Q1 2024 Dynex Capital Inc Earnings Call

Participants

Alison Griffin; VP - IR; Dynex Capital Inc

Byron Boston; Chairman of the Board & CEO; Dynex Capital Inc

Rob Colligan; CFO, EVP, & Secretary; Dynex Capital Inc

Smriti Popenoe; President, Co-Chief Investment Officer, & Director; Dynex Capital Inc

George Bose; Analyst; Keefe, Bruyette & Woods, Inc.

Doug Arthur; Analyst; UBS Group AG

Matthew Erdner; Analyst; JonesTrading Institutional Services LLC

Eric Hagen; Analyst; BTIG, LLC

Presentation

Operator

Thank you for standing by. My name is Jay, 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. (Operator Instructions)
I would now like to turn the conference over to Alison Griffin, Vice President of Investor Relations. You may begin.

Alison Griffin

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 from the homepage of the Dynex website at Dynex Capital.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 the webcast link on the homepage of our website.
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; Rob Colligan, Executive Vice President, Chief Financial Officer. It is now my pleasure to turn the call over to Byron.

Byron Boston

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 has the longest tenured mortgage Re. I joined the Company in 2008 with a goal of developing a new strategic plan for growing Dynex Capital 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 and people processes, technology and strategy to continue to perform in all future environments. We have successfully refreshed the skill set 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 from 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 community to further elaborate on our performance over the quarter and to further explain how we are positioned to continue to perform as the future unfolds.

Rob Colligan

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. So 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, 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 expect this to recur annually in the first quarter of each year.
Going forward. And beyond that, we delivered exactly what a mortgage rate 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 are common or preferred shares price at an extreme discount in the first quarter, Treasury featured remained our preferred hedging instruments. Hedge gains and losses are a component of re-taxable income and will be part of our distribution requirement with other ordinary gains and losses. This quarter, we realized a 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 upward 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 from 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

Thank you, Rob, and good morning, everyone. A 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 from 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 our 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 winds of agency MBS seen in November 2023 and October 2022. We feel the range of MBS spreads will be narrower going forward. Sponsorship for the sector has improved substantially since the fourth quarter of 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. And 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 a 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 defining 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 business 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 a 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

Thank you. financing 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 population 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 I 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.

Question and Answer Session

Operator

(Operator Instructions) George Bose, KBW.

George Bose

Again. This is both Good morning and thank you for the first question and thanks for the update on spreads quarter to date, can we also get an estimate of where your book value is?

Smriti Popenoe

Yes, good morning, Bose. So the book as of Friday, again, these are unaudited are not totally 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 oil terms.
Okay, great. That's helpful.

George Bose

Thanks. And then in terms of your just the current spreads and 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

Tom, I'll answer the first question first. We are seeing marginal returns on agency MBS anywhere from Com, 9% on the low end on to 18% on the high end. So high double digit ROEs on the on the current coupon mortgages on the cost of capital is an interesting question. We think of it in terms for common shareholders. Obviously, it's the dividend yield on and on 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 which is right now, it's the repo market. So we're really looking at a blended cost. And again, on a long-term level of the dividend when we think about the cost of capital.

George Bose

Okay, great. Thanks a lot.

Operator

Doug Arthur, UBS.

Doug Arthur

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

Smriti Popenoe

That's net of the April dividend.

Doug Arthur

Okay. Great. And then just more on the capital raising. Just I know you talked a little bit about the returns you're seeing in the cost of capital. But I guess just how do you think about what is an appropriate or payback period or kind of just if you could just help us a little bit more kind of through the thought process of the attractiveness of ARM and kind of your decision process to try to raise capital and deploy that? And then just along those lines from kind of how you think about it total, is it just the return as of the spread you buy it at? Or do you contemplate the potential for for tightening widening and kind of how you think about the risk reward from that perspective as well?

Smriti Popenoe

Absolutely. So on, I'll just say, you know right off the bat. We believe our company should eventually trade above book on 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 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 on in terms of, you know what the payback period is and so on and so forth, when we are raising, as I mentioned 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 and those payback periods which can range anywhere from 1.5 to 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 on a 10 basis points tightening. And OES. is a 5% increase in book value, which is which is instantaneous, right? So so once you factor in spread tightening those time periods to earn back any kind of dilution becomes that much faster. But we're not counting on that. And that's really upside over the long term if we expect spreads between the asset returns and the dividend yield to be accretive over time. That's a good enough reason for us to to raise. Does that answer your question, Doug?

Doug Arthur

It does. I'm just I guess just along those lines, how are you thinking about the impact of kind of issuing below book to now and kind of how that affects that trading in the short term and how that might impact your cost to capital some in the ultimate goal that you or belief that you articulated of getting back to trading at or above book?

Smriti Popenoe

Yes, I think I think it's very hard. And sometimes when you are in an environment like that one, we are in where mortgage spreads, it will be 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 one or two or three quarters. We're thinking about these decisions in terms of six, seven, nine, 10 quarters, and that's when you'll see the payback. So at the moment, right, the market isn't seeing or that or maybe investors aren't seeing necessarily the value of leasing. 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 going to be tighter over time. But even 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 just sort of buy into it. So I understand why why it's not being priced in right now. It doesn't deter us from wanting to come wanting to make the right long-term decision for shareholders.

Byron Boston

Excellent, Smriti. That last point, Doug, remember, we manage for the long-term and that we've always done that. We always will do that we think is the best way to manage a mortgage rate grade.

Rob Colligan

Rob shared data just one other point as well as others in this 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 discount would have been much larger than other forms of capital raising. So we're very cognizant of it is something that we focus on a lot. We don't want to be dilutive but right now, the ATM program and what we're able to accomplish in the quarter was actually very efficient.

Doug Arthur

Appreciate all those answers. Thank you.

Smriti Popenoe

Thanks, Doug.

Operator

Matthew Erdner, JonesTrading

Matthew Erdner

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

Yes. So one of the core principles is to have a relatively balanced coupon profile in terms of just looking at our outlook for interest rates and interest rate volatility. And we're about, I would say, 50 50 or 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 say that will deep discount on mortgages and higher coupons did underperform in the two episodes of spread widening that we saw in February and March. And so our allocation in that part of the coupons.

Rob Colligan

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

Smriti Popenoe

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 that we're comfortable with this level of leverage for this level of spreads and our view on market penetration, we have we have room to add leverage, then the capital raise in the first quarter allowed us to do that. So we think we can still take leverage up to the extent that we get opportunities to do that and again, look into 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 they how much they have on the way 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 the wides may not be as wide as as 22, 23 and the types may be a little bit tighter. So you're really getting on a much tighter level of mortgage spreads to to work with. And so that informs, you know why the leverage is where it is today. Do we have a level of leverage?

Rob Colligan

Sort of the end of the last week was about 8.5. So up a little bit from the end of the quarter and reflects the book value being down.

Matthew Erdner

Okay, great. Thank you, guys.

Operator

(Operator Instructions) Eric Hagen, BTIG.

Eric Hagen

Thanks. Good morning, guys. Can you maybe elaborate on some of the tail risk 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 with which could drive you to a more material tightening for spreads and what we will we might be looking out for there. Thank you, guys.

Smriti Popenoe

Yes, thanks. And thanks for the question. Look, I think I think the markets are relatively unprepared for a tick-up in inflation on the continuing strength in the US economy for a stagflation rate 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 unknown known unknowns relative to unknown unknowns on that, that's a that's a that's a risk that we're taking very seriously here. And we've always called this kind of an evolving macroeconomic environment, and it's doing exactly that, no one on here at Dynex expected inflation to come down in a straight line. You've seen some of Arlington post on on the connection with volatility.
And that brings me to the second part of your question. If mortgage spreads are are really very, very dependent here on macroeconomic volatility the more volatile, the macroeconomic data are and there's more delivered volatility. There's there's and therefore, that implicitly implied volatilities go up, that affects mortgage valuations. Mortgages tend to widen in those environments, right? So anything that brings mortgage volume and mortgage spread volatility and macro volatility down is very positive for mortgages. And we actually think that's not that's within the realm of possibility that the trajectory from 7% inflation to 3% inflation. Now we're just talking about 3% inflation to 2% inflation that 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 I'm just the technicals are so much better on this this go around. 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. So some of 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 23. So that's actually a very encouraging prospect.
And then finally, just dumb in terms of any other things that would that would cause mortgages to tighten and 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

Thanks That's really helpful. And maybe 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? And in other asset classes that might drive a commercial real estate. How do you even control for the actions of larger banks and their appetite for mortgages in duration?

Smriti Popenoe

But I think the larger banks never actually left the market that they 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, and that's been the marginal driver of mortgage activity in the first quarter. So on it to the extent that you get the larger banks stepping back up in terms of the level of purchases, I mean, that's a that's a massive tailwind for mortgage spreads, but I don't think that we've actually seen that just.

Eric Hagen

Yes. Got it. Thank you, guys, so much.

Smriti Popenoe

Thank you.

Operator

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

Byron Boston

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 Verity has explained. So thank you again for joining us today, and we look forward to chatting with you again next quarter.

Operator

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