they come in, I think that will govern part of how this net supply gets absorbed, but at these prices, I think you're still not there yet, with respect to how these – where these spreads will eventually end up.

Great, that's really helpful color. And then just one more, you mentioned where you think spreads could settle up, but just wondering how you're thinking about TBA specialness in the back half of the year in the context of the balance sheet reduction?

Yes. So it's going to be a tale of two halves, I would say. The first half of the year, I think we're going to – we continue to expect specialness in the roles. There's some really kind of neat nuanced dynamics in the lower coupon roles, because the Fed's still buying those coupons. And until the settlement cycle goes through in June and July, we expect to see the specialness relative to repo to stick in there until then. It should kind of normalize itself in the second half of the year. So the second half of the year is where we see some of that specialness start to fade off. And that's how we're thinking through our positioning with that kind of mindset.

Great. Thanks a lot for taking the question.

Sure. And I'll just say on the specialness right now, we've been rolling our advantage that we say – that we see in the role market right now is about 30 to 40 basis points, still special relative to repo. And that's kind of holding through levels that we see for April settlement.

Great. Thanks again.

Sure.

And your next question comes from the line of Christopher Nolan of Ladenburg Thalmann. Your line is open.

Hey, guys. Smriti, you earlier mentioned mortgage spreads widening 15 and 20 basis points further. Is that just for the quarter or is that your longer term vision?

So let me clarify that. I think 15 to 25 wider is what most Wall Street analysts are saying they could go to. Okay. And in bouts of volatility, I think they'd go even wider than that. But in general, to get back to levels where long-term, you're sort of sitting fair relative to swaps or treasuries, 15 to 25 is sort of where we think we see them settling out long-term. And the timing of that is look, it's tough. I think from here, I would say we've widened a fair amount, we've priced in some of this tapering and the quantitative tightening. And then from here to go wider, we're going to need to see a net seller come in like some selling either origination or we're going to have to start to see the quantitative tightening actually happen. So it could take some time to get that next 15 to 25 basis points. But on the other hand, look, I mean, we could trade with risk assets and be wider in the next month. So it's really hard to predict that and we try not to do that. What we try to do is just, is kind of watch the markets with some discipline, obviously, because we've got to have that. And then we respond as we see the chances come in. So the toughest thing on this right now is predicting the timing of spread widening. And I think we're not going to try to do that. We're actually going to try to be very responsive to that when we see it.

And my follow-up question, your comments earlier were in terms of when do you start to leverage up the balance sheet, focus on higher coupon RMBS and CMBS. What sort of coupons in RMBS and what percentage of the portfolio do you think could be in CMBS?

Yes, I mean, I have a – I dream of a time when we could go back to our 50/50 allocation to CMBS, it would be fantastic. We've seen spread widening in the agency, thus market here, thus far Freddie K 2s are wider. Nowhere close to where we're trying to be interested. And on those types of assets, I think we're just seeing the very beginning of a price adjustment as the Fed starts to exit. So we expect to see wider spreads in all of those sectors. And ultimately, I think they will be there for us. Right now, I think in the agency pass-through market, the 3% coupon sticks out to be a very cheap coupon and it's going to get cheaper. So I think that will be – that will have a role in our future sometime. So that would be probably a place where you'd see us put capital and look, I think again the biggest thing about this environment is you have global central banks basically telling you that they are ready to exit these markets. And that means the price of risk is going to change. It's going to change not only for agency mortgages, it’s going to change for non-agency mortgages, CRT paper, up in credit, down in credit, it's all going to change. And the only way to navigate this is to have a lot of liquidity and be super flexible and jump on the opportunities when they come. And that's I think what we're trying to do. So, I would say, for us, our natural position is to be diversified and we think we're going to get that shot.

Great. Thank you.

Sure.

And there are no further questions at this time. I turn the call back over to the management team for some closing remarks.

Thank you all for joining us today. Let me just leave you with this one quick thought. We believe government policy will drive returns. Currently, our government officials don't want the mortgage assets on their balance sheet, and we're very much so aligned with the Fed. We've reduced our balance sheet in preparation to take some of the assets that they don't want at much more attractive levels. So thank you so much for joining us and we look forward to chatting with you again, next quarter.

This concludes today's conference call. Thank you for your participation. You may now disconnect.