Dynex Capital Inc Q3 FY2022 Earnings Call

Good morning. My name is Dennis and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Third Quarter 2022 Earnings Conference Call. I would now like to turn the conference over to Alison Griffin, Vice President of Investor Relations. Please go ahead.

Thank you, Dennis. Good morning and thank you all for joining us today for the Dynex Capital third quarter 2022 earnings call. The press release associated with today’s call was issued and filed with the SEC this morning, October 24. 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. 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 Rob Colligan, Executive Vice President, Chief Financial Officer. And with that, it is my pleasure now to turn the call over to Byron.

Thank you, Alison, and good morning. And let me start the call off with a few messages, few thoughts for our shareholders and then Rob and Smriti will take over with more specifics. So to our shareholders, as I’ve mentioned in the past, this is an incredible moment in history. Across all major asset classes, prices have fallen and volatility has materially increased, especially during the last two to three weeks of the quarter. And even though all asset managers are in the same storm, I want you to know, we are not all in the same boat. The Dynex Capital boat was built to withstand a storm. We have been preparing for this type of environment for years. We have managed through markets like this before, and it is our experience and flexibility that will guide us through to the other side of this complex market cycle. Given these challenges and complexity, I want to maintain our tradition of transparency and open dialogue by simplifying my takeaways from this quarter into five key points. First, our portfolio is solid. Dynex is prepared for this market. Several years ago, we proactively moved up in credit and up in liquidity and we further increased our focus on liquidity after March of 2020. Our portfolio is government guaranteed and is backed by U.S. borrowers and U.S. real estate. Agency mortgage-backed securities are second in liquidity only to U.S. Treasuries and mortgage-backed securities have a history of being a very liquid and very efficient corner of the fixed income markets even in turbulent markets like the one we are in now. Second, our liquidity position is strong. Most of our liquidity is in cash, the most liquid asset of all, but we also have unpledged Agency securities that are easily financed or sold. As the markets took a decisive move toward chaotic volatility, we have been able to manage our balance sheet with confidence. We also have enough capital to be opportunistic when the market’s calm and we can take advantage of this great return environment. Third, our strategy was built for this. The core tenet of Dynex's investment strategy is preparation and flexibility. And over the past several years, we have said repeatedly that we believe surprises are highly probable. We began talking with our investors about the increasing complexity of global markets as far back as 2014. We understand through our experience that the global risk environment by its nature is too complex to allow us to predict what will happen. But that doesn't mean we can't prepare, which is what we have done. Fourth, our management team is experienced and disciplined. And in this volatile market environment, more than ever, you need an experienced and trustworthy team at the helm. We have proven the value of experience in the past, as we have reacted to other market events in a very thoughtful manner as shown in our long-term results. We manage our business for the long-term. And just as we have done in the past, we are determined to guide you, our shareholders, through this disruptive market environment. And as always, we are committed to providing transparency and insights into our strategy as we guide the Dynex ship through this storm to the inevitable sunshine that will come out tomorrow. With that, I'm going to turn the call over to Rob and Smriti and let them give you more details.

Thank you, Byron, and good morning all. The company reported a comprehensive loss of $2.20 per common share and a negative total economic return of 12.9%. The negative total economic return was driven by declines in the value of our mortgage-backed securities, and TBA positions exceeding the increasing value of our interest rate hedges as spreads widened significantly this quarter, especially in the month of September. Spreads are near historically wide levels, driven by recent economic policy and geopolitical risks. We believe our portfolio will recover a significant amount of value when the flows into mortgage-backed securities improve or simply as paydowns occur over time. Smriti will cover market activity including spreads in her comments. Earnings available for distribution or EAD was $0.24 this quarter. G&A expenses and EAD include a one-time cost of $2.7 million, or $0.06 of severance costs related to the CFO transition during the third quarter. At Dynex, our key strategies include the management of interest rate risk, liquidity management, and protecting shareholder value. We accomplish this through thoughtful asset selection and hedging activities. This quarter, we're highlighting the benefit of our hedging activities, as our earnings available for distribution calculation does not incorporate the positive impact of the company's interest rate risk mitigation strategies, because our primary hedging instrument is interest rate futures. If the company used interest rate swaps instead of futures, the hedge benefit of the swap would be included in both net interest spread and earnings available for distribution. Through September 30, Dynex has over $500 million of hedge gains, primarily on futures instruments. These realized hedge gains are recognized immediately for GAAP reporting but are deferred for tax that is amortized into REIT taxable income over the hedge period of approximately 10 years. The benefit of interest rate hedge gain amortization was approximately $9 million or $0.21 for the third quarter and is estimated to be $12 million or $0.25 per common share for the next five quarters. The total amount of gain to amortize into REIT taxable income can go up or down depending on the company's hedge position and movements in rates in subsequent quarters. Since hedge gains are a component of REIT taxable income, they will be part of the company's distribution requirements along with other ordinary gains and losses. As we move into the fourth quarter, we expect hedge gains will be supportive of the dividends in 2023 and beyond even if net interest income and earnings available for distribution decline due to rising financing costs. Please see the additional disclosures in our release. And be on the lookout for our 10-Q, which will have additional information and will be filed next week. I'll now turn the call over to Smriti for her comments on the quarter.

Thank you, Rob, and welcome, everyone. As a longtime sailor, I can certainly appreciate Byron's analogy of a boat navigating a storm. I've done that in real life with my family aboard our sailboat. During my 25 plus years of experience in the fixed income markets, I've often felt that sailing offers important lessons to me as an investor. I'll structure my comments today on our path through the storm, how we're navigating it, our short-term views and strategy, and then I'll turn to our long-term outlook. The storm we are in represents a transition from an era of low inflation, low interest rates, financialization, leverage, globalization, peace and a global pandemic. On the other side of the storm is an environment where the amount and mix of all of these factors will be different and there will be new factors to contend with. We believe the storm and its effects will present excellent long-term investment opportunities. But we have to navigate through the storm first. We prepared for this environment with the highest level of liquidity in over five years and the highest allocation to the most liquid instruments backed by U.S. real estate, Agency-guaranteed residential mortgage-backed securities. Our TBA position has given us flexibility and maneuverability to adjust risk. The financing markets are functioning in an orderly manner, our counterparties have access to liquidity, haircuts are stable; and from our perspective, there currently do not appear to be any signs of financing dislocation. We can trade our highly liquid futures hedges 24/6. Our balance sheet is marked to market daily, so there is no mystery about the value of our positions at the end of each day. We had anticipated that as global central banks withdrew liquidity and raised interest rates to combat inflation, the price of government bonds and risky assets would adjust down. This price adjustment has been underway since September of 2020. Treasuries and mortgage-backed securities have led the way and most of it has been orderly until this last quarter. So the storm really intensified in late September and early October. You can see this in Agency RMBS spreads, which widened dramatically in September and have continued the widening trend into the fourth quarter, now standing at levels within a few basis points of the peak spreads seen in March of 2020 as shown in our slide deck on Page 10. Simultaneously, the entire yield curve has shifted up. As of last Friday, the two-year is 157 basis points higher, and the 10-year is 125 basis points higher just since June 30th. This type of interest rate volatility has not been seen in the bond market since the early 1970s. You can see this represented in the charts in the slide deck on Page 24. As the year has progressed, the ride has really gotten rougher. Now here's what's unique about what's happened. In traditional Fed tightening cycles, the yield curve inverts, the carry in Agency RMBS is negative and it's usually not a great investment environment until the next Fed easing cycle. But it is different this time. Mortgage rates have been rising higher and faster than financing costs, causing spreads to widen to historically wide levels, making this the best investment environment in Agency RMBS since the great financial crisis, and we expect this to continue. Now, the recent moves are happening for several reasons. First, the structure of the Agency RMBS market is different. The largest non-economic buyer of Agency RMBS, that is the Fed, is stepping back, creating net supply into the market. Unlike at any other time since the 1970s, there is no go-away buyer. There's no GSEs. The banks are also out of the market and they have no appetite for MBS because their loan portfolios have grown. So now the marginal bid for mortgages is being driven by relative value players. This is money managers. They are facing outflows. So the technical demand picture for MBS is the poorest it has been in several decades. Second, there has been selling of Agency RMBS by many types of accounts, including non-U.S. based investors. Domestic money managers continue to face net outflows from fixed income, and MBS are a liquid asset and they are being sold first. So we expect this to continue. Finally, we're seeing higher than normal levels of supply for the environment because loan sizes for next year are getting baked in, origination pipelines are getting flushed and we're seeing some cash-out activity that's keeping volume elevated. We do expect this to reverse course over the next few months. So as the storm intensified, we used our instruments, our principles of risk management, disciplined top-down analysis, and a focus on capital preservation. In our last call, we discussed our strategy as being prepared for this rough ride with liquidity and dry powder as we entered an environment of higher returns, standing ready to deploy capital in what we saw as a persistent opportunity in Agency RMBS. We have also repeatedly discussed the idea that we are in an environment where surprises are highly probable and that we must be ready to adjust as those occur. That posture and mindset has not changed. As the ride became rougher here in October with no shortage of unexpected surprises from across the Atlantic, we made some tactical adjustments to the portfolio. Those reduced interest rate sensitivity and some spread risk, and you can see the direct results of that on pages 11 and 12 on our slide deck. The book value decline we experienced in the third quarter is a function of these market moves and mostly attributable to the gap being wider by about 50 basis points in Agency RMBS spreads in late September. Post-quarter end, as spreads have continued to widen about 15 basis points to 20 basis points across the coupons that we own, book value at the end of last week was down about 8% to 10% versus quarter end. Our liquidity is estimated at $430 million and leverage to total capital is approximately 7.2x. For your information, the book value during the quarter traded up as high as 7%, up from the second quarter end before ending the quarter down 15%. This should give you some idea of the volatility in spreads as well as the rebound potential in the portfolio. So now with the existing position, we hold more than enough liquidity and capital to withstand the spread shocks that we saw in 2008. As you can see on chart 10, that is another 40 basis points to 50 basis points wider from here in nominal spreads on the current coupon. We also stress our portfolios to include haircut increases and other unanticipated calls on liquidity. We are keenly aware of the potential for counterparty stress as well as the actions of other players in the market. And for those reasons and more, our view on the risk environment has shifted to a more cautious stance going into year-end. We've also rolled about 20% of our repo book over year-end, and we continue to term up financing to minimize year-end issues. Let's now look ahead. What usually comes after storms is some type of calming of disease. It's important to look and plan ahead with an intermediate-term view to steer the boat to its destination. At some point, the Fed will signal a pause or stop tightening. When that happens, there will be a period of lower volatility and evaluation. This is where we see a target-rich environment, which persists for some time. Agency RMBS returns are already in the high teens and low 20s, and we're really looking forward to getting to that target-rich environment, but we're not there yet. The key is being able to navigate through this rough ride in the near term to get to the longer term, stronger fundamental and technical environment. So we see at least four positive catalysts for Agency RMBS in the intermediate term. The first one, very simply, is the raw return in Agency RMBS. This can be a major catalyst. 5.5% to 6.5% base case yields; we haven't seen those in at least 15 years. These are great returns relative to a lot of other risky assets today and will likely be great returns in the future once you adjust for liquidity and credit risk. Second, lower net supply in the future. We are approaching a seasonal winter slowdown. Mortgage rates are at or near 7%. This will eventually slow originations to at least 50% of current levels, shrinking the overall net supply, forming a technical tailwind. Third, any decline in realized volatility is also a tailwind for MBS and will take spreads tighter. And finally, if a recession indeed materializes, Agency RMBS will be the credit risk-free asset to own versus riskier corporate and consumer-backed debt. A few other points on the intermediate-term. At current levels, MBS offer almost 200 basis points of spread over Treasuries. At nominal interest rates, that have not been seen for a credit risk-free asset in decades. These returns require less leverage to earn mid-teens or higher returns. Going forward, the mortgage market will be operating without a stabilizing agent, such as the Fed or the GSEs. This means spread volatility could be higher, but at the same time, returns will be higher. This is why we are calling the opportunity persistent. And finally, the demand for income remains strong. Global demographics still favor income-producing investments. Especially in the absence of a permanently rising stock market, investors may finally seek fixed income instruments at these higher yields. This is what can eventually turn the tide of money manager selling as inflows return into bond funds. So for now, while we have positioned the portfolio to a more neutral stance, we are also thinking about what the catalyst is for adding risk as we navigate through this near-term poor technical backdrop to the longer-term, stronger fundamental and technical backdrop for mortgages. An additional word on our positioning. We expect to be active across both our assets and our hedges over time. You can think of it as a position designed to weather the storm that will change as time goes on. The beauty of a flexible strategy with TBAs in the position is our ability to change as the market changes. As we continue to evolve our portfolio structure, we will provide additional timely disclosures to be fully transparent as we transition to a more long-term position. Until then, you can see by the numbers, we have moved to shield the portfolio from large moves in interest rates and cut our spread risk. I remind you to grade us by our long-term total economic performance, and that EAD alone is an incomplete metric to assess economic performance or dividend stability. As Rob mentioned, substantial hedge gains exist in the portfolio to support our forward dividend. A final word on the dividend and forward returns on Page 13 of the deck. As of last week, the weighted average market forward yield of our portfolio is approximately 5.4%, and we are hedged with Treasuries yielding about 4.2%. This produces 120 basis points of net spread at 8x leverage to common, a forward ROE of about 15%. This is the foundation of the economic return that supports our dividend. It will not be evident in earnings available for distribution, because that does not include the benefit of our futures. It will show up mostly in book value and in taxable income. In addition, just the current portfolio will add $0.70 per share in book value for every 10 basis points of spread tightening from these very wide levels, further boosting the forward return. Any incremental return will be driven by adding assets during this persistent and attractive investment opportunity in Agency RMBS, for which we are prepared. We expect to eventually return to a diversified portfolio over time, as new opportunities evolve. I'd like to leave you with the following thoughts: We are liquid and we are prepared for the storm that we are in. We expect the rough ride to continue for some time. And we've moved to mitigate interest rate risk and preserve capital as we navigate through this short-term transition to what we believe will be a highly favorable investment environment. MBS spreads are wide and returns are in the 19% to 25% range on the margin. While this is a target-rich environment, we would like to see the levels of macro risks subside before we change and add significant risk. In the intermediate term, we expect MBS to outperform many other asset classes as fundamentals and technical shift. This is the environment when book value can be recovered. We take our responsibility of capital stewardship very seriously. And the team and I remain focused on making the next decision to maximize value on your behalf. I'm truly grateful for your trust and confidence. And with that, I'll turn it over to Byron.

Thanks, Smriti. Let me remind you again, this is a historical moment that is evolving as we transition to a new global economic market and geopolitical environment. I want to also remind you that we have built Dynex Capital to withstand the surprise market gyrations that we're encountering during this transitional period. We're committed to providing long-term attractive returns to our investors and our focus on these long-term returns has not wavered in this environment. Take note of our track record as displayed on Slide 15. Dynex has proven to be a better cash-generating alternative to many other debt and financial alternatives through all cycles over the past 15 years. This is not our first storm and this will not be our last. Just as in the past, we're prepared to remain patient and disciplined until the sun comes out. Finally, we're in the boat with you. Both management and the Board are comfortable owning both Dynex Capital common and preferred stock as we ride out this current transitional period in history. The stormy environment will evolve. This transitional period will end, and we will have the flexibility to adjust our posture to a more offensive stance to take advantage of these truly attractive return opportunities. So with that, operator, we can open the call up for questions.

And your first question is from the line of Doug Harter with Credit Suisse.

As you guys look and balance the short-term and the intermediate to long-term, can you go through how you kind of arrived at that 7x leverage that you talked about and that you are at currently?

Hey, Doug, I didn't quite hear that. Say it over again.

Sure. Kind of as you guys look to balance the short-term versus the attractive intermediate to long-term, can you just talk about how you kind of arrived at the current leverage level?

Yes, good morning, Doug. This is influenced by two main factors: the current level of spreads in comparison to our expectations for their future movement and our attention to the technical aspects of the mortgage market. I mentioned previously that the triggers for spreads tightening are less numerous than those for widening in the near term. The 7x leverage reflects our portfolio's capacity to endure significant further widening. We believe maintaining this stance is prudent as we move through the upcoming months. We consider factors such as today's spreads, potential future movements, how much liquidity and capital we wish to retain, and our desired leverage. Ultimately, we aim to position ourselves effectively to seize opportunities that may arise, especially during challenging times.

And when that opportunity arises, where do you think you would feel comfortable taking on leverage as those catalysts begin to materialize?

Yes, look, that's like the $90,000 question which people have been asking us since July, right? And we have faced a lot of pressure from our investors and others saying, when are you going to take leverage up? How much are you going to take leverage up? And I think the right answer to that is, it depends. It depends on what the market is doing at that time. And what I can tell our investors, and I can tell you, and you've seen us do this now time and again is, when the opportunity presents itself, we will take advantage of it. It's going to be in the context of the broader macro environment. If we believe the risk-return trade-off is positive, that leverage will go up, right? So it's always going to be made in the context of that decision. And what I can tell you right now, we said in the deck, we think we have somewhere between 2 and 4 turns of incremental dry powder. That's what we hope to deploy but we'll do it slowly and we'll do it prudently.

Yes, let me mention something else, Doug. Smriti has indicated how significantly our book value fluctuated during the quarter. As we adjust to the changing world and environment, our book value could be substantially higher than it currently is, which will greatly influence our leverage. We will consider this as we manage the portfolio. We are not viewing this as a fixed point in time; you can observe the market's volatility. It's crucial to note the strong book value, as it was solidly up at the end of August. With such a high book value, leverage can decrease immediately by one or two turns. Therefore, it's essential to adopt a top-down perspective; if spreads tighten by 20 to 30 basis points, leverage will decrease. We will not wait for that to happen to make the necessary adjustments and investments.

Your next question is from the line of Bose George with KBW. Please go ahead.

Good morning, everyone. Continuing on the topic of leverage, with the current wider spreads, your mark-to-market leverage has increased. It's estimated to be around 9.5 now. You've mentioned the possibility of further widening spreads. Given this situation, how much are you willing to allow your mark-to-market leverage to increase? There's concern that at some point, you may choose to delever, which could limit the potential gains when spreads tighten. I'm interested in your thoughts on this.

Yes, we discussed the adjustments made in the portfolio. As of the end of last week, our leverage has decreased since the end of the quarter. The leverage to total capital we reported was 7.2 times. We opted not to take the write-up on the entire portfolio for additional spread widening, which we believe is the right strategy as we anticipate a challenging environment through year-end. Decisions regarding how high we would let the leverage go are now almost day-to-day. If we determine the market necessitates further deleveraging, we will act accordingly. Currently, we have sufficient liquidity and capital to withstand potential spread widening similar to what we saw in 2008 and beyond. Our liquidity position is strong enough for that scenario. However, whether or not we allow it to reach that point will depend on how we see the market evolving. In the intermediate term, we expect the environment to improve for various reasons I mentioned earlier. The raw returns are exceptional, and supply is decreasing. Unfortunately, those selling bonds in this market are letting go of what we own, and once this situation stabilizes, they will likely want to reclaim those bonds. It’s a delicate balance since we want to avoid sacrificing potential upside when the market rebounds, but we must reach that point intact. We are very aware of the associated risks and have not allowed our leverage to increase. We've made adjustments as part of our navigation strategy. Byron, do you have anything to add?

Yes, let me elaborate on the previous questions from Bose and Doug. When we mention improvements in credit and liquidity, we have increased the liquidity on our balance sheet, particularly with a 50 basis point movement on the 10-year. We've maintained sufficient liquidity to avoid the need for adjustments to the portfolio due to fluctuating leverage or margin calls. This has allowed us to effectively manage our balance sheet. While I understand that Smriti might feel differently given the stress that investment teams experience in today’s volatile market, we are in a strong position regarding liquidity. Companies lacking enough liquidity will feel pressure from leverage changes as they struggle to meet their needs. We, however, have planned for these scenarios, ensuring we have the liquidity to navigate unexpected situations. The main point is that while we may make tactical decisions as leverage shifts, those decisions will relate to our risk posture, not liquidity. A clear example of this is from March 2020 when we had ample liquidity and didn't have to worry about margin calls. We made several portfolio adjustments during that period, and by the year's end, everything was stable. For a reference point, you can review our decision-making process in 2020 compared to previous years. Back to you.

Okay. Great. That's helpful. Thanks, guys. And then actually just one on the funding markets. Any changes you are seeing there, volatility haircuts, anything to comment on?

The answer to that is no. The Agency RMBS repo market has been very, very stable. We have had zero haircut issues. The market is functioning in a very orderly manner. So no issues there.

Your next question is from the line of Trevor Cranston with JMP Securities. Please go ahead.

Hey, thanks. A question on the change in sensitivities you guys are showing as of October versus where you are at, at the end of the quarter. Can you go into some detail on what the changes you have made to hedge portfolio and the asset composition that have led to that material change particularly in the rate exposures?

Right. Yes. So a big portion of that, it's a combination of two things. It's a combination of hedges that we put on and second, a reduction in the credit spread sensitivity. So some reduction in the level of assets and some increase in the level of hedges. Trevor, what we are doing is making these adjustments sort of in real-time, and what we've committed to do on this call is, as we make those adjustments and we complete making those adjustments, we will actually give more detail around exactly what those moves were over time. So suffice it to say, what we are really trying to demonstrate in those two slides is, number one, as it relates to interest rate sensitivity, that's substantially down versus quarter-end. And then as it relates to sensitivity to credit spread, that's down some, but on a percentage basis less than the interest rate sensitivity in the book.

And then the question was on the coupon composition of the portfolio. Given how much rates have moved, obviously, the coupons shown in the portfolio as of September 30th anyways, are all trading at meaningful discounts. On the margin as you guys are deploying capital, can you talk about like if you guys are looking at deploying into current coupons? Or if you're still kind of focused on more discount securities?

And I know, that's a great question. One of the principles that you've probably seen us now follow for a few years is, you want to generally try to have instruments that are, I'm going to say, hedgeable and that you know the duration or you're trying to estimate the duration that’s as well as possible. The amazing thing about the coupons that we have owned and continue to own is, that right now with everything trading below $95 price, most of those coupons are fully extended. The duration of those is not hard to estimate and that's a really nice position to have in this volatile interest rate environment. So I'm very comfortable positioning us in that manner until we get through this transitional period. Now, as we go through the transition, we're evaluating all kinds of things, right? So yes, current coupons, we are evaluating that. There's risk and reward associated with the current coupon as well as the lower coupon. So the trade-off is always going to be what's the incremental return that I'm getting for the risk that I'm taking? And yes, current coupons offer more return. But there's a different type of risk involved. And there'll be a time and a place to put that risk on the balance sheet. We haven't felt like that's appropriate yet. But that is exactly the type of offensive thought process that we're going through at the moment.

Your next question is from the line of Jason Stewart with Jones Trading.

I wanted to ask about the cost to operate in sort of a defensive, lower leverage environment. And how you guys are thinking about that?

When you say the cost to operate, Jason, I mean just the overall cost of running the business?

Correct.

Our cost levels are essentially unchanged, despite market volatility causing some increases in our expenses. We've shifted to a higher level of focus, dedicating more personal time as we move from regular workdays to a continuous, around-the-clock environment. However, regarding the cost of running the business, we maintain a long-term outlook. We are investing adequately in our business to ensure we remain strong in the coming years. We are implementing significant changes in our technology platform and other areas that we believe will be advantageous in the future. We see the need for a robust asset management team like Dynex Capital, particularly as a cash-generating entity. I hope this information provides some clarity.

It's great. That is perfect. I wanted to ask you two other quick questions. One, any expected changes that you guys think come out of FHFA, given this environment?

Great question. Yes, I mean, I think this is the environment in which they open up the credit box to potentially change the affordability picture for as mortgage rates are up at 7%. We're looking at the loan size issue. Obviously, that is something that will come up here towards year-end. Those are two big factors. Nothing in the news so far that we can see where there's been movement towards opening up that credit box. We're looking at the November elections. That's going to be something that we're focused on as potential signaling of how this might evolve over the next two years. So, right now, I think nothing is on the radar as far as we can see in terms of any major changes here.

I have one other thing. This is just a Byron comment, which is, you asked it out in public, so I'm going to make the comment. As a country, the Agency security is a phenomenal asset for the United States. I would like our government and our FHFA to make Freddie Mac and Fannie Mae temporary stabilizing agencies for this market. They don't have to grow the portfolio like they did before. But it is ludicrous to have these organizations sitting there when they can actually be a stabilizing agent, ensuring that these markets trade smoothly. The mortgage market has traded anything but smoothly over the last few months. They could play a minor role, they could have played a minor role in March of 2020, and things would have been a lot easier. So you could talk to government regulators, bring that issue up. I worked at Freddie Mac. I know a role they can play. They don't need to play the big portfolio role they played before. But they can play a stabilizing agent in how the Agency mortgage market trades. And I would hope that one day, our regulators, FHFA or whoever else, will understand that.

Last one for me. How are you guys looking at buybacks on common or preferred versus investment opportunities? I mean, they both present pretty good opportunities in my view right now.

Long term returns are projected between 19% and 25%. Buybacks are sensible when investment opportunities outweigh your cost of capital, but that's not the current situation. Therefore, in this investment environment, we should focus on holding and deploying capital.

Your next question is from the line of Eric Hagan with BTIG. Please go ahead.

Hey, thanks. Good morning. Just a couple more on relative value within the coupon stack and how you guys think about managing liquidity, just in light of the paydown differential for securities across the stack and how you mix that with TBAs and pools? And then on the funding side, is there any value in borrowing with longer-term repo right now? Can you comment on the liquidity that you see for repo along the yield curve? Thanks.

I'll address your second question first, Eric. The ability to borrow across terms is something we've utilized effectively at Dynex, and it's central to how we navigate quarter ends. There is currently a term premium in the market for year-end, which isn't as large as we've seen in previous years, but it is still significant. Additionally, there's considerable uncertainty in the repo market regarding when the Fed will implement a 75 basis point or 50 basis point rate hike. There's ongoing price discovery for November, December, and beyond related to the size of these rate changes. However, none of this has hindered our ability to secure longer-term financing or the overall availability of financing. We successfully manage to term out our financing without encountering issues like haircuts. We're observing a typical term structure of interest rates, but this hasn't impacted our operations negatively. Regarding your first question about relative value and pools, our approach is guided by the principle of risk management. When dealing with fully extended coupons where prepayment risk is priced in, they are simpler to hedge. Holding lower coupons is primarily due to our ability to manage their duration risk using appropriate hedging instruments like futures. This is the main reason we own below-par coupons. Over time, this may change given the higher carry of higher coupons and shifting prepayment behaviors. The decision-making surrounding this is ongoing. Higher coupons present increased prepayment, extension, and contraction risks, alongside more complexity in hedging. Thus, we are still evaluating the relative value of these options. Those who invested in higher coupons during the transition from 2.5% to 4% have faced significant challenges in hedging them effectively. For us, focusing on lower coupons with extended profiles has provided stability as interest rates have risen. The current market environment further complicates the comparison of spreads between different coupon levels. In contemplating relative value, our primary focus is on the feasibility and methods of hedging. Though we constantly consider relative value, we reserve deeper discussions for when we near the end of this transitional phase. We are actively thinking about offense strategies, yet we recognize the macro risk factors influencing our decisions. It’s not simply about owning higher coupons based on fundamental beliefs; understanding the broader market risks is critical to our current strategy.

That's good color. I appreciate that. With respect to the comments around the dividend and such, are we hearing that your dividend will most likely be characterized as a return of capital for both 2022 and 2023? And any guidance I suppose on that? Thank you.

Yes, thanks, Eric. No, we are not saying that at all, because the hedge gains in particular, that would all be ordinary income, and we will look at the distribution calculation. So yes, we are not saying that at all. We are going to continue to provide color on our hedge gains and the impact on that to the portfolio, to financing and to taxable results, so everyone can understand where we are. We can be transparent. People in your seat can model out where we are and kind of understand the direction that we are going in.

Your next question is from the line of Christopher Nolan with Ladenburg Thalmann. Please go ahead.

Hi, guys. Are you continuing to issue any shares into the fourth quarter here?

With that price thus far. In this chaotic market, I appreciate you asking this question. This chaos indicates that we need to focus on every aspect of the balance sheet and endure the storm. We've used the boat analogy for a strong reason. Smriti is a sailor, and Tom Aken, our previous CEO, is also a sailor. We take this seriously. During a storm, you secure the boat and wait it out. This applies to both sides of our balance sheet. So, the short answer is that I can't say definitively. Right now, we are in a storm. If the storm shifted in mid-September, that brings up another key point: we are being patient with all aspects of the balance sheet. To clarify our message, we've discussed various topics, but the bottom line is that mid-September’s chaotic situation in the UK, along with recent inflation numbers, caused turmoil in market trading globally—across treasuries, mortgages, corporate markets, and more. In such a situation, a wise decision is to hunker down and wait for the storm to pass. That’s our strategy at Dynex. If there's one takeaway, it's that we are weathering the storm; our 'boat' is designed for tough conditions, and we have the liquidity to manage through it, which we prepared for several years ago.

And at this time, there are no further questions. I will now turn the call back to Byron for any closing remarks.

Thank you, all. I really appreciate you being here. Thank you for the questions. Stay tuned. We'll be transparent. We're hunkered down and we really appreciate all of you who are shareholders in the company. Thank you very much, and we'll look forward to chatting with you at our next call.

This concludes the Dynex Capital third quarter 2022 earnings conference call. Thank you for your participation. You may now disconnect.