Detailed Narrative
Market Developments and Fed Stance
The market saw significant movements in the curve, flattening due to a more hawkish Fed stance under new Chairman Kevin Warsh, who is committed to bringing inflation in line. Swap spreads have tightened, pushing the swap curve down further. The 10-year current coupon spread, after a three-year tightening trend, appears to have leveled off. Volatility, as measured by the MOVE index, spiked around February due to the war and remains elevated, with the index closing at 80 recently.
Portfolio Adjustments and Strategy
The company made fine-tuning adjustments to its portfolio in Q2, rather than significant growth. It shifted slightly down in coupon, concentrating holdings in 5%, 5.5%, and 6% 30-year coupons, moving away from specified pools due to their weak performance. This adjustment was accompanied by an increase in swap positions to better align the hedge book with the portfolio's new profile. The company's share count increased by approximately 1.5% during the quarter.
Funding Costs and Hedge Coverage
Funding costs have been favorable, with SOFR trading through Fed funds and repo funding spreads in the high single digits to low double digits. However, funding levels have started to drift slightly higher due to increasing bill issuance and a slight decline in money market AUM. The company significantly increased its hedge coverage, with 91% of repo funding covered by hedges, up from 72% in Q1, and swap notional balance growing to $10.1 billion.
Dividend Sustainability and Asset Yields
Management assesses dividend sustainability by comparing the dividend yield to the portfolio's GAAP earnings yield. For Q2, the dividend yield was 16.8% and the GAAP earnings yield was 16.7%, indicating strong alignment. While the company expects mortgages to continue cheapening, making the market more attractive for future deployment, current stock trading below book value limits immediate capital raising opportunities.
Management Fee Structure and Expenses
The company's expense ratio saw a temporary bump to 2% due to compensation costs related to share awards, which were 100% stock-based and not expected to be repeated. Management anticipates the expense ratio to trend back down towards 1.7%. The management fee structure is tiered: 1.5% up to $250 million, 1.25% up to $500 million, and 100 basis points for capital above $500 million, indicating potential for positive operating leverage with growth.