AGNC Investment's Q1 2017 Income Statement And EPS Projection - Part 2

| About: AGNC Investment (AGNC)
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Summary

I am projecting AGNC will report a relatively unchanged valuation fluctuation regarding the company’s derivative instruments and other securities for the first quarter of 2017.

Interest rate payer swaps with longer tenors experienced a minor increase in rates which slightly impacted valuations.

Partially offsetting this minor valuation gain is my projected minor valuation fluctuations within AGNC’s TBA MBS and U.S. Treasury portfolios.

My projection for AGNC’s net income and EPS for the first quarter of 2017 are stated in the “Conclusions Drawn” section of the article.

Part 3 projects the net valuation fluctuations within AGNC’s on-balance sheet MBS portfolio (largest asset class). As such, readers should hold off on final judgment until Part 3 is provided.

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 detailed projection of AGNC Investment Corp.'s (NASDAQ:AGNC) income statement (technically speaking, the company's "consolidated statement of comprehensive income") for the first quarter of 2017 regarding the following accounts: 1) interest income, 2) interest expense, and 3) gain (loss) on sale of agency securities, net. 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:

AGNC Investment Corp.'s Q1 2017 Income Statement Projection - Part 1 (Including Current Recommendation)

Focus of Article:

The focus of PART 2 of this article is to provide a detailed projection of AGNC's consolidated statement of comprehensive income for the first quarter of 2017 regarding the following account (including several "sub-accounts"): 4) "gain (loss) on derivative instruments and other securities, net." PART 2 will also discuss AGNC's projected net income (loss) and earnings per share ("EPS") amounts. For readers who just want the summarized account projection, I would suggest to scroll down to the "Conclusions Drawn" section at the bottom of the article.

By understanding the trends that occurred within AGNC's operations during the first quarter of 2017, one can apply this information to sector peers as well. As such, the discussion/analysis below is not solely applicable to AGNC but to the fixed-rate agency mortgage real estate investment trust (mREIT) sector as a whole. This includes, but is not limited to, the following fixed-rate agency mREIT peers: 1) Arlington Asset Investment Corp. (NYSE:AI), 2) ARMOUR Residential REIT Inc. (NYSE:ARR), 3) Cherry Hill Mortgage Investment Corp. (NYSE:CHMI), 4) CYS Investments Inc. (NYSE:CYS), 5) Annaly Capital Management Inc. (NYSE:NLY), and 6) Orchid Island Capital Inc. (NYSE:ORC).

Technically speaking, several years ago, AI changed its "entity status" from a REIT to a C-Corp. per the Internal Revenue Code ("IRC"). However, AI still maintained many "mREIT-like" characteristics including the type of investments held by the company and the amount of annual dividend distributions paid to shareholders.

4) Gain (Loss) on Derivative Instruments and Other Securities, Net:

- Estimate of $11 Million; Range ($239)-$261 Million

- Confidence Within Range = Moderate to High

- See Boxed Blue Reference "4" in Tables 4 and 6 Below Next to the March 31, 2017 Column

Projecting AGNC's gain (loss) on derivative instruments and other securities, net account is an analysis that involves several sub-accounts. This includes making assumptions within these derivative sub-accounts during the current quarter. One will never "fully" know management's derivatives activities for any given quarter until results are provided to the public. However, one can understand AGNC's overall risk management strategy and make a projection on these derivative sub-accounts using the balances that were represented at the end of the previous quarter.

Such a detailed analysis is wise to perform due to the typical events that unfold in regards to MBS prices, the fixed pay rate on newly created interest rate swaps, and U.S. Treasury yields. I believe this detailed analysis is critical once again in regards to the first quarter of 2017. When using this methodology, along with deciding specific quarterly assumptions, I have continued to provide highly accurate projections within this account over the past several years.

Now let us take a look at AGNC's gain (loss) on derivative instruments and other securities, net account. I show my projection for this figure in Table 4 below. All past (ACTUAL) sub-account figures within Table 4 are derived from AGNC's quarterly SEC submissions via the company's 10-Q or 10-K where applicable. All projected (ESTIMATE) sub-account figures within Table 4 below are calculated and derived from multiple tables/charts that will not be shown within this particular article.

Table 4 - AGNC Quarterly Gain (Loss) on Derivative Instruments and Other Securities, Net Projection (All Sub-Accounts)

(Source: Table created entirely by myself, partially using AGNC data obtained from the SEC's EDGAR Database)

Within AGNC's gain (loss) on derivative instruments and other securities, net account is the following four material sub-accounts that will be discussed below:

a) TBA MBS

b) Interest Rate Swaps

c) Interest Rate Swaptions

d) U.S. Treasury Securities

Each of the four material derivative sub-accounts listed above will be separately analyzed and discussed in corresponding order of the blue references under the "Ref." column in Table 4 above.

A) TBA MBS (Net Long Position as of 12/31/2016):

- Estimate of $40 Million; Range ($110)-$190 Million

- Confidence Within Range = Moderate to High

- See Black Highlighted, Blue Referenced Sub-Account "a)" in Table 4 Above Next to the March 31, 2017 Column

Let us first briefly get accustomed with this type of derivative instrument. Typically, AGNC uses a combination of both long and (short) TBA MBS contracts during any given quarter. AGNC enters into TBA contracts with a long position where it agrees to buy, for future delivery, MBS with certain predetermined prices, face amounts, issuers, coupons, and stated maturities. 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 ultimately an extension of the balance sheet, this increases 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. Since TBA contracts with a (short) position are ultimately a reduction of the balance sheet, this decreases AGNC's at risk leverage.

There are two main factors that impact this derivative sub-account's valuation in a given quarter. The first factor is the "net dollar roll" ("NDR") income (expense) generated on the net long (short) TBA MBS position. The second factor is the realized valuation gain (loss) upon the "settlement" of all TBA MBS contracts and the unrealized valuation gain (loss) on all contracts that have yet to be settled during the quarter (one example is a "re-rolled" TBA MBS position).

As of 9/30/2016, AGNC had a net long TBA MBS position of $14.9 billion (based on notional amount). AGNC decreased the company's net long TBA MBS position to $10.9 billion as of 12/31/2016. When calculated, this was a decrease of ($4.0) billion during the fourth quarter of 2016. While there was notable pressure on MBS pricing during the fourth quarter of 2016, dollar roll financing continued to look attractive when compared to agency repo funding heading into the first quarter of 2017.

As will be discussed further in PART 3 of this article, MBS net pricing across most coupons was relatively unchanged during the first quarter of 2017. As such, when compared to the prior quarter, AGNC's TBA MBS portfolio likely experienced a more "muted" valuation fluctuation during the first quarter of 2017.

Through interpreting management's comments via several prior investor presentations and earnings conference calls, I have made the assumption AGNC likely continued to keep a modest net long TBA MBS position (proportionately speaking) during the first quarter of 2017. Through a detailed analysis that will be omitted from this particular article, when combining the company's projected quarterly NDR income of $50 million and a quarterly net valuation loss of ($10) million, I am projecting AGNC's TBA MBS position had a total net valuation gain of $40 million for the first quarter of 2017.

B) Interest Rate Swaps (Net (Short) Position as of 12/31/2016):

- Estimate of $49 Million; Range ($201)-$299 Million

- Confidence Within Range = Moderate to High

- See Purple Highlighted, Blue Referenced Secondary Sub-Accounts "b)" in Table 4 Above Next to the March 31, 2017 Column

Let us first discuss the recent history of this derivative sub-account, which will lead to a better understanding of my projected total net valuation gain for the first quarter of 2017. AGNC had a net (short) interest rate swaps position of ($37.2) billion as of 12/31/2016 (based on notional amount). AGNC had interest rate payer swap additions of ($9.7) billion and interest rate payer swap expirations or terminations of $6.7 billion during the fourth quarter of 2016.

There was an elevated amount of activity within AGNC's interest rate swaps during the fourth quarter of 2016 for one main reason. Due to the Federal Open Market Committee's ("FOMC") rhetoric regarding slow, methodical increases to the Federal ("Fed") Funds Rate, management believed the risks associated with the fixed-rate agency MBS market were relatively unchanged going into the first quarter of 2017.

As such, management did not necessarily believe having additional interest rate payer swaps with longer tenors was needed, especially after the notable move in mortgage interest rates/U.S. Treasury yields during the fourth quarter of 2016. However, over the prior several quarters, markets have seen a steady, gradual rise in short-term interest rates which directly impacts mREIT borrowing costs (as discussed in PART 1; repurchase loan rates).

To combat this rise in borrowing costs, management believed AGNC's risk management priority was to increase the company's protection regarding the shorter-end of the yield curve. As such, AGNC notably increased the company's portfolio of interest rate payer swaps with shorter tenors. Due to AGNC's more cautious risk management strategy (in particular towards the shorter end of the yield curve), the company's hedging coverage ratio increased from 75% to 91% during the fourth quarter of 2016.

Using Table 4 above as a reference, there are two secondary sub-accounts to discuss when projecting a total net valuation gain (loss) for AGNC's interest rate swaps. The first secondary sub-account is AGNC's "net periodic interest costs of interest rate swaps" expense. If one recalls, this figure was first discussed in AGNC's interest expense account during PART 1 of this article. In regards to AGNC's interest rate swaps net (short) position as of 12/31/2016, the company had a weighted average fixed pay rate of 1.48% and a weighted average floating receive rate of 0.92%.

When excluding forward-starting interest rate swaps, this weighted average fixed pay rate was 1.46%. When calculated, AGNC's weighted average fixed pay rate (when including forward-starting interest rate swaps) increased 6 basis points ("bps") during the fourth quarter of 2016. However, AGNC's weighted average floating receive rate increased (14) bps. As such, the spread between AGNC's fixed pay rate and floating receive rate continued to gradually narrow.

When all factors and assumptions are taken into consideration, I project AGNC will record a slightly lower net periodic interest costs of interest rate swaps expense for the first quarter of 2017 when compared to the prior quarter. Through a detailed analysis that will be omitted from this particular article, I am projecting AGNC had a net periodic interest costs of interest rate swaps expense of $41 million for the first quarter of 2017. This calculates to a decreased expense of ($4) million when compared to the prior quarter. This should be seen as a cautious projection (possibility of an even higher reduction within this secondary sub-account).

The second secondary sub-account to discuss relates to the net valuation gain (loss) on AGNC's interest rate swaps. Basically across most tenors/maturities, there was a minor increase in the fixed pay rate of all interest rate payer swap contracts during the first quarter of 2017.

The fixed pay rate on interest rate swap contracts with a tenor/maturity towards the short-end of the yield curve (1-4 years) had a 10-20 bp increase during the first quarter of 2017. The fixed pay rate on interest rate swap contracts with a tenor/maturity towards the intermediate- and long-end of the yield curve (5-30 years) had a 5-10 bp increase during the first quarter of 2017.

Through a detailed analysis that will be omitted from this particular article, I am projecting AGNC's second secondary sub-account had a net valuation gain of $90 million for the first quarter of 2017. When both secondary sub-accounts are combined, I am projecting AGNC's interest rate swaps had a total net valuation gain of $49 million for the first quarter of 2017.

C) Interest Rate Swaptions (Net (Short) Position as of 12/31/2016):

- Estimate of ($3) Million; Range ($28)-$22 Million

- Confidence Within Range = High

- See Pink Highlighted, Blue Referenced Sub-Account "c)" in Table 4 Above Next to the March 31, 2017 Column

Let us first briefly get accustomed with this type of derivative instrument. Interest rate swaptions are options to enter into underlying interest rate swap contracts. Whereas interest rate swap contracts have no initial "up-front" costs (gains and losses are incurred as interest rates fluctuate over the life of the swaps), interest rate swaptions have implicit up-front costs (similar to an option contract; generally speaking).

Let us discuss the recent history of this derivative sub-account, which will lead to a better understanding of my projected total net valuation loss for the first quarter of 2017. AGNC had a net (short) interest rate swaptions position of ($1.2) billion as of 12/31/2016 (based on the notional balance of the underlying interest rate swaps).

AGNC had interest rate payer swaption additions of ($0.5) billion and no interest rate payer swaption exercises, expirations, or terminations during the fourth quarter of 2016. As of 12/31/2016, AGNC's interest rate payer swaptions had a weighted average of 6 months until expiration with an underlying interest rate swaps weighted average tenor/maturity of 8.3 years.

Through a detailed analysis that will be omitted from this particular article, I am projecting AGNC's interest rate payer swaptions had a total net valuation loss of ($3) million for the first quarter of 2017. The probability of AGNC's interest rate swaptions being worthless decreased last quarter.

The fixed pay rate of an interest rate swap of a similar tenor/maturity notably increased during the fourth quarter of 2016. Simply put, this increases the probability AGNC may exercise some (or all) of the company's interest rate swaptions prior to expiration. With that being said, there is still a chance some (or all) swaptions will expire worthless (ultimately management's decision).

D) U.S. Treasury Securities (Net (Short) Position as of 12/31/2016):

- Estimate of ($75) Million; Range ($225)-$75 Million

- Confidence Within Range = Moderate

- See Dark Blue, Brown, and Teal Highlighted, Blue Referenced Secondary Sub-Accounts "d)" in Table 4 Above Next to the March 31, 2017 Column

Let us first briefly get accustomed with this type of derivative instrument. AGNC purchases (or sells short) U.S. Treasury securities and U.S. Treasury security futures to help mitigate the potential impact of changes in MBS prices (hence the valuation of a majority of the company's investment portfolio). AGNC borrows securities to cover U.S. Treasury (short sales) under reverse repurchase agreements. AGNC accounts for these derivative instruments as "security borrowing transactions" and recognizes an obligation to return the borrowed securities at fair market value ("FMV") based on the current value of the underlying borrowed securities.

Let us discuss the recent history of this derivative sub-account, which will lead to a better understanding of my projected total net valuation loss for the first quarter of 2017. AGNC had the following three derivative secondary sub-account positions as of 12/31/2016: 1) long U.S. Treasury securities of $0.2 billion, 2) (short) U.S. Treasury securities of ($8.1) billion, and 3) U.S. Treasury security futures sold (short) of ($1.8) billion.

This is based on each secondary sub-account's face amount ("par"). When combining all three secondary sub-accounts together, AGNC increased the company's net (short) U.S. Treasury securities position from ($7.3) billion as of 9/30/2016 to ($9.7) billion as of 12/31/2016.

Three likely scenarios occurred within this derivative sub-account during the first quarter of 2017. If the assumption is made that AGNC switched back to a net long U.S. Treasury securities position during the first half of the first quarter of 2017, then the company would likely have a minor total net valuation gain for this derivative sub-account (higher end of my projected range).

If the assumption is made that AGNC materially increased its net (short) U.S. Treasury securities position during the first half of the first quarter of 2017, then the company would likely have a modest total net valuation loss for this derivative sub-account (lower end of my projected range).

If the assumption is made that AGNC maintained a modest net (short) U.S. Treasury securities position throughout most of the quarter, then the company would likely have a minor total net valuation loss for this derivative sub-account. The amount of the total net valuation change would be dependent on the timing of the net long (short) positions as yields fluctuated throughout the quarter.

These three scenarios are not "every" possible scenario that could have occurred within this derivative sub-account. However, I believe these three scenarios would have caused the greatest amount of FMV fluctuations. To put things in better perspective, yields on 5-, 7-, and 10-year U.S. Treasury securities increased (decreased) 0, (3), and (5) bps during the first quarter of 2017, respectively.

Since U.S. Treasury securities are one of the most liquid investments in the marketplace, AGNC trades these derivative instruments throughout the quarter. Through a detailed analysis that will be omitted from this particular article, I am projecting AGNC's U.S. Treasury securities and U.S. Treasury security futures had a total net valuation loss of ($75) million for the first quarter of 2017. This should be seen as a cautious projection.

As stated earlier, all remaining derivative sub-accounts within Table 4 that have not been specifically mentioned above are deemed immaterial for discussion purposes. As such, these immaterial derivative sub-accounts will be omitted from any analysis even though a projected net valuation gain (loss) has been included in Table 4. This includes valuation projections on the following derivative sub-accounts: 1) interest-only ("IO") and principle-only ("PO") strips; 2) debt on consolidated variable-interest-entities ("VIE"); 3) REIT equity securities (no position as of 12/31/2016); and 4) put options (when applicable).

When combining all the derivative sub-accounts together (both material and immaterial), I am projecting AGNC's derivative instruments and other securities, net account had a total net valuation gain of $11 million for the first quarter of 2017.

Brief Discussion of MTGE's and NLY's Derivatives Portfolio:

I see some general similarities between AGNC and the company's affiliate MTGE Investment Corp. (NASDAQ:MTGE) regarding hedging strategies. However, there usually are a few differences between AGNC's and MTGE's derivatives portfolio as well. One minor difference was each company's TBA MBS position as of 12/31/2016 (proportionately speaking). As stated earlier, AGNC had a net long TBA MBS position of $10.9 billion as of 12/31/2016. This was equal to 24% of AGNC's on-balance sheet MBS portfolio.

In contrast, MTGE had a net long TBA MBS position of $0.9 billion as of 12/31/2016. This was equal to 32% of MTGE's on-balance sheet agency MBS portfolio. Another difference to note was MTGE had a modestly lower net (short) U.S. Treasury securities position as of 12/31/2016 when compared to AGNC (proportionately speaking). When all derivative sub-accounts are taken into consideration, AGNC and MTGE had a hedging coverage ratio as of 12/31/2016 of 91% and 86%, respectively.

When it comes to AGNC's sector peer NLY, I see a couple similarities and differences that would impact the derivative sub-accounts described above. I will note one similarity and one difference here. AGNC and NLY had a similar TBA MBS position as of 12/31/2016. As discussed earlier, AGNC had a net long TBA MBS position of $10.9 billion as of 12/31/2016. In comparison, NLY had a net long TBA MBS position of $11.2 billion as of 12/31/2016. Simply put, both AGNC and NLY continued to utilize the financing advantage of the TBA forward market.

AGNC and NLY had a notable difference in each company's hedging coverage ratio as of 12/31/2016. As stated above, AGNC had a hedging coverage ratio of 91%. In sharp contrast, NLY had a hedging coverage ratio of only 53%. As such, NLY was more vulnerable if mortgage interest rates/U.S. Treasury yields modestly - materially increased during the first quarter of 2017. Simply put, this did not occur. As such, NLY's lower hedging coverage ratio at the start of the first quarter of 2017 was an advantage for the company when compared to AGNC. Further analysis of NLY's MBS and derivatives portfolios was discussed within the following two-part article:

Annaly Capital's BV, Dividend, And Valuation Compared To 15 mREIT Peers (Post Q4 2016 Earnings) - Part 1

Annaly Capital's BV, Dividend, And Valuation Compared To 17 mREIT Peers (Includes Q2 2017 Dividend Projection) - Part 2

A) Net Income (Loss):

- Estimate of $145 Million; Range ($105)-$395 Million

- Net Income Available to Common Shareholders of $0.42 Per Share (Excluding OCI/(OCL)); Range ($0.34)-$1.17 Per Share

- Confidence Within Range = Moderate to High

- See Red Reference "A" in Table 5 Below Next to the March 31, 2017 Column

Finally, let us look at my projection for AGNC's quarterly net income for the first quarter of 2017. This information is provided in Table 5 below.

Side Note: Four remaining accounts within AGNC's consolidated statement of comprehensive income that impact the company's net income (loss) amount are the following: 1) management fee income, 2) compensation expense, 3) general/administrative expenses, and 4) income tax provision (benefit). While all accounts have been projected within Table 5, these four accounts are deemed immaterial for discussion purposes and will be excluded from any analysis within this article.

Table 5 - AGNC Quarterly Net Income (Loss) Projection

(Source: Table created entirely by myself, partially using data obtained from AGNC's quarterly investor presentation slides)

Table 5 above is a summation of the following consolidated statement of comprehensive income accounts for the first quarter of 2017: 1) interest income of $308 million, 2) interest expense of $111 million, 3) loss on sale of agency securities, net of ($50) million, 4) gain on derivative instruments and other securities, net of $11 million, 5) management fee income of $4 million, 6) compensation expense of $10 million, 7) general/administrative expenses of $7 million, and 8) excise tax of $0.

Therefore, when these eight accounts are combined, I am projecting AGNC had net income of $145 million for the first quarter of 2017. After accounting for AGNC's quarterly preferred stock dividends, this would be earnings available to common shareholders of $0.42 per share.

Conclusions Drawn (PART 2):

To sum up the analysis above, I am projecting AGNC will report the following account figure for the first quarter of 2017 (refer back to Table 5 above):

4) Quarterly Net Gain on Derivative Instruments and Other Securities of $11 Million

I am also projecting AGNC will report the following net income and EPS amounts for the first quarter of 2017 (also refer back to Table 5):

A) Quarterly Net Income of $145 Million and Earnings Available to Common Shareholders of $0.42 Per Share

AGNC's projected net income of $145 million for the first quarter of 2017 is a notable decrease when compared to net income of $1.02 billion for the fourth quarter of 2016. This is mainly due to AGNC's projected net valuation gain of $11 million regarding the company's derivatives portfolio for the first quarter of 2017. For the same account in the prior quarter, AGNC recognized a net valuation gain of $753 million.

As stated in PART 1 of this article, AGNC's OCI/(OCL) amount is part of the company's consolidated statement of comprehensive income but EXCLUDED from the company's net income (loss) and EPS amounts. As such, I suggest holding off on a "final verdict" regarding AGNC's projected results for the first quarter of 2017 until PART 3 of this article is provided. In my professional opinion, I believe AGNC's "comprehensive income (loss)" amount is more important than the company's net income (loss) and EPS amounts.

My BUY, SELL, or HOLD Recommendation:

For my AGNC BUY, SELL, or HOLD recommendation, please see PART 1 of this article (link provided at the beginning of the article).

Final Note: PART 2 of this article is only a PARTIAL analysis of AGNC's consolidated statement of comprehensive income for the first quarter of 2017. As such, a "final" conclusion will not be provided yet. PART 3 of this article will just pick up where PART 2's analysis ends. PART 3 of this article will discuss AGNC's projected OCI/(OCL) and comprehensive income (loss) amounts. This will be followed by a projection of AGNC's BV as of 3/31/2017 and the company's CURRENT BV in late April, which will be available to readers prior to management's earnings press release for the first quarter of 2017.

Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader's current investing strategy. The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions.

On 9/12/2016 and 10/7/2016, I directly increased my position in AGNC at a weighted average purchase price of $18.985 and $18.745 per share, respectively. Each purchase had the same approximate monetary value. On 2/23/2017, I sold approximately 25% of my entire AGNC position (accumulated over seven years) at a weighted average price of $19.645 per share as my price target at the time of $19.55 per share was met.

On 3/17/2017, I sold approximately 15% of my existing AGNC position at a weighted average price of $19.684 per share. On 3/20/2017, I sold approximately 30% of my existing AGNC position at a weighted average price of $19.805 per share. On 3/28/2017, I sold my remaining position in AGNC at a weighted average price of $19.945 per share.

On 11/27/2015, I initiated a position in AGNCB; Series B preferred stock. On 12/7/2015, 12/9/2015, 12/14/2015, 1/14/2016, and 1/20/2016, I selectively increased my position in AGNCB. When combined, my AGNCB position has a weighted average purchase price of $23.215 per share. This weighted average per share price excludes all dividends received/reinvested. I currently hold (personally and through affiliated entities) 0.71% of the outstanding shares of AGNCB.

Each AGNC/AGNCB trade was disclosed to readers in "real time" (that day) via the StockTalks feature of Seeking Alpha. All trades/investments I have performed over the past few years have been disclosed to readers in real time (that day at the latest) via the StockTalks feature of Seeking Alpha. Through this resource, readers can look up all my prior disclosures (buys/sells) regarding all companies I cover here at Seeking Alpha (see my profile page for a list of all stocks covered).

Disclosure: I am/we are long AGNCB, 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.

Additional disclosure: I currently have no position in AGNC, AI, ARR, CHMI, CYS, NLY, or ORC.