Dynex Capital (NYSE:DX) has often been one of my favorite mortgage REITs. Their portfolio emphasizes CMBS (Commercial Mortgage Backed Securities), CMBS IO strips (interest only strips on CMBS), and agency ARMs (adjustable rate mortgages). The resulting portfolio goes together nicely with the CMBS positions having very little exposure to prepayments. Both kinds of CMBS positions are overwhelmingly tilted towards very high credit quality assets including agency securities and AAA securities.
While AAA-rated RMBS were a terrible investment in the last market collapse, the underwriting standards are dramatically stronger now and I see the AAA-rated CMBS as a very reasonable investment opportunity when considering the yield spread that they offer relative to treasuries. When an investor considers that LIBOR swaps have yields under the treasury rate, the result is a scenario where Dynex Capital can lock in a very reasonable cost of funds relative to the yield they expect to earn on the high quality assets.
Sold Out of Common Too Soon
Investors may remember that I sold out of my position in the common shares too soon. It was late in February of 2016 and after a major rally I decided it was time to take profits and move to cash. Having the cash freed up would allow me to buy back in if shares dropped back down and the last several months had seen absurdly large discounts to book value. At the time shares were about $6.22. Now shares are around $6.97.
Buying the Preferred Shares
After moving a significant portion of my portfolio to cash I started looking harder for investment opportunities that fit my ideal investment characteristics. One of the things I found was a reasonable margin of safety on the preferred shares of Dynex Capital. It's a position I wished I had taken sooner but I still managed to get a great deal on the shares of DX-A.
The two preferred series are the "A series" and the "B series". I refer to them simply as DX-A and DX-B. DX-A has an original coupon of 8.5% and can be called as soon as 07/31/2017. Since I bought these shares at a discount to par value, I was able to catch an 8.9% yield on cost with the potential for capital gains from a call. At the time the discount to par value was a fairly nice shield against call risk, but these shares now trade around par value. Despite that, I still see them as being quite attractive and I might add to the position.
There is a significant risk of a call coming down next summer due to the strong coupon rate of 8.5%, but the recent price is only $25.10 and by my estimate the stripped price (removing accrued dividend) is about $24.63.
DX-A vs. DX-B
The shares of DX-B offer a larger discount to par value which is great for call protection. I don't foresee any scenario where DX goes under. Management is more than competent and they have been very clear about the challenges that the sector faces. I would be dramatically more concerned about the potential for a collapse in a mortgage REIT where management did not demonstrate a preference for safety.
The reason I picked DX-A over DX-B was the difference in current yield. DX-A offered about 40 basis points of additional yield and at the time I wasn't as concerned about the potential for shares to be called.
Given the reduction in treasury rates and the significant chance for DX-A to be called, I would have to at least consider using DX-B for further allocations.
DX-B carries an original coupon of 7.63% and at a recent price of $23.55 offers an 8.09% current yield or 8.24% stripped yield.
Why I Hold Them
There are a few mortgage REITs that I see positioning their portfolio for some very intense risk over the next few years. Dynex Capital isn't one of them. Their preferred shares demonstrate a similar level of yield to some securities that I consider to be materially more dangerous.
There is certainly some risk here, but the huge coupon payments are more than adequate compensation. If I could still get into these shares at the 8.9% yield I found a few months ago I would have another active order trying to acquire them.
A Safer Comparison
Annaly Capital Management (NYSE:NLY) is taking on more credit risk but is also a much larger mortgage REIT. Annaly has a much higher ratio of common equity to preferred equity which is also favorable for reducing the risk of things turning south. NLY-C is their C series of preferred stock. It carries a 7.63% original dividend but only offers a 7.59% stripped yield compared to the 8.24% stripped yield on DX-B. The shares of DX-B also have a longer period of call protection. I wouldn't have thought that would be a big issue, but seeing DX-A move over par value is encouraging me to be more considerate of the call risk. For the .65% difference in stripped yield and more call protection, I would prefer DX-B to NLY-C. If the market turns south the fear based selling will probably push DX-B to lose more than NLY-C, but I would treat that as a buying opportunity if it happens.
Disclosure: I am/we are long DX-A.
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