American Capital Agency's Mid-Q4 2013 Composition And Valuation Analysis: Part 2

| About: AGNC Investment (AGNC)

Author's Note: PART 2 of this article is a continuation from PART 1 which was discussed in a previous publication. Please see PART 1 of this article for a composition and valuation analysis of American Capital Agency Corp.'s (NASDAQ:AGNC) MBS portfolio. PART 1 helps lead to a better understanding of the topics and analysis that will be discussed in PART 2. The link to PART 1's analysis is provided below:

American Capital Agency's Mid-Q4 2013 Composition And Valuation Analysis - Part 1

This three-part article is a very detailed look at AGNC's MBS and derivative portfolios. I perform this detailed analysis for readers who anticipate/want such an analysis performed each quarter. For readers who just want the summarized conclusions/results, I would suggest to just scroll down to the "Conclusions Drawn" section at the bottom of the each part of the article.

Focus of PART 2 of Article:

The focus of PART 2 of this article is to provide a mid-fourth quarter update on AGNC regarding its derivative portfolio. I feel this mid-quarter update will provide readers a general direction on how the first-half of the fourth quarter of 2013 has panned out regarding AGNC's derivative strategy. PART 2 of this article will mainly compare and contrast what has occurred so far in the fourth quarter of 2013 versus the third quarter of 2013 by analyzing AGNC's derivative portfolio regarding its composition. This will also help readers understand how the second-half of the current quarter could pan out as interest rates fluctuate.

I would like to first analyze AGNC's derivative portfolio as of 9/30/2013 and identify the changes AGNC made in the prior quarter which will impact the current quarter. The information derived in PART 2 of this analysis will ultimately assist in projecting a valuation for AGNC's derivative portfolio as of 11/15/2013 (which will be determined in PART 3).

B) AGNC's Derivative Portfolio - Composition and Valuation Analysis:

Let us first understand AGNC's derivative portfolio as of 9/30/2013 regarding its composition. This will include a net change analysis when comparing its 9/30/2013 balance to its 6/30/2013 balance. This will be followed by a derivative portfolio composition analysis for the first-half of the fourth quarter of 2013 broken down by the four main derivative instruments currently being used by AGNC.

Side Note: To better illustrate the nature and function of AGNC's derivative portfolio, I show each derivative instrument as being net "long" or "(short)." All net long positions have a "direct" relationship with AGNC's MBS portfolio regarding valuation movements. As such, if AGNC's MBS portfolio has a valuation gain during a specified time period, AGNC's net long derivative position(s) will likely have a similar valuation gain (and vice versa). All (short) positions have an "inverse" relationship with AGNC's MBS portfolio regarding valuation movements. As such, if AGNC's MBS portfolio has a valuation gain during a specified time period, AGNC's net (short) derivative position(s) will likely have an offsetting valuation loss (and vice versa). This can be confusing for some readers, but I feel presenting the information this way is the most effective when trying to truly show the nature of AGNC's derivative instruments. If a particular reader ever becomes confused while reading this article, I would suggest referring back to this side note to gain one's bearings.

It should also be noted not all of AGNC's derivative instruments are held for the sole purpose of mitigating a valuation loss on the company's MBS portfolio. AGNC holds different types of derivative instruments for different purposes. For example, AGNC has hedging instruments in place (interest rate swaps and swaptions) which help offset both a valuation loss on the company's MBS portfolio and the rising interest costs of repurchase ('repo') loans. Other derivative instruments (U.S. Treasury securities, "to-be-announced" ('TBA') MBS, and forward settling MBS) can have varying uses depending on whether each derivative instrument is net long (short). AGNC's U.S. Treasury securities, TBA MBS, and forward settling MBS typically have a direct relationship to the company's MBS portfolio when a net long position exists (non-hedging position). However, when these derivative instruments are in a net (short) position, an inverse relationship is typically developed and these instruments become hedges per se regarding valuation changes on AGNC's MBS portfolio.

However, AGNC's derivative portfolio is not implicitly designed to protect the company's book value ('BV') from "spread/basis risk." Spread/basis risk is the risk of an increase of the market spread between the yield on AGNC's MBS portfolio and the rates/yields on the company's derivative portfolio. The spread/basis risk between AGNC's MBS and derivative portfolios can cause short-term fair market value ('FMV') (aka "mark-to-market") fluctuations that are independent of general market interest rates. As such, spread/basis risk could relate to other factors which impact the current and future mortgage/fixed income markets. One recent example is the current and/or anticipated future monetary policies by the Federal Reserve. Therefore, while a net long (short) derivative position should move in a direct (inverse) correlation to AGNC's MBS portfolio under normal market conditions (regarding general valuations), there are at times when spread/basis risk causes a dysfunction between the two portfolios and their typical correlated valuation movements. Readers should be aware of such risk and understand this ultimately hinders management's strategies regarding the mitigation of BV erosion.

1) AGNC's Derivative Portfolio - Composition Analysis (As of 9/30/2013; Including Net Change Analysis):

Table 7 below shows AGNC's derivative portfolio as of 9/30/2013. Table 7 displays the following columns (in order from left to right): 1) derivative and other hedging instruments; 2) long (short) notional amount as of 6/30/2013; 3) additions; 4) settlements, terminations, expirations, or exercises; 5) long (short) notional amount as of 9/30/2013; and finally 6) amount of gain (loss) recognized in income on derivatives.

Table 7 - AGNC Derivative Portfolio Quarterly Activity (Third Quarter of 2013)

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Table 7 above shows each derivative's activity during the third quarter of 2013. Having Table 7 as a reference, let us first discuss how AGNC's derivative portfolio as of 9/30/2013 compared to its derivative portfolio as of 6/30/2013 regarding its overall composition. This will enable us to better understand what changes were made during the third quarter of 2013. This will ultimately help us when performing a mid-fourth quarter of 2013 valuation analysis on AGNC's derivative portfolio (in PART 3 of this article). Due to immateriality, the following derivative portfolio accounts and/or valuation changes will only be shown in Table 7 above and Table 8 below and not be discussed within this article: 1) TBA put option; 2) interest-only and principal-only strips; and 3) consolidated variable interest entities (VIE).

To better understand how AGNC's derivative portfolio as of 9/30/2013 changed when compared to its derivative portfolio as of 6/30/2013, Table 8 is shown below. Table 8 shows each derivative's net long (short) change for the third quarter of 2013 when compared to the second quarter of 2013. As such, Table 8 below provides key information on some recent quarterly net changes to the following four main accounts within AGNC's derivative portfolio: 1) net TBA MBS and forward settling MBS; 2) interest rate swaps; 3) interest rate swaptions; and 4) net U.S. Treasury securities (three separate "sub-accounts").

Table 8 - AGNC Derivative Portfolio Quarterly Net Changes (9/30/2013 vs. 6/30/2013)

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Using both Table 7 and Table 8 above as a general reference, let us begin our composition analysis for the four main accounts that make up AGNC's derivative portfolio as of 9/30/2013.

a) Net TBA MBS and Forward Settling MBS (Net (Short) Position as of 9/30/2013):

Using Table 7 above as a reference, AGNC had a net (short) TBA MBS and forward settling MBS position of ($7.3) billion as of 9/30/2013. For readers unfamiliar with AGNC's TBA MBS portfolio, I will provide a detailed overview. All discussions below refer to AGNC's TBA MBS portfolio and exclude a discussion of the company's forward settling MBS portfolio due to immateriality as of 9/30/2013.

Let us first discuss TBA contracts with a "long" position. AGNC enters into TBA contracts with a long position as an "off-balance sheet" means of investing in and financing MBS. Since TBA contracts with a long position are an extension of the balance sheet, this increases AGNC's "at risk" leverage. AGNC enters into TBA contracts with a long position where it agrees to purchase, for future delivery, MBS with certain predetermined prices, face amounts, issuers, coupons, and stated maturities. The date when AGNC is supposed to take future delivery on the TBA contracts with a long position is known as the settlement date. There are usually three options available to AGNC in regards to TBA contracts with a long position.

First, on or within a rather close timeframe to the settlement date, AGNC may decide to "re-roll" specific TBA contracts with a long position by moving the settlement date out to a later timeframe by entering into off-setting (short) positions. This is known as a "pair-off." AGNC net settles the paired-off existing long and newly created (short) positions in cash and simultaneously purchases similar yet new TBA contracts with a long position which have settlement dates further out into the future. This specific transaction is known as the "dollar-roll." The TBA contracts with a long position that are purchased with future settlement dates are usually priced at a discount to regular MBS in the current month (dependent on market conditions). This discount is referred to as the "price-drop." The price drop is the economic equivalent of "net interest carry income" on the underlying MBS over the roll period. Net interest carry income is just a fancier term meaning interest income less implied financing costs (funding the underlying MBS through repo loans). This is also referred to as AGNC's "dollar-roll income" generated when a TBA contract with a long position exists.

The second option in regards to AGNC's TBA contracts with a long position is to "transfer" the position via selling the contracts to a potential market purchaser. Although possible, this option is rarely exercised because such a transaction typically results in additional valuation losses on the part of AGNC. Even though this option is a rare occurrence, it should still be mentioned for full disclosure purposes.

The third option is to take delivery on the TBA contracts with a long position on the settlement date without re-rolling the company's position. If the third option occurs, then the TBA contracts with a long position are exercised and are "converted" to regular MBS regarding its accounting and valuation treatments. As such, these TBA MBS are converted from an off-balance sheet MBS position to an "on-balance sheet" MBS position. AGNC enters into TBA contracts with a long position because during specific time periods (and rate environments), dollar-roll financing can generate attractive risk adjusted returns and averts/delays funding through repo loans.

Using Table 7 and Table 8 above as a reference, AGNC continued to aggressively decrease the company's net long TBA MBS and forward settling MBS position during the third quarter of 2013. The quarterly change for this specific derivative account was a net long reduction of ($21.7) billion during the third quarter of 2013. As such, AGNC went from a net long TBA MBS and forward settling MBS position of $14.8 billion as of 6/30/2013 to a net (short) TBA MBS and forward settling MBS position of ($7.3) billion as of 9/30/2013. Management continued to perform such a large, quick reversal of AGNC's net long TBA MBS and forward settling MBS position due to the rapid rise in mortgage interest rates/U.S. Treasury yields during the latter half of the second quarter of 2013 and most of the third quarter of 2013. Specifically, as discussed in PART 1 of this article, when mortgage interest rates/U.S. Treasury yields rapidly rise, MBS price movements quickly decrease. As such, negative MBS valuations occur. Since TBA MBS and forward settling MBS are valued in a similar manner to regular MBS, when MBS prices quickly decrease, underlying net long TBA MBS and forward settling MBS valuations also quickly decrease. Depending on the specific coupon of a net long TBA MBS and forward settling MBS, these valuation losses can escalate.

Now that AGNC had a net (short) TBA MBS and forward settling MBS position as of 9/30/2013, let us briefly describe TBA contracts with a "(short)" position. Since TBA contracts with a (short) position are ultimately a reduction of the balance sheet, this decreases AGNC's "at risk" leverage. AGNC enters into TBA contracts with a (short) position where it agrees to sell, for future delivery, MBS with certain predetermined prices, face amounts, issuers, coupons, and stated maturities. The date when AGNC is supposed to provide future delivery on the TBA contracts with a (short) position is known as the settlement date. As was the case with TBA contracts with a long position, there are usually three options available to AGNC in regards to its TBA contracts with a (short) position.

First, on or within a rather close timeframe to the settlement date, AGNC may decide to re-roll specific TBA contracts with a (short) position by moving the settlement date out to a later timeframe by entering into off-setting long positions. This is known as a pair-off. AGNC net settles the paired-off existing (short) and newly created long positions in cash and simultaneously purchases similar yet new TBA contracts with a (short) position which have settlement dates further out into the future. This specific transaction is known as the dollar-roll. The TBA contracts with a (short) position that are sold with future settlement dates are usually priced at a discount to regular MBS in the current month (dependent on market conditions). This discount is referred to as the price-drop. The price drop is the economic equivalent of "net interest carry income" on the underlying MBS over the roll period. This is also referred to as AGNC's "dollar-roll expense" generated when a TBA contract with a (short) position exists.

The second option in regards to AGNC's TBA contracts with a (short) position is to transfer the position via selling the contracts to a potential market purchaser. Although possible, this option is rarely exercised because such a transaction typically results in additional valuation losses on the part of AGNC. Even though this option is a rare occurrence, it should still be mentioned for full disclosure purposes.

The third option is to provide delivery on the TBA contracts with a (short) position on the settlement date without re-rolling the company's position. If the third option occurs, then the TBA contracts with a (short) position are exercised and AGNC's existing regular MBS are sold. This is basically just another form of an "on-balance sheet" regular MBS sale regarding its accounting and valuation treatments. However, selling regular MBS via the TBA contract route requires the identification of the specific regular MBS to be delivered no later than 48 hours prior to the settlement date. AGNC usually identifies the specific regular MBS to be delivered within a few days of the 48 hour deadline.

AGNC enters into TBA contracts with a (short) position to lower the leverage on the company's MBS portfolio and provide TBA MBS valuation gains in a rising interest rate environment. Ultimately, when this strategy works properly, these TBA MBS valuation gains can modestly reduce BV erosion.

Now that we better understand why AGNC decided to change its derivative strategy within the company's TBA MBS and forward settling MBS account, let us further analyze which TBA MBS coupon rates changed between 9/30/2013 and 6/30/2013. For this analysis, Table 9 is provided below.

Table 9 - AGNC TBA MBS and Forward Settling MBS Quarterly Net Changes (9/30/2013 vs. 6/30/2013)

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Using Table 9 above as a reference, the quarterly net notional ('par') change within AGNC's 15-year 3.0% coupon TBA MBS was ($7.1) billion. This is due to the fact AGNC is continuing to realign its MBS portfolio into higher coupon MBS. As of 6/30/2013, AGNC had a net long position of $4.8 billion on its 15-year 3.0% coupon TBA MBS. As of 9/30/2013, AGNC had a net (short) position of ($2.3) billion. As such, AGNC took delivery on a material portion of this net long position during the third quarter of 2013. However, rather than sustain continued realized valuation losses on these newly converted 15-year 3.0% coupon TBA MBS in a rising interest rate environment, AGNC decided to lower its exposure to 15-year 3.0% coupon MBS. As such, AGNC immediately sold a portion of these newly converted 15-year 3.0% coupon TBA MBS. This partially explains why AGNC sustained such a material net valuation loss on the company's sold MBS for the third quarter of 2013. When referring back to PART 1 of this article, AGNC had a quarterly net decrease of ($2.8) billion regarding its 15-year 3.0% coupon MBS. This strategy helps AGNC offset additional future valuation losses if MBS prices are further suppressed in the coming quarters by a rise in mortgage interest rates/U.S. Treasury yields.

The same general trend occurred within AGNC's 15-year 3.5% coupon TBA MBS. The quarterly net notional ('par') change within AGNC's 15-year 3.5% coupon TBA MBS was ($2.3) billion. Again, this is due to AGNC converting a material portion of the company's 15-year 3.5% coupon TBA MBS. As of 6/30/2013, AGNC had a net long position of $1.4 billion on its 15-year 3.5% TBA MBS. As of 9/30/2013, AGNC had a net (short) position of ($0.9) billion. As such, AGNC also took delivery on a material portion of this net long balance during the third quarter of 2013. However, since the 15-year 3.5% coupon regular MBS has less price sensitivity when compared to the 15-year 3.0% regular MBS in a rising interest rate environment, AGNC kept a material portion of the newly converted TBA MBS on the company's balance sheet. When referring back to PART 1 of this article, AGNC had a quarterly net increase of $8.2 billion regarding its 15-year 3.5% coupon regular MBS. Again, the realignment of the MBS portfolio into higher yielding MBS coupons should help AGNC offset some of the BV losses associated with rapidly rising interest rates. I'm not saying valuation losses will not exist in a rapidly rising interest rate environment, however, the magnitude of these losses should be reduced if AGNC continues to realign the company's MBS portfolio into higher yielding MBS coupons.

Continuing with this trend, AGNC decreased its 30-year 3.0%, 3.5%, and 4.0% coupon TBA MBS by ($11.3) billion, ($0.9) billion, and ($2.7) billion, respectively. As stated in PART 1 of this article, this is due to the fact AGNC is continuing to realign its MBS portfolio into less price sensitive 15-year MBS and into higher coupon 30-year MBS. As of 6/30/2013, AGNC had a net long position of $7.6 billion on its 30-year 3.0% coupon TBA MBS, a net (short) position of ($4.4) billion on its 30-year 3.5% coupon TBA MBS, and a net long position of $6.0 billion on its 30-year 4.0% coupon MBS. As of 9/30/2013, AGNC had a net (short) position of ($3.7) billion on its 30-year 3.0% coupon TBA MBS, a net (short) position of ($5.3) billion on its 30-year 3.5% coupon TBA MBS, and a net long position of $3.3 billion on its 30-year 4.0% coupon MBS. As such, AGNC took delivery on a material portion of the company's net long 30-year 3.0% and 4.0% coupon TBA MBS during the third quarter of 2013. AGNC also slightly increased the company's net (short) position on its 3.5% coupon TBA MBS. However, rather than sustain continued realized valuation losses on these newly converted 30-year 3.0% coupon TBA MBS in a rising interest rate environment, AGNC decided to lower its exposure to 30-year 3.0% coupon MBS. As such, AGNC immediately sold a portion of these newly converted 30-year 3.0% coupon TBA MBS. This partially explains why AGNC sustained such a material net valuation loss on the company's sold MBS for the third quarter of 2013. When referring back to PART 1 of this article, AGNC had a quarterly net decrease of ($10.3) billion regarding its 30-year 3.0% coupon MBS. AGNC also had a quarterly net decrease of ($5.5) billion regarding its 30-year 3.5% coupon MBS. Again, this MBS portfolio realignment gets back to the strategy of offsetting additional future valuation losses if MBS prices are further suppressed in the coming quarters by a rise in mortgage interest rates/U.S. Treasury yields.

During the third quarter of 2013, AGNC rapidly changed its TBA MBS and forward settling MBS strategy from a net long position of $14.4 billion as of 6/30/2013 to a net (short) position of ($7.4) billion as of 9/30/2013. Instead of treating AGNC's TBA MBS and forward settling MBS position as an extension of the balance sheet (net long position), AGNC has now used the company's TBA MBS and forward settling MBS position as a "hedging" instrument per se (net (short) position). If mortgage interest rates/U.S. Treasury yields increase while AGNC has a net (short) TBA MBS and forward settling MBS position, AGNC should record derivative valuation gains which will help offset on-balance sheet MBS valuation losses. Since mortgage interest rates/U.S. Treasury yields first fell but then subsequently rose during the first half of the fourth quarter of 2013, management should have kept AGNC's TBA MBS and forward settling MBS portfolio in a net (short) position as rates reversed course and increased approximately 30 basis points ('bps') through the week ending 11/15/2013. Of course, looking in hindsight is always easier vs. predicting future interest rate movements for a particular quarter. As noted earlier, the valuation of AGNC's TBA MBS and forward settling MBS portfolio through 11/15/2013 will be discussed in PART 3 of this analysis.

b) Interest Rate Swaps (Net (Short) Position as of 9/30/2013):

Using Table 7 above as a reference, AGNC had a net (short) interest rate swaps position of ($50.2) billion as of 9/30/2013. AGNC had ($0.9) billion of interest rate swap additions and $6.3 billion of interest rate swap expirations or terminations during the quarter. Using Table 7 and Table 8 above as a reference, AGNC began to decrease the company's net (short) interest rate swaps position during the third quarter of 2013. The quarterly net notional balance change for this specific derivative account was a net (short) reduction of $5.5 billion or approximately 10% of AGNC's interest rate swaps net (short) position of ($55.7) billion as of 6/30/2013.

Table 8 above shows the quarterly net changes within this derivative account as a whole during the third quarter of 2013. However, Table 8 does not break out the specific interest rate swap maturities. To obtain further information regarding the quarterly net changes to AGNC's interest rate swaps, Table 10 is provided below.

Table 10 - AGNC Interest Rate Swaps Quarterly Net Changes (9/30/2013 vs. 6/30/2013)

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Using Table 10 above as a reference, the quarterly net notional change within AGNC's interest rate swaps with maturities of less than three years was an increase in the company's net (short) position of ($1.9) billion. The quarterly net notional change within AGNC's interest rate swaps with maturities of three to five years was a decrease in the company's net (short) position of $6.5 billion. The rest of the maturity groupings had minor (short) position changes. AGNC slightly decreased its overall interest rate swaps net (short) position during the third quarter of 2013 for two main reasons.

First, as discussed earlier, AGNC reduced the company's net long TBA MBS and forward settling MBS position by ($21.7) billion during the third quarter of 2013. As such, AGNC reduced the company's at risk leverage from a factor of 8.5x as of 6/30/2013 to a factor of 7.2x as of 9/30/2013. Since, when combined, AGNC's off-balance sheet TBA MBS portfolio and on-balance sheet MBS portfolio decreased ($16.1) billion during the third quarter of 2013, management felt a smaller net (short) interest rate swaps position was appropriate.

Second, during the last few weeks of the third quarter of 2013, mortgage interest rates/U.S. Treasury yields sharply decreased. As such, MBS prices quickly increased. As such, the probability of MBS valuation losses slightly decreased. As such, management felt the continued extremely high ratio of interest rate swaps versus MBS/repo loans was unwarranted.

It should be noted that adding to AGNC's net (short) interest rate swaps position in a rising interest rate environment comes at an added cost regarding a slightly higher average fixed pay rate on newly created interest rate swaps (disregards the notion of interest rate swaptions for simplicity). This is evidenced in Table 10 above under the "average fixed pay rate" column. This column represents the quarterly net change in AGNC's average fixed pay rate that the company pays to a counterparty in a specific interest rate swap. Most interest rate swap maturities had an overall slight increase in its fixed pay rate. In general, when mortgage interest rates/U.S. Treasury yields rise, the interest rate associated with the payer side of a newly created interest rate swap increases as well. In exchange, AGNC receives interest which is shown in Table 10 under the "average receive rate" column. Currently, AGNC's average receive rate is based on the three month London Interbank Offered Rate (LIBOR). Using Table 10 as a reference, the average receive rate actually slightly decreased during the third quarter of 2013. Since AGNC's weighted average pay rate slightly increased by 4 bps and average receiver rate slightly decreased by 2 bps, AGNC will generally pay an increased net periodic interest rate swaps expense during the fourth quarter of 2013. However, this notion assumes the company's net (short) interest rate swaps position has not changed. Since AGNC lowered the company's notional (short) position by approximately 10% by the end of the third quarter of 2013, this particular expense should be slightly lower for the fourth quarter of 2013. This projection assumes AGNC does not modestly increase its net (short) interest rate swaps position early in the fourth quarter of 2013. As noted earlier, the valuation of AGNC's interest rate swaps through 11/15/2013 will be discussed in PART 3 of this analysis.

c) Interest Rate Swaptions (Net (Short) Position as of 9/30/2013):

Interest rate swaptions are basically options to enter into underlying interest rate swap contracts. Whereas interest rate swap contracts have no initial upfront costs (gains and losses are incurred as interest rates fluctuate over the life of the swaps), interest rate swaptions have implicit upfront costs (similar to an option contract; generally speaking).

Using Table 7 above as a reference, AGNC had a net (short) interest rate swaptions position of ($20.2) billion as of 9/30/2013. AGNC had ($9.5) billion of interest rate swaption additions and $13.0 billion of interest rate swaption exercises, expirations or terminations during the quarter. Using Table 7 and Table 8 above as a reference, AGNC began to decrease the company's net (short) interest rate swaptions position during the third quarter of 2013. The quarterly net notional balance change for this specific derivative account was a net (short) reduction of $3.6 billion or approximately 15% of AGNC's interest rate swaptions net (short) position of ($23.8) billion as of 6/30/2013.

Table 8 above shows the quarterly net changes within this derivative account as a whole during the third quarter of 2013. However, Table 8 does not break out the specific interest rate swaption expirations or underlying interest rate swap maturities. To obtain further information regarding the quarterly net changes to AGNC's interest rate swaptions, Table 11 is provided below.

Table 11 - AGNC Interest Rate Swaptions Quarterly Net Changes (9/30/2013 vs. 6/30/2013)

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Using Table 11 above as a reference, the quarterly net notional balance change on the underlying interest rate swap within AGNC's interest rate swaptions with expirations of one to two years was an increase in the company's net (short) position of ($1.6) billion. The quarterly net notional change on the underlying interest rate swap within AGNC's interest rate swaptions with expirations of two to three years was a decrease in the company's net (short) position of $3.5 billion. The rest of the expiration groupings had minor (short) position changes. As was the case regarding the company's interest rate swaps, AGNC slightly decreased its overall interest rate swaptions net (short) position for two main reasons. Please refer to AGNC's interest rate swaps account above for a discussion of these two main reasons.

It should be noted that adding to AGNC's net (short) interest rate swaptions position comes at an added cost. This is evidenced in Table 11 above under the "cost" column. This column represents the quarterly net change in AGNC's option costs in association with entering into a specific interest rate swaption contract. Swaptions with option expirations of one to two years had a quarterly net cost increase of $59 million during the third quarter of 2013. This increase in net costs was mainly due to the underlying interest rate swap net (short) notional balance increase of ($1.6) billion during the third quarter of 2013. However, swaptions with option expirations of two to three years had a quarterly net cost decrease of ($95) million during the third quarter of 2013. This decrease in net costs was mainly due to the underlying interest rate swap net (short) notional balance decrease of $3.5 billion during the third quarter of 2013. The rest of the expiration groupings had minor net cost changes. As noted earlier, the valuation of AGNC's interest rate swaptions through 11/15/2013 will be discussed in PART 3 of this analysis.

d) U.S. Treasury Securities (Net Long Position as of 9/30/2013):

Using Table 7 above as a reference, AGNC had the following three sub-account positions as of 9/30/2013: 1) long U.S. Treasury securities of $4.9 billion; 2) (short) U.S. Treasury securities of ($1.9) billion; and 3) U.S. Treasury security futures sold (short) of ($1.7) billion. Using Table 7 and Table 8 above as a reference, when combining all three sub-accounts together, AGNC reversed the company's net (short) U.S. Treasury securities position of ($9.2) billion as of 6/30/2013 to a net long U.S. Treasury securities position of $1.2 billion as of 9/30/2013. As such, the quarterly change for this specific derivative account was a net (short) reduction of $10.4 billion during the third quarter of 2013.

Table 8 above shows the quarterly net changes within this derivative account, broken down by the three sub-accounts as a whole during the third quarter of 2013. However, Table 8 does not break out the specific maturities within these three sub-accounts. To obtain further information regarding the quarterly net changes to AGNC's U.S. Treasury securities, Table 12 is provided below.

Table 12 - AGNC U.S. Treasury Securities Portfolio (As of 9/30/2013 and Quarterly Net Changes (9/30/2013 vs. 6/30/2013))

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Using the top-half of Table 12 as a reference, AGNC had a net long 7-year U.S. Treasury securities position of $1.3 billion as of 9/30/2013. AGNC had a net long 10-year U.S. Treasury securities position of $1.7 billion as of 9/30/2013. AGNC had a net (short) U.S. Treasury security futures sold (short) position of ($1.7) billion as of 9/30/2013. This is based on each sub-account's face amount ('par').

Now using the second-half of Table 12 as a reference, the quarterly net face amount change within AGNC's U.S. Treasury securities with maturities of five years was a decrease in the company's net (short) position of ($1.8) billion. The quarterly net face amount change within AGNC's U.S. Treasury securities with maturities of seven years was a decrease in the company's net (short) position of $2.3 billion. The quarterly net face amount change within AGNC's U.S. Treasury securities with maturities of ten years was a decrease in the company's net (short) position of $9.1 billion. The quarterly net face amount change within AGNC's U.S. Treasury security futures sold (short) was a decrease in its net (short) position of $0.7 billion. As was the case regarding the company's interest rate swaps and swaptions, AGNC decreased its overall U.S. Treasury securities net (short) position for two main reasons. Please refer to AGNC's interest rate swaps account above for a discussion of these two main reasons. As noted earlier, the valuation of AGNC's U.S. Treasury securities through 11/15/2013 will be discussed in PART 3 of this analysis.

Now that we have an understanding of AGNC's derivative portfolio as of 9/30/2013 regarding its composition, let us briefly discuss American Capital Mortgage Investment Corp.'s (NASDAQ:MTGE) derivative portfolio as of 9/30/2013. This discussion will mainly compare and contrast AGNC's and MTGE's derivative portfolio as of 9/30/2013

Brief Discussion of MTGE's Derivative Portfolio (In Comparison to AGNC's MBS Portfolio as of 9/30/2013):

One material difference between AGNC's and MTGE's derivative portfolio in the first and second quarters of 2013 was the composition of each company's TBA MBS and forward settling MBS positions. AGNC held a net long TBA MBS and forward settling MBS position of $15.4 billion as of 6/30/2013. Meanwhile, MTGE only held a net long TBA MBS and forward settling MBS position of $91 million as of 6/30/2013. When calculated, AGNC's net long TBA MBS and forward settling MBS position as of 6/30/2013 was an extension of the company's MBS portfolio by 19%. In sharp comparison, MTGE's net long TBA MBS and forward settling MBS position as of 6/30/2013 was an extension of the company's MBS portfolio by only 1%.

As I projected in my relatively recent AGNC income statement and BV articles, I correctly made the assumption AGNC would follow in MTGE's "footsteps" and eliminate its net long TBA MBS and forward settling securities position during the third quarter of 2013. AGNC aggressively sold the company's remaining net long TBA MBS and forward settling MBS position due to negative valuations that occur as a direct result of rising mortgage interest rates/U.S. Treasury yields (discussed earlier).

AGNC held a net (short) TBA MBS and forward settling MBS position of ($7.3) billion as of 9/30/2013. Meanwhile, MTGE held a net (short) TBA MBS and forward settling MBS position of ($1.6) billion as of 9/30/2013. When calculated, AGNC's net (short) TBA MBS and forward settling MBS position as of 9/30/2013 offsets the company's MBS portfolio by (9%). In similar fashion, MTGE's net (short) TBA MBS and forward settling MBS position as of 9/30/2013 offsets the company's MBS portfolio by a slightly higher (17%). As of 9/30/2013, AGNC and MTGE now had a more similar proportional TBA MBS position when compared to the first and second quarters of 2013.

Now let us take a look at the rest of AGNC's and MTGE's derivative portfolio as of 9/30/2013 (also known as the hedging portfolio).

Table 13 - AGNC vs. MTGE Hedging Portfolio - Composition Summary (As of 9/30/2013)

Click to enlarge

Using Table 12 above as a reference, AGNC and MTGE had a slightly different hedging portfolio as of 9/30/2013. This was a change from AGNC's and MTGE's hedging portfolio as of 6/30/2013. As was discussed in a previous quarter's article, as of 6/30/2013, both AGNC and MTGE had a hedging portfolio that covered its repo loans, other debt, and net long TBA MBS position by 102% (hedging coverage rate).

As of 9/30/2013, AGNC had a hedging coverage rate of 93%. When compared to 6/30/2013, this equates to a decreased hedging coverage rate of (9%). This article already discussed several reasons why AGNC had a decreased hedging overage rate. In comparison, as of 9/30/2013, MTGE had a hedging coverage rate of only 77%. When compared to 6/30/2013, this equates to a decreased hedging coverage rate of (25%). As the percentages indicate, MTGE had a less hedged portfolio as of 9/30/2013 when compared to AGNC. Even though MTGE's proportional share of its non-agency portfolio increased from 11% of its total investment balance as of 6/30/2013 to 12% as of 9/30/2013, I was somewhat surprised by the sudden material decrease in the company's hedging coverage rate because of the results that were determined in PART 1 of this analysis.

Back in PART 1 of this analysis, when compared to AGNC, MTGE had a slightly more price sensitive fixed-rate agency MBS portfolio as of 9/30/2013. As a percentage of the company's fixed-rate MBS portfolio, AGNC had 53% of its portfolio in 15-year fixed-rate agency MBS, 2% of its portfolio in 20-year fixed-rate agency MBS, and 45% of its portfolio in 30-year fixed-rate agency MBS (a majority in either Fannie Mae (OTCQB:FMCC) or Freddie Mac (OTCQB:FNMA) MBS). In contrast, MTGE only had 40% of its portfolio in 15-year fixed-rate agency MBS, 2% of its portfolio in 20-year fixed-rate agency MBS, and 57% of its portfolio in 30-year fixed-rate agency MBS. When calculated, AGNC had 13% more of the company's fixed-rate MBS portfolio in the less price sensitive 15-year fixed-rate agency MBS and 12% less in the more price sensitive 30-year fixed-rate agency MBS. As such, a strong argument could be made that AGNC should have the less hedging coverage rate (as opposed to MTGE).

However, to play devil's advocate, one could make the argument MTGE's overall hedging portfolio has an advantage regarding a higher overall weighted average duration (estimate of interest rate sensitivity in years). However, I would counter with the notion that even though MTGE's hedges as of 9/30/2013 had an overall weighted average duration of (5.7) years versus AGNC's overall weighted average duration of (3.6) years, typically the MBS portfolio who has a modestly higher proportion of 30-year fixed-rate agency MBS should still have the higher hedging coverage rate (or at least only a slightly lower hedging coverage rate). MTGE's hedging coverage rate as of 9/30/2013 was (16%) less when compared to AGNC. I feel this is a pretty big difference in hedging coverage rates. Furthermore, it should be noted in the prior quarter MTGE also had a higher overall weighted average duration when compared to AGNC. However, as stated above, MTGE and AGNC both had a hedging coverage rate of 102% as of 6/30/2013.

Even when taking into consideration MTGE's higher overall weighted average duration, I have come to the conclusion AGNC's hedging portfolio was more cautious as of 9/30/2013. Again, this would benefit AGNC if a quick "spike" in rates were to occur (generally speaking; less of BV erosion). With that being said, I give the slight edge (strictly regarding a cautious hedging portfolio as of 9/30/2013) to AGNC.

The valuation of MTGE's derivative portfolio through 11/15/2013 will be discussed in PART 3 of this analysis.

Conclusions Drawn:

By examining AGNC's derivative portfolio as of 9/30/2013, I have shown how and analyzed why AGNC modestly decreased the company's derivative portfolio during the third quarter of 2013. This determination was mainly shown in Tables 7 and 8 above. These two tables showed the quarterly compositional changes within AGNC's derivative portfolio during the third quarter of 2013.

AGNC decreased its net long TBA MBS and forward settling MBS position by ($21.7) billion during the third quarter of 2013. As such, AGNC went from a net long TBA MBS and forward settling MBS position of $14.8 billion as of 6/30/2013 to a net (short) TBA MBS and forward settling MBS position of ($7.3) billion as of 9/30/2013. Management continued to perform such a large, quick reversal of its net long TBA MBS and forward settling MBS position due to the rapid rise in mortgage interest rates/U.S. Treasury yields that occurred during the latter half of the second quarter of 2013 and most of the third quarter of 2013. Instead of using AGNC's TBA MBS and forward settling MBS position as an extension of the balance sheet, AGNC has now treated the company's TBA MBS and forward settling MBS position as a "hedging" instrument per se. If mortgage interest rates/U.S. Treasury yields increase while AGNC has a net (short) TBA MBS and forward settling MBS position, AGNC should record derivative valuation gains which will help offset on-balance sheet MBS valuation losses. Since mortgage interest rates/U.S. Treasury yields first fell but then subsequently rose during the first half of the fourth quarter of 2013, management should have kept AGNC's TBA MBS and forward settling MBS portfolio in a net (short) position as rates reversed course and increased approximately 30 basis points ('bps') through the week ending 11/15/2013.

When accounted for as a whole, AGNC's interest rate swaps, interest rate swaptions and U.S. Treasury securities had a hedging coverage rate of 93%. When compared to a hedging coverage rate of 102% as of 6/30/2013, AGNC has slightly reduced the company's hedging portfolio during the third quarter of 2013. One could argue this was still a relatively high hedging coverage rate. The continued high hedging coverage rate is for the preservation of BV in case mortgage interest rates/U.S. Treasury yields once again materially increase over a relatively short period of time. The slight decrease in AGNC's hedging coverage rate is due to the following: 1) higher proportion of less price sensitive 15-year fixed-rate agency MBS when compared to 30-year fixed-rate agency MBS; and 2) recent "flattening-out"/reversal of mortgage interest rates/U.S. Treasury yields. If mortgage interest rates/U.S. Treasury yields were to once again quickly climb higher, I would anticipate AGNC would once again increase the company's hedging coverage rate.

Final Note: PART 3 of this article will be out in a week or so. PART 3 of this article will specifically value each of AGNC's four main derivative accounts through the week ending 11/15/2013. PART 3 will also include a projected BV per share amount as of 11/15/2013. This will be followed by an article about AGNC's fourth quarter of 2013 dividend range scenarios (prior to AGNC's quarterly dividend declaration in December 2013).

Disclosure: I am long AGNC, MTGE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.