Dynex Capital Inc (DX) 2017 Q2 法說會逐字稿

Good morning. My name is Lisa, and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Inc. Second Quarter 2017 Earnings Conference Call. (Operator Instructions) I would now like to turn the call over to Ms. Alison Griffin, Vice President, Investor Relations.

Thank you, Lisa. Good morning, everyone, and thank you for joining us. With me on the call today is Byron Boston, President and CEO; Smriti Popenoe, CIO; and Steve Benedetti, CFO and COO. The press release associated with today's call was issued and filed with the SEC this morning August 2, 2017. You may view the press release from the company's website at dynexcapital.com, under Investor Center as well as on the SEC's website at sec.gov. Before we begin, we wish 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 considerably 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, 2016, 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 the streaming slide presentation, which can be found through a webcast link under Investor Center presentation on our website. The slide presentation may also be referenced by clicking on the Dynex Capital Second Quarter 2017 Earnings Conference Call link on the presentation page of the website. I would now like to introduce and turn the call over to CEO, Byron Boston.

Thank you, Alison. Good morning, and thank you for joining us. There are several key points we would like to make today in our comments. One, we continue to believe this is a great time to be a mortgage REIT and generate an above average dividend yield. There are potentially strong tailwinds for the industry as we look out over the next 5 to 10 years. However, global risk remains high. As such, we have been making portfolio adjustments to increase the liquidity in our portfolio and to continue to emphasize the highest credit quality asset. In addition, the growth in our balance sheet will help drive earnings as we increase the overall liquidity in our book. Now I'm going to return the call over to Steve Benedetti, our CFO.

Thanks, Byron. I'm on Slide 3, if anyone's following the presentation. And I'll quickly review our second quarter and year-to-date results. We've earned 8 -- We earned $0.18 -- excuse me $0.19 in core net operating income this quarter and paid an $0.18 dividend. Year-to-date, we've earned $0.34 and paid a $0.36 dividend. Book value per share declined 1.9% to $7.38 from $7.52 at the end of the first quarter. And for the year, book value was up 2.9 -- 2.8% from $7.18 at December 31. Total economic value for the quarter was 0.5% and we've had a solid 7.8% year-to-date. The important thing to understand about our earnings is our diversified portfolio once again prove to be very beneficial. The positive impact of our prepayments from our commercial mortgage securities portfolio more than offset the negative impact of faster speeds in our ARM securities. So far this year, spread tightening in our commercial portfolio has mostly offset spread widening in our adjustable rate mortgage portfolio. Moving to slide 4. We have a -- we have diversified our fixed-rate mortgage securities portfolio by adding fixed-rate securities backed by residential loans. This brings our total fixed-rate portfolio to $1.7 billion. It's important to note that the positive convexity of fixed-rate securities backed by commercial loans will help mitigate the impact of the negative convexity from the residential securities in our portfolio. We've also continued to reallocate capital from our lower yielding ARM portfolio into the higher-yielding, fixed-rate portfolio. By increasing our investments in the residential fixed-rate securities, we materially increased the liquidity of our balance sheet. In a challenging global risk environment, liquidity is extremely important. Fixed-rate residential mortgage securities give us the ability to adjust our risk position rapidly. We increased the size of our interest earning assets this quarter, reflected in the increase in our adjusted leverage. With an increase in our portfolio -- with the increase in our portfolio, the high quality, highly liquid securities, we fully intend to increase the size of our balance sheet further in the third quarter.

Despite the higher leverage, we actually have increased our ability to manage risk, because of the increase in the liquidity of the investments. One of the most positive developments in 2017 has been the fact that the highest credit quality security with the most liquidity also offers the most attractive return opportunity. As we have done over the past 10 years, we've strategically allocated capital to be -- to the most attractive risk-return opportunity. Hence we are increasing our return, our credit quality and our liquidity as we grow our fixed-rate mortgage securities portfolio. Let me turn the call over to Smriti Popenoe to discuss our investment strategy.

Thank you, Steve. Let's turn to Slide 5 and take a look at the current portfolio on leverage. The diversity of our portfolio is displayed in the bar chart on the left. Over the past year, we've decreased the size of our lower yielding ARM portfolio and reallocated capital to higher investment returns in our CMBS IO portfolio, our fixed-rate commercial MBS portfolio and our fixed-rate residential MBS portfolio.

On the right, you can see we have also increased the size of our balance sheet in the second quarter and we fully intend to continue to increase the size of our balance sheet with highly liquid, high-credit quality securities. Let me note that the leverage numbers in this chart include the impact of TBA securities that are currently on the balance sheet.

On Slide 6 and 7, we have 2 different graphical views of our portfolio strategy. The first chart on Slide 6 gives us a visual of where our portfolio sits today. As we have said many times, we have gone up in credit and up in liquidity. This has not been a difficult decision for us, because asset prices are high and credit spreads are very tight across the entire investment opportunity set. Hence, we're happy to be at the top of the credit and liquidity spectrum, as displayed in the chart on Slide 6. Also note that in our 30-year history, Dynex has invested in every asset class on the left side of this page. Our disciplined approach to capital allocation and risk management along with the superior returns offered currently in the 30-year MBS sector warrants that as we continue to grow our balance sheet on the upper left box of this page. Today, on -- 97% of our portfolio is either Agency guaranteed or AAA-rated. Slide 7 is simply another graphical view of this strategy. On Slide 8, we offer more information about how we see our 30-year MBS purchases fitting into our overall investment strategy. This is the first time since 2008 that we view the risk-adjusted returns offered in the 30-year sector to far exceed other options. We recognize that the growth of Central Bank balance sheets have resulted in high asset prices and high and tight credit spreads. We're also aware that Central Bank would like to reduce the size of their balance sheets, which could have an impact on 30-year spreads over time. But we're also aware that their overall goal will be to create a slow, methodical, well-telegraphed process. Hence, the probability that their balance sheet reduction will be manageable for the investment community is high. Nonetheless, as you know, we are in uncharted territory in the global capital markets. We believe that if spreads widen on this high-quality, high-liquidity sector, it will only create a better return environment to generate attractive dividend yields. We are positioned with the capital and liquidity to take advantage of that opportunity. On Slide 9, we reiterate our macroeconomic views, which you may have heard us talk about before. In general, global fundamentals have improved but remain fragile. And the economic environment, we described as fragile for a variety of reasons. The first is that global debt is high and continues to increase. We have yet to hear a proposal out of Washington D.C. that will increase economic activity without a material increase in debt. Since 2008, despite the financial crash, global debt has continued to rise. These debt levels lead the global economy vulnerable to exogenous shocks. And historically speaking, debt binges rarely have ended without paying. The second reason we think the economy is fragile, is that the global geopolitical environment is extremely fragile and uncertain. Thirdly, we believe government policy will drive returns, this is something we'd said since 2008. No one knows what these policies will be. The executive branch of our government is unpredictable at this time, the legislative branch is unpredictable at this time and we expect to have 4 new members of the Federal Reserve Board of Governors appointed within the next year. There is more to our macro view, but let me emphasize that we're happy to add more liquidity to our balance sheet in this type of environment. On Slide 10, we reiterate the positive long term factors that will impact our company in the future, and really these are what forms the basis for our investment thesis. First, U.S. demographic trends are driving a significant increase in household formation and therefore, more demand in multifamily and single-family housing. This is why we're in the housing sector. Second, global demographic aging trends are driving a demand for income and yield investments. Third, you've heard us talk about this a lot, as government participation wanes, there's a large need for private capital and expertise in managing these complex assets in the housing finance system. And finally, the regulatory environment outlook is improving and could provide both investment and financing opportunities in the future.

On Slide 11, we describe how we're positioned to take advantage of these opportunities and also our risk posture. In terms of interest rate risk, we have structured our portfolio to be more interest rate risk neutral. And we have now included hedges incorporating the risk profile of 30-year RMBS, and as Steve mentioned, added interest rate swaps to manage our exposure to increase in financing risk. In terms of spread risk, we recognize that credit spreads are tight, however, we're really concerned with 2 major issues: First, we are uncomfortable with the tight spreads in lower credit rated and less liquid instruments. Second, as we have already stated, we find the current spread levels in Agency fixed-rate RMBS to continue to offer attractive long term returns. If spreads widen in this highly rated, highly liquid sector, we believe it will present an even better opportunity to generate attractive cash dividends over the long term and we're positioned accordingly. In terms of credit risk and liquidity, we continue to favor high-credit quality and highly liquid securities and we are positioned to take advantage of spread widening. I'll now turn it over to Byron to summarize.

If you'll start at Slide 13, let me summarize a few key points. Year-to-date, we've paid $0.36 in dividends per common share and reported core net income of $0.34 per common share. Second, we continue to believe the diversified investment strategy will generate superior risk-adjusted returns, given the complimentary cash flow and risk profiles of the commercial and residential sectors. There is a unique opportunity to generate returns in the 30-year, fixed-rate RMBS sector. We're allocating capital out of ARMs and have doubled our position in the 30-year sector since June 30, 2017. We expect to continue to opportunistically invest in this sector, which will help drive earnings for the remainder of the year. The risk-adjusted returns and the liquidity of the 30-year fixed-rate RMBS more than compensates for the relatively higher duration drift versus less liquid ARMs. The incremental liquidity also gives us the ability to shrink or grow the balance sheet rapidly. The global macro environment is still complex, you've heard us say this for a while. And asset prices are high. And the potential for spread widening is elevated. Finally, we have an experience management team and internally managed structure that creates shareholder alignment and a long-term history of disciplined capital allocation. Finally on Slide 14, one of my favorite phrases as always, I would like to remind you, long-term value is driven by above-average dividend yields. And with that, we'll open the call for questions.

(Operator Instructions) Our first question comes from the line of Bose George with KBW.

It's Eric on for Bose. I'm hoping you can actually tell us how much duration a typical Agency CMBS I/O position carries? And how sensitive do you think that duration is to backup an interest rate? You guys talked about spread widening. If you can get a little more clear on just the CMBS I/O position.

Sure. The duration on a new CMBS I/O, Eric, is about 4 years. And -- no see the -- it's complicated in the sense that -- the duration is about 4 years, the instruments are priced on the back end of the curve on the 10-year part of the curve. So you really have to incorporate both of those things in calculating the price sensitivity.

You should also note that the -- I think about 50% of our IO book was originated, Smriti correct me, prior to 2014?

Yes.

So we've been accumulating this book piece-by-piece for the last 7 years. We like the book, we think it's a core part of our portfolio. We think it's actually a natural fit for a mortgage REIT, because -- as Smriti said, it's maybe priced off along in the curve because the long duration of fixed-rate CMBS, but it actually is the duration is really on the short end of the curve. It cash flows every month and it rolls down the curve nicely. So just some additional thoughts.

We can give you a call offline also, just to walk you through how we do it.

No, that's really helpful. I'm just trying to get a sense, given your comments on spread widening and your caution around interest rates, just where that duration is concentrated. But that was a very helpful answer.

So -- let me emphasize on this. The interest rates and spread widening are 2 different things. I'm not worried about interest rate so much on this portfolio, we can deal with the interest rates. We do spend a lot of time discussing the spread widening across all sectors. And in the mortgage REIT portfolio, as I'm sure most of you've learned, spread widening is an event, is a risk that we all take. So another reason why we get excited about increasing the liquidity of the balance sheet, when you are in a kind of strange spread environment, such as this. That liquidity is really important, but over the long term the CMBS IO book is probably one of the better assets you can have in a mortgage REIT portfolio. But trust me, we are very much so on edge about where spread levels are today.

Your next question comes from the line of Trevor Cranston with JMP Securities.

I guess, based on your comments about the reason why you guys have chosen to increase liquidity and move into that TBA sector. Can you talk a little bit about why you've specifically chosen to concentrate on 30-years versus maybe some shorter duration or 15 years?

All right. Smriti, I'm going to let you take this in a second. But let me just point out, my career started in 1986, trading 15-year mortgage-backed securities. This sector, whenever you're out of a refinance period, it becomes richer, materially richer to a 30-year sector and it just stays there until you enter certain months on a refinance period and buying picks up in the sector. So if you really look at it, you go from a where we are, our -- the largest part of our fixed-rate portfolio is in -- is backed by commercial loans. Then the next you go, and that's generally maybe have a 10- or 12-year final, then you have a 15-year security with the 15-year final, then you've got 30-year. That 15-year, I'd argue, if you really looked at the fact, and I may have to come back to you on that versus a commercial versus 30-year, probably rich versus all the other sectors. So Smriti, you can go on with some more specifics about it.

Right. I think the simple answer there, Trevor, is that 15 years right now just don't offer the same risk-adjusted return. So even adjusted for the shorter duration and less convexity, there is also not that incremental return. The other issue is that the financing offered in the TBA markets in the 30-year sector right now is really compelling in terms of dollar roll. And there is also a lot more choice in terms of specified pools on the 30-year side, in terms of a variety of different instruments that you can pick from. And then last but not least, as Byron mentioned, not that there is a massive material difference in liquidity, but really the ability to get in and out of 30-years is really quite compelling in terms of liquidity.

Okay, that's helpful. And then in terms of reallocating capital away from the ARM portfolio. You obviously sold some ARMs in the second quarter. Can you maybe give us some color on how aggressively you guys might be looking to continue that reallocation or if you're sort of comfortable with the pace that you sold the ARMs at in the second quarter?

Right. Yes, so we're doing this extremely opportunistically, Trevor, and I think we noted in the presentation that the book is down about 40% since the beginning of this year. So but even since from last year, we actually chose to just let the book run off, and we're choosing to do that as well. So to the extent that we see good bids and we like levels that we're seeing, then we're going to continue to sell. To the extent that we don't find that in the market, we're comfortable hanging onto the position until we get the right level. So we don't feel like we're a compelled seller and we're really thinking in terms of the value and the ability to sort of redeploy that capital. But again, just in general, that book runs off at somewhere between $40 million to $50 million a quarter, so there's a natural deleveraging process that occurs. And we're okay, we're just letting that happen if we don't find the right levels in the market.

(Operator Instructions) Your next question comes from the line of Douglas Harter with Crédit Suisse.

Byron, I was just hoping you could help expand on this a little bit more. Sounds like you're describing that the environment still is complex. And just wanted to understand a little bit more as to what drove the timing for the increase in balance sheet this quarter?

Last quarter when we were in a conference call, we wanted to try to remind you, everyone, that we're not an Agency only REIT and that over the life of our -- specially last 10 years, we have allocated capital in a very disciplined manner. I would consider this move that we're making right now similar to the move we made in 2010 and '11 into the CMBS sector, not unlike that at all. And that sector stood there, in our opinion was actually extremely cheap. We didn't have a lot of company in term of how we added the assets at that point in time, that's why that CMBS IO book was built, half of it prior to 2014. So this is a similar situation, where this sector -- it's the highest credit quality, it's the most liquid. And this year after the election and the adjustment in yields and spreads, we find this sector the most attractive. And so when you look at slide, I think it was on Slide 6, where we show you that capital stack, it's pretty compelling to us to say at the top of the stack, both -- I've got credit quality and liquidity. This is a 2017 phenomenon. And it's the cheapest -- and it's the best risk-return profile. At any other time since 2008, I've had other options to invest in, but I would consider this similar to 2010 and '11, when we pushed into the CMBS sector. And at that time we not only took CMBS IO, we went down in credit to triple Bs and single As. And we came out of it that old credits rating in 2014 and spreads would just continue to tighten in. So you -- basically the description is, yes, the world is complex, you heard us say it, that word has been thrown around. But there are a lot of factors that are moving globally right now. And you hear words a lot about uncertainty, et cetera, et cetera. And then you look at where credit spreads are, they are tight. You look at what has happened to debt, debt has continued to increase. And then we see this opportunity, high liquidity, 100% government guaranteed paper offering a best return. Smriti, you want to throw something in on this?

I think the main -- the other main point, Doug, is that the complex environment that we've described has been one where you have bouts of volatility that are followed by periods of -- long periods of calm. So if we're positioned to manage that bout of volatility and survive that bout of volatility and invest during that bout of volatility, then you can reap the benefits during that period of calm. So the complexity is something, just a watch word that we have to make sure that we don't lose sight that, that bout of volatility can come and you need to be able to withstand that. And then the investment posture has to be one that can basically take you through that and then take advantage of that period of calm that follows. Now that's not to say that we believe volatility is going to go down or anything like that, it's just recognizing that there is an opportunity there to earn that incremental return when things do normalize.

And then Doug, I'm going to add again. I don't want to beat a dead horse, but I do really get excited about this. Liquidity, liquidity, liquidity and if volatility comes or any type of spread adjustments come, we know we're on chartered territory with the Central Banks globally. Having a desire to reduce their balance sheets, but liquidity, liquidity, liquidity. Throughout my career, liquidity will keep you in business. And it just so happens that the most liquid instrument right now offers the best risk-adjusted return. We think that's a great opportunity. So that's a long winded way, I hope that gives you some more color in terms of how we're thinking.

I guess, just as a follow-up to that. I guess having put on -- increased the balance sheet in a quarter that was relatively low volatility, I guess, how do you view your position to take advantage of that next bout of volatility?

So I'll start again. Smriti I'm going to let you jump in here. But I'm going to start with the word liquidity. Ultimately if I look back, we can go backwards: 2008, we can go then to the Enron situation; we can go then to the dot-com bubble; we can go to long-term capital crisis; we can go to the 1994, the currency crisis; we can move back to the '87 stock market crash; we can move to the early '80s with a severe inverted curve. The best position to be in was liquid securities, and the Agency sector has made it through all of them. Smriti?

So I'll be one level down on that, Byron. So Doug, the answer to that is, so duration and hedges are one thing that we're focused on in terms of having a more neutral duration position and then adjusting our hedge positioning so that we're incorporating some of that rate volatility that you can see in the 30-year mortgages. So I would also remind you guys that the TBA position relative to the other positions in our book, again, there's positive convexity in the CMBS book, there's positive convexity in the IO book. So we feel really good about the diversification, but we're also cognizant that our hedges have to change, right? In terms of the spread risk, I mean, if we do see an increase in spread ball, our defense is liquidity and the ability to basically get in and out of position and having an unencumbered cash and liquidity position to be able to withstand that, that type of spread volatility. So there's 2 ways you can hedge spread risk, you can either sell out your assets and shrink your balance sheet. We don't think it's the right time to do that because there is this return that we can earn. And so we're defending ourselves with a pretty big liquid assets position and then cash and unencumbered asset position. Does that make sense?

Yes, it does.

And Doug, I'm going to add on that. I'm going to just reiterate one point that Smriti made, which is really a big part of this. The return opportunity for our shareholders to earn a solid dividend here with this environment of bouts of volatility, periods of calm. You know what? That opportunity exists and we're supposed to take advantage of that for our shareholders, and that's exactly what we're doing. And it just so happens that there is a sector that we can use and we feel pretty good about it.

Just the last thing I'll say on this is that we don't feel like we're fully invested in this sector. It's a relatively small percentage of assets and capital at the moment. So we feel like our ability to just sort of grow the position as the opportunities are there, and there have been some opportunities even since quarter end, that we feel more confident that we can actually do that.

I think there are no further questions at this time.

Okay. We appreciate you all joining us for our second quarter call. We look forward to having you join us for our third quarter call. Hopefully we were clear, and if you have any other question we're always willing to have longer conversations off-line. Thank you again. Enjoy your day.

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