AGNC Investment Corp., a giant in the agency mortgage-backed securities (MBS) world, has painted a rosy picture of a "durable and favorable investment environment" emerging in 2024. They confidently declared short-term rates have peaked and MBS spreads have settled into a comfortable range. But a closer look at their Q1 2024 earnings call transcript (link to transcript) reveals a potential blind spot, one that could have a dramatic impact on their future returns – and on the entire MBS market.

While analysts have focused on immediate spread movements and the timing of Fed rate cuts, they've overlooked a crucial detail lurking in AGNC's hedge portfolio: a staggering $8.5 billion in interest rate swaps are set to roll off in the coming months. These swaps, put in place during the period of aggressively rising rates, currently contribute a hefty 20% to 25% of AGNC's total spread income.

Here's the catch: replacing that income won't be simple. AGNC is facing a multi-faceted challenge. First, the economics of the MBS market have shifted. While their current net interest margin hovers near a remarkable 300 basis points, implying an astronomical 25% to 26% return on equity, the actual achievable return, based on current MBS spreads, sits closer to the mid-to-high teens.

As these legacy swaps mature, AGNC's net interest margin will inevitably compress. They can attempt to offset this decline by putting on new swaps, but those will come with thinner positive carry than the expiring contracts. Additionally, while AGNC's portfolio asset yield remains 25 to 30 basis points below current market yields, the gradual process of rolling the portfolio over will only partially mitigate the income loss from expiring swaps.

This creates a crucial dilemma: maintaining their current dividend level could become increasingly difficult, especially if they're unwilling to ramp up leverage to compensate for the income gap. AGNC acknowledges that their dividend policy is driven by achievable economic returns, not inflated accounting earnings. But how long can they sustain a dividend that outstrips their realistic earnings potential?

Here's where things get really interesting – and potentially dangerous. AGNC isn't the only player heavily reliant on these high-carry swaps. Many other MBS investors, including other REITs and hedge funds, likely implemented similar strategies during the rate hiking cycle.

Hypothesis:

As this massive wave of swap expirations hits the market in the coming quarters, it could trigger a domino effect. Investors facing a sudden income crunch may be forced to delever, potentially selling off MBS holdings to reduce their exposure. This, in turn, could push spreads wider than AGNC anticipates, pressuring book values and further squeezing net interest margins.

AGNC's "durable and favorable" environment could morph into a vicious cycle of income compression, forced deleveraging, and widening spreads – a hidden time bomb ticking away in the agency MBS market.

The Numbers:

Potential Impact of Swap Expirations on AGNC's Net Interest Margin

The following chart illustrates the potential compression of AGNC's net interest margin as high-carry swaps expire and are replaced with new swaps at lower carry.

The answer remains to be seen. But one thing is certain: the agency MBS market is entering uncharted territory, and the performance of AGNC and its peers in navigating this unprecedented swap expiration event will be a crucial indicator of the market's long-term stability.

"Fun Fact: AGNC's CEO, Peter Federico, is a former professional football player, having been drafted by the Pittsburgh Steelers in 1988. He transitioned to the financial world, bringing his competitive spirit and strategic mindset to the MBS market. But will his playbook hold up in the face of this looming swap expiration challenge?"