Dynex Capital Inc Q1 FY2022 Earnings Call

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. 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 as well as on the SEC's website. 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 have said many times, we invest your capital with a long-term view. Our team has navigated many complex and volatile market environments, 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 consequences 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 responsive 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 environments. 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 environments 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.

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 needs an annual draw from 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.

Thank you. 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 of 100 basis points of the potential levered return. Can you just talk through, kind of comparing that spread widening and why returns only increased 100 bps?

Sure. It really depends on the coupon you choose to determine the returns. One notable change this quarter has been the shift in the coupon distribution relative to the current coupon, which has been rising. Currently, the coupon is at 4.5%, significantly impacting the marginal return. I believe this shouldn't be interpreted as just a 100 basis point change in the overall return. It's more about how the $102 price coupon has evolved over the last quarter. If you examine the entire coupon distribution, you'll find that the returns have increased accordingly, likely by about 2% to 2.5% from quarter to 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'll begin and then Smriti can provide additional details. We're very disciplined in our top-down approach, and you could probably trace back to around 65 to 70 basis points. We shared our thought process regarding the yield curve and anticipated spreads, and we positioned the portfolio accordingly. The key to benefiting our shareholders has been to remain calm, patient, and disciplined, especially during the fluctuations from 65 basis points up to nearly 290 on the 10-year. We maintained our perspective on the yield curve, rates, and spreads. Approximately a year ago, we conducted a couple of capital raises and were transparent about not deploying all of that capital, believing a better opportunity would arise. We're expecting a steeper curve, higher yields, and wider spreads. Our approach has been consistent—calm, patient, disciplined, and managing the short and long-term effectively. If you revisit our previous calls, you'll find that one of my objectives is to manage this portfolio in a way that feels harmonious, allowing shareholders to appreciate the process throughout. Smriti, feel free to share more specific information, but the overarching theme is that we've remained disciplined and patient.

From a more detailed perspective, there are three main points to consider. When we discuss hedge ratios, it's essential to understand the duration of our mortgage security, which is quite difficult to predict. One approach we take is thinking about duration in terms of anticipating future trends, similar to how a hockey player skates to where the puck will be. This approach requires a blend of scalability and a nuanced understanding of how mortgages function. Part of this involves hedge ratios—specifically, how we hedge and what instruments we use for hedging, which relates to positioning across the yield curve. In terms of our asset allocation, we focused on lower coupons that performed well. Our hedge strategy targeted the 10-year segment of the curve, which has recently mirrored the performance of our assets. We've consistently emphasized low leverage during this time, despite the allure of higher yields. Overall, our approach has proven effective, and as Byron noted, this strategy is fundamentally driven by our macroeconomic outlook. These factors combined have led to our current position.

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. One of the most interesting developments is that almost all of the coupon stack is at par or below par. Typically, when moving up in coupon, one would expect a transition from a discount to a premium, but that’s not necessarily the case here. We shifted our entire TBA position last quarter to higher coupons as spreads widened. We believe there is now a more balanced perspective on how rates could evolve, leading us to diversify our coupon distribution. Additionally, it's important not to focus too much on the book yields. Each quarter, we mark our balance sheet to market, and the bonds priced at $88 or $89 have approximately a 3% market yield. By preserving book value, we've maintained the forward net interest margin on those assets. Moving out of these assets will depend on two key factors: the prepayment speeds in the lower coupons, influenced by cash-out refinancing and turnover. We are monitoring these to inform our decisions regarding transitioning to higher coupons. Currently, our portfolio of 2 and 2.5 coupons is paying around 8 to 9 CPR last month, which is significant given that dollar prices are 11 points below par. We are closely observing this and do not feel tied to those positions. We believe there will be opportunities to move up in coupon as the Fed pulls back from higher coupons. Another perspective on low coupons is to view them as an on-balance sheet call option; the swaption and option volatility is currently high for both calls and puts. These positions offer positive carry call options within the portfolio. At this stage, we consider all these positions temporary and are reviewing them daily to determine the right time to exit. We feel confident about the current pricing and have hedged our positions effectively, with the forward net interest margin looking favorable. Moving forward, the focus will be on relative value.

Congrats on a great quarter. 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.

Thank you for the question, Eric. I would say it's not solely about the Fed's drawdown, although it is partially related. As the Fed halts its purchases of those coupons, we can expect the rolls in those coupons to decrease. That's certainly happening. However, the main factor will be the level of rates. In fact, we've recently observed that the rolls in Fannie 4s have dropped 4 ticks just in the past week. It's quite directional, and it can be challenging to strategize around that. Therefore, I would say it's less sustainable now than it was when the Fed was actively buying. We can anticipate increased volatility in those rolls. There is potential for carry if we can identify the right level on these dollar rolls, but overall, it's less sustainable at this time.

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, it's still pretty early in the year. But as we see it right now, we should be okay there.

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 normal distributions. 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. 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 in time. I always like to use the word this is a fat-tailed environment, and we try to say that to my team to remind them how many factors are in the channel that could surprise us. And so far, this decade, we've had one surprise after another. 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, 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 high-yield credit and so on. So I think there's a price element to that and there's also a fundamental viewpoint. We're coming out of a pandemic. We've got inflation. There're increases in general levels of borrowing. We don't know how the fundamentals are going to play out here. So I think that's why a wait-and-see approach is warranted. 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 are artificial levels of liquidity and cash propping up these assets to wait 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 I think is 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 want to 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.

Noted. That is a great job. I don't have anything to add to it. I'll just say that wider spreads are what we desire. We want more capital to be able to deploy it, simple. To our shareholders, thank you 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.