Dynex Capital Inc (DX) 2022 Q3 法說會逐字稿

Good morning. My name is Dennis, and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Third Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. (Operator Instructions) I would now like to turn the conference over to Alison Griffin, Vice President of Investor Relations. Please go ahead.

Thank you, Dan. Good morning, and thank you all for joining us today for the Dynex Capital's Third Quarter 2022 Earnings Call. The press release associated with today's call was issued and filed with the SEC this morning, October 24\. 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 in 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 our disclosures filed with the SEC, which may be found on the Dynex website under Investor Center as well as on the SEC's website. This conference 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. 

Joining me on the call is Byron Boston, Chief Executive Officer and Co-Chief Investment Officer; Smriti Popenoe, President and Co-Chief Investment Officer; and Robert Colligan, Executive Vice President, Chief Financial Officer. And with that, it is my pleasure to turn the call over to Byron.

Thank you, Alison, and good morning. And let me start the call off with a few messages, a few thoughts for our shareholders and then Rob and Smriti will take over with the more specifics. So to our shareholders, as I mentioned in the past, this is an incredible moment in history across all major asset classes. Prices have fallen and volatility have materially increased, especially during the last 2 to 3 weeks of the quarter. And even though all asset managers are in the same storm, I want you to know we're not all in the same boat. The Dynex Capital boat was built to withstand a storm. We have been preparing for this type of environment for years. We have managed through markets like this before, and it is our experience and flexibility that will guide us through to the other side of this complex market cycle. 

Given these challenges and complexity, I want to maintain our tradition of transparency and open dialogue by simplifying my takeaways on the quarter to 5 key points: First, our portfolio is solid. Dynex is prepared for this market. Several years ago, we proactively moved up in credit and up in liquidity, and we further increased our focus on liquidity after March 2020\. Our portfolio is government-guaranteed and is backed by U.S. borrowers and U.S. real estate. Agency mortgage-backed securities are second in liquidity only to U.S. treasuries, and mortgage-backed securities have a history of being a very liquid and very efficient corner of the fixed-income markets, even in turbulent markets like the one we are in now. Second, our liquidity position is strong. Most of our liquidity is in cash, the most liquid asset evolved, but we also have unplanned agency securities that are easily financed or sold. 

As the markets took a decisive move toward chaotic volatility, we have been able to manage our balance sheet with confidence. We also have enough capital to be opportunistic when the markets come, and we take advantage of this great return environment. Third, our strategy was built for this. The core tenant of Dynex's investment strategy is preparation and flexibility. And over the past several years, we have said repeatedly that we believe surprises are highly probable. We began talking with our investors about the increasing complexity of global markets as far back as 2014. 

We understand through our experience that the global risk environment, by its nature, is too complex to allow us to predict what will happen. But that doesn't mean we can't prepare, which is what we've done. Fourth, our management team has experience and discipline. And in this volatile market environment, more than ever, you need an experienced and trustworthy team at the helm. We have proven the value of experience in the past as we've reacted to other market events in a very thoughtful manner, as shown in our long-term results.

We manage our business for the long term. And just as we've done in the past, we're determined to guide you, our shareholders, through this disruptive market environment. And as always, we're committed to providing transparency and insights into our strategy as we guide the Dynex ship through this storm to the unimaginable sunshine that will come out tomorrow. With that, I'm going to turn the call over to Rob and Smriti and let them give you more details.

Thank you, Byron, and good morning all. The company reported a comprehensive loss of $2.20 per common share and a negative total economic return of 12.9%. The negative total economic return was driven by declines in the value of our mortgage-backed securities and TBA positions exceeding the increasing value of our interest rate hedges as spreads widened significantly this quarter, especially in the month of September. Spreads are near historically wide levels, driven by recent economic policy and geopolitical risks. We believe our portfolio will recover a significant amount of value when the flows into mortgage-backed securities improve or simply as pay-downs occur over time. Smriti will cover market activity, including spreads, in her comments. 

Earnings available for distribution, or EAD, was $0.24 this quarter. G&A expenses and EAD include a one-time cost of $2.7 million or $0.06 of severance costs related to the CFO transition during the third quarter. At Dynex, our key strategies include the management of interest rate risk, liquidity management and protecting shareholder value. We accomplished this through thoughtful asset selection and hedging activities. This quarter, we're highlighting the benefit of our hedging activities as our earnings available for distribution calculation does not incorporate the positive impact of the company's interest rate risk mitigation strategies because our primary hedging instrument is interest rate features. If the company used interest rate swaps instead of futures, the hedge benefit of the swap would be included in both the net interest spread and earnings available for distribution. 

Through September 30, Dynex has over $500 million of hedge gains, primarily on futures interments. These realized hedge gains are recognized immediately for GAAP reporting but are deferred for tax and are amortized into REIT taxable income over the hedge period of approximately 10 years. The benefit of interest rate hedge gain amortization was approximately $9 million or $0.21 for the third quarter and is estimated to be $12 million or $0.25 per common share for the next 5 quarters. The total amount of gain to amortize into REIT taxable income can go up or down depending on the company's hedge position and movements in rates in subsequent quarters. Since hedge gains are a component of REIT-taxable income, they will be part of the company's distribution requirements, along with other ordinary gains and losses. As we move into the fourth quarter, we expect hedge gains will be supportive of the dividend in 2023 and beyond, even if net interest income and earnings available for distribution decline due to rising financing costs. Please see the additional disclosures in our release and be on the lookout for our 10-Q, which will have additional information and will be filed next week. I'll now turn the call over to Smriti for her comments on the quarter.

Thank you, Rob, and welcome, everyone. As a long-time sailor, I can certainly appreciate Byron's analogy of a boat navigating a storm. I've done that in real life with my family aboard our sailboat, and during my 25-plus years of experience in the fixed-income markets, I've often felt that sailing offers important lessons to me as an investor. I'll structure my comments today on our path through the storm, how we're navigating it, our short-term views and strategy, and then I'll turn to our long-term outlook. The storm we are in represents a transition from an era of low inflation, low-interest rates, financialization, leverage, globalization, peace, and a global pandemic. On the other side of the storm is an environment where the amount and mix of all of these factors will be different, and there won't be new factors to contend with. 

We believe the storm and its effects will present excellent long-term investment opportunities, but we have to navigate through the storm first. We prepared for this environment with the highest level of liquidity in over 5 years and the highest allocation to the most liquid instruments backed by U.S. real estate, agency-guaranteed residential mortgage-backed securities. Our TBA position has given us flexibility and maneuverability to adjust risk. The financing markets are functioning in an orderly manner. Our counterparties have access to liquidity, haircuts are stable. And from our perspective, there currently do not appear to be any signs of financing dislocation. We can trade our highly liquid futures hedges 24/6\. Our balance sheet is mark-to-market daily, so there is no mystery about the value of our positions at the end of each day. 

We had anticipated that as global central banks withdrew liquidity and raised interest rates to combat inflation, the price of government bonds and risky assets would adjust down. This price adjustment has been underway since September 2020\. Treasuries and mortgage-backed securities have led the way, and most of it has been orderly until this last quarter. So the storm really intensified in late September and early October. You can see this in Agency RMBS spreads, which widened dramatically in September and have continued the widening trend into the fourth quarter, now standing at levels within a few basis points of the peak spreads seen in March 2020, as shown in our slide deck on Page 10. 

Simultaneously, the entire yield curve has shifted up. As of last Friday, the 2-year is 157 basis points higher, and the 10-year is 125 basis points higher, just since June 30\. This type of interest rate volatility has not been seen in the bond market since the early 1970s. You can see this represented in the chart in the slide deck on Page 24\. As the year has progressed, the ride has really gotten rougher. Now here's what's unique about what's happened. In the traditional Fed tightening cycle, the yield curve inverts, the carry in Agency RMBS is negative, and it's usually not a great investment environment until the next Fed easing cycle, but it is different this time. Mortgage rates have been rising higher and faster than financing costs, causing spreads to widen to historically wide levels, making this the best investment environment in Agency RMBS since the great financial crisis, and we expect this to continue. 

Now the recent moves are happening for several reasons. First, the structure of the Agency RMBS market is different. The largest noneconomic buyer of agency RMBS, that is, the Fed, is stepping back, creating net supply into the market. And unlike at any other time since the 1970s, there is no going away buyer. There's no GSEs. The banks are also out of the market, and they have no appetite for MBS because their loan portfolios have grown. So now, the marginal bid for mortgages is now being driven by relative value players. This is money managers. They are facing outflows. So the technical demand picture for MBS is the poorest it has been in several decades. 

Second, there has been selling of Agency RMBS by many types of accounts, including non-U.S.-based investors. Domestic money managers continue to face net outflows from fixed income, and MBS are a liquid asset, and they are being sold first. So we expect this to continue. And finally, we're seeing higher-than-normal levels of supply for the environment because loan sizes for next year are getting baked in. origination pipelines are getting flushed, and we're seeing some cash-out activity that's keeping volume elevated. We do expect this to reverse course over the next few months. So as the storm intensified, we used our instruments, our principles of risk management, disciplined top-down analysis and a focus on capital preservation. 

In our last call, we discussed our strategy as being prepared for this rough ride with liquidity and dry powder as we entered an environment of higher returns standing ready to deploy capital in what we saw as a persistent opportunity in Agency RMBS. We have also repeatedly discussed the idea that we are in an environment where surprises are highly probable, and that we must be ready to adjust as those occur. That posture and mindset has not changed. As the right became rougher here in October, with no shortage of unexpected surprises from across the Atlantic, we made some tactical adjustments to the portfolio. Those reduced interest rate sensitivity and some spread risk. And you can see the direct results of that on Pages 11 and 12 on our slide deck. The book value decline we experienced in the third quarter is a function of these market moves, and mostly attributable to the gap wider by about 50 basis points in Agency RMBS spreads in late September. 

Post quarter end, as spreads have continued to widen about 15 to 20 basis points across the coupons that we own, book value at the end of last week was down about 8% to 10% versus the quarter end. Our liquidity is estimated at $430 million, and leverage to total capital is approximately 7.2x. For your information, the book value during the quarter traded up as high as 7% up from the second quarter end before ending the quarter down 15%. This should give you some idea of the volatility in spreads as well as the rebound potential in the portfolio. So now, with the existing position, we hold more than enough liquidity and capital to withstand the spread shock that we saw in 2008. 

As you can see on Chart 10, that is another 40 to 50 basis points wider from here in nominal spreads on the current coupon. We also stress our portfolios to include haircut increases and other unanticipated calls on liquidity. We are keenly aware of the potential for counterparty stress as well as the actions of other players in the market. And for those reasons and more, our view on the risk environment has shifted to a more cautious stance going into year-end. We've also rolled about 20% of our repo book over year-end, and we continue to term out financing to minimize year-end issues. Let's now look ahead. What usually comes after storms is some type of calming of disease. It's important to look and plan ahead with an intermediate-term view to steer the boat to its destination. 

At some point, the Fed will signal a pause or stop tightening. When that happens, there will be a period of lower volatility and evaluation. This is where we see a target-rich environment, which persists for some time. Agency RMBS returns are already in the high teens and low 20s, and we're really looking forward to getting to that target-rich environment, but we're not there yet. The key is being able to navigate through this rough ride in the near term to get to the longer-term stronger fundamental and technical environment. So we see at least 4 positive catalysts for Agency RMBS in the intermediate term. The first one, very simply, is the raw return in Agency RMBS. This can be a major catalyst. 5.5% to 6.5% base case yields, we haven't seen those in at least 15 years.

These are great returns relative to a lot of other risky assets today and will likely be great returns in the future once you adjust for liquidity and credit risk. Second, lower net supply in the future. We are approaching a seasonal winter slowdown. Mortgage rates are at or near 7%. This will eventually slow originations to at least 50% of current levels, shrinking the overall net supply, forming a technical tailwind. Third, any decline in the realized volatility is also a tailwind for RMBS and will take spreads tighter. And finally, if a recession indeed materializes, Agency RMBS will be the credit risk-free asset to own versus riskier corporate and consumer back debt. 

A few other points on the intermediate term. At current levels, MBS offer almost 200 basis points of spread over treasuries at nominal interest rates that have not been seen for credit risk-free asset in decades. These returns require less leverage to earn mid-teens or higher returns. Going forward, the mortgage market will be operating without a stabilizing agent, such as the Fed or the GSEs. This means spread volatility could be higher, but at the same time, returns will be higher. This is why we're calling the opportunity persistent. And finally, the demand for income remains strong. Global demographics still favor income-producing investments, and especially in the absence of a permanently rising stock market, investors may finally seek fixed-income instruments at these higher yields. This is what can eventually turn the tide of money manager selling as inflows return into bond funds. So for now, while we've positioned the portfolio to a more neutral stance, we're also thinking about what the catalyst is for adding risk as we navigate through this near-term poor technical backdrop to the longer-term stronger fundamental and technical backdrop for mortgages. 

An additional word on our positioning. We expect to be active across both our assets and our hedges over time. You can think of it as the position designed to weather the storm that will change as time goes on. The beauty of a flexible strategy with TBAs in the position is our ability to change as the market changes. As we continue to evolve our portfolio structure, we will provide additional timely disclosures to be fully transparent as we transition to a more long-term position. Until then, you can see by the numbers. We've moved to shield the portfolio from large moves in interest rates and cut our spread risk. I remind you to grade us by our long-term total economic performance and that EAD alone is an incomplete metric to assess economic performance or dividend stability. As Rob mentioned, substantial hedge gains exist in the portfolio to support our forward dividend. 

A final word on the dividend and forward returns on Page 13 of the deck. As of last week, the weighted average market forward yield of our portfolio is approximately 5.4%, and we are hedged with treasuries yielding about 4.2%. This produces 120 basis points of net spread at 8x leverage to common, a forward ROE of about 15%. This is the foundation of the economic return that supports our dividend. It will not be evident in earnings available for distribution because that does not include the benefit of our futures. It will show up mostly in book value and in taxable income. In addition, just the current portfolio will add $0.70 per share in book value for every 10 basis points of spread tightening from these very wide levels, further boosting the forward return. Any incremental return will be driven by adding assets during this persistent and attractive investment opportunity in Agency RMBS, for which we are prepared. We expect to eventually return to a diversified portfolio over time as new opportunities evolve. 

I'd like to leave you with the following thoughts. We are liquid, and we are prepared for the storm that we are in. We expect the rough ride to continue for some time, and we've moved to mitigate interest rate risk and preserve capital as we navigate through this short-term transition to what we believe will be a highly favorable investment environment. MBS spreads are wide and returns are in the 19% to 25% range on the margin. While this is a target-rich environment, we would like to see the levels of macro risks subside to change and add significant risks. In the intermediate term, we expect MBS to outperform many other asset classes as fundamentals and technical shift. This is the environment when book value can be recovered. We take our responsibility of capital stewardship very seriously, and the team and I remain focused on making the next decision to maximize value on your behalf. I'm truly grateful for your trust and confidence. And with that, I'll turn it over to Byron.

Thanks, Smriti. Let me remind you again this is a historical moment that is evolving as we transition to a new global economic market and geopolitical environment. I want to also remind you that we have built Dynex Capital to expand the surprise market gyrations that we're encountering during this transitional period. We're committed to providing long-term attractive returns to our investors, and our focus on these long-term returns has not wavered in this environment. Take note of our track record as displayed on Slide 15\. Dynex has proven to be a better cash-generating alternative to many other debt and financial alternatives through all cycles over the past 15 years. This is not our first storm, and this will not be our last. And just as in the past, we're prepared to remain patient and disciplined until the sun comes out. 

Finally, we're in the boat with you. Both management and the Board are comfortable owning both Dynex Capital's common and preferred stock as we ride out this current transitional period in history. The stormy environment will evolve, this transitional period will end, and we will have the flexibility to adjust our posture to a more offensive stance to take advantage of these truly attractive return opportunities. So with that, operator, we can open the call up for questions.

(Operator Instructions) We will pause for a moment to compile the Q&A roster. And your first question is from the line of Doug Harter with Credit Suisse.

Thanks. As you guys looked and balanced kind of the short term and the intermediate to long term, can you go to how you kind of arrived at that 7x leverage that you talked about and that you are at currently?

Doug, I didn't quite hear that. State it over again?

Sure. Kind of as you guys look to balance kind of the short term versus the attractive intermediate to long term, can you just talk about how you kind of arrived at the current leverage level?

Yes. So it's a function of 2 things, right? The level of spreads where they are today relative to where we think they could go, that's the first thing. We're being very respectful of the technicals in the mortgage market and the probability here. I think as I said on the call, the catalyst for things to go tighter are fewer than the catalyst for things to go wider in the near term. So that 7x leverage reflects the ability of the portfolio to really withstand substantial further widening in spreads. And we believe that's the appropriate position as we navigate the next few months. So the things that we take into account, where are spreads today, where could spreads go in the near term, how much liquidity and capital do we want to have to be positioned with that? How much leverage do we want going into that? And then finally, as I mentioned, sometimes in the storm is when you can actually get most of your opportunities. We want to make sure that we're positioned in a way that we're not hampering our ability to take that offensive posture when the opportunity does come.

And when that opportunity comes, I guess, where would you feel comfortable taking leverage, kind of when you think that some of those catalysts are starting to play out?

Yes. Look, that's like the $90,000 question, which people have been asking us since July, right? And we have actually faced a lot of pressure from our investors and others saying, "When are you going to take leverage up? How much are you going to take leverage up?" And I think the right answer to that is it depends. It depends on what the market is doing at that time. And what I can tell our investors and I can tell you, and you've seen us do this now, time and again, is when the opportunity presents itself, we will take advantage of it. It's going to be in the context of the broader macro environment. And if we believe the risk-return trade-off is positive, that leverage will go up, right? So it's always going to be made in the context of that decision. And what I can tell you right now, we said in the deck. We think we have somewhere between 2 and 4 turns of incremental dry powder. That's what we hope to deploy, but we'll do it slowly, and we'll do it prudently.

Let me add one other thing. Yes. I mean one other thing on this, Doug. You heard Smriti tell you how broad our book value swung during the quarter. And so we're sitting here, and the world starts to change, the environment changes, and we're looking at a book value that could potentially going to be materially higher than where we sit. That's going to have a material impact on where leverage happens to be. We'll take that into account in terms of how we're managing the portfolio. So we're not sitting here thinking in terms of a static moment in time. You can see how much volatility that's in the marketplace now. But really take note about that big win in book value because we were up book value solidly at the end of August, right? And so it's pretty fascinating to see this. With the book value up that high, the leverage goes down immediately. The 1 2 turns potentially. So very important that we're thinking in terms of a top-down approach, where, if spreads are held at 20 to 30 basis points tighter, leverages had to down. We're not going to wait until they get there to make the appropriate adjustments and investors as we think about it. So just to add that little piece in there to give you some more clarity.

Your next question is from the line of Bose George with KBW.

Actually, just sticking to the theme of leverage. Obviously, with spreads wider here, your market-to-market leverage has increased, impact of the envelope is that the market-to-market leverage is around 95% now. And you noted that there is the risk that spreads widen further. With that backdrop, how willing are you or what's kind of the range you're willing to let your market-to-market leverage kind of run-up to, and I mean, is there -- because I guess the concern is there's some level at which you might want to deliver. And that clearly sort of removes some of the up side when spreads tighten. So just kind of how you're thinking about that. Thanks.

Yes. So Bose, we did talk about the adjustments that we made in the portfolio. As of the end of last week, our leverage is actually down. From quarter-end leverage, the total capital that we disclosed was 7.2x during my comments. So we have taken the opportunity to actually not take the write-up on the entire portfolio to further spread widening. And I think that's what we believe is the right approach here coming into what we still see is going to be a rough ride here through year-end. And again, in terms of like how high would you let it, that type of decision at this point is almost like a day-to-day moment-to-moment decision. If we believe the market environment requires further deleveraging, we're going to do that, right? But as of now, we're operating with enough liquidity and capital, more than enough liquidity and capital to withstand basically a spread widening out to the peak of 2008 and beyond. So the liquidity position will be able to withstand that. Whether or not we actually choose to allow it to do that is a function of where we actually see the market environment evolving.

Now in the intermediate term, we are saying the environment is going to improve for all the reasons I outlined in the call, right? You've got raw returns that are really outstanding. You've got supply that's coming down. And ultimately, unfortunately, the people who are selling bonds in this market are selling what we own. And when all this is over, they're going to want them all back. So at that point, it's going to be nice to have that. So it's a delicate line walking to say you want to -- you don't want to be in the position of giving up a lot of that upside when it eventually comes. But you got to get there. You got to make it there intact, and we're very, very cognizant of the risks involved with that. And so we haven't allowed our leverage to float up. We've made that adjustment, and that's part of how we're navigating this. And Byron, I think you want to add.

Yes, let me add something to this. From the last 2 questions, Bob's and Doug, as this -- when we say we went up in credit and up in liquidity, we increased liquidity on the balance sheet such that from 50 basis points on the team here, this ride, we've sat here and we've had plenty of liquidity not to worry about making adjustments to the portfolio because leverage is moving around or because margin costs have come in. We've been very easily actually managing our balance sheet. And Smriti have a problem saying this easily because they feel the stress that the investment team, as all investment teams do in the world with this type of market volatility. But in terms of the way I'm listening to your line of question around leverage, leverage will pressure those companies that don't have enough liquidity because they will scramble as leverage is moving to meet their liquidity. And if you look at their internal operations, they'll be scrambling. We don't have that issue because we went up in credit and up in liquidity. You can see all the decisions we made over the years. to have enough liquidity to deal with a surprising environment. 

And the real key is that as leverage moves around, we may make very tactical decisions, but it won't have anything to do with needing liquidity. It will have something to do with the risk posture we're taking. Your best example is March 2020\. They operated in exactly the same way. We had a ton of liquidity. We didn't worry about any type of margin calls. We adjusted the portfolio of 2 or 3x within that major storm and by the end of the year, everything was fine. So if you need a benchmark, go back and look at how we made decisions in 2020\. Look how we made them in 2019 before 2020, and look how we made in 2020\. Thank you.

Okay. Great. That's helpful. Thanks. And then actually just one on the funding markets. Any changes you're seeing there, volatility, haircuts, anything to comment on?

The answer to that is no. The Agency RMBS repo market has been very, very stable. We've had 0 haircut issues. The market is functioning in a very orderly manner. So no issues there.

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

A question on the change in sensitivities you guys are showing as of October versus where you were at the end of the quarter. Can you go into some detail on what the changes you've made to hedge portfolio and the asset composition or that have kind of led to that material change, particularly in the rate exposures?

Right. Yes. So a big portion of that is a combination of 2 things. It's a combination of hedges that we put on and second, a reduction in the credit spread sensitivity. So some reduction in the level of assets, some increase in the level of hedges. And Trevor, what we're doing is making these adjustments sort of in real-time. And what we commit to do on this call is as we make those adjustments and we complete making those adjustments, we'll actually give more detail around exactly what those moves were over time. So suffice it to say, what we're really trying to demonstrate in those 2 slides is: number one; as it relates to interest rate sensitivity, that's substantially down versus quarter end; and then as it relates to sensitivity to credit spreads, that's down some, right? But on a percentage basis, less than the interest rate sensitivity in the book.

Okay. Got it. And then the question was on the coupon composition of the portfolio, given how much rates have moved, obviously, the coupon's to show in the portfolio as of September 30, anyways, are all trading at meaningful discounts. I guess on the margin as you guys are deploying capital, can you talk about like if you guys are looking at deploying into current coupons or if you're still kind of focused on more discount securities?

Yes. And that's a great question. And one of the things that -- the principles that you've probably seen us now follow for a few years is you want to generally try to have instruments that are, I'm going to say, hedgeable in that you know the duration or you're trying to estimate the duration as well as possible. The amazing thing about the coupons that we have owned and continue to own is that right now, with everything trading below a $95 price, most of those coupons are fully extended. And so the duration of those is not hard to estimate. And that's a really nice position to have in this volatile interest rate environment. So I'm very comfortable positioning us in that manner until we get through this transitional peer now. As we go through the transition, we're evaluating all kinds of things, right? So yes, current coupons, we are evaluating that. There's risk and reward associated in the current coupon, as well as the lower coupon. So the trade-off is always going to be what's the incremental return that I'm getting or the risk that I'm taking. And yes, current coupons offer more return, but there's a different type of risk that's involved, and there will be a time and a place to put that risk on the balance sheet. We haven't felt like that's appropriate yet, but that is exactly the type of offensive thought process that we're going through at the moment.

Okay. That makes sense. Thank you.

Your next question is from the line of Jason Stewart with Jones Trading.

I wanted to ask about the cost to operate in a sort of defensive lower leverage environment and how you guys are thinking about that.

When you say the cost to operate, Jade, do you mean just the overall cost of running the business?

Correct.

Our cost levels are basically the same in terms of just, it hasn't increased in cost for having this type of market volatility where the cost comes on our time. Our focus level is at a materially higher level in terms of our personal time and how much time we're focused on the markets. You go from kind of normal workdays to a 24/7 type of environment, but in terms of just the cost fronting the business. We have a long-term perspective. And we're putting the right amount of money into our business to ensure that we are in great shape 1, 2, 3, 5 and 10 years, short term, medium and long term. 

So we're making some major changes in terms of our technology platform and other different areas that were really a year from now, 2 years from now, proved extremely beneficial. Furthermore, back to us believing that surprises are highly probable and the world has become more complex, we started to make these types of technology changes to put us in better shape to manage this type of market environment, the exact market environment. So this environment doesn't have any impact in terms of the overall cost of doing business. Our focus on the long term is still exactly the same. We're investing in people, processes and technology to build a sustainable organization over the long term. We believe that the world needs a solid asset management team like Dynex Capital, especially cash-generating vehicles such as this. So I hope that gives you some insight.

No, that's great. I think that's perfect. I wanted to ask you 2 other quick questions. One, any expected changes that you guys think come out of FHFA given this environment?

Great question. Yes. I mean, I think this is the environment in which they open up the credit box, to potentially change the affordability picture for -- as mortgage rates are up here at 7%. We're looking at the loan size issue. Obviously, that is something that will come up here towards year-end. Those are 2 big factors. Nothing in the news so far that we can see where there's been movement towards opening up that credit box. We're looking at the November elections. That's going to be something that we're focused on as potential signaling of how this might evolve over the next 2 years. So right now, I think nothing is on the radar as far as we can see in terms of any major changes here.

Can I add one other thing? This is just a buying comment. You asked it out in public, so I'm going to make a comment. As a country, the agency security is a phenomenal asset for the United States. I would like our government and our FHFA to make Freddie Mac temporary stabilizing agencies for this market. They don't have to grow the portfolio like they did before, but it's ludicrous to have these organizations sitting there when they could actually be a stabilizing agent and ensuring that these markets trade smoothly. The mortgage market has traded anything but smoothly over the last few months. They can play a minor role. They could have played a minor role in March 2020, and I think it would have been a lot easier. 

So as you talk to government regulators, bring that issue up. I worked at Freddie Mac. I know a role they can play. They don't need to play the big portfolio role they played before, but they can play a stabilizing agent in terms of how the agency mortgage market trades. And I would hope that one day, our regulators, FHFA or whoever else, will understand that.

Last one for me. How are you guys looking at buybacks on common or preferred versus investment opportunities? I mean, both present pretty good opportunities in my view right now.

Long-term returns at 19% to 25% marginal returns are -- buybacks make sense when your investment opportunities relative to your cost of capital are inverted. That's not the case right now. And so again, this is an investment environment in which we're going to want to hold and deploy capital.

Got it. Thanks for taking the questions.

Your next question is from the line of Eric Hagen with BTIG.

Just a couple more on the relative value within the coupon stack and how you guys think about managing liquidity, just in light of the paydown differential for securities across the stack and how you mix that with TBAs and pools. And then on the funding side, is there any value in borrowing with longer-term repo right now? Can you comment on the liquidity that you see for repo along the yield curve?

Yes. I'll answer your second question first, Eric. We -- I think the idea that you can borrow across term is something that we've used very flexibly and well here at Dynex. And it continues to be sort of a mainstay of how we get through the quarter-end and so on and so forth. So there is a term premium that is currently being charged in the markets to go through year-end. It is actually not as big as the term premiums that we've seen in the past for the year-end turn. But there is a premium, and I think that's a big piece. The other thing that you're seeing is substantial amounts of uncertainty in the repo market with respect to when the Fed will make their 75 basis point hike move or the 50 basis point hike move or 75%. So there's a lot of just price discovery that's going on for November and December and beyond with respect to the magnitude of rate hikes. So -- but none of that has prevented us from: a, being able to term out our financing; or b, just the availability of financing. So we are able to term things out. Financing is available. We've not seen any issues with respect to haircuts or anything like that. We are seeing a term structure to those interest rates, as you would expect. 

But again, not a problem with respect to actually how we operate. So your first question regarding relative value in (inaudible). So here's really how we're thinking about it. The first principle is just the principle of risk management. When you have coupons that are fully extended, and the prepayment risk is more or less baked into the price, they're much easier to hedge. So holding the lower coupons primarily is just simply a function of saying, I can -- I know what the duration is, and I'm able to hedge those instruments with instruments that are like that, like futures and so on and so forth. So that's the primary driver of owning coupons that are below par. Now over time, that will shift. That will shift because the carry-in higher coupons is higher. It will shift because of many other reasons, prepayments on the lower coupons could shift, it becomes lower, so on and so forth. So that is sort of the next decision to be made. And as you know, like in these higher coupons, you have more prepayment risk. You have more extension risk. You have more contraction rate. There's more convexity. So that relative value at this point is still sort of a thought process that we're going through. The higher coupons do offer more current returns. But the hedgeability of them, all of that is still in question because we're still in a transitional period.

Anyone who bought higher coupons in this move, as you've gone from 2.5% to 4%, and you thought you could hedge them with whatever duration your model said, that's been a very, very difficult trade. And for us sitting in the lower coupons with a more extended profile, that's been sort of a big stabilizer as we've gone up in interest rates here. It's also much more exacerbated when you see rates up spreads wider in the current coupon versus the lower coupon. So as we're thinking about relative value, the #1 thing is, can I hedge it, and how can I hedge it? That's first because we're still in the transitional period. The time to have the relative value discussion, of course, is all the time. But you then -- once you're approaching the end of that transitional period, that's when we'll be thinking through more about where do we play off and how we play often.

Now don't get me wrong. We're thinking about this all the time, but that's kind of the way we're approaching this. It's not an environment where you can just sit here and say, "Well, let me just own the highest coupons because that's what I think is fundamentally the right thing to do. You can't have that discussion without understanding that that's a macro risk decision, and that's what's really driving the way we're thinking right now.

That's good. I appreciate that. With respect to the comments around the dividend and such, are we hearing that your dividend will most likely be characterized as a return of capital for both 2022 and '23? And any guidance, I suppose, on that.

Yes. Thanks, Eric. No, we're not saying that at all because the hedge gains, in particular, that would all be ordinary income and will be part of the distribution calculation. So yes, we're not saying that at all. And we're going to provide -- continue to provide color on our hedge gains and the impact on that to the portfolio to financing into taxable results so everyone can understand where we are, we can be transparent, people in your seat can model out where we are and kind of understand the direction that we're going in.

Great. That's a helpful clarification. Thank you, guys.

Your next question is from the line of Christopher Nolan with Ladenburg Tallman.

Are you continuing to issue any shares into the fourth quarter here?

Did you say... Are we...

Issuing shares?

With our price this fall. This type of chaotic market, Chris, I appreciate you asking this question. This type of chaos says you hunker down on all aspects of the balance sheet, and you wait out the storm. That's the purpose. We pulled this analogy of the boat out for a very strong reason. Smriti is a sailor, and Tom Akin, who was CEO before this is a sailor. We're serious. In a storm, you hunkered down the bulk, put down anchor, and you wake the storm out. This is on both sides of the balance sheet here. And so no, the short answer is I couldn't answer that to say the period now. As of right now, we're in a storm. If the storm took an interesting twist mid-September. That's the other key point here is that if you lead them to a zone where we are patient on all aspects of the balance sheet. So you want to make sure everyone understands this point about what we're seeing. We've talked about a whole tone, coupons or vol. The bottom line is mid-September with the chaotic British situation along with the labs inflation number, created complete chaos and market trading across the globe, treasuries, mortgages, corporate, whatever you want to mention. 

And in a situation like that, a smart bolder hunkers down and weights the storm out. That's what we're doing in Dynex. If you want to take away any message from here, you say, they'll weigh the storm out. They have a boat that's built for a storm, and we got the ability to weigh the storm out because we built the boat with plenty of liquidity starting multiple years ago.

That's it for me. Thank you.

And at this time, there are no further questions. I will now turn the call back to Byron for any closing remarks.

Thank you all. I really appreciate you being here. Thank you for the questions. Stay tuned. We'll be transparent. We're hunkered down, and we really appreciate all of our shareholders in the company. Thank you very much, and we look forward to chatting with you at our next call.

This concludes the Dynex Capital Third Quarter 2022 Earnings Conference Call. Thank you for your participation. You may now disconnect.