Dynex Capital, Inc. (DX) Q2 2017 Earnings Report, Transcript and Summary

Good morning, my name is Lisa and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Inc’s Second Quarter 2017 Earnings Conference Call. [Operator Instructions] After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. I would now like to turn the call over to Ms. Alison Griffin, Vice President, Investor Relations.

Thank you, Lisa. Good morning, everyone and thank you for joining us. With me on the call today is Byron Boston, President and CEO; Smriti Popenoe, CIO; and Steve Benedetti, CFO and COO. The press release associated with today’s call was issued and filed with the SEC this morning, August 2, 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, Presentation on our website. The slide presentation may also be referenced by clicking on the Dynex Capital Second Quarter 2017 Earnings Conference Call link on the Presentation page of the website. I would now like to introduce and turn the call over to CEO, Byron Boston.

Thank you, Alison. Good morning and thank you for joining us. There are several key points we would like to make today in our comments. One, we continue to believe this is a great time to be a mortgage REIT and generate an above average dividend yield. There are potentially strong tailwinds for the industry as we look out over the next five to 10 years. However, global risks remains high, as such we had been making portfolio adjustments to increase the liquidity in our portfolio and to continue to emphasize the highest credit quality asset. In addition the growth in our balance sheet will help drive earnings as we increase the overall liquidity in our book. Now I'm going to turn the call over to Steve Benedetti, our CFO.

Thanks, Byron. I'm on Slide 3, if anyone is following the presentation, and I will quickly review our second quarter and year-to-date results. We earned $0.19 in core net operating income this quarter and paid a $0.18 dividend, year-to-date we have earned $0.34 and paid a $0.36 dividend. Book value per share declined 1.9% to $7.38 from $7.52 at the end of the first quarter and for the year our book value was up 2.8% from $7.18 at December 31st. Total economic value for the quarter was 0.5% and we have had a solid 7.8% year-to-date. The important thing to understand about our earnings is our diversified portfolio once again proved to be very beneficial; the positive impact of our prepayments from our commercial mortgage securities portfolio more than offset the negative impact of faster speeds in our ARM securities. So far this year, spread tightening in our commercial portfolio has mostly offset spread widening in our adjustable rate mortgage portfolio. Moving to Slide 4, we have diversified our fixed rate mortgage securities portfolio by adding fixed rate securities backed by residential loans; this brings our total fixed rate portfolio to $1.7 billion; it's important to note that the positive convexity of fixed rate securities backed by commercial loans will help mitigate the impact of the negative convexity from the residential securities in our portfolio. We have also continued to reallocate capital from our lower yielding ARM portfolio into the higher yielding fixed rate portfolio. By increasing our investments in the residential fixed rate securities we materially increased the liquidity of our balance sheet. In challenging global risk environment liquidity is extremely important; fixed rate residential mortgage securities give us the ability to adjust our risk position rapidly. We increased the size of our interest earning assets this quarter reflected in the increase in our adjusted leverage; with the increase in our portfolio the high quality highly liquid securities, we fully intend to increase the size of our balance sheet further in the third quarter; despite the higher leverage we actually have increased our ability to manage risk because of the increase in the liquidity of the investments. One of the most positive developments in 2017 has been the fact that the highest credit quality security with the most liquidity also offers the most attractive return opportunity; as we have done over the past 10 years we have strategically allocated capital to be to the most attractive risk return opportunity, hence we are increasing our return, our credit quality and our liquidity as we grow our fixed rate mortgage securities portfolio. Let me turn the call over to Smriti Popenoe to discuss our investment strategy.

Thank you, Steve. Let's turn to Slide 5 and take a look at the current portfolio and leverage. The diversity of our portfolio is displayed in the bar chart on the left. Over the past year we have decreased the size of our lower yielding ARM portfolio and reallocated capital to higher investment returns in our CMBS-IO portfolio, our fixed rate commercial MBS portfolio, and our fixed rate residential MBS portfolio. On the right, you can see we have also increased the size of our balance sheet in the second quarter and we fully intend to continue to increase the size of our balance sheet with highly liquid, high credit quality securities. Let me note that the leverage numbers in this chart include the impact of TBA securities that are currently on the balance sheet. On Slide 6 and 7 we have two different graphical views of our portfolio strategy. The first chart on Slide 6 gives us a visual of where our portfolio sits today. As we have said many times, we have gone up in credit and up in liquidity. This has not been a difficult decision for us, because asset prices are high and credit spreads are very tight across the entire investment opportunities. Hence we are happy to be at the top of the credit and liquidity spectrum as displayed on the chart on slide 6. Also note that in our 30-year history, Dynex has invested in every asset class on the left side of this page. Our disciplined approach to capital allocation and risk management along with the superior returns offered currently in the 30-year MBS sector warrants that as we continue to grow our balance sheet on the upper left box of this page. Today, on 97% of our portfolio is either agency guaranteed or AAA rated. Slide 7 is simply another graphical view of this strategy. On Slide 8, we offer more information about how we see our 30-year MBS purchases fitting into our overall investment strategy. This is the first time since 2008, that we view the risk adjusted returns offered in the 30-year sector to far exceed other options. We recognize that the growth of Central Bank balance sheets have resulted in high asset prices and tight credit spreads. We are also aware that Central Banks would like to reduce the size of their balance sheet, which could have an impact on 30-year spreads overtime. But we are also aware that their overall growth will be to create a slow methodical well telegraph process. Hence the probability that their balance sheet reduction will be manageable for the investment community is high. Nonetheless, as you know, we are an unchartered territory in the global capital markets. We believe that if spreads widen on this high quality, high liquidity sector it will only create a better return environment to generate attractive dividend yields. We are positioned with the capital and liquidity to take advantage of that opportunity. On Slide 9, we reiterate our macro-economic views which you may have heard us talk about before. In general, global fundamentals have improved, but remain fragile and the economic environment we describe as fragile for a variety of reason. The first is that global debt is high and continuous to increase, we have yet to hear a proposal out of Washington DC that will increase the economic activity without a material increase in debt. Since 2008, despite the financial crisis, global debt has continued to rise. These debt levels leave the global economy vulnerable to exogenous shocks and historically speaking debt binges rarely have ended without pain. The second reason we think the economy is fragile is that the global geopolitical environment is extremely fragile and uncertain. Thirdly, we believe government policy will drive returns, this is something we said since 2008. No one knows what these policies will be, the executive branch of our government is unpredictable at this time. The legislative branches are unpredictable at this time and we expect to have four new members of the Federal Reserve Board of Governors appointed within the next year. There is more to our macro view but let me emphasize that we are happy to add more liquidity to our balance sheet and this type of environment. On Slide 10, we reiterate the positive long-term factors that will impact our company in the future and really these are what forms the basis for our investment thesis. First, U.S. demographic trends are driving a significant increase in household formation and therefore more demand in multi-family and single family housing. This is why we are in the housing sector. Second, global demographic ageing trends are driving a demand for income and yield investments. Third, you have heard us talk about this a lot, as government participation wanes there is a large need for private capital and expertise in managing these complex assets in the housing finance system, and finally the regulatory environment outlook is improving and could provide both investment and financing opportunities in the future. On Slide 11 we describe how we are positioned to take advantage of these opportunities and also our risk posture. In terms of interest rate risk, we have structured our portfolio to be more interest rate risk neutral and we have now included hedges incorporating the risk profile of 30-year RMBS, and as Steve mentioned, added interest rate swaps to manage our exposure to increasing financing risks. In terms of spread risk we recognize that credit spreads are tight, however we are really concerned with two major issues, first; we are uncomfortable with the tight spreads in lower credit weighted and less liquid instruments. Second, as we have already stated, we find the current spread levels in agency fixed rate RMBS to continue to offer attractive long-term returns. As spreads widen in this highly rated highly liquid sector, we believe it will present an even better opportunity to generate attractive cash dividends over the long-term and we are positioned accordingly. In terms of credit risk and liquidity, we continue to favor high credit quality and highly liquid securities and we are positioned to take advantage of spread widening. I will now turn it over to Byron to summarize.

If you will turn to Slide 13, let me summarize a few key points. Year-to-date we have paid $0.36 in dividend per common share and reported core net income of $0.34 per common share. Second, we continue to belief the diversified investments strategy will generate superior risk-adjusted returns given the complementary cash flow and risk profiles of the commercial and residential sectors. There is a unique opportunity to generate returns in a 30-year fixed rate RMBS sector. We are allocating capital out of ARMs and have doubled our position in the 30-year sector since June 30, 2017. We expect to continue to opportunistically invest in this sector, which will help drive earnings for the remainder of the year. The risk adjusted returns and the liquidity of the 30-year fixed rate RMBS more than compensates for the relatively higher duration drift versus less liquid ARMs. The incremental liquidity also gives us the ability to shrink or grow the balance sheet rapidly. The global macro environment is still complex, you have heard us say this for a while, and asset prices are high and the potential for spread widening is elevated. Finally, we have an experienced management team and internally managed structure that creates shareholder alignment and a long-term history of disciplined capital allocation. Slide 14, one of my favorite phrases as always that I could remind you, long-term value is driven by above average dividend yields. And with that, we will open the call for questions.

[Operator Instructions] Our first question comes from the line of Bose George with KBW.

Good morning it's Eric on for Bose. I'm hoping you can actually tell us how much duration a typical agency CMBS-IO position carries and how sensitive do you think that duration is to back up the interest rate when you guys talk about spread widening, you can get a little more clear on just CMBS-IO position. thanks

Sure. The duration on a new CMBS-IO Eric is about four years. It’s complicated in the sense that the duration is about four years, the instruments are priced on the back-end of the curve on the 10 year part of the curve. So you really have to incorporate both of those things in calculating the price sensitivity.

You should also note that I think about 50% of our IO book was originated, Smriti correct me, prior to 2014?

Yes.

So we have been accumulating this book piece-by-piece for the last seven years. We like the book, we think it’s a core part of our portfolio, we think it’s actually a natural fit for mortgage REIT because as Smriti says, its maybe priced off the long and the curve because the long duration of fixed rate CMBS, but it actually is the duration is really on the short-end of the curve. The cash flows every month and it rolls down the curve nicely. So just some additional thoughts.

We can give you a call offline also just to walk you through how we do it.

No, I mean that’s really helpful. I’m just trying to get a sense given your comments on spread widening and your caution around interest rates. Just where that duration is concentrated but those are very good. Thank you.

So let me emphasize on this, the interest rate in spread widening are two different things. I’m not worried about interest rates so much on this portfolio. We can deal with the answer straight. We do spend a lot of time discussing the spread widening across all sectors. And in a mortgage REIT portfolio is that we have learned, spread whitening is an event in the risk that we all take. So another reason why we get excited about increasing liquidity of the balance sheet in a term of strength spread environment such as this. That liquidity is really important, but over the long-term the CMBS-IO book is probably one of the better assets you can have in a mortgage REIT portfolio, but trust me we are very much so on edge of the workforce spread that we are today.

That’s a very helpful answer. Thank you guys.

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

I guess based on your comments about the reasons why you guys have chosen to increase liquidity and moving to the TBA sector. Can you talk a little bit about why you specifically chosen to concentrate on 30-years versus maybe some shorter duration of 15 years?

All right, I will take this in just a second. Let me just point out. My career started in 1986 trading 15 year mortgage backed securities. This sector when every year out of the refinance period, it becomes richer materially richer to the third year sector. And it just phase there until it enters and it just stays although the refinance period and volume picks up in the sector. So if you really look at it, you go from a - the largest part of our fixed rate portfolio is backed by commercial loans. And in next you go not generally maybe have a 10 or 12 year plan. Then you have a 15 year security with a 15 year, then you got the third year. And that 15 year I would argue, if you really looked at fact the main convexity on that versus the commercial versus 30-year probably risk is worth all the other sectors. So, Smriti you can go with some more specifics about that.

I think the simple answer there Trevor is that 15 years right now just don't offer the same risk adjusted return. So even adjusted for the shorter duration and less convexity there is also not that incremental return; the other issue is that the financing offered in the TBA markets in the 30-year sector right now is really compelling in terms of dollar owned, and there is also a lot more choice in terms of specified pool on the 30-year side in terms of a variety of different instruments that you can pick form. And then last but not least as Byron mentioned not that there is a massive material difference in liquidity but really the ability to get in and out of 30s is really quite compelling in terms of liquidity.

And then in terms of reallocating capital away from the ARM portfolio you obviously sold some ARMs in the second quarter. Can you maybe give us some color on how you guys might be look into continue that reallocation if you're sort of comfortable with the pace that you sold the ARMs out in the second quarter?

So, we are doing this extremely opportunistically Trevor and I think we noted in the presentation that the book is down about 40% since the beginning of this year. So, but even since from last year we actually chose to deflect the book run off and we are choosing to do that as well. So, to the extent that we see good bids and we like levels that we are seeing then we are going to continue to sell. To the extent that we don't find that in the market we are comfortable hanging on to the position until we get the right level. So we don't feel like we are compelled seller and we are really thinking in terms of the value and the ability to sort of redeploy that capital. But again, just in general that book runs off at somewhere between 40 million to 50 million a quarter so if there is a natural deleveraging process that occurs, and we are okay with just letting that happen if we don't find the right levels in the market.

Okay. Thank you.

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

Byron I was just hoping you could help expand on this a little bit more. it sounds like you're describing that the environment still is complex and just wanted to understand a little bit more as to what drove the timing for the increase in balance sheet this quarter?

Last quarter when we were in our conference call we wanted to try to remind you everyone that we are not an ABC only REIT in that over the life of our certainly last 10 years; we have allocated capital in a very disciplined manner. I would consider this move that we are making that sounds similar to the move we made in 2010 and '11 into the CMBS sector, not unlike that at all. And that sector stood there in our opinion was extremely cheap, we didn't have a lot of company in terms of how we added the asset at that point in time, that's why that CMBS-IO book was built, half of it prior to 2014. So, this is a similar situation where this sector, it's the highest credit quality, it’s the most liquid and this year after you know the election and the adjustment in yields and spreads we find this sector the most attractive. And so when you look at I think it’s on Slide 6 where we showed you that capital stack it’s pretty compelling to us to stay at the top of the stack both I got credit quality and liquidity this is a 2017 phenomena and it’s the cheapest, and it’s the best risk return profile. At any other time since 2008, we had over options to invest in, but I would consider this similar to the 2010 and 11 when we pushed into the CMBS sector and at that time, we would not only CMBS-IO, we were down on credit to BBB and single As. And we came out of that all agitated in 2014 and spreads that just continue to tighten in. So basically the description is yes the world is complex and you heard us say it and that word has been flown around. But there are lot of factors that are moving globally and you hear words a lot about uncertainty et cetera, et cetera and then you look at where credit spreads are. They are tight, you look at what has happened to debt, debt is continued increase and then we see this opportunity high liquidity 100% government guaranteed paper offer investments. Smriti do you want to throw something around this?

I think the main, the other main point Doug is that the complex environment that is described has been one where you have boulder of volatility that are followed by long periods of comp. So if we are positioned to manage that boulder of volatility and survive that boulder of volatility and invest during that boulder of volatility then you can reap the benefits during that period of comp. So the complexity is something just a watch word that we have to make sure that we don’t lose sight at that boulder of volatility can come and you need to be able to withstand that. And then the investment posture has to be one that can basically take you through that and then take advantage of that period of comp that follows. Now that’s not to say that we believe volatility is going to go down or anything like that. It’s just recognizing that there is an opportunity there to earn that incremental return when things do normalize.

And then Doug I’m going to add again, I don’t want to be the dead horse, but I do well to get excited about, liquidity, liquidity, liquidity and if volatility comes or any type of spread adjustments come, we know we are an unchartered territory with the Central Bank globally. Having a desire to reduce their balance sheets but liquidity, liquidity, liquidity. Throughout my career, liquidity will keep you in business and it just so happens with the most liquid instrument right now and offers to best were risk adjusted return. We think it’s a great opportunity, so as the long winded way and hope that it gives you some more color in terms of how we are thinking.

And I guess this is a follow-up to that. You know I guess having put on increase the balance sheet in a quarter that was relatively low volatility. I guess how do you view your position to take advantage of that mix boulder volatility?

So I will start again and let someone jump in here. But I’m going to start with the word liquidity. Ultimately if I look back, we can go backwards, 2008 we can go then to the inline situation, we can go then to the dot.com - and then the long-term capital prices, the 1994 the currency prices moved back to the 87, stock market crash is then going to move to the early 80s was a severe inverted curve. The best position to be in was liquid securities and the agency sector has made it through all of them. Smriti.

So, I will be one level down on that Byron, so that Doug the answer to that is, so duration and hedges are one thing that we will focus on in terms of having a more neutral duration position and then adjusting our hedge positioning so that we are incorporating some of that rate volatility that you can see in the 30-year mortgages. So I would also remind you guys that the TBA position relative to the other positions in our book, again there is positive convexity in the CMBS book, positive convexity in the IO book, so we feel really good about the diversification, but we are also cognizant that our hedges have to change, right? In terms of the spread risks, I mean if we do see an increase in spread vol our defense is liquidity and the ability to basically get in and out of positions and having an unencumbered cash and liquidity position to be able to withstand that type of spread volatility. So, there is two ways you can hedge spread risk, you can either sell out of your assets and shrink your balance sheet; we don't think it's the right time to do that because there is this return that we earn and so we are defending ourselves with a pretty big liquid asset position and then cash and unencumbered asset position. Does that make sense?

It does. Thank you.

And Doug I'm going to add on that, I'm going to just reiterate one point that Smriti made which is really a big part of this. the return opportunity for our shareholders to earn a solid dividend here with this environment of bouts of volatility periods of comp, you know what, that opportunity is this, and we are supposed to take advantage of that bar of shareholders and that's exactly what we are doing and it just so happens that there is a sector that we can use and we feel pretty good about it.

The last thing I would say on this is that we don't feel like we are fully invested in this sector, it's just relatively small percentage of assets and capital at the moment. So we feel like our ability to sort of grow the position as the opportunities are there and there have been some opportunities even since quarter end, that we feel more confident that we can actually do that.

Thank you guys.

I think there are no further questions at this time.

Okay, we appreciate you all joining us for second quarter call; we look forward to having you join us for our third quarter call. Hopefully we are clear and if you have any other questions we are always willing to have long conversations offline. Thank you again. Enjoy your day.

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