Dynex Capital Inc
NYSE:DX
Earnings Call Analysis
Q4-2023 Analysis
Dynex Capital Inc
Dynex Capital has demonstrated resilience, managing to navigate through unprecedented market fluctuations and historical events such as a banking crisis and regional warfare in the Middle East. With a strategic implementation of excess capital from the previous year, the firm has positioned itself to leverage spread tightening in mortgage-backed securities (MBS), achieving a remarkable 12% total shareholder return in the past year. This performance outpaces the negative returns seen in broader bond market indices.
In a display of confidence about the current market conditions for Agency MBS, Dynex has underlined the historic opportunities for private capital in this asset class, as non-economic buyers recede. These securities are expected to yield high returns between high teens to low twenties percentages, especially when considering the potential for spread tightening. With a current dividend yield margin around 12%, these investments are seen as particularly attractive.
Dynex indicated the flexibility of its approach towards leverage, suggesting that it is prepared to temporarily raise leverage when beneficial and then backfill it with capital later. This strategic adaptability shows a commitment to judicious financial management and a readiness to take advantage of market opportunities to support growth.
Analysts at Dynex anticipate equilibrium spreads to come in the range of 100 to 140 basis points over the 7-year Treasury, compared to the current 140 to 190 basis points, suggesting a favorable environment for mortgage spreads. This potential narrowing, combined with the bank's re-entry into the market and an active CMO market, offers a supportive backdrop for the firm's investment thesis.
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Hello, and thank you for standing by. My name is Regina, and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Fourth Quarter and Full Year 2023 Earnings Results Conference Call. [Operator Instructions]
I would now like to turn the conference over to Alison Griffin, Vice President of Investor Relations. Please go ahead.
Good morning. Thank you for joining us for Dynex Capital's Fourth Quarter and Full Year 2023 Earnings Call. The press release associated with today's call was issued and filed with the SEC this morning, January 29, 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.
Thank you, Alison. Let me start by saying a few words about our Board member, friend and great teammate, Dave Stevens, who we lost this month. Dave was a true champion of the United States housing finance system and also the American homeowner.
For me personally, we worked together for over 20 years, 3 organizations, always locking arms to achieve a common goal. It never feels good to see a friend exit the road of lights. We will miss Dave, a great teammate, friend and most importantly, an absolutely wonderful human being.
While that was tough news to contend with earlier this year, I am proud of the remarkable work that Team Dynex continues to achieve. As an active manager, our team navigated historic volatility with scale. We came into the year with excess capital and deploy the capital in a disciplined manner throughout the year to position us to generate solid long-term economic returns.
As a result, Dynex shareholders have enjoyed industry-leading returns in the current decade. One full of surprises and immense volatility.
Our total shareholder return was 12% last year. Since the start of 2020 through the fourth quarter of 2023, our total shareholder return has been over 10%. This compares to the aggregate bond index ETF, which experienced losses of over 3%. We believe our ethical stewardship of shareholder capital continues to meet investors' needs, and produced differentiated results versus peers and other income alternatives.
I study history, and I can tell you that today's market presents a historic and persistent opportunity in agency mortgage-backed securities. Noneconomic buyers like the Fed and the GSEs have stepped away from the asset class. Private capital, like Dynex, now has the ability to earn more returns in this government guaranteed asset. I'm confident in our team's ability to navigate today's dynamic macroeconomic conditions and produce compelling shareholder returns. I am coaching them to incorporate the evolving landscape in 2024.
We have major elections throughout the world, including here in the U.S. As the Chairman and CEO, I am focused on navigating our company through gyrations and government policies. The outcome of elections will change the power structure and political dynamics in Washington. I've been pounding on the table that surprises are highly probable. We have seen that very clearly each year since the pandemic. The team factors this into their scenario preparation and thought process. This is why we believe investing in Agency RMBS is the most compelling risk reward. The liquidity and quality and Agency MBS are needed to navigate this environment.
As Smriti will describe in detail, the sector's fundamental and technical backdrop is improving. While we have the capability to invest across sectors and our balance sheet has been diversified in the past, we have a strong global risk opinion that keeps the bulk of our capital in Agency MBS.
Dynex has a unique value proposition. We have a seasoned team, a strong track record in extracting long-term returns from the mortgage market and a liquid and tradable vehicle with a tax advantage structure. We plan to continue to grow our business to offer our value proposition to more shareholders, as demographics drive more investors to seek income. More of the global population will need an ethical management team to deliver the returns they need.
I'll now turn it over to Rob and Smriti to give you the details.
Thank you, Byron, and good morning. Dynex delivered a solid quarter, with an economic return of 11.8% and 1% for the entire year, and total shareholder return was 12% for 2023.
Over the year, we added to our portfolio, manage our hedge book and raise new capital.
Last year was another historic year for bond markets. We experienced the highest yield since 2007, a major banking crisis and continued geopolitical unrest, with a major new war in the Middle East. Against this backdrop, we started the year with leverage of 6.1 turns and assets of $5.9 billion, as well as excess capital from our capital raising activities in 2022. We had an explicit strategy of holding higher levels of liquidity versus capital and borrowings.
Spreads widened dramatically several times during the year, driven by the failure of Silicon Valley Bank and other financial institutions in the first quarter, the debt selling crisis in the second quarter, portfolio sales of Agency RMBS by the FDIC, which lasted through the third quarter and macro volatility in October and November. As volatility increased and spreads widen, we opportunistically added to our portfolio, methodically increasing our portfolio from $5.9 billion to $7.4 billion.
In addition, as pricing between TBAs and mortgage pools collapsed from the FDIC sales, we took the opportunity to rotate our portfolio from about 50% pools and 50% TBAs, to 80% pools and 20% TBAs going into year-end. This improves our convexity profile and helped us lock in attractive yields on higher coupon specified pools. Last year, we increased our marketing and investor relations outreach and selectively raised capital throughout the year at a modestly accretive price-to-book ratio, which we also deployed during periods of wider spreads. We expect to continue our marketing and investor outreach efforts in 2024.
Our decision to opportunistically add to the portfolio throughout 2023 and maintain our invested position in the fourth quarter was a very clear benefit to book value, which increased over 20% from the lows we discussed on our last quarterly earnings call. Given the volatility experienced throughout the year and especially in the fourth quarter, we maintained our hedge portfolio and positioned for a steeper yield curve environment. The portfolio hedge cost was recognized immediately in book value, although we expect to receive a benefit of lower financing costs in the future, as is currently priced into the market.
As I've mentioned on previous earnings calls on the topic of hedging, hedge gains and losses are a component of REIT taxable income. That will be part of our distribution requirement with other ordinary gains and losses. This quarter, we added to our realized hedge gains and will carry a benefit into 2024 in future years. As we move into 2024, we expect the hedge gains will support earnings. Please see the table on Page 6 in the earnings release for more detail.
Finally, as you'll notice, we reduced our G&A expenses this year by actively focusing on expense management. I'll now turn the call over to Smriti.
Thank you, Rob, and good morning, everyone. I'll begin with a brief discussion of the critical decisions made in 2023 before providing thoughts on the investment environment and outlook. As Rob mentioned, we executed our strategy of adding to our portfolio at wider spreads throughout 2023. Post the SMB prices, during the debt ceiling crisis, over the summer as the FDIC executed pool sales and most importantly, we held our positions through the volatility in late October. Overall, we grew our exposure to Agency RMBS over the year by 30%, increasing our leverage to common by the same proportion. Our investment team as precise a great deal of patience and discipline. During the October volatility, we leaned into our liquidity and risk management to pull us through instead of selling assets at losses as many others were compelled to do. These decisions position shareholders to capture significant upside returns from tightening Agency MBS spreads to treasuries.
Turning to the macro environment. We continue to construct our strategy for an environment with widely distributed outcomes. The markets are focused on the Fed's monetary policy and the potential for substantially lower policy rates as realized inflation falls towards the Fed's 2% target. Currently, the markets are pricing in 150 basis points of rate cuts in 2024. These would have a direct and very positive impact on our future financing costs, as we carry about $7 billion in financing relative to about $4 billion in long-term hedges. For every 25 basis points of realized lower financing costs, our total economic return improved by 2%, all else being equal.
In addition to substantial benefits to financing costs, we believe the eventual lowering of rates would result in nominal Agency MBS spread tightening to longer-term equilibrium levels between 100 and 140 basis points over the 7-year treasury yield. We have already seen the reentry of banks into the sector in the fourth quarter, and we expect our participation to increase, as regulatory uncertainty from the Basel to the end being rolled and the path of Fed policy rates are clarified.
To the extent this scenario materializes, we believe any decline in realized volatility, which we are already experiencing in 2024 would also provide the impetus for tighter MBS spreads. While we believe these factors position us to capture significant upside in the medium term, we remain very respectful of the significantly different global environment that we operate in. We base our long-term economic view on the interaction between rising human conflicts, changing demographics, a rapidly evolving technological landscape, including the deployment of AI, rising global debt levels and unsustainable fiscal dynamics in the U.S. and major developed economies.
In our view, the geopolitical world order has permanently shifted to alter the structural economic setup for the coming decades. Nationalism, protectionism and regional conflicts contribute to rising friction costs. Concept driven supply shocks can translate to higher volatility, impacting inflation and interest rates. As aging populations demand more health care and the time of support, cost to provide those services are rising. This is manifesting as a massive budget gap in the U.S. We view the widening U.S. fiscal gap at a significant factor in driving the level of yields and value of the U.S. dollar over the next 2 to 5 years.
The U.S. economy also remains exposed to significant policy risk in the upcoming election year and beyond. We're also watching for known unknowns in China, Japan and Europe as these economies evolve and their government policy response. As always, we plan for alternative scenarios and exogenous shock and remain open to adjusting our strategy. The broader factors I've just described continue to support the majority of our capital being invested in Agency RMBS, which offer a historically accretive investment opportunity. We believe MBS will perform well in a soft landing, outperform risky assets in a hard landing. We expect equilibrium spreads to be in a tighter lower range, further supporting new terms.
Finally, I want to acknowledge the loss of an avid supporter of Dynex and fellow Board member, Dave Stevens. I will miss him, and he will be missed by all of us at the company.
I will now turn it over to Byron for his final comments.
Thank you, Smriti. I'd like to leave you with the following thoughts. The investment opportunity in Agency RMBS is historic, and Dynex is uniquely positioned to take advantage of it, with our experience and focus on risk management. Our investments last year put us in excellent position to generate solid returns in the coming years.
I'm also excited to promote greater collaboration between our executive leadership team and the Board in my new role as Board Chairman. Alongside Dr. Julia Coronado, our Lead Independent Director, and other Board members, we will work closely together to strategically manage our business and shareholders' capital with consideration of the evolving macroeconomic environment.
While visibility is limited to the very near-term, we consider multiple exogenous factors that can widen the distribution of outcomes. Book value preservation is a focus of how the team will generate total economic return. Importantly, ethical stewardship remains at the core of everything we do.
Thank you for your support, and we look forward to discussing our results with you next quarter.
I'll now turn the call over to you, operator, for questions.
[Operator Instructions] Our first question will come from the line of Trevor Cranston with JMP Securities.
Looking at the rate positioning slide as of 12/31, it looks like you guys were set up to generally do better if rates move higher, particularly at the longer end of the yield curve. And that's obviously come to pass so far as we sit in January today. So I was wondering if you could maybe sort of update us as we sit today, kind of on your rate positioning and your view on the upgrade risk versus downgrade risk where we sit today.
Trevor, thank you for the question. So yes, you're right. The hedges are contemplated in the back end of the yield curve, and we are positioned to benefit from a steepening yield curve, where front end rates go down, and back end rates either remain the same or go higher. So a lot of this is driven by the macroeconomic view that we described during the prepared remarks. And really recognizing that while we may have some level of market pricing in the front end, as I mentioned, there's 150 basis points of cuts already priced in to the front end, the yield curve, which will really benefit our financing costs. In the long-term, we feel like it makes more sense, given a number of other factors that have hedges concentrated in the back end of the curve.
So in general, we're positioned actually to benefit from a steeper yield curve, and that's what's reflected in the hedge positioning.
And then just in terms of just an update from year-end, I believe the book value is up about 1% or so to [ $13.50 ] area.
Got it. Okay. That's very helpful. And then as you look across the portfolio, particularly in the higher coupon exposures. If we were to get a rally in rates from here, say, down another 50 basis points or something, can you talk about what kind of prepay response you'd expect, like, for example, in 5.5% and what kind of protection you have on those pools?
Yes, absolutely. Yes. One of the big things we did last year was rotated into higher coupon specified pools, and there was a pretty significant collapse in those pay-ups over the summer. So we have gone into prepayment-protected pools in those coupons.
Having said that, right? If you get a serious rally back down to where mortgage rates are down to 4% or lower, a lot of that protection will be compromised, just simply because these will be -- there'll be new lows in mortgage rates then it would be -- we'd expect to see a pretty fast speeds.
Given the primary rate that would really create a lot of prepayment risk in the 5.5% is anything below 6.5%. So that's what you'd have to go through in order to really create a big prepayment response.
We still think that the convexity protection that we have is real and we'd have a benefit from it. The reason we've stayed in the low pay-up specified pool is that, to the extent that you don't see it, right? We would not have lost a significant amount of pay up. And in general, diversified coupon positioning, you can see that we actually have less of the 5.5% and 6% coupons than we do of the lower coupon, is because we're expecting the fact that quick drop down in rates could create a pretty significant response in those coupons.
Got it. Makes sense.
Your next question comes from the line of Doug Harter with UBS.
You talked about the kind of the ongoing attractiveness of the agency market. Do you envision yourselves raising additional capital to try to take advantage of it, could leverage move higher? Just how are you thinking about possibly expanding the portfolio in this environment?
Doug, thank you for the question. Look, I think Byron mentioned that this is a historic opportunity, and it's a persistent opportunity. We remain in that environment. And so to benefit our shareholders in this kind of investing environment, it makes a lot of sense for us to raise of deploy capital.
So that was our strategy. At the end of '22, we -- we had -- I think in '22, we raised over $250 million in capital. That capital got invested in '23. We raised a little bit more in '23. I think that continues. The raising and deploying when you have accretive investment opportunities is a good strategy in the long-term for our shareholders. We're going to continue to do that.
I think to the extent that environment continues, we will keep doing. The returns are still in the mid-teens ROE. So we feel very good about that right now.
And can you just remind us how you think about -- when you say accretive, how you think about that? Is that accretive to book? Is that accretive to returns, and kind of the thought process you go through before deciding to raise capital?
Absolutely. I mean we think about everything you described. One is what is the immediate price-to-book impact of any kind of capital raising. We think about mostly, the long-term return potential in the capital invested relative to the cost of capital, right?
Right now, you're able to earn a double-digit return from the carried on mortgages relative to hedges, without incorporating any kind of spread tightening. So when you add the spread tightening potential into the future, you're really looking at high teens low 20s long-term returns. So we view those types of returns in the context of our marginal dividend yield being in the 12%. These are great investments. So that's kind of how we think about it.
In the long-term, will our shareholders benefit from this raise us raising and deploying capital. And we believe the answer is yes. And in that case, we're making the decision to raise and [indiscernible].
Just to add a little color to that. You also asked about leverage. We do have the ability, if we see an opportunity, to take leverage up and then add to our capital base at a different time. I do think the market, given our performance, will give us opportunities to raise and grow.
But sometimes it's not exactly the right timing, right? Over time, our price to book has gotten smaller. That gap has gotten smaller. The market's understanding our performance. We will have the ability to grow. But if it's not exactly at the right time, will temporarily take leverage up and backfill it with capital and be very judicious about that throughout the year and going forward.
Your next question will come from the line of Bose George with KBW.
I just wanted to ask about hedging, just with the rotation more into pools versus TBAs. Does that change anything in terms of how you view the use of treasuries versus swaps? Or are you just thoughts on that?
Bose, not really. We still see the capital cost of using interest rate swaps to be about twice as much as [indiscernible] future.
On a capital-adjusted basis, there was a really expensive hedges and they limit flexibility in times of stress. So our macro view really drive the selection of the hedges.
Having us be in pools really doesn't make a difference. Yes, you have a different type of financing that you're hedging in the repo markets relative to [indiscernible] but we still feel like we're in the right hedge structure.
Okay. Great. And then Smriti, you mentioned the benefit of rates going down to your spread. Can you just go over that again? And is that a benefit to the economic return or to GAAP EPS? Or yes, just kind of a little more detail on that would be great.
Yes. The long-term, so you know how we think in total economic return curve, right? And if you want to decompose that, it's really, we think, in terms of like the benefits of the financing cost. So all of the equal, if the financing costs go down by 25 basis points and nothing else changes, you say the shape or the yield curve doesn't change our investment mix slightly change.
The positive benefit would be 2% in economic return. So you could just think of just financing costs going down is about 2% on the total economic return.
Okay. Great. And then just one last one. Just what are your expectations just for longer-term mortgage spreads? You talked about spread tightening, just thoughts on where it goes and sort of the cadence?
Yes. Look, I think there's something very important happened in the fourth quarter, right? The Fed stance on monetary policy changed in December, maybe call it a pivot. But once that happens, stocks, corporate bonds and Agency MBS, they all benefit from that change in stance. So that's the first one, right?
Last year, banks were a net seller. They sold about 250 billion in mortgages. The Fed net sold about 300 billion in mortgages. All of that is shifting because if the Fed not goes from being a tightening stance to a neutral stance and potentially even an easing stance, you have the possibility of banks starting to come back in, right?
That's already happened. If you look at BofA's results this past quarter, they were a net buyer of about $17 billion in mortgages. All of that kind of shifts the technical within the mortgage market, right?
And then we've also seen housing activity in terms of turnover. It's starting to pick back up again. We've seen that in the existing home sales numbers, the turnover activity is starting to rise again.
All of this to us points to equilibrium spreads more in sort of like the 100 to 140 basis point range over the 7-year treasury, relative to the 140 to 190 that we're sitting in right now.
Now is it going to happen today, tomorrow? And this all could happen, right? If you get a decline internal yields because the Fed is using all of that. So we're not saying it will happen. We're saying there's a real possibility that it could happen. Those factors in play now, where the fundamentals and technicals have shifted.
So the range of spread is actually lower, if you will, in the sense that instead of being from 140 to 190, maybe we're sitting in the 120 to 160 kind of range. So that's kind of how we're thinking about it. But in the long-term, as banks come back in, the CMO market gets active, the curve steepens, all of these things are supportive of tighter and lower spreads on an equilibrium basis.
Your next question comes from the line of Matthew Erdner with Jones Trading.
Can you talk about the relative attractiveness of TBAs versus cash at the moment? And looking at the balance sheet, you guys have a lower cash position since 2020. So can you talk about that and just where you've been deploying that across the coupon stack?
Yes. I think -- so our TBAs versus pools, the relative attractiveness?
Yes.
Okay. So right now, I would say, it's the story in TBAs depends on the coupon. The higher coupons are still financing at a level that is lower than -- actually, no, the higher coupons are financing at a rate that is about equal or slightly higher than pools. In the value coupons, like the 4%, 4.5%. Those are actually trading very special relative to pools. So it actually behooves you to have a TBA position in those coupon.
In the lowest coupons, it's actually very difficult to figure out, just because there's no production in the 2%, 2.5%, et cetera. So that just depends on what's happening in the lowest coupon.
But right now, the specialness in the role is actually limited to the 4% coupon and the 4.5% coupon. Everything else is either trading on top of pools or slightly above pool.
And in terms of cash versus unencumbered asset, I think that was your other question. We've continued to keep a fairly big allocation to our liquidity position, and Rob can give you the exact number of what we closed the year at. But what -- cash earned close to 5.5% here.
So that's not as big a drag on earnings as it was when if wait for [ deal ] which, at that point, you would be more inclined to hold pools or assets that yielded higher. So at this point, with cash rates so high, we don't hesitate to hold cash, if that was really your question was going.
Yes, that's helpful. And then talking about the supply and demand technicals, with the Fed kind of getting towards the end of Q2, do you guys have an opinion on -- if the Fed gets back in the market and when that might occur?
Look, we can really go by what the Fed is communicating -- or has communicated with respect to QT. Lorie Logan gave a speech in January that I think is what kept a lot of us [indiscernible]. From what we can tell, they're interested in being quantitative tightening based on what they call the least comfortable level of reserves, right?
The biggest part of QT, you really need to think about it is that there's -- it puts a floor on QT and put the floor -- unlock the thing that put the floor on the amount of duration coming into the market. And that in and of itself, I think, is very supportive for mortgage spreads.
Even if they reinvest only in treasuries, it takes out a yielding asset out of the market. It creates crowding out of private capital, and that creates a demand for safe securities. And that's, I think, very supportive.
The other possible outcome of the end of QT is that delivered volatility goes down, because the Fed's back in buying securities in the market, that's also really supportive of mortgage spreads. And that -- those are the things that I think just add to the idea that there's been a shift in the technicals in the mortgage market.
That's helpful.
[Operator Instructions] And your next question will come from the line of Eric Hagen with BTIG.
Do you guys feel like there's good liquidity in the funding market to put on longer dated repo right now to take advantage of what's priced into the forward curve? And what's the shortest that you can envision running the repo book if -- conviction builds around the Fed cutting maybe sooner rather than later?
Thank you for the question. So really, the way we think about financing. Number one, I'll tell you, availability of financing is not an issue. We continue to have counterparties offer us financing. We're able to fund out the term. I think we reported our weighted average term to maturity -- original term to maturity is like 78 days. So we're not having any trouble running longer-dated financing, anything like that.
So availability has been just fine. There's been pressure around quarter end, as you've seen, right? Like since September, there was a little pressure, December, there was a little pressure. So in general, we try to manage around those by funding out term. So that hasn't been a problem for us.
So yes, there is the ability to lock in financing to the extent that we want and we disagree with the market's pricing, et cetera, et cetera.
You've seen us manage this book for a long time, Eric. And we're always balancing 2 things. One is whether there will be quarter-end pressure and balance sheet pressure or event-driven pressure, versus the risk of kind of running an overnight/shorter maturity book.
And we currently land somewhere in the middle. Some of our financing is going to be locked up and terms. Some of it is going to be not locked up and maybe rolling a little sooner.
Typically, we have not been an overnight thunder, and we very rarely taken our financing lower than 30 days out. So we are looking to take term at opportunistic levels when we see that in the marketplace.
In general, we tend to be more focused on avoiding funding disruptions than kind of trying to make money off the financing book. It's a risk that we just don't feel like it's good for us to expose our shareholders, too. So we end up actually just really respecting where we get our financing and making sure that it's locked up before we -- if there's any kind of economic return benefit that we can get from thinking about the Fed expectations versus not, we would be using hedges to help us take advantage of that.
Yes. I appreciate that response. We're still a full year away, actually, a little bit more than a full year, but how are we thinking about the fixed to floating rate preferred stock rolling into the floating lag next year and maybe how you think about the cost of the capital structure overall, if spreads are tighter or wider and what the Fed is going to do?
Yes. I mean, don't forget, a big part of that, if not all of it, is part of the hedging that we do on the liability side, right? So from an economic perspective, we feel really good about the fact that entire issue is hedged with our features position.
In general, so again, it's going to be a question of what are the available opportunities, where can we refinance should we want to. We'll go through the exact thought process as we approach the call date.
Yes. Appreciate it.
We have no further questions at this time. I'll turn the call back to Byron Boston for any closing remarks.
Thank you very much for joining our call today. Just remember, we have a long-term view, skilled risk management, disciplined allocation of capital, a very experienced team, and most of all, we take a very ethical approach as to how we manage our business.
So thank you for joining us, and we look forward to speaking to you again next quarter. Thank you.
That will conclude today's meeting. Thank you all for joining, and you may now disconnect.