Dynex Capital, Inc. (DX) Q4 2018 Earnings Report, Transcript and Summary

Good morning. My name is Jacqueline, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital, Inc., Fourth Quarter 2018 Earnings Results and Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Alison Griffin, Vice President of Investor Relations, you may begin your conference.

Thank you, Jacqueline. Good morning, everyone, and thank you for joining us today. With me on the call, I have Byron Boston, President and Chief Executive Officer; Smriti Popenoe, Chief Investment Officer; and Steve Benedetti, Chief Financial Officer and Chief Operating Officer. The press release associated with today’s call was issued and filed with the SEC this morning, February 7, 2019. 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, 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, 2017, as filed with the SEC. The document may be found on the Dynex website under Investor Center as well as on the SEC’s 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. The slide presentation may also be referenced under Quarterly Reports on the Investor Center page. I would now like to turn the call over to our CEO, Byron Boston.

Thank you, Alison. Good morning, and thank you all so much for joining our call. Let me start by saying that, we have made a great effort to expand our presentation to include as much information as possible to help you understand how we are thinking about the global macro environment and our current portfolio construction, our earnings and the risks that we have chosen to take to generate income for our shareholders. Please look closely at the entire deck, including the appendix to gain better insight on our thoughts today. Regarding our current investment thesis, it is important to note that our disciplined thought process remains valuable as it has over the past decade. In today’s presentation, we try to be more specific about certain details to help you better understand. However, don’t misunderstand that we have written – what we have written or what we say. We’re never trying to predict the exact path of future events. What we are trying to do is assess the probability of events and to identify the most dominant factors that may ultimately influence the future path of economic activity, interest rate and global asset price levels. In 2014, we noted that the global markets had become more complex and that surprises were highly probable. Our response to this environment over the past few years has been to go up in credit and to increase our liquidity. We also indicated that we would increase our leverage and we would deploy more capital when the spread environment improved and future potential returns increased. In the fourth quarter of 2018 and on into the first quarter of this year, we have followed through on our strategy, as we have invested more capital and higher returns than we have seen in two to three years. As you can see, we maintained our discipline in deploying capital by waiting until returns improved to grow our balance sheet. Now please turn to Slide 3. We want you to fully understand these key points from today’s presentation. First, we continue to generate solid cash flow in today’s environment in spite of 100 basis point rise in financing costs in 2018. We came into the fourth quarter with a strong liquidity position that allowed us to take advantage of wider spreads. We’re seeing improved economic return opportunities. We raised capital to deploy at these returns and expect these opportunities to develop more frequently. Second, we’re in a low-return environment characterized by interest rates that spend more time in a narrower range than in recent history. This is occurring at a time when global risks are intensifying. For example, in our view, it is probable that increasing global debt, demographic trends, technology advances and human conflict could keep the 10-year treasury below 3.5% and within a range, a broader range of 2% to 4% for a substantial period into the future. Furthermore, there are multiple global factors that could rapidly force interest rates to and below the low-end of this narrower interest rate range. As of today, negative side effects of monetary policy tightening are already developing in the global economy and impacting global capital markets, limiting the most recent rise in interest rates. Furthermore, another factor representative of this low-return environment is the fact that the amount of debt globally trading at negative interest rates is trending higher again. Hence, when we consider this low-return environment, the investment returns that we are currently seeing offer compelling opportunities for our shareholders. Our third takeaway that we want you to remember is something that we have reminded you of for the past few years. There are long-term factors that continue to favor our business model. Now these factors include: first, demographics, which support a growing demand for cash yield as the world’s population ages. This global demand for yield supports the long-term valuation of mortgage REITs. Securitized mortgage assets supported by the U.S. government are among the safest investments that generate yield in a globe burdened with uncertainty. Second, there is a need for private capital in the U.S. housing finance system, as the Federal Reserve Bank attempts to reduce its investments in Agency RMBS and GSEs reform – and GSE reform creates new investment opportunities. Furthermore, demographics also support the need for more housing in the United States. Now I’ll turn to Steve to discuss our fourth quarter results.

Thank you, Byron. For the fourth quarter, we reported a comprehensive loss of $0.52 per common share and a net loss of $1.34 per common share. The comprehensive loss was due to declines in fair value of our hedges in excess of increases in the fair value of our investments. We also reported core net income of $0.18 per common share for the quarter. As you can see from our results, our net interest spread and adjusted net interest spread declined during the quarter, as the Federal Reserve continued to increase rates and we compensated by increasing our portfolio leverage. Book value declined at $6.02 from $6.75 at the end of the third quarter, but the story there is spread widening on assets as markets began to seriously price in a policy mistake. Markets have somewhat recovered and our book value was an estimated $6.20 at January 31, after considering the monthly dividend for January in our recent equity issuance. I’ll turn it back over to Byron.

Thanks, Steve. Now please turn to Slide 5 to look at our key macro themes. A key element of our macro thesis is that the global economy is fragile, because growth has been driven by enormous accumulation of global debt and extraordinary central bank intervention. This is happening at a time when global risks are intensifying. We believe the ability for interest rates to rise rapidly and remain elevated over the long-term is limited. Also, at Dynex, we have always believed the Fed is data-dependent, as they have often historically been. Continued central bank support of economies also supports demand for risk assets. Bouts of volatility must be used to deploy capital when market dislocations create opportunity. And then finally and really very important to understand, unpredictable government policies inject considerable uncertainty and raise the probability of surprise events that impacts – that impact markets. Now on Slide 6. We try to be more specific regarding our thought process on interest rates. Our most important thought process is not that interest rates will rise or fall. More importantly, we believe there are forces that will work to keep rates in a narrower range than has been seen historically since 1980. The amount of global debt acts as a governor of how high interest rates can rise. On the other hand, new supply of debt acts as a governor of how low interest rates can go in the absence of a crisis. Now turn to the next two slides – number – Slide #7 and #8, where we try to show the history of debt and interest rates in both the United States and Japan over long periods of time. There are common themes in both graphs. It is important to note that we’re not predicting that the U.S. will become like Japan. We’re simply showing you some facts regarding the level of debt and the trend in interest rates. Number one, you can see that both countries have had enormous increases in debt over the past 40 years or so. Note the substantial increase in debt after the 2008 crisis. And then number two, you can see that interest rates in both countries have come down materially, as debt has continually risen. It is important to note that there are multiple play – factors at play in each economy. However, the extreme increases in debt will continue to be a major factor in limiting the economic growth. Note that 2% to 4% range identified on the U.S. chart, and note the rate – that rates have remained below 2% in Japan for 20 years or so. Now, let’s look to Slide 9. We are identifying one of the strongest influences on global asset price levels and spreads. That is the size of the global central bank balance sheet. As you can see, these balance sheets were increased by three to four times and are expected to remain at these levels for sometime into the future. This forms the basis of our view that government policy will drive returns. Please turn to Slide 13, and let’s discuss the return environment. Simply put, the return environment improved in the fourth quarter and we took advantage of the opportunity by deploying existing capital and raising new capital, which we also rapidly deployed. The return environment allowed us to execute on our diversified strategy, as we invested in both Agency commercial securities and Agency residential securities. Also noted on Slide 14 is that the structure of available returns across asset classes still favors an up in credit and increased liquidity strategy. We continue to maintain sufficient cash and unencumbered assets to weather surprise volatility. Now finally, please turn to my favorite slide on Page 17. We continue to believe that in this low-return environment that long-term returns over the next five to 10 years will be heavily driven by dividends. We also believe that in up in credit and up in liquidity strategy is extremely important in an environment, where global risks have intensified. In this range-bound low rate environment, our current strategy allows us to generate high-quality cash flow, while giving us the flexibility to respond to a surprise global downturn or event. As we said in our last conference call, we believe we are within striking distance of the Fed [indiscernible] tightening of financial conditions. We’ve responded in a disciplined manner to that view by holding enough capital and liquidity to be able to invest in December and early January. And based on our view, we chose to raise additional capital to take advantage of this opportunity. Over the past year, our book value has been volatile. And if you look at our long-term return charts, there have been other periods when our book value has fall off. Nonetheless, it is important that you remember that above average dividends will help to cushion book value volatility over the long-term. And also note that as we look to the future, we expect to see market opportunities that will allow us to add book value over time. Finally, in 2019, we will celebrate our 31st year as a public company. Our management team brings significant experience and expertise in managing securitized real estate assets through multiple economic cycles. And also the entire senior management team invested alongside of our shareholders in our recent capital raise in January. We continue to believe that alignment between our shareholders and management is critical to our future success. And with that, operator, we – we’re ready to open the lines for questions.

Thank you. [Operator Instructions] Your first question comes from Doug Harter from Credit Suisse. Your line is open.

Thanks. I know, we – when you raised capital, you gave us an update of book value. But can you just talk about, kind of how the markets have performed since that January 25 update? Kind of what types of returns you were able to deploy the capital and kind of how you – how spreads have rebounded so far this quarter?

Yes. Hi, Doug. So through the end of January and into February, we’ve seen some improvement in spreads. So 30 years are tighter versus where they were in December, I would say, they’ve given back about a third to a little over a third of the widening that we experienced in December. So they’re still wider relative to, say, where we were in September, October and November of last year. And they’ve given – they’ve taken back some of that widening about a third, a little over a third. The DUS paper is also wider relative to where we were in the fourth quarter – early fourth quarter. We’ve given back about a third of that widening as well, meaning, that spreads have come back in. As we mentioned in the the return environment slide, the return’s ROEs and I’m talking about our net interest income ROEs here, we’re seeing those in the range of 12% to 15% on the Agency CMBS, probably more towards the lower-end of that range at this point. And then on the 30 years, depending on the coupon, it’s really between 10% and 14% or 15% on that asset class as well. So the thing to remember is that, increased book value means less return on equity on marginal investing. So while it’s nice to have a pop back in book value, I really would like to have – generally wide spreads to put capital. So it’s a bit of a tradeoff.

Understood. Thanks for that color, Smriti.

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

Thanks. Good morning, and congrats on 31 years as a public company. That’s excellent. The pools held on balance sheet, the 30-year fixed, what percentage of those are specified pools…

Those are…

…versus generic pass-throughs? Thanks.

They’re all spec pools, Eric. There are going to be pools that have WACS or low WALA, low WAC plus low WALA low balance. We tend to stay away from a lot of the very, very high pay of pools, so they are spec pools. They have some characteristics that we’ve determined that will help us cushion any type of prepayment risk. But they’re not just generic pools that we’ve just taken delivery of just off the TBA market.

Got it.

[Multiple Speakers] it have some kind of convexity protection.

Got it. Thanks. That’s helpful color. And then on the expense ratios, it’s nice to see that come down a little bit. Just given the capital raise at the end of January, any ability to possibly bring that down even further? I realize that there’s maybe a partial offset with the book value correction, but just some color on the expense ratio going forward would be nice? Thanks.

Yes. Sure, Eric. On the margin, that capital, we’re not going to need to add any G&A expense really on the margin. So by definition, by expanding the capital base, and as you correctly point out, there is some mark-to-market in the capital base. So as the capital base goes down from the mark-to-market, the ratio goes up. But on that, we added that capital. We’ve recovered some of the mark-to-market. So on balance, we – the ratio should go down, and we expect it to go down.

One other point on that, Eric, is that the new capital we deployed very, very quickly, the week of raising. So – and we’ve seen a pretty big recovery post the Fed. So, I think our raise was on Monday. We had most of it deployed within a couple of days. And the Fed came on Wednesday and was very supportive for those spreads thereafter. So that will help as well.

Got it. That’s great. And then on the hedging side, just given the relatively flat yield curve, I mean, where on the curve does it make the most sense to add hedges as existing hedges mature? Thanks.

Yes. I’m so glad you asked that question, because this is a very unique environment, where depending on what you think the duration of an asset is, it really doesn’t matter sort of where you put the hedge on and a lot of our hedges that we put on early in the horizon are now positive carry hedges, because LIBOR has risen well above the pay rate on a lot of those hedges. We are carrying a bigger hedge position. We’re thinking a ton about our curve risk. If you look at our macro view, I mean, our macro view really supports putting longer duration hedges on versus shorter duration hedges. So as we’re looking to add new assets, that’s been our bias. So that’s – but it’s a very good point to make, which is that, at this point, it really isn’t costing us a lot of money to have a hedge on against higher rates.

Great. That’s helpful color, guys. Thank you very much.

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

Good morning, everyone.

Hi, David.

Hi. I just wanted to – the leverage obviously was up this quarter and you described some of that. But should we expect it to remain around these levels, or was some of the increase due to the anticipated capital raise?

Yes. So this is also a great question. Thanks, David. So one thing that we really wanted to focus on, the leverage last quarter went from 6.7 to 8, and that’s driven by two things. One is a real increase in the size of our balance sheet that reflects the investments that we made in the portfolio. And that’s one way you can tell whether a company has adequate liquidity or not to invest in times of distress is if their balance sheet goes up, they put money to work and they have the liquidity and capital to survive any kind of disruption. So we were able to do that in the fourth quarter. So our partial increase in leverage was attributed to the higher size of the balance sheet. The second item, which is more temporary and it fluctuates around a lot is just the level of the book value. So as the book value goes down, you will see the calculated leverage go up and that was the second piece. But really, what we think about in terms of what’s driving longer-term returns for our shareholders is whether or not the balance sheet size grew. So it did grow to 8x to total capital at the end of the year. We think that’s an appropriate level of leverage and possibly could take it higher based on investment opportunity.

Okay. That’s great. Thank you very much.

You’re welcome.

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

Hey, guys.

Hi.

On the incremental capital that you’ve raised, equity capital, assuming that you leverage those current levels. I estimate that spreads – if spreads come in anymore than they already have – investment spreads, I mean, between yield and cost of funds, then you’re not going to be covering the dividend for these incremental shares. Is that a fair way to look at it?

So – hi, Chris, it’s Steve. So you’re saying, what did you – what was your assumption as to what the capital was ultimately yielding, right, on an ROE basis?

Yes. I’m just using 224 basis points investment spread, Steve, and I’m assuming the capital is levered around 6.5 times?

Yes. I think that incremental capital will be at a slight – at a higher leverage than that, because we’re adding – the blended company leverage includes, lower levered things like Agency IO, as an example. So when you’re adding the DUS and the pass-throughs, those generally go on into little higher leverage. So I think, Smriti mentioned and we have in our slides that, based on our current assumptions, we’re adding assets at 12 to 15 ROE and the DUS in 10 to 15 in the Agency pass-throughs.

Yes, and we’ve said in the past that the Agency RMBS, we think about in terms of leverage area about 9 times, and the Agency CMBS is higher somewhere between 10 and 12 times.

Okay. So it’s fair to say that the days of the lowered leverage that you guys had recent quarters is not likely to be revisited in coming quarters? I mean, just…

Yes. I mean, I think, we – there’s actually a slide where we talk about that in the deck. I believe it’s Slide 22, where we talk about the fact that we have a more highly liquid balance sheet. Byron mentioned that that’s one of the key tenets of navigating through this macro environment. And what we’re saying on Slide 22 is that, right now, we have liquid assets. They have a lot of flexibility in our ability to respond to any type of market shock. So that’s one reason we feel the higher leverage is appropriate. The second thing that gives us some confidence here is just the amount of regulatory infrastructure and work that’s been put into place that supports levering highly liquid assets. And when I say that, I really mean highly liquid assets, such as treasuries, agency mortgage-backed securities, whether commercial or residential. I’m not saying that I would recommend us taking up high leverage on illiquid assets or credit assets. So this is really one of the core things that we’re thinking about, as we build the portfolio. At the end of the year, the leverage did go up from 6.7 to 8. It reflected investing in higher ROE, but yes, higher leverage, more liquid assets, and we would expect that to continue.

Okay. And so you guys are sort of betting on that mortgage rates are plateauing? Is that a fair way to look at it?

When you say mortgage rates, do you mean the mortgage rate to the consumer who is actually borrowing money?

Actually, yield being on the bonds?

I’ll tell you what we are saying. We are saying that there are forces and this is really important, that will limit rapid increases in interest rates and there are forces that will work to push into – the lowest level of rate push rates back up unless there’s a crisis. And so that rates are in a much narrower range. If you look historically, when we say 2% to 4%, we really don’t – really believe in 3.5% to 4%. We’re just using that range where we can be identified on the chart. That – that’s a much narrower range when I started trading in 1986, 1987, 1988, 1994, you’re talking, in some years, 300, 400, 500 basis point type moves in interest rates, and then again, when I compare it to Japan. So it’s not so much is calling, where rates will be. We are saying, we’re in a narrow environment and we’re saying that in that type of environment, it favors a strategy such as this. And we do have some negatively convexed assets on the balance sheet. We feel more comfortable with those given that overall macro view.

We’re not really saying that. We think market spreads will continue to tighten or anything from here. We’re prepared for volatility in mortgage rates, that’s what we expect. We expect that mortgage spreads will be volatile. We have a liquids position. We have capital to put to work when the – when mortgage spreads widen. And we think that will persist for sometime, because the Fed is still figuring out what they’re going to do with their balance sheet.

And it’s not only just the Feds, Smriti, it’s also – it’s global central banks. That chart that we’ve got, we show you the size of the global central banks. You must digest the fact those balance sheets increased by taking securities out of the global capital markets. And those balance sheets are still the same size and growing. Now the psychology in the United States has been, "Oh no, the Fed is reducing its balance sheet”. But what we’re showing you here on Slide 9 is that, those large balance sheets really are supportive of the overall spread environments. So that is a core factor. We track that closely to have some – to form our future opinion in terms of spreads. And as I said at the beginning, it’s not about predicting exact interest rates or spreads, it’s about identifying the factors that will have the largest influence on how future pass will evolve in front of us.

And I think we feel like we can construct an accretive investment strategy in the Agency RMBS and Agency CMBS market, that will navigate that environment, right? So one interesting fact on the mortgage market right now is about 50% of the outstanding Fannie universe is currently refinanceable. And if rates go up 25 basis points, mortgage rates, that number goes up to 81%, doesn’t become refinanced.

Not refinanced.

And then that – and then you go up another 25 basis points, 91% becomes unrefinanceable. So there’s just – there’s an interesting dynamic here, I think, in the mortgage market with where we are in rates, what the range of rates can be, what the Fed is doing, that over the long-term is going to create good opportunities for us to make some investments. And that’s really the point.

And with all that to our shareholders, we’re saying, it is still a good time to generate cash flow from these assets. And over the long-term, we believe our shareholders and ourselves that we’re shareholders in our company, will he happy that we continued to generate cash flow in this environment. And yes, you should look to the yield on these assets and you should look to the leverage. There’s not a lot of other funky things you have to do to understand how is Dynex Capital making money today. It’s not that complex. I hope that answers a lot of stuff we’ve thrown at here, Chris, but you just want to understand how we’re seeing.

I appreciate the detail, Byron. Okay. Thanks, guys.

Thanks, Chris.

There are no more questions. I’ll turn the call over to Byron Boston.

I hope you appreciated our call. I hope you appreciated that we are trying to be as open as possible in terms of how we think. We’ve been consistent. We haven’t changed our thought process over the last few years. You can go back and you can listen to our conference calls going back to 2014. And by the way, I did do that. I looked back and looked at my transcripts to ensure that I’m consistent. It’s very important to us that our shareholders understand the risk there we’re taking and why we’re taking that risk. So thank you so much for joining us on this call, and we look forward to speaking with you again on – within three months. Thank you.

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