Dynex Capital Inc (DX) 2023 Q2 法說會逐字稿

Good morning. My name is David, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Dynex Capital Second Quarter 2023 Earnings Conference Call. Today's conference is being recorded. (Operator Instructions). Alison Griffin, Vice President of Investor Relations, you may begin your conference.

Good morning, and thank you for joining us today for Dynex Capital's Second Quarter 2023 Earnings Call. The press release associated with today's call was issued and filed with the SEC this morning, July 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.

As 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 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 our 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 Rob Colligan, Executive Vice President, Chief Financial Officer. And with that, it is my pleasure to turn the call over to Byron.

Thank you, Alison. Good morning, and thank you for joining us for our second quarter earnings call. Our total economic return for the quarter was 5.7%, and year-to-date, we have generated 1.7%. These results are being delivered in a period of unprecedented market volatility. Like a well-balanced boat, Dynex continues to navigate the evolving global environment. We have structured our portfolio to emphasize liquidity, which we believe is essential to manage through the many potential outcomes in the future. We use a very patient and flexible mindset as we take care of your capital and profit from the attractive returns offered in the market today.

As I lean on my 40 years of investing experience, leading Dynex into the next decade, several factors stand out to me. Tailwinds for housing from demographics at supply are very strong.

Our thesis for growing investment capital in high-quality sectors of housing is highly supportive. The Federal reserving banks are reducing their footprint in this sector of the economy, creating a generational opportunity for private capital. This investment opportunity is happening in an environment that is complex and evolving and needs disciplined processes, skilled risk management and capital allocation. These are foundational elements of how the team at Dynex manages your money and are a big part of how we generate long-term results.

In our view, income will continue to be in demand with aging global populations and will become more important as the baby boom generation finally retires. This generation, in particular, is highly levered to housing and equities and has the potential to significantly impact and be impacted by valuation changes in both asset classes. We believe income continues to be undervalued in the global markets. You can see that in the price of bonds and Agency RMBS, even in Dynex stock relative to more risky asset classes. At Dynex, we're managing our portfolio to generate high-quality economic earnings that support the level of our dividend which can be a reliable source of income for shareholders for many years to come.

As I mentioned on these calls in the past, we're at a big moment in history, and we're managing our business as such. From our perspective, the global landscape demands a high degree of focus and preparation. That's what the team is working on every day and to discuss the results of their efforts, I'll now turn it over to Rob and Smriti to provide details.

Thanks, Byron, and good morning. For the second quarter, the company reported book value of $14.20 and comprehensive income of $0.79. The book value performance plus the dividend delivered an economic return of 5.7% for the quarter. Despite an increase in rate and spread volatility during the quarter, our book value rose particularly related to how we hedged our portfolio. We also took advantage of investment opportunities during the quarter and added assets near the widest spread levels in May.

During the quarter, we added over $2 billion of specified pools as pay-ups collapsed, particularly for the higher coupons, and we reduced our TBAs by $1.5 billion. Despite the increase in the size of our investment portfolio this quarter, leverage is down slightly to 7.7 turns given book value appreciation.

We believe that comprehensive income and total economic return are the most complete ways to judge our earnings power. And as a reminder, our EAD does not include the benefit of our hedging activities. We continue to use features as a primary hedging instrument due to the depth and liquidity of the features market as well as lower capital requirements compared to a similar swap instrument.

In the second quarter, Dynex had net hedge gains of $170 million and have unamortized net hedge gains of $650 million at quarter end. These hedge gains helped to offset the increase in financing costs. Page 8 of our earnings release provides our estimate of hedge gain amortization over time. Please also see Page 6 in our earnings presentation, which highlights the components of portfolio returns and the recent trends in net interest income and hedge gains. For the second quarter, we recognized $21 million of hedge gain amortization for tax purposes or approximately $0.38. Since these hedge gains are a component of REIT taxable income, they will be part of our distribution requirement along with other ordinary gains and losses.

As we discussed last quarter, we expect hedge gains will be supportive of the dividend. The total amount of gain that we amortize into REIT taxable income can go up or down depending on the hedge position and movement in rates in the future. Dynex did end the quarter with a substantial unrealized gain on its hedges. With that, I'll now turn the call over to Smriti for her comments on the quarter.

Thanks, Rob. Many factors, including rising debt, inflation, demographics, geopolitics and technology. Our interacting to create what we call a flat- fat-tail environment. Our investment strategy is set in this context.

Fundamental, technical and psychology continue to evolve with no clear direction yet on the level of rates or the shape of the yield curve. Scenario planning, therefore, remains our focus as well as evaluating returns in the context of a smaller Fed balance sheet and higher real interest rates. The markets continue to be volatile. Interest rates have fluctuated within a wide but established range over the last 12 months. 2-year treasury yields recently peaked at 5%, 10-year treasuries around 4%. The front end of the treasury yield curve has been the most volatile. We've seen over 100 basis point range and 2 through 5, while the back end has remained in a tighter 50 basis point range.

Our coupon profile, combined with our hedge strategy and liquidity have all contributed to our ability to hold our position through the volatility and remain focused on the intermediate term, where we believe there is tremendous upside for MBS valuations. We have strong conviction around the attractiveness of Agency RMBS in the intermediate to long-term. Agency RMBS has been the first sector to feel the direct impact of quantitative tightening and the Fed's monetary tightening. While in our view, other risky asset classes like credit-sensitive RMBS, CMBS, CLOs and equities have not yet fully reflected the 500-plus basis point increase in the risk-free rate, quantitative tightening and the sustained positive real long-term interest rates.

Agency RMBS still offer the best forward risk/reward when viewed in this context and we believe they would have significant upside in scenarios when riskier assets more fully reflect the inevitable impact of higher financing costs and tighter financial conditions. While we continue to believe we're in the midst of a persistent long-term opportunity, short-term technicals will likely dominate Agency RMBS spread volatility.

Specifically, lack of demand from banks and quantitative tightening by the Fed is keeping supply up and demand down. Money manager demand is strong, but sporadic and can turn into selling as spreads tighten. Spreads have found a footing around 150 basis points over the 7-year treasury and have been bouncing around between 150 and 170 with occasional moves to 190 when volatility is high.

We expect spreads to be in this range at these wider levels and to continue to gap out during periods of volatility, providing a persistent investment opportunity. In the long-term, we see upside. That is tighter spreads from lower realized volatility as the Fed ends its tightening campaign. FDIC sales ending by the mid-fourth quarter, lower net supply as summer seasonal taper off. And if a credit downturn materializes, Agency RMBS will become a sought-after asset.

Turning now to our actions. Since the first quarter, we have been methodically investing capital as spreads have widened. Our portfolio has grown by $1.25 billion, about 20% in the first half of this year during which we experienced the widest spread since the great financial crash. Leverage is up this year from year-end, 1.6x to total capital or 1.9x to common. Most of this rise is attributable to an increase in our assets as book value is only modestly lower year-to-date. You can see the evolution of the balance sheet on Page 13 in the investor deck. We added higher coupon specified pools as spreads widened. One of the interesting dynamics in the markets has been the reaction to the FDIC sales. Lower coupon demand has been solid.

And as such, spreads in lower coupons have been remarkably stable. Instead, the market seems to adjust the pricing of higher coupons when FDIC sales are occurring, which has provided us with opportunities to reposition the portfolio. The cheapness is spilled over into the specified pool market, which we took advantage of by swapping out of TBA and into prepayment-protected pools with loan balances less than $275,000 or other favorable characteristics. The net effect on our portfolio was that we increased our spread duration at wider spreads, which means that our portfolio benefits more as spreads tighten. Lower coupons outperformed higher coupons, as shown on Page 23. So we rotated into higher coupons on a duration neutral basis. This has the net impact of increasing asset balances and leverage. These new positions also increase spread duration and benefit from tighter spread.

You can see all these changes laid out on Slide 13 from right to left. The portfolio asset balance has grown, leverage is higher, and we have a more diversified coupon profile and we're now weighted more towards pools versus TBA.

Please note that we're now providing additional details on the pools versus TBA composition of the portfolio, as well as the weighted average pay up by coupon on Page 21 of the supplemental section of the presentation. We think pay up at risk is an important element in measuring the valuation sensitivity of pools and book value risk and believe this disclosure provides further transparency with respect to the pricing and liquidity of our balance sheet.

We reduced our hedge position this quarter at higher rates to match our asset profile and balance our interest rate sensitivity modestly towards lower rates. We believe MBS spreads could likely trade more directionally in the short-term as FDIC sales are ended. This means that in higher rate scenarios, the decline in supply can potentially result in tighter spreads. The net impact on the portfolio is shown on Page 14. Note that we're not predicting lower rates. In fact, we're prepared for a variety of scenarios to evolve. The current positioning matches the new asset risk profile as higher coupons have a different sensitivity to lower rates. As always, we remain vigilant and we'll adjust hedge ratios as we see the environment develop.

Lastly, the team did an excellent job navigating through the debt ceiling with no disruption to financing. We're now focused on the upcoming negotiations for the budget, the Fed hike path as well as the year-end term in terms of managing financing risk. So we've grown our balance sheet as spreads widen this year with a very methodical approach. We're positioned with dry powder still available and continuously assessing the global macro environment with our disciplined approach.

Looking ahead, we're comfortable with the dividend coverage in our forward return profile over the medium- and long-term. We're currently invested in the market at accretive levels relative to our cost of capital with liquidity and dry powder available to withstand shocks or take advantage of shocks by adding to the balance sheet.

From here on out, our willingness and desire to add to the balance sheet will remain a function of the overall risk environment, which as I mentioned earlier, is still evolving. While we believe we're in a highly favorable investing environment that does support carrying higher leverage than what we have on now, we're operating with a deep respect for the complexity of the global macro conditions and we're prepared to adjust this as necessary. I continue to be excited about the prospect of a target-rich investment landscape to put the power of the Dynex team to work for our shareholders.

With that, I'll now turn it back to Byron.

Thank you, Smriti. I would like to leave you with the following thoughts. In this environment, it is more important than ever to ask yourselves the question, who is managing your money? What's their time horizon? Are they focused on planning for multiple scenarios that can play out in the future? Are they flexible? Are there incentives aligned with yours? Are they ethical? Are they producing high-quality, sustainable economic earnings? Do they have a transparent balance sheet? Are the assets marked frequently to market or mark to a model with subjective assumptions? Asking these questions is essential because these factors are important elements of the ultimate return on your investment.

When you buy Dynex stock, you're getting a team with a flexible mindset and long-term focus. Our core values of stewardship, performance and integrity are at the center of our actions. Our balance sheet is priced daily. Our income is based on observable realized results. Management has a material interest in the company and our focus on preservation of book value and paying long-term sustainable dividends allows us to deliver attractive returns, not just today, but well into the future.

With that, I would like to open the call to questions.

(Operator Instructions) We'll take our first question from Trevor Cranston with JMP Securities.

You briefly mentioned the impact of the failed bank portfolios clearing the market, potentially having on spread directionality. Can you expand a little bit on how you think those portfolios being cleared up for the market will impact MBS spread volatility overall and how you guys are thinking about positioning the portfolio ahead of that supply overhang clearing up?

Right. Yes. So we've -- so thing number one is, I think we've seen spread widening as the FDIC had sold these bonds. No question about it. And our portfolio is larger as a result. So we've taken advantage of that spread widening by putting money to work. That's thing number one. Thing number two, interestingly is that the supply came in lower coupons, and originally the market had anticipated that lower coupons would suffer as a result. That's not what happened. Lower coupons have actually done quite well because the demand for these securities was there from money managers essentially, who really couldn't buy these securities in the open market, and this is one of the first times that this kind of product has been available in this amount of size.

And so the investing opportunity was good for money managers, okay? And as a result, higher coupon, which is the stuff that's actually being produced, the 4, 4.5, 5, 5.5, those ended up suffering. And so that actually gave us a chance to rotate up a coupon. That was one of the things that we did over the last 2 quarters. So in terms of how much longer there is to go, et cetera, so the FDIC is about 75% of the way through selling all of the pass-throughs, which is just the generic 30-year, 15-year, 20-year Agency MBS, 75% done. The CMOs, which are the more complex structured products based off of agency pass-throughs, that's about 50% done. And then there's another slug of CMBS Ginnie Mae project loans, et cetera, all agency that's still remaining to be restructured and completed. So on net, I would say we're probably halfway through the entire supply.

And as long as the supply is overhanging we feel that there's this opportunity and also that spreads will stay out here at this wide level between 150 and 170 over the 7-year treasury and then -- I'm quoting nominal spreads here, and then really gapping out when things are volatile. So we feel very well-positioned for this environment. We've anticipated these wider spreads to the extent that you're seeing the gapping, those are things that we view as really chances to invest. So any other -- did I cover everything that you wanted there? Trevor, I might have missed the second half.

No. Well, I was just sort of wondering like as we approach the sort of the end of those asset sales, I was wondering how you guys are approaching kind of the leverage on the portfolio, does it make sense to you sort of add leverage as that supply clears on?

Yes, that's a great question. So I mean, I feel like we have taken up the balance sheet, okay? And I think our thought is that once the FDIC sales are completed, that is a very positive technical for mortgage spreads and that you should see some level of tightening, maybe the tights get a little tighter than 150 off. But the longer-term structural lack of demand for mortgages is still out there, right? Because banks are still not in buying and the overhang of the sales should contribute to some tightening. But I think other factors would have to come into play as well, like we said, lower volatility and seasonal. All of that is going to help out in the third and fourth quarter. But there's no question. This is an opportunity to add assets, and that's kind of how we're viewing it.

Next, we'll go to Douglas Harter with Credit Suisse.

Can you just talk about how you are sizing the ability to continue to add leverage to the portfolio kind of as you see these buying opportunities?

Yes. So Look, from the end of the year, we -- I believe we closed the year at 6.1x leverage to total capital. Rob, correct me if I'm wrong.

Correct.

So we are up from that level. And I think over time, you've seen our balance sheet flex up and down based on spreads and other factors. At this point, we're still of the view that the investing environment is good enough that there's more room for us to be able to add leverage here 2 to 3 more turns at this point and still be well within our long-term sort of risk/reward parameters, okay? What's preventing us from running the highest amount of leverage at this point is like just this idea that we're not out of the woods yet globally. We have still a fair amount of play between inflation and growth and geopolitical factors and other things where you could get surprised one way or the other. So we've been very methodical about saying, this is the amount of risk I think this environment can sustain.

Is it possible for us to take on more risk and over time, that will pan out for our shareholders because of our intermediate view absolutely, right? But it's something that we're not taking lightly just given all the other factors. But there's no question if we feel like there is certainty around any of these things, like the curve gets steeper or we get some kind of the flat-fat-tail distribution doesn't look so flat or fat in terms of the tails and that's the time to make that decision.

All right. I appreciate that. And a few times you've referenced spreads relative to the kind of 7-year treasury. Can you just talk about what it is that has you referencing that point on the curve?

Nothing -- basically, a big part of the mortgage coupon stack is below par, Doug. So like our assets, on average, the market value of our assets is like $95 price, I think, thereabouts. So those assets tend to be longer in duration, right? Have more stable cash flows just as they're not -- they don't have that prepayment option that's in the money right now. And that area of the curve is more commensurate with where the cash flows are. So we tend to look at things either directly versus the 7-year part of the curve or versus a blend of the 5 and the 10-year and often that ends up being there. If you're looking at higher coupons, like (inaudible) account, something like that, it would be more appropriate to look at maybe a lower point on the yield curve like the 5-year treasury, for example.

Next, we'll go to Bose George with KBW.

Just wanted to ask about where you think book value is quarter-to-date?

Yes. So quarter-to-date, our book value is down about 1%, and it's traded in a relatively tight range, even though mortgages are wider and rates have been bouncing around. So it's relatively tight in that.

And then just in terms of the current -- given the current spreads, where are the ROEs just given your leverage in kind of the high 7s?

Yes. So we're seeing marginal returns in the 165 area over 7 years. And we're kind of thinking of those returns in the 15% to 18% ROE level just depending on how much we use for hedge costs with respect to options or something else of 15% on the lower side, maybe 18% on the higher side if you end up not hedging as much of the optionality.

Next, we'll go to Matthew Erdner with Jones Trading.

Could you talk a little bit about the ATM issuance during the quarter? When that happened? And then, I guess, what would target you guys to hit the ATM market again?

Yes. I think that -- thank you, Matt. That was earlier in the quarter, and we've talked a lot about our capital issuance and just our overall goals with respect to capital. In general, and I've said this publicly on calls many times, when we think about ATM issuance when the cost of issuing all in, is cheaper than the investment opportunity, the return on investment. So as long as that's the case, we believe we're making an accretive decision for our shareholders. Now lots of things factor into that, the price-to-book, dilution is that -- all of that is factored in. But just philosophically, we are in a historic investment opportunity. And it's an environment where we think our shareholders will benefit tremendously from having capital invested in this environment, and therefore, it becomes an environment in which we should raise capital.

So just philosophically, that's kind of how we look at it. The timing and -- of what we -- when and how we actually do it, obviously, we're looking to minimize the cost and really do the most accretive issuance that we can, right? So that's been our framework. I mean we look at all the metrics that everybody else looks at. We look at price-to-book, we look at dilution, we look at the marginal cost of capital, all of that. And this quarter, obviously, it wasn't accretive for us to do that. Now we do have investment opportunities. We preferred at this point to take up leverage and then be very disciplined about the capital allocation to one that's cheaper for us to issue. And if that ever does come about, then -- and it's accretive for us to do that, we'll do that.

(Operator Instructions) Next we'll go to Eric Hagen with BTIG.

Maybe just a quick follow-up on leverage. I mean how are you guys thinking about the amount of leverage you're using in light of the fact that the yield curve is inverted? Even though spreads are wide and relatively attractive, like do you feel like you could support more leverage if the Fed takes rates even higher? And then conversely, is there more leverage that you could, maybe look to take out or put on if the curve becomes more positively sloped?

Sure. Thanks, Eric. Yes. Look, so the curve being inverted, there's 2 interesting aspects of that. As long as the yield curve is inverted, you're going to want to use hedges to generate return and by using hedges, you're effectively taking some of that inversion out of your P&L, if not all of it, depending on the type of hedge you choose, okay? So the curve being inverted and the Fed taking rates up higher to the extent the curve remains inverted, I think those will be -- we're somewhat indifferent to that. So what really matters is what is the hedge return on mortgages even in an inverted yield curve. And by the way, if the Fed does take rates up further, you're probably going to see an adjustment to mortgage spreads at that point as well.

So that's kind of what we focus on with respect to leverage in an inverted curve environment is just what is the hedge return? Is it better or worse than the last time we put capital to work? But if the curve steepens, that is a massively positive tailwind for Dynex and really anyone who's operating a levered position. So we see that as an extremely positive thing. And what we would want to do is position for that in advance by taking hedges off actually. So you can take advantage of that steepening in the yield curve.

But in general, the decision to take up leverage or not is really based on 2 things. One is, what is the marginal return, two is what's the global risk environment and how comfortable are we doing that. Any type of green shoots or signals that we're going to see that pushes us in a steep curve direction would be a scenario where I think we'd be more comfortable running higher levels of leverage. So I hope that gives you a sense for like the decision thought process.

Yes. That was helpful. Maybe one on the hedge gains that you're harvesting for tax purposes. Do you feel like that has any bearing on how you manage the portfolio? Or do you feel like is the message here that the near-term tax burden really isn't very significant even though the gain sort of stands out?

I would say there's two things because the EAD doesn't reflect the hedge gains or the hedging activity, you've got to include the hedge gain period, right? So that's how you factor that in. I think there's a slide, Page 6 on the deck that basically says, look, funding costs are going up, but they're offset by these hedge gains and here they are. I'm going to let Rob answer the question with respect to the distributable income for tax purposes. I think that's a different question, and you should answer that.

Sure. Yes, thanks for the question. I don't think we're managing the book for a tax result, maybe answer your question super directly. And you heard a lot of color from Smriti today on how she is managing, how she's thinking about the book, how we're thinking about leverage, but we keep putting information in on the hedges because it's a big number that has to be accounted for. It has to be part of the analytics. It has to be part of your review. And it has helped us manage rising repo costs and financing costs and will continue to be a benefit for us for years to come. So factoring that into your analysis and projections is important, and we want to provide a lot of transparency around what we've done, how we've done it and not only the impact from GAAP accounting perspective, but tax and distribution requirement as well. So if there's other questions or if anyone needs more information around that, we'd be happy to share.

There are no further questions at this time. I'll now turn the call back over to Byron Boston for any additional closing remarks.

Thank you very much, and thank you all for joining us for our conference call. We clearly look forward to seeing you again next quarter. And just keep in mind, Dynex is prepared, we're preparing. And we really appreciate the opportunity to manage your capital. Thank you very much.

This does conclude today's conference call. You may now disconnect.