Dynex Capital Inc (DX) 2018 Q2 法說會逐字稿

Good morning. My name is Virgil, and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Inc. Second Quarter 2018 Earnings Results and Conference Call. (Operator Instructions)

Alison Griffin, you may begin your conference.

Good morning, everyone. This is Alison Griffin, Vice President, Investor Relations for Dynex. Thank you for joining us. I have with me on the call today Byron Boston, President and CEO; Smriti Popenoe, our EVP and CIO; and Steve Benedetti, our EVP, CFO and COO. The press release associated with today's call was issued and filed with the SEC this morning, August 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 or risks, please refer to the annual report on Form 10-K for the period ending December 31, 2017, as filed with the SEC. The document may be found on the Dynex website under Investor Center as well as on the SEC's 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 the Dynex Capital website. The slide presentation may also be referenced under Quarterly Reports on the Investor Center page on the website.

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

Good morning. Thank you, Alison, and thank you all for joining our call this morning. It is important to us this morning that you understand the core tenet of tenants of our investment thesis. We will be repeating thoughts that we have shared with you before. But we want to make sure all of our investors have a clear understanding of how we are managing our business today.

As you can see, we have been able to continue to pay an $0.18 dividend. We should also see that we continue to earn a solid stream of net interest income. And you should also see that we have been able to -- that we have not deployed all of our capital to date, and we are maintaining flexibility to invest at better returns in the future. Our positions reflect our current macro views, which I will explain after I first go over the results for the second quarter.

Please turn to Slide 3. In general, we had a steady uneventful quarter. As I mentioned, we maintained our dividend of $0.18. We earned $0.18 in core net operating income. We had a small book value decline of 2%. These results were produced -- actually produced a total economic return of $0.04 per share or 0.6%. When considering our results, let me remind you of the Eurodollar contracts we used to hedge our financing this year. We use Eurodollars for flexibility with timing of hedges. For the year 2018, we have a series of contracts totaling $650 million, notional per quarter that expire in March, June and September 2018, respectively.

Sorry about that. I had forgot to turn my phone off, I apologize. Year-to-date, these contracts have had a favorable impact of $2.1 million on comprehensive income. They directly offset increases and financing costs related to fed hikes, and we expect them to continue to do so. Our leverage temporarily decreased at the end of the quarter as we sold assets to redeploy capital and better return opportunities. It is important to note that we continued to reduce our ARM portfolio and to redeploy capital into 30-year agency residential securities. The capital from asset sales was redeployed in July and has resulted in our leverage increasing to slightly over 6.5x.

Now please turn to Slide 4, and let me explain our thoughts. We have a very strong opinion that is reflected in the structure of our portfolio. Furthermore, you should note that the decision to pursue our current structure reflects the fact that our board and the management team at Dynex are in the same boat as our shareholders. We all have a meaningful net worth exposure to the success of Dynex.

Here are the core tenets of our investment strategy. First, we believe the ability for interest rates to rise rapidly and remain elevated over the long term is limited. Why? It is simple. There's just too much global debt. We are in uncharted territory with large central bank balance sheets. And the markets are very vulnerable to surprise events, such as occurred this quarter when there appeared to be political instability in Italy.

Second, we're invested in the highest-quality and most liquid assets simply because this sector offers the best risk-adjusted returns. And we will show you the returns in the later slides. And given that we're a levered investor and that there are -- is a large amount of global uncertainty, and most of all, that the global markets are in a transitional period as the central bankers attempt to change the policy, it is an appropriate environment to invest in high-quality assets that produce a solid return.

Finally, we have repeatedly told you over the past 2 years that there are favorable long-term trends that should support our business model. So while we are able to generate good cash flow today, we continue to believe the return opportunities will improve as the Federal Reserve reduces its balance sheet and more investors seek higher cash dividend yields.

Please turn to Slide 5. So I would put our thoughts -- so how have we put our thoughts in action? We have sold practically all of our ARM portfolio over the past year. For years, this sector was a core part of our strategy. We changed our opinion of this sector when the liquidity and the expected returns declined materially. As of today, we have less than $40 million in ARMs on our balance sheet. We have also increased our exposure to 30-year fixed rate residential securities because it is the most liquid real estate-backed sector, and it offers the best risk-adjusted return across the universe of investment opportunities. Most importantly, this sector has performed well through every major crisis since I began trading in securities in 1987. We have maintained our investments, and our portfolio of securities' backed by commercial real estate because we like having a diversified portfolio. Over the long term, the cost of managing and hedging of diversified portfolio, commercial and residential securities, we expect to be cheaper than a portfolio of only residential securities whose cash flows are uncertain.

Please turn to Slide 6, and you can see another view of the portfolio. As you can see, 90% of our portfolio is United States government-sponsored agency securities. You can also see that 56% of our portfolio is backed by residential securities, and 44% is backed by commercial securities. When you consider Dynex as a hybrid REIT, understand the hybrid or diversified nature of our portfolio consists of a combination of residential and commercial securities. We have chosen to deemphasize, taking more credit and illiquidity risk at this time.

Please turn to Slide 7. Here you can see one of the benefits of our diversified portfolio. Shown in the pictures, simply put, if you look at the size of the bars and consider that the size of the bars correlate with the cost of hedging that security, you should understand why we enjoy diversifying our portfolio with both commercial and residential assets. As you can see in the first column that the Dynex portfolio was more stable than the second column of residential-only securities. And as a result, we expect that hedging and managing a portfolio -- a diversified portfolio to cost less over time. Another very important benefit that is not shown on this page is that the commercial securities have helped reduce the prepayment risk of our aggregate portfolio over the past 10 years.

So please turn to Slide 8. This is important slide because we want you to see how we view the return opportunities. We're excited that in this world of elevated uncertainty that the highest quality most liquid asset offers the most compelling levered risk-adjusted returns. The current structure return reflects yield compression as market participants reach for outright yield by sacrificing credit quality or yield. The underlying driver of this behavior is a function of the global central bank monitoring policies. We believe that it is highly probable that the current structure of yields will adjust in the future as central banks attempt to shift their policies to a more restricted stance. As we wait for these adjustments, we believe it is appropriate to take the leverage risk of investing in the top of the capital stack, as shown on Slide 8, and the flexibility that, that provides.

Now please turn to Slide 9. And note that you have seen Slide 9, 10 and 11 in prior presentations. We repeat them here because we stick to our long-term investment thought process as we manage the Dynex portfolio. There continues to be favorable long-term trends for this business model. As the future unfolds, we believe the large amount of cash dividends generated by this business model will be a huge differentiator of future returns. To generate this cash, we believe there will be more opportunities to invest as the Federal Reserve reduces its balance sheet, regulators push to increase private capital on the housing finance system and yield spreads adjust to a lower level of government participation. Demand for cash yield will continue as the world ages and quarterly cash returns become more valuable to a growing sector of the population.

Furthermore, there have been multiple questions about what we think about the consolidation in the industry. Simply put, we don't see any particular special value that has been created by the mergers to date. As we have just stated, we believe there are great opportunities for this business model as the future unfolds. The number one goal is to get through this transitional period and have capital to invest, as we are anticipating return opportunities to improve in the future. Long-term returns will be driven by how the respective management teams will react to a highly uncertain global environment that will unfold in front of us. Investors need opportunities to invest in a variety of management team and investment strategies. From our perspective, size will not be the determining factor for success.

Now please take a look at our long-term return charts on Slides 10 and 11. A key point that I've always made with these charts is that the above-average dividend yield will be the driver of returns. First, focus on the 2003 to 2018 time period on Slide 11. I want to remind you all of our investors that during this 15-year period, the Federal Reserve has tightened and eased credit, and our company has continued to generate income and dividends over time. Book value has fluctuated, but long term, our above-average dividend yield has offset short-term fluctuations in book value.

Now look at Slide 10. Note the separation of the lines between 2008 and 2015. Equity prices have increased materially over the past 10 years. It is highly probable that equity returns will moderate at best and decline at worse as the future unfolds. When this happens, the DX return line will be driven by high-quality cash flows from the levered securities backed by the U.S. government. Simply put, we believe every investor should seek exposure to higher-quality assets today given the huge run up in global asset prices over the past 10 years and the potential for these asset prices to correct.

So with that operator, we will open the lines up for questions.

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

Byron, the leverage ratios are down this quarter. Where do you think they will be heading in the second half of the year?

We've got again -- we've been able to maintain for the last, I think, 1.5 years, in or around the mid-6s in terms of leverage, and we continue to generate our income at that level. We talked -- actually about 1.5 years ago, Chris, we mentioned that we've got the ability to take our leverage up one term. We've chosen not to. It reflects our macro opinion. And we've increased our leverage slightly this quarter as we redeployed the capital, and we're maintaining flexibility. We have the option to increase, but we've been able to generate an appropriate return at this level and we've been satisfied at this point.

And I guess, my follow-up is on TBAs. Right now, the TBAs are roughly 25% of your total assets, which look like that's sort of the upper limits where you go to. Are you seeing improved economics of TBAs relative to balance sheet financing or not this quarter? Are you seeing the economic advantage of using off-balance sheet vehicle less?

Chris, it's Smriti. So that actually fluctuates. The attractiveness of TBAs at the moment is actually less than owning pools. And we do manage that very actively in terms of slipping out of the TBAs and into pools as we see the financing. And the TBAs deteriorate versus on balance sheet financing. So that 25% should shift up and down through the quarter.

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

A question following up on your comments about the benefits of having a diversified portfolio compared to being completely in residential or commercial assets. Can you comment on sort of how you guys are thinking about as long as Agency RMBS remain the most attractive investment for you in terms of returns, how large of a portion of the overall portfolio you guys are willing to make that?

I don't know that we have said it, like exact amount of how large we will go. Part of the issue that, Trevor, will be how important will those, for certain cash flow to the commercials, be to us given the environment that will unfold in front of it. So clearly, volatility plays a role in this. And then the most volatile environments we're really happy to have the commercial security and in the least volatile environment -- I mean, in the most volatile, we're happy to have the commercial security. In the least volatile, we're happy to take a little more yield of the residential security. It will vary. It will vary because they look out into the future. It's more difficult to predict exactly how -- what scenario that will play out in front of us. Relative to volatility, definitively played a role in the decision-making. Smriti, do you want to add anything?

No.

Okay. And then second question. Can you guys quantify how much benefit there was in the second quarter from spread between LIBOR and repo funding cost?

I can give you an estimate, Trevor. I think that number again was about $0.01 to $0.015. Again, that we believe -- as we we're thinking and planning about the future, that spread actually came down from the first quarter into the second quarter. And it's stabilizing right around here to maybe slightly tighter as we think about the next 2 quarters.

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

Your core income number does not include the economic impact of your Eurodollar position. Is there any way for you to give us some idea what the economic impact of that was this quarter?

Hey, Dave, it's Steve. It was -- within comprehensive income, it was $200,000 this quarter. It's $2.1 million year-to-date. The fluctuation in that will be because those are based on mark-to-market of those positions. So as the market fluctuates, that's what's recorded in our total economic return on compressive income effectively.

Okay, great. And then just curious, what was increase in legal expenses?

So we've disclosed in our Q, there's an action that's been around for a long, long time. It's picked up a little bit in terms of things that we'd have to do to respond to things that the plaintiffs are doing, and it's just cost of those types of activity is what happened this quarter.

(Operator Instructions) You're next question comes from Doug Harter with Crédit Suisse.

This is actually Josh on for Doug. Byron, given the positioning of the portfolio, are you more worried about rates rising or falling rates from current levels?

Now that's an interesting question, and I appreciate you asking. So let me use that example I just talked about with the Italian situation. We watched the 10-year yield ride to about [3.10%, 3.12%], and every one globally was about as bearish as you can get. And then you suddenly had the new -- that there may be a breakdown in the Italian government for me, and you suddenly had a 32 basis point drop in rates. So the definition of the environment, in my opinion, is best defined by surprises are highly probable. I do believe that rates can rise given the economic environment. They could get there, if not -- if everything goes perfectly. But what has been shown is there are multiple global factors that can shift and change the level of rates in a nanosecond. That's one of the tougher challenges today. That's why we like the liquidity, and that's why you won't hear me -- you wouldn't have been around, but you would've heard me about 14 years ago, in 2004, I was pounding a table, outright bearish. And when the Fed decided it was about to start tightening credit at that point. Very difficult to take that strong of a stance today because you're very vulnerable to rapid movements in both directions in interest rates. But if you sit here and everything goes perfectly, as many people have projected, and there is growth in the global economy and nothing really happens globally and everything stays calm, my guess is you're going to have a rise in rates that will then create a situation, will put a downward pressure on global growth because you have so much debt globally, that will create a move back down in rates. So that's how we think we're managing an environment. It's not as simple as, "Yeah, I think rates may go up." For how long? A day? 2 days? You're very subject to surprises. So we're managing a volatile environment. Volatility is low but subject to rapid movements.

There are no further questions at this time. I will turn the call back over to the presenters.

Thank you so much for joining us today. We will look forward to chatting with you again in 3 months on our third quarter conference call. Thank you.

This concludes today's conference. And you may now disconnect.