Dynex Capital, Inc. (NYSE:DX) Q3 2023 Earnings Call Transcript

Dynex Capital, Inc. (NYSE:DX) Q3 2023 Earnings Call Transcript October 23, 2023

Dynex Capital, Inc. misses on earnings expectations. Reported EPS is $-0.28 EPS, expectations were $-0.11.

Operator: Good morning. My name is Rob and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Third Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Alison Griffin, Vice President of Investor Relations. You may begin your conference.

Alison Griffin: Good morning, and thank you for joining us today for Dynex Capital’s third quarter 2023 earnings call. The press release associated with today’s call was issued and filed with the SEC this morning, October 23rd, 2023. You may view the press release on the home page of the Dynex website at dynexcapital.com, as well as on the SEC’s website at sec.gov. Before we begin, we wish to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan, and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified.

The company’s actual results and timing of certain events could differ considerably from those projected and/or contemplated by those forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, please refer to 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 home page 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 now my pleasure to turn the call over to Byron.

Byron Boston: Thank you, Alison and good morning, everyone. I’d like to begin by congratulating my longtime colleague and friend Smriti, on her nomination to the Dynex board. Smriti and I have worked together since 1997. In these 25-plus years, we have forged a unique partnership based on trust, friendship, and an uncompromising focus on performance. I’m glad to have her with me on the board as we face a rapidly evolving business landscape. Over the last few months, I have spent a lot of time with shareholders discussing the macroeconomic environment. I will share my main thoughts and my comments today before turning it over the call to Rob and Smriti. There are three major factors that I have been focused on as we grow our business here at Dynex.

Number one, human conflict. I have long emphasized the setting of investment strategy in the context of a global macroeconomic environment. For some time now, I have also identified human conflict as an important consideration. We are now seeing it play out around the globe and within our own country. Number two, global debt. It has risen rapidly to levels that are quickly becoming unsustainable as the cost of financing has risen dramatically. While the need for more financing is also increasing due to human conflict and demographics among other factors. Number three, balance sheet transition. There is a major transition underway globally as central banks run off their balance sheet. Private capital needs to take on the risk that was previously announced on government balance sheets at uneconomic price levels.

We are witnessing a massive and ongoing price adjustment in assets across the risk spectrum, because private capital demands a higher risk premium to hold those same assets. At the intersection of these factors, the probability of accidents increases exponentially. You’ve heard me say this as the prices are highly probable in a complex macroeconomic environment. What we have done at Dynex is to keep our shareholders in the game by investing in the most liquid asset that is yielding an above average long-term return. As the global economy transitioned from central banks to private capital, agency mortgage-backed securities have faced the earliest and steepest price correction. Our book value has felt the impact of this correction, since the second quarter of 2022.

We have anticipated and prepared for book value volatility with high levels of liquidity and a flexible position. While no one likes to see book value decline, the majority of the impact of book value has been due to spread whitening, a risk we believe is organic and acceptable as we are invested in the highest quality asset with a guaranteed return of capital. The bonds in our portfolio are money good. As I lead Dynex, my focus remains on generating long-term sustainable returns. In that regard, our past performance provides a strong foundation to work from as we navigate what is clearly an unpredictable and evolving environment. I see a compelling business opportunity in agency mortgage-backed securities to earn above average returns adjusted for the risk.

We have positioned our shareholders to benefit from this in the long-term. I know I’ve mentioned this on previous calls, but I continue to believe experience and skill are the key elements for success in this environment. I have been doing this for a long time. Extracting the yield spread available in mortgages is complex and requires skill. There’s more spread available to earn today than in the last 20-years, and the team here at Dynex is one of the best in the business to be able to accomplish this. I’ll now turn it over to Rob to review the quarter.

Rob Colligan: Thanks, Byron, and good morning. For the third quarter, the company reported book value of $12.25 and a comprehensive loss of $1.59. The book value performance plus the dividend delivered an economic loss of 11% for the quarter. The performance this quarter reflects both rate increases and spread widening. We continued the trend of the second quarter by adding pools and reducing TBAs this quarter. Leverage increased this quarter to 8.5 turns, compared to 7.7 turns last quarter. As a reminder, our EAD does not include the benefit of our hedging activities. We continue to use features as our primary hedging instrument, due to the depth and liquidity of the markets, as well as lower capital requirements, compared to a similar swap instrument.

In the third quarter, Dynex had net hedge gains of $217 million and have unamortized net hedge gains of $830 million at quarter end. These hedge gains help to offset increase in financing costs. Page seven of the earnings release provides our estimate of hedge gain amortization over time. Please also see page six in our earnings presentation, which highlights the components of portfolio returns and recent trends in net interest income and hedge gains. For the third quarter, we recognized $18 million of hedge gain amortization for tax purposes, or approximately $0.33. Since the amortization of hedge gains are a component of REIT taxable income, they will be part of our distribution requirement along with other ordinary income and expenses. As we discussed last quarter, we expect hedge gains will be supportive of the dividend.

As of now, we’re projecting the fourth quarter to have hedge gains of $24 million, or $0.41 per share. The total amount of gain to amortize and to REIT taxable income can go up or down, depending on the hedge position and movement in rates in the future. Dynex ended the third quarter with an unrealized gain on its hedges. With that, I’ll now turn the call over to Smriti for comments on the quarter.

Smriti Popenoe: Thank you Rob. I’d like to thank Byron and the other members of the Dynex Board for my nomination and appointment to the Board of Directors. I’m delighted to join them in steering our company’s growth in the coming years. Signing various board documents in the past months gave me a new perspective on what it means to be a steward of our shareholders capital. I feel humbled and grateful for the responsibility and will continue to work diligently to fulfill it. I also want to welcome T.J. Connelly to the Dynex team. He joined us in September to head up strategy and research. T.J. has a long history with Byron and me going back over 20-years. He brings a wealth of experience in asset management, macroeconomic analysis, modeling, and technology.

He will spearhead our thought leadership efforts and you will begin hearing from him directly in the coming months and quarters. His addition greatly broadens our decision-making capabilities and I’m thrilled to have him as part of our team. Let me start by covering the markets and decisions around positioning, after which I will give you my thoughts on the outlook. Last quarter, U.S. Treasuries resumed one of the deepest and most prolonged drawdowns in nearly 50-years since the inception of major bond indices. Through last week, U.S. Treasury yields have risen some 75 basis points to 100 basis points on the year, to levels not seen since 2007. The yield curve has reversed a significant portion of its inversion and has continued to steepen into the fourth quarter, meaning that longer maturity treasury bonds are moving higher in yield relative to shorter term treasuries.

These changes represent major shifts in market expectations for the future path of interest rates. The agency MBS market has felt the impact of higher rates. Weighted average OASs of our portfolio widened 15 basis points through quarter end, and we are wider by an additional 15 OASs since quarter end. Spreads now stand at both year-to-date and multi-year-wide on a nominal and option-adjusted basis. Book value declined by $1.95 or 13.7% on the quarter, driven equally by rates and spreads, and as a result adjusted leverage also increased from 7.7 times to 8.5 times. Year-to-date, our models attribute the majority of the move in book value to wider spreads. Over the quarter, we adjusted our hedge ratios, which were designed for a portfolio that included higher coupons in a heavily inverted yield curve environment.

Our adjustments incorporated more optionality and protected the position from a less inverted or steeper yield curve. You’ll see the impacts of our positioning on page 14. The net result is a position that is less exposed to changes in the level of rates. Our focus remains on the net spread between agency RMBS and our treasury hedges. The recent moves in agency RMBS spreads are happening for several reasons. You’ve heard me discuss in the past of how the native balance sheet for mortgage risk in our country is changing. For much of the last 15-years the U.S. Federal Reserve was the largest holder of agency RMBS and before that the GSEs retained portfolios with the largest holders. These entities crowded out private capital and removed a risk premium from the asset class.

Private capital must now replace these government balance sheets. And in agency RMBS, that risk premium has now returned. Spreads are historically wide and they compensate private capital appropriately for the risk. This is why I have been saying we are in the middle of a persistent investment opportunity for our shareholders. As we show on slide nine, agency RMBS spreads to a blend of treasuries are likely to trade in the 120 basis point to 200 basis point range. We are currently near the wide end of that range. And we expect that returns from owning hedged agency mortgages will be sustainably higher for some time. While volatility and spread widening has caused pockets of stress, the best managed mortgage rates like Dynex remain a source of stability for the U.S. Housing System.

We see that in the financing markets, which continue to function in an orderly manner, our counterparties have access to liquidity and haircuts are stable. They report that their customers’ liquidity profiles remain solid. Our hedges are in the most liquid part of the global financial system, the exchange traded U.S. treasury futures market. So what does this mean for Dynex shareholders? We are invested in money good assets trading at historically low prices that offer accretive forward returns. Agency RMBS return projections look about as robust as I’ve seen them in my 10-plus years at Dynex and nearly 30-years as a fixed income investor. With that, I’ll turn it over to Byron.

Byron Boston: Thanks, Smriti and Rob. I would like to leave you with the following thoughts. The opportunity to earn a compelling return only mortgages on a hedge basis is as attractive as I’ve ever seen in my 40-plus year career. Our portfolio is mark-to-market daily, and while there can be periods of volatility, lower prices mean higher future returns on bonds like ours. That our money good. Our management team is extremely skilled at earning his returns and our portfolio is well positioned to earn outsized returns going forward. Very important for you to understand, we, the management team and the board, own our stock. Management has a material interest in the company and our focus is on extracting the historic returns available in the market today. With that, operator, I will open the call to questions.

See also Bill Gates’ Investment Company’s 10 Newest Stock Picks and 12 Best Dividend Stocks For Passive Income.

Q&A Session

Operator: [Operator Instructions] And your first question today comes from the line of Bose George from KBW. Your line is open.

Bose George: Hey, everyone. Good morning. Actually, first I wanted to ask that you guys noted book OAS is at 14 basis point — 15 basis points this quarter. Can you just give us an update on what that means for book value?

Smriti Popenoe: Yes. Hi, Bose. The number I quoted was actually as of a couple of days ago. So the number since quarter end is closer to 25 OAS on our portfolio. And the book value has been volatile somewhere between 10.50 and 11.50 as of last week per share, so that’s where it’s been ranging. I do want to say a couple things, you know, just on what’s been happening in the last week, right? One of the main observations we have in terms of why OASs are wider is — it’s been a technical widening. This is not a widening that’s based on the credit quality of the asset or that the money isn’t coming back at par, right? These are money good assets. It’s been really a factor of technical selling. One of the most interesting things that has happened in the sector is that money managers very wisely went overweight mortgages earlier this year.

That’s because they were the cheapest asset out there. They were cheap versus corporates. We like to make a joke internally, they were cheap versus Bitcoin, they were cheap versus everything, right? So that was the appropriate trade to do. And what’s happened with the sell-off in the last few weeks is that they have been receiving redemptions. And when those redemptions come, they choose to sell the most liquid asset. We felt this last year at the same time in October, where the most liquid asset got sold, that happens to be the asset that we own. And that’s actually one of the biggest drivers of why mortgage spreads are sitting out here in the past week. So this is technical selling. The selling is happening as money managers get redemptions.

And for that reason, we just want to be cognizant that this isn’t a judgment on the quality of the asset. And our level of comfort withholding this asset class is the idea that these are money good.

Bose George: Yes, yes, that’s absolutely — that definitely makes sense. Thanks. And then, actually, just given the declining book value since quarter end, obviously your leverage is higher, all else equal. How are you guys just thinking about leverages? Would you let it ride up a little bit, just given this uncertainty, and hold the assets? Or is there a situation where you might have to reduce the size of the portfolio to get your leverage back in a range where you become more comfortable?

Smriti Popenoe: Yes, look, one of the nicest things about the way we have been positioned coming into this environment is having a massive amount of liquidity. So we’ve closed the quarter with $450-plus million of cash and unencumbered assets. That leaves us in a very flexible position here as we look at what’s going on in mortgages. You know, you guys know us to be very astute risk managers. We’re sitting here evaluating exactly all of those decisions every day for on behalf of our shareholders, right? One thing that gives us a lot of conviction in our position and anything that we do to manage it. Number one, we’re sitting here with a very liquid asset. Number two, we’re sitting with a big pile of liquidity. Number three, we have the scale to manage through these volatile environments, right?