Dynex Capital - Q1 2023

Transcript

Operator (participant)

Good morning. My name is David, I'll be your conference operator today. At this time, I'd like to welcome everyone to the Dynex Capital Q1 2023 Earnings Conference call. Today's conference is being recorded. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there'll be a question-and-answer session. If you'd like to ask a question during this time, simply press the star key followed by one on your telephone keypad. If you'd like to withdraw your question, press star one once again. Thank you. Alison Griffin, Vice President, Investor Relations, you may begin your conference.

Alison Griffin (VP of Investor Relations)

Good morning, and thank you for joining us today for Dynex Capital's Q1 2023 earnings call. The press release associated with today's call was issued and filed with the SEC this morning, 24 April 2023. You may view the press release on the homepage of the Dynex website at dynexcapital.com, as well as on the SEC's website at sec.gov. Before we begin, we wish to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties. Some of which cannot be predicted or quantified.

The company's actual results and timing of certain events could differ considerably from those projected and/or contemplated by those forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, please refer to our disclosures filed with the SEC, which may be found on the Dynex website under Investor Center, as well as on the SEC's website. This conference call is being broadcast live over the Internet with a streaming slide presentation, which can be found through a webcast link on the homepage of our website. The slide presentation may also be referenced under Quarterly Reports on the Investor Center page. Joining me on the call is Byron Boston, Chief Executive Officer and Co-Chief Investment Officer, Smriti Popenoe, President and Co-Chief Investment Officer, and Robert Colligan, Executive Vice President, Chief Financial Officer.

With that, it is now my pleasure to turn the call over to Byron.

Byron Boston (CEO and Co-CIO)

Thank you, Alison, and good morning, everyone. Let me start with a few key points. As I mentioned in the past, this is an incredible moment in history. Global risks may have increased, but most importantly, we're at a historical opportunity in the mortgage-backed securities market. Spreads are at a generational wide level with an opportunity for private investors to step in and make accretive long-term investments. Second, this decade is a massive period of change. The globe has been jolted by multiple crises that is creating changes for social, political, economic, and geopolitical arrangements. Enormous amounts of change mean higher volatility and unknown consequences. Nonetheless, our team is experienced and disciplined. We've proven the value of experience in the past as we have responded to other market events in a very thoughtful manner, as shown in our long-term results.

We've managed our business for the long term, and just as we've done in the past, we're determined to guide you, our shareholders, through this disruptive market environment. Third, our strategy is built for this environment. For some time now, Dynex has been preparing for a high probability of unanticipated events and surprises. In fact, you have even heard me say surprises are highly probable. We've also characterized the environment as evolving, and to us, that means we must be very careful about drawing strong conclusions as many factors remain in a state of flux. We've now experienced two turbulent market events in the last 6 months. First, the LDI crisis originating in the U.K., and now the banking crisis in the U.S.

Both events represent exactly the kind of surprises that our liquid balance sheet, flexible mindset, and preparation is designed for, and we continue to manage your capital with this disciplined approach. As many of you know, I started my career in the financial markets in 1981. The current period has a lot of similarities to when I began in the business. Multiple financial crises raged throughout the 1980s. Ultimately, the FDIC and RTC were tasked with selling billions in assets, and private investors stepped in to take advantage of generationally wide mortgage-backed security spreads. There were no GSE portfolios or Fed to take down any of the risk.

While today we're not witnessing the same scale of disruption as the 1980s, however, we are at generationally wide mortgage-backed security spreads, and private investors now have the chance to step in and take on the risk just as they did in the 1980s. With my long history in the markets, I see a compelling investment opportunity here while spreads go wider. We consider the bulk of the widening behind us. In the medium-term to long-term, we see a very real possibility of tighter spreads that will eventually allow the recovery of book value. We believe the capital we have invested and the dry powder we yet retain to deploy will generate strong returns for our shareholders, creating value for years to come. Smriti will provide further details on all of this in her comments. I want to emphasize how Dynex Capital is uniquely situated to this opportunity.

I often talk about experience and discipline in our management team. Managing the duration and complexity of 30-year agency mortgage-backed assets truly requires an exceptional set of skills. To do it on a levered basis requires a complete understanding of the risks. Thorough discipline processes and a very flexible mindset. We have demonstrated our ability to do this well, particularly during the first three years of this volatile decade. I'll turn now to Rob, who will discuss our financial results, and Smriti, who will take you through our strategy for the environment

Robert Colligan (EVP and CFO)

Thanks, Byron, and good morning. For the quarter, the company reported book value of $13.80 per share and a comprehensive loss of $0.54 per share. The book value performance plus the dividend delivered an economic loss of 3.7% for the quarter. The portfolio was positioned for spread tightening, which occurred for the H1 of the quarter, resulting in a mid-quarter book value of approximately $15.50. Going into the end of the quarter, spreads widened and the 10-year Treasury fell, particularly after the failure of several banks. This combination resulted in asset losses and hedge losses going into quarter end. We continue to believe that our portfolio will recover a significant amount of value when volatility lessens, investor demand for mortgage-backed securities improve, or simply as pay downs occur over time.

We added TBAs and pools to our portfolio this quarter as spreads widened, which added 1.4 turns of leverage and represents the majority of our leverage increase from 6.1 turns to 7.8 turns during the quarter. Earnings available for distribution or EAD was negative this quarter. Our EAD does not include the benefit of our hedging activities. We continue to use features as our primary hedging instrument due to the depth and liquidity of the features market, as well as lower capital requirements compared to a comparable swap instrument. In the Q1, Dynex realized $89 million of hedge gains, bringing our unamortized hedge gain to $766 million at the end of the quarter.

This is a material number that has insulated the company from rising rates and has clearly protected book value from a dramatic rise in rates over the last year. As mentioned last quarter, these hedge gains are amortized into REIT taxable income over the hedge period of approximately 10 years. The earnings release provides our estimate of hedge gains by quarter for 2023, for the full year 2024, and then years thereafter. For the Q1, we recognized $18 million or approximately $0.34 per share related to our hedge book. The total amount of gain to amortize into REIT taxable income can go up or down depending on the company's hedge position and movement in rates in subsequent quarters. We have experienced some value degradation in our hedge book since we rolled our futures in February as long-term rates have dropped.

Although they are up in value since quarter end as rates have once again reversed direction. Since our hedge gains are a component of REIT taxable income, they will be part of our distribution requirement along with other ordinary gains and losses. As we discussed last quarter, we expect the hedge gains will be supportive of the dividend in 2023 and beyond, even if net interest income and EAD decline due to higher financing costs. Page six in our earnings presentation highlights the components of portfolio returns and recent trends in net interest income and hedge gains. Finally, I wanted to mention that we limited the utilization of our ATM program this quarter as we felt this was a period for capital deployment and market pricing was less favorable. With that, I'll now turn the call over to Smriti for her comments on the quarter.

Smriti Popenoe (President and Co-CIO)

Thank you, Rob, and good morning, everyone. At a high level, I'm very excited about the opportunity we are seeing to invest in agency residential mortgage-backed securities. This excitement is tempered with a deep respect for the complexity of the global macroeconomic environment. Let me explain. From a macro perspective, we still frame the environment as evolving, and we are seeing a series of transitions occurring in the global economy. Specifically, transitions from pandemic to post-pandemic, disinflation to inflation, peacetime to wartime, globalization to de-globalization, dollarization to de-dollarization, non-renewable energy to renewable energy, quantitative easing to quantitative tightening, zero and negative interest rates to positive interest rates, geopolitical unipolarity to multipolarity and regionalization, automation to artificial intelligence, and many more. This led us to characterize the investing landscape as having a flat fat-tail distribution, as we discussed during last quarter's earnings call.

Our risk and investment strategy continue to be set in this context. Against this backdrop, we are now seeing the evolution of a historic, even generational investment opportunity in the agency RMBS market. We already believe spreads were attractive last year when they widened in November and then tightened quite substantially in January. Due to the banking turmoil in March, we now have an even more extended opportunity to make investments. As many of you know, the FDIC has engaged BlackRock to sell the assets held by SVB and Signature Bank. These assets, totaling $98 billion, are in the control of BlackRock's Market Advisory Group and will be sold over the next nine months. I'll discuss this development alongside my other comments today. Why are we calling this a generational opportunity?

Please turn to page 10 of the earnings deck. This slide shows the history going back to 1985 of current coupon agency MBS nominal spreads hedged assuming an equal mix of five and 10 year treasuries. I want to highlight five periods. The early 1980s, 1998-2003, 2007, 2008, 2020, 2022 through today. These periods represent a major deviation from the average level of MBS spreads and are usually followed by periods of much tighter spreads, even if it takes two to three years. In our view, these are periods during which capital deployment and investment results in outsized forward returns, and we are right in the middle of one such great opportunity.

On the very left side of the chart, you can see MBS spreads spiking as the liquidations rose from the savings and loan crisis. In many ways, we're in a similar situation. Banks are net sellers of mortgages, home prices are falling moderately, private capital dominates the bid for agency MBS. We are different in two important aspects. First, we don't believe we are in the same scale of crisis atmosphere with continuous large-scale liquidations of the same magnitude. Second, the stock effect of the Fed's MBS holdings, even with quantitative tightening, is a powerful stabilizing agent for mortgage spreads. You can see that in the post GFC spread spikes. They're much lower than 2008 or the 1980s because of how big the Fed's balance sheet is.

On the very right-hand side of the chart, you can see the dramatic move wider since late 2021 in mortgage spreads, representing a tripling from the levels at the lows. We believe that most of the transition to wider spreads in agency RMBS is now behind us. While spreads may fluctuate and gap wider on occasion, spreads today broadly reflect the risk premium that's demanded by private capital, the net supply picture from quantitative tightening, seasonal supply, and some but not all of the risk premium for the sales from the FDIC takeover of the failed banks. We expect spreads will remain at wider levels until the bulk of the sales are complete, and hence we view this period as extremely beneficial to remain invested and to continue investing.

This is not to say that we think no further bank failures can occur or that more sales are unlikely. That's still possible. We're simply pointing out that a significant amount of repricing has already occurred. We are of course always contemplating what could take spreads out to 2008 levels. We believe substantial stress in the banking system with forced asset sales could get us there. There are mitigating factors today with banks' ability to tap the discount window and the BTFP, Bank Term Funding Program. These things would cushion or slow any type of disruption resulting from such stresses. As I mentioned previously, the stock effect of the Fed's balance sheet is also a stabilizing factor.

The irony of the current situation is that while there does seem to be an immediate opportunity, we're tempering that enthusiasm with a deep respect of the many ways in this situation can actually develop. A final point to note on this slide is that we have preserved a significant portion of our book value through the bulk of the transition to wider spreads. Book value was in the $17 range in August of last year, and as Rob mentioned, as high as $15.50 in early February. Book value can rise even with a modest tightening in spreads. Let me now turn to our positioning and outlook. We remain focused on liquidity and flexibility and the opportunistic deployment of capital. On net, we've been moving our position up in coupon while also adding assets on weakness.

We added a little over $1.1 billion in assets for the quarter at wider spreads in February and March. This took leverage to total and common capital about 1.4 times up from year-end. We've largely maintained our position in lower coupons, twos and two and a half. They currently make up 20% of assets by fair value. These remain positively convex assets, offering positive spreads to treasuries with prepayment upside relative to both market and model expectations and remain supported by the demand for housing. We are managing our hedge position with a medium-term outlook for rates in the curve because of the medium to long-term inflationary forces we describe on page seven.

We believe the Fed is focused on inflation, and in the absence of a significant economic downturn, can continue to look past any moderate economic weakness to maintain the restrictive financial conditions needed for inflation to decisively turn towards their 2% target. These factors can result in range-bound yields at the long end of the yield curve, which also provides solid fundamental support for tightening of the mortgage basis once the supply shock of the FDIC sales goes through the system. At today's level of mortgage spreads, we're more focused on the mortgage basis as the major source of alpha generation as opposed to curve and rates positioning on hedges. We see opportunity to add assets across the coupon stack and would favor adding both current coupons and discounts based on relative value at the time, preserving some flexibility with TBA and selectively investing in pools.

I'll briefly cover what we know about the FDIC sales and our expectations for how conditions may evolve. The total amount of securities to be sold is $98 billion. 55 of which are agency and Ginnie Mae securities and $43 billion CMOs. The first sales happened last week, about $1 billion. Mortgage spreads did widen in response. The sales are expected to ramp up to $1.5 billion-$2 billion per week. This should last about 25 weeks if they keep up the current pace. We expect this to end sometime in October. We also expect concurrent sales of the CMOs to begin in about two weeks. These are expected to bring duration and hedging flows into the market that will further impact rates and spreads.

All told, we estimate the duration equivalent of $69 billion 10 years will be sold, over half of which is in the pass-through bucket. Over the course of these sales, we expect to find opportunities to deploy capital at attractive levels. What can shareholders expect from us? As I've said, this is a very accretive investment environment by which I mean the return on capital exceeds our dividend yield. We expect to be active and opportunistic investors. We can reallocate existing capital, raise and deploy capital, as well as raise leverage. All three remain very powerful options and comprise significant upside over the long term as we outline on slide 12.

In the medium term, as Rob mentioned, we expect bullish support for agency MBS spreads to come from any decline in delivered volatility, the relative attractiveness of the agency-guaranteed cash flow offering significant returns over treasuries, as well as on a risk-adjusted basis versus credit-sensitive investments. We remain highly respectful of the global macro situation. We're looking ahead to the debt ceiling, which we believe can be a major risk flashpoint. We are planning accordingly. A final point going back to the spread slide on page 10. I want to highlight Dynex's performance. We began our existence in current form in January 2008 at the beginning of the Great Financial Crisis. Between 2008 and 2019, we generated a cumulative total economic return of 106%.

From 2020 to 2022, this decade, Dynex has delivered industry-leading performance, outpacing our peer group of agency and hybrid REITs by an average of 28% and 52% respectively on a cumulative basis. We're excited about the prospect of a target-rich investment landscape to put the power of the Dynex team to work. Our demonstrated performance in managing transitions is the direct result of having the experience, skill set, mindset, and expertise to navigate exactly this type of environment. With that, I will turn it back to Byron.

Byron Boston (CEO and Co-CIO)

Thank you, Smriti. Let me reiterate. First, we are seeing a compelling generational opportunity to invest in agency residential mortgage-backed securities. Our stock trades at a discount to book. We pay an attractive and consistent monthly dividend that we believe is sustainable. We have ample dry powder to take advantage of attractive investment opportunities as they develop. We think the stock offers strong value at these levels. The Dynex team is personally invested alongside our existing shareholders. We will continue to invest as we see value. Second, it is important now more than ever to be able to rely on our team with a clear strategy and deep experience in navigating complex environments. It's also important to have transparency in your investments. The Dynex balance sheet can be clearly and cleanly valued. We use mark-to-market valuations to calculate our book value daily.

All of our assets are marked and reflected in earnings and book value. We do not have any held-to-maturity investments or other unrealized losses that are hidden from sight. These are essential aspects in assessing not only who manages your capital, but where your capital is invested. We take responsibility as managers and stewards of your savings very seriously. We thank you for your trust and look forward to updating you on our performance and the environment next quarter. With that operator, we will now open the call for questions.

Operator (participant)

Thank you. At this time, I'd like to remind everyone in order to ask a question, press star then the number 1 on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. We'll take our first question from Trevor Cranston with JMP Securities. Your line is now open.

Smriti Popenoe (President and Co-CIO)

Yes. Hi, Trevor. Thank you for the question. Yeah. One thing I want to say is, you know, there are different ways in which mortgage spreads can widen, right? In 2020-2021, you had a transition in interest rates. Same in 2021-2022. Mortgage spreads widened at that time really because the underlying cash flows of the instruments themselves was affected. You went from an interest rate regime of like 1.5% 10-year notes or 0.5% 10-year notes to 4%, 5% levels of rates. That's where extension risk or, you know, the actual mortgages change their cash flow and, you know, can therefore widen, if you will. Those types of spread widening events are ones that we believe, you know, are controllable.

You can think through the way the duration of an instrument changes, and you can hedge for that. Okay? What we saw in November of last year and what we're seeing now in March of this year, and even here going forward with the FDIC sales is different because the underlying cash flow of the instruments aren't actually changing much at all. You know, interest rates have been super range-bound, right? You're seeing an imbalance between the supply and demand of mortgages. It's very technical in nature, that gives us some confidence 'cause you can actually hedge the instruments better. To answer your question directly on the FDIC sales, we did see some mortgage spread widening. You know, it's not to say that we won't see more spread widening.

We actually expect to see a fair amount of spread widening. The marginal bid at this point really is money managers, That's who you're seeing stepping in to take some of this product down. From what I understand, they're still relatively underweight lower coupon securities. Mortgages are starting to look attractive relative to corporates. Those would be rationales for money managers to allocate money into the sector. We do expect, you know, as time goes on, that we're gonna see periodic bouts of widening, you know, from here. Is it gonna be the 60, 70, 80 basis point type widening that we've seen? You know, I don't think so. We're already here at 170 basis points nominal spread to treasuries. They look very cheap to corporate bonds here on a risk-adjusted basis.

That's where we see the demand coming from.

Byron Boston (CEO and Co-CIO)

Can I add one other thing?

Trevor Cranston (Equity Research Analyst)

Okay, go ahead.

Byron Boston (CEO and Co-CIO)

Hey, Trevor. One question is, how far will a government-backed bond widen versus other non-government-backed assets? The one is I've seen a couple of times in history where they widen suddenly a ton, and then capital accumulates and really chases after the assets, which brings spreads back in. It's worth describing a situation where spreads will move around, but you've got to ask yourself, how far will a government-backed asset widen versus other assets that don't carry a similar guarantee?

Trevor Cranston (Equity Research Analyst)

Sure. That makes sense. I guess, to the extent that there is, you know, some incremental widening that occurs as these sales happen, and you know that potentially has some impact on book value, can you talk about how high you'd be, you know, willing to let your leverage drift in that scenario given that, you know, there'd potentially be a more attractive investment opportunity to take advantage of on the, on the flip side of that?

Smriti Popenoe (President and Co-CIO)

Yeah. I think, you know, look, this is why we've emphasized cash and unencumbered assets of a really high amount relative to our the amount of repo that we hold. I would say there's two major factors on leverage here. You heard me say, you know, we like the investment opportunity, but we're tempering it because we see, you know, the global macro environment evolving. The number one consideration for us always in terms of increasing leverage or adding assets is going to be what is the macro environment. If that happens to be something, you know, where we expect to have a fair amount of degree of caution, I would say our appetite to increase leverage will be lower, right?

In the large scheme of things, this period is actually a period in which you should be okay taking leverage up, over and above sort of what you think your normal operating leverage numbers are because of the long-term investment opportunity. In reality, you know, I feel like if we see that investment opportunity when spreads widen, our willingness to do that while it will be tempered by the macro risk that's in the environment, is going to be higher than, you know, when if spreads were say, you know, 30 or 40 basis points tighter. On average, our inclination would be to run higher levels of leverage.

Trevor Cranston (Equity Research Analyst)

Yeah. Okay. Appreciate the comments. Thank you.

Smriti Popenoe (President and Co-CIO)

Sure.

Operator (participant)

Okay, next we'll go to Doug Harter with Credit Suisse. Your line is now open.

Douglas Harter (Director)

Thanks. Can you just talk about the repo market and how much you're dealing with maturities around the time of potential debt ceiling and just how that influences your last comment around, you know, this being an environment where you should be comfortable taking higher levels of leverage?

Smriti Popenoe (President and Co-CIO)

Yeah, I think that's a great question, Doug. It's great to hear from you. Look, we think this is a major risk flashpoint. We believe financing should be adjusted to reflect the risk of potential issues, you know, leading up to it and even including a potential default by the US, even if it's for a short period of time, right? You're already seeing sort of some dislocations in the bill market. We have not actually seen a ton of activity in the repo market that would suggest that the availability of financing is impaired right now. It's actually quite flush with cash. All the money that's moved into the money funds is out in the repo markets right now. You can see that in bill rates. Short-term bill rates are super low right now.

Below 4%. Some of that is starting to bleed through into the agency repo market in terms of availability of funding. Okay? You know, just in terms of the way we typically manage around quarter ends and, you know, events like this, our strategy has been to term things out past certain dates. You know, we continue to employ that strategy. We haven't had any issues with the ability to term finance debt at all. We do think, you know, having this upcoming risk is one of the other reasons that we're tempering our willingness, if you will, to take leverage up without consideration of that very important factor.

Douglas Harter (Director)

So-

Smriti Popenoe (President and Co-CIO)

[crosstalk]Can I say one more thing?

Robert Colligan (EVP and CFO)

Sure. Absolutely.

Smriti Popenoe (President and Co-CIO)

You know, there's one other piece. Yeah. Which is having the TBAs on our balance sheet makes it really easy for us to take the leverage off. If you think about, I think our leverage ratio, Rob, can you talk about the difference between the repo leverage versus the total?

Robert Colligan (EVP and CFO)

Sure, yeah. Our repo leverage alone is only about 3.4 turns, so the rest of our leverage is, you know, TBA and other. To Smriti's point, and she'll, you know, give you some more color on this, it's much faster for us to adjust if needed.

Douglas Harter (Director)

Got it. How would you think about if we get a successful resolution of the debt ceiling, you know, and spreads remained attractive, you know, what would be kind of the higher end of a range you might be comfortable with in this type of widest, widespread environment?

Smriti Popenoe (President and Co-CIO)

You know, look, in the past, right, you might think of different types of leverage levels. If you go back to that chart on page 10, you know, when spreads are wide, you know, we've thought of leverage levels in the low teens, I would say. Right? When spreads are wide, you wanna be able to run higher levels of leverage. When spreads are sort of in the middle of the range, maybe you bring that down to sort of like the eight, nine times level. When they're at the tighter end of the range, you actually wanna run lower leverage because you're taking advantage of tighter spreads. You know, at the higher end of things, you know, you're running in, I'm gonna say 10 to 12. Don't hold me to that.

Douglas Harter (Director)

Sure.

Smriti Popenoe (President and Co-CIO)

That's kind of the idea, right, is just you. There are higher levels of leverage. All of this, I would say, you just can't sit there and believe that you can run it as sort of a rule of thumb without considering the risk environment, right? You know, if all else were equal, we felt comfortable, you know, yes, you know, the leverage can rise to the low double digits and those would be, you know, massively accretive investments that were gonna be made over time is because we expect those spreads to come back in.

Douglas Harter (Director)

Great. Thank you.

Smriti Popenoe (President and Co-CIO)

Sure.

Operator (participant)

Next, we'll go to Bose George with KBW. Your line is now open.

Bose George (Managing Director)

Hey, everyone, good morning. Actually, could we get an update on book value quarter to date?

Smriti Popenoe (President and Co-CIO)

Yes. right now, I guess through Friday, I think we're down between 1% and 2%.

Bose George (Managing Director)

Okay, great. Thanks. Just wanted to switch to an accounting question. Can you remind me, is there a way to disaggregate how much of the treasury futures mark, you know, would have corresponded to like a periodic payment on the swap side?

Robert Colligan (EVP and CFO)

Good question, Bose. There is, but you get into nuances and assumptions around cheapest to deliver in that. Very few people do a disaggregation between carry and mark-to-market. You know, that's why we've put the total amount out there so people can see what we've earned and, you know, what's been supportive or what's buffered higher repo costs.

Bose George (Managing Director)

Yeah. Yeah.

Robert Colligan (EVP and CFO)

It's a good question. I haven't seen many like solve that, answer very well.

Bose George (Managing Director)

Okay. The $0.34 is the amortization of previous marks, right?

Robert Colligan (EVP and CFO)

That is correct. Yeah. That's a simple-

Bose George (Managing Director)

Okay.

Robert Colligan (EVP and CFO)

Not to go into more of a technical answer, but you know, we've put our total gain out there. You know, we've used the straight line approach. Being a REIT, and the tax impact is important, so that's why we're putting out that disclosure. If we were in swap form, we would probably have more gain up front given the moving rates and the shape of the curve. You know, in order to give a simple answer, you know, we're just giving the total gain and how it will actually impact REIT tax and income this time.

Bose George (Managing Director)

Yep. Yep. Okay. No, that makes sense. Thanks a lot.

Operator (participant)

I'd like to remind everyone it's star one if you have a question. Next, we'll go to Eric Hagen with BTIG. Your line's open.

Eric Hagen (Managing Director and Mortgage and Specialty Finance Analyst)

Thanks. Good morning. A couple questions here. When you think about how the hedges are allocated and maybe matched with the asset side of the balance sheet, how much is hedging the current coupon TBA versus the pools in the portfolio? How do you see that hedge ratio evolving for TBAs versus pools going forward? Following up on a question around leverage, just how does the slow prepayment environment, as just a factor in itself, kind of drive the amount of leverage you're willing to tolerate? How does that triangulate with the amount of liquidity you carry? How much liquidity do you envision carrying if your leverage were to even go up a little bit more? Thanks.

Smriti Popenoe (President and Co-CIO)

Okay.

I'll take the second question first, which is the prepay environment, which is an interesting thing, I think. I think we've gone through probably the slowest period of prepays in the last three to four months, and from here on out, I think prepays will start to rise due to seasonal factors and just existing home sales, you know, ramping up off the bottom. You know, in terms of the slow prepay, yes, we do carry leverage. We do carry liquidity, right, to be able to manage the way the yield of an instrument changes over time as that pull to par comes back. That's an important factor in thinking through, you know, having cash on hand to pay the dividend and so on and so forth.

It's not a big material consideration, Eric. We're carrying sufficient amounts of cash and unencumbered assets to be able to cover all of that. On the margin, it does not actually make a lot of difference in terms of our ability or willingness to take leverage up or down. You know, the main driver of whether or not we're gonna make a marginal investment or is gonna be, you know, does the marginal investment make a return that exceeds the cost of capital? In this environment, you know, that is also tempered with the macro question, you know, should we, should we take up that risk? Leverage is more a function of that. The amounts of levels of liquidity we carry are a function of the macro volatility we expect.

The strategy is to carry enough liquidity and unencumbered assets to be able to make the margin calls when spreads widen so that you have excess capacity to put that extra capital to work when the spreads have widened and book value has declined, right? We're anticipating book value to decline as spreads widen. We wanna be prepared for that with the extra liquidity. Then we want to be able to deploy, you know, that dry powder at that time to make that marginal investment. When spreads tighten in, you'll get the benefit of that. That's the second question. Your first question, remind me what that was again real quick.

Eric Hagen (Managing Director and Mortgage and Specialty Finance Analyst)

Yeah. We're looking at the hedge ratio between TBAs-

Smriti Popenoe (President and Co-CIO)

Oh, okay.

Eric Hagen (Managing Director and Mortgage and Specialty Finance Analyst)

-and pools, and how you guys-

Smriti Popenoe (President and Co-CIO)

Right.

Eric Hagen (Managing Director and Mortgage and Specialty Finance Analyst)

Think about that. Thank you.

Smriti Popenoe (President and Co-CIO)

Yeah. I would say, you know, look, we. The instruments that we hold, many of them, in fact, almost all of them trade at par or below par, right? These are instruments that in general, even at these level of interest rates, are going to be longer-durated securities. Some of them, the current coupons have sensitivity to the five-year part of the curve. Some of them have more sensitivity to the seven and 10-year part of the curve. In general, you know, we on a blended basis, we think our sensitivity is somewhere between that five and seven-year part of the curve. That's how we're thinking about that hedge ratio.

When the hedge ratio changes, and I think you're right on that, is really when the underlying cash flows start to shift. For the cash flows to shift, we think mortgage rates have to really start to fall much below 6% and, you know, approach maybe 5.5% or so for cash flows to change or go the other direction, 7% or above. You're now sitting sort of in this sweet spot where you're range bound in treasuries, you know, your mortgage durations aren't changing that much, so we're not really feeling a great need to mess around with the hedge ratio. That's kinda how we think about it. It's mostly on an aggregated basis.

The current coupons are more sensitive to the five-year part of the curve and below, but many, you know, most of our assets are actually sitting much below par, and that's why we have the longer-durated hedges.

Eric Hagen (Managing Director and Mortgage and Specialty Finance Analyst)

Yep. Really helpful. Thank you guys very much.

Smriti Popenoe (President and Co-CIO)

Sure.

Operator (participant)

There are no further questions at this time. I'll now turn the call back over to Byron Boston, CEO, for any additional or closing remarks.

Byron Boston (CEO and Co-CIO)

Thank you very much, all. As I said earlier I just wanna make sure I was not muted. Thank you again for joining our call this quarter. We look forward to chatting with you again next quarter. Thank you very much.

Operator (participant)

This does conclude today's conference call. You may now disconnect.