Dynex Capital, Inc. (DX) Q3 2016 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the Dynex Third Quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker's remark there will be a question-and-answer session [Operator Instructions] Thank you. I would now like to turn the call over to Alison Griffin, Vice President, Investor Relations. You may begin your conference.

Thank you operator, good morning everyone and thank you for joining us. With me on the call today is Byron Boston, CEO, President and Co-CIO; Smriti Popenoe, EVP and Co-CIO; as well as Stephen Benedetti, EVP, CFO and COO. The press release associated with today's call was issued in file with the SEC this morning, November 1, 2016. You may view the press release on the company's website at dynexcapital.com under Investor Center, 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 the Annual Report on Form 10-K for the period ending December 31, 2015, as filed with the SEC. The documents may be found on the company's website under Investor Center, as well as on the SEC website. This call is being broadcast live over the Internet with a streaming slide presentation which can be found through our webcast link under Investor Center, also on our website. The slide presentation may also be referenced by clicking on the Dynex Capital's third quarter 2016 earnings conference call link on the presentation page of our website. I would now like to turn the call over to Byron.

Good morning, and thank you very much for joining us. I'm going to briefly review our performance for the quarter, discuss the global macro environment, and our investment thesis and provide our outlook. Early in the quarter, markets were focused on Brexit and relayed fall out, but as the quarter went on we returned to a period -- a relative period of calm in which interest rate increased and credit spreads tight. Our financial results for the quarter are as follows; we reported comprehensive income of $0.27 per share, core net operating income of $0.20 per common share, a sequential decline of $0.01 per share, and year-to-date we have earned $0.63 and we've paid $0.63 in dividends. Book value per common share increased by $0.07 or 1% to our $7.76 per share, total economic return for the quarter is 2.6% and is 8.8% on a year-to-date basis. Net interest spread remained stable quarter-over-quarter at 1.87%. Our book value rose during the quarter as the positive impacted of tighter spreads more than offset the decline to the rise in interest rates. Our modest decline in core income was driven by modestly fast prepayment fees on hybrid RMS and our decision to allow the portfolio to continue to pay down and build liquidity. CPR on our agency residential securities increased to 18.9% for the third quarter from 17.4% in the second quarter. We saw October CPRs declined 18.3% and currently expect prepayment to moderate for the balance of the year as seasonal factors dominate. Turning to our outlook; many of the same factors that we have mentioned in prior quarters remain significant, and serve as the underpinnings to our investment and the hedging strategies as sown on Slide 4 and 5. We believe that long-term fundamentals, as we believe long-term the fundamentals that have angered global bond yields have not dissipated, and there are still several factors that will limit and sustain rise in long-term rates. In particular, excess global leverage continues to destabilize global growth, over capacity, both labor and manufacturing, the inability of countries to stimulate aggregate demand without the expansion of credit and weak income growth will further limit inflation. Demographic trends should also bolster demand for fixed income assets in the future, keeping long-term yields lower. In the near term of our outlook, we are still faced with extraordinary government involvement in the capital markets, which has distorted asset prices. A subtle shift is also occurring, as it appears that Central Bank policy rhetoric is moving away from quantitative easing and pushing for governments to do more on the fiscal policy front. Near-term, measured inflation in the U.S. is stabilizing, it could rise simply due to the fact that energy and commodity prices are modestly improved from the low levels a year ago. Given this backdrop the Federal Reserve appears poised to raise interest rates in December. We believe that regardless of whether they raise the funds rate in December, over the medium-term the lack of significant progress toward growth and inflation could limit the number and frequency of future rate hikes by the Fed. So turning to Slide 6; in this environment we've kept our leverage low and invested in high quality assets, while maintaining a long duration portfolio position. We continue to believe that the aforementioned factors will prevent a sustainable move significantly higher in interest rates given our eye of global debt, moderate inflation, and mediocre global demand. We stated last quarter that we would add duration as rates increased, and the recent backup in rates has resulted in better investment opportunity; so we have added assets thus far during the fourth quarter. Our portfolio diversification is a key element of our strategy. Our high quality CMBS and CMBS IO investments reduce our exposure to greater risk versus low rated instruments and reduces the overall prepayment volatility of the portfolio; and our agency adjustable rate securities provide complementary cash flow with little extension risk and will benefit if short-term rates rise. On Slide 7 and 8, we provide our outlook for the company. We are seeing better investment opportunities today versus the last two quarters due to the steeper yield curve and credit spreads remain stable. We remain focused on agency guaranteed asset and AAA rated CMBS IO as we believe they offer the best relative value over the long-term. We expect a modestly -- we respect to modestly grow our earnings asset balance, and leverage in the fourth quarter to position us to help mitigate any negative earnings impact of a potential fed fund rate hike in December. Let us turn now to funding costs; in 2016 we chose to reduce hedging positions and related cost is consistent with our macro view that the Fed would be limited in its ability to hike rates. Dynex shareholders have benefited because our affected funding cost have been lower than they otherwise would have been this year. And we look forward to the future there are both positive and negative factors affecting funding. We expected funding costs to rise due to the regulations -- due to regulations, and more recently markets have begun to price in the higher likelihood of an increase in Fed funds in December. On the positive side, our agency guarantee portfolio is poised to fully benefit from money fund reform regulation. This has dramatically increased the cash available, and number of cash providers for the financing of high quality assets. For those that listen to our calls on a quarter-to-quarter basis, we take a long-term view in our approach to managing this company and our business. We have constructed a diversified investment portfolio that is generating solid cash flow despite, the low rate yield-to-yield environment. Because of our willingness to allow the balance sheet to do leverage this year, we are in a position to opportunistically increase our capital allocation, especially during periods of volatility. There has been a lot of discussion in the marketplace around agency residential credit risk transfer securities, and their place in the portfolio such as Dynex. We evaluate this sector and returns constantly, and believe the agency credit risk transfer is an essential sector to the success of our housing finance system in which entities like Dynex can and should play a major part. As currently structured however, the market prepared risk transfer securities to not yet offer the features or returns we believe are necessary to attract long-term investors such as ourselves. We continue to provide feedback to the GSEs, evaluate long-term financing alternatives and believe that such asset mavens will become part of our investment portfolio. And now let's turn Slide 8, 9 and 10; these are my favorite slides, especially Slide 10. And I just want to make few points that I've said over and over again for the last several quarters, but I do want to repeat myself. If you look at especially Slide 10, you'll see returns over the last 13 years or so; this time period is unique because we've had multiple market cycles. And here are major points; above average dividend yields can be a major driver returns for investors in a stagnant low returns global environment. Dividends should help the question [ph] potential volatility in book value resulting from complex from a very complex and uncertain background environment. Changing demographics will drive long-term investment opportunities in the housing finance system. There is a huge need for yield globally and that will continue to support yield oriented vehicles such as Dynex capital. The complexity of the market environment requires vigilance in managing risk and discipline capital allocation, consistent with our long-term philosophy. And please look on Slide 10. I would urge all of our investors to be patient due to this uncertain environment. And continue to rely upon our long-term perspective in terms of the market. These are my favorites Slides, we will continue to use them on a quarter-to-quarter basis and I would urge you to really focus on Slide 10. Because you have in this chart on every market cycle that one could imagine. So, with that I'm going to turn it over and open the call for questions. Barbra.

[Operator Instructions] Your first question comes from Douglas Harter from Credit Suisse.

Thanks, can you talk about how you think about your hedging strategies of euro-dollars versus swaps, especially in the context of why dollar increasing faster than repo rates.

Yes, so Doug this is Smriti, thank you for the question. So we have been as Byron stated during the call, earlier this year we made a very specific and deliberate decision to reduce hedging costs by lifting current pace swaps. And we've chosen to really make our hedges in the futures market are using forward starting slot. The reason we did that was that we had a very explicit view that the federal reserve would have, very limited in its ability to raise hike, not only in 2016 but going into 2017. So we make that trade-off up very deliberately it's based on our macro view. We think that's been actually a winner for Dynex shareholder this year because rather than paying interest expense this year, when the fed really wasn't expected to hike much, they saved that cost over this time horizon and accrued that benefit. We're constantly looking at this in terms of the trade-off between how much it costs us to lock in financing, verses where the market is pricing things at the moment. We've chosen to be in the futures market just given that macro view. So our portfolio actually got the benefit of lower repo costs throughout this year. And now we manage that pretty actively going forward.

Doug, one other -- just the high level point on that. Managing our hedging costs, in my opinion is the most important issue, managing this business at this point I'm -- it's got complex environment. Our longer term view continues to be that we may have the set be active for some period of time but I feel extremely confident that we have a global environment that is limited, in its ability to withstand materially larger interest rates. We are very confident also that I believe we have a global environment, that can't necessarily withstand a really a flat -- higher yield and flatter yield curve in the U.S. So that's in the backdrop there's in the situation short term that we will have to manage to, so we will be like adjusting hedges from time to time, but in general as Smriti, pointed out there managing hedge costs is paramount.

I guess along those lines of managing hedge costs, if I look at that the table, you're your pay rate is scheduled to jump from 64 basis points in the fourth quarter to 2% in 2017. I guess how should we think about your ability to manage that extra cost?

So again, part of that pay rate at 2% we talk about it just in terms of the impact to core-net operating income, and the PML now the actual market value benefit or a detriment is in our book value, and as we said last quarter and you know we'll say it again this quarter you can expect us to really manage on how that expense is incurred in our earnings stream, so that's something Doug, that you could probably see changing fairly rapidly as we come up against some of those futures contract maturing.

So with that look like just pushing out the maturities of those, or canceling some of the sort of current pay for the 2017's, and terming amounts just to try to understand what the impact would look like?

Yes, I think it would literally be thinking about what would be futures oriented hedges verses current pay oriented hedges and how that trade-off happened so, I don't expect us to change it -- to make the decision to really change the economic outcome very significantly, but I expect us to really be managing how those hedges impact our economic return and our book value.

And as of the management of those edges again, and that's kind of the point out making a second ago was that -- that's a dynamic process that will be managed, it will always be managed, and did I say managing hedge cost is like the most -- of most important parts of our job, we're not in environment, so if look it up back the call all ways through, maybe 2011-ish or so, about three or four years, we managed it very consistent manner because the environment was much more of stable, and that's the most complex, it would do – there was a lot of global risk, we review is much easier to tell year quarter-to-quarter basis, with the edges might look like, and what adjustments we might do, projected value or impact earnings, it is much more difficult today.

Great, thank you guys.

Your next question comes from Bose George at KBW.

Good morning. In terms of on the assets side, can you just talk about how this spread tightening, during the quarter, it might change any capital reallocation decisions going forward?

So this spread tightening so far this quarter.

I'm actually referring more to 3Q, but yes, I mean further you can discuss after quarter and as well, but just any changes in how you view the different asset classes.

So there's been a couple of things that have happened in the market over the third quarter, we saw a lot of spread tightening, pretty much across the board in the risk markets okay, but there were a couple of areas that didn't tighten in as much as other areas, so for example agency CMBS didn't tighten in as much as agency RMBS, fix rate RMBS, and then AAA non-agencies CMBS also did not tighten in as much as a lot of other high quality assets. Those areas and particularly IO's still we remain wider than where we have seen level save versus year end, alright, so those are areas, and that as the market has sold off those spread levels have not tightened in, so against post quarter end what we saw in those particular asset classes, and I'm specifically referring to agency Fannie Mae bonds, as well as AAA non-agency CMBS and CMBS IO, those assets have actually not tightened in as rates have gone up, still with a steeper curve and higher yields, they still offer relatively attractive returns compared to earlier this year.

Okay, perfect.

Let me add one point here because it is a really important point -- and you hear a lot of conference calls, everyone want to talk about their strategy doing X, Y or Z. You are in global environment that we could grab from my careers, there's no rate absolute returns per say, they're great relative returns, during zero to negative interest rate environment, and even if the fed increases or rates rise a bit, you are in a zero to negative interest rate environment, and the probability that there's a fed policy here is extremely high, but this environment is backed up on further defined by an enormous amount of global debt, conflicting governmental policies, and that's the backdrop. So we talk about spread moving here, spread moving a little spread movement is that -- yes, we are sticking with our strategy, we would in a major business decisions we think about it historically, in 2014 we went up in credit, we got out of our low credit rating instrument, and we've got a philosophy of high in term to move our overall credit exposure, so with agency in AAA, and spread may move around, they may tighten, they may widen which we try to lean on that the CBS products, a shorter duration instrument, that actually amortizes the rolls that occur similar situation in terms of agency ARMS. So spread may move here or there, you hear a lot of stories about this relative value; this strategy, that strategy; we're sticking to our thought process, and there is a defining moment in early 2014 where we said, we believe the overall global environment is complex and fragile but we made some major adjustments at that time. We haven't shifted, we've still got our agency ARMs, we still got our CMBS exposure, our CBS is heavily there because we have not taken-off the table that you could have a materially surprising low -- lower rate environment meeting where we are today, so we're protecting ourselves repayments, that's come through this year, that's come to in a big way, we're very happy with it. So I'm only adding that in there, because it's just spreads -- not I'm not turning over with these types of spreads, with these type of variations in terms of the spread sheet, we got a philosophy in terms of how we structure this portfolio, will believe in it over the long-term and at the end of the day, the old cliché, we're sticking with it.

Okay, that makes sense, thanks. And then if you're switching to leverage, could you remind me do you have a kind of target leverage for the portfolio and the different asset classes?

We definitely have a leverage target different asset classes bows, the idea of a target leverage that, we tend to think about it more in terms of how much earning assets we have at any given time, and how big the size of the balance sheet is, so our balance sheet is down, are close to $800 million to $1 billion from the peak levels, maybe in 2013. as far as target leverage per asset class one of the -- one of the things we like about the diversified portfolio that we have, is that we can earn the same ROE's, and the CMBS market by taking a lot less leverage, and that's an attractive feature of that asset class for us and so on average as Byron, mentioned during the call you can expect us this quarter to maintain our grow the balance sheet because we are seeing these incremental returns and we're thinking through what we're able to earn. But in general, our target leverage on -- for example, the AAA CMBS IO is substantially lower than what it would be for say AAA, CMBS or agency guaranteed MBS. I think our leverage is up slightly quarter-over-quarter.

Okay, great, thanks. Actually just one more; the comment Byron had made on the CRT market, in terms of -- you mentioned Byron that you don't like some of the features that are being offered, is that the read eligibility issue that's a concern or there are lot of other things as well that you don't like about that market?

I think so there is a couple of things; one is the way that market is currently structured as a derivative, not being read eligible, not being readied securities. And then also the lack of permanent financing or more durable financing I would say, those are the things that being a long-term investor in med sector, they are not features that are -- that make us comfortable putting capital in for 10-15 years because that's what that type of investment requires. So having it be a derivative, having it be not read eligible, not having a rating on the securities, and then really having the street -- finances other than in a very short-term repo [ph] format. Those are the things that we feel will need to change in order for us to really make it sort of a permanent part of what we would look at in terms of investment alternatives. There are many things that are good about it; the fact that there is diversification of credit, its high quality, you can pick and choose your risk spots, all those things are good. But there are some features about it that we're thinking through in terms of what we need to make those types of investments.

And then let me add this on here Bose, I love the credit risk transfer securities; I love the concept. I believe for our housing finance system, that Washington should lay off all the credit risk, this house of credit [ph], there is no reason why we need to have those there. I'd like to see them take advantage of the current amount excess liquidity in the global system where they try to create further refine these securities to be attractive to the maximum amount of the investments globally. So I like the concept that these securities, I think the underlying credit is in good shape because regulators are really clamped down so hard that there are very few risky loans being made in this overall environment. But if you listen to our macro view, you look at how we adjusted our portfolio, you will realize that we're not looking to try to be -- I don't know if you would think, that is not even the right word, isn't even cutting edge. We just -- we are really managing our risk in a very diligent fashion. And so we -- go ahead, Smriti.

Well, the key point there is look, we can make 12% returns in different ways and we are trying to hit that efficient frontier with you well. So for example, am M3 stacker deal right now trades around 400 basis points, you lever that three times you're going to get 12%, 13% or 14% return. You're running that with a repo financing that's highly callable. We think that there is a better way, a more durable way to make that 12%, you don't have to take as much risk, you don't have to put a non-rated derivative on your balance sheet, there is a better way to do that. So number one, if I'm trying to make 12% what's the best way for me to make that 12%; and number two, if I want to lock up my capital for that many years or that much amount of time, the amount of risk that I have to take to make that 12% in a stacker versus something else right now, you know to us it doesn't seem like a good trade-off. And that's also a statement about the returns, right. So at some point that trade-off will make sense but that's kind of how we're thinking about it right now.

Okay, great, very helpful. Thanks.

[Operator Instructions] Your next question comes from Trevor Cranston of JMP Securities.

Thanks. Most of my questions have been asked but I did want to follow-up on one of the comments Byron made in the prepared remarks about seeing maybe less focus from global central banks on quantitative easing. I was wondering if you could just talk about how you guys are thinking about the potential -- what the potential impact quantitative easing would be, particularly in terms of the longer end of the yield curve and credit spreads. Thanks

Trevor, when we say it's not less quantitative, what they've done is -- you can hear the dialogue changing and you can hear them begging basically, the politicians to layer on the fiscal policy, they will provide some type of fiscal help at this point. But that's a real change in the dialogue. The other part of the change in the dialogue -- of course I heard in the Europe this year is around really the shape of the yield curve and what's happening to banks globally and are they -- that's a secondary element of the dialogue. Another third element of the dialogue is around without using the word systematic risk, they are concerned about risk pockets creeping up throughout the system. I think the Boston Fed mentioned commercial real estate, I don't think they had a very good explanation in how they mentioned that risk but they did mention it. So there is the differences in the dialogue that we've heard, they are literally begging the politicians, please do something fiscal year because we're almost out of bullets here at this point in time, they're not going to lighten up on quantitative easing from this, but they may adjust how they are doing things but that's not the point we are making. I'm going to let Smriti chime in.

Yes, I mean I think we watched this stuff Trevor as you know, on a pretty minute basis. And in one of the things because we are long duration in our portfolio, we have to be very mindful of how much interest rate exposure we have and that's not only on an outright basis but where on the yield curve that positioning is. So when we say that we have a long duration exposure, that's correct but we are very actively managing where on the yield curve that position is being taken. If you look at our earnings presentation at the back, we think and talk about the exposure relative to flattening, steepening, it was giving you guys some definitions of that and also just how the portfolio behaves in these different environments. So you can expect us very much -- so yes, we -- over the long-term there is a long duration position here but very, very active with respect to where on the curve it is, what are we hearing from Central Banks, how should we change that position and manage that.

Got it. Okay, that's helpful. Thank you.

Thanks, Trevor.

[Operator Instructions] I will now turn the floor back over to Mr. Byron Boston for any additional or closing remarks.

I'll just reiterate Slide10, if you don't notice any slide, look at Slide 10; the purpose of that slide is not to show really Dynex's performance versus the other -- it's really to show entire industry and to really emphasis the power of above average dividend yields overtime and being patient what the sector can really pay-off. And what we'll see as we go forward, the global risk is high but there is an enormous amount of tailwind behind our mortgage rate sector, and we're positioning ourselves -- I like the way Smriti describe to you how do we get 12%? How do we get 10%, 8%? We don't want to stretch for too much yield in this type of environment but it's a low return environment, all investors globally should be reducing the return expectations in general. So with Dynex, we're going to stick with what we are doing for the last 13 years which is keeping a routine eye in terms of risk, not trying to get too far out on the risk spectrum, try to deliver cash flow to our shareholders which we understand is extremely important. And we appreciate you all for joining us on this call. And we look forward to chatting with you at the end of the year. Thank you.

Thank you. This concludes today's conference. You may now disconnect.