Dynex Capital, Inc. (DX) Q4 2017 Earnings Report, Transcript and Summary

Good morning. My name is Denise, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Dynex Capital Inc. Fourth Quarter Results Conference Call [Operator Instructions]. After the speakers' remarks, there will be a question-and-answer session [Operator Instructions]. Thank you. Steve Benedetti 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, our President and Chief Executive Officer; Smriti Popenoe, Executive Vice President, Co-Chief Investment Officer; and Alison Griffin, Vice President of Investor Relations. The press release associated with today's call was issued and filed with the SEC this morning, February 21, 2018. You may visit the press release on the homepage of the Dynex Web site at dynexcapital.com, as well as on the SEC's Web site 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, anticipates, 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 may be found on our Web site under Investor Center, as well as on the SEC Web site. This call is being broadcast live over the Internet with a streaming slide presentation, which can be found through a webcast link on the homepage of our Web site. The slide presentation may also be referenced under quarterly reports on the Investor Center page. I'd now like to turn the call over to our CEO, Byron Boston.

Good morning. Thank you, Steve and thank you all for joining our call this morning. It is my pleasure to discuss our results for the fourth quarter and full year of 2017. In preparation for this call, I look back and reviewed by comments that I made at the beginning of 2017. Most of our thoughts have not changed, while we have not adjusted our larger strategic views, we continue to adjust our portfolio tactfully to deal with the evolving marketplace. Nonetheless, there're two major differences driving the macro environment; regulatory policy is continuing to become less restrictive; and Washington has implemented an aggressive fiscal policy driven by debt. We continue to believe the markets are in a transitional period that will ultimately lead to a very attractive return environment for mortgage REITs. I will discuss all of our thoughts after I first review our fourth quarter results and our full year 2017 results. On the whole, 2017 was a good yare for our shareholders. Let's first look at the fourth quarter on slide three. We finished the year with a steady fourth quarter that helped solidify strong 2017. During the quarter, we paid a cash dividend of $0.18 per common share while earning core net operating income of $0.20 per common share. Book value was down slightly to $7.34 from $7.46 at the end of the third quarter. More importantly, the full year results of 2017 are more interesting, please turn to slide four. The year was marked by a steady decline in volatility despite the year starting with enormous policy uncertainty from Washington DC. We earned more in core income than we paid in cash dividends despite the fact that during the first quarter of the year, our earnings were short of our cash dividend run rate. For the full year, we paid $0.72 in cash dividends and we earned $0.73 in core net operating income. During the year, we reallocated capital into more liquid higher ROE investments by transitioning from hybrid ARMs into 30 year fixed agency securities. We added hedges to limit the impact of fed hikes on funding costs. And we produced our earnings without increasing our leverage in a meaningful way. Year end 2017, we stood at 6.4x leverage versus 6.3x at the end of 2016. In addition to the return generated from spread income, we also added 2.2% increase in our book value during the year. Needless to say, we're happy with our results. Now please turn to slide five for more specific thoughts regarding our focus and results for 2017, and let me just emphasize two points. In '17, we continued to emphasize liquidity in our asset selection and in the amount of cash and liquid assets on our balance sheet. And we maintained a diversified portfolio between securities backed by residential property loans and those backed by commercial property loans. Next, we have three slides, slide six, seven and eight, highlighting the shifts we have made in our portfolio over the years. You can see a definitive commitment to the 30 year residential fixed rate sector. Let me reiterate our key reason for this shit, liquidity first. It is our opinion that when lower credit assets are priced to low yields and credit spreads, it is best to move capital into the most liquid high quality asset sectors. This myth that we sold the majority of our ARM portfolio as a sector’s forward return and liquidity has declined materially. It also meant that we continue to pass on investing our capital in the lower credit sectors. Another key reason for the shift was that the 30 year sector despite being the most liquid and highest credit quality asset in the mortgage backed security space, cheapened materially early in 2017 to offer very, very attractive forward returns. And we have always been very disciplined in our capital allocation decisions and 2017 was no exception. Let's turn to slide nine and take a look at the macroeconomic environment. As I previously stated, many of our thoughts continue to be the same as 12 months ago. We believe government policy will drive returns. This has been a core tenet of our investment thought process since 2009. We believe we are currently in a transitional environment that will ultimately create a more attractive return environment for mortgage REITs. We believe the continued rapid growth in global debt will create a drag on global economic growth and exacerbate any sudden drop in aggregate demand. We believe that rapid rate increases will ultimately have a negative impact on equity valuations and economic activity, especially given the absolute amount of global debt outstanding. However, as I mentioned in my opening statements, there've been a couple of policy developments that have changed the probability distribution of potential future scenarios. The U.S. tax cuts will be short term positive as real cash is pumped back into the economy. However, the negative effect of the resulting massive increase in debt will be the most dominant impact over the long term. These tax cuts plus increased debt issuance plus the fact that the major central banks around the globe would like to reduce the size of their balance sheets has increased the probability that 10 year yields can breakthrough 3%. Nonetheless, we believe that this increase in rates will ultimately have a negative impact and potentially lead to around stripping rates similar to 1994 or the 1987 experience. Please turn to slide 10 and let's discuss the return environment. At the core of our thought process today is that the return environment will improve as rates rise or spreads widen or both. We are assuming that any meaningful move higher in rates from the current levels will be marked by steepening yield curve, a positive for our potential future investment opportunities. We're also assuming that as the Federal Reserve Bank continues to reduce their balance sheet, their mortgage assets will have to offer returns that are attractive for private capital to invest. This again is a positive for Dynex Capital. Discipline would be key to managing through this transitional environment. We will continue to adjust our hedges and balance sheet size appropriately as the market environment shifts. Duration and leverage will be our key variables that we will adjust through this transitional period. In any given quarter, our duration might swing between zero to one. In addition, given that over 90% of our assets are government guaranteed, we have the ability to increase the leverage of our portfolio if we feel the return environment warrant such actions. Now let's review a couple of moments in history that we feel are worth noting. Please look at slides 12 through 13. I lover slide 12, on slide 12 we use the 1987 market experience, that was my first year as a fixed income trader and we used this picture to show you the rapid increases in bond yields can have a very negative impact on equity valuations and then when equity prices begin to drop, bond yields can rapidly reverse and drop as a result. What this means for our strategy is that we need to be cautious on getting caught with too many hedges against our portfolio if rates were to decline rapidly. On slide 13 we simply show that so far in 2018, we've got a minor glimpse of what can ultimately happen in a much larger manner. Then look at slide 14 and this is another one of my favorite periods to understand, 1994 through 1995. In 1994, the Federal Reserve Bank increased short term interest rates and long term interest rates responded and ultimately rose close to 250 basis points. The rapid increase in rates caused by central bank eventually help create a situation where rates completely reversed course in 1995. As we manage this transitional period, we will be using more hedges to reduce the impact of rising rates, while remaining vigilant to adjust those hedges if rates fall or reverse course. Now let's turn to slide 15. We continue to believe that favorable secular trends should support our business model. Global demand for yield will continue demographic support for the demand for yield -- well demographics will support the demand for yield even if rates rise. Investment opportunities will increase in the U.S. Housing finance system as the government continues to reduce their balance sheets. And reduced regulations should have a more favorable impact on our ability to finance our portfolios. Let me finish by reflecting on the last 10 years. January of this year marked by 10th anniversary at Dynex. We began to rebuild Dynex's balance sheet in 2008, the worst financial collapse since the 1930. We had to create a corporate strategy, establish credit relationships, make smart investment and hedging decisions and raise equity all during a period when many mortgage REITs along with other major financial institutions were going bankrupt. We developed our core principles and we are stuck with a very disciplined strategy, emphasizing risk management and opportunistic capital allocation. Over the last 10 years through December 31, 2017, we have generated a compounded total shareholder return of 143% versus 131% for the rest of 2000 and 126% for the S&P 500. Please see the picture on slide 17, and do note that above average dividend yields are very, very powerful for us over time. Throughout that time, we've dynamically allocated our capital in RMBS, CMBS, CMBS IO and loans, taking advantage of the most favorable relative return opportunities. We have declared cash dividends on our common stock of approximately $392 million or $9.67 per share over these 10 years. Collectively, our management team averages over 30 years experience managing fixed income related asset successfully navigating multiple market and business cycles. And most importantly, we are organizing the shareholder friendly internally managed structure with significant insider ownership. Now part of the reason I want to give you this recap is that this management team has been in various major capital permitting seats in the fixed income marketplace starting in 1981. It is our opinion that above average dividend yields such as offered by Dynex common stock and preferred stocks will be a major driver of returns over time. Compounding large cash dividends will continue to buffer book value valuations, also over time. Most importantly, we are generation our cash income mainly from assets created through the U.S. Housing finance system. These transitional periods have come and gone multiple times throughout history. Please note 2018 represents our 30th year in existence. With that operator I will open the call up for questions.

[Operator Instructions] Your first question comes from Eric Hagen from KBW. Your line is open.

Byron, I think you said on the -- I think you may have mentioned in the start of your remarks, tactical versus strategic allocation. Should we think of the move into the longer duration assets still as a tactical allocation for the portfolio or would you say that's perhaps more permanent at this point? Thanks.

So the tactical decision, I really want to refer to these hedging decisions, which I know all of you want to know. Hey, what's the duration gap now, it's moving around. And we're not, we've moved it around, so this is a tactical decision throughout this quarter and I gave you an example of zero to one. Now from this allocation to the higher credit quality assets is very strategic. As far as I am concerned, when I look back through history, it's the one sector that has come through every single major transitional period in the markets. So as a company, as a corporation, as a fiduciary of our shareholders’ capital, we feel it's extremely prudent that we move to a more liquid, higher credit quality position at this point in the overall economic cycle. Remember we're a leverage player so we are -- at these type of credit spreads, we don't want to leverage lower credit assets, especially when we can generate these type of returns at the top of the capital stack. So that's a real corporate strategic decision. For some in and out of agencies, could be a quick tactical decision but we're in this sector and this cycle, depending on how long this cycle takes.

You guys also provided some good color on the expected book value change for a narrow yield curve in the slide deck. But how does that -- how could we think about the changes or your sensitivity for net interest income due to a more narrow yield curve? Thanks.

So you mean from a book value perspective or net interest income?

Earnings, yes? I think you said that -- go ahead Byron…

I don't know if I can give you an actual number on that, but accept to say that we definitively and throughout -- as you can see it in our numbers in '17, we definitively added hedges to deal with -- from a net interest income, we've also added hedges from time to time to deal with book value. Smriti, do you want to add something to that?

Yes, I mean you're asking about REPO coverage here, Eric. We're currently slightly over 100% covered and we expect to maintain a pretty high level of coverage somewhere between 75% and 100% coverage with respect to the REPOs. And in the K, we actually provide you guys a table with that sensitivity. So you'll have that when we release the K.

Your next question comes from Doug Harter with Credit Suisse. Your line is open.

Byron, you talked about how in some of these transitional periods, rate increases are followed up with rate declines. Can you just talk about whether adding optional hedges makes sense in that type of environment and if so your current thoughts on that?

So yes, we do think about options strategies a lot. It's difficult -- at this point, I think we've been doing more delta hedging than options strategies. Overtime, I think it does makes sense to add options. We're looking at options in terms of our ability to get in there and flatten out the profile some. At the moment, we're actually finding its more capital efficient and income efficient to use non-option based hedges, but that's on our radar at all times.

And Doug I want to go back, it seems -- I know we've had this conversation before, and you've asked that question. But we always -- we're considering option strategy that we're making the choice to obviously due the delta hedging strategy. One of the main keys has been we've been a period of what I would call bouts of volatility and then periods of comp, and long periods of comps. So if you look at this current cycle, you could go back to November 2016 and you can consider this one long bear market, you hit the low at the election and rates have really risen since then. However, it took a jolt and then you had this long period of declining volatility and really a flat rate environment between 2% and 2.50% and now you've taken another move through 2.50%, 2.60% up toward 3%. It is uncertain right now whether we're right now in still with this cycle of period of bouts of volatility periods of comp, that period of comp becomes really expensive with options, it crushes.

The other thing for us Doug is that our 30 year position is still I think 40 something percent of our assets 42%, so it's not swinging the entire book around as much as you'll see for people with more concentration in that sector. The DUS in the CMBS IO give us a significant amount of positive convexity that we're not dealing with as much duration drift or convexity when we do see the swings. So options based strategies are definitely on our list of things to -- that we look at relative value wise and right now it's just made more sense for us to delta hedge.

And then what is your outlook as far as agency spreads as the fed reduces its balance sheet. And can you -- included in that is do you expect any carryover into the agency CMBS that you're on?

So our view is that as the net supply later in the year starts to increase that is either due to seasonality, mostly due to seasonality, but also because the fed is going to start to be a not a net buyer of all the supply that's coming out, so it’s later in this quarter early in the next quarter and through the summer, we really see the net supply picture in 30 year mortgages to be increasing. And we think that's going to be true regardless of whether mortgage rates are at 4% or 4.5%. And that is going to bleed into 30 year MBS spreads. I think that is something that we expect a decent amount of spread widening to come in the 30 year fixed rate sector. With respect to the agency CMBS sector, it's a very different -- it's not your grand dad CMBS DUS market, if you will, the supply picture is very, very different in that market. The buyers are very different. You've seen a lot of cross over investors or tourist investors coming in from CMBS and corporate. That I think is going to be more technical. It will be more supply driven and it's more tied to IG spreads. So there is and there can be some correlation between 30 years and DUS spreads in real periods of disturbance or disruption in the markets. But we're actually thinking that that market will have some cushioning relative to just the pure 30 year impact from the fed lack of purchases. So more widening will happen in the 30 year fixed market than the DUS market as a result of the fed not participating in that market. DUS spreads could be disrupted on their own but we're thinking the linkage isn't as strong.

Your next question comes from Trevor Cranston with JMP Securities. Your line is open.

A follow-up on the last question about the impact of the fed becoming smaller presence in the agency market. Could you talk about how you think that'll impact the financing and specifically the specialness in dollar rolls as they become smaller and smaller player? Thanks.

So the coupon that they've been the most active in has been the Fannie between 0.5 or the 3.5 coupon. We've seen the role come off on gently in that sector. I think it's more of a demand story than a supply story there. So that coupon is -- we don't own that coupon we've avoided that coupon for that reason. I do think the dollar roll in that particular coupon really is more driven by fed activity. Going forward, though, I have to say the roles in general are going to be impacted by two things, which coupon is going to be the production coupon, as well as the level of interest rates and the prepayment risk that's within the mortgage sector. So for example, Fannie 4.5s we expect the role should be just fine, because it's right now not the production coupon, prepayments are low and generally that's high positive carry coupon. Fannie 4s again, we expect decent role performance there, driven by the prepayment experience and they're not yet a production coupon. 3.5s can be the production coupon, they're the power coupon so we expect them to perform there. These are not being really produced that much but it's also the discount coupon. So it really depends on the production coupon, Fannie 3.5 I believe because they've been the fed coupon, will probably underperform role wise, the most going forward. But again it's really dependent on what the interest rate picture is and the actual supply picture.

And then you guys made the comment that you've been more so focused on delta hedging the portfolio as opposed to optional hedges. With the rise in the rates we've seen an increase in volatility so far in 2018. Can you say if there has been any meaningful changes to the coupon distribution you own in your agency portfolio as durations have generally extended? And also maybe provide an update on how you're seeing book value trend so far this year? Thanks.

So our book value between December 31st and now is down less than 3%. We have tended to use swaps to hedge our portfolio. We have not gone up or down in coupon in terms of changing that position. We've picked the coupons that were in for very specific reason. We have more of a barbell type strategy in our coupon selection. So our delta hedging is really going to be more active on the swap side. And I just want to clarify that something that when Byron mentioned that the duration really swinging between zero and one, or those are not hard numbers, our duration can and will go negative if we believe actively that there's a reason for us to go there. It can also swing longer than one if we believe there's a real reason to take that incremental duration risk. And then also yes there's some natural duration drift in the portfolio and there's going to be some swinging around as a result of the negative convexity in the pass-throughs. But really we're making very deliberate decisions in terms of whether we want our duration gap to be closer to zero or closer to one or higher. Those are deliberate decisions when we talk about it swinging around we're just not allowing the book to swing around. The other point I'll make again is at the moment we are about 6.5 times levered, 6.3 times as of December 31st and that leverage we're not increasing that leverage at this point. So that duration gap isn't moving because we're adding a number of securities, that's the other point I wanted to make sure that you guys had. So really our duration hedging has been in the swaps sector.

[Operator Instructions] Your next question comes from Christopher Nolan with Ladenburg Thalmann. Your line is open.

How many spread tightenings are you anticipating for 2018?

We have no reason to believe anymore than three. Part of the reason Chris that I point out that '94 and '87 experience is the fed will stop when it's time to stop, and so we sit on the edge of our seats. So I'm glad you asked that question, because it gives me chance to just explain this a little bit better in terms of okay fine, you say there's three coming. The fed is still very, very much so focused on what is the economic development that’s in front of them, meaning the economic statistics that are coming out and what is happening in overall global financial stability. So in 2004 our prepared period, I was very bearish, it was negative for negative duration, and we took one view. I don't think this is a type of environment that you can just say that. So the fed says they want to go three times, I think these tax cuts kind of complicate things since that we're still not sure how much or what the full impact of this will be, they could go more, they could go less, depending on how the overall global economy evolves.

And Byron, as I recall in your comments, you mentioned that you're expecting a steeper yield curve. Is that correct?

Yes, so here's the theory behind that, which is for you to really get rates moving, you need growth, you'll need inflation and you need to really see solid inflation. And if you see that then yield curve should be steepening up. Or the amount of debt supply that U.S. government deliver to the marketplace plus the fed balance sheet, late starting -- especially starting in the fourth quarter, third and fourth quarter, has the potential to really pressure long leads more than most people anticipate. Everyone is focused on the fact that the treasury plans on issuing a lot of debt in the short end of the curve, but we believe that to really have a meaningful increase in rates, there needs to be some inflation along with that that will imply that the curve should really steepen up.

Final question, should we view the level of TBAs are now which are roughly 25% of total assets the limit as to how much you can grow the TBA book, or could it grow further?

With respect to the asset test we're going to manage that to be about 25%, Christopher. And we're watching that obviously between pools and TBAs. And then to the extent that we have the opportunity to increase pools then we can commensurately increase the TBA position.

Your next question comes from David Walrod of Jones Trading. Your line is open.

Could you talk about the return opportunities you're seeing in the current marketplace and how you view that relative to share buybacks?

Well, I’ll do this. Smriti, do you want to just talk about the specific return opportunities and then I'll take the share buyback part?

So right now we are seeing 30 year mortgage spreads about where we left off at the end of December. We view that as not yet attractive with respect to adding leverage here. We may on the margin replace run-offs at these types of returns but we don't view them as attractive enough to increase leverage.

And David we view -- we're very serious when we talk about these tailwinds, especially when you consider the government's desire to reduce their balance sheets. We believe mortgage REITs and especially Dynex Capital are in position to play a role in managing these assets as the government continues to unload them on the marketplace. However, capital will be needed to manage these assets. So in past where you might have been making one set of decisions around buybacks, this future opportunity changes that equation a bit. So we're very excited about that opportunity but we need capital to be able to take advantage of it. So whereas as a few years ago we were quick to turn and buyback stock, immediately, we feel there’s some other factors that have to be considered in our future decisions.

There are no further questions. At this time, I’ll turn the call back over to Byron Boston.

As always, we really appreciate you all plugging into our call, happy to follow-up with anyone and thank you again. And we’ll look forward to chatting with you again probably in April. Thank you.

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