Dynex Capital Inc (DX) 2016 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Dynex third-quarter earnings conference call. (Operator Instructions)

I would now like to turn the call over to Alison Griffin, Vice President Investor Relations. You may begin your conference.

Thank you, Operator. Good morning, everyone, and thank you for joining us. With me on the call today is Byron Boston, CEO, President and co-CIO; Smriti Popenoe, EVP and Co-CIO; as well as Steve Benedetti, EVP, CFO and COO.

A press release associated with today's call was issued and filed with the SEC this morning, November 1, 2016. You may view the press release on the Company's website at dynexcapital.com under Investor Center as well as on the SEC's website at SEC.gov.

Before we begin, I would like 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 materially 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 the annual report on Form 10-K for the period ending December 31, 2015, as filed with the SEC.

The document may be found on the Company's website under Investor Center as well as on the SEC website.

This call is being broadcast live over the Internet with a streaming slide presentation that can be found through webcast link under Investor Center, also on our website. The slide presentation may also be referenced by clicking on the Dynex Capital third-quarter 2016 earnings conference call link on the Presentation page of the website.

I would now like to turn the call over to Byron.

Good morning and thank you very much for joining us. I'm going to briefly review our performance for the quarter, discuss the global macro environment and our investment thesis, and provide our outlook.

Early in the quarter, markets were focused on Brexit and related fallout, but as the quarter went on we have returned for a relative period of calm, in which interest rates increased and credit spreads tightened.

Our financial results for the quarter are as follows. We reported comprehensive income of $0.27 per share, core net operating income of $0.20 per common share, a sequential decline of $0.01 per share. And year to date we have earned $0.63 and we have paid $0.63 in dividends.

Book value for common share increased by $0.07 or 1% to $7.76 per share. Total economic return for the quarter is 3.6% and is 8.8% on a year-to-date basis. Net interest spread remained stable quarter over quarter at 1.87%.

Our book value rose during the quarter as the positive impact of tighter spreads more than offset the decline to the rise in interest rates. Our modest decline in core income was driven by modestly fast prepayment speeds on hybrid ARMs and our decision to allow the portfolio to continue to pay down and build liquidity. CPRs on our agency residential securities increased to 18.9% for the third quarter from 17.4% in the second quarter. We saw October CPRs decline to 18.3% and currently expect prepayments to moderate for the balance of the year as seasonal factors dominate.

Turning to our outlook, many of the same factors that we have mentioned in prior quarters remain significant and serve as the underpinnings to our investment and hedging strategies, as shown on slides 4 and 5. We believe that long-term fundamentals -- we believe long term the fundamentals that have anchored global buying yields have not dissipated and there are still several factors that will limit a sustained rise in long-term rates.

In particular, excess global leverage continues to destabilize global growth. Overcapacity, both labor and manufacturing, the inability of countries to stimulate aggregate demand without the expansion of credit and [we gain] income growth will further limit inflation. Demographic trends should also bolster demand for fixed income assets in the future, keeping long-term yields lower.

In the near term, however, we are still faced with extraordinary government involvement in the capital markets, which has distorted asset prices. A subtle shift is also occurring as it appears that central bank policy rhetoric is moving away from quantitative easing and pushing for government to do more on the fiscal policy front.

Near-term, measured inflation in the US is stabilizing and could rise simply due to the fact that energy and commodity prices have modestly improved from their low levels a year ago.

Given this backdrop, the Federal Reserve appears poised to raise interest rates in December. We believe that regardless of whether they raise the funds rate in December, over the medium-term lack of significant progress toward growth and inflation could limit the number and prevent future rate hikes by the Fed.

So turning to slide 6, in this environment we have kept our leverage low and invested in high-quality assets while maintaining a long-duration portfolio position. We continue to believe that the aforementioned factors will prevent a sustainable move significantly higher in interest rates, given a high global debt, moderate inflation and mediocre global demand.

We stated last quarter that we would add duration as rates increased, and the recent backup and rates has resulted in better investment opportunities. So we have added assets thus far during the fourth quarter.

Our portfolio diversification is a key element of our strategy. Our high-quality CMBS and CMBS IO investments reduced our exposure to credit risk versus lower-rate instruments and reduces the overall prepayment volatility in the portfolio. And our agency adjustable rate securities provide complementary cash flows with little extension risk and will benefit if short-term rates rise.

On slide 7 and 8 we provide our outlook for the Company. We are seeing better investment opportunities today versus the last few quarters, due to the steeper yield curve, and credit spreads remain stable. We remain focused on agency-guaranteed assets and a AAA-rated CMBS IOs, as we believe they offer the best relative value over the long term.

We expect to modestly grow our earnings asset balance and leverage in the fourth quarter to position us to help mitigate any negative earnings impact of a potential Fed fund rate hike in December.

Let us turn now to funding costs. In 2016, we chose to reduce hedging positions and related costs, consistent with our macro view that the Fed would be limited in its ability to hike rates. Dynex shareholders have benefited because our effective funding costs have been lower than they otherwise would have been this year.

As we look forward to the future, there are both positive and negative factors affecting funding. We expected funding costs to rise due to regulations, and more recently markets have begun to price in the higher likelihood of an increase in Fed funds in December.

On the positive side, our agency-guaranteed portfolio is poised to fully benefit from money fund reform regulation. This has dramatically increased the cash available and number of cash providers for the financing of high-quality assets.

For those that listen to our calls on a quarter-to-quarter basis, we take a long-term view in our approach to managing this Company and our business. We have constructed a diversified investment portfolio that is generating solid cash flow despite the low-rate yield environment. Because of our willingness to allow the balance sheet to deleverage this year, we are in a position to opportunistically increase our capital allocation, especially more during periods of volatility.

There has been a lot of discussion in the marketplace around agency residential credit risk transfer securities and their place in a portfolio such as Dynex. We evaluate this sector and returns constantly and believe that agency credit risk transfer is an essential factor to the success of our housing finance system, and with entities like Dynex [CAM] it should play a major part.

As currently structured, however, the market for credit risk transfer securities does not yet offer the features or returns we believe are necessary to attract long-term investors such as ourselves. We continue to provide feedback to the GSEs, evaluate long-term financing alternatives and believe that such assets may eventually become part of our investment portfolio.

And now let's turn to slides 8, 9 and 10. These are my favorite slides, especially slide 10. And I just want to make a few points, as I said over and over again for the last several quarters, but I do want to repeat myself.

If you look at especially slide 10, you will see returns over the last 13 years or so. This time period is unique because we've had multiple market cycles. And here are our major points. Above-average dividend yields can be a major driver of returns for our investors in a stagnant level-return global environment. Dividends should help to cushion potential volatility in book value resulting from a very complex and uncertain macro environment.

Changing demographics will drive long-term investment opportunities in the housing finance system. There is a huge need for yield globally, and that will continue to support yield-oriented (inaudible) such as Dynex Capital.

The complexity of the market environment requires vigilance in managing risk and disciplined capital allocation consistent with our long-term philosophy. And please note on slide 10 -- I would urge all of our investors to be patient through this uncertain environment and continue to rely upon our long-term perspectives in terms of the market.

These are my favorite slides. We will continue to use them on a quarter-to-quarter basis. And I would urge you to really focus on slide 10 because you have within this chart every market cycle that one could imagine.

So with that I'm going to turn it over and open the call for questions.

(Operator Instructions) Doug Harter, Credit Suisse.

Can you talk about how you think about hedging strategies of Eurodollars versus swaps, especially in the context of LIBOR increasing faster than repo rates?

Thank you for the question. We have been -- as Byron stated during the call, earlier this year we made a very specific and deliberate decision to reduce our hedging costs by lifting current pay swaps. And we have chosen to really make our hedges in the futures market or using forward starting swaps.

The reason we did that was that was that we had a very explicit view that the Federal Reserve would be very limited in its ability [to rate] hikes not only in 2016 but going into 2017. So we make that trade-off very deliberately. It's based on our macro view.

We think that has been, actually, a winner for Dynex shareholders this year because rather than paying interest expense this year when the Fed really wasn't expected to hike much, they saved that cost over this time horizon and accrued that benefit. We are constantly looking at this in terms of the trade-off between how much it cost us to lock in financing versus where the market is pricing things at the moment. We've chosen to be in the futures market, just given that macro view.

So our portfolio actually got the benefit of lower repo costs throughout this year and we manage that pretty actively going forward.

One other just high-level point on that -- managing our hedging costs, in my opinion, is the most important issue for management in this business at this point in time in this kind of complex environment. Our longer term view continues to be that we may have the Fed be active for some period of time, but I feel extremely confident that we have a global environment that is limited in its ability to withstand materially higher interest rates.

We are very confident also that I believe we have a global environment that can't necessarily withstand a higher yield and flatter yield curve in the US. So, that's in the backdrop.

There is some situations in the short term that we will have to manage through, so we will be adjusting hedges from time to time. But in general, as Smriti pointed out, managing hedge costs is paramount.

Along those lines of managing hedge costs, if I look at the table your pay rate is scheduled to jump from 64 basis points in the fourth quarter to 2% in 2017. How should we think about your ability to manage that extra cost?

So again, part of that pay rate at 2% -- we talk about it just in terms of the impact to core net operating income. And the P&L, the actual market value benefit or detriment, is in our book value. And as we said last quarter, and we will say it again this quarter, you can expect us to really manage how that expense is incurred in our earnings stream.

So that's something, Doug, that you could probably see changing fairly rapidly as we come up against some of those futures contracts maturing.

So what would that look like? Just pushing out the maturities of this (multiple speakers) or canceling some of the current pay for the 2017s and terming them out, just to try to understand what that impact would look like?

Yes, I think it would literally be thinking about what would be futures-oriented hedges versus current pay-oriented hedges and how that trade-off happens. So I don't expect us to make a decision to really change the economic outcome very significantly, but I expect us to really be managing how those hedges impact our economic return and our book value.

And the management of those hedges -- again, that's the point I was making a second ago, that that's a dynamic process, that will be managed and will always be managed. And when I say managing hedge costs is like one of the most important parts of our job.

We are not in an environment -- so, if you looked at us back -- let's call it 2008 through maybe [2011-issuer] so, for about three or four years, we managed it in a very consistent manner because the environment was much more stable in that sense.

Even though it was complex, there was a lot of global risk, it was much easier to tell on a quarter-to-quarter basis what those hedges might look like and what adjustments we might make to protect book value or impact earnings. It's much more difficult today.

Great. Thank you, guys.

Bose George, KBW.

On the asset side, can you just talk about how the spread tightening during the quarter might change any capital reallocation decisions going forward?

Are you referring to the spread tightening so far this quarter?

Actually I was referring more to 3Q, but yes, further you can discuss after quarter end as well. But yes, any changes in how you view the different asset classes.

So there's been a couple of things that have happened in the markets. Over the third quarter we saw a lot of spread tightening pretty much across the board in the risk markets. Okay? But there were a couple of areas that didn't tighten in as much as other areas.

So, for example, Agency CMBS didn't tighten in as much as Agency RMBS, fixed-rate RMBS. And then AAA non-Agency CMBS also did not tighten in as much as a lot of other high-quality assets. So those areas and particularly the IOs, still remain wider than where we have seen level [say] versus year end. All right?

So those are areas that, as the market has sold off, those spread levels have not tightened in. So again, post quarter end what we saw in those particular asset classes, and I'm specifically referring to agency Fannie Mae DUS bonds as well as AAA non-Agency CMBS and CMBS IOs. Those assets have actually not tightened in as rates have gone up.

So with a steeper curve and higher yields, they still offer relatively attractive returns compared to earlier this year.

Okay, perfect.

And let me add one other point because I think this is a really important point. You are going to hear a lot of conference calls and everyone will talk about their strategy doing X, Y or Z.

You are in a global environment that if we think of it from our careers, there's no great absolute returns, per se. There are great relative returns. You are in a zero to negative interest rate environment. And even if the Fed increases or rates rise a bit, you are in a zero to negative interest rate environment.

And the probability that there is a Fed policy error is extremely high, but this environment is backed up (inaudible) is defined by an enormous amount of global debt, conflicting governmental policies. And that's the backdrop.

So when we talk about spreads moving here or spreads moving, little spread movement, this, that and the other -- we are sticking with our strategy. And our major decisions as we think about this historically, in 2014 we went up in credit. We got out of our lower credit rated instruments, and we've got a philosophy of trying to stay high in terms of our overall credit exposures, so with agency and AAA -- and spreads may move around. They may tighten, they may widen. We are trying to lean on the CMBS IO products and the shorter duration instruments that actually amortize this and rolls down the curve. Similar situation in terms of agency ARMs.

So spreads may move here or there. You are going to hear a lot of stories about this (inaudible) advise this strategy, that strategy. We are sticking to our thought process. And there's a defining moment in early 2014 where we said we believe the overall global environment is complex and fragile.

So we made some major adjustments at that time. We haven't shifted. We still got our agency ARMs. We still got our CMBS exposure. Our CMBS is heavily there because we have not taken off the table that you could have a materially surprising lower-rate environment than even where we are today.

So we are protecting ourselves from prepayments. That is come through this year. It has come through in a big way and we are very happy with it.

So I'm only adding that in there because it's just -- spreads are going to move -- I'm not turning over with these type of spreads, these type of variations in terms of spreads. We've got a philosophy in terms of how we structured this portfolio. We believe in it, over the long term. And at the end of the day (inaudible) we are sticking with it.

That makes sense, thanks. Okay, just switching to leverage, can you remind me do you have a target leverage for the portfolio and the different asset classes?

We definitely have a leverage target for different asset classes. The idea of a target leverage, Bose -- we tend to think about it more in terms of how much earning assets we have at any given time and how big the size of the balance sheet is. So our balance sheet is down close to $800 million to $1 billion from the peak levels maybe in 2013.

As far as target leverage per asset class, one of the things we like about the diversified portfolio that we have is that we can earn the same ROEs in the CMBS market by taking a lot less leverage. And that's an attractive feature of that asset class for us.

And so, on average, as Byron mentioned during the call, you can expect us this quarter to maintain or grow the balance sheet because we are seeing these incremental returns. And we are thinking through what we are able to earn. But in general, our target leverage on, for example, the AAA CMBS IOs is substantially lower than what it would be for, say, AAA CMBS or agency-guaranteed MBS. I think our leverage is up slightly quarter over quarter.

Okay. Great, thanks. Actually, just one more -- the comments Byron had made on the CRT market -- in terms of this status you mentioned, Byron, that you don't like some of the features that are being offered. Is that the REIT eligibility issue that's a concern? Or there are a lot of other things as well that you don't like about that market?

So there's a couple of things. One is the way that market is currently structured as a derivative not being REIT-eligible, not being REITed securities, and then also the lack of permanent financing or more durable financing, I would say -- those are things that, being a long-term investor in that sector, they are not features that make us comfortable putting capital in for 10-15 years because that's what that type of investment requires. Okay? So having it be a derivative, having it be not REIT eligible, not having a rating on the securities and then really not having the Street finance it other than in a very short-term repo format -- those are things that we feel will need to change in order for us to really make it a permanent part of what we would look at in terms of investment alternatives.

There are many things that are good about it: the fact that there is a diversification of credit, it's high quality, you can pick and choose the risk spots. All those things are good, but there are some features about it that we are thinking through in terms of what we would need to do to make those types of investments.

And then let me add this on here. I love the credit risk transfer securities. I love the concept. I believe, for our housing finance system, that Washington should lay off all the credit risk that's housed at Freddie and Fannie. There's no reason why we need to have those there.

I'd like to see them take advantage of the current amount of excess liquidity in global systems, where they tried to create, further refine these securities to be attractive to the maximum amount of investors globally. So I like the concept of the securities. I think the underlying credit is in good shape because the regulators are really clamped down so hard that there are very few risky loans being made in this overall environment.

But if you listen to our macro view, if you look at how we adjusted our portfolio, you will realize that we are not looking to try to be, I don't know if you would say -- it's not even the right word, isn't even cutting edge. We are really managing our risk in a very diligent fashion. And so -- go ahead, Smriti.

Well, the key point there is, look, we can make 12% returns in different ways and we are trying to hit that efficient frontier, if you will. Right? So, for example, an M3 stacker deal right now creates around 400 basis points. If you lever that three times, you are going to get 12%, 13%, 14% return. You are running that with a repo financing that's highly callable.

We think that there's a better way, a more durable way to make that 12%. You don't have to take as much risk, you don't have to put a non-rated derivative on your balance sheet. There's a better way to do that.

So number one, if I'm trying to make 12%, what's the best way for me to make that 12%? And number two, if I'm going to lock up my capital for that many years or that much amount of time, the amount of risk that I have to take to make that 12% in a stacker versus something else right now -- to us doesn't seem like a good trade-off. And that's also a statement about the returns. Right?

So at some point, that trade-off will make sense. But that's how we're thinking about it right now.

Okay, great. It's very helpful, thanks.

(Operator Instructions) Trevor Cranston, JMP Securities.

Most of my questions have been asked, but I did want to follow up on one of the comments Byron made in the prepared remarks about seeing maybe less focus from global central banks on quantitative easing. I was wondering if you could just talk about how you guys are thinking about the potential -- what the potential impact of less quantitative easing would be, particularly in terms of the longer end of the yield curve and credit spreads. Thanks.

When we say -- it's not less quantitative easing. What they have done is you can hear the dialogue changing and you can hear them begging, basically, the politicians to layer on fiscal policy, so provide some type of fiscal help at this point in time. That's a real change in the dialogue.

The other part of the change in the dialogue -- plus I heard it in Europe this year, is around really the shape of the yield curve and what's happening to banks globally and are they --? That's a secondary element of the dialogue.

Another, third, element of the dialogue is around -- without using the words of systemic risk, they are concerned about risk buckets creeping up throughout the system. I think the Boston Fed mentioned commercial real estate. I don't think they had a very good explanation in how they mentioned that risk, but they did mention it.

So there is some differences in the dialogue that we have heard from this. They are literally begging the politicians, please do something fiscally here because we're almost out of bullets here at this point in time. They are not going to lighten up on quantitative easing from this, but they may adjust how they are doing things. But that's not the point we were making.

I'm going to let -- Smriti, do you want to chime in?

Yes. We watch this stuff, Trevor, as you know, on a pretty minute basis. And one of the things, because we are long duration in our portfolio we have to be very mindful of how much interest rate exposure we have. And that's not only on an outright basis, but where on the yield curve that position is.

So when we say that we have a long-duration exposure, that's correct. But we are very actively managing where on the yield curve that position is being taken. If you look at our earnings presentation at the back, we think and talk about the exposure relative to flattening, steepening, even you guys some definitions of that and also just how the portfolio behaves in these different environments. See you can expect us, very much so, yes, over the long term, there is a long-duration position here but very, very active with respect to where on the curve it is, what are we hearing from central banks, how should we change that position and manage that.

Got it. Okay, that's helpful. Thank you.

At this time there are no further questions. I will now turn the floor over to Mr. Byron Boston for any additional or closing remarks.

I'll just reiterate -- slide 10. If you don't notice any slide, look at slide 10. The purpose of that slide is not to show really Dynex performance versus the other. It's really to show the entire industry and to really emphasize the power of above-average dividend yields over time. And being patient with the sector can really pay off.

And we will see it as we go forward. Global risk is high, but there's an enormous amount of tailwinds behind the mortgage REIT sector, and we are positioning ourselves -- I liked the way Smriti described to you, how do we get 12%. You can get 12 -- or how do we get 10%, 8%. We don't want to stretch for too much yield in this type of environment. It's a low-return environment. All investors globally should be reducing their return expectations in general.

So at Dynex we're going to stick with what we have been doing for the last 13 years, which is keeping very keen in terms of risk, not trying to get too far out on the risk spectrum, trying to deliver cash flows to our shareholders, which we understand is extremely important. And we appreciate you all for joining us on this call. And we look forward to chatting with you at the end of the year. Thank you.

Thank you. This concludes today's conference. You may now disconnect.