Dynex Capital, Inc. (DX) Q1 2017 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the Dynex Capital First Quarter 2017 Earnings Conference Call. At this time, all participants have been placed in a listen-only mode and the floor will open for your question following the presentation [Operator Instructions]. It is now my pleasure to turn the floor over to Alison Griffin, Vice President, Investor Relations. Please go ahead.

Thank you, Glory. Good morning, everyone and thank you for joining us. With me on the call today, I have Byron Boston, CEO, President and Co-CIO; Smriti Popenoe, EVP, Co-CIO; as well as Steve Benedetti, EVP, CFO and COO. The press release associated with today’s call was issued and filed with the SEC this morning, April 27, 2017. You may view the press release from 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, 2016 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 First Quarter 2017 Earnings Conference Call link on the Presentation page of the website. I would now like to turn the call over to Byron Boston.

Thank you very much, Alison. Good morning, I will be talking from our quarter slides desk, so please follow along. Some of my comments today will be familiar to some of you, however, we're recognizing a shift in mortgage reached stock ownership across the entire industry, so we want to ensure that those who're listing to Dynex conference call for the first time will get a clear idea of the principals that guide our decision making on a daily basis and how we continue to allocate capital on a very disciplined manner. First, let's turn to Slide 3 and start with our results. For the first quarter 2017, we had a solid quarter generating economic return on book value of 7.2%, driven by an increase in book value of 4.7% and we paid an $0.18 per share dividend. We've also generated core net operating income of $0.15 per common share and our balance sheet leverage was 5.8% at the end of the first quarter. Here our key thoughts regarding our first quarter results. We once again benefited from our diversified balance sheet. Our increase in book value was driven by our portfolio of CMBS interest-only securities, spread tighten on these assets throughout the quarter. We’ve been a steady investor in this product sector of the past seven years as this strategy has consistently provided excellent return opportunities. We view this product sector as a core part of our portfolio because it is higher yielding AAA rated short duration security. The difference between our core earnings of $0.15 and our dividend payment of $0.18 was mainly driven by catch up premium adjustments on our agency hybrid adjustable rate portfolio. Over the past year, the unanticipated prepayment has steady increased. Many of you know this product has been a core bedrock of our portfolio over the past nine years. However, due to the reduced returns, we've not chosen to invest marginal capital in this sector and we will continue to either allow the portfolio to run off or reallocate our capital to other agency back mortgage sectors. It is important to note that our earnings level is a reflection of our risk position. Our assessment of the current environment has kept the size of our balance sheet down, and we're underleveraged for a high quality strategy of Agency in AAA-rated securities. Our current capital base could support a significant increase in the knowing assets, depending on the risk of the asset and the spread levels at the time of investment. Please turn to Slide 4. We want to remind you that our risk pasture in the postseason markets come from our long history and deep experience managing securitized products within a mortgage reach structure. Over the past 29 years, Dynex capital has had virtually at some point every type of business model associated with housing finance. Dynex is operated across the entire spectrum of the mortgage value chain from the favorite of the borrower. We've been an originator of both residential and commercial loans, a servicer in both sectors and an investor in every securitized asset class from RMBS, CMBS, ABS and MSRs. As such, we’ve played a critical role in providing financing for homeowners and real estate investors through multiple market cycles. And the most recent business cycles since the crises, we've deliberately chosen to operate on the right-hand side of this spectrum closer to the savers. Please turn to Slide 5. Today, our strategy is focused on securities with the highest credit quality and the highest level of liquidity as shown in the upper left-hand section of this page. This strategy reflects our view of global risk and return opportunities. Please turn to Slide 6. Let me emphasize that we're not an agency residential REIT. We have run a diversified portfolio since inception in 1988. Today, we've chosen to move our capital allocation up to credit curve to the high quality assets because credit spreads are tight across more fixed income asset classes, and we're concerned about the overall global risk environment. What really important to note on the short is how our portfolio has evolved since 2010. We're very disciplined in our capital allocation and our assessments of risk to return. Note the three points in time highlighted in these pie charts. You can see that our portfolio has changed over the past 9 years. Today, our invested capital is diversified and CMBS sector we owned either securities with agency guarantees or AAA ratings. And within the RMBS sector as our agency ARM portfolio runs off, we intend to invest in agency fixed rate securities. We view these securities as the largest most liquid highest credit quality and some of the best return opportunities today. Furthermore by investing in these more liquid securities will have the flexibility reallocate capital as all the return opportunities develop. Now please turn to Slide 7. The concepts on this slide have not changed since I joined Dynex in 2008. Our key tenants disciplined capital allocation, disciplined risk management and diversification will drive our long-term results. Let me now explain our macro view which underpins our overall risk pasture, which you can see on Slide 8 and I'll just quickly summarize. Global economic fundamentals have improved. Government policy will continue to drive returns, and this is a big one, global debt and U.S. debt are at all time high levels creating a fragile global economy vulnerable to exogenous events. Globalization has created an irreversible connectedness between our economy and the rest of the world and credit spreads are tight. Three key points to make regarding the Federal Reserve Bank on Slide 9, we are respecting the fact that the composition and culture of the Federal Reserve Bank could change over the next two years. This fragile economic environment increases the potential or tightening easing cycle by the fed similar to 1994 to 1995. Also the probability of the change in the fed's mortgage-backed securities and treasury securities portfolio reinvestment strategy has materially increased. Given these factors about the fed and the other global macro economic factors on Slide 8 and on Slide 10, I want to point out that we are very concerned about a complete rounds trip where rates rise and are not sustainable at the higher levels as we witnessed in 1994. I am now going to turn to our risk pasture given this macros economic background on Slide 11, and I'll go through our four main sectors of risk that we are thinking about. Interest rate risk, we have structured the portfolio to be more neutral with respect of market value fluctuation some changes in interest rates. There are many global factors that will ultimately determine the level of rates. We expect to dynamically and opportunistically manage our portfolio. Spread risk, spreads on all major fixed income asset classes are close to their tightest levels since February 2016. Volatility in high quality asset spreads, particularly in Agency MBS has been muted by central bank quantitative easing activities. We expect asset spreads to be vulnerable to widening due to changes in central bank involvement in these markets, which would present an great opportunity to add assets. Credit risk, we remain invested in the highest quality assets, which includes Agency and AAA rated securities. Credit spreads on lower rated tranches have tightened substantially and are vulnerable to economic weakness and sector related default risk. This risk is further exacerbated when these positions are funded with short term repo, a risk we do not believe offers long-term value at these levels. Finally, liquidity and leverage risk, we are focused on high quality earnings assets that are highly liquid, which gives us the flexibility to reallocate capital. We will also dynamically manage leverage and liquidity to opportunistically increase the size of our portfolio which we expect to ultimately drive earnings. Now, please turn to Slide 13. Let me reiterate our thoughts on the tailwind that we see for Dynex. U.S. demographic trends are driving a significant increase in household formation and therefore more demand in multifamily and single family housing. Global demographic, aging trends are driving the demand for income and yield investments. As the government's participation in the housing and finance system vain, there is a large need for private capital and expertise in the housing finance system. And finally, there is strong potential for an improved regulatory environment. And finally if you turn to Slide 14, let me summarize. We believe this is an environment where capital preservation is important and having the flexibility to strategically deploy capital is also important. We manage our business looking how we pass the horizon of the next two quarters. We're investing in capital and current opportunities with an eye towards long-term returns. We're going to be very judicious environment especially considering U.S. Federal Reserve Bank and European Central Bank balance sheet policies could really affect asset pricing levels. You can expect us to be investing in the current environment, looking for opportunities to strategically grow our balance sheet with an emphasis on the long-term. We will conclude and we always do with our long-term charts which are simply meant to display the powered dividends overtime. We believe above average dividends will drive returns over several years in the future. That’s one reason that the management and the Board continues to be very comfortable investing in the stock of Dynex capital. With that, operator, we can open the lines of questions.

[Operator Instructions] Your first question comes from the line of Mickey [indiscernible].

I wanted to start by asking about your globalization theme. I'm curious whether for what factors you're monitoring to continue to support your globalization theme given the new administration America First strategy?

Mickey, can you ask you a favor, you were very faint we could barely hear the question. Could you repeat it again?

Hold on let me find the first one. Is that better?

That's much better.

Byron, what I was saying, what factors are you monitoring to continue to support your globalization theme given the new administration America First strategy?

It was a great question. Where we find ourselves since the election is a physiological move in asset price levels. Before the election, the economy actually both in Europe and in U.S. was improving. But the big move after the election was completely physiological and anticipation of policy moves that would produce growth, employment et cetera, et cetera. So, we're obviously monitoring what's happened in Washington, DC. It makes a very uncertain environment to predict the policies given the huge stratifications amongst our overall or our country in terms of our views for the future what can actually get done in Washington, DC. So, as we said, government policy will drive returns and so we want to continue to follow along what happens in Washington, DC. We will continue to track the balance sheets of both central banks the ECB in fact more than just those two also the Japanese. But the ECB's balance sheet and the Federal Reserve, we'll also be tracking who will be the new fed governors. We've got five new governors that potentially will be in place by the end of 2018. We think that can have a significant change in the overall culture at the fed. We will be tracking global trades, global trade flows, because that’s been a big part of what the current administration has talked about. The one fact that has impacted us, so let's say we didn’t have the election, we'd recognize actual the economic environment got better last fall. But when we say better, it's still extremely fragile. So, we continue to try to monitor the potential for shocks, surprising events that will catch most people off guard. That’s been our opinion since the beginning of 2014. At that point we said, we felt the globe was more complex and very vulnerable to surprises. And since 2014, that’s all we have had. So, that’s the way we are managing our book of business and monitoring a variety of factors and recognizing and that we must be flexible and we must be nimble.

You've mentioned the fed and that actually is part of my next question. What assumptions has your team made in your investment strategy about the scope and timing of the fed potentially shrinking its MBS portfolio?

It's a -- this is a -- so first point, it’s a number one part of this and why we also talk about 90, 94 and 95. The fed is an unchartered territory. This is completely new. So, no one really knows, they don’t know and neither anyone outside of the fed really know and understand what will be the impact or how they relatively proceed. They are trying to figure that out. So, we recognized that is very uncertain. The reason we like to think about 1994, 1995, a lot of times when we talk about the fed, we ignore the fact that there has been enormous policy years that have been made in history. And so let's just continue to recognize here Dynex Capital, the risk of a policy by the fed especially if you change the personnel at the Federal Reserve Bank. Now imagine this, you saw the personnel change in Washington, DC in an executive branch, and you saw what happen over the first months that they were in office and how many -- you can look and say, oh my gosh, what's going on. That was something in market, everyone watched what was happening. Now imagine, five new fed governors coming into position where in fact you maybe placing people there who -- they've the same attitude, we are going to do something different in the prior fed governors. So, we really don’t know. We're in uncharted territory that’s the number one thoughts of we have baked into our thought process. And then our investment teams had more specifics in terms of assuming -- look you know, let's take with the fed is fed, let's used as a baseline. They talked about wanting to reduce the balance sheet at the end of this year. If they do we think that will have a potential widen of fixed rate assets spread on the agency side that will be a great opportunity because today there are some decent returns offered in that sector. We think that will be better with the fed, really truly starts to exit the mortgage markets and that’s a great opportunity for mortgage REIT industry as a whole and any other investor in these securities.

One last follow-up question more of a modeling question. With the higher compensation expense accrual in the quarter due to factors like improved economic return for the Company. Was there something non-recurring in nature for the quarter?

It's Steve Benedetti. That was more just the timing related to the beginning of the year and some true-up activity from the prior year, so I will look at that more as a non-recurring.

So, if we last year on average, we can get a sense of what the next nine months might look like. Is that right?

Yes, that should work.

Your next question comes from the line of Trevor Cranston of JMP Securities.

Follow up on the question about your comments Byron on the fixed rate agency securities. We've heard a variety of views on what's spreads might do when the fed eventually decides to begin reducing the balance sheet. Can you comment on how much of the spread widening you thinks you need to see before there'll be attractive enough to add in a material way to Dynex's balance sheet? Thanks.

So, I will emphasize the most interesting point about the fed balance sheet is that there in completely uncharted category, but we do view this opportunity potentially spread widely as an opportunity. I am going to let Smriti give specific about the ranges of spreads that we're think that are out in the market place in anticipation of this.

Right and I think so in terms of just the scenarios that we're configuring, Trevor. We've got anywhere between for a very slow path, a very telegraph path, relatively low impact on spreads, maybe 5 basis points of widening. Surprises in terms of what the market anticipates, I think you could get initial widening of 10 basis points, 15 basis points something like that. And then really anything where at the end of the day, it isn’t the fed reducing its balance sheet that’s going to drive spreads or necessarily, right. What ends up happening is that, there are bonds that are going to hit the market and there aren’t enough investors to take up that incremental supply. And so, the way we’re thinking about it is, who is going to be the marginal investor away from the fed and where did those spreads eventually settle without the impact of the central bank or government sponsored enterprise into in that market. And we've said repeatedly on these calls that the risk in this market in the third year fixed rate markets is the exit of the fed. Now have been said that, they continue to remain the most liquid securities in the world I would say. They continue to be government guaranteed effectively with the in person guarantee for the GSEs. And at this point, they are offering somewhere in the low teams to mid teams returns. So, you have to consider that in your calculus. At this point, we think they are modestly attractive to the extent that they widen 10 or 15 basis points. They would be more attractive and that’s honestly the reason for why we're entering this environment with the balance sheet and the liquidity position that we have. As Byron mentioned, we have flexibility and the ability to sort of redeploy that any capital we currently we have and that’s effectively what our strategy is. So, we've heard things ranges for anywhere from you know 5 to 20 basis points wider and none of those are in our opinions reasons to be afraid of the sector in anyway shape or form. They just represent opportunity.

And then Byron, I think in you made a comment earlier about the primary driver of the gap between the dividend and core earnings being the premium amortization catch up on the agency RMBS portfolio. And I saw in the press release the disclosure of the $0.9 million catch up. I don’t recall seeing that disclosure from you guys before. Is that new and is something that will be a regular part of your quarterly results going forward? Or is there some reason why that was sort of a one-time adjustment that’s only going to be happening this quarter? Thanks.

So, Trevor, this is Steve. We haven’t referred to it in that passion but that typical nomenclature that folks are using everybody seems comfortable with that. We've had amortization adjustments related to changing speeds in our release before sometimes they get offset by prepayment activity on the CMBS and CMBS IO book. We will do a -- going forward to the extent we have these adjustments; we will make sure we highlight them clearly. I would look at this one as the combination of we had some faster speeds this quarter than we had modeled at the end of last quarter and then we modestly took up longer term speed which drover that adjustment.

And Trevor let me add one thing. One of another fact to understand here is that this portfolio has performed phenomenally from a prepayment perspective. We were very selective back in 2008, 09, 10, 11 when many of these securities are purchased over three four years ago. We purchased securities with interest owned features on them, which decreased the probability that we would experience prepayments. The portfolio has done well, but when we look that over last 12 months is that prepayment speeds have increased more than anticipated. And as such, yes, you are seeing that there but we haven't fully experienced this type of prepayment experience in the past. And with our diversified book of business what is always happened, we have to get some prepayments on this residential side of the book. The CMBS portfolio had provided a positive offsetting those prepayments experience. So, if you look at the ARM book and now it's dynamic, if look at the cost -- ARM sector in U.S. it's changed. It’s a different sector now which is why we are not doing that sector as an opportunity for margin capital of that.

Your next question comes from the line of Doug Harter with Credit Suisse.

This is actually Josh on for Doug. You mentioned you are currently running a lower level of leverage giving your asset mix. Can you talk about maybe some of your target leverage levels that you think about especially in the context of your macro outlook and maybe what would have to change for you to get comfortable increasing your leverage from here? Thanks.

Let me just say that if you were to -- let's say, if you were to compare the way we may have thought five years ago to now when we had lower credit assets on our balance sheet, we had BBB single A rated assets. We would have been hovering. We would have been thinking 6x leverage as being in or around 5.5 to 6x in appropriate level for that type of balance sheet, because we were not going to carry a lot of leverage on the lower credit asset. In a portfolio where you have all Agency and AAA rated securities, you can at least think about a portfolio this means one turn higher. And so, we continue to think -- we don’t have at least specific target for it. We have a principal which is we're not going to take too much leverage risk or liquidity risk just to pay an unnecessary dividend. But we're going to take with the portfolio such this an appropriate amount of risk to generate attractive over the long term. So that’s the principal and we're sitting here near 6x. Our goal would be to have a larger balance sheet, but we’re going to do it in a very judicious manager as opposed to say and I am just going to plow in July of our balance sheet higher and a risk environment such as we have today. When spreads are really, really tight, I want to be up to capital stacked, and I want to be very judicious in that deployment of capital.

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

Good morning guys, it's Eric on for Bose. Byron, I thought the opening comments were very valuable as far as the evolution of Dynex does, it was great. So what you would be looking for to move back into some of those opportunities you said that Dynex used to be in some of those deeper credit opportunities? And is it even elastic to assume that those opportunities will exist in a much more robust way for mortgage rates again in the near future?

I can give you two words on wider spreads and a wider spread and a global risk environment that doesn’t give the impression that there could a credit issue of some sort. But the first step is wider, wider credit spreads. The other point is if you look at the long-term of mortgage REITs, the one product sector that has whether 94, 1998, early 2000 crises, 2007, 2008 has been agency mortgage-backed securities. And I emphasize, we’re not an agency REITs, we just find the sector to be the most attractive in the current type rate global risk environment. And so, we’ve allocated our capital in this direction and it really reflects our risk view. And what I like to say -- I'll place some other ideas, residential credit risk given the regulatory environment where many of these loans are being originated. I think it’s a great risk to be able to take. However, it's just price, it's too high, the spreads are too tight there especially for me to take an asset with residential credit risk in the lower levels and put it on [repo]. So, we do have some principals in which we're making our decisions and I hope this helps you understand, how we’re thinking about this, but the lower credit areas are still part of our opportunity set. We just chose in today's environment to move to the top of the capital stack.

I would add that the, things like MSRs, we've also chosen to stay away from those businesses because of the regulatory environment and that continues to be an absolute minefield even with the idea that philosophy of regulation is going to change with the current administration. What you see in the headlines everyday is a type of risk that we have not been willing to take here at Dynex. So, those types of opportunities I think, we're going to have to figure out the right structure. I think that is possible, Eric. So, the deeper credit it's an issue of price and being able to level that up in a safe manner. And then the issue of MSRs and other business models actual operating businesses, we've always have to view that we need to see a through the cycle return that reflects the regulatory environment and that type of risk. And that’s not the same that it can never happen, but that’s opportunity that we would end up following when those things line up.

[Operator Instructions] Your next question comes from the line of David Walrod of JonesTrading.

My questions have been asked and answered. Thank you.

Hey, David.

Yes.

It has been brought to my attention that you have been on the planet now another year.

Thank you so much.

At this time, there are no further questions. I'll now turn the call to Byron Boston for and additional or closing remark.

I thank you all for plugging into our first quarter conference call. We look forward to have you on our second quarter conference call. We are still focused; still our heads down, our brains are working very hard. And we thank you very much and we will see you next quarter.

Thank you for participating in the Dynex Capital first quarter 2017 earnings conference call. You may now disconnect.