Dynex Capital Inc Q4 FY2020 Earnings Call

Ladies and gentlemen, thank you for being here and welcome to Dynex Capital, Inc.'s conference call for the Fourth Quarter 2020 Annual Results. At this moment, all participants are in listen-only mode. After the presentation by our speakers, there will be a session for questions and answers. I will now turn the conference over to your speaker today, Ms. Griffin. Thank you, and please proceed.

Good morning. This is Alison Griffin, Vice President, Investor Relations. Thank you for joining us today. With me on the call today, I have Byron Boston, Chief Executive Officer; Smriti Popenoe, President and Chief Investment Officer; and Steve Benedetti, Executive Vice President, 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 4, 2021. 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 our disclosures filed with the SEC, which may be found on the Dynex website under Investor 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 Investor Center page. And with that, I now have the pleasure of turning the call over to our CEO, Byron Boston.

Thank you, Alison. Good morning. As CEO of Dynex, I am very proud to report that in 2020, we delivered a 15.2% total economic return and a 17% total shareholder return. I've been at Dynex for 13 years and no other year has demanded as much active decision-making as 2020. We stuck with our discipline and excelled. We didn't just protect shareholders' money; we made money for our shareholders in 2020. Our book value increased and we delivered a solid dividend. This performance stands in contrast to most of the mortgage REIT and many other investment alternatives for investors seeking income. Now as you can see on Slide 5, Dynex has now delivered industry-leading performance on a one, three, and five-year basis. And when you look at our long-term chart on Page 17, you can see that we have delivered solid returns through multiple market cycles during my tenure at Dynex Capital. This performance reflects my instinct philosophy of how to manage a mortgage REIT for the long term. And that same philosophy is guiding our investment approach today. We believe in risk management first followed by disciplined capital allocation. As experienced and skilled investors, we have been cautious about leveraging lower credit liquid assets since 2016. When spreads are tight, this strategy looks attractive during the short term, but ultimately crumbles when liquidity dissipates in a crisis. This is what happened last year when the prices of the liquid assets dropped dramatically, as COVID-19 intensified and creditors demanded more cash or margin in response. The takeaway here is that it was no surprise that the market reacted the way it did. We witnessed the same reaction in every major crisis in recent memory. The Dynex management team has successfully managed through these intensified risk events throughout our careers and we were prepared. 2020 was a challenging year but in our opinion, not a Black Swan event. As we indicated at the beginning of 2020, we saw the global risk environment intensifying, so we were prepared for increased volatility. While it is impossible to predict the time at a specific event, we foresaw a higher risk profile building and the global financial markets. Our experience and insight gave us the edge to actively manage our portfolio to provide our shareholders strong returns. We managed our book exactly as we told investors we would. For years we have emphasized liquidity and diversity in our portfolio. And this discipline served us well in 2020. Our 2020 performance was not a coincidence or good luck, but rather years of thoughtful planning around our portfolio and a team of talented people ready to actively manage the book of business in volatile times. As a CEO and coach, I could not be prouder. Now, from my human capital perspective, we have a world-class team with unmatched skills and experience, and 2020 was the year when the management team mattered more than anything. Our team has weathered significant crises in the past, from long-term capital management to the Great Recession. And as we've learned again this past year, nothing surpasses experience. We have the institutional knowledge to address many market disruptions and to identify new opportunities that may come along. Our team is diverse, which is critical to our strategy. Risks do not stay within borders and our team's worldwide perspective is invaluable when dealing with a global crisis. Now, COVID-19 disrupted many work environments, but we already had the advantage of enabling our people to work remotely long before it became a necessity, just as risk is borderless, so too was talent. Our employees who were accustomed to working outside the office remained calm and focused during the quarantine, filtered out the noise to actively manage our risk and effectively maintained key relationships and confidence with lenders, regulators, and investors. So over the past 12 months, we have taken a strategic view of both sides of the balance sheet with the goal of being able to grow and scale the company efficiently and in a stakeholder-friendly manner. We made several moves. We retired two of our higher-cost preferred stock issues and replaced them with our new Dynex Capital preferred suite. During the last two weeks, we issued approximately $56 million in common equity in line with our long-term strategy to grow our capital base. It's very important to note that the return environment is conducive for absorbing any costs associated with our capital activities. Our ultimate goal is to increase our stock's liquidity and offer investors the opportunity to invest in Dynex via multiple products, including our fixed dividend C preferred and our higher yielding common stock. We've been in business for 30 years and we're fully committed to delivering solid cash flow and attractive total returns to our shareholders well into the future. Now as a company, our greater purpose is for two of our main stakeholders and constituencies: the individual savers and the communities across America. We're building this company for the long term because we believe in America and our role in helping individual savers achieve a respectable return on their savings from financing real estate assets. The capital that we bring to the table is critical for housing and the real estate community. As long as savers need cash income, and housing and real estate finance exists in America, our business model will remain relevant and critical. Most importantly, we are deeply committed to the highest ethical standards because savers need management teams with integrity as stewards of the capital. Our management team operates with integrity and an unwavering commitment to our values and to supporting our community. We take our fiduciary responsibility very seriously and strive to be good stewards of capital, transparent in our actions and good corporate citizens. At Dynex, we're building a diverse and multi-generational organization with a 30-year vision that we believe will create enormous value for shareholders, stand the test of time, and prepare us for the future. I feel fantastic about 2020 and I'm very positive about 2021 and beyond. I will now turn the call over to Stephen Benedetti and Smriti Popenoe. Before I turn the call, I want to highlight that we have promoted Smriti Popenoe to President of our company. This is another reason that I am excited as a CEO and a coach. All of our stakeholders should be elated about her promotion and what this means for the future of Dynex. As I said earlier, we have a 30-year vision that includes getting the right people in the right places, with the right skill sets and experience. So now with that, I'm going to turn it over to Steve and Smriti and they're going to give you some more details about 2020 and beyond.

Thank you, Byron, and good morning, everybody. The fourth quarter continued the excellent performance for the company for 2020. For the quarter on a per common share basis, we record a comprehensive income of $1.23, total economic return of $1.22, or 6.7% based on the beginning book value per share of $18.25, and core net operating income of $0.45. For the year on a per common share basis, we report a comprehensive income of $2.88, total economic return of $2.73, and core net operating income of $1.94. 2020 performance was highlighted by active portfolio and risk management and dynamic capital allocation, which enabled us to take advantage of improving asset valuations over the year and declining funding costs. Realized and unrealized investment in TBA gains, net of hedges, were approximately $1.83 per common share driving a large part of the comprehensive income and total economic returns for the year. For the fourth quarter, both comprehensive income and total economic return were bolstered by the strong performance of lower coupon RMBS during the quarter, particularly in TBA securities, relative to associated hedges and to a lesser extent increasing value on CMBS IO securities. Core net operating income sequentially declined from $0.61 last quarter to $0.45 this quarter, principally as a result of the smaller average balance of interest-earning assets and modestly declining asset yields. In addition, general and administrative expenses increased by $2.1 million during the fourth quarter from year-end incentive compensation accruals reflecting a catch-up adjustment for accrued bonus expenses for management's achievements of its corporate goals and objectives this year. Net interest spread and adjusted net interest spread both slightly declined by 2 basis points, respectively, quarter-over-quarter. Prepayments increased but were well within expected ranges. Agency RMBS prepayment fees were 17.1 CPR for the quarter, while overall portfolio CPR, including the CMBS portfolio, were approximately 15.1 CPR. Adjusted net interest spread continues to benefit from the favorable TBA dollar roll conditions versus on-balance sheet repo. As a reminder, the company utilizes the prospective method for amortizing investment premiums, and as such, our results fully reflect the actual realized prepayments during the quarter and do not include cumulative catch-up amortization adjustments that are based on long-term assumptions and can potentially distort near-term results. As it relates to book value, the driver of the $0.83 per share increase during the fourth quarter was net gains from continued spread tightening on investment assets, particularly in both lower coupon TBAs and pools. Treasury future hedges also helped to offset the impact on investment valuations from the sell-off in interest rates during the quarter. We estimate that book value per common share at the end of January is up approximately 1%, inclusive of the impact of the capital raise announced last week. We ended the year with investment assets including TBA securities of $4.2 billion and leverage at 6.3x shareholders' equity, similar to the end of the third quarter. Overall, investment assets including TBA securities were down on an average basis by approximately 7% as compared to last quarter. This quarter, we added 15-year agency RMBS investments through TBA positions and overall the portfolio composition is approximately 84% RMBS investments including TBA securities and approximately 16% invested in CMBS and CMBS IO. Let me also mention that the tax character of the dividends on the company's equity capital. For 2020, dividends in both the preferred stock and common stock were 100% capital gain income. That concludes my prepared remarks and I'll turn the call over to Smriti for her comments on the quarter and the year.

Thank you, Steve. Let me start by saying that I appreciate the confidence that the Board and Byron have placed in me. I'm honored and delighted to serve the company's shareholders in my new role as the President. I'm going to briefly cover our 2020 performance and then shift to our outlook for 2021. In extreme volatility events like March 2020, there can be a lot of risk and with that comes opportunity. With thorough planning, respecting the probability of such events, we were positioned with higher levels of liquidity. We successfully managed the portfolio rapidly in February, before conditions deteriorated, positioned ourselves to weather the extraordinary market events of March and rebalanced our investments in April to take advantage of the remarkable recovery in asset prices through year-end. Our annual total economic return of 15% is only the third best in Dynex's history since 2008, but it is remarkable in that it was earned in an outlier year like 2020. Moving on to 2021, I'll start with a summary of our macroeconomic view. To deal with the pandemic and its aftereffects, central banks have implemented highly accommodative policies designed to increase employment, increase inflation, and put the economy on a growing trajectory. The flood of unprecedented liquidity has raised the price of financial assets globally. Governments around the world are also implementing debt financed fiscal policy to close the gap on lost GDP from the pandemic and to drive future growth; this is likely going to lead to a period of massive deficits. Against this backdrop of unprecedented monetary and fiscal stimulus, we have the health crisis that much of the globe is still dealing with. In the near term, we expect to see a period where the tug of war between the negative impacts of the pandemic and the positive impacts of the vaccine occur. In the medium term, the stimulus plus the impacts of more vaccinations could eventually lead to a period of higher growth, as more of our services-driven economy is able to come back online. The Fed also remains committed to a broad recovery in employment and an overshoot of inflation over 2%. In the long term, we believe the world has been permanently reshaped by the pandemic, and its impact will continue for many years to come across broad segments of our economy and many aspects of our daily lives. This will continue to be a focus for Dynex in our macroeconomic process. Right now, our macroeconomic view leads us to prepare for a somewhat bumpy transition to a steeper yield curve as one of the more probable scenarios for 2021. We believe this is also a more favorable environment for higher returns. Turning now to our current positioning and economic return outlook. Our goal is always to manage the balance sheet to generate a total economic return to meet or exceed the dividend, rather than think solely about core earnings versus the dividend. We are focused on capital preservation and generating returns over the long term. Our experience shows that this focus results in higher total shareholder returns and creates long-term value for shareholders. We believe the broader investment environment remains favorable with financing costs anchored well into 2022 and beyond. Give me a second here. First, financing costs are anchored well into 2022 and beyond. Agency MBS are liquid lower-risk assets. And third, we believe the market will evolve to a steeper curve environment that is ideal for earning wider net interest spreads. We expect returns to move into the 10% to 12% range and could offer mid-teens returns if spreads widen. We are entering this period with solid performance quarter-to-date; book value since year-end is up about 1% net of the equity raise. We have a strong liquidity position of $375 million and tremendous upside earnings power on the balance sheet. Leverage stands slightly over six times today and we still believe a liquid strategy is appropriate for the environment. Let me explain why we believe a steeper curve is possible. While financing costs are expected to stay close to zero through 2023, the back end of the yield curve will face pressure from Treasury issuance, possible increases in realized inflation, and expectations for inflation as the economy begins a path to recovery and gains traction in the second half of 2021. This will likely result in higher long-term Treasury yields. A steeper yield curve is a very positive factor for net interest spread expansion, as it offers the chance to invest at higher yields especially as prepayments slow. In steeper yield curve environments, agency RMBS spreads also tend to widen because they now have to compete with other assets including Treasuries that offer higher yields, and realized volatility in steeper yield curve environments is usually higher. This has the potential to further add to returns. If you go back to 2012, 2015, and 2018, all periods with tight MBS ready to start the year, the curves deepened and MBS widened. In 2012, it happened even with the Fed doing QE. So we're not predicting this will happen. We think there's a path for this scenario. And if it happens, it will be one where we can invest capital at higher returns. We also see a scenario where the low volatility environment keeps spreads range-bound and book value stable. Give me a moment here. At this point, we're seeing a massive revision to net supply numbers for 2021. Not just because of refinancing at low mortgage rates, but also because of new household formation or migration out of cities, home price appreciation, all of which are causing MBS supply to balloon much higher than expected. We believe this will afford us the opportunity to also invest at better returns. Finally, if rates decline and the curve flattens, given the current tightness and high dollar prices of MBS, we feel that spreads will move wider in a lower rate environment and we have the capital and liquidity to invest in that scenario. While they may not occur as exclusively as I've described, my point is that we believe all of these scenarios offer us the opportunity to manage and invest our capital accretively. Our core portfolio is also positioned to benefit in a steeper curve. This has been the market scenario so far this year. We currently have an RMBS portfolio allocation of 20% to 15 years, which outperforms in a steepener relative to 30s. We've increased our allocation to long-term option based hedges to better insulate the portfolio from rising long-term rates. You can see on Page 10 of the slide deck that the portfolio performs relatively well across several types of rate shocks, both parallel and non-parallel. I want to reemphasize that we have tremendous earnings power on the balance sheet. A one-time increase in leverage invested at an 8% total economic return adds $0.19 per share per year in economic return, at 10% that's $0.24, at 12% it's $0.29. We think we have the room to take our total leverage up at least 2x from today's levels at the right time and possibly higher if the return environment is better. Here's what I'd like to leave you with. The favorable investment environment is supported by low and stable financing costs well into 2022 and beyond. We expect to be able to opportunistically invest our capital at more accretive levels as the market evolves over the years. There's tremendous earnings power in the balance sheet, and we're comfortable with our ability to generate returns to cover or exceed the dividend over the year. I'll now turn it over to Byron.

Thanks Smriti. Let me reiterate and summarize quickly, we believe this is a favorable investment environment that has the potential to improve as the year evolves. Having our financing costs low and stable for some time into the future is an enormous benefit for our shareholders. Nonetheless, we continue to maintain our discipline of scenario planning to ensure we are prepared for future economic or market surprises. Now please take a look at the long-term chart on Slide 17 again, and let me emphasize for those of you who have listened to us over the years and you are long-term investors, we always close with this chart. You'll see a difference on the chart: we've used the Russell 2000 Value Index and the shift is mainly because of the unusual attraction and performance returns of the tech sector. So we tried to create something that is a little more comparable. But we could have created charts with ten-year charts, we could have created numerous other different types of vehicles and the picture looks very similar. This displays the power of above average dividends, the power of a long-term risk management strategy, and the power of successfully managing through major credit market corrections. We have proven time and again in my 13-year tenure that our philosophy, disciplined process, and long-term thinking lead to superior returns achieving over this time period many of us could not. The management team, our Board of Directors, and I are delighted to invest alongside our current investors, because we believe in our future. There are many other investors out there who should have Dynex in their portfolios. So we invite you to join us. With that operator, I'd like to open the call for questions.

Your first question comes from the line of Bose George with KBW.

Hey, everyone, this is actually Mike on for Bose. I just want to say congrats on a really strong year. I know it was challenging, and very great results. So my first question was, you recently did a secondary offering. I was wondering if you can just kind of talk a little bit about the decision to do this at a slight discount to book value. Given the backdrop that spreads are fairly tight and then I was wondering if you could also provide a little bit of color on the expected timeline for capital deployment.

So let me start and I will let Smriti chime in here. I appreciate this question; this is a phenomenal time to absorb the costs of us managing the right side of our balance sheet. And that's what I consider this capital raise to be. Let me recap the last couple of years, beginning of 2019, we raised about $50 million, we then issued preferred stock, we refinanced our higher cost of preferred A, we then paid off our preferred B, we came back in 2020, we were well-timed in the thought-out issuance of equity. We have already absorbed the cost of issuing equity; it's not too much about above or below book, it's about the cost of issuing the equity and growing the company. Can we absorb the costs or are our shareholders still in great shape over the long-term? The answer is yes. What's the benefit of it? We're trying to give our shareholders more liquidity. We've been told multiple times that, you guys have a great company, great management team, but to be below $500 million; we'd like to see you guys get above $500 million, and we will be able to join in, join the party. As such, the more other investors we can get involved with Dynex, we truly believe that we should be in more portfolios, and we believe that management team, we have something to offer over the long-term. That's our goal over the long term. When we say we want to grow the company in a shareholder-friendly manner, that means that the time is very attractive now, given the potential power in the balance sheet for generating income to absorb any of the costs, in terms of overall growing the company at this time. And that's the key, is how do you manage the cost of growing the company? This is a phenomenal time for being able to manage through that. All of our shareholders should benefit as we bring down our cost ratio and other decisions that we're looking to make for the long-term.

In terms of when you asked a question about the timing? I think, again, that the number one thing we think about is investment opportunity and not just the investment opportunity today, but what we think we can do with the capital over the long-term. So as I mentioned, we're thinking about not only the return environment today, but the evolution of the return environment that we see actually being very long-term accretive to our shareholders. So at lower returns, you should expect the balance sheet to have lower leverage; at higher returns, we will be increasing the size of the balance sheet.

Great. That's helpful. And then, another question was, so dollar roll income remains pretty strong. 2020 was obviously a great year for this. I was wondering if you could just talk a little bit about the expectations for 2021. Do you expect us to remain above, say, 2019 levels?

So dollar roll income in 2020, especially during the last two quarters of 2020? I think was extraordinarily favorable. The implied financing rates at the time were somewhere in the minus 50 basis points range. I think that those types of levels for 2020 will probably not be repeated in 2021. Overall specialness that should be lower, right? So right now we're seeing specialness be somewhere in the 20 basis point range versus the 40 to 50 basis point range for last year. So will there be special dollar rolls in 2021? Yes. Will it be as much as it was last year? No. I think that's generally the expectations for the markets at this point as well.

Let me add one more thing and revisit your first question to ensure everyone understands Dynex Capital's long-term vision. As we grow our company, we are excited to demonstrate the importance and value of being nimble. We're not aiming to be the largest in this industry, nor do we intend to simply issue equity to achieve that status; that is not our objective. We aim for a size we believe brings significant value, and the size-to-cost ratio that many discuss didn't hold much weight in 2000. In fact, there were companies so large they struggled to adjust their balance sheets. I want to emphasize that when we make strategic decisions regarding the right side of our balance sheet, we do so thoughtfully and with discipline, just as we do for the left side.

Your next question is from the line of Eric Hagen with BTIG.

I have a couple of questions. First, can you discuss your portfolio, particularly which hedges you plan to incrementally add and what your thresholds are for rates or volatility before you consider moving away from using short-dated options? Additionally, regarding specified pools, is there anything that would make you more optimistic? On the capital side, I support the decision to retire the preferred as a strategy to manage leverage. Does this change in your capital structure affect your overall outlook on leverage for the macro portfolio and the overall portfolio, specifically how much leverage you plan to maintain?

I will take the portfolio questions and address a part of leverage as well. You asked about the hedges and our thoughts on that. Generally, we are favoring Treasury-based hedges because they are liquid, which provides us with a lot of flexibility to trade around the clock. Futures will play a significant role in our hedging strategy; we've decided to position our hedges toward the back end of the yield curve to slightly lean towards a steeper curve for portfolio protection. This should be a consistent theme. We have been successful using Treasury options and shorter-dated options as a relatively cost-effective way to manage the rise in yields so far. In the fourth quarter, we shifted that strategy to incorporate longer-dated options. We had done that a bit last year as well, and it's something we are considering again as the shorter-dated options mature or expire heading into next year. You will see that shift occurring as we rebalance the portfolio. Regarding specified pools, we anticipate that they will begin to decline in value as expectations for prepayment patterns change and their relative worth compared to TBAs decreases. Once we witness this decline returning to the market, specified pools may regain attractiveness. Currently, many of these pools are trading closely to theoretical pay-ups. However, there is some risk that higher rate scenarios could drive these values down. For us to re-enter this market, that kind of price adjustment would be necessary. On the topic of leverage, we consider that when returns are in the range of 8% to 9%, our leverage would be around 6% to 6.5%. As returns increase, we expect our balance sheet to expand. We're ready for any scenario that may arise. For instance, in a scenario where spreads are tightening, we can invest when there are mismatches in supply and demand, allowing for capital deployment and improved returns. All of this gives us the ability to act quickly if a good opportunity for long-term economic returns presents itself. Hence, there’s significant flexibility and potential here. Byron, do you have anything to add?

Yes. Really, here's a key one on that: back to being very strategic and disciplined and thoughtful about what we do. In my 13 years being here, our leverage has gone from zero to 9.5 to 10, back down again in the middle. We're very thoughtful about how we make those decisions. Last year was unusual in the sense that we did have to move our leverage up and down a couple of times. I do remember when we took our leverage down right after the March period. It seems like a few of you out there were a little skeptical about our ability to move our leverage backup. We told you we could move it up in a nanosecond and that's exactly what we did. We moved it back up again. These are not just haphazard decisions. We have a philosophy; we have an opinion about how to manage this company over the long term. We're really skilled at managing leverage. Our resumes have years and years and decades of managing leveraged portfolios. So I just want to make sure you understand that we're not haphazard about these decisions.

Next question from the line of Trevor Cranston with JMP Securities.

I may have missed this. But given your comments on spec valuations being fairly full, did you guys mention if your intention with the capital raise was to deploy primarily into TBA? And I guess, if that is the case, can you maybe comment on more broadly speaking, how much room you have, in terms of how much TBA you have in the portfolio versus pools? Thanks.

Yes. We didn't specifically address TBAs versus specs in our comments. Generally, we currently prefer TB agent or coupon TBAs when the timing is right. Spec pools, especially in lower coupons we are considering, are somewhat saturated at this point, so we will lean towards TBAs. Regarding your second question about available room, there are a couple of perspectives. The main limitation, and Steve can correct me if I’m wrong, is that it’s an income test rather than an asset test. The proportion of TBAs on our balance sheet at any given moment is not determined by the total assets, but rather by the income they produce. Based on our analysis, we have considerable flexibility in expanding our TBA book relative to the rest of our portfolio before we encounter any limitations. I believe we can go above 50% at this time.

Your next question from the line of Jason Stewart.

One more on the preferred, if you don't mind. Could you talk a little bit more about your decision to retire with regard to the cost of the preferred? Or was it more of a decision to lower that as a percentage of capital over the long-term?

In terms of the cost period, we now have one preferred option. On the right side of the balance sheet, it's straightforward for our shareholders: two choices, preferred C with fixed coupons and lower yield, or common stock with higher yield. Investors can choose what they want to invest in. We've simplified the right side of the balance sheet. There are ongoing debates about the appropriate amount of preferred stock, which depends on our global economic environment and macro risk perspective. Our approach is very disciplined and top-down. Currently, our financing costs are fixed. When evaluating leveraged investments or mortgage REITs, it's essential to consider where your financing costs are; they need to be low and stable for good returns. This position will influence the instruments we use on the right side of the balance sheet. It's not as straightforward as a simple equation; it’s definitely a decision influenced by the environment, made with the same disciplined process as our other decisions.

Got it. That makes sense. And Smriti, I think you said in a steeper yield curve environment and I'm using quotes 'prepays should slow.' I'm wondering if you could elaborate on that and maybe discuss the factors that perhaps make prepaid slower or don't, including primary, secondary spreads and how you think that plays out. Thanks.

Yes, that's a great question. That's why I used the term "should" instead of "will." Currently, we are observing a significant movement in primary and secondary spreads. The mortgage origination community is motivated to take advantage of favorable conditions. I don't expect to see prepayments slow down immediately with the next 10 to 25 basis points increase. It will take some time for mortgage rates to reach a meaningful rise, which I would estimate to be between 3% and 3.25%. Once mortgage rates stabilize at that level for a while, that's when we might see prepayments start to slow. We are not relying on a slowdown in prepayments to achieve higher yields; there are other ways we can benefit from the return of incremental curve steepness. Additionally, as the curve steepens and we exhaust some of the easier refinancing opportunities, we should start to see a burnout effect. This burnout may not happen next month or the following month, but by the third or fourth quarter, we can expect to see it in the mix. In the short term, over the next few quarters, we do not anticipate significantly lower speeds even with higher rates. They may slow down, but not as much as they did in the past when the curve was steeper. I want to highlight that one of the interesting aspects of mortgage valuations in a steeper curve is not just the prepayment rate but also the realized volatility that occurs with the long-term yield curve fluctuations. This volatility influences investors' willingness to hold mortgages compared to other assets. As a result, the pricing of mortgages adjusts to account for that added risk, leading to wider mortgage spreads when the curve steepens. So when considering where returns will come from, it's important to look beyond just prepayment slowing; the valuation implications of this scenario matter as well.

Your next question is from Christopher Nolan with Ladenburg Thalmann.

Hey, it's Chris Nolan from Ladenburg Thalmann. Smriti, congratulations on your promotion, well deserved. I think between you, Byron, and Steve, and everyone on Dynex is in good hands and continues to be in good hands. I'm looking at Page 15 of your presentation. If I'm reading it correctly, it looks like you guys are implying that your target leverage ratio is increasing to 7 to 9 turns from 7 to 8 before, so a fair reading of that.

So the 9 would only happen in a really attractive return environment. I think that's really the key.

And should we expect the leverage ratio to increase including TBAs in the first quarter considering the redemption and the new issuance and so forth?

What I would say is that at this moment, we believe there is a significant chance of net supply exceeding demand, even demand from the Fed. We think this will provide an opportunity to invest capital. If that situation arises, we will invest capital. The timing is the key factor. One thing we have learned over the years is that focusing on the short term often leads to losing returns in the long term, which is not our goal. Our aim is to deploy capital at the right level, so we will be disciplined about it.

And let me just add one thing; one thing we think about we go by our macro top-down process. So what is it that we really know here? We know our financing costs are low and stable for some period into the future. The next thing we know is the federal government, sovereign governments, especially the United States, are selling an enormous amount of debt every single week. The other thing we know is that net mortgage supply is increasing and mortgage originators are selling a ton of bonds every week, even with the Fed's involvement. So spreads are tight. But they're not just tight because of the Fed's involvement; they are tight because of the Fed plus other investors. At any point in time here in 2021, you have the probability of an imbalance in the current occurring, either for short durations or for longer duration periods of time. If you think about 2013, everyone talks about a tightening, and basically what you had was a short-term imbalance. That enormous amount of sellers developed, as one of the leaders in that era were mortgage originators, the spreads go out to really wide spreads, and then in 2014, spreads came back and yields dropped again. You're in a situation again, it's really important to understand this. Financing costs are fixed. There's an enormous seller of Treasuries, and there's an enormous seller of mortgage-backed securities. And the only thing that keeps over the check is as long as a few additional buyers, in addition to the Fed, try to stand in the way of the selling. In my opinion, our opinion, this creates a phenomenal opportunity in 2021 for the potential for a steeper curve and wider spreads. It doesn't have to be some massive, enormous event that takes place. These things can happen in a very orderly fashion. But I'm telling you, I'm giving you three things that we know for a fact. We can't predict the future, but these are three things we know. I will reiterate, financing costs are fixed and stable; there's an enormous seller of Treasury; and there's an enormous seller of mortgage-backed security that happens to be mortgage originators, and mortgage net supply is growing.

Great. Byron, given that, it looks like to me, reading the presentation that you guys are increasing your core ROE target range to 10% to 12% from 8% to 10% before, is that a fair reading of that?

What we believe is that, with the movement of spreads and the steepness of the curve, you listened to how I just said it: my financing costs are fixed. A steeper curve means that overall yields are going to rise versus my financing costs and that's going to increase returns. If you layer on top of that bouts of widening spreads, that increases returns. That's the way we look at it. And that's how I strongly feel about this scenario in 2021. So then when we give you the numbers, we're just giving you the numbers to say this is what we think things can widen out to given an environment today with durable low tech; 10% to 12% is a phenomenal return, actually probably you may see some other bouts of yields of returns above 12%.

Okay, given all that, where you're thinking on the dividend, because it looks like to me that you guys are poised for increasing the dividend.

That's what I want to emphasize. So many mortgage REIT investors choose mortgage REITs by yield. Anything you should have learned in 2020 is that the mistake? We believe in generating a solid cash dividend for our shareholders and a total return and total economic return experience. So we're always balancing. Well, how much are we paying versus how much risk are we taking with our book value? That's why we start with our macroeconomic view; because we don't want to take too much risk in the short-term, jack up our dividend to some level, and then blow our shareholders away with book value deterioration. Then you have this long-term hit on book value. That's not our goal. That's why we use the long-term charts to show you our performance. It's not understood by many people. We know when we tell you this story there are some of you out there who just don't get it. You didn't get it 10 years ago, you didn't get it five years ago. We're really emphasizing that this is the way we think in terms of yield growth, cash yield, and a total economic return experience. Smriti, do you have anything you want to add to this?

I want to clarify that we are not predicting a crisis. What we are saying is that as mortgage spreads widen, you should anticipate that we will invest capital. We are focused on achieving a total economic return, which means we believe it is beneficial for us to position ourselves for a higher return environment in which to deploy capital. We have already identified investment opportunities even this quarter. We are aware of the various scenarios that may develop, and we are disciplined in our approach to investing our funds. We are not forecasting any kind of drastic spread widening. We believe that a steeper yield curve is favorable, as it generally leads to wider net interest spreads, ultimately resulting in higher returns for the entire sector. This is an encouraging perspective. As for our dividend, it will always align with the economic returns we generate, and we will consult with the Board to determine how much profit to distribute versus retain when we achieve those returns.

And I would now like to turn the call back over to Mr. Boston for final remarks.

Thank you all for joining us today. We're just again as I said earlier, we're excited about 2020 and we're excited as we look into the future. Thank you for all of our shareholders for joining us on this journey. As I said earlier, we would like to have others take a closer look. Thank you again. And please join us for our first quarter call sometime in the month of April. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.