Dynex Capital - Q1 2024

Transcript

Operator (participant)

My name is Jael and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Inc. First Quarter 2024 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, press the star one again. Thank you. I would now like to turn the conference over to Alison Griffin, Vice President of Investor Relations. You may begin.

Alison Griffin (VP of Investor Relations)

Good morning, and thank you for joining us for Dynex Capital's first quarter 2024 earnings call. The press release associated with today's call was issued and filed with the SEC this morning, April 22nd, 2024. 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, Chairman and Chief Executive Officer, Smriti Popenoe, President and Chief Investment Officer, and Rob Colligan, Executive Vice President, Chief Financial Officer. It is now my pleasure to turn the call over to Byron.

Byron Boston (Chairman and CEO)

Thank you, Alison. We delivered a solid 2.1% total economic return for the quarter, and as a company, we continue to execute on building our company with our long-term strategy and vision. Listed on the New York Stock Exchange in 1989, Dynex is the longest-tenured mortgage REIT. I joined the company in 2008 with a goal of developing a new strategic plan for growing Dynex Capital's balance sheet, paying a steady above-average dividend, and to protect our shareholders' capital over the long term. During this period, we have guided our shareholders through multiple extraordinary market cycles. We have consistently made the necessary decisions to adjust our people, processes, technology, and strategy to continue to perform in all future environments.

We have successfully refreshed the skill sets of our board of directors multiple times and focused on developing the talent of our team to reduce key person risk and to increase the probability that we continue to pay our dividend and deliver attractive returns. One of the strongest factors in our success is that we have always been guided by a core set of principles and values. Our goal is not to win at any cost, but we will do what is ethically correct to guide our shareholders through all market environments. Over the past eight years, global risks have continued to intensify, and the Dynex team is ready, disciplined, and well-prepared. I will now turn the call over to Rob and Smriti to further elaborate on our performance for the quarter and to further explain how we are positioned to continue to perform as the future unfolds.

Robert Colligan (EVP and CFO)

Thank you, Byron, and good morning to everyone joining the call this morning. Dynex delivered an economic return of 2.1% for the quarter, and book value ended the quarter at $13.20 per common share. The drop in the 10-Year Treasury that started last October began to reverse course as the expectations for federal funds rate cuts began to fade. While the 10-Year Treasury was up approximately 30 basis points from the end of the year, book value was essentially flat. This quarter, we raised $87 million of new capital, which was deployed in February and March when spreads were wider. The reduction of book value was about $0.07 in the quarter related to this capital raise. We had one other item affecting earnings this quarter. To comply with the accounting standards for share-based compensation, we had an accelerated vesting condition.

The impact of this acceleration compared to a standard vesting schedule reduced earnings by $0.05, and I expect this to recur annually in the first quarter of each year going forward. Beyond that, we delivered exactly what a mortgage REIT should deliver in a period that had lower volatility. We delivered a stable book value and a healthy dividend. We also announced the renewal of our stock buyback program, which allows us to buy up to $100 million of common stock and $50 million of preferred stock. Our previous program expired at the end of the quarter, and we need to always have a program in place to ensure that we can support the stock price and buy shares if or when our common or preferred shares price at an extreme discount. In the first quarter, Treasury futures remained our preferred hedging instrument.

Hedge gains and losses are a component of REIT taxable income and will be part of our distribution requirement with other ordinary gains and losses. This quarter, we realized the hedge loss, which reduced our aggregate gains, but we still have a large cumulative benefit for the portfolio.... Post quarter end, our hedges continued to perform well as rates continue their march upwards. In an inverted yield curve environment like we have now, we expect our hedges to have a positive carry, which will support earnings. Please see page 6 in the earnings release covering the hedge portfolio and Page 11 in the earnings presentation for more detail on this topic. With that, I'll now turn the call over to Smriti.

Smriti Popenoe (President and CIO)

Thank you, Rob, and good morning, everyone. The global economy continues to transition to the post-pandemic new normal. We have been planning for an evolving environment, bouts of volatility and periods of calm. In the near term, our risk management framework includes tail risks for modestly higher policy rates and much lower rates overall as well. We remain highly cognizant of geopolitical risks, especially elections here in the United States. We expressed our view last quarter about the unsustainable U.S. fiscal trajectory. This remains a factor in our rates positioning. Therefore, our investment and capital management strategy continues to be designed for a bumpy ride. We remain focused on high-quality, liquid Agency RMBS, which offer compelling long-term risk-adjusted returns. Our portfolio is positioned to meet our long-term target returns at today's spread levels. We see bouts of volatility as opportunities to add assets.

Spread tightening and eventual Fed eases are tailwinds and upside, but they are not necessary for us to generate returns. Agency MBS returns are attractive and accretive today versus our cost of capital. We expected volatility in economic data to be a major factor driving MBS spreads. So far this quarter, we have seen higher volatility versus last quarter, and as a result, our models have option-adjusted spreads approximately 15 basis points wider across our portfolio. We remain well off the wides of Agency MBS seen in November 2023 and October 2022. We feel the range of MBS spreads will be narrower going forward, as sponsorship for the sector has improved substantially since the fourth quarter 2023 with the return of banks. In addition, it is expected that the Fed will soon be announcing a reduction in the pace of its quantitative tightening campaign.

While this reduction may not impact MBS directly, any change which adds reserves to the banking system is yet another positive for the sector. We expect that short-term technicals of higher supply will push spreads wider, all else being equal, and this might be exacerbated by market volatility. Over the medium and long term, however, we continue to expect tighter equilibrium spreads for Agency MBS. In the absence of severe disruptions, we would regard any short-term widening as a dip buying opportunity. I'd like to cover our thoughts around capital raising in this environment. All our capital decision-making is driven by the same top-down, macroeconomic space thinking that drives our investment process. Our primary criterion when raising capital is whether we expect to earn a long-term investment return that meets or exceeds the long-term level of the dividend.

In today's investment environment, we believe there's a compelling opportunity to earn this type of return in Agency MBS. This is driven by the transition from the risk being housed on public balance sheets like the Fed to private capital like Dynex. In other words, we believe the total economic return from growing and scaling the business in a healthy investment environment exceeds the cost of capital, is accretive to shareholders, and lays the foundation for the market to put a higher valuation on our unique platform. As always, we stand ready to buy back the stock in extreme disruptions, and here again, we evaluate the marginal return on buybacks versus investments. Every decision has a long-term lens on it. Finally, we believe there are significant strategic benefits to growing the company. Building resilience and scale is an important strategic goal to ensure the longevity of our company.

Moreover, factors such as index inclusion can drive additional shareholder return and liquidity in the stock. Our view remains that today's spreads offer compelling returns, enhanced by tighter long-term equilibrium mortgage spreads. We remain focused on delivering long-term total economic return to our shareholders. I'll now turn it over to Byron.

Byron Boston (Chairman and CEO)

Thank you, Smriti. Our company is uniquely positioned for this environment. Today, we are generating income from a government-guaranteed asset class with flexibility and expertise to pivot across the credit spectrum. We have an experienced team with a stewardship mindset, a disciplined process, and a track record of excellence. Our actions are guided by a long-term strategic process that we believe will continue to drive shareholder value well into the future. We're growing our income-generating company as the demographic need for stable income is increasing due to the aging of global populations. In the U.S., the need for income is expected to rise as the baby boom generation moves through retirement. I just returned from an educational trip to China, Hong Kong, and South Korea, and observed similar trends in those countries. These demographics support the long-term value of the Dynex platform, providing further upside to shareholders....

I will be sharing more on this in a thought piece later this week. We thank you for your interest in Dynex and look forward to speaking with you again next quarter. I will now open it up for questions.

Operator (participant)

Thank you. The floor is now open for questions. If you have dialed in and would like to ask a question, please press star one on your telephone keypad to raise your hand to join the queue. If you would like to withdraw your question, simply press star one again. If you're called upon to ask your question and are listening via loudspeaker on your device, please pick up your handset and ensure that your phone is not on mute when asking your question. Your first question comes from the line of Bose George of KBW. Your line is open.

Bose George (Managing Director and Senior Equity Research Analyst)

Hey, guys, this is Bose. Good morning. Actually, for the first question, thanks for the update on spreads quarter to date. Could we also get an estimate of where your book value is?

Smriti Popenoe (President and CIO)

Yes. Good morning, Bose. So the book as of Friday, again, these are unaudited, not fully closed numbers, at $12.26. So that's down about 7%, and that's really commensurate with the 15 basis points of spread widening in OAS terms.

Bose George (Managing Director and Senior Equity Research Analyst)

Okay, great. That's helpful. Thanks. And then in terms of your current spreads, where would you estimate the current ROEs are? And you noted it's above your cost of capital. When you think about your cost of capital, is that essentially the common dividend, or how do you see your cost of capital?

Smriti Popenoe (President and CIO)

I'll answer the first question first. We're seeing marginal returns on Agency MBS, anywhere from 9% on the low end to 18% on the high end, so high double digits ROEs on the current coupon mortgages. The cost of capital is an interesting question. You know, we think of it in terms for common shareholders, obviously, it's the dividend yield. And on when we are thinking about optimizing sort of the balance sheet itself, it's a blend of the common, the preferred, and then any other financing vehicles we use, which is right now it's the repo market. So-

Bose George (Managing Director and Senior Equity Research Analyst)

Okay.

Smriti Popenoe (President and CIO)

We're really looking at a blended cost and again, a long-term level of the dividend when we think about the cost of capital.

Bose George (Managing Director and Senior Equity Research Analyst)

Okay, great. Thanks a lot.

Smriti Popenoe (President and CIO)

Sure.

Operator (participant)

Your next question comes from the line of Doug Harter of UBS. Your line is open.

Douglas Harter (Director and Senior Equity Research Analyst)

Thanks. Just first to clarify that book value update you gave, how does that treat the April dividend?

Smriti Popenoe (President and CIO)

That's net of the April dividend.

Douglas Harter (Director and Senior Equity Research Analyst)

Okay, great.

Smriti Popenoe (President and CIO)

That's-

Douglas Harter (Director and Senior Equity Research Analyst)

And then, you know, just more on the capital raising. You know, just, you know, you talked a little bit about the returns you're seeing and the cost of capital, but, you know, I guess just how do you think about what is an appropriate, you know, payback period or, you know, kind of just if you could just help us a little bit more, you know, kind of through the thought process of the attractiveness of, you know, kind of your decision process to-

Smriti Popenoe (President and CIO)

Yeah

Douglas Harter (Director and Senior Equity Research Analyst)

... to raise capital and deploy that. You know, and then just along those lines, you know, kind of how you think about is it total— is it just the return as of the spread you buy it at, or do you contemplate the potential for tightening, widening, and kind of how you think about the risk reward from that perspective as well?

Smriti Popenoe (President and CIO)

Absolutely. I'll just say, you know, right off the bat, we, we believe our company should eventually trade above book. The reason is that the value of the infrastructure we've created here at the company is not being reflected in the valuation. That's, that's number one. However, in the short term, we are raising capital because of the compelling returns and our long-term view of those returns. All right? In terms of, you know, what the payback period is and so on and so forth, when we are raising, as I mentioned in, in my prepared comments, we're really evaluating the long-term ROE versus the long-term level of the dividend. When that is accretive, it makes sense for us to raise. In our, in our theoretical process, we don't give ourselves credit for spread tightening.

Those payback periods, which can range anywhere from 1.5 years-2 years, become a matter of months when you include spread tightening. So for example, if you look on the page in the deck where we talk about our risk profile, a 10 basis points tightening in OAS is a 5% increase in book value, which is instantaneous, right? So once you factor in spread tightening, those time periods to earn back any kind of dilution become that much faster. But we're not counting on that, and that's really upside. Over the long term, if we expect, you know, spreads between the asset returns and the dividend yield to be accretive over time, that's good enough reason for us to raise. Does that answer your question, Doug?

Douglas Harter (Director and Senior Equity Research Analyst)

It does. You know, just I guess just along those lines-

Smriti Popenoe (President and CIO)

Yeah

Douglas Harter (Director and Senior Equity Research Analyst)

... you know, how are you thinking about the impact of, you know, kind of issuing below book to, you know, and kind of how that affects the trading in the short term and how that might impact your cost to capital? ... you know, and the ultimate goal that you, or belief that you articulated of getting back to trading at or above book?

Smriti Popenoe (President and CIO)

Yeah. I think, you know, it's very hard sometimes when you are in an environment like the one we are in, where mortgage spreads are really at the wider end of the range, and we're actually going, floating back and forth in that wide end of the range, it's very hard to quickly see the payback from these types of decisions, okay? So in the short term, I don't expect payback in the next 1 quarter or 2 quarters or 3 quarters. We're thinking about these decisions in terms of 6 quarters, 7 quarters, 9 quarters, 10 quarters. That's when you'll see the payback.

So I don't at the moment, right, the market isn't seeing or maybe investors aren't seeing necessarily the value of these things, but I can tell you, the moment we see a definitive trend tighter in mortgage spreads, you will see that payback, and at that point, I think it starts to become a cumulative and virtuous story. Right now, there's still a level of uncertainty in terms of not just the level of mortgage spreads, but the range of mortgage spreads, which, by the way, we believe is gonna be tighter over time, but even now versus last year, we expect mortgage spread volatility to be lower. But I think part of this is just investors need to see one or two quarters of that spread tightening come in to sort of buy into it.

So I understand why it's not being priced in right now. It doesn't deter us from wanting to make the right long-term decision for shareholders.

Byron Boston (Chairman and CEO)

Excellent, Smriti. The last point, Doug. Doug, remember, we manage for the long term, and that's—we've always done that. We always will do that. We think it's the best way to manage a mortgage REIT. Go ahead, Rob.

Robert Colligan (EVP and CFO)

Sure, Doug. Just one other point. We, as well as others in the space, have used the ATM programs. When you think about other capital markets alternatives, the ATM is right now the most efficient way for us to raise capital. So while it was at a small discount, the discounts would have been much larger in other forms of capital raising. So we're very cognizant of it. It's something that we focus on a lot. We don't want to be dilutive, but right now, the ATM program and what we were able to accomplish in the quarter was actually very efficient.

Douglas Harter (Director and Senior Equity Research Analyst)

I appreciate all those answers. Thank you.

Smriti Popenoe (President and CIO)

Thanks, Doug.

Operator (participant)

Your next question comes from the line of Matthew Erdner of JonesTrading. Your line is open.

Matthew Erdner (Director and Senior Equity Research Analyst)

Hey, good morning, guys. Thanks for taking the question. Could you talk a little bit about capital allocation and the thought on rotating into the TBAs?

Smriti Popenoe (President and CIO)

Yeah. Hi, Matt. So one of the core principles is to have a relatively balanced coupon profile. And in terms of just looking at our outlook for interest rates and interest rate volatility, we're about, I would say, 50/50, thereabout, in the higher coupons versus the lower coupons. So we were slightly underweight the higher coupons coming into the quarter relative to sort of like, I would really say, you know, the real deep discount mortgages. Higher coupons did underperform in the two episodes of spread widening that we saw in February and March, and so our allocation went to that part of the coupon stack.

Matthew Erdner (Director and Senior Equity Research Analyst)

Yeah, that's helpful. And then, if you're able to provide leverage quarter to date, and just your thoughts around, you know, how you're thinking about leverage, given the volatility that we've seen over the past couple of months.

Smriti Popenoe (President and CIO)

Yeah. I'll let Rob give you the exact change in leverage for the quarter. But in general, I would say that the amount of leverage that we have on right now is... we're comfortable with this level of leverage for this level of spreads and our view on markets. We have room to add leverage, and the capital raise in the first quarter allowed us to do that. So we think, you know, we can still take leverage up to the extent that we get opportunities to do that. And again, look, you know, this is the kind of market environment where you have to not only stand ready to take leverage up, but you've got to be ready to take it down because of just so many of these exogenous shocks.

Right now, our view is that mortgage spreads will really start to trade in a tighter range than how much they have the range that they've been in 2023 or 2022. That's predicated upon just banks coming back into the market, and there being a much stronger technical bid for mortgages. So, you know, the wides may not be as wide as 2022, 2023, and the tights may be a little bit tighter, so you're really getting a much tighter level of mortgage spreads to work with. And so that informs, you know, why the leverage is where it is today. Do we have a leverage up, though?

Robert Colligan (EVP and CFO)

Yeah, so leverage towards the end of last week was about 8.5, so up a little bit from the end of the quarter.

Matthew Erdner (Director and Senior Equity Research Analyst)

That's helpful-

Smriti Popenoe (President and CIO)

That really reflects the book value being down.

Matthew Erdner (Director and Senior Equity Research Analyst)

Okay, great. Thank you, guys.

Operator (participant)

Again, if you would like to ask a question, please press star one on your telephone keypad. Your next question comes from the line of Eric Hagen of BTIG. Your line is open.

Eric Hagen (Managing Director and Mortgage and Specialty Finance Analyst)

... Hey, thanks. Good morning, guys. Can you maybe elaborate on some of the tail risks that you see in the market right now? I think you mentioned something in your opening remarks. And in addition to that, maybe addressing some of the conditions which could drive, you know, more material tightening for spreads and what we might be looking out for there. Thank you, guys.

Smriti Popenoe (President and CIO)

Yeah. Thanks, Eric. Thanks for the question. Look, I think the markets are relatively unprepared for a tick-up in inflation, continuing strength in the U.S. economy or a stagflationary type of scenario that results in the Fed actually having to put hikes back on the table, but then the economy actually doesn't perform so well. So those are two things on the list where, you know, when you think of known unknowns, relative to unknown unknowns, that's a risk that we're taking very seriously here. We've always called this kind of an evolving macroeconomic environment, and it's doing exactly that. No one here at Dynex expected inflation to come down in a straight line. You know, you've seen some of our LinkedIn posts on the connection with volatility.

And that brings me to the second part of your question. You know, mortgage spreads are really very, very dependent here on macroeconomic volatility. The more volatile the macroeconomic data are, there's more delivered volatility. There's and therefore, implied volatilities go up. That affects mortgage valuations. Mortgages tend to widen in those environments, right? So anything that brings mortgage spread volatility and macro volatility down is very positive for mortgages. And, you know, we actually think that's within the realm of possibility. The trajectory from 7% inflation-3% inflation, now we're just talking about 3% inflation-2% inflation. The volatility of the data is much lower here. So you should see delivered vol start to come down, and that's very supportive for mortgage spreads.

The other part I would say is just the technicals are so much better, this go around. You know, we did have some spread widening here in April. It's been remarkably orderly. We have not seen a substantial amount of dash for cash, kind of, run for the hills, sell all, sell all the mortgages you own. That has not happened, even though we're seeing the same types of interest rates levels that we saw back in October, November of 2023. So that's actually a very encouraging prospect. And then finally, just in terms of any other things that would cause mortgages to tighten, I talked about the Fed tapering quantitative tightening. That, in and of itself, may not affect mortgages directly, but you've got to think on the margin, they're increasing bank reserves.

Banks have been actually investing more in securities rather than loans, and any time there's a bid for that duration or that risk-free asset, we think that's supportive of mortgage spreads as well.

Eric Hagen (Managing Director and Mortgage and Specialty Finance Analyst)

Thanks. That's really helpful. Maybe, you know, a follow-up on the spread conversation. I mean, you mentioned banks coming back into the market. I mean, how meaningful do you think pressure is in other asset classes that might drive that, like commercial real estate? And how do you even control for the actions of larger banks and their appetite for, you know, mortgages and duration?

Smriti Popenoe (President and CIO)

Look, I think the larger banks never actually left the market. They're on the margin, their bid drives a lot of what's going on. In the first quarter, interestingly, it's actually been not the larger banks, it's been the middle-tier banks and smaller banks that have wanted to buy CMO floaters. That's been the marginal driver of mortgage activity in the first quarter. So, you know, if to the extent that you get the larger banks stepping back up in terms of the level of purchases, I mean, that's a massive tailwind for mortgage spreads, but I don't think that we've actually seen that just yet.

Eric Hagen (Managing Director and Mortgage and Specialty Finance Analyst)

Got it. Thank you, guys, so much.

Smriti Popenoe (President and CIO)

Thank you.

Operator (participant)

That concludes our Q&A session. I will now turn the conference back over to Byron Boston for closing remarks.

Byron Boston (Chairman and CEO)

Simply put, we thank you all for joining us today. We want to remind you that we have a very long-term strategy, and we're always thinking forward, as Smriti has explained. So thank you again for joining us today, and we look forward to chatting with you again, next quarter.

Operator (participant)

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