Dynex Capital Inc (DX) 2017 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Dynex Capital Inc. Third Quarter 2017 Earnings Conference Call. (Operator Instructions) Thank you.

I would now like to turn today's conference over to Alison Griffin, Vice President, Investor Relations. Please go ahead.

Thank you, Susan. Good morning, everyone, and thank you for joining us today. With me on the call, I have Byron Boston, CEO and President; 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, November 1, 2017. 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, 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 a streaming slide presentation, which can be found through a webcast link under Investor Center on the Presentations tab. The slide presentation may also be referenced by clicking on the Dynex Capital Third Quarter 2017 Earnings Conference Call link on the Presentation page as well.

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 today. The third quarter was a good quarter for Dynex, as volatility remained low and our strategy of further restructuring our portfolio to emphasize high credit quality and liquidity paid off. As mentioned earlier this year, we adjusted the size of our balance sheet and hedge portfolio to manage our level of earnings and risk posture.

Our results reflect our belief that throughout the quarter that a low-volatility environment would exist and it would allow us to generate solid net interest income.

Let me go through the facts as outlined on Slides 3 and 4. We earned $0.19 while paying out $0.18 in dividends. So far this year, we have earned $0.53 while paying out $0.54 in dividends. With book value rising 1.1% this quarter, we generated a total economic return of 3.5% for the quarter or 14% annualized. We have increased the size of our balance sheet by continually adding additional earning assets throughout the year.

Let me put this quarter into historical perspective. Our portfolio has changed over the past 5 years, but our core investment principles are the same. We have a diversified portfolio of bonds, backed by both commercial and residential loans. The majority of these assets were originated through the U.S. housing finance system, and as a result, we consider our balance sheet a very safe option for the long term because of the relative credit quality of The United States of America. We believe this is extremely important at this point in the global economic cycle where uncertainty is abound.

More specifically, over the past 4 years, we have had 2 major portfolio restructurings. Please look at Slide 5 and 6. First, we began to go up in credit in 2014 as asset prices rose, spreads tightened and the global risk environment became materially more complex. Second, we began to rotate out of our ARM portfolio over the past year, as shown on Slide 5, as we projected that future returns on that book of business could decline materially.

As you can see, we have replaced our ARMs with 30-year fixed-rate securities backed by residential loans. Today, we're comfortable with a portfolio that is majority fixed rate, highly liquid, top credit quality and still diversified. For example, the negative convexity added to our portfolio by the addition of over $1 billion in 30-year fixed-rate residential securities is balanced by the positive convexity of our $2 billion portfolio of commercial securities.

We continue to hold our CMBS IO portfolio because of its unique nature, relative attractiveness and the above average return we continue to earn on this book of business. We slowly and methodically accumulated this portfolio over the past 8 years. It generates a material amount of cash flow monthly, it rolls down the yield curve and, frankly, we may never be able to duplicate this portfolio for some years into the future. Most importantly, the majority of this portfolio was financed with a longer-term committed line of credit.

As can be seen on Slide 6, we've been disciplined capital allocators for the past 10 years, strategically allocating our capital according to our top down view of risk and returns. As such, today, we feel strongly that our current focus on high-quality assets and liquidity will prove to be the best strategy as the future unfolds. As we mentioned earlier this year, we will continue to adjust the size of our balance sheet and our duration to manage our earnings and risk exposure.

Let me call your attention to Slide 11. Our macro view is an important driver of our portfolio construction. Across the globe, we see a pickup in economic activity. However, we consider this growth to be fragile. The 5 main sources of fragility are: One, global debt is at an all-time high and has never decreased despite the 2008 crash. Two, central bank balance sheets have exploded and has been a major factor supporting economic growth and asset price levels. It continues to be uncertain what impact the reduction in these balance sheets will have on global growth. Three, geopolitical risk are high and uncertain. Four, the economic benefits of this pickup in global growth and asset prices has been distributed unequally and hence this has led to a rise in populism and nationalism throughout the global. The results of these various populist movements is uncertain. And then, finally, inflation will be a key wildcard as the future unfolds. The academic community, including our own Federal Reserve bank, continues to be perplexed by both inflation and productivity. Hence, we continue to feel that surprises are highly probable. We also are particularly focused on the fact that over the past 3 decades, all Fed tightening episodes have been followed by rapid reversals and subsequent decreases in interest rates to lower and lower levels. We believe the underlying factors driving these results have not changed.

As a result of our macro outlook, we are happy to be invested in the highest-quality assets with the most liquidity. Furthermore, and most importantly, we can earn a solid return for our shareholders while we are invested in these securities.

Let me once again state that we are not an Agency-only REIT. We much more prefer to have a broader, diversified asset base across various credit instruments. However, given the current structure of asset prices, spreads and returns, we are very comfortable with our current balance sheet.

Finally, I want to emphasize the long-term positive trends that support our business model. One, substantial global demand for yield supports long-term valuations of mortgage REITs. Two, there is a large need for private capital in the housing finance system as the federal government attempts to reduce the size of their balance sheets. And then finally, there is the potential for better returns as housing finance reform is closer today than at any point over the past 10 years.

And then, finally, as always, we will remind you on Slide 13 that long-term returns will be driven by solid above-average dividend yields and risk management. In the long term, it will be managements' response to the surprises that are produced from this changing global environment that will have the most impact on returns.

In 2018, Dynex Capital will be entering its 30th year of existence. The experience of this management team stretches over a period from 1981 until today. Our Board of Directors, senior management, our investment team, our accounts, our back office personnel have experience throughout multiple market environments in a variety of asset classes. More than anything else, we believe this experience will drive value to our shareholders in the future.

And with that, operator, we can open the call up for questions.

(Operator Instructions) And your first question comes from the line of Eric Hagen, KBW.

Eric?

And we will go to the next question.

Yes, let's go to the next question.

Your next question comes from the line of Christopher Nolan of Ladenburg Thalmann.

Chris Nolan, Ladenburg Thalmann. Byron, the increase in AOCI on the balance sheet, could you -- what was driving that? Was that increase unrealized for the Agency book or something else?

Chris, this is Steve Benedetti. It was a combination of things but predominantly on the Agency RMBS and the CMBS investment portfolios.

Got you. And then, going forward, given that, sounds like, you guys are sticking with the strategy of more liquid, higher-quality balance sheet, we shouldn't -- I'm anticipating increased leverage on the balance sheet going forward. What's the peak debt-to-equity ratio you guys are sort of looking at right now?

You said what's the peak potential leverage we might consider?

Yes, please.

So prior, we had been focusing at around 6x leverage, if you go back over -- back beyond 5 years or so ago. At this point, we think of 7x leverage, is not the peak level, but we think of ourselves in or around that, and we'll be managing it around. Sometimes we may be above, sometimes we may be below that level. So in general, one of the adjustments we've made in moving up to a higher-quality assets is to think of our, what we call, our center point of our leverage spot up at least 1 turn of leverage versus it was 4, 5 years ago.

Understood. Final question, and thank you for the color on the geopolitics and your big picture view on things. The outlook that you have sort of reflects a long-term trend of just lower rates, in general. Is -- what would change your perspective on this? What would change your perspective to go further out on the risk curve than you currently are?

So I think I'll give you a little thing, but I think what you said is that you think some things you heard, kind of, reflects more belief in a lower rate environment. What would change that? Am I correct?

Correct, yes.

Yes. So here -- that's a great question. So inflation I listed here, that's a huge wildcard. So when I look into the rate environment and I look at, you heard phrases like 2.40% on the 10-year, 2.60% on the 10-year, 3%. 3% is a ginormous level. And from our perspective, we don't have information yet that says that we can make our way through 3% and sustain that. That in my opinion really has to come along with some type of inflation numbers that actually -- and it's not just a move back up to 2%, because you hear that all the time. You hear the ECB say it. You hear our Fed, they're all -- inflation will go back to 2%. Well, fine. 2%, and then what? If it's going to be 2% and then back down to 1.90% or 1.80%, then you're not really changing the environment much. So we'll be watching closely to see inflation, and that's a real impact to drive into rates. We'll be looking closely in terms of what happens in Europe and the ECB's attempt to make any changes in their current balance sheet strategy that can have some potential surprise impact. We don't believe that all the central banks, Bank of England, ECB, the Federal Reserve of the U.S. and the Bank of Japan, they all went in the same direction. They all started to expand their balance sheet simultaneously. We don't believe that they have the ability to all shrink their balance sheet simultaneously without having an adverse negative impact on the global economy and potentially on inflation. So we're keeping our her eyes closely in terms of inflation. We are managing our book in a flexible sense, in the sense that we feel it's very difficult to predict exactly how the future will unfold, but we must be prepared and have really thought through a variety of scenarios, so we can react appropriately. That's one of the keys of having a more liquid balance sheet. We can adjust both the size of our balance sheet and our hedge exposure in a minute. And we appreciate having that.

Your next question comes from the line of Eric Hagen, KBW.

So am I coming through this time?

Yes, we got you, Eric.

Okay, great. Sorry about that. I'm not sure what happened before. Can you talk about the relative value between owning CMBS IO versus other, perhaps, negative-duration assets in this environment?

Let me give you a philosophy of how we view the CMBS IO. We believe that is a great core asset for a mortgage REIT. It's a shorter-duration instrument. A lot of the times it's priced off of a long end of the yield curve when it's originated. It cash flows every single month, and it rolls down the curve. So we believe we like that as a core instrument for a mortgage REIT business model. We believe that, especially, given that a lot of our IO book is stripped off of multifamily product, it also is backed by federal agencies, that over the long term, this is one of better sector to invest than in the CMBS, if you're going to hold it. It's money good over the long term but being in this part of the capital stack with an IO stripped off of the senior cash flows. So when we look at, lower-credit assets is what we can compare to BBB, single-A rated paper, the longer-duration paper, we must prefer the IO. Smriti, you want to add something to that?

I do. I think the biggest difference between the CMBS IOs and other negative durated assets is call protection, right? So you've got the lockout feature that basically makes these IOs positively convex. It's a major difference between the 2. I think also what makes us favor the CMBS IOs versus other negatively durated assets is the financing that we have. We have committed financing for these assets that makes it very much easier to think through the long-term returns. And then last, but not least, again, you just think about the relative term default risk versus balloon risk, that's another big difference between residential and commercial. So our view is that the long-term ROEs are better in the CMBS IOs, risk adjusted.

That's a very helpful answer. I appreciate it from both you guys. Byron, expanding on some of your comments about how fragile the environment is right now, how concerned should investors be about moves in interest rates being exacerbated by convexity hedging as the ownership of MBS rotates away from the Fed going forward?

I think that issue is probably out in the future. Smriti, what do you think? How far out in the future?

I believe it's a major issue. But again, I think, again, it comes when the supply really hits in mid- 2018. I think that's really why you want to count on experience and the ability basically to have been through these market cycles and understanding how when daily vol is much higher, how do you hedge these things, how do you think about your hedge ratios. That's why we're more vigilant about that. But I agree. Again, it happens somewhere mid-2018 in terms of that.

So it's out in the future, Eric, and it will be more and more of the product is in the marketplace. And the Fed is continually to sit there to allow that volatility to exist. The other thing that we like about our portfolio again, we talk about this diversity. I don't think we've ever been, except in maybe 2008, where -- no, not even then, where we did not have a decent amount of commercial assets to balance the positive convexity of that book to balance out some of the negative convexity of any other residential assets. And the ARM book didn't have that much negative convexity to start with. So that's how we would be thinking about it from our perspective. But at some point, if the Fed really does succeed in continuing down this path for the next 1, 2, 3, 4, 5 years, they will be adding more price volatility back or a negative convexity back into the capital markets over time.

Your next question comes from the line of Douglas Harter, Crédit Suisse.

I think this, kind of, fits in or feeds off of the last conversation. But I guess, just how do you think about how much extra interest rate risk you're willing to take as more of the portfolio moves to more liquid Agency book? And then, just how do you think about the trade-off of risk -- of interest rate risk and the reward from higher returns today?

Here is the challenge on that point. We want to manage and hedge through any adjustment in -- especially, any long-term adjustments in terms of interest rates. The challenge today and what we've been saying since 2014, we've used the phrase, surprises are highly probable. So it's difficult to predict. So think about the last couple of weeks in terms of interest rates. You had all of this talk of a certain guy or this guy being at the Head of The Fed, interest rates go up 10, 15 basis points. Then turn and they go back down in the other direction. And so you're in a period where it's -- the probability of surprise is very, very high. So we want to manage through any type of interest rate exposure. We found out a new piece of information that said, you know what, we're going to 3%, we're going to be adjusting our portfolio accordingly. I, however, really want to emphasize this point. Why I brought up this historical issue about the Fed raising rates and having to rapidly reduce them. Please go to your Bloomberg, and here is the prime example. 1994 and 1995, you will see this increase in rates starting at the end of '93, going through '94 as the Fed tightened credit to only find out in '95, there were rates completely reversed all the way back down again by the end of 1995. I believe and we believe at Dynex that that's highly probable, that because of this huge increase in global debt and because of the fragility of the global economy, the unequal nature of the income distribution, that material movements up in rates will create an environment in which rates will come back down again. And so that's the -- where we sit today. We are fully aware though that there is a ton of information that still has to come out in front of us. We will adjust our portfolio accordingly to new risk opinions as they evolve.

Got it, and that makes sense. I guess, in that context, it looks like, depending on which measure you use, kind of, the interest rate sensitivity did move up this quarter. Is that something that you would expect to continue? Or I guess, just how should we think about sizing of that, kind of, as the portfolio mix changes?

You want to go first?

Doug, it's Smriti. Yes, so I think basically there, there's 2 things. One is just the amount of TBA or 30-year in the mix versus other assets and how that has changed over time. I would say the following, right? Mortgage spreads have come in a fair amount between September and now. I think that a change -- a material change from the level that we're at right now would really take a cheapening of mortgages relative to other asset classes. So our duration did change, that long duration is commensurate with the directional spread movements that we're protecting against. The convexity, as Byron mentioned, is cushioned by positive convexity in other asset classes. And I would say, a move materially larger from where we are now would take another significant, sort of, cheapening or widening in 30 years where we felt the risk-adjusted returns were really attractive enough to increase the allocation to that.

That makes sense.

Doug, can I add one thing? I do think that this environment -- so if you were to look at us over 10 years, let's go back to 2008, we took a stance on the outlook, interest rates, et cetera, and we really literally didn't budge for about 5 years. And we didn't care what the Fed said about inflation going up, rates rose on us, we stuck with our opinion. I think it's more difficult to take that large of a stance today. So by creating a more liquid balance sheet, we have more flexibility to manage this portfolio. What we were doing before was taking advantage of illiquid instruments, we diversified more down the credit stack which is, again, more illiquidity. It was very beneficial for us. But in this environment, I think we'll be challenged to make adjustments and so will all other management teams, which is why I brought up our experience at the end. Smriti, you want to [throw] something else in there?

I think that's a really important point just because we're very cognizant of the negative convexity in the book. Yes, it's cushioned. We expect a delta hedge and manage that convexity. We're by no means sitting here thinking that that's something that doesn't need to be actively managed. And once again, I would say the experience really matters in terms of the amount of time we've each had in the seat managing this type of asset when the Fed has not really been involved, I think that's a big deal right now.

(Operator Instructions) Your next question comes from the line of Trevor Cranston, JMP Securities.

Another question on the Agency portfolio. So obviously, you guys sold down a decent chunk of the ARM book over the quarter. Can you say with the remaining ARMs you have on the balance sheet, are those primarily longer reset ARMs at this point? And is that a category you guys are comfortable continuing to hold what you have left? Or is that something you'll opportunistically look to sell and maybe reallocate into the 30-year sector?

Trevor, it's Smriti again. So yes, the answer is, we do have a mix of what's left. Nothing we own is really that much long to reset. We own some seasoned 10-1s and then some post reset ARMs that really at this point depending have -- they've done relatively well coming into this quarter. But we would be looking to reallocate out of that sector. The relative return between ARMs, even seasoned ARMs with better behaved prepayment versus 30-year are still -- it's more compelling towards 30s. We're just thinking about the timing of that and being opportunistic about it. So we expect to rotate out of the remaining ARMs as well.

Okay. Is the ability to do that more dependent on, sort of, where market spreads are at in any point of time? Or is that, sort of, governed by the liquidity in the ARMs space?

The answer is yes, to both of those things, interestingly. You just have -- it's an interesting market. You have to take the pockets of liquidity when you get them. So that has been in some ways a driver of how we've been opportunistic about selling. And then, obviously, we're very comfortable, for example, just selling the ARMs and buying treasuries or doing something in between before we find the ability to reinvest in the 30-year market. So that's again another strategy that we've been using, just to be very flexible about when the reinvestment happens and timing it appropriately.

Your next question comes from the line of Christopher Nolan, Ladenburg Thalmann.

Byron, given that proposed tax reform might include removing the deductibility of mortgage interest rates, is that one of those events which could create some volatility to market that you'd look to capitalize on?

Boy, that one is -- there is a pretty good list of stuff that we got that could create volatility. That one isn't necessarily up near the top of the list. I think there's a variety of others that are probably much higher than that from our perspective. Policy though is -- I mean, we still believe government policy will drive returns. But as we all know now, policy, whether it's in the U.S. or whether it's overseas, highly unpredictable. And in fact, maybe the most predictable place now happens to be China, which is a totalitarian government. They have full control. But surprisingly, I don't know that I would say that it would be at the top of my list of things that would put towards the volatility that we're concerned as the most.

Yes. I mean, it would actually help our position just because we would expect supply to come down. MBS would be tighter. And I think basically you'd have home prices stop going up as much and less turnover, less refinanceability. So it would tighten spreads, I believe.

We have reached our allotted time for questions. I would now like to turn the conference over to Byron Boston for any closing remarks or comments.

Just to close off, I appreciate all of you participating in our call, and I really appreciate the questions. And let me just emphasize, I ended my opening comments trying to just highlight the amount of time that the personnel at Dynex have been involved in this space. We weren't in peripheral roles, we weren't analysts, we weren't investment bankers. We have been basically capital allocators in these capital markets for a very long time. And when we look to the future, as much as you want to talk about interest rate risk or spread risk, what we recognize is our -- we are going to have to be ready and willing to react to a completely evolving global environment. We believe we bring the skill sets to the table to do it. We're actually very excited about it, because we do believe that if there's some great tailwinds behind the business model, we'll get an opportunity to do it. And we're not -- we don't have blinders on. We're not saying that we predict exactly how this will evolve. But I respect the questions that you guys have, and I'm going to emphasize the last comments we made in my opening remarks, which is emphasizing how long Dynex has been at this, how many different market environments we pulled this company through. And I applaud Steve Benedetti who pulled Dynex through the 1990 -- 1998 asset correction. And I will simply say that we're prepared for the future, and we're looking forward to it. Thank us so much for joining us, and please join us on our fourth quarter call. Thank you.

Thank you for participating in today's conference. You may now disconnect.