Dynex Capital, Inc. (DX) Q4 2016 Earnings Report, Transcript and Summary

Good morning. My name is Stephanie and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital, Inc. Fourth Quarter 2016 Earnings Conference Call. [Operator Instructions] Thank you. I would now like to turn the call over to Alison Griffin, Vice President, Investor Relations. Please go ahead.

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, Co-CIO; and Steve Benedetti, EVP, CFO and COO. The press release associated with today’s call was issued and filed with the SEC this morning, February 15, 2017. You may view the call or the press release rather 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 document maybe 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 a webcast link under Investor Center on our website. The slide presentation may also be referenced by clicking on the Dynex Capital Fourth Quarter 2016 Earnings Conference Call link on the Presentation page of the website. I now have the pleasure of turning the call over to Byron.

Good morning. Thank you, Alison and thank you all for joining us. 2016 was a year defined by three major bouts of volatility followed by periods of comp. The volatility originated on three different continents: China, earlier in the year; Europe, midyear with the Brexit vote; and the U.S. in the fourth quarter with the election. The other major event worth noting was the OPEC agreement involving the cooperation of many countries across the globe. To us at Dynex, it is indisputable that there has been an irreversible trend and connectedness between the U.S. economy and the rest of the world. Our company generates income from real estate assets in America, supported by the country’s domestic growth, which we believe is an excellent option in an increasingly uncertain global environment. Our portfolio in 2016 generated solid cash flow for the quarter and the year. We generated total shareholder return of 21% for the year. Our book value performance reflected our long duration position but was impacted by the rise in interest rates post-election. Our results for the quarter were as follows: GAAP net income of $1.36 per share; core net operating income of $0.20 per share; book value ended the quarter at $7.18, a decline of 7.4% from September 30; quarterly dividend – our quarterly dividend stood at $0.21 per share; and economic total return on book value for the quarter was negative 4.8%. Now for the full year of 2016, GAAP net income was $0.69 per share; core net operating income of $0.83 per share; total dividend declared and paid were $0.84 per share; book value ended the year at $7.18, a decline of 6.8% from $12.31 in 2015; and our economic return on book value for the year was a positive 4%. Now, key points to note on our performance. We earned – we substantially earned our dividend for the fourth quarter and the full year. Our book value declined 6.8% as a result of a positive duration gap maintained throughout the year that supported income generation. The book value decline was contained due to our portfolio construction of short-duration hybrid ARMs combined with agency assets backed by commercial loans. Let me now turn to the macroeconomic environment and investment environment on Slide 4. We see four major macro tailwinds for Dynex Capital. First, the pace and timing of household formation is shaping new trends in rental and housing demand as you see in the charts is on an upward trajectory. Incremental demand for housing creates more investment opportunities for Dynex. Second, as we see the government’s role shrink in housing, there will be a large need for private capital and expertise to manage housing assets. Companies like Dynex, with the expertise to manage credit and interest rate risk, are well positioned to make accretive investments on behalf of our shareholders. Third, an improving regulatory environment has the potential to create positive opportunities on the asset side and liability side of our balance sheet. Lastly, the world’s aging population supports the demand for assets that generate income. The demographic trend not only supports the value of the assets in which we invest, but is also a source of capital for us to potentially grow. Now, let’s turn to the environment. Our core macroeconomic thesis has been built on four tenets described on Slide 5. At this point, we see the U.S. economy on relatively solid footing with increasing inflation and the strong labor market. As we have repeatedly said since 2008 now more than ever, central bank and government policy will be the dominating factor in driving returns. We also believe the increasing level of global debt is a drag on growth and poses a serious destabilizing threat to the world economy, particularly if left unmanaged. We continue to believe there has been an irreversible trend and connectedness between the U.S. economy and the rest of the world, which means that it will be difficult for any part of the world to meaningfully diverge without consequently affecting the rest of the globe. Balance against this is still the risk of an exogenous event that could introduce rates and spread volatility. Please turn to Slide 6. With respect to the Fed, we believe they will react to the stronger data and economic momentum as well as potential fiscal policy actions by the new administration. Several key changes are forthcoming with respect to the Fed with new appointments that will likely change the culture and mindset of the bank. The likelihood of a change in investment policy regarding the size and composition of the Fed’s balance sheet has also increased. The most important thing to keep in mind, however, is the possibility of a tightening, easing round trip and the transitional period associated with such a move as occurred in 1994/1995. Please see the chart on Slide 6. We view the coming year and beyond as such a transitional period and the likelihood of a round trip is fairly significant. Dynex has been through several of these transitions and the key influences on our result has been disciplined risk management and capital allocation and the power of the dividend over the long-term to cushion intermediate fluctuations in book value. What has also been key is the transitional markets provide opportunity to deploy capital at attractive levels. Now turn to Slide 7. In general, our overall portfolio construction continues along the same themes, a diversified high credit quality, agency guaranteed or AAA-rated with an emphasis on liquidity, extension protection and prepayment lockout. From a hedging perspective, we are reacting to a stronger U.S. economy, a Federal Reserve that may potentially be more active, new fiscal policy that may impact inflation and Federal Reserve behavior. We expect to be actively managing this position and will shift opportunistically. On Slide 8, we continue to believe that up in credit and up in liquidity is the right strategy. It gives us the opportunity to be nimble and redeploy capital into attractive investments as we see them develop. Extension protection and prepayment lockout continue to be features of the portfolio allowing us to manage through a variety of environments. You can expect us to continue to allocate capital and manage our risks using our disciplined framework. As structured, we believe our position is appropriate for this transitional environment and affords us the option to earn an above average return on invested capital, while preserving the flexibility to react to higher yields and/or wider spreads where we can make meaningful, attractive, accretive investments for higher returns in the future. Now let me just summarize. In 2016, there were three major bouts of volatility. The first bout originated in Asia at the beginning of the year, the second originated in Europe in the middle of the year and the third originated in the United States at the end of the year. We managed through the first two bouts of volatility with ease, but the third bout of volatility was swift, concentrated and led to a decrease in book value. Throughout the year, we earned and maintained our dividend, which provided a solid cushion to help offset the book value decline at the end of the year. Now look at charts on Slide 9 and 10. Many of you have seen these before. You can see similar market trends as 2016 play out over multiple years. Our ability to generate an above average dividend, meaning in comparison to the average stock in the S&P has offset bouts of volatility and risk players in the past. Over the past 13 years, we have managed through many transitional periods in the markets, a massive Fed timing cycle and rise in rates, a massive financial crash and unprecedented drop in global interest rates and many risk players that have originated from all parts of the globe. Throughout this period, we have maintained a core set of principles in managing our business. Disciplined risk management and disciplined capital allocation are keys to success. If you recall in 2008, we built a high quality portfolio of agency ARMs to manage through the great financial crash. When the market provided the right opportunity in late 2009 and early 2010, we went down in credit in the multifamily sector. Then in late 2014, early 2015, we sold our lower credit assets and moved up in credit to the higher rated more liquid agency securities and AAA rated tranches as we became concerned about the complex global environment. Transitional periods and financial markets occur, we will hedge our portfolio appropriately for the risk factors we see today. Over the long-term, we expect to continue to generate above average dividend to manage through a volatile market as you can see displayed in the results on Slide 9 and 10. And then one final side note, please look at Slide 11. You can see that we offer three equity securities in the marketplace. As an investor, you have three ways to earn above average dividend yields with Dynex Capital. And with that, I will open the call for questions.

[Operator Instructions] Your first question comes from the line of Doug Harter with Credit Suisse.

Thanks. Byron, in light of those comments and you have been saying for awhile that it’s kind of an uncertain world, are you changing the risk tolerances around the portfolio to try to have tighter ranges in book value performance?

Let me say this. We will as we see the risk factors, we absolutely will. Well, we didn’t, if you look at 2016, the results are almost identical to the duration position that we were running. As we – what we try to lay out here in the appropriate manner is we are looking at the risk factors today and we will adjust and be nimble with our hedging strategy to reflect our risk views. So the answer is yes, when appropriate. What’s important to understand in the point we are trying to make is long-term that we find this transition period is short.

Got it. And then thinking about kind of where you view spreads today across – kind of across the board and the risks to those in the environment that we are in?

Spread risk is a risk that mortgage reached there in general. If you look at spreads the last year, spreads on a tighter end of the range. And if we thought spreads were really, really wide to be honest with you that we probably have a bigger portfolio and a larger balance sheet right now, but we don’t. And that’s what we referred to as trying to be nimble and wanting to take advantage of wider spreads. It’s almost been a straight line in 2016 whether you look at high yield, CMBS. Agencies performed a little differently versus if you look at agencies, treasuries and swaps you can come up with two different opinions. But if you think about credit spreads globally, they have – we have been on a steady tightened cycle over the last several months. And in that environment, we become a little more cautious in terms of the size of our balance sheet.

Alright. Thanks Byron.

Your next question comes from the line of Bose George with KBW.

Thanks. Good morning. It’s Eric on for Bose. Maybe following up a little on the credit spread conversation that Doug was just having with you, what is your base case expectation for how spreads could behave if long rates were to track significantly higher from here and at the same time, we do get a couple of Fed hikes both this year and next?

So there are multiple paths here, so let’s say if rates go up and the central banks of the globe continued to behave as they are today. I think you are going to end up still seeing significant spread support. And so the key thought to this answer, to be honest with you, is really there are multiple scenarios here, a huge amount, in fact all of them are related to government behavior. Heavily, number one, how will the central bank balance sheet of the globe react to the environment, if they continue to invest money that provides enormous amount of support for spreads. There could be an adjustment in terms of spreads. We at Dynex, we still are not believing in a sustained move and we do think about 3% on the 10-year. The ability of the global economy to handle a material sustained move, higher in interest rate about 3% on 10-year. So we do think there are limitations. It really comes from our view of global debt. Global debt is at an all-time high. We think it will ultimately prove to be a limiting factor in terms of where interest rates can go and ultimately where spread risk resides.

Thanks.

We would add one [indiscernible].

One more point on that is just that in previous environments, we weren’t sitting with as much event risk around government policy as we are sitting right now, right. So for the first time, you are faced with the potential that the Fed changes its investment policy around their balance sheet, how that impacts the market. It will be the first time and we have said this many times that you won’t to have a government entity involved in the mortgage market, if that indeed ends up being the way they do it. And I think the second thing is just with GSE reform, all of these things have been on the table in the past, but the likelihood of those things changing materially I think really impact your willingness to really take a lot of spread risk in here. So just the level – it’s not that it’s uncertain. And the way I kind of think about it is the number of outcomes as well as the range of outcomes. It’s just substantially higher.

Right, that’s a very thoughtful response. One more if you don’t mind for me, I want to ask about the agency ARMs even though that portfolio seems to be in runoff mode, what are your expectations for prepayment speeds on both current recent loans and longer reset ARMs? Thanks.

Yes. I think so there, you are very rightly thinking about that. We – there has been an increase in prepayment speeds. It happened in the fourth quarter. And I think it’s continued here in the first quarter. What we see there is just the steepness of the yield curve is affecting prepayment behavior. And as these bonds approach reset date, as they get to the point where homeowners are actually seeing mortgage interest rates rise and the LIBOR rise, you are seeing people lock-in longer term financing rates. So that’s going to factor in just in terms of, as Byron mentioned, it’s how we are thinking about asset allocation and capital allocation in the future. But for now, it doesn’t appear that the normal seasonal slowdown that you would see in December, January, it’s really sort of making a big impact at least in the op market, to be honest with you.

Got it. Thanks for the comments guys.

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

Hi, good morning. Thanks. One question on the funding side, there is the – you mentioned in the press release that increase in funding costs had a little bit of an impact in the fourth quarter. Can you talk about what you are seeing in the repo markets so far in 2017 maybe versus where you were seeing things priced in December and towards the end of the year and if there has been any meaningful change there? Thanks.

Absolutely. Hi, Trevor. So, effectively – so the repo markets really went through a truly big transition in the fourth quarter of last year, okay. We went through the money market reform process. That caused a severe spike, which had basically worked itself through the markets. And right now, what I would say is the ratings that we are seeing today reflect that tightening that the Fed put in, in December, alright? So in terms of the level of rates, you are just seeing yes, repo rates are higher than they were on average and we are probably seeing on average somewhere between 5 to 10 basis points higher versus the average of the fourth quarter, alright? And then in terms of availability, there has been a pretty significant difference. I mean, there is a lot of cash in the markets right now. Couple of reasons one, we think obviously more structural related to money market reform. That money is here. It’s here to stay. We think as that money work through the system. You will see its impact on 1-month and 3-month LIBOR and also coming back obviously into repo rates. And then secondly, you have got two things kind of moving over us coming in the next few months, debt ceiling negotiations. We have got treasury basically tax receipts, things like that, that are causing a lot of flushness in the cash markets right now. But overall, I would say availability is good. Yes, the pricing is higher and it’s just reflecting what we see as the economic effect of that tightening in the fourth quarter.

And let me add one other thing just a high level comment on the regulatory environment. I am actually excited and very interested to see how we evolve at this point. There are some major personnel changes happening in Washington, DC. And even though government policy is very uncertain at this point, the one thing that I believe that the highest probability event is that regulation will change and we believe that it may have a positive impact here on both sides of the balance sheet. So, we are anxious and excited to see ultimately how that evolves. But what has happened is it has taken the dark cloud from over our heads in terms of the kind of valid nature of the regulators in Washington, DC that could have led to even a potential, more tighter financing environment in the future. We believe that’s off the table at this point. So, we are kind of sitting kind of anxious and kind of excited to see how this changing regulatory environment evolves in front of us. We believe there will be positive opportunities on both the asset and liability side of the balance sheet.

Got it. Okay, thanks very much for the comments.

[Operator Instructions] At this time, there are no additional questions. I would like to turn the conference back over to Byron Boston for closing remarks.

Thank you very much. I appreciate everyone joining us this morning. Let me make one final comment just listening to the questions that Doug, Bose and Trevor answered. A lot of questions that you may have will depend on making some type of specific prediction about government policy something that we are not willing to do here today. What’s your main point we are trying to make is that we are nimble, comes to hedging, coming to investment we will adjust the portfolio appropriately. At our long-term behavior, at our long-term principles in terms of how we manage this business are the same and we put the long-term charts in there, so you can just look back and just be reminded of our behavior in the past. And with that, I appreciate you guys joining us and we look forward to you joining us in our next quarterly conference call.

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