The risk management actions we take may lower our earnings and dividends in the short term to further our objective of maintaining attractive levels of earnings and dividends over the long term. In addition, some of our hedges are intended to provide protection against larger rate moves and as a result may be relatively ineffective for smaller changes in interest rates. There can be no certainty that our Manager's projections of our exposures to interest rates, prepayments, extension or other risks will be accurate or that our hedging activities will be effective and, therefore, actual results could differ materially.
Income from hedging transactions that we enter into to manage risk may not constitute qualifying gross income under one or both of the gross income tests applicable to REITs. Therefore, we may have to limit our use of certain advantageous hedging techniques, which could expose us to greater risks than we would otherwise want to bear, or implement those hedges through a taxable REIT subsidiary ("TRS"). Implementing our hedges through a TRS could increase the cost of our hedging activities because a TRS is subject to tax on income and gains.
Trends and Recent Market Impacts
The first three quarters of 2015 were challenging for the entire fixed income market as global economic weakness, particularly in Europe and China, created uncertainty for the U.S. economic and interest rate outlook. This uncertainty fueled interest rate volatility and wider spreads between most fixed income securities and benchmark interest rates, including agency MBS. Against this backdrop, we prioritized risk management, operating with lower leverage and a smaller net duration gap (the difference between the estimated interest rate sensitivity of our assets and our liabilities and hedges), thereby preserving our ability to take advantage of potential future opportunities that we believe could enhance our longer-term earnings potential.
First Quarter Highlights
During the first quarter, U.S. interest rates declined, consistent with the general decline in interest rates across the globe. The yield on the 10-year U.S. Treasury note fell 24 basis points ("bps") to end the first quarter at 1.93%. Despite the modest aggregate decline in interest rates, intra-quarter swings were extreme by historical standards. The yield on the 10-year U.S. Treasury note fell 50 bps in January, increased 60 bps in February and early March, and ended the quarter with another 30 bps decline.
Prior to the first quarter of 2015, we made several changes to the composition of our asset and hedge portfolios that were intended to mitigate the negative impact of interest rate volatility. In particular, we reduced our exposure to higher coupon, generic agency MBS, reduced leverage and increased our hedges, shortening our net duration gap to less than one year. In the first quarter, we further reduced our “at risk” leverage to 6.4x as of March 31, 2015, compared to 6.9x as of December 31, 2014. Our asset composition, inclusive of our net TBA position, was largely unchanged over the quarter with ≤ 15-year fixed rate securities representing 37% and 30-year fixed rate securities representing 58% of our investment portfolio as of March 31, 2015. Our hedge ratio (defined as the ratio of our interest rate swaps, swaptions and net U.S. Treasury position outstanding to our repurchase agreements, Federal Home Loan Bank advances, other debt and net TBA position outstanding) increased to 78% as of March 31, 2015 from 76% as of December 31, 2014, modestly reducing our net duration gap. Together, these actions muted the month-to-month fluctuations in our net book value and limited our aggregate net book value change to a loss of $(0.21) per common share or -0.8% for the first quarter, despite the considerable intra-quarter moves in interest rates. As a result, economic return for the first quarter was 1.7%, based upon $0.66 in dividends per common share and the $(0.21) decline in our net book value per common share.
Second Quarter Highlights
During the second quarter, interest rates reversed course, more than reversing the decline in the first quarter, with the yield curve steepening appreciably during the quarter. The 10-year U.S. Treasury note ended the quarter at 2.33%, 40 bps higher than March 31, 2015 and 16 bps higher than December 31, 2014. The spread between 2- and 10-year U.S. Treasury rates increased 32 bps to 169 bps as of June 30, 2015. Despite the yield curve steepening, option adjusted spreads (“OAS”), or the spread between agency MBS and other benchmark interest rates adjusted for the cost of the embedded prepayment optionality inherent in agency MBS, widened significantly during the second quarter.
Our "at risk" leverage declined during the second quarter to 6.1x and our hedge ratio increased to 84% as of June 30, 2015, while our net duration gap extended to approximately one year, largely as a result of higher interest rates and a steeper yield curve. Following moderate portfolio rebalancing actions taken during the quarter, inclusive of our net TBA position, ≤ 15-year fixed rate securities decreased to 34% and 30-year fixed rate securities increased to 61% of our investment portfolio as of June 30, 2015.
Although we entered the second quarter with a very conservative portfolio composition and our lowest “at risk” leverage level since 2008, the combination of higher interest rates, a steeper yield curve and wider mortgage spreads led to a decline in our net book value of $(1.53) per common share to $24.00 per common share as of June 30, 2015 from $25.53 per common