Dynex Capital, Inc. (DX) Q1 2018 Earnings Report, Transcript and Summary

Good morning. My name is Kim, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Dynex Capital’s First Quarter 2018 Earnings End Results Conference Call [Operator Instructions]. After the speakers' remarks, there will be a question-and-answer session [Operator Instructions]. Thank you. Alison Griffin you may begin your conference.

Thank you, Kim. Good morning and thank you for joining us everyone. With me on the call today I have Byron Boston, President and CEO; Smriti Popenoe, EVP and 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, May 2, 2018. You may view the press release on the homepage of the Dynex website at dynexcapital.com 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, 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, 2017 as filed with the SEC. This document may be found on our 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 on the homepage of our website and on the Investor Center page. Our slide presentation may also be referenced there as well. I now have the pleasure of turning the call over to Byron Boston.

Good morning. Thank you, Alison and thank you all for joining our call this morning. It has only been a very short period of time since our last conference call in February. I can say with confidence that we’ve not changed our overall investment thesis. It is our opinion that, first we are in a transitional period to a higher return environment. Second, the large amount of global debt and large central bank balance sheets have created a fragile global economic environment. Government policies will drive returns, but unfortunately the uncertainty around these policies is adding to the fragility of the economic environment creating global markets where surprises are highly probable. As such, our portfolio continues to be heavily invested in high quality, high liquid assets because we are anticipating an improved return environment. We continue to maintain a high level of overall liquidity in terms of cash and unlevered assets. Let's go over to the results for the first quarter, please turn to Slide 3. Despite the rate and volatility environment, we maintained our cash dividend of $0.18 per common share. Furthermore, we also generated core net operating income of $0.18 per common share. Due to the rise in rates and our positive duration GAAP we posted a small unrealized 3.6% decline in book value for the quarter. It is important to note that our diversified portfolio helped to reduce the impact of the rising rate environment, as our commercial portfolio helped to offset any negative impacts from our residential book. Throughout the quarter, we were able to hold our leverage relatively steady at 6.4 times and as a result, we still have room to increase leverage in the future as we are anticipating a better return environment. These results produced a small economic loss on book value for common share of 1.2% for the quarter. Let’s turn to our portfolio composition on Slides 4 and 5. You can easily see how we have chosen to emphasize credit quality and liquidity in our portfolio. We have decreased non-agency assets in our portfolio and we have increased our agency and treasury positions to 92% of our balance sheet. However, it is important to note that within this heavy concentration and agency assets, we continue to diversify our book between commercial and residential assets. 56% of our portfolio is backed by residential securities, while 44% is backed by commercial assets, mainly in the multifamily sector. This diversification is really important to us and has been a key investment thesis at Dynex for the past 10 years. The commercial assets helps stabilize our duration profile and reduces prepayment risk and fluctuations on a monthly basis. We believe that returns offered in the lower credit, less liquid assets sectors do not compensate us for the overall macro, global risk environment in which we operate. Furthermore, the relative return of lower credit assets versus high quality assets continues to be extremely tight and drives our opinion that the only place to invest marginal cash is in the most liquid highly rated securities. Now please turn to slide six and seven and let me elaborate on our investment thesis. As I mentioned earlier, we believe markets are in a transitional period to a higher return environment that will be favorable for Dynex Capital. Several catalysts have put the transition in motion. One, the U.S. central banks desired to tighten credit and reduce the size of their balance sheet. Two, the US fiscal policy is materially increasing the amount of debt that the market must absorb on a monthly basis. In addition, high and increasing global debt levels have created a very fragile economic environment. Then finally, the probability of surprises has increased. It has increased and is heavily driven by the very uncertain global government policies. As a result of these factors we are anticipating higher returns in the future. The above factors all point to opportunities to invest capital as long term accretive returns for Dynex shareholders. A key to our success will be managing effectively through this transition period. We will manage through the current environment as we have throughout our career with disciplined risk management and opportunistic capital allocation. However, the most important component of our current strategy is liquidity, liquidity, liquidity. Our focus on liquidity gives us investment options to increase net interest income when opportunities arise. Please turn to Slide 8 and 9. We have 205 million U.S. Treasuries available to redeploy into higher spread assets. We have 225 million in hybrid ARMs that can also be reallocated to higher yielding in assets. Also, we're covering our dividend with a modestly leveraged balance sheet which gives us the option to increase earning assets when spread widen and returns improve. Furthermore, our overall cash and unlevered securities position will allow us to weather any book value volatility and deploy capital - new capital at higher returns. We fully expect that investing capital at wider spreads and higher returns will be the main driver of above average results in the future. Finally, let me really emphasize that there are a long-term trends that support our business model. First, substantial global demand for cash yield will continue to support long-term valuations of mortgage REITs. Simply put the population of investors seeking above average cash yield is increasing and we’ll continue to do so until the next decade. Second, expanding investment opportunities from the growing supply of assets as the Fed reduces its balance sheet, but the other global central bankers joined the fit and get to a point where they also begin to reduce their balance sheet the opportunity will continue to improve. Simply put, at central bank balance sheets are reduced, assets will have to reprice the levels where private capital will be willing to assume the risk. Now that helps me illustrate the size of this opportunity, please turn to slide 10 and 11. There was a great opportunity for Dynex, as the federal government attempts to reduce its presence in the U.S. housing system. There is a consensus throughout Washington that the government should play a reduced role. Hence there is a great opportunity for private capital vehicles such as Dynex. Let's just focus on the residential mortgage market on slide 10. This market is an enormous market with 10 trillion in loans outstanding. As you can see in the top graph, 6.2 trillion of these loans are in agency securities. Now note in the lower chart that the government owns 33% of this agency marketplace. This is the first time in our careers that the U.S. government is deliberately reducing the size of their balance sheet. And as you can see, the amount of supply is substantial. There’s enough private capital globally to support the government's desire to reduce their overall exposure. However, we anticipate prices in spreads to slowly adjust as the Fed's balance sheet continues to run-off. These are the factors that make us believe that we have a tailwind for our business. Our management team has the skills and experience to weather the transitional period and to reallocate capital until the best return opportunities for our shareholders. And then finally on slide 11, I always liked to end on this long-term chart. At Dynex we're always focused on the long-term, note when the lines run together and when they separate. When we have the opportunity to invest our capital at better returns, we fully anticipate that are above average dividends will continue to drive our long-term returns above these market averages. You can still see that illustrated back in 2008 and ‘09 as we deployed capital at much wider spread at that point in time and as markets adjusting to the future of the next five years, we believe above average dividends - heavy driver of future returns and will -- and overall impact the picture that you see here five years out. Thank you. And we will open the line up for questions

[Operator Instructions] We'll pause for just a moment to compile the Q&A roster. Your first question comes from the line of Doug Harter from Credit Suisse. Your line is open.

Thanks. Byron. You talked about, at some point looking to increase leverage. Can you talk about kind of whether we're there yet or you still sort of preserving liquidity and playing and not ready to play offense yet?

The we're still preserving liquidity Doug, and what I will say, I don't know if you asked the question? Someone may have asked a year ago about that same question, and we said that, we may have one turn of leverage in this and we were bought at the same level as we are today. So we've been able - the last four or five quarters to maintain this leverage and continue to generate appropriate dividends. So we still have room, if we see the right assets. And then, and here's what else is key, -- when we talk about our strategy, we're making a very deliberate decision of which risk we are willing to take. And what we are saying is, we believe in this environment, in this global environment, you're better off taking a bit higher leverage on really liquid, high quality assets than taking lower leverage on some of the lower credit quality assets. Same situation existed in ‘04, ’05, ’06. Unfortunately, many people didn't realize that until some damage had been done in ‘08.

Got it. And then, if you could just, along those lines of sort of just said as the more liquid assets, but higher leverage. Now I guess how do you view where your rate risk is today compared to the prior quarter and in prior periods of time?

And when you say rate risk…

I guess, book value risk to, -- if we see a continued move higher in rates either kind of parallel or flattening?

So we have added more hedges to our book of business. And we continue to - I'm going to let Smriti get more specific on what we've done. But we have added more a head to start book of business. And in general, I'll give you a high level of, nonetheless Smriti get a little more specific. Here's where our concern happens today. We believe that because of global debt, because of the fragile environment that yields may go up. You haven't because of what the government did at the end of last year with that tax cut and is huge increase in debt. You probably increased the probability that you could push yields a bit higher. We are challenging the thought processes of their ability to hold at higher levels. And it's really a function of the amount of global debt. And we are really concerned about getting ourselves too wedded to a portfolio that has enormous amounts of swaps against securitized assets. So we're trading around our position. We are adjusting the throughout the quarter. But as of today versus, you look back a year ago, we do have more hedges on. Smriti you want to elaborate?

Yes. So I'll just backtrack for a second on the dry powder question Doug. In addition to the leverage, there's just another piece in terms of dry powder. So the way the assets are currently allocated, we also have the ability you have close to 425 or 450 and what I would call lower yielding assets that can be redeployed at the right time into higher yielding assets. And then secondly, obviously there's a leverage lever that we can pull. So there's more than just one way to increase your net interest margin. One, obviously is to take leverage up, but the other is to redeploy those assets. And at this point, if we don't feel like we have to increase leverage or the opportunity isn’t so fantastic, we're going to pick redeployment over leverage. On your risk question, so if you can look at page 20 in the in the deck, we show you our risk profile in December versus March. Our net exposure to a parallel up 50 is down slightly, but you'll see really where the hedges are, are in the backend of the yield curve, that's where most of the new hedges that have been put on, have been. So the steepening of exposure is actually substantially less versus December. So you can see that on page 20 there.

Okay, great. Thanks.

In terms of -- just again, I know a lot of guys have been asking, so I'll just preempt the question, versus the end of the quarter our book value is down very minimally versus the end of the quarter. So we've had a pretty big rise in rates and not had much of an impact on book value.

Very helpful. Thank you.

Your next question comes from Eric Hagen from KBW. Your line is open.

Thanks. Good morning. My first question is on hedging, just to follow up to what you were maybe just talking about. Just the $1.6 billion in forward starting swaps, can you just tell us where on the curve those set and just how far out in time they start?

Yeah, those are one to two years out and they're between five and seven year hedges. So, once they start they pay for five to seven years.

Yes. Great. That's helpful. And then just the next…

Curve, as you can probably see on the risk charts as well. They're hedging the belly and the back end.

Yes. Thanks. That's helpful. My next question is just on liquidity. Can you just discuss the liquidity and just maybe there's competition for CMBS IO right now? And just how that spread, just maybe the levered ROE compares for those assets versus agency pools and TBAs?

Sure. When you say liquidity, do you mean just the amount of ability to sell assets and buy assets?

Yeah, I mean, I guess liquidity just in the sense of what Byron was talking about in his opening comments.

Okay. So more in terms of the ability to the type of assets, so the -- right now I would say, we have emphasized higher liquid positions. Our leverage actually without our TBA position is at 4.9 times versus the 6.4 that we reported. And we talk about that because it's very easy to reduce that leverage, that extra 1.5 times if we think the opportunity exists to reduce it or even take that up. So that's one thing. So having that flexibility, I think in a liquid instrument is very important. That's one reason we shifted to a more liquid strategy because we've wanted to have that flexibility to take it up or take it down because that's what this environment needs. In terms of our ability of our trade things, I would say again, the more esoteric a particular asset is and more sort of unique the instrument is, it is harder to trade those assets. And that's one of the reasons liquidity really matters. The second thing I would say that part of your question on CMBS IOs, those instruments have not made sense for us on a levered basis -- levered ROE basis. We see the returns on those at market leverage at around 6% to 8% right now where you can finance them in the open market. And they don't offer that - a compelling return relative to pass throughs which again are sitting, depending on the coupon and depending on how much credit you give yourself to the role, those are sitting closer to the mid double digits ROE and depending obviously on the leverage assumption that you use. But we think of those in terms of 10 to 12 times leverage and the returns are somewhere between 12 and 15, so much better returns on a much more liquid instruments relative to the IOs. And as we've said on these calls before, we're letting that IO book run-off as a result.

Yes. Thanks for getting specific with the ROE. That's helpful. Thank you.

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

All right, thanks. Good morning. You guys have talked a lot about the focus on you know more liquid securities in the near term and also your expectation that we're in a transitionary period to a higher return market. Can you maybe elaborate on how you're thinking about the balance between holding more agency CMBS and the risk that poses to your book value in the near term? Potentially if spreads are too widen, as the Fed removes itself from the market versus the carry you would give up in the near term? And incrementally more dry powder you would have if you were just running with the lower leverage currently. Thanks.

Trevor, I am going to let Byron take the first crack at that and then I'll give you this specifics.

Yes. The - one is in trade-off Trevor. And it's one that we make on a daily basis. I feel -- and I'm trying not to sound like it is, they always, still guides you like an old country preacher because I am very excited about the position that we've got by having this type of liquidity. Smriti brought up something a second ago which is, that we can take our leverage down relatively rapidly. Likewise, we can move our leverage up if necessary. And so with the tradeoff Trevor on a - that the key part of this business is that it's a tradeoff. Why do I like to liquidity? Because we're prepared for surprises, at the end of the day that's what we're prepared for, it surprises. And so the, as I stated earlier, we believe that the power of investing the dry power at wider spreads will offset any book value volatility in the near term. That's our opinion. Smriti you want to be more specific?

Yes. I mean, I think you actually said it in your comments which is that, we're sitting here at 6.4 times leverage, we're covering the diff and we have options to raise that earnings power either with reallocating assets or increasing leverage. And that that idea of, if we really felt very strongly that agency CMBS was the place to go, they would be a lot bigger percentage of our total assets then the 30 something odd percent they are today. So I think we're expressing a cautious view by stepping in to the amount that we are. We believe we have the flexibility to change up or down based on whether we think there's a big widening coming or not. But it's giving us the opportunity to make that dividend coverage now. And then fully expecting that, we'll be able to take advantage of any wider spreads by deploying capital at that time, we have excess capital. Obviously, that's why the leverage is sitting down here to be able to deploy at the wider spreads and better return.

Here's what I would say to my shareholders, we're in an environment -- we believe that the power of being able to put capital to work at these wider spreads, when I look at slide - a long-term chart on slide 11, the power of really being able to put capital work at wider spreads, especially if you're saying that the, you know, the agency product, high quality product really widens out. It's really very, very demeaning. It's a meaningful return opportunity that we believe will be created and it'll offset any of the -- over the long-term any of the volatility that may be created in the short term. That is truly what we believe here. And that's what we've experienced throughout our careers. And as I emphasized always with every shareholder is, we are always thinking about the long term here at Dynex, while all shareholders will have long term exposure to the company.

The other point I'd make on that, is that we're not here trying to expose ourselves to what we think is a permanent widening. If that happen, that's the reason to have the flexibility to take the position up or down.

Yep. Okay, that's helpful. And then last question, with the widening we've seen between three months LIBOR and like agency REPO rates in the last few months. Can you guys comment if you have a view on whether or not you expect that current relationship between those rates to stay at current levels or widen or potentially normalize over the rest of the year? Thanks.

Sure. Trevor, so we do have an opinion. Our view is that, that spread has gotten out to a pretty wide amount, at this point starting to narrow back in. It's a function of some near term factors and some longer term factors. It is a structural change in the environment. We don't believe it's going to stay here at these levels, but it's not going to narrow back to the levels that it was say a year ago or pre the tax law change. So there's a structural element to this that is going to maybe put back something in the order of 10 to 15 basis points back into that basis, that didn't exist before. So when we think about long-term returns and how we're evaluating you, our paychecks positions for example, there's going to be a near term tailwinds maybe over the next two to three quarters and then a slow normalization back down again.

Got it. Okay. Thank you.

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

Hi, is it fair to say that given the rise in your cost of funds that your hedging position didn't dissipate? It's what’s happening on the short end with LIBOR built into your REPO?

There's actually a timing lag, Chris. So some of those, -- a lot of it has to do with the dates which at which our swaps reset relative to how the REPO reset. Our REPO’s reset once a month and the swaps reset once a quarter, so some of it is a timing lag. The other difference really between one quarter and the other is that we had swamps that were existing in the year 2017 that rolled off in the beginning of the year 2018. So we felt the brunt of some of that. Even though, we had existing hedges to cover those REPO that existing hedges were struck at higher level. So that was -- that's really the two reasons why there's a big jump like that.

Smriti, how much of the increase was due to the timing issue?

I'd have to come back to you on that. I mean just, if it gives you, if it helps you on, in terms of how much the REPO exactly is covered. Coming into this year we had close to 100% of the REPO covered. So a lot of it is, is timing. And then from here in March 31 onwards, for the next sort of, we - the eight quarters we have 70% to 80% of the book currently covered. That gives you an idea of what the future exposure is?

So is it fair to say that because the timing issue, we should see a reverse effect where your funding costs should actually go down a little bit, all things being equal in the second quarter relative to the first?

I would say further increases are better protected versus -- I'm not sure, I could tell you that there's a reverse. But I could tell you that, you probably -- further increases are probably cushioned.

Okay. And then Byron, for several quarters you've been discussing positioning the portfolio for potential opportunistic times to invest and could you sketch out a little bit, a scenario that sort of have in mind? Is it something where mortgage spreads widened dramatically relative to treasuries? Just sketch out what you have in mind in terms of driving us overall strategy. What's worse scenario are you thinking about?

Sometimes it's funny, people think you're talking about Armageddon into some sort. That's not necessarily what has happened. Let's just focus on the Fed. Let's say, if nothing else happens but the Fed. Now, the one thing that they are very clear about it, they don't want to be the source of unwanted volatility. So they're going to slowly roll that portfolio off. And as it rolls off, the assets, half the price to where private capital will own them. There will be more and more and more assets in the marketplace, both treasuries and mortgage securities. So if it's there -- from what I can take from their public statements, their desire will be, there will be very slow, low volatility transitional period, which is great for us, the Dynex. When you manage a book like this, low volatility is fantastic. So if nothing else, everything else remains globally, totally calm the Federal Reserve continues to reduce their balance sheet. And let's say, the ECB does nothing but just thoughts purchase it, but they don't start to sell theirs and Japanese don't do anything. And the Central Bank of England does something. But the Fed reduces that 2 trillion and a mortgage assets that we see there, slowly the assets will move into a price, what the private capital can own them. Furthermore again, what I love about the position now, if you compare us versus if you go back eight, nine years ago when we were in IOs, we were in single family rentals. We were in non-perform - we were in MPLs, we were in BBB, CMBS. We were a single A rated CMBS. For us to get to where we want to go do that trade, to move down to that sector again, we'll have to see those prices adjust. We could make an argument that you get into a little more, that's a different type of transitional periods in it. The Fed is just simply, slowly allowing assets to run off. Smriti you want to add something to this?

I do. I mean one thing that is important to emphasize is that opportunistic doesn't always mean that you have to buy one spreads or wider. One of the things, one of the scenarios we do think about Chris is that, may be they don't like. Maybe there is, right now we actually have a view that they will. But there is a scenario that they don't, and then the opportunistic purchases that you go ahead and take the, redeploy your assets or take that incremental leverage to capture the fact that there's a low vol environment instead of a high vol environment. So we see that as both of those situations as opportunities. Our current assessment knowing and living in these markets for more than 20 years is that when you see this much net supply that's going to come your way, we have not yet seen the impact of that on spreads. And to the extent that we're constantly thinking about the demand for these assets and where that demand's going to come from, MBS have to compete now with much more attractive treasuries. Corporates have widened. So those pressures are sort of in the market. And our view is that, yes, there's going to be some widening, but we're constantly looking out for the fact that, you know, perhaps the opportunity really is that, they don't move much and then it is appropriate to take the leverage up at that point. I hope that helped?

That’s helpful. Very well, thank you for taking my questions.

Hey Chris, one other point I want to make to you on one of your earlier questions. You asked about the cost of funds. We did at the end of last year, put on some euro/dollar futures, there’s a series of contracts for the -- well, they started at the end of last year and they were for the March, June and September contract for 650 million in notional. Those are economically equivalent to hedges of funding costs because of the nature of those contracts, we can't include them in core. So for this quarter we -- the March contracts expired for a plus $900,000 that's not in core, that really covers the funding costs from March 15 to June 15, if you will, because it's the three month LIBOR contract. So there will be similar explorations in June and September as well. So I just wanted to highlight that. You're not going to see that in reducing our cost of funds, but economically it's essentially the same. It isn't our comprehensive income from a GAAP point of view, but not in core.

Okay. Thanks for the clarification. Steve.

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

Good morning. I just - a kind of a generic question, I'm just given everything that you've talked about globally, can you talk about REPO availability? And I guess the competition that you're seeing them on REPO providers?

Hi, Dave. Yes. I think that's an appropriate question. We have seen a lot of strength in the availability of financing and the competition to offer us financing. The number of counterparties proliferating with respect to agency collateral in particular. If you guys recall, three, four years ago people thought no one would finance the agency mortgages and now people are crawling out of the woodwork trying to offer us lines. So the competition is - we've seen new businesses startup. We've seen, existing folks that didn't want agencies, suddenly want agencies. We have new liquidity in some of them more esoteric sectors, particularly in the agency CMBS IO market. So it is a better environment, I would say in terms of both availability and quite frankly, that's affecting price. So we are starting to see REPO margins come down relative to where the GCF markets have been pricing that spread. So it is actually another positive factor I would say in terms of being a levered investor in here.

Okay. Thank you.

Thanks Dave.

Your next question comes from Eric Hagan from KBW. Your line is open.

Thanks. Just to follow up on the spread conversation. Can you just remind us how you guys determine relative value with regard to spreads? Are we talking more of an OAS factor? Are we really kind of talking about nominal spreads over benchmark interest rates?

So I always have a saying, which is, you can't eat OAS. You can kind of -- OAS gives you the directionality of where things are and incorporates a bunch of different things. But the way we really think about returns over the long term is, we look at hedged returns. So you haven't -- the yield on an asset, you have to understand the prepayment profile of that asset and then your hedge that you're going to use for that time horizon. And, we really track that hedge return overtime. It's, harder to do. It's harder to incorporate vol and other things like that. But at the end of the day, we're in business to generate a cash dividend that requires net interest margin. That's how we produced net interest margin. And obviously leveraging is a part of that. But Eric, OAS gives us the directionality. We really look at things on a nominal spread over swaps and adjusting obviously for dollar price and so on when we make that. And I'm talking in third MBS. All of our assets, actually we evaluate in the same way on a hedged ROE basis.

Yes. That makes sense. Thanks for the follow up.

[Operator Instructions] There are no further questions at this time, I turn the call back over to the presenters.

Just one more, on the funding side I did forget to mention, there's just a lot more discussion about peer to peer financing and direct financing. These are things that, years ago when -- again, we think about the long term implications of the business. We had seen regulations come into play and the regulations were creating a bottleneck. And the markets have really found a way to get around -- not to get around to circumvent the regulation, but more a way to get buyers and sellers together in - even in that sector and that direct financing or peer to peer type of financing is another sort of development I would say just in the last 12 months. That's really coming to ahead on the financing side.

Yeah, I think Smriti we'll end on that comment. That is a very interesting comment because we didn't include that when talk about are tailwinds. There's clearly been a new -- there's a new regulatory environment in Washington, D.C. and I can say that in general, the regulatory changes that are there are more favorable to our business model than what was there in the prior administration. And that includes along the funding perspective. So with that, we're going to finish our call. We really appreciate you guys, -- everyone participating on the call and look forward to more – reporting our second quarter results sometime in July. Thank you.

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