Tom Akin – Chairman & Chief Executive Officer
Byron Boston – President & Chief Investment Officer
Alison Griffin – Vice President, Investor Relations
Trevor Cranston – JMP Securities
Steve Delaney – JMP Securities
Dynex Capital Inc. (DX) 2013 JMP Financial Services and Real Estate Conference Call October 1, 2013 11:30 AM ET
Trevor Cranston – JMP Securities
Okay, so it’s time to get started with the next presentation. I’m Trevor Cranston. I cover mortgage finance stocks for JMP along with Steve Delaney. The next presenting company this morning is Dynex Capital, ticker DX.
Dynex is actually one of the oldest mortgage REITs in the entire universe; it’s also one of the more diversified companies that we cover. The other main point of distinction for us is that they’re an internally-managed company which differentiates them among the peer group now. The company invests in both residential and commercial mortgage-backed securities with a focus on low duration and high credit quality investments. They recently declared a $0.27 dividend for Q3 which gives the stock about a 12.5% yield and they have a market cap of just under $500 million currently.
Presenting for the company today, we have the CEO Tom Akin and the CIO Byron Boston. Also with the company in investor relations we have Alison Griffin sitting up front here. So with that I’ll turn it over to Tom to start off.
Thanks Trevor, and thanks everybody for coming in. I noticed Hatteras was in here earlier today and IVR was in here earlier today, and both their stocks are down. So we’re going to try to say as little as humanly possible because our stock is up on the day. I told Steve we may not even present today just to play it safe.
But we are Dynex. Everybody read that because we can’t say anything about the forward-looking statements of the company. We do have 55 million of common; we have an A and a B. We issued the B earlier this year. The yields on them: on the A is $8.66 and $8.47 on the B. As you can see, both of them are trading below par and I think they’re both interesting.
Our price to book right now is 0.98. We’re not happy about it, but vis-à-vis our competitors as you all know, if you’re mortgage REIT investors, a lot of our competitors are trading at 0.85, 0.90. What’s the average, Steve, right now – 90% of book? Below that? Okay. So you might say we’re the tallest midget or one of the taller midgets in the room right now, but we’d like to say it’s because we’ve managed the company in a very conservative manner.
I have been Chairman of the company since 2003. I’ve been CEO since 2008. Byron joined me in 2008, and we were in cash when the credit crisis hit, and we’ve always managed the portfolio in a sort of understanding that we were going to be a volatile rate environment, and so we’ve acted accordingly.
What we’re going to try and discuss today is the longer-term nature of Dynex as a mortgage REIT. There are a lot of mortgage REITs out there. Some of them act as public hedge funds; some of them act in the interest of the investors. Some of them act in the interest of the management teams and take on some substantial amount of risk, and we’d like to tell you that we’re internally managed and we feel that we try to marry those two different divergent forces and come up with a happy medium.
I personally own about 3 million shares of the stock. Byron is very much invested in the stock. So when -- we always like to say “We eat our own cooking,” so we’re very interested in the performance of the company.
Our mission is basically to manage a REIT with a focus on capital preservation and providing risk-adjusted returns reflective of a diversified leverage fixed income portfolio. And the point there is risk-adjusted returns you should probably point out, I want to point out; and then leveraged fixed income portfolio. When you run a leveraged portfolio, you live at the guise of your credit counterparties. We’re very well aware of that, and therefore we are very intent on making sure they’re very happy.
Our core values are generating dividends, manage our leverage conservatively. We are one of the more conservatively managed leverage. We run about 6x leverage right now. We had a massive extension in our leverage with the latest pullback from 6.3 to 6.8. A lot of guys went from 8 to 10, 9 to 11 – we did not have those issues. We remain owner/operators. A lot of our board owns shares; we pay a lot of our management compensation in shares, so we are owner/operators.
We like to maintain a management of integrity and highest ethical standards and a risk management culture – we’ll get into that; and focus on the long term. We really do not run a public hedge fund, okay. We run a long-term investment portfolio. We did not buy fifteen years; we did not buy thirty years. We didn’t think you could manage those given our core values and given our mission. It would have taken excessive risk, and we never thought that risk-adjusted returns were reflective of adding either the 30’s or 15’s. We can get into an argument about that in the Q&A.
Okay, so what has been happening? This is just the last five quarters. It’s probably more exemplary to go back a little bit further, but let’s just take this for what it is. We just announced our dividend; it went from $0.29 to $0.27. It’s reflective of the heightened risk in the marketplace right now. Our spread, our net interest spread has gone down. A lot of that has to do with a lot of variables in the marketplace. We think that given the current environment that narrowing is probably as narrow as it’s going to be for a while. We see things actually starting to widen out just a little bit or stabilize.
Our book value went from $10.31 – let’s say $10.50 to $8.94. That’s a massive move. I mean you could go back and say “Well gosh, Tom, what kind of capital preservation is that? If you drop from $10.50 to $9.00, that’s 15% in a period of one quarter.” We will get into that. $0.50 of it was because of the interest rate move which is well within our tolerance. $1.00 of it is from spreads widening, and really it was in a portfolio where spreads widen. We take a lot of spread risk, because we’re going to recapture that spread risk as the portfolio matures. So to me it’s sort of like a short-term thing.
If you go back to the beginning of 2012, our book value was $9.00. So, spreads narrowed and the book value went up to $10.50; spreads are widening and we go back to $9.00. Did really anything change dramatically? Did we add risk? Did our cash flow really change demonstrably? No, it was just a valuation of the portfolio. We’re still the same company; we still have a great portfolio that we can ride down the yield curve. It’s short term enough that in two years from now we will not be trading at say a seven-year average life; we’ll be trading at a five-year average life. So it moves down dramatically.
We don’t have a 30-year bond that was claiming to be a five-year average life security that’s now a 15-year average life security. We really have solid maturities on that. Really our longest is a 10:1 ARM product.
Our return on common equity has stayed pretty consistent in that 13$ range here for a while and that you know, allows us to be able to pay a dividend that right now is about 12%. With that I’d like to turn it over to Byron Boston, the President and CIO of Dynex. He’s been with the firm since 2008, has managed this portfolio. We have a diversified portfolio model which I think makes us a little bit different than most.
Thanks, Tom. To effectively use the time what I’m going to try to do is I’m going to probably skip around through a couple of slides and I’m going to try to just hit you with what I think are the most important messages that I can give you today. And I’ll make some assumptions… Alright, let’s just, I want to emphasize a couple of things about Dynex’s portfolio. Here’s the risk that we basically have taken over the last five years.
We introduced this slide probably four years ago. The looks that were given to us were a little strange but simply we were saying that we were focused on hybrid ARMs in the CMBS sector – one of the reasons we did not want to take extension risk. And so we used this simplistic slide to showed what extension risk looked like, and we just used two different prepayment assumptions for a 30-year security, a 15-year security and a hybrid ARM. And as you can see over to the right, average life extension: the 30-year would extend nine years, the 15-year three years and the hybrid ARM one year. And that’s basically what you saw in Q2. And as such we were happy with the portfolio we put together.
Why did we not want to take that risk? Tom mentioned already we’re an internally managed company where all of the management team and the board have material net worth exposure to Dynex Capital. And so with our shareholders we’re all in the same boat – it’s not a risk that we chose to take. And if you look at our portfolio, the way we performed in June, we were generally running a 6x leverage book as a corporation as a whole plus or minus a bit. Into March we finished with a 6.3 leverage ratio; by the end of June the portfolio moved out to 6.8. We were under very little pressure to adjust the portfolio despite the 100 basis point rise in rates. We were never a poor seller throughout that time.
The adjustments that we made since Q2 still have the same focus on hybrid ARMs. We have adjusted a bit in terms of taking a little more of a defensive posture, adding a few more hedges of Euro and dollars, but the core philosophy of the portfolio remains the same. As you can see we’ve got a capital allocation CMBS v. RMBS – 60% of the book being allocated to the CMBS sector with 41% being allocated to the RMBS sector. And then the more significant piece is the majority of our book of business happens to be agency-backed paper.
If you look at the right side of this slide you’ll see that in general, the majority of our book of business either matures/resets in ten years or shorter. So again, back to the conservative nature of Dynex Capital – we’ve chosen to limit our exposure beyond 120 months to maturity. We’re pretty well diversified across those sectors. The shorter end of our book of business happens to be seasoned hybrid ARMs. The intermediate sector there where you see 35% is a mix of some CMBS and hybrids, and then the longer 85 to 119 months – there are some hybrids there but there’s also some of our longer, what we would call our single-A rated CMBS paper.
We take prepayment risk; we take duration risk. As of this moment we’re not being paid a lot of money to take an enormous amount of duration risk. So we’ve extracted a fair amount of duration out of our book of business. Most of our duration is centered on the short end of the yield curve. We believe the backdrop that we’re in where the Federal Reserve is intent on holding short rates lower for some considerable amount of time in the future, we believe our book is structured to be able to take advantage of that.
The long end of the yield curve has a little more risk from our perspective and we’ve attempted to neutralize that part of our book. We’ve been in that posture for some time, but if you were to consider where we stand today and our overall outlook we are first in a more defensive mode and secondarily continue to look for opportunities to take advantage of the current environment.
Instead of really rehashing more about what took place in Q2 let me just summarize a couple of main bullet points and then I’ll just reemphasize on our strategy and our outlook. There was a massive technical and psychological shift in the marketplace. It impacted hybrid ARMs in a manner that most people didn’t expect. I’ve been a trader of these securities since 1986. I came out of the University of Chicago; I started trading mortgage-backed securities on the street. It’s not unusual to see this type of technical supply/demand imbalance.
What has happened in Q3 in hybrid ARMs which has been fantastic is that an enormous amount of bonds have changed hands. The market has functioned very well. Many of the bonds are in even stronger hands at this point in time. There has been a liquidity shift across the street, a function of some regulatory issues and the unusual nature of the market environment that we’re in.
So what has Dynex done? We’ve got more of a defensive posture, risk management first. It is my personal opinion that you don’t need to be smarter than the average bear to succeed at managing a mortgage REIT. However, I do believe you need to be a very talented risk manager, and as such, as being owner/operators of this company our number one focus at this point in time happens to be on risk.
We don’t want to be completely blinded to the fact that there are some great opportunities and with a steep yield curve and some wider credit spreads it continues to be a conducive environment for mortgage REITs to generate solid returns. However, again we’ve taken a more defensive posture. We’ve added more Euro/dollar swaps at this point in time and we’ve continued to have a portfolio structured to perform in a variety of market environments with limited extension risk.
We’ve talked over the years about shock absorbers in our portfolio. We really include that our book of business rolls down a yield curve nicely as a function of being hybrid ARMs and CMBS. We also have slowing prepaying speeds that will be a positive backdrop for our portfolio, and then overall the spread environment – especially having the credit component within our book of business, we continue to still believe over time that as rates rise that will provide a positive shock absorber to the book of business.
So overall as we look out into the future and as I mentioned, we still believe that the macro environments provide some great opportunities for mortgage REITs but we must be very diligent in our focus on risk management. The higher volatility environment is something that we do want our investors to understand that that does generate additional costs. Tom mentioned earlier we did cut our dividend by $0.02 this quarter, but the book of business continues to be solid and we continue to still feel very confident in this book of business.
Our leverage ratio again went from 6.3 to 6.8 at the end of Q2. We do anticipate that coming back down to 6.3. That’s a function of us not having reinvested many of our, most of our prepayments that have come back off of the portfolio over the last three months.
We’re proud of the fact that we were not in a forced sale position, that the portfolio was structured to deal with even the surprises that we saw in June. And again, I want to leave you with just a thought process that as owner/operators we’re emphasizing the risk management of the book of business first and we continue to look for additional opportunities as the market stabilizes in the future.
With that I’m going to turn it back over to Tom with those main points. Tom, you can finish up and really talk about the long-term nature of our company.
As Byron mentioned we’ve always invested for the long-term; the portfolio was set up for that. It’s not a trading portfolio. It’s not a [suite] portfolio but at the same time we set it up over the long-term. We’ve just come through what I consider to be an extremely difficult environment. A lot of our competitors were down as much as 30%, some of them 35%. We’ve had a little bit of a pullback which is fine, which is acceptable, but we have shock absorbers on the other end of this that will offset that as time goes on.
The nice thing about Dynex as an owner of 3 million shares myself is that time is my friend. I like to have time go on. So we can ride down the yield curve. Those of you who remember Marty Leibowitz in riding down the yield curve – that’s exactly what we’re going to do. And we have a portfolio that does not have a lot of extension risk and we’re looking forward to continued volatility. But the thing about volatility is that it works both ways. I could make a case for the 10-year to go to 4% and I could make a case for the ten-year to go to 1%. And if I knew which way it would go then I guess I could go all-in but that’s not the way we do.
We assume there’s going to be some volatility, manage around that and we create a portfolio that cash flows. It’s continuing to cash flow and we expect that to happen over the next two, three, four, five years. Questions?
Steve Delaney – JMP Securities
Well repo is going up. It was interesting – I was listening to IVR, and he was saying “Repo is getting better, it’s all wonderful,” and I’m going “He must be living in a different world than we are.” But the bottom line -- I shouldn’t say that. But the bottom line is the banks, let’s step back for a second and imagine you’re the government. You just experienced a massive credit crisis. There was too much leverage in the system. There’s a lot of talk about excitement and more leverage in the system, and they’re still trying to figure out how to wring leverage out of the system.
The only way you wring leverage out of the system is you basically make the availability of capital more difficult, more expensive, and they’re doing that to the banks. They’re doing that to the banks – they’re making their capital ratios go up. There’s a lot of people saying that everybody ought to have 10% or even more capital. And so, we run a leveraged business. We borrow money through the banks to the Fed, and they’re going to make it difficult for the banks, so they’re going to make it slightly more difficult for us.
In a normal environment, our repo rates should have been substantially lower. They’re a little higher and I think that’s going to make things a little bit different. But Steve, I don’t see that as being a massive thing going forward. It’s just something you’re going to have to pay attention to, but Byron…
There’s a real business opportunity. There’s cash in the system; there’s plenty of cash to lend against attractive assets. So, there’s cash and there’s assets, and the guys in the middle are being pounded from a regulatory perspective. And the government’s trying to push more capital into the system and bring leverage out of the financial system. It would be great if they would just say “We don’t want the investors to have the same mid-teens earnings expectations that they have.”
So but as we look to the future, a lot of brainpower is being put into the fact to go around the current structure because there’s legitimate cash. There’s plenty of cash to lend against good securities, so that’s the structure of it. It still exists. There are a lot of positives, but there’s some regulatory uncertainty as the government forces more capital into the financial system. There’s a lot of theory that repo will go down at certain banks. There’s at least one research piece out there recently written where it said “Look, repo business has great return on asset and as a result a great ROE business.” There will be other processes created to go around the current structure of the top eight banks getting really pounded from a leverage perspective.
And you saw the Fed is going to test the direct repo market. So I mean they’re talking about, I think $400 billion line which in our world is nothing, but nevertheless I do think that good quality assets -- I mean if you take a look at what the money market guys are getting, they’re not getting that additional capital. They’re not making that additional money – it’s just being sopped up by the banks because they’re unsure of what’s going to happen. So, to me we’re maybe at the worst case scenario right now, and I think it’s going to clean up a little bit, because capital is like water – it will find where it needs to get to. And there’s -- occasionally, you’ll get a little dam or impediment but it will find its way to that level, and I think we’ll see repo rates go down.
Trevor Cranston – JMP Securities
Really quickly can you maybe comment a little bit on what you have seen with prepaid speeds for hybrid ARMssince you have (inaudible)?
Sure. So at the beginning, as we entered this financial cycle, this turn that happened in May, our prepayment speeds were at peak levels that we’ve seen over the last five years. At this point, there’s been a major collapse in the refi index and that’s reflected a steady slowing of prepayment speeds. In the ARMs sector, the speeds are not like dropping off a cliff, but they have a steady slowing period. We expect that to continue right on into the October, November, December, going into January of next year without some major move in rates.
And even if we get, let’s say a move back down in rates, I don’t think you’re going to see the same highs in prepayment speeds that you may have seen in the past. So there’s some burnout in the system, but right now immediately we are seeing slower prepayment speeds and we do expect that to continue.
I’ve got 90 more seconds – I just want to put up one slide, and to me it’s sort of the slide that lets me sleep at night knowing that our portfolio is rolling down the yield curve. And what’s happening when you have such a steep – one thing we did, we steepened the yield curve dramatically. And if you look at the fact that most Fed pundits think that the Fed’s not even going to remotely start raising rates until 2015 on the short end. So that means as our portfolio rolls down the yield curve from let’s say seven- to five -year average life, you’re going to pick up as you can see a 7.1 becomes a 5.1 – it goes up $1.00 price from let’s say par 88 to 102.22. The yield goes from 2.02 to 1.39. That’s a shock absorber.
As our portfolio moves down the yield curve we make money automatically just because it’s rolling down the yield curve. If you take a 30-yar security that goes from being a 30-year security to a 28-year security not so much; or even a 15-year security that goes from a 15- to a 13-year security – not so much. So our point is that this is going to have a dynamic effect on our portfolio. That’s why we designed it to be that way. Byron’s an old-time bond guy, I’m an old-time Salomon Brothers quant. It’s the way we roll and we’re going to roll down the yield curve and that’s why I think we’re going to be very content with the portfolio over the long term.
Thank you much and if anybody wants to see us we’re in the breakout room…
Trevor Cranston – JMP Securities
The [Remboulet Room] across the hall.
Thank you much.
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