Dynex Capital Inc (DX) 2017 Q4 法說會逐字稿

Good morning. My name is Denise, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Dynex Capital, Inc. fourth quarter results conference call. (Operator Instructions) Thank you.

Steve Benedetti, 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, our President and Chief Executive Officer; Smriti Popenoe, Executive Vice President and Co-Chief Investment Officer; and Alison Griffin, Vice President of Investor Relations.

The press release associated with today's call was issued and filed with the SEC this morning, February 21, 2018. You may visit the press release on the homepage of the Dynex website at dynexcapital.com 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 Dynex -- our 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 on the homepage of our website. The slide presentation may also be referenced under Quarterly Reports on the Investor Center page.

I'd now like to turn the call over to our CEO, Byron Boston.

Good morning. Thank you, Steve, and thank you all for joining our call this morning. It is my pleasure to discuss our results for the fourth quarter and full year of 2017.

In preparation for this call, I looked back and reviewed my comments that I made at the beginning of 2017. Most of our thoughts have not changed. While we have not adjusted our larger strategic views, we continue to adjust our portfolio tactfully to deal with the evolving marketplace.

Nonetheless, there are 2 major differences driving the macro environment: regulatory policy is continuing to become less restrictive and Washington has implemented an aggressive fiscal policy driven by debt.

We continue to believe the markets are in a transitional period that will ultimately lead to a very attractive return environment for mortgage REITs. I will discuss all of our thoughts after I first review our fourth quarter results and our full year 2017 results. On the whole, 2017 was a good year for our shareholders.

So let's first look at the fourth quarter on Slide 3. We finished the year with a steady fourth quarter that helped solidify a strong 2017.

During the quarter, we paid a cash dividend of $0.18 per common share while earning core net operating income of $0.20 per common share. Book value was down slightly to $7.34 from $7.46 at the end of the third quarter.

More importantly, the full year results of 2017 are more interesting. Please turn to Slide 4. The year was marked by a steady decline in volatility despite the year starting with enormous policy uncertainty from Washington, D.C. We earned more in core income than we paid in cash dividends despite the fact that during the first quarter of the year, our earnings were short of our cash dividend run rate. For the full year, we paid $0.72 in cash dividends and we earned $0.73 in core net operating income. During the year, we reallocated capital into more liquid, higher ROE investments by transitioning from hybrid ARMs into 30-year fixed-rate agency securities.

We added hedges to limit the impact of Fed hikes on funding costs, and we achieved -- and we produced our earnings without increasing our leverage in a meaningful way. Year-end 2017, we stood at 6.4x leverage versus 6.3x at the end of 2016.

In addition to the return generated from spread income, we also added 2.2% increase in our book value during the year. Needless to say, we're happy with our results.

Now please turn to Slide 5 for more specific thoughts regarding our focus and results of 2017. And let me just emphasize 2 points. In '17, we continued to emphasize liquidity in our asset selection and in the amount of cash and liquid assets on our balance sheet, and we maintained a diversified portfolio between securities backed by residential property loans and both backed by commercial property loans.

Next, we have 3 slides, Slide 6, 7 and 8, highlighting the shifts we have made in our portfolio over the years. You can see a definitive commitment to the 30-year residential fixed-rate sector.

Let me reiterate, our key reason for this shift: liquidity first. It is our opinion that when lower credit assets are priced to low yields and credit spreads, it is best to move capital into the most liquid, high-quality asset sectors. This meant that we sold the majority of our ARM portfolio as the sector's forward return and liquidity has declined materially.

It also meant that we continue to pass on investing our capital in the lower credit sectors. Another key reason for the shift was that the 30-year sector, despite being the most liquid and highest credit quality asset in the mortgage-backed securities space, cheapened materially early in 2017 to offer very, very attractive forward returns. We have always been very disciplined in our capital allocation decisions, and 2017 was no exception.

Let's turn to Slide 9 and take a look at the macroeconomic environment. As I previously stated, many of our thoughts continue to be the same as 12 months ago. We believe government policy will drive returns. This has been a core tenet of our investment and thought process since 2009.

We believe we are currently in a transitional environment that will ultimately create a more attractive return environment for mortgage REITs. We believe the continued rapid growth in global debt will create a drag on global economic growth and exacerbate any sudden drop in aggregate demand.

We believe that rapid rate increases will ultimately have a negative impact on equity valuations and economic activity, especially given the absolute amount of global debt outstanding. However, as I mentioned in my opening statement, there have been a couple of policy developments that have changed the probability distribution of potential future scenarios.

The U.S. tax cuts will be short-term positive as real cash is pumped back into the economy. However, the negative effects of the resulting massive increase in debt will be the most dominant impact over the long term. These tax cuts, plus increased debt issuance, plus the fact that the major central banks around the globe would like to reduce the size of their balance sheets, has increased the probability that 10-year yields can break through 3%.

Nonetheless, we believe that this increase in rates will ultimately have a negative impact and potentially lead to a round trip in rates similar to 1994 or the 1987 experience.

Please turn to Slide 10 and let's discuss the return environment. At the core of our thought process today is that the return environment will improve as rates rise or spreads widen or both. We are assuming that any meaningful move higher in rates from the current levels will be marked by a steepening yield curve, a positive for our potential future investment opportunities. We are also assuming that as the Federal Reserve Bank continues to reduce their balance sheet, the mortgage assets will have to offer returns that are attractive for private capital to invest. This again is a positive for Dynex Capital.

Discipline will be key to managing through this transitional environment. We will continue to adjust our hedges and balance sheet size appropriately as the market environment shifts. Duration and leverage will be our key variables that will -- that we will adjust through this transitional period. In any given quarter, our duration might swing between 0 to 1. In addition, given that over 90% of our assets are government guaranteed, we have the ability to increase the leverage of our portfolio if we feel the return environment warrants such action.

Now let's review a couple of moments in history that we feel are worth noting. Please look at Slides 12 through 13. I love Slide 12. On Slide 12, we used the 1987 market experience. That was my first year as a fixed income trader. And we use this picture to show you that rapid increases in bond yields can have a very negative impact on equity valuations. And then when equity prices began to drop, bond yields can rapidly reverse and drop as a result.

What this means for our strategy is that we need to be cautious on getting caught with too many hedges against our portfolio if rates rise -- if rates were to decline rapidly.

On Slide 13, we simply show that for -- so far in 2018, we've got a minor glimpse of what can ultimately happen in a much larger manner.

Then look at Slide 14. This is another one of my favorite periods to understand, 1994 through 1995. In 1994, the Federal Reserve Bank increased short-term interest rates and long-term interest rates responded and ultimately rose close to 250 basis points. The rapid increase in raise caused by Central Bank tightening eventually helped create a situation where rates completely reversed course in 1995. As we manage this transitional period, we will be using more hedges to reduce the impact of rising rates while remaining vigilant to adjust those hedges if rates fall or reverse course.

Now let's turn to Slide 15. We continue to believe that favorable secular trends should support our business model. Global demand for yield will continue, demographics support for the demand for yield -- demographics will support the demand for yield even if rates rise. Investment opportunities will increase in the U.S. housing finance system as the government continues to reduce their balance sheets. And reduced regulation should have a more favorable impact on our ability to finance our portfolios.

Let me finish by reflecting on the last 10 years. January of this year marked my 10th anniversary at Dynex. We began to rebuild Dynex's balance sheet in 2008, the worst financial collapse since the 1930s. We had to create a corporate strategy, establish credit relationships, make smart investment and hedging decisions and raise equity, all during a period where many mortgage REITs, along with other major financial institutions, were going bankrupt. We developed our core principles and we have stuck with a very disciplined strategy, emphasizing risk management and opportunistic capital allocation.

Over the last 10 years through December 31, 2017, we have generated a compounded total shareholder return of 143% versus 131% for the Russell 2000 and 126% for the S&P 500. Please see the picture on Slide 17 and do note that above-average dividend yields are very, very powerful force over time.

Throughout that time, we have dynamically allocated our capital in RMBS, CMBS, CMBS IO and loans, taking advantage of the most favorable relative return opportunities.

We have declared cash dividends on our common stock of approximately $392 million or $9.60 -- $9.67 per share over these 10 years. Collectively, our management team averages over 30 years experience managing fixed income related assets, successfully navigating multiple market and business cycles. And most importantly, we are organizing a shareholder-friendly, internally managed structure with significant insider ownership.

Now part of the reason I wanted to give you this recap is that this management team has been in various major capital committee seats in the fixed income marketplace starting in 1981. It is our opinion that above-average dividend yields, such as offered by Dynex common stock and preferred stocks, will be a major driver of returns over time. Compounding large cash dividends will continue to buffer book value by valuations also over time. Most importantly, we are generating our cash income mainly from assets created through the U.S. housing finance system.

These transitional periods have come and gone multiple times throughout history. Please note, 2018 represents our 30th year in existence.

With that, operator, I will open the call up for questions.

(Operator Instructions) Your first question comes from Eric Hagen from KBW.

Byron, I think you said on the -- I think you may have mentioned on the -- in the start of your remarks, tactical versus strategic allocation. Should we think of the move into the longer-duration assets still as a tactical allocation for the portfolio? Or would you say that's perhaps more permanent at this point?

Well, okay. So that's a great question. So the tactical decision -- I really want to refer to these hedging decisions, which I know all of you will want to know, hey, what is your duration gap now? It's moving around, and we're not -- we've moved it around. So this is a tactical decision throughout this quarter, and I gave you an example of 0 to 1. Now from a -- this allocation to the higher credit quality assets is very strategic. As far as I'm concerned, when I look back through history, it's the one sector that has come through every single major transitional period in the markets. So as a company, as a corporation, as a fiduciary of our shareholders' capital, we feel it's extremely prudent that we move to a more liquid, higher credit quality position at this point in the overall economic cycle. Remember, we're a leveraged player, so we are -- at these type of credit spreads, we don't want to leverage lower credit assets, especially when we can generate these type of returns at the top of the capital stack. So that's a real corporate strategic decision. For some, in and out of agencies could be kind of a quick tactical decision, but we're in this for this sector and this cycle depending on how long this cycle takes.

Great. Great. That was great color. You guys also provide some good color on the expected book value change for a more narrow yield curve in the slide deck. But how does that -- how can we think about the changes or your sensitivity for net interest income due to a more narrow yield curve?

So you mean to -- from a book value perspective or net interest income?

Yes, earnings. Yes. I think you give this -- go ahead, Byron, I'm sorry.

I don't know if I can give you an actual number on that but except to say that we definitively and throughout -- and you can see it in our numbers in '17, we definitively added hedges to deal with -- from a net interest income. We've also added hedges from time to time to deal with book value. Smriti, do you want to add something to that?

Yes. I mean, you're asking about repo coverage here, Eric? It's -- we're currently over -- slightly over 100% covered, and we expect to maintain a pretty high level of coverage, somewhere between 75% and 100% coverage with respect to the repos. And in the K, we actually provide you guys a table with that sensitivity. So you'll have that when we release the K.

Your next question comes from Doug Harter with Crédit Suisse.

Byron, you talked about how in some of these transitional periods, rate increases are followed up with rate declines. Can you just talk about whether adding optional hedges make sense in that type of environment? And if so, your current thoughts on that.

I think I'll take it, Doug. So yes, we do think about option strategies a lot. It's difficult -- at this point, I think we've been doing more delta hedging than option strategies. Over time, I think it does make sense to add options. We're looking at options in terms of our ability to get in there and flatten out the profile some. At the moment, we're actually finding it's more capital efficient and income efficient to use nonoption-based hedges. But that's on our radar at all times.

So -- and Doug, I want to go back. I know we've had this conversation before and you've asked that question. We always -- we're considering option strategies and we're making the choice, obviously, due to the delta hedging strategy. One of the main keys has been, we've been in a period of what I would call bouts of volatility and then periods of calm and -- long periods of calm. So if you look at this current cycle, if you go back to November 2016, and you can consider this one long bear market, right? You hit the low at the election and the rates have really risen since then. However, it took a jolt and then you had this long period of declining volatility and really kind of a flat rate environment between 2% and 2.50%. And now you've taken another move through 2.50%, 2.60% up toward 3%. It is uncertain right now whether we're right now in a -- still with this cycle of period of bouts of volatility, periods of calm. That period of calm become really expensive with options -- crushes.

The other thing for us, though, guys, is that our 30-year position is still, I think, 40-something percent of our assets, 42%. So it's not swinging the entire book around as much as you'll see for people with more concentration in that sector. The DUS and the CMBS IO give us a significant amount of positive convexity that we're not dealing with as much duration drift or convexity when we do see the swings. So options-based strategies are definitely on the list of things to -- that we look at relative value-wise. And right now, it just made more sense for us to delta hedge.

Makes sense. And then what is your outlook as far as agency spreads as the Fed reduces its balance sheet? And can you -- included in that, do you expect any carryover into the agency CMBS that you own?

Yes. I'll take that as well, Doug. So our view is that as the net supply later in the year starts to increase. That is either due to seasonality -- mostly due to seasonality, but also because the Fed is going to start to be a not a net buyer of all the supply that's coming out. So later in this quarter, early in the next quarter and through the summer, we really see the net supply picture in 30-year mortgages to be increasing. And we think that's going to be true regardless of whether mortgage rates are at 4% or 4.5%. And that is going to bleed into 30-year MBS spreads. I think that is something that we expect a decent amount of spread widening to come into 30-year fixed-rate sector. With respect to the agency CMBS sector, it's a very different -- it's not your granddad's CMBS, DUS market, if you will. The supply picture is very, very different in that market. The buyers are very different. You've seen a lot of crossover, investors or tourist investors coming in from CMBS and corporates. That, I think, is going to be more technical. It will be more supply driven and it's more tied to sort of IG spreads. So there is and there can be some correlation between 30 years and DUS spreads in real periods of disturbance or disruption in the markets. But I'm -- we're actually thinking that, that market will have some cushioning relative to just the pure 30-year impact from the Fed's lack of purchases. So more widening will happen in the 30-year fixed market than the DUS market as a result of the Fed not participating in that market. DUS spreads could be disrupted on their own, but we're thinking the linkage there isn't as strong.

Your next question comes from Trevor Cranston with JMP Securities.

A follow-up on the last question about the impact of the Fed becoming a smaller presence in the agency market. Can you talk about how you think that will impact the financing and specifically the specialness of dollar rolls as they become a smaller and smaller player?

Thanks, Trevor. So the coupon that they've been the most active in has been the Fannie 3.5 or the 3.5% coupon. We've seen that the roll come off gently in that sector. I think it's more of a demand story than a supply story there. So that coupon is -- we don't own that coupon. We've avoided that coupon for that reason. I do think the dollar roll in that particular coupon really is more driven by Fed activity. Going forward, though, I have to say the rolls in general are going to be impacted by 2 things, which coupon is going to be the production coupon as well as the level of interest rates and the prepayment risk that's within the mortgage sector, all right? So for example, Fannie 4.5s, we expect the roll should be just fine because it's right now not the production coupon, prepayments are low. And generally, that's a high positive carry coupon. Fannie 4s, again, we expect decent roll performance there driven by their prepayment experience and they're not yet a production coupon. 3.5s can be the production coupon. They're the power coupon. So we expect underperformance there. And Fannie 3s are not being really produced that much, but it's also the discount coupon. So it really depends on the production coupon. Fannie 3.5s, I believe, because they've been the Fed coupon, will probably underperform roll-wise the most going forward. But again, it's really dependent on what the interest rate picture is and the actual supply picture.

Okay. That's helpful. Then you guys made the comment that you've been more so focused on delta hedging the portfolio as opposed to optional hedges. With the rise in rates we've seen and the increase in volatility so far in 2018, can you say if there's been any meaningful changes to the coupon distribution you own in your agency portfolios as durations are generally extended? And also maybe provide an update on kind of how you're seeing book value trend so far this year.

Sure. So our book value through -- between December 31 and now is down less than 3%. We have tended to use swaps to hedge our portfolio. We have not gone up or down in coupon in terms of changing that position. We've picked the coupons that we're in for a very specific reason. We have more of a barbel-type strategy in our coupon selection. So our delta hedging is really going to be more active on the swap side. And I just want to clarify something that when Byron mentioned that the duration really swinging between 0 and 1, or those are not hard numbers. They can -- our duration can and will go negative if we believe actively that there's a reason for us to go there. It can also swing longer than 1 if we believe there's a real reason to take that incremental duration risk. And then also, yes, there's some natural duration drift in the portfolio and there's going to be some swinging around as a result of the negative convexity and the pass-throughs. But really, we're making very deliberate decisions in terms of whether we want our duration gap to be closer to 0 or closer to 1 or higher. Those are deliberate decisions. When we talk about it swinging around, we're just not allowing the book to swing around. The other point I'll make again is, at the moment, we are about 6.5x leverage, 6.3x as of December 31. And that leverage, we're not increasing that leverage at this point, right? So that duration gap isn't moving because we're adding a number of securities. That's the other point I wanted to make sure that you guys had. So really, our duration hedging has been in the swaps sector.

(Operator Instructions) Your next question comes from Christopher Nolan with Ladenburg Thalmann.

How many Fed tightenings are you anticipating for 2018?

We have no reason to believe any more than 3. Part of the reason, Chris, that I point out that '94 and '87 experience is the Fed will stop when it's time to stop, and so we sit on the edge of our seats. So I'm glad you asked that question because it gives me a chance to just explain this a little bit better in terms of, okay, fine, let's say there's 3 coming. The Fed is still very, very much so focused on what is the economic development that's in front of them, meaning the economic statistics that are coming out and what is happening in overall global financial stability. So in 2004, our compare period, I was very bearish. It was negative -- far negative duration. It took 1 view. I don't think this is a type of an environment that you can just say that. So the Fed says they want to go 3x, I think these tax cuts kind of complicate things in a sense that we're still not sure how much, what the full impact of this will be. They could go more, they could go less depending on how the overall global economy evolves.

And Byron, as I recall in your comments, you mentioned that you were expecting a steeper yield curve, is that correct?

Yes. So here's the theory behind that, which is for you to really get rates moving, you need growth, you'll need inflation and you need to really see solid inflation. And if you see that, then yield curves should be steepening up or the amount of debt supply that the U.S. government's going to deliver to the marketplace plus the Fed's balance sheet especially starting in the fourth quarter, so third and fourth quarter, has the potential to really pressure long rates more than most people anticipate. Everyone's focused on the fact that the Treasury plans on issuing a lot of debt in the short end of the curve. But we believe that to really have a meaningful increase in rates, there needs to be some inflation along with that, that will imply that the curve should at least steepen up.

Final question, should we view the level of TBAs right now, which are roughly 25% of total assets, sort of the limit as to how much you can grow the TBA book? Or could it grow further?

With respect to the asset tests, so we're going to manage that to be about 25%, Christopher. And we're watching that, obviously, between pools and TBAs. And then to the extent that we have the opportunity to increase pools, then we can commensurately increase the TBA position.

Your next question comes from David Walrod with JonesTrading.

Could you talk about the return opportunities you're seeing in the current marketplace and how you view that relative to share buybacks?

Well, I'll do the -- Smriti, do you want to just talk about the specific return opportunities? And I'll say -- talk about the share buyback part.

Sure. Yes. David, so right now we are seeing 30-year mortgage spreads about where we left off at the end of December. We view that as not yet attractive with respect to adding leverage here. We may, on the margin, replace runoff at these types of returns, but we don't view them as attractive enough to increase leverage.

And David, we view -- we're very serious when we talk about these tailwinds, especially when you consider the government's desire to reduce their balance sheets. We believe mortgage REITs and especially Dynex Capital are in position to play a role in managing these assets as the government continues to unload them on the marketplace. However, capital will be needed to manage these assets. So in past, where you might have been making one set of decisions around buybacks, this future opportunity changes that equation a bit. So we're very excited about that opportunity, but we need capital to be able to take advantage of it, so whereas a few years ago we were quick to turn and buy back stock immediately, we feel there's some other factors that have to be considered in our future decisions.

There are no further questions queued up this time. I turn the call back over to Byron Boston.

As always, we really appreciate you all plugging into our call. Happy to follow up with anyone, and thank you again. We look forward to chatting with you again probably in April. Thank you.

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