Dynex Capital, Inc. (DX) Q1 2022 Earnings Report, Transcript and Summary

Thank you for standing by. My name is Cheryl, and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital First Quarter Earnings Conference Call. [Operator Instructions]. Thank you. Alison Griffin, you may begin your conference.

Thank you, operator. Good morning, and thank you all for joining us today for the Dynex Capital First Quarter 2022 Earnings Conference Call. The press release associated with today's call was issued and filed with the SEC this morning, April 27, 2022. 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, assume, anticipate, estimate, project, plan, continue, will and similar expressions identify forward-looking statements. These forward-looking statements reflect our current beliefs, assumptions and expectations based on information currently available to us and are applicable only as of the date of this presentation. These forward-looking statements 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 are 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 our disclosures filed with the SEC, which may be found on the Dynex website under Investors Center as well as on the SEC's website. This conference 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 Investors Center page. Joining me on the call is Byron Boston, Chief Executive Officer and Co-Chief Investment Officer; Smriti Popenoe, President and Co-Chief Investment Officer; and Steve Benedetti, Executive Vice President, Chief Financial Officer and Chief Operating Officer. And with that, it is my pleasure to now turn the call over to Byron Boston.

Thank you, Alison, and thank you, everyone, for joining our first quarter earnings call. I am incredibly proud of the Dynex team and the first quarter results we achieved as we skillfully navigated a historically volatile macro environment in which all major bond indices produced negative returns, as you can see on Slide 5. This is the second such rapid market disruption in the fixed income market that we have seen in the last 2 years, during which we generated double-digit returns. In the first quarter, we generated a total economic return of 3.5%. And our total economic return for our common shareholders since January 1, 2020, has been 21.3%, all while maintaining an average book value around $18 per share during this period, as you can see on Slide 6. There's a reason for these exceptional results. It's because of the skills of our experienced team, our risk management, our flexible mindset, our disciplined and patient approach to investing and our differentiated top-down macro approach to capital management. As I said many times, we invest your capital with a long-term view. Our team has navigated many complex and volatile market environment, including the 1987 stock market crash, the 1998 long-term capital crisis, the 2008 great financial crisis, the 2013 taper tantrum and, most recently, the pandemic turmoil of 2020 and now the first quarter of 2022. All of the lessons learned from these historic events help us maintain perspective when navigating today's complex and volatile market environment. Our focus on our global top-down macro approach is fundamental to our strategy and our success. We have been consistent and transparent in sharing our macro views with the market and how these views have translated into our disciplined investment process. We have been positioned with increased liquidity and flexibility for some time. We continue to expect turbulence and uncertainty in global markets. The Russian invasion of Ukraine has intensified the unpredictability of geopolitical risk, and we expect this conflict to have both short- and long-term market consequences. There also continues to be uncertainty around federal reserve actions to combat inflation and the corresponding impact that has on interest rates, credit spreads and the U.S. economy. But with volatility and uncertainty also comes opportunity, and we are beginning to see opportunities to generate attractive long-term returns through increased leverage. We remain very well positioned to take advantage of market opportunities which we believe will persist for an extended period of time. We're being measured with our approach, while our balance sheet and our mindset remain flexible. We have adjusted our portfolio and we expect to navigate this environment with patience and discipline as market conditions evolve, looking for opportunities to generate accretive returns. I want all of you, our shareholders, to have confidence, confidence in our team and in our unique and disciplined approach. What makes us unique are our unwavering commitment to ethical principles, our philosophy that starts with risk management and ends with disciplined capital allocation, our sound investment strategies that are based on top-down macroeconomic analysis and, most importantly, our skilled and experienced people who work day in and day out to protect capital and generate attractive risk-adjusted returns to you, our shareholders. And with that, I will turn the call over to Steve Benedetti to give you more specifics regarding our first quarter performance.

Thank you, Byron, and good morning all. For the quarter, the company reported a total economic return of $0.64 per common share and comprehensive income of $0.65. The total economic return of $0.64 includes a dividend of $0.39 and an increase in book value per common share of $0.25. Comprehensive income of $0.65 consists of $0.44 in earnings available for distribution and $0.21 in positive fair value adjustments on our investment portfolio position net of hedges for the quarter. Earnings available for distribution per common share, a non-GAAP measure, was $0.44 this quarter versus $0.45 last. Average interest-earning assets and leverage were largely unchanged, while adjusted net interest spread increased 5 basis points during the quarter. Agency RMBS yields increased 11 basis points, while TBA drop income yields improved by 21 basis points. Agency RMBS yields benefited from slower overall prepayment speeds during the quarter, which were 9 CPR versus 11 CPR last quarter. The increase in yields on TBAs was primarily due to the reallocation into higher coupons during the quarter. Offsetting these items was an increase in repo financing rates of 5 basis points. As a reminder, the company predominantly uses treasury futures and swaps to hedge its exposure to interest rate risk. Unlike interest rate swaps, these instruments do not have a calculable periodic cost that can be allocated to current period hedge expense and therefore are not included in earnings available for distribution. Rather, the benefit or cost of these instruments is included in changes in fair value, total economic return, comprehensive income and book value per share. As it relates to book value, the driver of the $0.25 per common share increase resulted primarily from the company maintaining its hedge position throughout the quarter which mitigated declines in the fair value of the investment portfolio as interest rates increase and as RMBS spreads widened. The company's book value also benefited from its lower coupon Agency RMBS allocation which experienced less spread widening relative to higher coupon assets. It's important to note that our on-balance sheet asset prices and our book value as of March 31 and reflects rate and spread volatility that occurred during the quarter. It also reflects the substantial repricing of mortgages and, as such, reflects market yields for our investments based on spot and forward rates on that date. All else equal, assuming projected prepayment speeds and forward interest rate curves are realized as they existed on March 31, the yield on our Agency RMBS assets from a GAAP fair value basis is approximately 3% which drives forward total economic return and is substantially higher than the 182 basis points effective yield for the first quarter based on an amortized cost basis. From a portfolio perspective, investments inclusive of TBA securities increased on a quarter-over-quarter basis by $235 million, mainly due to TBA investments and our $4.9 billion as of the end of the quarter with 91% invested in Agency RMBS and 9% invested in CMBS and CMBS IO. From a hedging perspective, we maintained our notional coverage of approximately $4.4 billion throughout the quarter, principally in U.S. Treasury short positions. That concludes my prepared remarks, and I will turn the call over to Smriti for her comments on the quarter.

Thank you, Steve, and good morning, everyone. Let me start by saying we have witnessed historic moves in the first quarter, the fastest drive in yields and the largest percentage change in yields in 42 years. The trend continues into the second quarter, with yields up an additional 30 to 40 basis points across a steeper curve. We also saw the fastest increase in mortgage rates since 1985 to over 5%, levels not seen in 12 years. These moves were accompanied by a rapid widening of nominal and option-adjusted Agency RMBS spreads that have repriced in a sustained manner to levels that we haven't seen since the last quantitative tightening cycle in 2018. We believe we're on the brink of a historic opportunity to invest in Agency RMBS, which I will discuss in more detail in my remarks. We've maintained a book value in this environment, ending at $18.24 on March 31 and holding between $17.50 and $18.10 thus far in April. We entered the first quarter with our portfolio focused in 2 coupons: 30-year UMBS 2s and 2.5s . We felt these were the right place to be in a rapidly rising interest rate environment. As spreads in higher coupons have widened, we've responded by moving our entire TBA position from lower coupons into UMBS 3s and 3.5s. This adjustment substantially mitigated the adverse impact of spread widening that we've seen this quarter across all coupons, but particularly in lower coupons. Now turning to our macroeconomic outlook. The consistent overall theme remains, which is that government policy will be the main driver of returns. We believe that the global economy is in transition from the emergency phase, when aggressive government policies were used to buffer the direct impacts of the pandemic, to the post-pandemic phase, where we face the consequence of massive liquidity infusions and fiscal stimulus. The Dynex team has been prepared for elevated volatility, also the increased probability of surprise factors and a bumpy ride in the markets. We continue to be alert for changes in the economic weather, focusing on future inflation; labor market dynamics; global and domestic growth; the psychology, messaging and actions of central banks; war- and pandemic-related disruptions; as well as domestic and global geopolitics. We are maintaining an up in credit, up in liquidity position, holding significant amounts of dry powder for investment during bouts of volatility and, most importantly, a flexible portfolio and mindset to respond to evolving conditions. I want to take a few minutes to talk about our approach to managing this environment. I use terms like prepared, ready and respond to highlight our approach. Rather than trying to predict the future, we focus on scenario planning, which allows us to respond rather than react to market events. This is an important distinction and one of the keys to Dynex's success in navigating volatile market environment. We continuously evaluate our decisions for accuracy rather than whether we were right or wrong. This allows our team to have a performance improvement mindset, with clear thinking that reduces the emotional component of decision-making. How do we put this into practice? During transitional environment such as the one we're in, our focus is on capital preservation. We measure ourselves, and we encourage you to measure us, on the total economic return that we generate. We believe our shareholders are best served by the preservation of capital in our business model, which is focused on generating returns over the long term. At Dynex, we aim to generate earnings that meet or exceed the level of the dividend while ending up with the same or higher book value per share at the end of a period. By doing this repeatedly, we work towards a strong capital base that is available to deploy for future investment opportunities. Now it isn't always possible to keep book value intact. And there are situations, like the one we're in, where book value may decline and yet we might still be in a position to make long-term accretive investments for our shareholders as we did in 2020. In this kind of environment, we aim to minimize the damage to book value from controllable losses by focusing on our hedge ratios, positioning across the yield curve and managing our overall leverage to protect capital. By minimizing the downside hits to book value, we reduce the amount of time it takes to recover the capital and earnings. We can then deploy the capital at the right time and position ourselves to benefit from potential spread tightening in the future. These are the foundational elements of our investment strategy for the environment, and it is exactly what we executed in the first quarter. Now let me turn to why we believe this is a historic opportunity. The largest noneconomic buyer, the U.S. Federal Reserve, is stepping back from the MBS market. And unlike the short burst of spread widening that we saw in 2019 and 2020, we believe the conditions are ripe for a sustained investment opportunity. The Fed has also consistently messaged a desire to own fewer MBS on their balance sheet, providing a structural opportunity for private capital to step in. The MBS market has been the leader in pricing the impact of quantitative tightening, returns are higher now than in 2018, with a significant amount of widening already behind us, possibly the majority of it. From this point on, we anticipate going through a cycle of spread. Yes, they're wide mouth. We think they could go wider because the amount and pace of quantitative tightening being contemplated by the Fed is higher than it was in 2018. It's also the first time that we will not have the GSE portfolios in the secondary market. We ultimately expect support at the wider spread levels as agency-guaranteed MBS will be viewed as an attractive cash flow alternative versus risky credit-oriented investments. We see this as a very positive investment environment for Dynex. We've done a good job of preserving our shareholders' capital to date, and it is important to understand that at current levels of returns, we believe we can quickly earn back any incremental book value declines. This is supported by the significant dry powder that we have to invest. We are positioned with over $500 million in available liquidity. Our decision to deploy capital will be driven by 2 factors. First, our view of the overall macroeconomic environment, which we still believe to be vulnerable to unexpected shocks. This necessitates prudent decisions on leverage. And second, the overall level of mortgage spreads which, while already attractive today, may provide better opportunities at the wider spread levels that we expect. Let me add that at today's level of the balance sheet, we are in position to earn or exceed the level of the dividend in earnings available for distribution for the second quarter. And we expect to be able to maintain that with an additional 2 to 3 turns of leverage even as financing costs rise to the 3.5% implied by the forward curve in 2023. From a hedge ratio standpoint, given the complexity of the global environment and the rapid move higher on interest rates that we've already experienced, we see the chance for rates to go either higher or lower from here, and that calls for a different portfolio strategy. We therefore diversified our coupon holdings to be more balanced with about 40% of the Agency RMBS portfolio now in 3 and 3.5. While our hedges remain in the 10-year part of the curve, we expect to be more active in managing our hedge ratio in the coming quarters. We've successfully managed through the significant widening in spreads and a historic rise in rates. We're experienced at this and believe we've positioned the book to be cushioned against the worst of the widening. We stand ready to deploy capital as we move into this more favorable return environment, and we're looking forward to building a very solid stream of cash flow that will position us to deliver strong performance in the long term. I'll now turn it over to Byron.

Thank you, Smriti. I've also said on these calls that when choosing how to invest your money or assess relative performance in our sector, the key factors for consideration should be management team quality and total economic return performance. I believe the best thing we have done for shareholders over the past 2 years is the preservation of our capital. Because of our focus on preserving capital, Dynex is now extremely well positioned to capitalize on this big moment in history. We believe Dynex Capital should be in the portfolios of many types of investors. What our performance demonstrates is that we have the ability to hedge our portfolio risk while we generate an above-average cash dividend yield for our investors. If you're running a traditional 60-40 investment portfolio strategy and consider diversifying your fixed income portfolio with either Dynex common or preferred stock, if you're an endowment that leads an annual draw in your portfolio, our above average dividend yield can help meet your needs. If you are in retirement or approaching retirement, you need an asset management team that you can trust over the long term, so you can simply enjoy life. Dynex Capital offers a unique investment opportunity. We are an experienced and ethical management team with strong core values, a long-term mindset, a track record of preserving capital and, very importantly, a game plan for navigating the current unanticipated market environment. To our existing shareholders, I encourage you to stay with us on this journey. And to those who are not yet Dynex shareholders, I invite you to join us. Operator, please open the lines for Q&A.

[Operator Instructions]. The first question is from Doug Harter of Credit Suisse.

First off, congratulations on the good book value performance for the quarter. I guess I just wanted to follow up. If I look at the available returns that you show in your presentation, despite the spread widening you saw, you're kind of only showing a widening 100 basis points of the potential levered return. Can you just talk through kind of sort of comparing that spread widening and why spreads only -- returns only increased 100 bps?

Sure. So I think it depends on the coupon that you pick to identify what the returns are, right? One of the most interesting things that's happened over the quarter is the change in the coupon distribution with respect to what is the current coupon. And as the current coupon has migrated higher and higher. So right now, if you think about it, the current coupon is actually 4.5%. That is a big driver in terms of what that marginal return looks like. So from our perspective, I wouldn't take that as a only 100 basis point change in the overall return. It's simply a function of what is the $102 price coupon and how has that changed over the last quarter. If you really look at the coupon distribution in total, you'll actually see that the returns are higher by the appropriate amount. So probably close to 2% -- 2%, 2.5% quarter-over-quarter.

Got it. Okay. That is helpful. And I know you talked a little bit, it was somewhat coupon distribution, but I guess any more color that you can give us kind of how you kind of navigated the widening of kind of all spreads and still kind of produced a positive book value return in the quarter.

Doug, I'm going to start and I'm going to let Smriti follow up with any micro details. So we are very disciplined about our top-down approach. And I think you could probably go back to [indiscernible] about 65 to 70 basis points. We gave you a view of thought process about the yield curve, about anticipated spreads, and we started to position the portfolio at that time. And we literally -- the best thing that we've done for shareholders is remaining calm, patient and disciplined because it's been a gyrating ride from 65 basis points all the way up here to 200 and -- I mean 280, 290 on the 10-year. But we literally sat still with our opinion about the yield curve, about rates, about spreads. You'll recall also back, I don't know, a year or so, we did a couple of capital raises. We were very open. We said we're not deploying all of this capital because we don't believe that this is the perfect time to do so. We believe there's going to be a better opportunity. We're anticipating steeper curve, higher yields, wider spreads. We've been on this. We've been very disciplined. And the best thing I can tell you that we delivered for shareholders is being calm, patient, disciplined and having a short leading the long-term deal. And as literally, if you go back and listen to all those calls, you're going to hear us talk one of my goals is to make our management of this portfolio look to you and other shareholders like a symphony, move from one movement to the next where you enjoy the music the entire time. Smriti, if you want to add some more specific details. But literally, we've been very disciplined, very patient, very calm with the same overall theme.

I would say just on a more detailed perspective, Doug, it's really 3 things. When we talk about hedge ratios, it's really making sure that you understand what the duration of our mortgage security is. It's very hard to predict what the duration of our mortgage security is. So one of the things that we do is we -- I think Wayne Gretzky said, you don't skate to where the puck is, but you skate to where the puck is going to be. And we think about duration in those terms. And it takes some amount of scale and some amount of art and understanding how mortgages work. So part of it is hedged ratios. How do you hedge and what do you use to hedge. So that's positioning across the yield curve. I think it's all of the above with respect to saying our asset allocation, it was in lower coupons, lower coupons did great. Our hedge selection was in the 10-year part of the curve, that part has really sold off in line with the assets. And then look, we've been talking about low leverage all along through this period. It's not a popular thing when there's so much carry to be had in the yield curve, but I think it's served us really well. And obviously, as Byron mentioned, this is all driven by a macro view. So those 4 things together kind of get us here.

Your next question is from Trevor Cranston of JMP Securities.

You guys talked some about the movement up in coupon during the quarter. I was curious if you could maybe talk some more about how you're thinking about positioning within the coupon stack as rates have continued to move higher in the second quarter. It looks like most of the portfolio is probably discount bonds now. I guess I was particularly curious in the context of when you look at the effective book yield on your assets, it's substantially below market rates and it seems like there'd be a large amount of yield you could pick up by continuing to move the portfolio up in coupon. So just curious how you guys are thinking about that.

Sure. Yes, one of the most interesting things that's happened is almost the entire coupon stack is at par or below par, right? So when you're moving up in coupon, typically, you think about I'm going from a discount to a premium, but really you're not. So let me take this a couple of different ways. One is we've shifted our entire TBA position last quarter up in coupon as spreads widened in the higher coupons. I think we are respecting just the idea from here on that there's a more balanced view of how rates could go from here, and that's what leads us to have a more diversified coupon distribution, okay? The second thing I would say is that you don't want to think about the book yields per se. Every quarter, we're really marking our balance sheet to market. Those bonds that now sit at $88, $89 price discount, they're a 3-ish percent market yield. And because we preserve book value, we've really essentially preserved the forward NIM on those assets. So a movement out of those assets at this point is really going to depend on 2 things. One is, what are the prepayment speeds in these lower coupons going to be, okay? That's driven by cash out refinancing and turnover. So we're watching those to say, is this something -- these are the gauges that we feel like we need to watch to get out of those positions relative to the higher coupons. And right now, just so you guys know, our portfolio of 2 and 2.5, the pools that we own, paid about 8 to 9 CPR last month and that's worth a lot when dollar prices are 11 points below par. So we're watching that. And by no means do we feel married to those positions. And I think there will be an opportunity for us to go up in coupon as the Fed starts to step away from the higher coupons. But that's something that we're watching. The other way to think about the low coupons is we think about them as like an on-balance sheet call option. Swaption ball and option ball is really elevated on both the call side and the put side. So these are -- right now, there are positive carry call option that we have on the portfolio. And so at this point, I would say all these positions are temporary. We're obviously watching every single day in terms of when it's appropriate to get out of them. But we feel very comfortable at the prices where things are. We've had these hedged. The forward NIM looks good. So really now at this point it's going to be about the relative value going forward.

Got it. Okay. That makes sense. And in terms of as you guys are looking to invest paydowns or potentially increase leverage, can you talk about how you're thinking about spec pools given how much pay-ups have come down versus TBAs at this point?

Yes. So the interesting thing about specified pools, I'll just give you some color on -- it's kind of bifurcated between the lower coupons versus the higher coupons. So 2s to through 3s, you've seen just massive reduction in the pay-ups versus TBAs for those coupons, and that's appropriate because the dollar prices on those coupons are so much lower. 3.5s and above, the pay-ups have come down, and they've come down as dollar prices have come down. But in that instance, on the premium side, I say premium, but the higher coupon side, the percentage of theoretical that you're getting is still actually about the same. So those look a little expensive relative to TBA. So in the higher coupons, I think the TBAs are still going to be where we go. The low coupons, they've gotten really beat up. And you guys know this already, we kind of stayed in the low pay-up world for that reason. Those might start to look a little bit more attractive. The other thing that's happening in the lower coupons is that because you have bonds that are $88, $89 price now, the seasoning starts to matter. And so you have a really nice buffer to pay-ups because the seasoning will start to count. So at this point, I would say 3.5s and above, TBA still look better, cheaper versus specs. 3s and below, we're a little bit indifferent and we'll look to pick up call protection if we think it's really cheap. But we're happy with the spec pool positions we have in the lower coupons right now.

Got it. Okay. Last thing. Do you guys have an estimate as to how book value has moved since the end of the quarter?

Yes. I mentioned on -- in my comments that we've been sort of sitting between $17.50 and $18.10 thus far in April.

Your next question is from Eric Hagen of BTIG.

Congrats on a great quarter. Just a follow-up on the TBA. Just a follow-up on the TBA. Just want to get your perspective on the dollar roll and how that responds in the 3 and the 3.5 as the Fed starts to draw down the portfolio.

Eric, thank you for that question. So I would say it's less a function of the Fed's drawdown. Well, it's partially related. So as the Fed stops buying those coupons, you would expect to see the rolls in those coupons start to come off, all right? That's definitely the case. The bigger driver is going to be the level of rates. So you can actually see just in the last week or so, the rolls in Fannie 4s has come down 4 ticks. It's really directional. So it's -- and it's a very difficult thing to sort of lock in and play that game. So it's less sustainable, I would say, than it was when the Fed was buying. So the volatility in those rolls is going to increase. The carry is there, if you can hit the right level on these dollar rolls. But at this point, I would say it's less sustainable, okay? So as the Fed steps away, you have more production. Without a bid for that production, the specialness in these rules is not going to be sustainable without a very deep bid from a going away buyer. And so it's just less sustainable at this point.

Right. That's helpful color. And then on the hedging side, I just want to get your sense for what kind of market conditions I suppose would -- what would they need to look like in order to change the approach to hedging instead of with the futures, but across the curve? And how you also think about maybe replacing the swaptions with volatility potentially staying relatively high.

Yes. I think the way to think about the hedges at this point, because we have a pretty flat yield curve, that's a factor. The second factor is just the overall direction of rates, right? So at this point, I think our inclination would be -- to be, I would say, more neutral relative to the level of rates. We've said in the comments that we think that we need to have a more balanced approach and we'll be more thoughtful about where on the individual points on the curve. With respect to the swaptions, it's really tough here when you think about the level of ball. So with everything at a discount at this point, there's less of a need to use swaptions. So we're not as married to kind of continuing to have swaptions at the moment. And we do think about other ways to buy ball, right, like in spec pools or something else. So that's another piece of how we're thinking about it. From here, like we are going to be much more active in managing the hedge piece. I think we noted that in my comments. So you're right in terms of taking that up. For me to tell you it's going to be in the 2-, 3-, 5-year part of the curve at this point, don't yet have the level of certainty to say how it's going to be. I do know that we're going to be positioning our book and have positioned our book to have a more balanced view of rates from here on out.

Your next question is from Bose George of KBW.

I just wanted to go back to the discussion on sort of incremental returns. And I think, Smriti, you suggested that ROEs are up 2%, 2.5%. So just can you just talk about where levered ROEs are just given your current leverage?

Yes. So I'm not going to tie it necessarily to our current leverage. I will say that on the margin, we're seeing return somewhere between 12% and 14%, depending on the coupon, depending on the day, depending on the hedges that you pick, all right? So -- and the interesting thing about that is that the hedged returns already include, they already include the financing costs going up to 3.5% as implied by the forward curve. So that's why we say this is historic. And the other reason, 12% to 15% might not sound like great shakes here, but the reason it is historic is the sustainability, right? The largest noneconomic buyer has stepped away and it's telling you that they're stepping away, they don't want to own more of these. So the ability for these returns to be there for some time is really the other piece that you want to be thinking about. So these levels of mortgage spreads we have not seen since 2018, 2019. And that's the other piece here. I think that's important to understand. So I would say to you that the current returns in the 12% to 14%, I mean, we see mid-teens definitely possible within about of volatility.

And when we create -- when these returns are calculated at Dynex, it's a true risk-adjusted return. Like we -- as Smriti said, it's got built in there, a solid rise in rates and financing costs. And I think that's very important because when you ask different companies about their returns, one of the challenges you have is, well, what are they assuming in their calculations. And we're not very liberal when we are making these calculations. If anything, we're going to be on very disciplined and very conservative in the process. And what's exciting about that is if, in fact, you add assets at these wide levels, I mean you're looking to hold them all over the long term. And then, in fact, some of those risk factors turn out to be better than anticipated, that actually gives you the opportunity to make higher returns. So I just want you to understand the philosophy behind the return numbers.

Okay. Great. That's helpful. And then just actually back to the book value discussion. And again, I see great job with that this quarter. What was the duration gap going into the quarter?

Yes. We don't look -- we don't disclose that both. And I think the way to really think about it is what assets did we own relative to the hedges that we had on. And the way I would say that we were positioned was we were hedging for the extension risk that we thought was present in the 2s and 2.5s. We were hedging for the extension risk. And so I do want to make this point. This is really important because we talk about controllable risks like and say hedge ratio durations, et cetera. One of the most interesting things about being an MBS portfolio manager is really dissecting how much of your return came from duration drift versus what I call true spread widening. And spread widening actually happens when -- on days where treasuries or your hedge goes up in price and value of your asset goes down, right? That's a difficult thing to hedge. But when treasuries -- when your hedge and your assets are going in the same direction, you want to be as accurate as possible when those things are moving together. So our assessment on the 2s and 2.5s for extension risk or the way the duration was going to move was we felt like they were going to move actually quite correlated with Treasury. So our hedge ratio was appropriately adjusted for that. So that's how I would think about it. We don't really think about duration gap because it's a real -- it's a spot metric, it tells you what your duration is today, it doesn't tell you how your duration is going to move 25 or 50 basis points from now. And so it might give you a false sense of security in that sense.

And then, Smriti, tied back to your comment earlier, with [indiscernible] Gretzky's comment about skating where the puck will be, that's very important in managing a mortgage-backed securities portfolio. If you are a 65 basis points on the [indiscernible] which is where we are, we believe that all probability, the [indiscernible] is going to be closer to 2%. You need to think about your mortgage-backed securities duration as to where they would be if the 10-year is actually up another 100 basis points.

Your next question is from Christopher Nolan of Ladenburg Thalmann.

Back to the ROE question. Given that you're covering the dividend and you're seeing book value appreciation and your levered ROEs are in your target, what motivation could you have to increase your leverage? It seems like you're hitting on your targets without much leverage.

I think it would be the opportunity to put assets on -- at an accretive level, Chris, relative to the cost of capital. When we think about the risk-adjusted returns, given the macro environment, if we have that opportunity, you would step into that. And I think this is that kind of environment.

So you can see increasing your leverage some time, assuming the volatility in the market remains some time in 2022?

Yes. I think I would think about it as the next few quarters are going to be really important with respect to how risk assets reprice. And you've heard us say probably in June or March of last year, as quantitative tightening comes in, risky assets are going to adjust like the price of crypto, equities, Bitcoin, credit, everything, right, is going to adjust to the liquidity drain that's coming. And mortgages have led the way. So -- and we expect this bumpy ride. In that bumpy right, could there be and will there be some chances to put some capital to work at really good levels? Yes, that has to be done in the context of this global macro environment that deserves a lot of respect, quite frankly. So will we take leverage up? Opportunistically, yes. Do we think the next 2 to 3 quarters is critically important with respect to how these prices evolve? Yes. And I think what people can expect us to do is do what we've always done. We're doing it thoughtfully, we're not rushing in. These returns are good returns relative to the cost of our capital. And we're being judicious about when we put the money in.

And assuming the returns do go up, what's the thoughts on the dividend? Would it be an increase in the base dividend or dividend supplement? Any thoughts on that?

The one thing that I'll say, Chris, and I've said it many times before, we start with our macroeconomic view. And we have a very strong view of our global risk. Dividend levels at this point is a matter of risk management. We need to be very cautious about moving the dividend in any direction. And so we think of the long term, we think of a total return experience for our shareholders. We think first book value preservation. And one thing I will say is that we're not your stock where if you're looking for someone to give you 15%, 16% dividend yield, we're not that person. We're offering a different product here at Dynex Capital. We're trying to give you a good long-term total return experience. And the dividend is just one input into that process. And I really want to emphasize this [indiscernible] view because this is an unbelievable moment in history. It is really -- there's just -- there's risk, we're prepared for it. We started preparing for it years ago when we first started talking about complex about 6 or 8 years ago, we've leaned into it more and more and the dividend is just one input. But I will tell you, [indiscernible] the product manager now. We're not -- if you're -- we're looking to generate cash income from our shareholders, and then we're looking to protect the value of our balance sheet while we're generating that cash income. But we are not the product where we're looking to just say, let me just lay out 15%, 16%, 17% dividend yield and then give you a bad total return experience. We're offering a different product. I hope that gives you some very good color on it.

Your next question is from Jason Stewart of Jones Trading.

Congratulations on navigating a really difficult environment. Just following up on the dividend question. Steve, is there any REIT requirement? I get that we're still very early in the year. Or any limitation as we think about REIT income and the payout?

Jason, at this point, we feel like at the current dividend level, we're okay to navigate any of the REIT requirements. But as you point out, pretty early in the year still. But as we see it right now, we should be okay there.

Okay. And then pulling way up, what gets -- Byron, Smriti, I guess you guys are constructive on the credit side of the story. Is it more about spread level? Or is it more about your thought on perhaps positioning for a recession? I mean just what do those 2 toggle in your minds?

Again, Jason, I'm going to start like a disciplined man, I'm going to start at the top, global macro view. I call them fat tail environment for those [indiscernible] normal distribution. There are an enormous amount of factors in the tails. And the expected outcomes do not have as high a point, the expected probability attached to them that you would normally think. With that type of backdrop, when you think about credit and credit assets and you look at the sheet we have in our presentation, you'll realize that you're taking on more and more illiquidity risk when you are playing most credit assets. We're emphasizing liquidity and we have been for multiple years now. We've been up in credit and up in liquidity. And we've been in that position because of our macroeconomic view. There's nothing there on the landscape that's changing our view at this point of time. I always like to use the word this is a fat-tailed environment, and we try to say that to my team is to remind them how many factors are in the channel that could surprise us. And so far, this decade, get one surprise after another surprise after another surprise. And we're prepared for it. We feel very strong about our liquidity position. So when we talk about credit, you're starting to talk about taking more illiquidity risk as you move down in credit. We're not ready to do that at this point.

And what I would say also, Jason, there is we don't think it's a good risk reward as before QT has begun. So I would want to see the price of risk assets adjust to a level of liquidity where the Fed isn't supporting large parts of the market, as I've mentioned, all the way from cryptocurrency down to like high-yield credit and so on. So I think there's a price element to that and there's also a fundamental, okay? We're coming out of a pandemic. We've got inflation. There's an increase in general levels of borrowings. We don't know how the fundamentals are going to play out here. So I think that's -- a wait-and-see approach is correct. I would take you back to 2007. In 2007, as spreads widened going into the financial crisis, things looked really attractive from a historical perspective. And if you had stepped into credit at that time, you would have made a colossal mistake. So we are very, very cognizant of that type of situation here as the Fed is starting to step away. And not that we're saying that's going to be repeated, but there's a lesson to be learned when there's artificial levels of liquidity and cash propping up these assets to wait for a bit before you can really see the true colors, the fundamentals that underlie some of the instruments that are out there.

Okay. That's very helpful color. Last question for me. When we think about share repurchases, can you just remind me, I know the stock looks like today is probably getting close to book, which is, I think, a reflective of a great quarter. But as it trades down to 85% to 90% of book, is that something that you would still entertain?

I think the way to think about it, Jason, is we're telling you and the market that we believe we're on the brink of a historic investment opportunity. And in that environment, cutting the dividend or buying back shares isn't sort of the #1 thing on our list. We want the capital. We preserve the capital. We think the capital can be deployed. We think we can make good money, much higher than the level of our cost of capital. And so that capital needs to be here for us to be able to invest in. So I would very strongly say that, that's our mindset here. And I don't know, Byron, if you wanted to add anything with regards to the strategy or anything else.

No. That is a great job. I don't have anything to it. I'll just say wider spreads. We want more capital to be able to deploy it, simple.

We completed the allotted time for questions. I will now turn the call over to the presenters for closing remarks.

To our shareholders, thank you very, very much for giving us the opportunity to manage your money. We appreciate you being here today and for those who are not here who will listen to this call at some other point. And that concludes our call, and we look forward to speaking with you again next quarter. Thank you again.

This concludes today's conference call. Thank you for your participation. You may now disconnect.