Dynex Capital, Inc.
Q2 2021 Earnings Call Transcript

Published: 28 Jul 2021

[Operator:]

Good day and thank you for standing by. Welcome to the Dynex Capital, Inc.'s Second Quarter 2021 Earnings Results Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. I would now like to hand the conference over to your first speaker today, Ms. Alison Griffin, VP of Investor Relations. Thank you. Please go ahead, madam.

[Alison Griffin:]

[Byron Boston:]

Good morning. Thank you, Alison and thank you everyone for joining our call. 2021 continues to be a good environment for Dynex to deploy capital. Our financing cost remain pegged at very low levels and has resulted in steady earnings and a wider net interest spread, as shown on slide 25. We began this year believing we will get multiple opportunities to invest at attractive returns as the yield curves deepens our spreads widen. As such, we have raised capital, maintained lower leverage and methodically deployed capital at attractive return levels. As of mid-year, we are sticking with our strategy.

[Steve Benedetti:]

Thank you, Byron and good morning everyone. For the second quarter, we reported a comprehensive loss of $0.98 per common share and a total economic return of minus $0.93 per common share or a minus 4.6%. We also reported coordinate operating income of $0.51 cents per common share, an increase of 10% over last quarter's $0.46 per common share and well exceeding our $0.39 quarterly common stock dividend. Book value per share declined $1.32 or minus 6.6%, principally from economic losses on the investment portfolio of $48 million or $1.49 per common share, driven in part by mortgage spread widening and in part due to the lower rate environment during the quarter versus our hedge position. In terms of specific performance, TBAs and dollar roll positions continue to be important contributors to results for the quarter, adding an incremental $0.06 per common share to core net operating income, which is partially offset by lower earnings from a smaller pass through portfolio.

[Smriti Popenoe:]

Good morning, everyone and thank you, Steve. I want to start by building on Byron's comments by describing the principles that have been consistent throughout our portfolio management history here are Dynex. The first is a sound macroeconomic process and framework to assess the environment; the second is a flexible mindset to be able to pivot when the environment shifts; and finally, the right amount of patience and decision making. The environment we have been in since January 2020 has required all three of these principles in real time, especially now, as the markets are still seeking a direction and level. The most important principle for what we are in right now is patients while we continuously assess the environment because the passage of time is what is now needed for the data and the market direction to become clear. Even so, this remains a very favorable environment in which to generate long-term returns. As shown on slide 25, our repo financing cost declined 7 basis points over the quarter. Financing in the TBA market has continued to be strong, contributing 1% to 3% excess core ROE versus pools. Since your end, as Byron mentioned, we have used bouts of volatility to invest capital and we did that late in the second quarter and have done so into the third. As spreads tightened in late April, we reduced our leverage by a full turn and as returns are now in the 10% to 12% core ROE range, we have reinvested a portion of that capital, growing the balance sheet from a low point of 4.5 billion in the second quarter to 5.6 billion thus far in the third quarter. We allocated out of TBAs into specified pools, as payoffs declined substantially in May and we added outright marginal investments in Fannie 2.5 specified pools as well as Fannie 2 TBAs with wider spreads in June and July. Our total economic return year-to-date is 2.4% with book value on June 30 at 18.75, relatively unchanged versus year end. In the third quarter thus far, MBS spreads are wider, and as the yield curve has flattened dramatically in July, book value has fluctuated with yields in a range of flat to down about 5% versus quarter end. To put the book value move in context, about half the book value decline in the second quarter was due to MBS spread widening, and the remaining half is attributable to our hedge position that is concentrated in the back end of the yield curve. Post quarter end, MBS spreads are modestly wider but the book value decline is directly attributable to our hedge exposure to the long end of the yield curve.

[Byron Boston:]

Thanks Smriti. I want to leave you with three words opportunities, patience and trust. First, we continue to be in an evolving global environment that will give us opportunities to invest our capital at attractive long-term returns. Our portfolio continues to be structured for a steeper curve and wider spreads. We continue to operate with lower leverage and higher levels of liquidity which will allow us to take advantage of these opportunities, as they develop. Second, our decades of experience in the business leads us to be very patient as the world and the capital markets continues to adjust to this evolving global environment. Since this new era in history began in January of 2020, we have maintained patience in managing our balance sheet, tactfully increasing our capital base and methodically investing money into wider mortgage spreads and higher yields. We will continue with this mindset. At Dynex Capital we offer you two products to gain access to above average dividend yield. Our common stock offers a great multi-dividend yield with a book value that will fluctuate as the market environment continues to evolve. On the other hand, our preferred stock offers less price fluctuations with a lower dividend yield than the common. Finally, we want you to continue to trust us with your money. At Dynex Capital, our number one purpose is to make lives better by being good stewards of individual savings. Over the past 14 years, since I joined Dynex, we have earned your trust and we have managed our business with an ethical focus, remain patient and looking for the right opportunities to invest your savings at attractive long-term returns. We are consistent and we will remain patient as we let the global environment evolve and we will continue to make wise decisions on behalf of our shareholders. Please take a note - look at our long-term return on slide 13. I love this chart. Dynex continues to offer a great alternative to many larger financial institutions. And with that, operator, we can open up the lines for questions.

[Operator:]

Thank you, sir. Our first question is from Doug Harter from Credit Suisse. Your line is open.

[Doug Harter:]

Thanks. You mentioned that that you would I guess be comfortable with up to two additional terms of leverage. I guess just can you help us think about how - what the pacing of adding that leverage could be? Is our current returns attractive enough to want to continue or I guess what are the - what are you looking forward to look to continue to add to the portfolio, like you kind of began to do on the last couple months?

[Smriti Popenoe:]

Right. Good morning, Doug. Thanks for the question. So, yes, I think we've sort of brought the leverage back to levels that we feel comfortable holding for the moment. From where we sit right now, we are still generating returns well in excess of the dividend and we feel like we can be more opportunistic over the coming quarters. So, to really take that leverage up, I think we would need to see additional spread widening from here, which we anticipate can happen, as the market gets more clarity on the taper and the timing of that. So in the next two quarters, we expect to be able to add to that. We're not in any specific rush at the moment, just given how strong the current balance sheet in terms of returns, what it's throwing off.

[Doug Harter:]

And then kind of as you're adding assets, can you just talk about kind of what type of hedges you would be adding against that many changes to kind of the hedge portfolio construction?

[Smriti Popenoe:]

Yes, I think, as we've started to look at marginal hedges, our thought process is to use more of the yield curve at this point and then implied one on options had come down a significant amount in the second quarter. They've popped back a little bit now but options continue to remain a very good strategy in terms of really protecting against some of the longer-term moves. So I think maybe, from here on out, really protecting more of the yield curve, the front end of the yield curve in particular and then options constructed in that part of the curve as well is how we're thinking about hedging going forward.

[Doug Harter:]

Great. Thank you.

[Operator:]

And our next question, we have Eric Hagen from BTIG. Your line is open.

[Eric Hagen:]

Hi, thanks. Good morning. I think you guys mentioned some of the technical factors that are underpinning the market and the potential for volatility. I'm just curious how you think the dollar role specifically evolves in light of the potential Fed policy and how strong you think bank demand will be, if the Fed is pulling back?

[Smriti Popenoe:]

Hi, Eric. Thank you for the question. So this is - we - it's an interesting conversation to have because a year ago when - in June of last year, we were kind of getting the same questions about dollar rolls and how specialness could last long - how long it could last and etc., etc. And 14 months later, we're still seeing very, very strong financing rates in the dollar roll market. And just to give you some numbers on that, in the first quarter, I would say, the average financing levels that were available in the market were in the negative 50 to 70 basis points. That came down a little bit in the second quarter to say, negative 50 basis points. These are still massively, massively accretive levels here. And as the year evolves, we expect that to soften and again, with net new supply into the market that will come down. But again, we expect that to be still offering some level of advantage relative to pause for some time, as the technicals persist. Bank demand is going to be a driver of that and bank demand is directly related to two things. One is, you can see the level of the RRP in the marketplace right now, over 800 billion. That's a big indicator of potential bank demand. Secondly, just the demand for C&I loans that the economy is still coming out of this pandemic, and when there's lack of C&I loan demand, banks tend to invest in MBS. And we think that picks up here into the third and fourth quarters so that'll provide additional technical support. And then last, but not least, we've actually seen a really interesting dynamic with MBS now offering potentially compelling returns versus investment grade corporates. And at some point, when the tapering happens, that is going to be another dynamic that will support mortgage spreads as money managers get out of the riskier assets and into higher quality assets like mortgages. So those are all pretty strong near-term technicals for the role as well as MBS spreads.

[Eric Hagen:]

Got it. Great. Thank you very much. A follow-up on the hedging is whether your appetite to hedge at the short end of the curve will be a function of moving TBAs back on the balance sheet and holding pools, or the plan to start layering in swaps, regardless of the mix on the asset side.

[Smriti Popenoe:]

I think we're very cautious on swaps for a couple reasons. One is just the transition out of labor and obviously, there's a huge amount of noise right now on silver swaps, etc. So, we think of it more in terms of using the front end like Euro dollars or futures and it's independent of whether the assets are on balance sheet or off balance sheet. So, in general we are thinking about the entire curve and our hedges in the future will incorporate a bigger mix of front-end hedges as well as options.

[Eric Hagen:]

Great. Thank you very much.

[Smriti Popenoe:]

Welcome.

[Operator:]

And for our next question, we have Trevor Cranston from JMP Securities. Your line is open.

[Trevor Cranston:]

Hey, thanks. Good morning. Follow up question on your views of MBS spreads and risks of additional widening. I guess looking at spreads throughout the second quarter, it seems like higher coupons generally performed worse than lower coupons. When you think about risks within the coupon stack and risks of spreads may be widening further as taper evolves, do you view the risk with spread widening is more concentrated in lower coupons or how are you guys thinking about that with regards to the coupon stack. Thanks.

[Smriti Popenoe:]

Hi, Trevor. Thank you. Thank you for the question. I think the answer is yes to all of that because you really got two dynamics the upper part of the coupon stack, Fannie threes, three and a half, and fours and anything above that, that this spread whining is more driven by fundamentals, which is really that refinancing option is getting more efficient, not just because mortgage rates are lower, but because the FHFA and GSE and government policy is now starting to open that box up for more people to refinance, right. So that upper part of the coupon stack is going to be challenged, simply from the fundamentals being worse. And so that will have a difficult time in terms of spreads. The lower part of the coupon stack is really going to be more technical because whatever gets refinanced from the upper part of the coupons stack is going to show up as supply in the lower part of the coupon stack. And then you'd also combine that with tapering from the Fed, which has been buying the lower coupon. So we think about that as sort of an even mix and the only reason I'm saying even, is because technical demand still will remain in the lower part of the coupon stack, giving that a bit of support relative to the higher coupon. So, in general, I think everything is going to be wider. The reasons for widening will be different. There are a lot of people out there wishing or hoping for burnout in the higher coupons, people that may or may not come. And if it does, you might see that higher coupons perform better relative to low coupons. But in general, you should see these returns start to get better over the next couple quarters.

[Trevor Cranston:]

Okay, that's very helpful. And then a question on the hedging and repositioning, you guys mentioned the possibility of a whipsaw and rate scenario, and why you're continuing to use hedges at the 10 year part of the curve. Can you maybe add some further discussion around kind of why you think it's less likely that rates continue to drop and kind of what the big risks are there that might cause the 10 year to continue pushing lower? Thanks.

[Smriti Popenoe:]

Yeah, I mean, we don't think it's less likely that the 10-year rate won't come down. I mean, we were actually very respectful of a scenario where the 10-year rates could come down. I think our view coming into this quarter was that we'd have a range bound market, and that you could see surprises data to become clear. So as we've done that, we've felt like most of this move coming down here has been technical in nature. And that's what's given us some confidence to hold that position and prepare for a whipsaw backup in rates. There's a lot of market psychology that has driven rates down here as well. That can quickly change with the advent of a vaccine or COVID pill or whatever it is, right. So, we're just cognizant of that potential whipsaw risk in the market. And at the same time we're thinking through the scenarios that might lead us to lower rates. We haven't seen the impetus for us to reposition the hedges to make that decision yet but we're remaining open to do that, right. So I don't want to give the impression that we believe it's less likely; even if it is less likely or it's not about likely and the likelihood, it's about how persistent that scenario could be relative to that whipsaw risk. And right now it looks like that whipsaw risk in our assessment is a little bit greater than how persistent a downgrade scenario could really be from here. I let Byron chime in as well, because I know he's some thoughts on there.

[Byron Boston:]

Yeah, a couple of high-level thoughts on that. First off, since January 2020, there's been enormous whipsaw that is one defining factor about this current environment in which we're operating. When you're managing a leveraged portfolio, like a mortgage REIT and one thing you don't want to do is get caught trying to trade every flip and turn in the market, it can be extremely costly to do that. So we have had a philosophy from the first day I ever got here actually from the first day I started Sunset Financial in 2004. Understanding the cycle or environment in which you're operating, structure your portfolio accordingly and be patient. So I can give you many times in the past where in fact, we've done that and about Sunset Financial when doing the Greenspan's conundrum. That one went on for probably a year or so and we're very patient in that environment. I can go on with keep bringing examples at Dynex Capital. Here's another interesting fact. The 10 year yield below 1% has to come with some really ugly factors. Think about it. 10 year below 1%, it's really a different world. So we're holding our position we've been in and we've structured our portfolio in this manner. Smriti, when we started back when - I think rates were at 50 to 65 basis points over 10 years.

[Smriti Popenoe:]

Yeah.

[Byron Boston:]

And we've managed our book of business accordingly. Part of the factors we know that has led to this violent move down from 175 is that the amount of shorts in the market and short covering. As I've already said, we're not - we don't take major positions on the market and make major calls, we adjust our portfolio and our risk position for the long term and based on our very disciplined assessment of the factors that are really at play at any point time in any cycle.

[Trevor Cranston:]

Gotcha. Okay, that's helpful. I appreciate all comments. Thank you.

[Smriti Popenoe:]

Thanks, Trevor.

[Operator:]

Our next question is from Bose George from KBW. Your line is open. Once again, Bose George, your line is now open.

[Bose George:]

Hi, guys. Good morning. Sorry, my mute was on. I just wanted to start with a question on spreads again. You guys did talk about potential for some more widening. Just curious about your thoughts on how much of this spread widening has already happened, sort of ahead of tapering?

[Smriti Popenoe:]

Yeah. Hi, Bose. Thank you for the question. I would say so we're about in our models, 15 to 20 basis points wider versus the tights. I would say anywhere between - we're expecting another 10 to 15 basis points, potentially. Anything above that would just be a massive buying opportunity. So I think really, some of this tapering risk has been priced in, you're also seeing some of the risk that's been priced in, it is just lower rates and higher supply here. So it's hard to tell, which is which. But you could continue to see widening here somewhere in 10 to 15 additional OAS from here on. I wouldn't be surprised to see the market react poorly to supply and push things even wider but that's about what we're thinking from here on now.

[Bose George:]

Okay, great. That's helpful. Thanks. And then just wanting to go back to Doug's question early on leverage, but did you say that leverage is still around the current point in level and just given strong returns here and there's no - you'd probably take it up in the future but at the moment, it's still around current levels, just wanted to clarify.

[Smriti Popenoe:]

Yeah, I did. Yes, I think right now we're maintaining the size - our earning assets size is about 5.6 billion and we're going to keep that size. And, as we see new opportunities develop, again, we want to see more widening from here before adding to the balance sheet. We're very comfortable with this level of the balance sheet supporting not only the dividend but also cushioning excess earnings cushioning any kind of book value fluctuations between now and year end. And so, we like where we are today, it gives us a lot of flexibility to either take it down if we feel like we need to or add to it, as we see spreads become more attractive.

[Bose George:]

Okay, great. Thanks and then just one more clarification. On the book value, you said it fluctuated between zero and five, but right now is it down around 5%?

[Smriti Popenoe:]

It's been between zero and 5% and it really moves with the level of yields. So at the lower levels of yields, it's at the lower end of that range and at the higher levels of yields, it is at the upper end of that range.

[Bose George:]

Okay, great. Thanks.

[Operator:]

Our next question is from Christopher Nolan from Ladenburg Thalmann. Your line is open.

[Christopher Nolan:]

Hey, guys. Steve, the 68.3 million from the offerings, is that net or gross.

[Steve Benedetti:]

That's net, Chris.

[Christopher Nolan:]

Great. And then I guess, given all the moving pieces where you're having strong core earnings, but in this quarter, at least, you had a loss, a GAAP loss. What's the prospect of a possible dividend supplement?

[Byron Boston:]

So, right now, Chris, our dividend policy we feel very, very comfortable with. And I think I may have spoken in the past year, we're pretty adamant about our dividend policy for this macroeconomic environment and we answered this a few quarters ago. We talked about surprises are highly probable. We talked about being in a very evolving environment. And feeling very comfortable holding this dividend where we are today, as we manage through this environment. As we continue to generate earnings, it gives us a lot of flexibility, cushions in book value, other options and other situations. But in a global macroenvironment like this, Dynex Capital has always prioritized risk management. The dividend policy is part of that process. So we're looking to generate an attractive total economic return, which includes the dividend. But when you think about CPR, you got to think about your risk management, as the overall return for the shareholders continues to be attractive over time. So when we talk about also a 1% ten year, 1.25%, 1.50% ten year, our dividend level is substantially higher than those levels. Trying to achieve the 10, 11, 12, 13 type percent dividend yields in a world where yields have consistently fallen that's not the type of risk that we'd like to take. We'd like to take the higher returns when we can generate them but our long-term goal remains the same. 8% to 10%, over the long term, holding booked a steady over the long term. Or another way to say that is an 8% to 10% CPR over the long term in an environment of 1% ten year yields. That makes sense. Did I answer your question?

[Christopher Nolan:]

Yeah. Yeah. And I guess the final question is the earning asset volumes of $5.6 billion in July, if I heard that correctly, I presume that includes TBAs.

[Smriti Popenoe:]

It does, Chris.

[Christopher Nolan:]

I mean, back of the envelope, it seems like your leverage ratio have gone up. I know you've - when you're talking to George Bose, you said it was flat.

[Smriti Popenoe:]

Yeah, no, it depends on the book value, obviously, right. So it's going to fluctuate with that. It's going to fluctuate with that. We think about just the earnings power of the balance sheet. The earnings power of the balance sheet sits at 5.6 billion and the leverage, all else being equal, if book value is down, obviously it will pick up, right.

[Christopher Nolan:]

Got it. Okay, that's it for me, guys. Thank you.

[Operator:]

Our next question is from . Your line is open.

[Unidentified Speaker:]

Thank you. Good morning, folks.

[Byron Boston:]

Good morning, James.

[Unidentified Speaker:]

Hi. You talked about your rate expectations and implicit yield curve expectations, the kind of the derivative bet and all that. And we heard about it on enough of the previous calls from other people in the space as well as the non-call warns, so to speak. A lot of people seem to be betting heavily on burnout. From what I've heard from you folks, burnout is - it doesn't seem to be as much of an expectation as I am hearing from other people. But I don't hear you with more IO and certain kinds of season pools that are more burnt out. I'd love you guys to have a couple of level conversation about what you think in terms of burnout and where are we in the marketplace, maybe making false expectations by expecting it?

[Smriti Popenoe:]

Okay, so couple of - from big picture to little picture. Burnout is something that we have been very cautious about adding to our portfolio just buying something because we believe there is burnout, the number one reason for that has been just a fundamental shift in the structure of the way the mortgage market operates. You now have an environment which is massively dominated by non-bank originators, and non-bank originators, many of whom went public this year with the equity market, not really some specs and other things like that. So now these non-bank originators have a public market mandate to produce earnings on a quarterly basis and show growth on a quarterly basis. That creates an environment where you now have a group of companies that is heavily incentivized to refinance every mortgage that's out there within the rules of the game that are being laid out. So that's thing number one. So that says to us, any mortgage that's out there that can be refinanceable, look out, because it's going to be on the target. And so that's thing number one. The second thing we've noticed and we track this very closely, is the levels of staffing at these organizations. There's reports that are available that tell you whether they're fully staffed or not fully staffed. These organizations are fully staffed and they're ready to go. And this last move down in rates has just been a - is going to be an earnings bonanza for those companies, right. So then the third thing we look at is, is GSE policy and government policy in general, that is also pointing in the direction of broadening the envelope of borrowers who can refinance at this point. Cash out refinancing is more prevalent. You've got home prices that have gone up, that's going to help people that were originally burned out or didn't have that incentive to refinance. And then you have just the actual box, a credit box, the 50 basis point adverse market refinancing fee that got waived. So, all of these things are pointing in the direction of, reducing the protection that you get from burnout. So that's just a very fundamental thing to begin with. The second thing - so then that's just the big picture, from where we sit today, do we think there's individual little pockets of things that you can purchase that might have burnout? Sure, you find some 120 wallets , it's not something that you can scale up as a strategy, and make a core part of how you're running your portfolio. So I think, if you're hearing that people have some ways of adding to as a 10% of your assets or whatever it is, that's not improbable, but it is something we don't expect that burnout is a core part of an investment strategy on our side, simply because the facts in the market are really pointing very much against that being an investment strategy that that's going to survive in this type of environment.

[Unidentified Speaker:]

Thank you very much for the answer.

[Smriti Popenoe:]

You're welcome.

[Operator:]

I am showing no further questions at this time. I will now turn the call back over to Mr. Byron Boston. Thank you.

[Byron Boston:]

Thank you, operator and thank you all for joining us today. Stay calm, stay patient, and be prepared. And we look forward to chatting with you next quarter. Thank you.

[Operator:]

Thank you, presenters. Ladies and gentlemen, this concludes today's conference call. Thank you for your participation and have a wonderful day. You may all disconnect.