Annaly Capital Management - Q1 2024

Transcript

Operator (participant)

Note that today's event is being recorded. I would now like to turn the conference over to Sean Kensil, Director, Investor Relations. Please go ahead, sir.

Sean Kensil (Director of Investor Relations)

Good morning, and welcome to the first quarter 2024 earnings call for Annaly Capital Management. Any forward-looking statements made during today's call are subject to certain risks and uncertainties, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the disclaimer in our earnings release in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date hereof. We do not undertake, and specifically disclaim, any obligation to update or revise this information. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release.

Content referenced in today's call can be found in our first quarter 2024 investor presentation and first quarter 2024 supplemental information, both found under the Presentation section of our website. Please also note this event is being recorded. Participants on this morning's call include David Finkelstein, Chief Executive Officer and Chief Investment Officer, Serena Wolfe, Chief Financial Officer, Mike Fania, Deputy Chief Investment Officer and Head of Residential Credit, V.S. Srinivasan, Head of Agency, and Ken Adler, Head of Mortgage Servicing Rights. With that, I'll turn the call over to David.

David Finkelstein (CEO and CIO)

Thank you, Sean. Good morning, and thank you all for joining us on our first quarter earnings call. Today, I'll briefly review the macro and market environment, along with our first quarter performance, then I'll provide an update on each of our three businesses and conclude with our outlook. Serena will then discuss our financials, after which we'll open the call up to Q&A. Now, beginning with the macro landscape, the first quarter of 2024 was characterized by surprisingly resilient economic data, a healthy labor market, and an uptick in inflation. Consequently, interest rates sold off modestly on the quarter as the market priced out roughly half of the rate cuts that were expected at the beginning of the year. Now, despite rising rates, risk assets performed well over the quarter as volatility declined and money flowed into both equity and fixed income markets.

Banks also reemerged as modest buyers of treasuries and Agency MBS in the first quarter, a welcome development given their absence over the past couple of years. Now, in addition, the Federal Reserve made it clear that it considers policy rates and balance sheet management to be separate tools as they have begun discussing slowing the pace of the Fed's treasury securities runoff. We're encouraged by this development, as this approach allows for a more gradual decline in bank reserves, thereby stabilizing liquidity, potentially reducing treasury supply to the private sector, and strengthening banks' deposit growth, all positive for fixed income and Agency MBS. Now, against this supportive backdrop, all three of our housing finance strategies performed well in the quarter, with production coupon Agency MBS spreads roughly 5 basis points tighter, credit spreads 25-100 basis points tighter, and the MSR market experiencing modest multiple expansion.

As a result, we delivered a 4.8% economic return for the quarter with an EAD of $0.64 and leverage at quarter end of 5.6 turns. Now, as the second quarter has unfolded, continued strong economic data, coupled with stalled progress on disinflation, has driven a further repricing of forward rate expectations, as well as an increase in volatility. This current risk-off tone has led to marginal spread widening across agency and credit and justifies our leverage profile, which is at its lowest level of the cycle. Now, notwithstanding lower leverage, prevailing return environment gives us confidence in the durability of the portfolio earnings profile, and we believe that our current dividend is appropriately set for 2024, given our expectations for earnings this year.

Now, shifting to the businesses and beginning with Agency, the portfolio ended the quarter modestly lower to accommodate growth in the residential credit and MSR businesses. We continued to gravitate up in coupon, with our weighted average coupon increasing 20 basis points to 4.76%, reducing our holdings of 4% coupons and lower by over $5 billion in favor of predominantly 5.5% and higher. We've continued to favor production coupons as they provide the widest nominal spreads and, as evidenced by their performance this past quarter, the best returns in a range-bound rate environment. They also stand to benefit from potential spread tightening should option costs decline due to a steeper yield curve or lower implied volatility. Our Agency CMBS portfolio was largely unchanged over the quarter.

Spreads in the sector tightened 10-15 basis points on continued broad-based demand, outperforming Agency MBS and providing incremental excess returns while improving our overall convexity profile. Now, as it relates to interest rate management, the notional value of our hedge portfolio declined slightly as we moved hedges out the curve, leading to a modest decline in our hedge ratio. As our existing front-end swap position has been rolling off, we've replaced that risk with hedges in the intermediate and long-end part of the yield curve, closely aligning our hedges with the interest rate risk of our assets. In addition, our increased allocation of Swaps relative to Treasuries that we discussed last quarter benefited our overall return given the widening of swap spreads during the quarter....

Now, the short-term outlook for Agency MBS has become somewhat more challenging, as recent inflation reports have delayed the start of the cutting cycle and led to a pickup in volatility. However, we remain constructive on the sector, given the potential of sustained bank demand and the expected upcoming reduction in Fed treasury runoff, factors that should be supportive of Agency MBS and were absent in the prior widening episodes. Meanwhile, hedge carry remains attractive, with historically wide nominal spreads. Now turning to Residential Credit. The portfolio ended the quarter at $6.2 billion in market value and $2.4 billion of equity, which comprised 21% of the firm's capital at quarter end. Resi credit spreads tightened meaningfully to start the year, given the supportive fundamental backdrop, with triple A non-QM spreads 35 basis points tighter and below IG CRT M2 70 basis points tighter.

The credit curve continued to flatten as the issuance and supply of subordinate assets remained limited. Now, the growth in our portfolio was driven by our organic Onslow Bay strategy through increased whole loan purchases and retention of OBX securities. Given tightening spreads, we opportunistically reduced our CRT portfolio and other segments of our third-party securities holdings into strong demand. The Onslow Bay correspondent channel had another record quarter as we registered $3.7 billion of expanded credit locks in Q1, up 40% quarter-over-quarter. We settled $2.4 billion in loans, the vast majority of which were sourced directly via our correspondent channel. Our pipeline remains robust, with $2 billion of locks at quarter end and continued momentum into the spring selling season.

Most importantly, our credit discipline remains strong as our current pipeline is characterized by a 68 LTV and a 753 FICO, with only 3% of our locks greater than 80 LTV. We were able to take advantage of the supportive capital markets by pricing 7 securitizations, totaling $3.3 billion in Q1, generating $328 million in assets for Annaly's balance sheet at low- to mid-double-digit returns. Subsequent to quarter end, we priced an additional non-QM transaction, with retained assets exhibiting similar expected returns. Now, looking forward, the further expansion of the Onslow Bay channel has positioned Annaly as a market leader in the residential credit market, allowing us to manufacture our own credit risk while retaining control over all aspects of the process.

Now shifting to our MSR business, our portfolio ended the first quarter at $2.7 billion in market value, representing $2.3 billion in the firm's capital. MSR transaction volumes continued to be elevated in the first quarter, given challenging originator profitability, while demand and pricing remained firm. Despite elevated supply, we were disciplined, finding better opportunity and relative value post-quarter end. In early April, we committed to purchase just over $100 million in market value of a bulk package, which we expect to close in the second quarter. We're confident we've constructed one of the highest quality conventional MSR portfolios in the market, characterized by our industry-low 3.07% note rate and exceptional credit quality.

Fundamental performance of our MSR portfolio has continued to outpace our initial expectations, with our holdings realizing a three-month CPR of 3%, rising float income given increased escrow balances and minimal borrower delinquencies. All of these factors have contributed to our MSR portfolio exhibiting highly stable cash flows at double-digit returns. Now, given Annaly's diversified strategy and ample liquidity position, we currently do not utilize a significant amount of recourse leverage on the MSR portfolio, as it is advantageous to supplement leverage with lower-cost agency repo. However, with $1.25 billion of committed warehouse facilities, we're positioned for additional MSR growth should pricing be favorable. Now, looking ahead, we're optimistic about the outlook for our three businesses, and we continue to see attractive risk-adjusted returns across each of our investment strategies.

However, bouts of volatility remain a key risk, as we have been reminded in recent weeks, and we remain vigilant. Annaly continues to be well prepared, given our conservative leverage position and capital structure, our ample liquidity, and a diversified capital allocation strategy that can outperform across different interest rate and macro landscapes. And while we continue to make progress in allocating incremental capital towards our residential credit and MSR strategies, we like our current capital allocation and are disciplined in pricing and selective in the sourcing of assets. And overall, we're proud of the unique platform we've built with three established and fully scaled businesses on our balance sheet, and we believe this model can continue to deliver superior returns relative to sector, just as we have over the past couple of years. And now, with that, I'll hand it over to Serena to discuss our financials.

Serena Wolfe (CFO)

Thank you, David. Today, I will provide brief financial highlights for the first quarter ended March 31, 2024. Consistent with prior quarters, while our earnings release discloses GAAP and non-GAAP earnings metrics, my comments will focus on our non-GAAP EAD and related key performance metrics, which exclude the PAA. Our book value per share as of March 31, 2024, increased from the prior quarter to $19.73, based largely on asset spread appreciation with minimal interest rate exposure. With our first quarter dividend of $0.65, as David mentioned earlier, we generated an economic return of 4.8%. Rising rates and spread tightening for credit assets resulted in gains on our hedging portfolios of $2.19 and gains on our Resi and MSR investments of $0.17.

Outpacing losses on our Agency investment portfolios of $2.04 as implied volatility declined and asset spreads tightened. Earnings available for distribution decreased by $0.04 per share to $0.64 in the first quarter compared to Q4 2023. EAD declined on lower swap benefits as some of our positions matured. Gross interest expense increased as average repo and securitized debt balances increased by approximately $3.6 billion. The net financing impact on the EAD was mitigated by continued improvement in asset yields, as average asset yields ex PAA further rose quarter-over-quarter, 22 basis points higher than in the fourth quarter at 4.87%. Asset yields benefited from the Agency MBS portfolio, continuing its up-in-coupon strategy and the Onslow Bay correspondent channel experiencing record growth in whole loan purchases as attractive yields.

Net interest margin reflected the changes to EAD in the first quarter, with the portfolio generating 143 basis points of NIM ex PAA, a 15 basis points decrease from Q4. Similarly, net interest spread decreased 13 basis points quarter-over-quarter to 109 basis points. Total cost of funds increased quarter-over-quarter, rising 36 basis points to 3.78%. As I previously highlighted, swap benefit continues to normalize as positions expire, reducing net interest on swaps by $49 million and increasing cost of funds by 32 basis points, accounting for much of the quarter-over-quarter impact. On the other hand, average repo rates were stable through the quarter, declining nominally by 1 basis point. Turning to details on financing, we continue to see strong demand for funding for our agency and non-agency security portfolios.

Our repo strategy is consistent with prior quarters, with the book positioned around Fed meeting dates as we look to take advantage of any future rate cuts. As a result, our Q1 reported weighted average repo days were 43 days, down just 1 day compared to Q4. During Q1, we continued sourcing additional funding capacity for our credit businesses. To increase financing optionality for our Onslow Bay platform, we closed additional warehouse facilities approaching $1 billion in size, which included expanded product offerings and non-mark-to-market features at 2-year term. As of March 31, 2024, we had $3.9 billion of MSR and home loan warehouse capacity at a 34% utilization rate, leaving substantial availability.

Annaly, unencumbered assets increased to $5.3 billion in the first quarter, compared to $5.2 billion in the fourth quarter, including cash and unencumbered Agency MBS of $3.5 billion. In addition, we have approximately $900 million in fair value of MSR that has been pledged to committed warehouse facilities. They remain undrawn and can be quickly converted to cash, subject to market advance rates. We have approximately $6.2 billion in assets available for financing, unchanged compared to last quarter. We believe that our disciplined approach to liquidity and credit leverage leaves us well prepared to confront market risks, such as the volatility of the previous few weeks.

Lastly, we have continued to efficiently manage our expenses, resulting in a decline in our OpEx to equity ratio to 1.35% for the first quarter, compared to 1.41% for the fourth quarter of 2023. That concludes our prepared remarks, and we'll now open the line for questions. Thank you, operator.

Operator (participant)

Thank you. We will now begin the question and answer session. As a reminder, to ask a question, you may press star then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw it, please press star then two. At this time, we will pause momentarily to assemble our roster. Today's first questioning comes from Bose George with KBW. Please proceed.

Bose George (Managing Director)

Hey, everyone. Good morning. Could I get an update for book value quarter to date?

David Finkelstein (CEO and CIO)

Sure, Bose. Good morning. So as of our last flash, which was Tuesday's close, net of our dividend accrual, we were off just inside of 3%, inclusive of that dividend, just inside of 2% off.

Bose George (Managing Director)

Oh, okay. Perfect. Thank you. And then I noticed the targeted return on your MSR increased to 12-14 from 10-12. You know, was that, is that sort of just better yields in the market, or is there, like, a different leverage assumption, or just get curious what drove that?

David Finkelstein (CEO and CIO)

It's predominantly the increase in float income associated with higher short rates projected. But, Ken, you want to elaborate?

Ken Adler (Head of Mortgage Servicing Rights)

Yeah, as you may know, you know, ownership of the MSR asset involves the MSR owner owning the benefit of the floating income, maintaining those escrow accounts. So the higher for longer change in rates just translates to a much higher yield at the exact same multiple. So it's really just the math on that.

Bose George (Managing Director)

Okay, great. Thank you.

David Finkelstein (CEO and CIO)

Thanks, Bose.

Operator (participant)

The next question comes from Doug Harter with UBS. Please proceed.

Douglas Harter (Equity Research)

Thanks. Can you talk about how MSRs are performing kind of in this, you know, as rates continue to increase, and, you know, and their effectiveness in hedging the MBS portfolio?

Ken Adler (Head of Mortgage Servicing Rights)

... Yeah, absolutely. This is Ken. Thanks for the question. In terms of spot performance, I mean, the speeds you can see in the presentation, extremely stable, delinquency is extremely stable. And as the prior question alluded to, we have an increase in cash flow, expected cash flow over time as the earnings on the float are not expected to decline given the rate cuts coming out of the market in terms of the expected pricing. In terms of hedging the MBS portfolio, you know, slower speeds are good for the MSR and the mortgage universe trading at a discount. Slower speeds are not a good outcome for mortgage-backed securities. So we do have that hedging property.

David Finkelstein (CEO and CIO)

Yeah. Doug, I'll just add to Ken's point. Look, when we buy MSR, you know, standard speaking, it's often a hedge for the duration of the portfolio. When it's deep out of the money, there's two other hedge benefits we get, as Ken discussed. First is the higher float income hedges the higher for longer and short rates and financing associated with the agency MBS. And secondly, the turnover, which is lower in a higher rate market environment, is better for MSR. So those two factors have led to a shift in the benefits associated with MSR for our portfolio.

Douglas Harter (Equity Research)

Thanks. And then the increase in the Onslow Bay correspondent activity is—how much? Is that kind of adding new customers? Is that getting deeper with existing customers? Kind of, if you could give a little more color behind the increased activity there.

Mike Fania (Deputy CIO and Head of Residential Credit)

Hey, Doug. Thank you. This is Mike. Thanks for the question. I think a lot of it is the correspondent channel is not yet mature. We still believe that there's over 100 correspondents that are originating non-QM and DSCR loans that are not currently our captive customers. So we've been very aggressive in trying to build up the correspondent. So, you know, some of that volume is just through the maturation of the correspondent channel. Some of it is spring seasonals, right? So we've certainly benefited from that, which is one relative to Q4. And I think a lot of it is also the growth in the actual market itself.

You know, large non-banks have rolled out these programs, and they have been very active participants in not only potentially taking market share from, you know, some of the smaller niche specialty finance players, but they're building market share as well. And the borrower, you know, within the non-QM DSCR market, is also a little bit less sensitive than an agency or jumbo market, you know, to rates. You know, about a quarter of the volume that we're doing right now is cash out. That number is, you know, 7%-8% within the agency market. So I think there's a number of factors that are leading to the increase in volumes. But I'll say one of the largest drivers is just the actual build of the correspondent, adding new originators to the platform.

Douglas Harter (Equity Research)

Great. Thank you.

David Finkelstein (CEO and CIO)

Thank you, Doug.

Operator (participant)

Our next question comes from Rick Shane with J.P. Morgan. Please proceed.

Richard Shane (Head of Consumer and Specialty Finance)

Thanks, everybody, and good morning. Look, I'm looking at slide six, and I know, Bose had asked a question here as well. There's convergence between the returns on the three strategies. And I'd love to explore in the current environment, sort of the base case, higher for longer, what you think the right tactical approach is. And then if you could, let sort of lay out if we saw the tail scenarios, one tail scenario being additional hikes, the other being, cut sooner than we thought, how you would position yourself, in the context of these three choices? Basically, I want to understand how you're thinking about things now and what the risks are or what the opportunities are if you make a strategic call.

David Finkelstein (CEO and CIO)

Sure. Thanks, Rick. So just in terms of overall capital allocation, as I mentioned in our prepared remarks, so we do very much like, where we are, where we are at today. We think the three sectors are all fully scaled, obviously, that and the portfolio is in a good balance right now, and I think it shows up in, in our economic returns over the, over the past many quarters. So, so we're happy with where we're at. In terms of relative value, you know, agency looks perfectly fair here. We're, we're certainly sensitive to higher volatility that could, could materialize, albeit we don't expect to see anything like we saw last fall. But nevertheless, it's something we're sensitive to, so we're a little bit underlevered on the agency side.

But our allocation is, you know, nearly 60%, and that's the core of the portfolio, and that's where our liquidity is, so we like it there. In terms of the other two sectors, both are adding accretive returns, both in terms of book value, and they're supporting the dividend. So we like where we're at. And then when we look at, you know, from a relative value and a capital allocation percentage in terms of expected returns under various scenarios, this allocation here today gives us the best bang for our buck when we stress the portfolio with shock rates up or down.

Now, in terms of how we would position in the scenario you mentioned, whether it's higher for longer versus or even hikes, potentially, versus, you know, the potential for cuts. Look, the way we look at it is we are carrying a very small amount of interest rate risk, but you're not getting paid for it. The rates market is, we think, to be relatively fairly priced. We have sold off over 80 basis points on the long end this year. And it's been warranted, given the much stronger data that we've seen and the surprise uptick in inflation. But when you look out to the horizon and think about longer term rates, you know, 5-year rates, 5 years forward in Treasuries is at 4.65, which we think looks perfectly reasonable.

Ten-year real rates are, you know, roughly 2.25%. And then globally, rates are quite competitive with nominal ten years, 150 basis points over the rest of the G7. So the rates market looks to have priced in, you know, the stronger growth and the higher inflation that we've recently seen. And another point to note, with respect to rates markets relative to the Fed, for example, is the market has priced in a much higher neutral rate than the Fed's long run average. We're over 4% now when we look out the curve on very short rates. And so the markets is reasonably well priced for uncertainty associated with, you know, the potential for higher, for longer or even hikes.

And the way we would position ourselves if we did anticipate hikes is we maintain a conservative approach with respect to interest rate risk. We're already at the lowest leverage we've been at since 2014. And so we feel good about that, and we're prepared for it. And the positive aspect of it, as I mentioned in our prepared remarks, is that we're able to earn returns that support, you know, a 13% yield on book. And so we feel really good about it, and we're prepared for that type of uncertainty.

Now, on the other hand, if all of a sudden, you know, higher rates and, you know, the trajectory of policy does create unintended consequences in interest rate sensitive sectors, for example, whether it's regional banks or CRE and housing, the Fed does have to, you know, react in a way that's much more accommodative, much quicker. We're gonna have plenty of opportunity to position the portfolio in a more aggressive fashion as that materializes. So we're not worried about missing anything. You know, right now, our leverage is at where it's at because, you know, candidly, the range of outcomes has increased to the intent of your question. And we need to get through this bout of volatility.

And so we're gonna remain relatively conservative, but we're prepared for downside, and we can easily react if policy becomes much more accommodative, and all of a sudden rates are improved quite a bit. Does that help?

Richard Shane (Head of Consumer and Specialty Finance)

It does, and I apologize for asking such an open-ended question, but I really have to say I enjoyed the answer. It's very helpful, and thank you.

David Finkelstein (CEO and CIO)

Anytime, Rick.

Operator (participant)

The next question is from Jason Weaver with JonesTrading. Please proceed.

Jason Weaver (Head of Specialty Finance and Real Estate Research)

Hey, good morning. I was wondering, can you give us a ballpark on the incremental NIM you're targeting for the whole loans going into the Onslow-Bay securitizations, and what you think your capacity is there in what might be a weaker origination environment?

Mike Fania (Deputy CIO and Head of Residential Credit)

Hey, Jason, this is Mike. When you say NIM, you're talking about, you know, some form of projected gain on sale in terms of where we're at?

Jason Weaver (Head of Specialty Finance and Real Estate Research)

If you had any internal target for that? Yes.

Mike Fania (Deputy CIO and Head of Residential Credit)

Yeah. You know, that's not a metric that we've given out historically, but I will say in terms of when we're actually pricing our loans, you know, when we're putting out a rate sheet, we are targeting close to, you know, mid-teens ROEs based upon retaining, call it, you know, 10% market value, and then maybe a small nominal amount of recourse leverage. So you're looking at 6%-7%, you know, dedicated deployed capital on those whole loans at, you know, mid-teens ROEs in terms of where we're setting the risk and the rate sheet.

David Finkelstein (CEO and CIO)

Yeah, Jason, just to add, you know, as I talked about in my prepared comments, you know, as we added OBX Securities to the balance sheet, we reduced our third-party securities. You know, the way Mike is able to organically create assets, it's much cheaper, we think, than third-party securities. And credit has done quite well, as I'm sure you're aware. And so we've reduced that component, the third-party component of the balance sheet, to make room for what is candidly much more attractively priced OBX Securities. And we'll continue to do that.

Jason Weaver (Head of Specialty Finance and Real Estate Research)

All right. Thank you. That's helpful. And then, David, maybe expanding on your earlier prepared remarks a little bit. What do you think about the impact of QT curtailment on your agency portfolio strategy? Does it change the approach at all?

David Finkelstein (CEO and CIO)

You know, it, it gives us more confidence in the near-term horizon. And you know, it's very incremental what the Fed would do. And I think everybody's aware they're likely to begin the taper either in May or in June, and they'll reduce the runoff of their Treasury portfolio by roughly 50%. And what that will do is it'll help you know, provide comfort to private market participants that there's less Treasury supply coming to the market. It'll help banks in so far as deposit growth will be able to be deployed into fixed income in terms of their liquidity. And ultimately, that'll help Agency MBS.

You know, banks did reemerge as buyers, both Treasuries and Agency MBS, so, in the first quarter, and we're hopeful that that'll continue. And reduce Treasury supply from the Fed will help fixed income markets overall and indirectly, the Agency MBS market. But we don't expect them to reduce their runoff in Agency MBS. You know, we don't expect them to buy Agency MBS in any event other than a crisis-type period, for the foreseeable future. But the reduced Treasury supply will be helpful for all fixed income markets.

Jason Weaver (Head of Specialty Finance and Real Estate Research)

All right. Thanks again for taking my question.

David Finkelstein (CEO and CIO)

You bet, Jason.

Operator (participant)

Our next question is from Trevor Cranston with JMP Securities. Please proceed.

Trevor Cranston (Managing Director)

Hey, thanks. On the MSR business, you know, as that continues to grow and gain scale, can you talk about, you know, how you would think about potentially bringing the servicing function in-house? And kind of generally, how you think about the trade-offs between, you know, using sub-servicers and having an in-house servicing function? Thanks.

David Finkelstein (CEO and CIO)

Yeah, sure. So, we've looked at servicers in the past and have seen a number of them come to market. What we've learned is that it's much more efficient for us to outsource servicing. In the absence of significant scale, it's a very low-margin business, and we have considerable amount of flexibility by using multiple high-quality sub-servicers. It's very competitively priced. We have good recapture relationships, and we also have better access to assets. As a consequence, we're not a competitive threat to the mortgage origination community. You know, by outsourcing servicing, it's better for our overall business.

Now, that could change at some point, but right now, we really like the relationships we have on the sub-servicing side, and we're going to maintain that posture for the time being.

Trevor Cranston (Managing Director)

Got it. Okay, that makes sense. And then, you know, in light of the significant moves we've had in rates here in April, can you comment on any, you know, changes you made within the portfolio, particularly, you know, in Agency MBS or with the hedges?

David Finkelstein (CEO and CIO)

Sure. So we did actually sell early in the quarter, $2 billion Agency MBS, and some of that was outright. So, part of that was anticipatory and, you know, we're certainly glad we did. You know, we will manage our rate exposure here as the market evolves. We're currently running at about a half-year duration, which we're comfortable with, but we're certainly cautious. You know, Agency MBS, we think in this sell-off, they've been better behaved, certainly in the fall, primarily because fall has been a little bit better, this time around. And, you know, there's more fundamentally positive factors in the market, today than there were last year.

You know, the bar for the Fed to hike is higher today than it was last year. As we just talked about, the QT taper is likely to be underway. The composition of Treasury issuance is in a better place than it was last fall, and money's actually flowing into fixed income. So we feel a little bit better about the market in this rate sell-off than we did, you know, last year. And, you know, when we were in October, it was sort of a no end in sight mentality, and that doesn't exist today, and that should be supportive of the agency market. But we're gonna stay conservative.

You know, to the extent there's cheapening, more cheapening in the basis, we're gonna cover those mortgages that we bought and we anticipate doing so. And it is advantageous to sell early, and we'll trade it around. So, that's pretty much the story, Trevor.

Trevor Cranston (Managing Director)

Okay. Appreciate the comments. Thank you.

David Finkelstein (CEO and CIO)

You bet, Trevor.

Operator (participant)

The next question is from Eric Hagen with BTIG. Please proceed.

Eric Hagen (Managing Director)

Hey, good morning. How you guys doing? Hey, it looks like the preferred stock is gonna go fully floating rate by the end of June. Right now, the pref's are, you know, around 15% of the equity capital structure. How does your outlook for leverage and positioning of the portfolio maybe respond to the cost of that preferred? And, you know, even at your current valuation and when you look at the environment, do you think it actually makes sense to maybe scale up with more preferred right now?

David Finkelstein (CEO and CIO)

Yeah. So in terms of our capital structure, you're right, it's roughly 13.5% of our capital is in preferred, and Series I's do go floating here in June. And how we look at it is our cost of preferred capital will be, you know, a little over 10% at that time, which is relatively high, but it's also important to note that we're at the highs of the rate cycle. And so when we look at our cost of prep, we look at it over a longer horizon compared to the forwards, and it does come down with ultimate Fed cuts, so to around 9% or thereabouts. And then we compare that level to the asset yield on the portfolio.

When you look at the relationship, even at the spreads today versus asset yields, that spread is actually higher today than the long run average. So we're comfortable with the elevated cost of preferred capital in this floating rate environment, even with the I's going floating, which is, you know, we'll have a relatively immaterial cost burden, less than $0.01 a quarter it'll add to our prep costs. So not that material. And then with respect to, you know, potentially issuing more pref, we like our capital structure where it's at. The pref market hasn't really opened up. There's been a couple of very recent bank transactions, but generally speaking, it's still relatively quiet.

To the extent it does, and, we get some firmness in pricing in the, you know, mid to upper, upper single digits, call it. To be able to issue and potentially even refi, we would certainly look at it. But, we like the low leverage in our capital structure as it stands, and, and we'll keep an eye on that market.

Eric Hagen (Managing Director)

Yeah. I mean, along the same lines, I mean, as you guys scale up with the MSR, is there room for unsecured debt just as a, you know, kind of more effective duration match maybe versus using secured?

David Finkelstein (CEO and CIO)

... Well, look, we have $3.5 billion of essentially cash and Agency MBS on the balance sheet, so we don't need the debt. And right now, you know, as I mentioned in my prepared remarks, a lot of that capital to fund the MSR is coming from excess liquidity. And, you know, we do have ample warehouse capacity, and we compare that warehouse capacity and the cost of warehouse financing through debt markets. And the fact of the matter is that issuing unsecured debt would be funding that MSR at a cost that's much higher than, you know, term committed warehouse financing, and so it wouldn't make sense for us, and particularly given the fact that we don't need the liquidity to go to the debt markets. So certainly it's not something we're actively considering.

Eric Hagen (Managing Director)

Yep. Thank you, guys. Appreciate it.

David Finkelstein (CEO and CIO)

Thanks, Eric.

Operator (participant)

Again, if you do have a question, please press star then one on your telephone keypad. The next question comes from Kenneth Lee with RBC Capital Markets. Please proceed.

Kenneth Lee (VP)

Hey, thanks for taking my question. Good morning. Just one for me. You mentioned in the prepared remarks that dividends are set appropriately for 2024. Wondering if you could just further flesh this out. Is this dependent upon rate volatility to potentially decline, or does it depend on a, on a certain Agency MBS spread range? Thanks.

David Finkelstein (CEO and CIO)

Well, you know, it's a function of where the asset yields on the portfolio are and looking at the forwards and trying to give some guidance for a little bit further out the horizon, given the fact that we're lower levered. Just an attempt to provide a little comfort that we can operate at lower leverage and still generate a yield that is certainly competitive. And it's the durability of the earnings power of the portfolio that I just wanted to highlight there. And now, look, quarter-over-quarter, EAD is going to ebb and flow. But when it comes to the economic earnings of the portfolio, we do feel quite good about covering it. You know, the second quarter, our NIM will go up very modestly, we anticipate.

And in the absence of a shock to the market, we feel reasonably good about where the earnings picture is for 2024.

Kenneth Lee (VP)

Great. Very helpful there. Thanks again.

David Finkelstein (CEO and CIO)

Thanks, Ken.

Operator (participant)

The next question comes from Merrill Ross with Compass Point. Please proceed.

Merrill Ross (REIT research)

Thank you. I wanted to ask about the lower swap benefit, and I expect that would continue. The hedge ratio dropped to 97%. Maybe you could give us a ballpark for where it would be as the positions expire throughout the year, and-

David Finkelstein (CEO and CIO)

Yeah. Merrill, it was a little difficult to hear you on that, but, what I think you asked is about the roll down on the, on the, hedge portfolio and where the hedge ratio, would go. So just, real quickly, when you look at our, our swap book currently, we did have roughly $5 billion roll off in the first quarter. The second quarter is very light. It's actually just $1.25 billion. And when we look at that front-end swap position, 0-3 years, it's roughly $18 billion, notional, and it has an average life of, average maturity of 1.46 years.

So if you think about it, over the next three years, you know, we're gonna tap that on average in a year and a half, and so it's pretty evenly distributed. Now, the way to think about it is as those swaps run off, also what's happening is Agency MBS are running off. And when you look at the asset yield on our portfolio, which is in the 4.80s on a book yield basis, and you look at reinvesting that runoff into new Agency MBS and production coupon MBS at a yield somewhere in the 6.25 range. Right, Srini?

There abouts.

Thereabouts. So what you'll see over the next number of years is a pretty orderly runoff of the hedge portfolio, which we'll replace out the curve and make sure that we're hedged for the environment. But also you're gonna replenish yield by reinvesting agency runoff and increasing the asset yield over time. So we like the hedge portfolio where it's at. We'll manage for the environment, and we're gonna stay reasonably well hedged now.

Merrill Ross (REIT research)

Thank you.

David Finkelstein (CEO and CIO)

Thank you.

Operator (participant)

At this time, there are no further questioners in the queue, and this does conclude our question-and-answer session. I would now like to turn the conference back over to David Finkelstein for any closing remarks.

David Finkelstein (CEO and CIO)

Thank you, and thanks everybody for joining us today. Have a good rest of the spring, and we'll talk to you next quarter.

Operator (participant)

The conference is now concluded. Thank you for attending today's presentation, and you may now disconnect.