Dynex Capital (NYSE:DX) reported Core EPS of $.22 for the first quarter of 2016. The result clearly covers the dividend of $.21. While some mREITs are enhancing Core EPS with low quality adjustments, Dynex Capital uses a very high quality adjustment process that produces values that I believe are reflective of the underlying earnings power of the portfolio. The total economic return came in at .5% for the quarter or an annualized 2%.
The following slide demonstrates the allocations of assets and equity. For most of my analysis I would focus on looking at the asset allocation, but this time I want to reference both:
The total level of assets at the end of the first quarter is lower than at the end of Q4, but a slight deleveraging isn't too big of a challenge. The more interesting factor is that Dynex Capital had materially increased their cash position at the end of the quarter and that cash may be deployed during the first quarter. Remember that yields were falling during the first quarter, but rising slowly so far in the second quarter. In short, DX may be able to reinvest their cash at higher yields.
Most Attractive Factor
Dynex Capital is running a portfolio primarily composed of three types of assets. Those assets are agency RMBS with adjustable rates, CMBS and CMBS IOs. The allocations between the CMBS and CMBS IO are primarily focused on securities that either carry agency guarantees or at least AAA ratings. These securities are very attractive in my view because they offer excellent credit quality while offering a significantly higher yield than treasuries.
A better yield than treasuries might not sound like much, but at the longer end of the yield curve the treasury rates have moved dramatically below the LIBOR rates. Since mREITs can effectively lock in a significant portion of their cost of funds through the LIBOR swaps, the most relevant spread is the difference between asset yields and the cost of funds after hedging costs. Since CMBS contain provisions against prepayments to compensate the owner of the CMBS if a prepayment occurs, the CMBS portion of the portfolio is materially less exposed to prepayments than the general RMBS market. On the other hand, DX does incorporate some prepayment rates through their adjustable rate agency RMBS.
While the combination of CMBS and LIBOR swaps can do a great deal to allow an mREIT to lock in both the yield on assets and the cost of funds, the one weakness there is the lack of a quick amortization schedule to bring cash flows back into the portfolio for reinvestment. The position in agency RMBS is exposed to prepayments and should be expected to have a material CPR level that brings significant cash flows into the portfolio. A decline in the rate of prepayments would be favorable, but the silver lining to prepayments is the opportunity to reinvest proceeds. Since the spreads between assets and LIBOR swaps has been increasing, the opportunity to reinvest and hedge is becoming more attractive.
The position in CMBS IO strips provides an even faster amortization schedule and gives Dynex Capital more cash flows to reinvest. If there is further spreading between asset yields and the cost of hedging with LIBOR swaps, it would make this position even more favorable because it would mean the cash flows would be invested at a better spread. This is an area with very mREITs involved.
The total economic return was positive for the quarter which is a respectable accomplishment in and of itself given the spread widening that occurred during the quarter. When the spreads widen it hurts book value but it also indicates better opportunities for reinvestment in future periods. If the spread were to shrink back down, it would create immediate gains in book value, but it would also mean weaker opportunities for reinvesting proceeds.
Overall I continue to view Dynex Capital as one of the high quality mREITs, but I'm currently not holding common equity in any of the mREITs due to the significantly smaller discounts to book value present now relative to the last several months. If Dynex Capital were trading at those larger discounts to book value, I would be very interested. I've been aiming for discounts of at least 20% or so to book value. Shares are currently trading at an 11% discount to the Q1 book value.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PREFERRED SHARES OF ANY MREIT over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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