Dynex Capital Inc (DX) 2018 Q1 法說會逐字稿

Good morning. My name is Kim, and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital's First Quarter 2018 Earnings and Results Conference Call. (Operator Instructions). Thank you. Alison Griffin, you may begin your conference.

Thank you, Kim. Good morning and thank you for joining us everyone. With me on the call today, I have Byron Boston, President and CEO; Smriti Popenoe, EVP and CIO; and Steve Benedetti, EVP, CFO and COO.

The press release associated with today's call was issued and filed with the SEC this morning, May 2, 2018. You may view 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 are risks, please refer to the annual report on Form 10-K for the period ending December 31, 2017 as filed with the SEC.

This document may be found on our website under Investor Center as well as on SEC website. This call is being broadcast live over the Internet with the streaming slide presentation, which can be found through our webcast link on the homepage of our website and on the Investor Center page. Our slide presentation may also be referenced there as well.

I now have the pleasure of turning the call over to Byron Boston.

Good morning. Thank you, Alison, and thank you all for joining our call this morning. It has only been a very short period of time since our last conference call in February. I can say with confidence that we have not changed our overall investment thesis. It is our opinion that, first, we are in a transitional period to a higher return environment. Second, the large amount of global debt and large central bank balance sheets have created a fragile global economic environment.

Government policies will drive returns, but unfortunately the uncertainty around these policies is adding to the fragility of the economic environment creating global markets where surprises are highly probable. As such, our portfolio continues to be heavily invested in high quality, high liquid asset. Because we are anticipating an improved return environment, we continue to maintain a high level of overall liquidity in terms of cash and unlevered assets.

Let's go over to the results for the first quarter. Please turn of Slide 3. Despite the rate and volatility environment, we maintained our cash dividend of $0.18 per common share. Furthermore, we also generated core net operating income of $0.18 per common share. Due to the rising rates in a positive duration gap, we posted a small unrealized 3.6% decline in book value for the quarter. It is important to note that our diversified portfolio helped to reduce the impact of the rising rate environment -- rate environment as our commercial portfolio helped to offset any negative impacts from our residential book.

Throughout the quarter, we were able to hold our leverage relatively steady at 6.4x and as a result we still have room to increase leverage in the future as we are anticipating a better return environment. These results produced a small economic loss on book value per common share of 1.2% for the quarter.

Let's turn to our portfolio composition on Slides 4 and 5. You can easily see how we have chosen to emphasize credit quality and liquidity in our portfolio. We have decreased non-agency assets in our portfolio and we have increased our agency and treasury positions to 92% of our balance sheet.

However, it is important to note that within this heavy concentration in agency assets, we continue to diversify our book between commercial and residential assets, 56% of our portfolio is backed by residential securities while 44% is backed by commercial assets, mainly in the multi-family sector. This diversification is really important to us and has been a key investment thesis with Dynex for the past 10 years.

The commercial assets help to stabilize our duration profile and reduce prepayment risk and fluctuations on a monthly basis. We believe the returns offered in the lower credit, less liquid asset sectors do not compensate us for the overall macro global risk environment in which we operate. Furthermore, the relative return of lower credit assets versus high-quality assets continues to be extremely tight and drives our opinion that the only place to invest marginal cash is in the most liquid highly-rated securities.

Now please turn to Slides 6 and 7 and let me elaborate on our investment thesis. As I mentioned earlier, we believe markets are in a transitional period to a higher return environment that would be favorable for Dynex Capital. Several catalysts have put the transition in motion. One, the U.S. Central Bank's desire to tighten credit and reduce the size of their balance sheet; two, the U.S. fiscal policy is materially increasing the amount of debt that the market must absorb on a monthly basis. In addition, high and increasing global debt levels have created a very fragile economic environment.

Then finally, the probability of surprises has increased -- has increased and is heavily driven by the very uncertain global government policies. As a result of these factors, we are anticipating higher returns in the future. The above factors all point to opportunities to invest capital as long-term accretive returns for Dynex shareholders. A key to our success, we'll be managing effectively through this transition period.

We will manage through the current environment as we have brought our career with disciplined risk management and opportunistic capital allocation. However, the most important component of our current strategy is liquidity, liquidity, liquidity. Our focus on the liquidity gives us investment options to increase net interest income when opportunities arise.

Please turn to Slides 8 and 9. We have $205 million U.S. Treasuries available to redeploy into higher spread assets. We have $225 million in hybrid ARMs that can also be reallocated to higher yielding assets. Also we are covering our dividend with the modestly leveraged balance sheet, which gives us the option to increase earning assets when spreads widen and returns improve. Furthermore, our overall cash and unlevered security position will allow us to weather any book value volatility and deploy capital -- new capital at higher returns.

We fully expect that investing capital at wider spreads and higher returns will be the main driver of above average results in the future. Finally, let me really emphasize that there are long-term trends that support our business model. First, substantial global demand for cash yield will continue to support long-term valuations of mortgage REITs. Simply put the population our investors seeking above average cash yield is increasing and will continue to do so into the next decade.

Second, expanding investment opportunities from the growing supply of assets as the Fed reduces its balance sheet. If the other global central bankers join with the Fed and then get to a point where they also begin to reduce their balance sheet, the opportunity will continue to improve. Simply put, as central bank balance sheets are reduced, assets will have to re-price the levels where private capital will be willing to assume the risk.

Now, to help me illustrate the size of this opportunity, please turn to Slides 10 and 11. There is a great opportunity for Dynex as the federal government attempts to reduce its presence in the U.S. Housing Finance System. There is a consensus throughout our [Washington] that the government should play a reduced role. Hence there is a great opportunity for private capital vehicle such as Dynex.

Let's just focus on the residential mortgage market on Slide 10. This market is an enormous market with $10 trillion in loans outstanding. As you can see in the top graph, $6.2 trillion of these loans are in agency securities. Now note in the lower chart that the government owns 33% of this agency marketplace. This is the first time in our careers that the U.S. government is deliberately reducing the size of their balance sheet and as you can see the amount of the supply is substantial.

There is enough private capital globally to support the government's desire to reduce their overall exposure; however, we anticipate prices in spreads to slowly adjust as the debt best balance sheet continues to run off. These are the factors that make us believe that we have a tailwind for our business. Our management team has the skills and experience to weather this transitional period and to reallocate capital into the best return opportunities for our shareholders.

And then finally on Slide 11, I always like to end on this long-term chart. At Dynex, we are always focused on the long-term. Note, when the lines run together and when they separate. When we have the opportunity to invest our capital at better returns, we fully anticipate that our above average dividend will continue to drive our long-term returns above these market averages. You can surely see that illustrated back into 2008 and 2009, as we deployed capital at much wider spreads at that point in time. As markets adjust into the future over the next 5 years, we believe above average dividends will -- heavy driver of future returns and will overall impact the picture that you see here 5 years out. Thank you. And we will open the line up for questions.

(Operator Instructions). Your first question comes from the line of Doug Harter from Credit Suisse.

Byron, you talked about, at some point looking to increase leverage. Can you talk about, kind of whether -- were there yet or you've sort of preserving liquidity and playing, and now ready to play often?

We're still preserving liquidity, Doug. And what I will say, I don't know if you asked the question -- someone may have asked a year ago about that same question, we say -- we may have one turn of leverage in us and we were about at the same leverage what we are today. So we've been able to over last 4 to 5 quarters to maintain this leverage and continue to generating that appropriate dividend. So we still have room, if we see the right asset. And then in the view [what else is achieved], when we talk about our strategy, we're making a very deliberate decision of which risk we are willing to take. And what we are saying is, we believe in this environment -- in this global environment, we are better off taking a bit higher leverage on really liquid, high-quality asset than taking lower leverage on some of the lower credit quality assets. Same situation existed in '04, '05, '06, unfortunately, many people didn't realize that until some damage had been done in '08.

Got it. And then, if you could just -- along those lines of -- sort of, what you just said of the more liquid assets, but the higher leverage, I guess how do you view, where your -- where your rate risk is today compared to the prior quarter -- in prior periods of time?

And when you say rate risk, you mean --

I guess book value risk to -- yes, if we see a continued move to higher in rates, either, kind of parallel or flattening?

So we have -- we have added more hedges to our book of business. And we continue to -- I'm going to let Smriti get more specific on what we've done, but we have added more hedges to our book of business. And in general, probably be high level. I'm going to let Smriti get a little more specific.

Here's where our concerns happens today. We believe that because of global debt, because of the fragile environment that yields may go up , you have that because of what the government did at the end of last year with their tax cut, there's huge increase in debt. We probably increased the probability that you could push yields a bit higher. We are challenging the thought processes of their ability to hold at higher levels, and it's really a function of the amount of global debt. And we are really concerned about getting ourselves too wedded to a portfolio that has enormous amount of swaps against securitized assets. So we are trading around our position, we are adjusting throughout the quarter. But as of today versus -- if you look back a year ago, we do have more hedges on. Smriti, you want to elaborate?

Yes. So I'll just backtrack for a second on the dry powder question, Doug. In addition to the leverage, there is just another piece in terms of dry powder. So the way the assets are currently allocated, we also have the ability to -- have close to 425 or 450 in what I would call lower yielding assets that can be redeployed at the right time into higher yielding assets and then secondly, obviously there is a leverage lever that we can pull. So there is more than just one way to increase your net interest margin. One, obviously is to take leverage up, but the other is to redeploy those assets. And at this point, if we don't feel like we have to increase leverage or the opportunity isn't so fantastic, we're going to pick redeployment over leverage. On your risk question, so if you can look at Page 20 in the deck, we show you our risk profile in December versus March. Our net exposure to a parallel up 50 is down slightly, but you'll see really where the hedges are in the back end of the yield curve, that's where most of the new hedges that have been put on have been. So the steepening exposure is actually substantially less versus December. So you can see that on Page 20 there. In terms of -- just again, I know a lot of guys have been asking, so I'll just preempt the question. Versus the end of the quarter, our book value is down very minimally versus the end of the quarter. So we've had a pretty big rise in rates and not had much of an impact on book value.

Your next question comes from Eric Hagen from KBW.

My first question is on hedging, just to follow-up to what you were, maybe just talking about. Just the $1.6 billion in forward starting swaps, can you just tell us where on the curve those sit and just how far out in time they start?

Yes. Those are 1 to 2 years out and they're between 5- and 7-year hedges. So once they start, they pay for 5 to 7 years.

And then just --

-- around the curve as you can probably see on the risk charts as well. They're hedging the belly in the back-end.

My next question is just on liquidity. Can you just discuss the liquidity and just maybe the competition for CMBS IO, right now? And just how that spread, just maybe the levered ROE compares for those assets versus agency pools and TBAs?

When you say liquidity, do you mean just the amount of ability to sell assets and buy assets?

Yes, I mean I guess liquidity just in the sense of what Byron was talking about in his opening comments.

Okay. So more in terms of the ability to -- yes, the type of assets. So right now, I would say we have emphasized higher liquid positions. Our leverage actually without our TBA position is at 4.9x versus the 6.4x that we reported. And we talk about that because it's very easy to reduce that leverage that extra 1.5x, if we think the opportunity exist to reduce it or even take that up, so that's one thing. So having that flexibility, I think in a liquid instrument is very important. That's one reason we shifted to a more liquid strategy, because we wanted to have that flexibility to take it up or take it down, because that's what this environment needs. In terms of our ability to trade things, I would say again the more esoteric a particular asset is and more sort of unique the instrument is, it is harder to treat those assets, and that's one of the reasons liquidity really matters. The second thing I would say, the part of your question on CMBS IOs, those instruments have not made sense for us on a levered basis -- levered ROE basis. We see the returns on those market leverage at around 6% to 8% right now, where you can finance them in the open market and they don't offer that -- a compelling return, relative to pass throughs, which again are [sittings] depending on the coupon and depending on how much credit you give yourself to the roll, those are sitting closer to the mid double-digits ROE and depending obviously on the leverage assumption that you use, but we think of those in terms of 10x to 12x leverage and the returns are somewhere between 12x and 15x leverage. So much better returns on a much more liquid instrument relative to the IO's and as we've said on these calls before, we're letting that IO book runoff as a result.

Thanks for getting specific with ROE. That's helpful.

Your next question comes from Trevor Cranston from JMP Securities.

You guys have talked a lot about the focus on more liquid securities in the near-term and also your expectation that we're in a transitionary period to a higher return market. Can you maybe elaborate on how you're thinking about the balance between holding more agency MBS, and the risk that poses to your book value in the near-term, potentially if spreads are to widen as the Fed removes itself from the market versus the carry would give up in the near-term, and incrementally more dry powder you would have, if you were just running with the lower leverage currently?

Trevor, I'm going to let Byron take the first crack at that and then I'll give you the second thing.

If you wanted to trade off, Trevor -- and it's one that we make on a daily basis. I feel and I'm trying not to sound like it, as I always feel a guy to you like an old country preacher, because I am very excited about the position that we've got by having this type of liquidity. Smriti brought up something a second ago, which is that we can take our leverage down relatively rapidly. Likewise, we can move our leverage up, if necessary. And so if you trade-off, Trevor, on a -- that the key part of this business is that, it's a trade-off. Why do I like the liquidity? Because we're prepared for surprises. At the end of the day, that's what we're prepared for, surprises. And so -- as I stated earlier, we believe that the power of investing the dry powder at wider split will offset any book value volatility in the near-term, that's our opinion.

Smriti, do you want to be more specific --

Yes, I mean, I think you actually said it in your comments, which is that we're sitting here at 6.4x leverage, we're covering the div and we have options to raise that earnings power either with the reallocating assets or increasing leverage. And that idea of -- if we really felt very strongly that agency MBS was the place to go, they would be a lot bigger percentage of our total assets than the 30 something odd percent they are today. So I think we're expressing a cautious view by stepping in to the amount that we are, we believe we have the flexibility to change up or down based on whether we think there is a big widening coming or not, but it's given us the opportunity to make that dividend coverage now and then fully expecting that, we'll be able to take advantage of any wider spreads by deploying capital at that time. We have excess capital, obviously, that's why the leverage is sitting down here to be able to deploy at the wider spreads and better returns.

Here's what I would say to my shareholders, we are in an environment -- we believe that the power of being able to put capital to work at these wider spreads, when I look at slide -- a long-term chart on Slide 11, the power really been able to put capital to work at wider spreads, especially if you're saying that the agency product -- high quality product really widened out, it's really very, very -- it's a meaningful return opportunity that we believe will be created and it will offset any of the -- over the long-term any of the volatility that may be created in the short-term. That is truly what we believe here and that's what we've experience throughout our careers and as I emphasize always with every shareholders, we are always thinking about the long-term here at Dynex, where all shareholders will have long-term exposure to the company.

I mean, the other point I'd make on that is that -- we're not here trying to expose ourselves to what we think is a permanent widening. If that happens, that's the reason to have the flexibility to take the position up or down.

And then last question, with the widening we've seeing between 3-month LIBOR and like agency repo rates in the last few months, can you guys comment if you have a view on whether or not you expect that current relationship between those rates to stay at current levels or widen or potentially normalize over the rest of the year?

Sure Trevor. So, we do have an opinion. Our view is that, that spread has gotten out to a pretty wide amount at this point and starting to narrow back in. It's a function of some near-term factors and some longer-term factors. It is a structural change in the environment. We don't believe it's going to stay here at these levels, but it's not going to narrow back to the levels that it was say a year ago or pre the tax law change. So there is a structural element to this that is going to maybe put back something in the order of 10 to 15 basis point back into that basis that didn't exist before. So when we think about long-term returns and how we're evaluating our [paychecks] positions for example, there is going to be a near-term tailwind maybe over the next 2 to 3 quarters and then a slow normalization back down again.

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

Is it fair to say that given the rise in your cost of funds that your hedging position didn't sustain, what was going to happening on the short end with LIBOR relative to your repo?

There is actually a timing lag Chris. So some of those -- a lot of it has to do with the dates which our swaps reset, relative to how the repo resets. Our repos reset once a month and the swaps reset once a quarter, so some of it is a timing lag. The other difference really between one quarter and the other is that we had swaps that were existing in the year 2017 that rolled off in the beginning of the year 2018, so we felt the brunt of some that. Even though we had existing hedges to cover those repo, the existing hedges were struck at higher levels. So that was -- that's really the 2 reasons why there's a big jump like that.

How much of that increase was due to timing issue?

I'd had to come back to you that, I mean just -- if I give you, if it helps you on, in terms of how much the repo exactly is covered. Coming into this year we had close to 100% of repo covered. So a lot of it is timing. And then from here -- March 31 onwards, for the next sort of 3 to 8 quarters, we have 70% to 80% of the book currently covered. That gives you an idea of what the future exposure is.

So is it fair to say that because of the timing issue, we should see a reverse effect where your funding cost should actually go down a little bit or has it been equal in the second quarter relative to the first?

I would say further increases are better protected versus -- I'm not sure I could tell you that there is a reverse, but I could tell you that you probably -- further increases are probably cushioned.

And they Byron, for several quarters you've been discussing positioning the portfolio for potential opportunistic time to invest and could you sketch out a little bit a scenario that you sort of have in mind? Is it something where mortgage spreads widen dramatically relative to treasuries or just sketch out what you have in mind in terms of driving us overall strategy, what worst scenario you're thinking about?

Sometimes it's funny people think you're talking about Armageddon or some sort, that's not necessarily what has happened. Let's just focus on the Fed, let's say nothing else happens, but the Fed. Now the one thing that they were very clear about is, they don't want to be the source of unwanted volatility. So they're going to slowly roll that portfolio off. And as it rolls off, the assets have toward private capital, we'll own them. There will be more and more and more assets in the marketplace, both treasuries and mortgage securities. So from what I can take from their public statements, their desire would be, there will be a very slow, low volatility transitional period, which is great for us at Dynex. When you manage a book like this, low volatility is fantastic. So nothing else, everything else remains globally, totally calm, the Federal Reserve continues to reduce their balance sheet and let's say the ECB does nothing but just stops purchases but they don't start to sell theirs and Japanese don't do anything and the Central Bank of -- Bank of England does [that] , but if the Fed reduces that $2 trillion in the mortgage assets that we see there, slowly the assets will move into a price, private capital then own them. Furthermore, again, when I look about the position now, if you compare it versus -- if you go back 8, 9 years ago when we were in IOs, we were in single-family rentals, we were in non-performing, we were in NPLs, we were in triple BBB CMBS, we were single-A rated CMBS, for us to get to where we want to go do that trade, to move down in that sector, again, we have to see those prices adjust. We can make an argument as that you get to a little more -- that's a different type of transitional period and that is just simply slowly allowing assets to run off. Smriti, do you want to add something to this.

I do. I mean one thing that is important to emphasize is that opportunistic doesn't always mean that you have to buy when spreads are wider. One of the scenarios we do think about Chris is that, maybe they don't widen, maybe there is -- right now we actually have a view that they will, but there is a scenario that they don't and then the opportunistic purchases that you go ahead and take the -- redeploy your assets or take that incremental leverage to capture the fact that there is a low vol environment instead of high vol environment. So we see that as both of those -- those situations as opportunities. Our current assessment, knowing and living in these markets for more than 20 years is that when you see this much net supply that's going to come your way, we have not yet seen the impact of that on spreads and to the extent that we're constantly thinking about the demand for these assets and where that demands going to come from. MBS have to compete now with much more attractive treasuries, corporates have widened, so those pressures are sort of in the market and our view is that, yes, there's going to be some widening, but we're constantly looking out for the fact that, perhaps the opportunity really is that they don't move much and then it is appropriate to take the leverage up at that point. I hope that helps.

Chris, one other point I want to make to you on one of the earlier questions. You asked about the cost of funds. We did at the end of last year put on some Eurodollar futures. There are series of contracts for the next -- while they started at the end of last year and they were for the March, June and September contract or $650 million in notional. Those are economically equivalent to hedges of our funding costs, because of the nature of those contracts we can't include them in core, so for this quarter -- the March contract expired for a plus $900,000 that's not in core. That really covers the funding cost from March, 15 to June 15, if you will, because it's the 3-month LIBOR contract. So there will be similar expirations in June and September as well. So, I just wanted to highlight that, you're not going to see that in reducing our cost of funds, but economically it's essentially the same. It is in our comprehensive income from a GAAP point of view, but not in core.

Your next question comes from the line of David Walrod from JonesTrading.

I just -- kind of a generic question. Just given everything that you've talked about globally, you talked about repo availability and I guess the competition that you're seeing among repo providers?

Hi, Dave. Yes, I think that's an appropriate question. We have seen a lot of strength in the availability of financing and the competition to offer us financing. The number of counter-parties proliferating with respect to agency collateral in particular, if you guys recall, 3, 4 years ago people thought, no one would finance agency mortgages and now people are crawling out of the wood, trying to offer us lines. So the competition is -- we've seen new businesses start up, we've seen existing folks that didn't want agencies, suddenly want agencies. We have new liquidity in some of the more esoteric sectors, particularly in the agency CMBS IO market. So it is a better environment, I would say, in terms of both availability and quite frankly that's affecting price. So we are starting to see repo margins come down relative to where the [GCF] markets have been pricing that spread. So it is actually another positive factor, I would say in terms of being a levered investor in here.

Your next question comes from Eric Hagen from KBW.

Just a follow-up on the spread conversation. Can you just remind us how you guys determine relative value with regard to spreads? Are we talking more of OAS factor or we really kind of talking about nominal spreads over benchmark interest rates?

So I always have a saying, which is, you can't OAS. You can kind of -- OAS gives you the directionality of where things are and incorporates a bunch of different things. But the way we really think about, returns over the long term as we look at hedged returns, so you have the yield on an asset, you have to understand the prepayment profile of that asset and then your hedge that you're going to use for that time horizon and we really track that hedged return over time. It's harder to do, it's harder to incorporate borrowing and other things like that, but at the end of the day we're in business to generate a cash dividend that requires net interest margin. That's how we produced net interest margin and leverage is a part of that, but Eric OAS gives us the directionality we really look at things on a nominal spread over swaps and adjusting obviously for dollar price and so on, when we make that. And I'm talking in 30-year MBS, all of our assets, actually we evaluate in the same way, on a hedged ROE basis.

(Operator Instructions). There are no further questions at this time. I'll turn the call back over to the presenters.

Just one more comment. On the funding side, I did forget to mention, there's just a lot more discussion about peer to peer financing and direct financing. These are things that, years ago when -- again we think about the long-term implications of the business, we had seen regulations come into play and the regulations were creating a bottleneck, and the markets have really found a way to get a -- not to get around to circumvent the regulation, but more a way to get buyers and sellers together even in that sector and that direct financing or peer to peer type of financing is another sort of development, I would say just in the last 12 months. That's really coming to ahead on the financing side.

Yes, I think that's -- Smriti we'll end on that comment. That is a very interesting comment, because we did include that, we'll talk about our tailwinds. There's clearly been a new -- there's a new regulatory environment in Washington, D.C., and I can say that in general, the regulatory changes that are there are more favorable to our business model than what was there in the prior administration, and that includes along the funding perspective.

So with that, we're going to finish our call. We really appreciate you guys -- everyone participating on the call and look forward to reporting our second quarter results sometime in July. Thank you.

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