American Capital Agency Corp. (NASDAQ:AGNC)
2014 Morgan Stanley Financials Conference Call
June 10, 2014 1:50 pm ET
Gary Kain - President and Chief Investment Officer
Cheryl M. Pate - Morgan Stanley
Cheryl M. Pate - Morgan Stanley
Good afternoon and welcome to our next presentation. We have American Capital Agency, one of the largest mortgage REITs in the industry today with over $70 billion of assets in its portfolio as of first quarter, and AGNC has really had a differentiated strategy focused on sophisticated asset selection and hedging with a focus towards preserving book value. And here with me today to speak is Gary Kain, AGNC's Chief Investment Officer. We're going to run this as a firefight check and we'll leave some time at the end for some audience Q&A. So with that, we'll get it started.
Thanks, Cheryl, and thanks for the opportunity to join you here. I remember presenting here last year about this time, early June 2013, and I will say I feel a lot better about being here this year than remembering back to early or mid-2013. I mean at this conference last year we were very transparent about how the world was changing, what was happening to book value, we talked about rebalancing and re-hedging the portfolio, we talked about selling mortgages, and we talked about how we had to be extremely defensive. Again, here we are in 2014 in June and the conditions are much, much more favorable and things are really going in – not in the exact same magnitude but going in the opposite direction.
And as most of you know, interest rates have generally come down over the course of the year, mortgage performance has been pretty strong which is obviously favorable for book value and other return measures. But just quickly, if we went back to the end of this year, clearly the consensus was toward interest defense tapering. Look what happened in 2013. Now we know as of December, the Fed is tapering, they are going to continue to taper, interest rates are going to go up, mortgages are going to continue to perform poorly, and there was a pretty strong consensus around that.
We didn't agree with that and we talked about it publicly back in February when we did our earnings call, our Q4 2013 earnings call, and we're very glad that we made some of the decisions that we made back then. We increased our duration gap, we stopped reducing leverage, we reduced our swaption portfolio, we bought back a lot of our stock in Q4, we bought the stocks of other agency REITs. So that was a key turning point to us. We felt that the market was oversold and there were some really good opportunities and I think that's been critical to kind of getting off to a good start here in 2014, but I know this forum is a discussion and it's really about Q&A rather than prepared remarks. So I will stop at this point and move to questions.
Cheryl M. Pate - Morgan Stanley
Sure. And you're right, a lot have changed in a year since we were last up here. So maybe we can just start from a big picture perspective. Obviously this time last year there was a lot of fear of QE3 unwind, a lot has not really come to pass in terms of what we'll see in the mortgage market this year, maybe you can just kind of give us the state of the industry as we see it today in terms of your outlook for mortgages and as well as that presence in the market?
Sure. So if you think about what we've seen transpire, I think it's important, when you think about the tapering, and one of the kind of drivers of how we thought about positioning as we enter this year is, maybe you take yourself back to the second quarter of 2012 before the Fed announced QE3, and you say, okay, what were the dynamics then, rates were lower, we had a fair amount of mortgage origination averaging, let's say $110 billion, $120 billion a month in mortgage originations, mortgage spreads were maybe a little – they were probably actually a little tighter than where we started this year or not that different.
And then when you roll forward what's happened, if we were having this discussion before QE3 was announced, and we said the Fed was going to buy 1.3 trillion of the agency mortgages over a two-year period beginning in 2012 going through September of 2014, and then they'd probably reinvest paydowns for another year, we all would've said, mortgages would be dramatically tighter in relation to other rate products than they were in 2012, and as of the beginning of the year this wasn't the case. And so that formed one piece of the – that's one thing to really keep in mind.
So when you think about the impact of the Fed and the tapering, yes, they are going to end QE3 under almost all circumstances. We've gotten information from Dudley saying that they are likely going to reinvest paydowns for a longer period of time than the market had envisioned. And when you add up the numbers, when the Fed stops adding mortgages in September, October, they will own about 32% of the market. And what happened is, every other investor start with the REIT something we all kind of know something about, average REIT leverage is lower than it's been in a long – really in the history of the REIT space or at the agency component of the REIT space, lowest since the crisis.
REITs are also better hedged than they used to be. There are mortgages that they own along with the rest of the universe, have ready extended, there's less extension risk. So REITs are in incredibly comfortable position if interest rates change or they would love the opportunity to kind of add to portfolios at wider spreads at this point.
You look at money managers, you look at overseas investors, pretty much everyone has reduced their holdings of agency MBS and a lot of it occurred in the shakeout of 2013. So money managers are extremely underweight agency mortgages and when you put that against the backdrop of the fact that all other asset classes are tight as well and have performed very well, the bottom line is, the outlook for mortgages is not that bad.
And the other thing you have to keep in mind is the supply picture, and we can go into different pieces of it, but just at a very high level, mortgage net supply has been anemic this year versus expectations of 200 billion. Gross supply has been averaging 60 billion to 70 billion a month down from that 120 billion we talked about before. So when you look at the technical backdrop for mortgages, it actually looks very good. When you look at the pricing, it's relatively full, but so is every other asset class basically on the planet at this point.
Cheryl M. Pate - Morgan Stanley
Right. One of the strategies that you've employed to benefit from the current market environment has been the TBA market or the dollar roll strategy. Can you maybe share your thoughts on how long this advantage in funding cost I guess essentially or pickup in spread, how long you would expect that to persist given the dynamics that we're seeing in the market?
Sure. The important thing when it comes to dollar rolls or buying TBAs and then basically continuing to roll your TBAs out and not take delivery and put pools on repo the way we would normally fund them, their specialness is associated with that and the Fed's purchases are a big chunk of it. But the number one driver at this point is, it is related to the Fed purchases but it's the stock effect that the Fed owned so much of the pass-through universe that it's very hard to find generic securities to fill trades, and so people have to – so then the financing is special. We don't see those conditions changing. We see that at this point many of those shore to the special financing opportunities relate more to the stock effect of the Fed's purchases rather than just the flow effect.
So, some of it is flow effect which will probably slow down over the next three to six months, but favorable financing is likely to be with us for quite some time in a number of coupons. And so this is really important when we go back to the conversation we just had about relative value, because IG is expensive, junk bonds are expensive. Spanish debt, I guess it was yesterday I think, Spanish 10-year debt got to 2.57, I think we're at 2.63 on the U.S. 10-year, okay. So I think it was at this time last year, Spanish 10-years were probably 5.70 versus our 10-year actually probably being about 2.50.
So when you think about kind of where everything else is, it's interesting because mortgages give you one thing back, right, and that is that while the yields have come down because they have tightened relative to treasuries or swap rates, if you can finance them special and you can get the equivalent of negative 50 basis points financing, then that makes the asset class much more attractive. So as things are tightening up, I think it's more and more important for investors who play in the mortgage space to take advantage of the opportunities that are presented by the conditions that are tightening up prices. And so, from our perspective to not engage in the dollar roll market and to be a large player in the mortgage space really doesn't make sense.
Cheryl M. Pate - Morgan Stanley
All right, that makes a lot of sense. Maybe we can spend a couple of minutes on what areas of the MBS market are most attractive. Currently you had been growing pretty significantly in the 15-year, that came down a little bit in the first quarter. Where you're seeing the best relative attractiveness in the market today?
Sure. As we had talked about for most of I guess really the last 12 months, is we were preparing for a scenario down the road where maybe interest rates are higher, where mortgage spreads at the end of the Fed's program will eventually widen one of the things, and we still believe this, is that at some point, two, three, four, five years from now, mortgages will be cheaper. And when that – that will be when the Fed's portfolio is actually – when they are not reinvesting paydowns, when they become a smaller part of the market, that's going to have to be absorbed by private investors and they probably will demand wider spreads, you will probably see that in other asset classes as well.
We didn't and don't think that's going to happen right away, but one of the big advantages to 15-year is that they are largely gone by the time you're sure this is going to happen. And so, you don't have to put the pressure on yourself as a portfolio manager to figure out exactly – to sell just in time before that happens, it's sort of naturally going to pay down. So, structurally we much prefer the 15-year cash flow to a 30-year cash flow with an eight or nine year average life that really doesn't shorten that much over time.
Now that being said, 15 years in the first quarter but more so in the beginning of the second quarter got to levels that were where other – lots of other investors realized they couldn't just concentrate in 30-year mortgages, and so 15-year mortgages got in our minds more expensive on a relative basis. So, that is something that we will react to, and so we have reduced our 15-year position somewhat in response to that. But again I want to reiterate that there's no question for us which cash flow we like better, but we also have to be cognizant of the return environment and the pricing environment.
And what I would say is that 15 years were sort of two or three months ahead of 30-years, in that they were good – usually it's the opposite, but they were a good leading indicator. What happened was other investors that didn't need short duration assets like money managers sold 15-years last year because they wanted the higher yields and they wanted the higher returns of 30-year. So weren't around to sell into bank and REIT bids for 15-years this year, so there was no-one to kind of get in the way of the spread tightening.
What we've seen is, toward the end of the first quarter and really in the second quarter, we had money managers now selling lots of 30-years and that kept 30-year spreads from tightening and actually widened them out kind of in March and April, and that created almost the same opportunity that you saw in 15-years three months earlier in the 30-year market. But now what you're finding is that pretty much in both cases, the willing sellers that were waiting for an opportunity to sell into a little better performance of mortgages in both cases have done that and there really isn't a lot in the way of tightening from here in either asset class today.
Cheryl M. Pate - Morgan Stanley
One of the things that we spoke to, you said a little bit in your prepared remarks and definitely with the seam and the fall, you were able to be opportunistic and increased your duration gap to take advantage of what you were seeing in the market and have brought it down slightly from those levels. What type of environment would you need to see to take a wider duration gap from here?
What I would say is there's a couple of things. There were two reasons why we increased our duration gap at the end of the year to 1.5 years, which in the REIT space 1.5 years is not a long duration gap but for someone that operates the way AGNC does, that was actually the widest duration gap we have had at a quarter end since we started reporting it in 2010. So we generally don't – we tend to want to manage interest rate risk because of the other risk that we have, such as spread widening and so forth, we certainly have to and feel the need to limit interest rate risk, and duration gap is one important measure in that.
But one thing that's really important, and the number one driver that got us comfortable going out there and would get us comfortable going back there or beyond that level is, it's important that we not also have extension risk. And so when we actually manage our portfolio, Peter Federico, our Chief Risk Officer, actually isn't looking at our duration gap on a daily basis and saying, okay it moved a 10th of a year, he's thinking about what is our exposure if interest rates go up 100. And so, we are much more focused on what happens to our duration gap in a rising rate environment and in a falling rate environment, but the rising rate environment tends to be the constraint.
And so what I think people should think about is, in our minds we're comfortable with that up 100 duration gap being in the neighborhood of two years, kind of in that zip code, at the higher end, and then more often it will tend to be somewhere closer to 1.5 years. But in terms of what would get us comfortable, it's a combination of things, it's not just the level of rate. I mean the conditions that we saw at the end of last year were perfect, you had higher rates, you had a lot of fear in the marketplace, you had mortgage durations that were fully extended so there was very little extension risk in the portfolio. All of those things were going in the same direction.
And so, it is likely if interest rates went back to – if the 10-year went back to 3%, all of those same conditions would likely be in place again. And so, we would probably see our duration gap extend. On the other side, as interest rates are coming down and the durations of our mortgages are shrinking, we don't feel like we have to maintain our current duration gap. The good thing about the current situation and the lack of negative convexity in our portfolio right now is, we don't have to be continuously rebalancing. We have plenty of risk cushion on either side.
And so, what I would differentiate, which is an important difference from last year at this time, is that the volatility, 10 and 20 basis points in each direction right now, doesn't force rebalancing actions and doesn't cost us money the way it did a year ago because our risk positions are lower and the risk positions in the market are lower as well.
Cheryl M. Pate - Morgan Stanley
One of the other unique strategies that you guys deployed last year was investing in some of the other mortgage REITs and that obviously was dealt pretty nicely given where valuations have moved to. So how do you think about that strategy in the current environment, does it give you access to maybe portfolios you couldn't buy in the open market or is there a reason to still look to hold other REITs in this environment?
It's a very good question. The topic of our investments in other REIT stocks has obviously gotten probably a lot more discussion than maybe needed to, but I won't say we were surprised by that in any way, shape or form. Look, the genesis of that idea was, we were comfortable with the mortgage market, we were comfortable with the interest rate environment, we had a ton of mortgages at the time, whatever, 60 billion plus, and we just got to the point where we felt we needed to first buy back our own stock, which we did in huge size, 7% in the fourth quarter, in one quarter, but then we're still holding a lot of mortgages even buying back our stock and selling mortgages against it, and when you can buy a portfolio of those mortgages at $0.75 or $0.80 on the dollar, that seemed like – and you're an investor that's completely comfortable with the risk of those embedded securities, in our minds it really was a no-brainer and we really had to do it, understanding the kind of supporting our competitor and understanding that we were relying on a different management team and all those things, but the prices were that compelling for the underlying assets.
By the same token, getting to kind of the gist of your question, if other REITs are at – have a price-to-book of 1, then none of those same issues apply. And so, it is really unless we really liked the management team or the assets and couldn't find them, we would be unlikely to own other REIT stocks and none of the reasons why we bought them in the first place would still apply.
So, what we've kind of told you is, we're a buyer in most cases of more aged other REIT stocks, and our own stock for that matter, obviously at somewhere in the neighborhood of 80% of book, and at 100% of book they really don't make any sense. And then in between there, it's going to be a lot based on – the decision making process is going to be one based on your shorter-term perspective on market conditions and so forth and just liquidity within both the mortgage market and the equity space as to where and when you look to exit those positions.
But I want to stress that when we entered this – I mean the scenario that we've seen in terms of price-to-book ratios was sort of our base case kind of scenario. This is not kind of in terms of book values but in terms of price-to-book ratios. But we were very prepared for a scenario where the stock prices languished for three to six months longer or a year. I mean we are very comfortable being able to assess these other portfolios, even with the limited information intra-quarter, and we would be comfortable holding them for an extended period of time if pricing dictated it. So we're not in a rush to sell them. On the other hand, if they appreciate enough, they are not going to make sense.
Cheryl M. Pate - Morgan Stanley
All right, it makes sense. Maybe I'll just pause for a moment to see if there's any questions from the audience.
You talked about the market conditions for the mortgage securities market being favorable. How long do you think that will persist, and I guess specifically, when the Fed starts to increase short-term interest rates, do you think that will change those conditions or do you think the conditions will remain favorable and what do you see the sort of dynamics of the yield curve and of the market being at that time when short rates start to increase?
That's obviously a very good question, and I guess the Fed keeps trying to stress that they are very data dependent. And what I would say is, we've been getting a fair amount of information from the Fed in terms of their response function, and their response function is one that's very interesting, which is they seem to care more and are willing to act differently based on the market's reaction to what they've said or what they are about to do or what data just came out. And if you look at Dudley's last speech, he kind of said, we'll tighten slower if the market overreacts and maybe we're willing to tighten a little faster if the market flex us or is fine with it. And so, that coupled with their decisions around when they started the tapering process really indicates that the Fed is going to make every effort to contain some of the volatility that typically comes at the beginning of a Fed's tightening cycle.
The other thing is, Dudley's comments around extending the reinvestment in mortgage securities, for example, is really important. If they weren't reinvesting and buying anything, then they start tightening cycle, you could expect to see more volatility in the price of mortgages versus other instruments. So, my sense is, and we don't rely solely on this and there could be new information, but the Fed seems to be focused on doing this in a – they do want to tighten but they also want to do it in a kind of deliberate manner.
And what I would say is, where do I get scared that that doesn't happen, it comes down to inflation numbers. Look, the central bank can want to be very tame and very supportive and worry about this. Where their hand gets pushed is if inflation really starts to pick up. The reality is, they can't be that slow. And I think the one thing that we draw a lot of comfort from, and everyone's got to make their own decision around this, is there have been – people have called loudly for inflation for about four or five years as a result of QE and other things that are going on. We do think the economy is improving but we don't see inflation getting scary anytime soon.
You can look at all the global trends, you can look at sort of the loss of momentum in the housing market, you can look at the job picture, there's a number of reasons why you should probably be pretty comfortable that inflation is not going to get out of control. And in that case, taking that back to the mortgage market, the supply picture is going to remain very benign, the Fed for the next year is going to at least -- is going to be reinvesting paydowns when they roll out of QE3, money managers, banks, foreign investors, everyone has reduced their positions in mortgages, almost everyone is waiting for a widening to be able to reinvest in this product.
So, big picture, we see none of the conditions in place for a, we'll call it, near-term blow-up in spreads, but I do want to reiterate what I said earlier that the equation is different when you go two, three, four years out and that's when I think you will see better buying opportunities so to speak or wider spreads.
Gary, so can you just talk about – you just mentioned people are waiting for spread widening to reinvest, but what happens in the interim? If you own mortgage-backed securities when spreads widen, how well protected are you against that happening? Spreads are a lot more – seem a lot more narrower than they were a few months ago or last year, last July. So how do you manage that, can you hedge that, how well protected are you against that, and how confident are you that even if spreads widen, investors won't wait from – they might expect even more widening at the point that that kicks in?
So great question, and I want to just first off be very upfront. Spread widening is not something we can generally hedge, okay. It is something that is inherent in our positions. We can hedge interest rate risk, you can do certain things on the margin that could maybe – if you believe spread widening is correlated with interest rates, then you can do some things to maybe try to capture that, but it's nowhere near a perfect hedge. So, first off, an investor should assume that spread risk is something that we take. Now, your main tools around that are, how long are the mortgages you own, do you have 15-year with a shorter average life and a shorter exposure to spread moves, and what is your leverage, how much do you own at the time, how big is your position. Those are your big tools.
But what I want to stress is the huge difference last year was pretty in interest rate space was a crisis environment. You had a confluence of events. Everyone – like the consensus this year was that rates are going higher and spreads are going wider because the Fed is tapering. The consensus last year was, I don't care where spreads are at the beginning of the year, I don't care if production is 150 billion a month, I don't care what's going on, the Fed is buying so much that there's no way interest rates are going higher and there's no way that spreads are going to widen much. And because of that, everyone was on the same side of the fence. Turns out, we didn't want to make the same mistake again where everyone lined up on the other side this time and you could easily have been – the consensus in a sense was wrong twice, which generally tends to happen in the markets.
So going back to your point, look, we can't really hedge it. The reason we have comfort – look, I mean mortgages have tightened a fair amount over the course of this year but in particular over the last two to three months, and the driver of that tightening has been a better understanding of the origination dynamics, the fact that there aren't enough bonds coming out, it's a better understanding of how much the Fed already owns, but most importantly it's been the fact that money managers and other actively managed accounts have gotten extremely underweight mortgages, which means they just don't have much more to sell.
And all of the things created the quick spread widening that seemed to go on for a while last year and just keep getting worse, which were all the opposite reasons. You had massive origination, pipelines were getting flushed, you had convexity or hedge-related selling like on the part of REITs but also from banks and from servicers, you had money managers getting redemptions that were fully loaded on agency mortgages having to sell them. When you put again all of those dynamics, almost every single one of them really can't repeat this time.
So, are there bad scenarios, can spreads widen? Yes, they can. Are they full? Yes, they are. But again, the other difference is, every other product is full. And mortgages, when you think about their technical backdrop, are in better shape than most other things out there, at least in my opinion.
Cheryl M. Pate - Morgan Stanley
On sort of month to month basis, as you are thinking through your portfolio, what's the trade-off and the decision making between duration and leverage, how do you think about it?
I'm sorry, duration and…?
It's a great question. There are kind of two key elements of – there are many other ones but two obvious elements of risk, right – we can increase our interest rate exposure, take a larger duration or convexity gap, we could also just run with higher leverage. And really it's interesting that the duration exposure or rate exposure generally is something that adds risk quicker than increased leverage, and this is sort of counterproductive – I mean are counterintuitive. Most people assume that leverage is the number one driver of risk. Hedging, in most scenarios, having a better hedge portfolio that's a little more levered generally has a lower risk position than a maybe slightly less levered portfolio that's a 6 versus 8 but with less hedges and no options or something.
So, from a risk perspective, I think there's a misconception that leverage is more risky than kind of running a duration gap. We generally view that to be the opposite, doesn't always work out that way. But it's really you're addressing different things. If you feel that the mortgage basis, if you feel like agency MBS have a good technical backdrop or are likely to perform very well, you like the cash flows and returns that are being kicked off, then you're going to tend to air toward more leverage.
If on the other hand you feel that interest rates are high, you think agency mortgages are tight but the yield curve is steep and you can make money off the curve, then you're going to air on the side of just running a larger duration gap and you're really not going to want to load up on kind of the mortgage specific risk.
And so, if you went back to where we were at the end of last year, we kind of felt conviction on both but we had a little more conviction in the near-term on rates, which was why we had a 1.5 year duration gap, plus given the idiosyncratic risk that we had seen the volatility in the basis, we were running at 7.5x leverage, which is about half a turn below where we kind of averaged over the four or five years before.
So, we weren't high in leverage even though we liked the basis, but that was more of a function of the times. I think if we weren't in – the other issue you have to think about around both leverage and duration gap is the idiosyncratic nature of the situation with the Fed being such a big player and so forth, but that affects both sides.
Cheryl M. Pate - Morgan Stanley
Okay. Well, I think we're out of time but thank you as always for presenting with us today.
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