American Capital Agency Corp. (NASDAQ:AGNC)
Q2 2016 Earnings Conference Call
July 28, 2016 11:00 AM ET
Katie Wisecarver - Investor Relations
Gary Kain - Chief Executive Officer
Christopher Kuehl - Executive Vice President and Chief Financial Officer
Peter Federico - Senior Vice President and Chief Risk Officer
Bernie Bell - Senior Vice President and Chief Accounting Officer
Douglas Harter - Credit Suisse
Bose George - Keefe, Bruyette & Woods, Inc.
Joel Houck - Wells Fargo Securities, LLC
Brock Vandervliet - Nomura
Good morning and welcome to the American Capital Agency’s Second Quarter 2016 Shareholder Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.
I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.
Thanks Dan. Thank you all for joining American Capital Agency’s second quarter 2016 earnings call. Before we begin, I’d like to review the Safe Harbor statement. This conference call and corresponding slide presentation contain statements that to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of AGNC. All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice.
Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of AGNC’s periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC’s website at SEC.gov. We disclaim any obligation to update our forward-looking statements unless required by law.
An archive of this presentation will be available on our website and the telephone recording can be accessed through August 13, by dialing 877-344-7529 or 412-317-0088 and the conference ID number is 10087919.
To view the slide presentation, turn to our website, AGNC.com, and click on the Q2 2016 earnings presentation link in the upper right corner. Select the webcast option for both slides and audio or click on the link in the conference call section to view the streaming slide presentation during the call.
Participants on the call today include Gary Kain, Chief Executive Officer; Peter Federico, Executive Vice President and Chief Financial Officer; Chris Kuehl, Senior Vice President of Mortgage Investments; and Bernie Bell, Senior Vice President and Chief Accounting Officer.
With that, I will turn the call over to Gary Kain.
Thanks, Katie, and thanks to all of you for your interest in AGNC. As we announced earlier this month we closed the acquisition of our manager which effectively internalizes AGNC’s management structure. This transaction represents a transformative step for AGNC and significantly enhances our value proposition to investors. I will have further comments on the internalization and its impact for shareholders later in my prepared remarks.
With respect to our second quarter results we are pleased with AGNC’s 13% annualized economic return against the backdrop of significant interest rate volatility. Despite a very challenging environment this is our third straight quarter of positive economic returns. Early in Q2 interest rates increased as the Fed's communication became decidedly more hawkish.
That trend reversed later in the quarter as the combination of weaker economic numbers and the Brexit vote completely changed market sentiment. We continue to believe international events and the actual or anticipated responses of Global Central Banks and Politicians will continue to dominate U.S. financial markets for quite sometime. As a result the risk to the global economy remains decidedly to the downside.
Against this backdrop it is important not to be overly focused on the near-term economic releases or the widely varying rhetoric from Fed leaders, as the short-term fluctuations have frequently been reversed in favor of the longer-term downward trend. We strongly believe that we are in fact in a lower for longer interest rate environment as evidenced by around 10 trillion of global sovereign debt that's trading at negative yields and U.S. tenure rates having recently touched all-time lows.
In this environment managing prepayment risk will once again be an important source of Alpha generation and critical to risk management. As Chris will discuss we don't expect a massive refi event, but that doesn't mean mortgage investors can be complacent about the composition of their holdings.
With that introduction let me turn to Slide 4, and quickly review our results for the quarter. Comprehensive income totaled $0.73 per share. Net spread income, which includes dollar roll income, but excludes catch-up am increased to $0.56 per share from $0.52 per share for the prior quarter.
Since the acquisition of our manager didn't occur until Q3. This result was not impacted by any of the improvement in our operating cost structure, which will begin to impact results beginning in the third quarter. We also announced our decision to lower our monthly dividend from $0.20 per share to $0.18 per share. We understand that this may seem contrary to the recent increase in our net spread income and the anticipated cost savings from the internalization.
As we have discussed on prior earnings calls our dividend policy is not based upon our net spread income. In this case our decision to lower the dividend was a function of a number of different factors. The single largest driver was the rallying interest rates which coupled with a flattery yield curve and the performance of agency MBS impacted our near term outlook.
While this environment is positive in that lower for longer should enable AGNC to produce consistently solid returns over the intermediate term. Today's very low rates reduce carry and serve as a disincentive to run a materially positive duration gap. As such it makes sense for us to pay a slightly lower dividend. As I mentioned earlier economic return was materially positive at 3.3% for the quarter or 13.3% on an annualized basis. As a result of the combination of our $0.60 dividend and the $0.13 increase in our book value.
On Slide 5, our June 30, leverage was essentially unchanged at 7.2 times. As noted we closed the internalization transaction on July 1, and paid the $562 million purchase price with cash, thus increasing our effective leverage relative to tangible book value. Pro forma for the cash payment our leverage relative to tangible book was 7.7 times. This increased leverage profile was consistent with our views regarding the lower for longer interest rate environment and the strong technical backdrop for U.S. fixed income assets.
At this point let me turn the call over to Chris to discuss the market and our portfolio.
Thanks, Gary. Turning to Slide 6, I’ll start with a brief review of what happened in the markets during the quarter. Interest rates were again volatile with 10-year swap rates ending the quarter 26 basis points lower at 1.38% as of June 30.
Mortgage has performed well despite prepayment fears starting to surface again given the sharp move lower in rates. And while prepayment risk is elevated it's very manageable and importantly the technical backdrop for agency MBS is strong given the lack of available yield for global fixed income investors coupled with a consistent Fed reinvestment bid that will likely be in place through 2017.
Turning to Slide 7, we have a graph that provides some perspective on today's prepayment environment relative to the last major prepayment events in 2012. As you can see in the top panel 10-year swap rates reached record low yield levels just a few weeks ago and while the rates market has since sold off, we are still near historic lows.
It's interesting to note that the refi index which is a leading indicator of where prepayment speeds on an aggregate basis are headed is approximately 40% lower today than where it was during the last major refi events in 2012. There are several reasons for this.
First as you can see in the top panel mortgage prices are lower today given materially wider spreads and a flatter yield curve and therefore primary mortgage rates to borrowers are not as low as they were in 2012 despite today's historically low treasury and swap rates.
Second borrower burnout is another reason for today's relatively low refi index rating. Earn out is a modeling term used to describe the fact that a borrower’s refinance response tends to be more muted after repeated exposure to a given rate incentive. In other words a borrower that has been exposed to a given incentive two or three times in the past and has not refinanced is less likely to refinance than a borrower seeing the same incentive for the first time.
Lastly, the HARP program is a large driver of prepayment activity four years ago. And while the program is still active, volumes are less than 10% of what they were in 2012 as most of the borrowers that are willing and able to use the program have already done so. In order to experience a repo event like what we had in 2012, we would need to expose borrowers to new lows in mortgage rates and stay there for several months.
That said it would be wrong to characterize today's prepayment landscape as benign. We do expect prepayments on some specific cohorts to reach CPR’s in the low-30s such as 2014 [indiscernible]. Against this backdrop, asset selection and proactive portfolio management is critical.
And to this point, let's turn to Slide 8. As you can see in the table on the bottom of Slide 8, the vast majority of our higher coupon holdings in both 15-year and 30-year MBS are backed by loans with either lower loan balances or loans that were originated through the HARP program. Additionally, the majority of these positions is seasoned and therefore have accumulated some degree of burnout.
During the second quarter, we continued to add higher quality call protected specified pools as valuations lagged the increase in prepayment risk early on in the quarter. And while we still have TBA position, the majority of these holdings are in lower coupons and therefore have manageable prepayment risk in the current rate environment. In addition, many of these TBA positions are in coupons or dollar roll financing is still attractive relative to repo. And so we are being compensated with additional net interest carry.
In today’s lower rate environment with elevated prepayment risk, proactive portfolio management is critical to generating returns and will be a differentiating factor and performance.
I’ll now turn the call over to Peter to discuss funding and risk management.
Thanks, Chris. I'll begin with our financing summary on Slide 9. Our on-balance sheet funding cost at quarter end was 77 basis points, up 3 basis points from the prior quarter. This increase in costs was due to a modest increase in the maturity of our repo funding and a slight increase in the cost of our Federal Home Loan Bank advances. The build out of our in-house broker-dealer Bethesda Securities is proceeding according to plan.
During the second quarter Bethesda Securities completed its regulatory application process and received its Financial Industry Regulatory Authority or FINRA membership. We are now in the final stages of building our clearing infrastructure with Bank of New York Mellon. We have also submitted our application to the Fixed Income Clearing Corp and are awaiting final membership approval. We expect the platform to be fully functional in the next month or so and to begin executing funding transactions on a limited basis later in the third quarter.
Turning to Slide 10, I’ll quickly review our hedging activity during the quarter. Given the rally in rates and our view that interest rates will likely remain range bound, we took steps to rebalance the size and maturity composition of our pay fixed swap portfolio. In total during the quarter, we terminated $5.6 billion of existing pay fixed swaps and entered into $2.6 billion of new pay fixed swaps.
As a result, our pay fixed swap portfolio balance at quarter end decreased to $35 billion down $3 billion from the prior quarter. Given the reduction in our swap portfolio, our aggregate hedge ratio declined to 79% in the second quarter down from 83% in the prior quarter and down from 96% at the end of the third quarter 2015.
Lastly, on Slide 11, we provided a summary of our interest rate risk position. The rally in rates caused the duration of our asset portfolio to shorten about a half a year. The rebalancing actions that I mentioned with respect to our swap portfolio resulted in a similar shortening in the duration of our hedge portfolio. As a result, our net duration gap remained unchanged quarter-over-quarter at zero years.
In the current environment, we are comfortable operating with a relatively small duration gap for the following reasons. First, our duration risk profile is fairly symmetric to rate movements in either direction given the composition of our asset portfolio. Second, given the historically low level of interest rates and the substantial flattening of the yield curve that has occurred over the last several quarters, we see relatively little benefit to operating with a large duration gap.
With that, I will turn the call back over to Gary.
Thanks Peter. Before I open up the call to questions, let's turn to Slide 12, so I can give you a quick update on the purchase of our manager. As a result of the transaction AGNC is now internally-managed. Additionally a subsidiary of AGNC will manage MTGE providing approximately 15 million per year in fee income at MTGE’s current NAV.
We are also pleased to announce that as of July 20 all business functions are fully staffed and we now have 52 full time employees. Following the internalization we expect AGNC’s annual run rate operating expenses will be approximately 90 basis points of shareholders' equity. And that is without the benefit of MTGE’s management fee. If we included that income stream the net cost would be around 70 basis points.
As you can see on the next slide our expectation is AGNC will have the lowest cost structure among mortgage REITs by a large margin. On the far right AGNC’s operating expenses are 25% lower than any of our competitors and around 40% lower than that of any of the larger mortgage REITs. And that is again without the benefit of the MTGE fee income. The concept that fees a matter is well established in the investment world, but fee levels are particularly important in this lower yield environment.
Further when we account for the leverage in AGNC’s portfolio our average fee as a percent of our asset base is closer to just 10 basis points. This low cost structure serves as a key component of AGNC’s enhanced value proposition for shareholders, which we summarize on Slide 14.
As noted on the slide AGNC has been an industry leader significantly outperforming its peer group with respect to economic and total stock return since 2009. AGNC’s substantial improvements to its cost structure will directly benefit its financial performance going forward.
In addition even as an externally managed company AGNC had a reputation for being very investor friendly, with a strong track record of repurchasing shares, monthly dividends and NAV releases and transparent portfolio and risk disclosures. Internalization further strengthens the alignment between management and shareholder interests.
With respect to liquidity which is critically important in today's market AGNC is the second largest mortgage REIT and the largest internally managed player in the space. In fact the AGNC is more than twice the size of the next largest internally managed mortgage REIT. When you combine these benefits with best-in-class risk management we believe the value proposition for our shareholders is clear and compelling.
With that, let me open up the call to questions.
[Operator Instructions] And our first question comes from Douglas Harter of Credit Suisse. Please go ahead.
Thanks. When you look at your hedge portfolio and think about the - the kind of the world where in? Do you think there are more changes that need to be made to it if we truly are in this range environment or do you feel like it was well-positioned as of June 30?
Hi, Doug, this is Peter I would say for the current environment we feel comfortable as I mentioned you look back on our hedge portfolio and our hedge ratio over the last year or so we're down about 20% it could be a little lower as we see the environment unfold, but in general you know there's still a lot of two way rate risk at least we believe there's still two way rate risk.
So we're comfortable with this a small duration gap. We're comfortable with our hedge ratio right now may be biased to be a little bit lower going forward. The other thing that I would add is there's obviously a lot of changes in volatility in the market with respect to LIBOR and swap spreads. And we continue to have a reasonable size position with our treasury hedges cost 15% to 20%.
As we see this swap market evolve over the next, one or two or three quarters. We may shift some of our hedges between swaps and treasuries, but in general overall I think our hedge portfolio is pretty well-positioned.
Right. And then you guys had also mentioned that pay-offs had kind of lagged pre-pay expectations as the quarter was going on. How do you see that pay-ups on spectacles today relative to those expectations?
Sure. So I mean generally speaking valuations are still fair I mean as I mentioned earlier you know we added a few billion in third year high quality call protected pools during the second quarter. You know evaluations that we thought are very attractive. So there's been a lot of volatility in rates, the shape of the curve, coupon swaps within the pass-through market. And that combined with a deal or risk appetite that's not quite as deep as it used to be definitely creates some opportunities.
I think the markets also have been somewhat conditioned to be a little complacent with respect to prepayment risk given that we've had a couple sort of false starts or refi ways that many refi events that didn't materialize over the last couple years one back in early 2015 and another one earlier this year.
And so generally speaking we think call protection stories are reasonable. But we're also very happy with the positioning and balance of the current portfolio and feel like we're positioned well for the current environment, but also if mortgage rates were to rally another 25 or 30 basis points you know at which point we would have a pretty significant refi events in front of us, we feel like we're set up well for that.
Great. Thank you.
And our next question comes from Bose George of KBW. Please go ahead.
Hey, guys, good morning. Actually first just a clarification on the pro forma book value estimate, can you give us the risk leverage relative to the new pro forma book and it just add the actual number?
You mean the actual book value number that we use in that calculation.
Well, we took our ending equity balance of 7.702 billion and reduced to 562 billion. So the equity number that we used in that 7.7 calculation was 7.121 billion.
Okay. Actually just in terms of how you treat the MTGE contract. I mean do you give that some pro forma value or it's just whatever it comes in through your earnings?
We certainly will. One of the things that we obviously have to do as you go through an exercise of valuing that transaction will do that in the end of the third quarter and at the end of the third quarter you'll see we’ll give you a breakdown of how we allocate that 562 between intangible assets and goodwill. The majority of it though will be good will.
Okay, thanks. And then actually just switching the leverage of 7.7 times, is that a good run rate going forward? Do you think that's kind of where you want to be?
Bose, yes, I think that's, you know, in the ballpark, so to speak. I mean it’s obviously going to be a function of market conditions and where spreads go, but you know, what we've said, generally, 7.5 to 8 is kind of, we'll call it a default-type position. And at this point, we really do feel that U.S. fixed income has good technical support, so, we don't really feel like there's a compelling reason to be outside of that range.
So I'd say that this is kind of a good place for us to you know to be at this point. I mean it may vary a little bit with market conditions, but we feel comfortable there.
Okay, great. Thanks.
And our next question comes from Joel Houck of Wells Fargo. Please go ahead.
Good morning, thanks. I want to get your guidance perspective on rate volatility, more specifically. Do you think it's achieved here and if so given I think you made some earlier comments about two-sided REIT risk or something to that effect. Is an increase in swaptions, warranted how are you thinking about other hedges beyond kind of the traditional ones?
I think we do believe we're in sort of a lower for longer environment. We think there'll be volatility, kind of you know there certainly will be volatility kind of around, we'll call it this new lower range, but we don't see the need to add significant optional protection at this point.
Just given both the composition of the portfolio, kind of market conditions I mean, while the Fed, could get another, you know, tightening in the kind of the risk to much higher rates seems pretty low at this point. Just given the global economic environment and obviously you can make some arguments for U.S. rates continuing to drop quickly, but I think there are some headwinds for that, to that as well.
So given where the portfolio is, the duration of the portfolio don't collapse that much in a falling rate environment. So, we might add options here or there on the margin, but I don't see that as being kind of a major focus.
Okay. Earlier this morning, one of your peers on their call talked about increasing your allocation to treasury and how that was attractive, especially when you take into consideration the negative financing rates. Do you see it the same way as that, obviously they view that rates going lower, perhaps you're not as convinced of that? What's your view Gary on the relative attractiveness of increasing the long treasury book at the expense of negatively convex NBS?
Yes. Joel, let me start and then Gary can chime in. There are times in the treasury market where our long position can make sense. What we saw over the last week or two, was that the on the run five -year treasury got very special. Trading negative, 100, 200 basis points at times, so, there's real economic benefit to be along that treasury.
On the flipside, when you use treasuries for hedges, you have to be careful to avoid being short that treasury, for example, our five-year treasury hedges are on off-balance sheet treasuries where the repo rate is actually positive 30 more or like generic collateral. So you have to be very specific, very, very cautious about where you place your hedges.
You can in times, make money by being long, but what I would say is that that specialness is very fleeting, right. It only last a week or two or three weeks until the new five-year treasury or the new refunding. So I'd say it's sort of more of a short-term tactical trading pattern.
Yes, what I'd just say, it's kind of, when we - what Peter had mentioned earlier with respect to our overall hedges and I know we've gotten questions on multiple calls in the past about it, I mean, we are tending to have roughly 15% of our hedges be in short treasury positions.
So what you would end up seeing if we were bullish on treasuries or we would just reduce the component of that hedge or short position, rather than - I mean, there have been times when we’ve had a long treasury position, but essentially that's a long treasury position versus swaps.
So, again, you would - if we were, you know, if we preferred, if we sort of preferred treasuries to mortgages, you'd see us lower our leverage and you would see us kind of end up reducing our treasury's short position, well before you would actually see a long position. So I think, we just think about it a little differently.
Okay. That's very helpful. And the last one, as you guys pointed out, your pro forma operating expense, the equity is 88, how will that move depending on, what I'd imagine, is an internal-managed company is going to be incentive compensation. And if you outperform either your benchmark appear however that's calculated, what's a reasonable range, so when we're modeling this, we don't get caught being too low or too high on that number?
Yes. Joel, again, I’ll start a little bit and then Gary can talk a little bit about his view on the sort of performance nature. Following the announcement of the internalization, we announced sort of a pro forma cost structure and Gary mentioned the 90 basis points and 70 basis points. If you think about it from a 90 basis points perspective and the G&A being about where it is at $24 million, $25 million.
Our expectation is that the other incremental cost would be somewhere in the neighborhood of $40 million to $45 million, so that would put our total cost in the neighborhood of sort of on-plan or sort of target cost structure of somewhere between called 67 to 70-ish or so million dollars. So that sort of gives you the starting point for the calculation of clearly we will have performance measures and some variability around that and Gary can talk philosophically about how we'll approach that.
Yes, I mean, look we plan on essentially having, running the Company differently and having a scorecard and then obviously as you mentioned, if there's stronger performance compensation costs will be lower if there is weaker performance. Compensation cost will be lower, but I think big picture, don't expect massive variations, those differences will be meaningful, but they're not going to significantly change that.
I mean I think you're going to see that variation around, but being in terms of like plus or minus not even 50% of the compensation number. Call it in the 25 to 50, 25 is probably going to be a bigger move in one direction or the other. So I don't think you're going to end up, from a big picture perspective, being off sides in the modeling if you start with the base case.
Okay. And but if you think about, like where the cost structure was it's clearly, shareholders are going to get at least 100 little more than 100 basis points of economic value benefit on a go-forward basis?
Yes, I mean if you think about it from a dollar perspective number, off the second quarter, maybe it's a little bit easier to look at it that way. When you sort of pro forma or annualize the management fee and our G&A. That number is about $125 million versus the number that I just quoted you, which is like $67 million to $70 million. So it's that sort of magnitude of difference whereas the economic dollar benefit at least based off second quarter results.
What I think everyone should be focused on at this point, I mean we're basically not going to continue to go back to say where we used to - what would have been the case had we been internally - externally-managed on a go-forward basis. Look, our focus is going to be on the maintaining, kind of a very low cost structure going forward and best in industry cost structure.
So the focus will be on the 70 and 90 basis points and trying to and that's what we'll be talking about going forward with respect to our operating efficiency is trying to obviously kind of maintain what we believe is a core competitive advantage at this point. And that's what we kind of view as our benchmark as we look forward.
All right. Thanks for the answers guys.
And our next question comes from Brock Vandervliet of Nomura. Please go ahead.
Great. Just two questions. I guess first off, if you could it seems like the swap spreads have widened, particularly going into the third quarter, if you could just touch on some of the dynamics that may be driving that seems set up for a good tailwind behind your book value?
Sure, this is Peter. I will start with that and then we’ll get to the second question. Yes, there has been a decided move in swap spreads over the last week or two and really I think you can see the origin of it with the move in three-month LIBOR, where our three-month LIBOR has for the longest time post, last Fed move has been around 62, 63 basis points and now it’s 75 today.
So it's moved 12 basis points. Part of that is the upcoming money-market reform, the key thing that takes effect in October is that prime funds will be moving to a floating NAV that's changed their buying patterns and their behavior. It's caused them to avoid certain maturities, like the three-month bucket, it's caused them to reduce some of their willingness to buy Japanese bank, CP, for example.
And so in short, it's driven up three-month LIBOR, which then, correspondingly causes swap spreads to widen. So it’s one of the reasons why we like being short swaps in the current environment. We think these things are going to ultimately continue to have some impact and you're right, it'll benefit us this quarter.
We also do expect though, that just from a funding perspective, some of these changes, not only will affect swap spreads and the value of our hedges, but they'll also improve our overall liquidity. For example with the prime funds going to daily NAVs, we do expect some money to move out of prime funds and into government funds and ultimately providing more liquidity to the MBS market and to the treasury market. So some of the moves we think are actually going to be positive for us.
Great, okay. Thank you for that color Peter. Just as a follow-up and this is not a back-handed way of asking the integration question with MTGE, but just as a standalone, you’ve had this kind of stub position in non-agency securities for a while. Does that make sense, would you potentially take that up, what is the landscape look like I guess in non-agencies right now?
So, I think we talked a little about this on the last call and the AAA, non-agency position was something that would have made sense, a larger position would have made sense against the backdrop of the flub of financing, which as we've talked about, is going away for us in the not too distant future. So the advantage there was you could fund AAAs at pretty much the same level as you could fund agencies with the flubs and since you're getting incremental yield, then you could kind of leverage that position and get incremental value from it.
I think without being able to leverage flub financing, and having to use wholesale financing for AAAs, we honestly don't view that position as being all that attractive. So, I wouldn't expect it to grow. Its fine in a sense for unlevered positions that are sitting in the box, so to speak, that we're not financing, then you can get some benefit from it, but that's not going to be a large position. So, I wouldn't expect any significant growth in that position at all.
Okay, great, thank you.
And we have now completed the question-and-answer session. I would like to turn the call back over to Gary Kain for concluding remarks.
I'd like to thank everyone for your interest in AGNC and we'll talk to you again next quarter.
The conference has now concluded. An archive of this presentation will be available on AGNC’s website and a telephone recording of this call can be accessed through August 13 by dialing 877-344-7529 or 412-317-0088. And the conference ID number is 10087919. Thank you for joining today's call. You may now disconnect.
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