Dynex Capital, Inc. (NYSE:DX) Q4 2022 Earnings Call Transcript

Dynex Capital, Inc. (NYSE:DX) Q4 2022 Earnings Call Transcript January 30, 2023

Operator: Good day and welcome to the Dynex Capital Fourth Quarter and Full Year 2022 Earnings Call. Today’s call is being recorded. And I would now like to turn the conference over to Alison Griffin, Vice President of Investor Relations. Please go ahead.

Alison Griffin: Good morning and thank you for joining us today for the Dynex Capital fourth quarter and full year 2022 earnings conference call. The press release associated with today’s call was issued and filed with the SEC this morning, January 30. You may view the press release on the homepage of the Dynex website at dynexcapital.com as well as on the SEC’s website at sec.gov. Before we begin, we wish to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified.

The company’s actual results and timing of certain events could differ considerably from those projected and/or contemplated by those forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, please refer to our disclosures filed with the SEC, which maybe 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 Rob Colligan, Executive Vice President, Chief Financial Officer.

And with that, it is my pleasure now to turn the call over to Byron.

Byron Boston: Thank you, Alison. Good morning and thank you for joining us today. We started this decade at Dynex, believing that surprises would be highly probable and 3 years into it, the surprises continue to come. I have been active in the financial markets since 1981, with a four-decade long career that began with a deep curiosity for economics. As a trader and banker on Wall Street, I learned disciplined processes for risk management. And my experience since then has laid a tremendous foundation for navigating this current period. I can say with all my years of having been on this planet that we are at a big moment in history. Last year, we saw more volatility than I had witnessed since my early years on Wall Street. Bond markets had the worst year of returns since 1926.

Our performance for the year reflected some of this turmoil. Our total economic return for the year was negative 9.45%. We are a big proponent of preserving book value and we never like being in a position of losing capital. So on a standalone basis, this is a disappointing result. Nonetheless, Dynex outperformed major fixed income indices and our peer group and we continue to deliver industry leading returns. In the context of a worst performance in almost 100 years for the bond market, we made disciplined and deliberate choices in managing our risk. And as you can see on Pages 4 and 5, we remain the top performer over for 3-year and 5-year period. Against a historically difficult backdrop and markets, I take enormous comfort in this relative result.

As a fellow shareholder, I focus on how we are building long-term value. Please turn to Page 9. You can see we started the decade at $18.01 in book value and we have delivered $19.51 as of December 31, including cumulative dividends. Although book value is lower, we did not subject our shareholders to large unrecoverable, realized losses in either 2020 or 2022. As I stand here today, looking at the investment landscape, I see a favorable investment environment that supports a recovery in book value over time without the need to take excessive risks to recover capital while we continue to generate a solid return for you. As I said earlier, we are at a significant moment in history. We are anticipating that this decade will bring new opportunities and unique challenges.

Global markets are fragile because of the rapid buildup of debt. We believe central bank balance sheets matter. The removal of liquidity has the potential to impact a broad section of the investing landscape. Global complexity continues to be amplified by human conflict. As such, we are making decisions with these factors in investing your savings with a long-term in mind. As your asset manager, we have demonstrated the ability to shift risk over the past 15 years. I want to emphasize we do not consider ourselves an agency-only REIT nor we invested in an agency RMBS, because it is the hot thing to do. We believe that this environment calls for liquidity and flexibility. Agency RMBS are highly liquid, government guaranteed assets and offer excellent returns.

Therefore, they are our current investment of choice. We remain prepared for an evolving macroeconomic environment, which we believe will eventually lead to a wider set of investment opportunities. As the captain of the Dynex ship, I want you to know that we have the tools to manage through this environment. Inverted yield curves are unique to periods of significant Fed tightening. Smriti and I have shared the experience of managing through an inverted yield curve in 2003 through 2006 in a public company mortgage REIT, where significant amount of value came through our hedging strategy. As Smriti will describe, hedging is an important part of how we navigated this inverted yield curve environment. As demographics shifts globally towards an aging population, the need for income is getting increasingly apparent.

Dynex Capital is an expert in delivering income. As such, we are making decisions to invest in people, processes and technology as we build our company for the long-term. Our business model and strategy are designed to thrive and find opportunities across multiple markets scenarios. We believe that this sets us apart and you are seeing evidence of that differentiation in our results. I am proud of the loyalty, dedication and efforts of our team. And I am very proud of the results that produced both in 2020 and 2022 and so far this decade as a whole. Our commitment to providing attractive long-term returns for our shareholders is unwavering and we are excited about the opportunities ahead of us. And with that, I will turn the call over to Rob Colligan to provide more specifics regarding our fourth quarter performance.

Rob Colligan: Thank you, Byron and good morning to everyone joining the call today. For the quarter, the company reported book value of $14.73 per share and comprehensive income of $1.17 per share. The book value performance plus the dividend delivered an economic return of 6.2% for the quarter. The portfolio benefited from spread tightening which occurred in the fourth quarter and drove increases in the value of our mortgage-backed securities and TBA positions. Our thesis of book value recovery based on spread tightening still holds true. We believe that our portfolio should recover a significant amount of value when investor demand for mortgage-backed securities improve or simply as pay-downs occur over time. Smriti will cover more granular details as well as our views on recent market activity and our outlook for the future in her comments.

Earnings available for distribution was $0.03 for the quarter. As discussed last quarter, this does not include the benefit of our hedging activities. If the company utilize swap instruments instead of futures, EAD would be dramatically different. Our decision to use futures is based on the depth and liquidity of the futures market as well as lower capital requirements compared to a comparable flop instrument. That provides equivalent rate protection. While it’s rare for extended periods of interest rate inversion to exist, it’s not a completely new market environment. With rate inversions, income needs to be generated from the management of interest rate risk, primarily from appropriate hedging strategies. In the fourth quarter, Dynex realized $205 million of hedge gains bring our year end hedge gain to $691 million.

This is a material number that has insulated the company from rising rates and has protected book value from a dramatic rise in short-term rates as the Fed continues to use rate policy in an attempt to tame inflation. As mentioned last quarter, these hedge gains are amortized into REIT taxable income over the hedge period of approximately 10 years. The benefit of interest rate hedge gain amortization was approximately $12 million for the fourth quarter and $22.5 million for the year. The earnings release provides our estimate of hedge gains by quarter for 2023, for the full year 2024, and then years thereafter. The total amount of the hedge gain to amortize into REIT taxable income can go up and down depending on the company’s hedge position and movement in rates in subsequent quarters.

We have experienced some value degradation in our hedge book so far in 2023 as long-term rates have receded, although the hedge loss has been outpaced by asset gains, which results in our book value increasing to $15.10 to $15.20 as of now. If the current shape of the yield curve persists, we do expect to have additional hedge gains in 2023. Since hedge gains that are a component of REIT taxable income, they will be part of our distribution requirements along with other ordinary gains and losses. As we discussed last quarter, we expect the 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 financing costs. Please see Page 8 in our earnings presentation that highlights these earnings components and recent trends in net interest income and hedge gains.

In the release, you will see the effective yield on our assets has increased this quarter. This is due to two primary factors. At the end of the third quarter, we reduced the balance of our lower coupon 2% and 2.5% securities and added 4.5% and 5% coupons to our portfolio. Also given the rise in rates, prepayment speeds continue to slowdown, which added a modest increase in yields this quarter. Lastly, we added $92 million of new capital this quarter via our ATM program. We added liquidity to our balance sheet at a time where returns are mid to high-teens and exceeded our cost of capital. With that, I will now turn the call over to Smriti for her comments on the quarter.

Smriti Popenoe: Thank you, Rob and good morning everyone. Rob has covered a great deal of detail on our financial performance in 2022. My comments today will be focused on our current macroeconomic thinking, our risk, portfolio posture, opportunities and outlook for 2023. There are three key elements underlying our macroeconomic thesis. First and this one has been a consistent theme since 2015. The global environment is increasingly complex, with rising global debt, increasing human conflict, rapid technology changes and shifting demographics. This leads us to favor more liquid strategies. Second, global central banks have embarked on a monetary tightening cycle against this complex backdrop. How long the tightening cycle lasts, how effective it is?

The intended and unintended consequences are yet unclear. This leads us to prepare for multiple scenarios and unforeseen events. Third, quantitative tightening, which is seen currently as running in the background, can have a significant impact on the price of risk going forward. We believe the draining of liquidity has the potential to be a major driver of the repricing of risk in this decade. We think this can occur even if the Fed is cutting rates as the balance sheet continues shrinking. This leads us to hold assets that can be easily valued and traded at those valuations, saving dry powder for when valuations on all assets, especially less liquid assets reflect fundamental value with less distortion from central bank balance sheets. In our view, these factors have shifted the yardstick by which to measure what is a fair return for the risk environment.

It is easy to be beguiled by a return that seems higher than we have seen in the last 8, 10, even 15 years. We are taking the approach that the last 15 years of market history must be viewed by considering the distortion of quantitative easing on prices. The team and I have focused on evaluating returns in the context of the future. This is a key foundational element of our thinking. Finally, a characteristic of the investment landscape that we are calling a flat distribution, fat tails, making predicting outcomes very, very difficult, because there are more probable outcomes, more equal probability of each outcome, a wider range of outcomes and the possibility of skewed distributions and exogenous events. Many investors use models with implicit normal or log normal distributions to measure risk and return.

We believe the results from such models must be viewed with the lens of a very different reality. Our risk and investment strategy are set in this context. Next, I will discuss the specifics of the investing environment. I will tackle financing costs and the inverted yield curve first and then address asset valuations, our spread outlook and expected returns. A key feature of the investing landscape today is the inverted yield curve. Short-term interest rates are higher than long-term interest rates. This has been driven by the Fed tightening to almost 5% and long-term interest rates falling driven by investor expectations for future Fed easing either due to recession and/or inflation declining to 2%. Whether you believe what the market has priced in or not, an inverted yield curve has consequences for levered investors like us, because it means that in the short-term, financing costs will be higher, but they are expected to fall in the intermediate and long-term.

If we funded all our assets in the repo market and had no hedges, our income would suffer in the short-term, but improve in the long-term assuming the market’s prediction came true. But the reality is different. Dynex shareholders have benefited from our hedging strategy, which locks in financing rates for longer periods of time, so that fluctuations in short-term interest rates are mitigated. Our current strategy of hedging with treasury futures in September 2020 effectively locked in 10-year financing at very low rates on hedges, largely mitigating the impact of the 400 plus basis points rise in financing costs. As Rob mentioned, those hedges have generated a gain position of $691 million as of December 31 and they are reflected in book value.

Another important point to remember in an inverted yield curve environment is that asset returns must still be viewed on a hedged basis so that you can incorporate the value of locking in lower long-term financing costs by hedging. When we view returns today in this context, we see the investment environment as continuing to be favorable offering low to mid-teens returns in agency RMBS. So, the key takeaway on inverted curves, they can be managed with hedges and the Dynex team has significant experience managing through these types of environments. A last point on financing, the availability of financing remains very strong. Repo markets are functioning smoothly and financing remains widely available, especially for the liquid assets that we own.

Let’s now turn to assets. Credit spreads are broadly tighter year-to-date. We see this as the evidence of the power of the liquidity that still remains in the system and the need for cash to be put to work. Our book value is higher as a result, as Rob mentioned, between $15.10 and $15.20, up from $14.73 at year end. As shown on Page 14, agency RMBS spreads to 7-year swaps are settling in about 80 basis points higher from the tight level seen in 2021, a more than doubling of spreads. We see this as a favorable investment environment, because it’s possible to earn hedge returns using leverage of 7x in the low to mid-teens. We have currently invested at these levels with the option and flexibility because of our liquidity position to add assets when spreads are wider.

You can also see on the chart that most times that spreads have gotten this wide or wider, there has been a reversion to the mean, if you will. This is a longer term tailwind to book value. We say longer term because there is a major difference between the past spread cycles and the one that we are in. The past spread cycles had the GSEs, Fannie and Freddie with large portfolios supporting spreads in the 1990s and early 2000s. I know because I was there and probably executed some of those trades bringing spreads back in line. Post-2008 you have the Fed. In today’s environment, we have neither. In fact, the Fed is shedding mortgage assets from its balance sheet. We are now seeing the ability for MBS to tighten 10 to 20 basis points as volatility declines, but the catalyst for much tighter spreads the 30 to 50 basis points tightener is not as apparent.

Where could this bid eventually come from? Over time, we think banks maybe a powerful bid. If fixed income funds experienced major inflows money managers could be a strong bid, but new cash will be needed to increase exposure to RMBS. So we are not investing today with the hope of an immediate reward of tighter spreads. We have invested capital with the idea that today’s returns meet or exceed our all-in cost of capital. And if spreads go a lot wider, we can add incremental value by adding assets at wider spreads. So for this reason, we feel like we can be more patient in our investing process. For now, we expect spreads to be range bound, reflecting technical factors of demand and supply. Agency RMBS spreads have been highly correlated with risk assets in general and we believe that trend continues in 2023.

We anticipate that volatility in the macro economic environment will translate into chances to deploy capital. We believe it is essential to maintain lower leverage, higher liquidity, a more neutral duration position and a patient disciplined approach to fully capture the value offered when volatility hits. You can see this is reflected in our risk positioning on Pages 15 and 16. I want to make another point as we look at the risk position. Our leverage as of December 31 was 6.9x to common with $6.4 billion in assets. As you can see on Page 16, for a 20 basis point tightening and spreads on agency RMBS and a 50 basis points on CMBS IOs, our book value rises by 9% or $1.35. Conversely, if spreads widened 20 basis points the opposite happens.

And therefore, we respect and maintain lower leverage and liquidity so that when we do get to those wider levels, we can potentially invest. But as you can see at plus or minus 9%, this profile does not suggest that we are under-invested, under-levered taking a defensive or cautious approach. In our view, we have plenty of risk on for this environment. It produces an economic return to support the current level of the dividend. You can expect us to continue to reallocate assets opportunistically and manage the portfolio dynamically, because this is what we expect the environment to dictate. I’d like to leave you with the following thoughts. We have focused on preserving capital and generating returns for the long-term. Our performance in 2022 positions us to recover book value without the need to take excessive risks to recover capital.

We are highly respectful of the evolving macroeconomic environment. We are focused on measuring risk-adjusted returns with an eye to the future and not the past. As such, we will be patient and deliberate in our decision-making. Our portfolio and liquidity is currently structured, support the economic return necessary to pay the current level of the dividend about 10.5%. We continue to have upside potential from dry powder and the ability to deploy capital at accretive levels. I am deeply grateful for the trust you placed in us as we manage your capital. I will now turn it back to Byron.

Byron Boston: Thank you, Smriti. Let me conclude with some final thoughts. We are in an evolving environment and at a unique transitional period in history. It is important now more than ever to be able to rely on a team with a clear strategy and deep experience and navigating complex environments. We are patient, disciplined, focused on execution, and on driving long-term shareholder returns. We are investing our money alongside you. So our goals are aligned and we take the responsibility as managers and stewards of your savings very seriously. We believe that Dynex Capital represents a compelling investment opportunity. Our stock trades at a discount to book. We pay an attractive and consistent monthly dividend that we believe is sustainable.

And we have ample dry powder to take advantage of attractive investment opportunities as they develop. For our existing shareholders and stakeholders, I thank you for your trust and joining us on this journey. For those of you who are not yet our shareholders, I hope we have made a compelling case for you to join us. With that, let’s open the call up for questions.

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Q&A Session

Operator: Thank you. We will take our first question from Eric Hagen with BTIG.

Eric Hagen: Hey, thanks. Good morning. I got a few questions. In the higher coupon pools, can you say what the loan age is and the prepayment profile more generally, maybe just how you plan on toggling between the TBAs and the pools and the higher coupons? And then the second question is do you see any risk or potential that mortgage rates could come down into the 5s, call it the mid-5s and what kind of read-through do you see with respect to supply and demand for MBS and other kind of scenario? Thanks.

Smriti Popenoe: Hi, Eric. Good morning and thank you for your questions. So in the higher coupon pools there are new wall of pools, mostly I would say, not excessively high pay-up. So again, we are trying to limit the exposure to high pay-up pools to be able to cut down on that the pay-up exposure, right. So the idea there is again, you are playing the hedged return game, right, between TBAs and pools. And so over time we are kind of thoughtful about where we purchase our convexity. Sometimes that convexity is better often in pool form. Sometimes when the securities are trading at a big discount, we like the flexibility of TBA and then eventually being able to swap out. So that’s kind of been our mindset with the higher coupons.

And our pool position at this point is mostly in the 4.5% very, very small position in the bonds. With regard to your second question, do we think that mortgage rates could drop? And I think the answer to that is yes, I think we actually included a slide in our investor presentation this time, it might be in the appendix that has some of our views on the mortgage market dynamics. It’s on Page 12 actually, but yes, I mean, we believe that just even if interest rates in the broad markets don’t change, there is the possibility of primary, secondary spreads coming in because of competition, the need for mortgage originators to continue producing, profitable returns for their shareholders, that is a strong impetus for mortgage rates to decline regardless of whether treasury yields decline.

So could you get that to below 5%, I would say is a stretch, definitely below 6% is a possibility. And then how that affects demand and supply? I think that was your last question. Am I right?

Eric Hagen: Yes, exactly.

Smriti Popenoe: Yes. So, look, right now, I think there is levels of cash-out refinancing that are starting to get limited a little bit by the GSE policy. But the bottom line on any kind of decline in mortgage rate from here on out is an increase in supply without necessarily a corresponding increase in demand. So that is a technical factor that we are very focused on.

Rob Colligan: Hey, you want to €“ let’s make one other comment here about these higher coupon 6s and others that have been originated. What I found fascinating was an article in the Wall Street Journal about Rocket Mortgage and their sales pitch at this point. A lot of loans have been made on around debt consolidation. And it is €“ as they make these higher coupon mortgages, many originators are assuring to the borrowers that they will be able to refinance these mortgages within 2 years or so. So there is €“ it’s very interesting to see you want to understand what’s happening between the borrower and the lender to get a real understanding of value. These higher coupon mortgages are being originated and especially the really highlight the 6s where they are being assured €“ the borrowers are being assured, they will get the opportunity to refinance within a couple of years.

So it’s an interesting dynamic that you want to really understand that is happening at the front end of the mortgage market.

Eric Hagen: Yes, absolutely. Thank you guys very much.

Smriti Popenoe: Thanks, Eric.

Operator: We will take our next question from Doug Harter with Credit Suisse.