Dynex Capital, Inc. (DX) Q1 2015 Earnings Report, Transcript and Summary

Good day and welcome to the Dynex Capital Incorporated First Quarter Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Alison Griffin. Please go ahead.

Good morning everyone. The press release associated with today’s call was issued and filed with the SEC this morning, April 29, 2015. You may view the press release on the company’s website at dynexcapital.com under Investor’s center as well as on the SEC’s website at sec.gov. Before we begin, I’d like 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 are 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 the Annual Report on Form 10-K for the period ending December 31, 2014, as filed with the SEC. The document may be found under the Company’s website under Investor center as well as on the SEC website. The call is being broadcast live over the Internet with a streaming slide presentation, and can be found through a webcast link under Investor center on our website. The slide presentation may also be referenced by clicking on the Dynex Capital’s first quarter 2015 earnings conference call link on the presentation page of the website. With me on the call today, I have Byron Boston, CEO, President and Co-CIO, Thomas Akin, Executive Chairman, Smriti Popenoe, EVP and Co-CIO; and Steve Benedetti, EVP, CFO and COO. I now have the pleasure of turning the call over to Byron.

Thanks Alison and good morning. If you would turn to slide 3, you can see our long-term performance since 2008. If I were to use a few words to describe our posture during the first quarter of 2015, it would be steady, disciplined, methodical, and analytical. One year ago, we identified the global financial/economic environment as being complex. Meaning that there are multiple economic, financial, regulatory, and geopolitical factors that are interacting and varies that can create potential surprises. And hence, this is not the environment for taking on large unnecessary risks. Hence, for the past ten months we have made some adjustments to our portfolio. However, we have not changed or underlined investment thesis or our approach to the market. We are continuing to focus on short duration, high credit quality assets. We’ve continued to emphasize a diverse asset portfolio, while allocating the majority of our capital to the CMBS sector. We are continuing to manage our leverage conservatively, even though we increased our leverage this quarter, we continue to be a full term of leverage below our peak balance sheet two years ago. Furthermore, the total size of the balance sheet continued to be approximately 20% below peak levels. And finally, we’re continuing to focus on risk management, while generating an above average dividend yield for our shareholders. We are in a lower return environment globally, and all asset classes. And we continue to believe that earning an above average dividend yield, such as offered by Dynex Capital, is a smart investment strategy for long term investors. I will now turn the call over to Steve Benedetti and Smriti Popenoe to give you more details of our first quarter performance.

Thanks Byron. I’ll cover parts of slide 5 through 8, for those who might be reviewing the presentation. For the quarter, we reported comprehensive income per common share of $11.3 million or $0.21 per common share. Consisting of net loss of $0.21 and other comprehensive income of $0.42. We also earned $0.23 of core earnings, and declared a $0.24 dividend to our common shareholders. Core earnings were flat to last quarter as average interest earnings assets were relatively unchanged from last quarter. And our net interest spread was down a modest one basis point. Most of the purchase activity was in the beginning of the quarter, when spreads were a little bit wider, but did not settle until later in the quarter, or even the second quarter. And will not see the benefit increase in our earnings assets until this quarter. Pre-payments on our hybrid ARMs remain below projections, resulting in a net positive amortization adjustment of approximately $800,000 or a little over $1.00 per common share. Overall total economic return to shareholders was 8% on an annualized basis, consisting of a $0.24 to common dividend, and the decline in book value during the quarter of $0.06. We reported quarter in leverage of 5.7 times shareholders capital, and 5.4 times if you remove reliabilities related to forward settled transactions. We actively managed our hedge position during the quarter, repositioning our duration risk on different points of the curve based on assets added. We added $390 million in current-pay swaps, and $425 million in forward-starting swaps, and terminated $205 million in current-pay swaps during the quarter. Turning to slide 6, we’ve prepared an overview of our financial performance that we believe will better help our shareholders, and analysts understand our results. As you know, we no longer file hedge accounting, and our reported GAAP results will therefore include fair value adjustments on our hedge portfolio. But not the corresponding changes in fair value of assets. This can result in large gains or losses, depending on movements and rates during the quarter. So looking at slide 6, you can see a reconciliation of core earnings to GAAP net income, or loss to comprehensive income. Walking through this slide, as you can see, core net operating income includes net interest income on our investments, plus the quarter’s period hedge costs, G&A expense and preferred dividends. Net loss this quarter includes core earnings, gains on sale of investments, and the mark-to-market in other losses on our derivatives. Comprehensive income includes all of these previous items, plus the change in fair value of our assets, which in our view makes it the most complete indicator of our performance for the quarter. We like to think core earnings is the return we generate from our assets, less cost of hedge liabilities, and comprehensive income as our total economic return factoring in changes in book value. Turning to slide 7, book value was down slightly to $896, versus $902 per common share from the prior quarter. Looking at the chart on this slide, changes in book value from quarter-to-quarter can be thought of as the core earnings of the company, less the common dividend declared. Plus or minus the changes in the value of our assets net of hedges. And in this quarter we issued restricted stock as part of our compensation program, which resulted in a one-time reduction of approximately $0.03. We like this presentation because it links core net operating income to book value changes, and combines the changes in hedge fair value with changes in asset values. Unlike the GAAP presentation, which includes changes in hedge fair value in reported earnings. With that, I’ll turn the call over to Smriti.

Thanks Steve. I’ll be covering slides 10 through 16 for those following along in the presentation. As you know at Dynex, we have a top down investment approach, so I’m going to discuss macro-economic factors first, and then drill down to our position and the changes over the quarter. The key macro theme in 2015 continues to be global divergence, across gross inflation and Central Bank actions. This quarter we saw the beginnings of a highly aggressive easing program by the ECB. The full impact of which is yet to be felt across the globe. All of the remaining factors on this page are still in place, as we identified the beginning of this year. And the important point to remember, is that any, and all, of these factors could change the timing and the pace of the Federal Reserve’s actions. Turning to page 11, the implications for the investment environment in which we operate, also remained the same. Global yields are low, risk premiums which actually had increased earlier in the first quarter, have rebounded back to the level seen about a year ago. And I’d like to remind everyone of something we pointed out last quarter, which is that there is really no playbook for exiting QE. The Federal Reserve has to manage a fragile economy, with divergent global policies and divergent economic trajectory’s, which we’ve identified as a complex environment. And, to us, what this means is that surprises are more likely, creating volatility and perhaps opportunity. We also could see the FED in motion this year, we identified this factor last quarter, but the data would really have to line up just so. We still see downside risk with the data lining up, but we can’t rule out the FED increasing interest rates, and with that, potentially a flatter yield curve is likely. So in this investment environment, we really have to be disciplined and deploy capital in places where we see good risk return trade-offs. Before I cover our activity for this quarter, I want to take a moment to remind you of the path that we have taken thus far. As Byron mentioned early last year, we identified this environment as complex, and the second quarter as spreads tightened, we took profits on our riskiest triple B and single A-rated assets. In the fourth quarter, as spreads widened, we selectively deployed that capital into more liquid, higher credit quality securities. Turning to page 12, we entered this quarter with a solid liquidity in capital position, but continued to make similar types of adjustments. First, we made approximately $600 million in purchases, which were netted with one-off and included forward settlements, grew our portfolio position to about $3.9 billion. Second, our financing portfolio increased from $3 billion to $3.2 billion. And as we’ve mentioned in the past, we’ve been actively managing that financing position. Our original contractual base to maturity went from 144 to 116 over the quarter. And this reflects our shift from longer term repo, that we use to protect ourselves from rate spikes through year-end, to slightly shorter maturities as the market was pricing in too aggressive rate assumptions for 2015. With regards to our remaining maturities, this just reflects our desire to stay away from quarter-ends, where we see funding pressures. As Steve mentioned, our leverage increased from 5.1 to 5.7 times during the quarter. Without the impact of unsettled positions, this would have ended the quarter 5.4 times. We expect leverage to come down slightly as we receive prepayments over the quarter, but look for us to maintain these levels of leverage. Our purchases last quarter consisted primarily of agency CMBS, backed by multi-family properties. Most of which were added at the beginning of the quarter, during which we experienced the wider spreads. In this low yield environment, agency multi-family CMBS bonds offer us compelling risk adjusted returns, because they have limited prepayment risk, limited expansion risk, stable cash flow, lower spread risk, and an agency guarantee. We also added to our non-agency residential positions, by investing in the senior most shortest duration tranches of non-performing loan securitization. These assets are expected to have a duration between one and two years, and offer an attractive return profile, with relatively stable cash flows. You can see the impact of all of these actions on the next page on our overall assets and equity allocation. The chart on the left shows the growth in our CMBS position, 78% of which is now agency guaranteed. The chart on the right shows our equity allocation, very similar story there. With all of these changes, let’s turn to our position going forward on page 14. As I mentioned, we entered the quarter with a very solid and liquidity in capital position. As we’ve said repeatedly, our current portfolios constructed to perform in a variety of market environments. We continue to maintain our long duration position, but we’ve changed where we choose to take that duration exposure. Our exposure to a parallel shift up in interest rates by 100 basis points is estimated to be about 3.3% of book value, using our models. And for [Indiscernible] we lose about 0.5% of our book value, about twice the position as of December 31st. And this is where we measure the interest rates as the two year rise in 25 basis points, and the ten year rise in 75 basis points. So our exposure here is more weighted to the back-end of the yield curve. Keep in mind that these numbers are model generated, and what we’ve found is that over time, as rates decline, models tend to underestimate duration. So to get a fuller picture of risk, you have to factor in spread risk. And to that end, we’re showing our exposure to a 25 basis point, widening in spreads across our portfolio, to be an additional 5.5% of book value. The combination of rates and spreads should give you a better picture of the total risk in our position. We have detailed tables on all of this information on page 15. Let me now turn to our strategy going forward on page 16.Last quarter we said that the balance sheet will increase modestly over the year, as we selectively deploy capital. And that our focus was going to be on diversifying an opportunistic investing. We continue to see investment opportunities in agency multi-family CMBS and RMBS, particularly what we call does bonds agency multi-family CMBS in short duration NPL securitizations. GSC risk transfer securities continue to be an area of focus for us. The key issue here still remains financing stability, entry point, part of the capitals stacked with the best risk return, and relative value compared to similar assets. To date, we have not found a risk adjusted returns attractive enough. We continue to stick with our shorter duration deemed in agency RMBS, and let me remind you, we have no exposure to dollar rolls as a result of our lack of exposure to 30 and 15 years. But we still could find a time when fixed-rate MBS will be cheap enough, and extend enough to be attractive to us, we just haven’t seen that yet. As you know, we also have an authorized $50 million share buyback program, which we have used in the past, and intend to use in again. When we see the stock trading down below our threshold discount to book. We’ve also given you an insight into our risk profile. Since quarter end we actually reduced our Eurodollar position in September and December Eurodollar contracts, by $1.3 billion and $600 million in notional respectively, as we assess the cost of the contracts to be greater than the marginal benefit provided at exploration. You can expect us to continue to manage this position with a focus on protecting book value through a variety of scenarios, but let me remind you that we maintain the flexibility to manage what promises to be a very dynamic market environment. And finally, with regard to our financing position, we continue to manage our maturity and counterparty profile aggressively. We have formed a captive insurance subsidiary, and have applied to membership into the Federal Home Loan Bank system. Let me also remind you that application does not guarantee membership, and that the term such as borrowing capacity and the term of borrowing, are yet to be determined. With that, I’ll turn the call over to Byron.

Thank you. Let me summarize what we’ve been doing over the past ten months. In response to the unique global financial picture. We have reduced the size of our balance sheet, reduced our spread risk, increased our overall liquidity, and increased the credit quality, and specific liquidity of the bonds in our portfolio. These changes have put us in better shape for 2015 and beyond. We are expecting surprises as we move forward in this complex environment. However, as we continue to show you can earn solid net interest income over time. We believe this continues to be a great time to generate an above average dividend yield for our shareholders. Nonetheless, we will need to manage through peers, the volatility and surprises. Hence we will continue to make the necessary adjustments to maintain the appropriate risk posture. Let me put our returns in perspective. If you look at slide 18, you will see that Dynex Capital offers an above average dividend yield versus other asset classes. When you look at the S&P 500 at 1.93%, and if we were to add the ten year treasury onto this graph it would be in or around 2%. Then you compare to equity REITs at approximately 3.9%, commercial mortgage REITs at approximately 7.6%, and there’s Dynex Capital at 11.70. We manage for the long-term, and over time, this differential in yield will have a meaningful impact on wealth accumulation. So in closing, I want to assure you again that in all the decisions we make and in all we do every day, our interest to or directly align with yours. Everyone on our management team has invested significantly in Dynex, and the actions we take on your behalf will affect us all. And with that operator we will open the floor, we’ll open the call for questions.

Thank you, we will now begin the question and answer session. [Operator Instructions] Our first question comes today from Doug Harter with Credit Suisse.

Last call you guys had talked about kind of adding assets over the course of the year. Anyway, it seems like you added a little bit more in the first quarter than I was expecting. Did the return environment, I guess just - can you give a little bit more detail of kind of where spreads were on the agency CMBS that made them so attractive?

Yeah, Doug we included a chart in the appendix of the presentation. And its page 28, so this just gives a historical spread on agency, multi-family CMBS overtime. And as you can see spreads that actually come down since the paper tantrum going into the end of 2014. Really sort of peaking in early January and mid-January, these were returns we hadn’t seen on these multi-family securities in some time. So it seemed like the right time to step in and buy those. The other piece of this is that, this is the very generic 10, 9.5 multi-family security, we’re actually able to add incremental returns as we pick more unique structures in the sector. So this is just a representative sample if you will, we’re actually able to add incremental return versus this for more esoteric instruments that are traded in this sector. So that was one piece, and then the other piece really was early in the quarter, there were folks just clearing out non-agency pipeline. So, again, this NPO securitization market was really having some trouble getting off the ground earlier this year. And we were able to put some capital in, at really attractive levels relative to where they ended the quarter.

Hey Doug, let me just chime in on one other part of this, which is that this is kind of what we were explaining last year when we started to say, let’s take the liquidity of the balance sheet up, because what we’re looking for are these pockets of opportunities that do arrive to put capital to work. Now it’s always in the same thing that Smriti described earlier, last year we sold our lower credit quality assets, and now we’re seeking to add more liquid assets and higher credit quality assets. We saw couple of windows, with a couple of larger positions, so you said it was larger than you anticipated. It’s probably larger than we anticipated, but we did see a couple of trade opportunities evolve with larger positions to put more capital to work that we took advantage of. So as we look toward the future, and you think about Dynex towards the future. We are perched on the limb like a hawk. And we’re basically looking for those types of pockets of opportunity to appear. And throughout my history of managing money, pockets of opportunities have always shown up.

So just to further that, I guess how active should we think you would be on potentially selling some of these, if that opportunity were to sort of close and return, spreads got, what you view as tight again? Would you - I guess in this environment, do you view yourselves as kind of more actively moving, selling assets, buying assets than you would in other environments?

Yes, we do see ourselves doing that Doug. I think that’s sort of the nature of the environment that we’re in. We’re trying to say that this is an environment in which we need to be dynamic. We need to be willing, and able, and ready to reposition risk across the curve, buy and sell assets. And if you notice in some of our disclosures, we have talked about assets that we’ve sold this quarter. So we’re constantly looking at our portfolio, in those terms, to be able to take gains when it’s appropriate and reinvest that capital when we get that opportunity, so yes.

And if you compare it historically Doug over the last, if you go back three or four years ago, this is different. And it’s the different part in what I was trying to emphasize my comments now. And I think I’ve done it every quarter, in trying to emphasize that our underlying thesis and our approach to the market really hasn’t changed, but the environment does dictate that we be nimble. You really can’t sit here in this type of environment and just hold your hands. So you have to be very nimble in this environment. And it is very different than three or four years ago.

[Operator Instructions] Our next question comes from Trevor Cranston with JMP Securities.

I just wanted to follow-up on the question about kind of the spreads on the investments you added this quarter. I was trying to back into the yield by looking at the disclosure of the CMBS yield in the press release, just went from 409 to 370, would seem to imply a yield on the new purchases of maybe something in the kind of 325, 330 range. And I was looking at that versus the 188 rate on the swaps you added, which kind of gives you something like 140, 140ish type spread. Does that sound right to you, or is there anything I’m looking at incorrectly there?

It’s one way to look at it, we tend to look at it a little bit differently. The swaps we add on, obviously has to do with more of our view on the curve and how are managing the overall risk of the position, Trevor. And then the assets that are being added is a blend of both agency and non-agency securities. So I’m not sure I would think of it kind of in an aggregated fashion.

Well, and it seems like future really again - you think you have a question a couple of quarters ago and I said that the probability that it makes it much more difficult to predict the balance sheet, book value and certain other factors. Much more difficult to cover the environment. And it’s really more, it’s heavily a function of our managing the book of business. And I think that’s - it’s partially what Smriti was trying to explain in terms of how we put on the blend of assets that we put on. Where we ultimately hedge them across the curve and how we adjust those hedges throughout the quarter.

And a couple for modelling before we get to 10-Q, would the swap additions in the quarter, the rate seems to suggest that the maturity of something around seven years. How do you reconcile that with the hedge table you have in the press release that shows something like 280 million of swaps effective - 2022?

Some of those swaps are forward-starting swaps, so there’s, we use a number of different options to hedge our position. We have current pay swaps that will show up in each of those years. And then there’s other ones that start either one, two, three, four or five years from now.

Okay, so the forward-starting swaps aren’t necessarily included in that table?

They should be in that table.

Yeah, they’re in the table Trevor. And so you can see how the notional amounts of their hedge positions move around a little bit from period-to-period. Some are current pay level burn-off and some are forward-starting that will potentially replace the current base.

Right, and maybe we kind of go through this with you on a call if you like.

Yeah, that’d be great. Last thing for me, I missed the numbers you guys gave at the end of the prepared remarks about the changes you made to Eurodollars since quarter end, could you just repeat those for me?

Sure, we took off 1.3 billion in September, Eurodollars. And 600 million in the December contracts.

Yeah, so on that table, Trevor, when you’re looking at that press release that table is on a weighted average basis. So 1.3 billion is for a quarter, and this table will have a further balance of the year. So we essentially lift it most of the Eurodollar futures contracts that are on that table in the press release, does that make sense? And again we can cover that offline too.

Hey Trevor, thanks a lot. And we’re more than happy to spend the time to try to make sure that you understand some of the additional actions and changes to the balance sheet.

Yeah, I’ll follow-up later today. Thank you for that.

Our next question comes from Jason Stewart with Compass Point.

I know you touched on what you sold briefly. And I’m flipping through the presentation, but could you just go back through where you found investments to be unattractive from a risk reward. And maybe give us some commentary if that’s something you expect to continue?

Absolutely, yeah. So one of the things we’ve been doing as we discussed earlier. So in the second and third quarter of last year we found that the lower rated tranches to be unattractive from a risk reward. And we go through this every day. So this last quarter, we looked at some seasoned CMBS IO positions that we felt had increased exposure to certain types of properties, or we felt like the - really the spreads had come in to such an incredibly tight level that we didn’t see much upside and continuing to hold those securities. So we sold some CMBS IO’s, and then in a very similar fashion we sold a walk-up agency, agency RMBS, highbred armed securities that we had already converted into being floaters. And these securities, again, had reached such an incredibly high price that we felt like it was better for us to take gains in those positions. Or if they were still sitting at a loss to basically minimize the loss in those positions, because we viewed the incremental carry that we would earn from holding those positions, is to be not worthy of the potential loss, if the market reversed course. So those are two areas that we’ve been looking at very closely. We continue to look at all kinds of reasons rationale, but our methodology is really to look at where our capital is invested right now. What we expect the future returns to be, and if we don’t like the profile of the expected returns, in terms of either spread risk or a symmetry, we talk actively about reducing those positions and we do so.

One other for me, the threshold for share repurchases, I know it moves depending on opportunities, but could you just remind us of how you’re thinking about that threshold with the current investment environment?

With our buybacks, and we did buyback a very small amount this quarter. We look at it as a use of our capital. And so obviously we’re looking at all use of capital at the same time. And we generally bought the stock back, we’re adding 10% to 15% discount book in that range, to book value. So that’s kind of the way we think about it, and maybe the range that you ought to be thinking about.

[Operator Instructions] There appears to be no further questions at this time. So I’d like to turn the conference back over to management for any closing remarks.

Thank you very much. And I’ll just remind you again of the four words that I started off the conference call with. And I hope now that you’ve listen to - our presentation you’ll understand why that described the first quarter, with these four words. Steady, disciplined, methodical, and analytical. And we look forward to the remainder of 2015. Thank you very much for joining us on this call. We look forward to chatting with you in the future.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.