Dynex Capital, Inc. (NYSE:DX)
Q2 2016 Earnings Conference Call
July 27, 2016 02:30 PM ET
Alison Griffin - Vice President of Investor Relations
Byron Boston - Chief Executive Officer, President and Co-CIO
Smriti Popenoe - EVP, Co-CIO
Stephen Benedetti - EVP, Chief Financial Officer and COO
Douglas Harter - Credit Suisse
Bose George - KBW
Good day and welcome to the Dynex Capital Inc., Second Quarter Earnings Conference Call and webcast. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please also note that this event is being recorded.
I would now like to turn the conference over to Ms. Alison Griffin, Vice President of Investor Relations. Please go ahead.
Thank you, operator. We would like to apologize and thank everyone for their patience today as we worked out the technical difficulties this morning for our call. And thank you for being able to join us this afternoon. The press release associated with today's call was issued and filed with the SEC this morning, July 27, 2016. You may view the press release on the company's website at dynexcapital.com under Investor Center, 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 Annual Report on Form 10-K for the period ending December 31, 2015, as filed with the SEC. The document may be found on the company’s website under Investor Center as well as on the SEC website.
This call is being broadcast live over the Internet with a streaming slide presentation which can be found through our webcast link under Investor Center on our website. The slide presentation may also be referenced by clicking on the Dynex Capital's Second Quarter 2016 Earnings Conference Call link on the Presentation page of our website.
I would now like to turn the call over to Byron Boston, CEO, President and Co-CIO.
Good afternoon, and thank you very much for joining us. With me today I have Smriti Popenoe, Executive Vice President and Co-Chief Investment Officer and Steve Benedetti, Executive Vice President, CFO and Chief Operating Officer. I’m going to briefly review our performance for the quarter, discuss the global macro environment and provide our outlook. For most of the second quarter 2016, we experienced a return to a period of com following a severe about a volatility at the end of the first quarter.
The events in Europe dominated the last week of the second quarter with interest rates dipping to all-time lows. Our financial results are detailed on page three, and for the quarter, we declared a dividend of $0.21, generating core EPS of $0.21, experience an increase in book value of $0.15 that generated a total economic return of 4.8% and year-to-date that brings our total economic return to 5.2%. On a year-to-date basis approximately 72% of our common stock dividend is a return of capital as noted on slide 29 in the appendix.
Our results were driven by the following; one, reduced hedging costs was positively impacted both net interest margin and book value during the quarter. Two, the diversified portfolio of agency guarantee CMBS, AAA rated CMBS and agency on securities that continues to outperform from a prepayment perspective, particularly versus an agency RMBS only portfolio.
Last quarter we articulated some key macro themes that are the underpinnings of our view and rationale for our investment and hedging positioning as shown on slide five. They continue to be valid as we look ahead for the coming months, specifically we highlighted large amounts of global debt is negatively impacting overall global stability and economic performance. Extraordinary government involvement in the capital markets, the central bank interventions and regulatory changes. Technology that have connected us all globally and a global currency war that has having unintended consequences that we believe could create or exacerbate in stability and could limit how much interest can rise.
As of this global uncertainty including here in the U.S., and what you have is a set of complex factors producing market volatility followed by periods of com as global governments intervene further into the capital markets. We expect this pattern to continue.
The aftermath of [indiscernible] is a perfect example of this uncertainty. Given these macro things and in our opinion there are negative influence on U.S. monitor policy and the potential for high market volatility, we believe our portfolio and strategy well positioned for the environment.
Our most notable strategy in this regard has been to maintain a long duration portfolio position. As rates have fallen, we have benefited and that helped offset some of the losses from wider credit spreads. We continue to maintain a long duration portfolio position as we are skeptical that will move higher interest rates will be sustainable given high global debt, modern inflation and mediocre global demand. In fact, if interest rates do rise, we will be willing to reduce our hedges further and add to the duration position.
We believe this strategy will support our ability to generate income in the month ahead. Our diversified asset strategy as shown on slide seven is contributing directly to maintaining a high quality of earnings, allowing us to generate higher net interest income, while cushioning the portfolio in a variety of different environments. This is particularly evident in the last few quarters as we have benefited from prepayments in our CMBS portfolio, offsetting and even adding to our overall quarterly returns.
We continue to modestly deleverage our balance sheet to build liquidity and capital which we expect to deploy under the right conditions. Up and credit remains our investment strategy of choice, favoring agency wrap paper. CMBS is more compelling than RMBS, and we are being very selective and tightened, particularly sensitive to risk retention rules and quality of deals.
As we have stated many times in the past, we take a long term view with our business model and our strategies. Please see slides 11 and 12, two of my favorite charts.
Over the last year, as a result of the market environment, we have experienced more book volatility than in the past but we continue to believe in the high quality assets that we own in the solid cash flow that generate. We do expect to make adjustments and redeploy capital from lower yielding assets with limited upside and to those that have more positive return profiles overtime.
Finally, from a strategic perspective we believe that above average dividend yields as provided by Dynex will be a major drive of returns for the next 5 to 10 years. Our well diversified portfolio that is largely agency guarantee currently yielding 12% and trading at a 10% discount to book value is a compelling value proposition in this environment of historically low and negative interest rates.
And now we’ll have a Q&A session started by Alison Griffin, we’ll post a few questions to ourselves after the situation this morning we did pull our analysts and asked them to give us the most important questions that are pressing on their minds. And we’ll walk through those questions and then, if you got some questions yourselves, please feel free to dial in and we’ll open the conference call line up after we go through the first five or six questions. Alison.
Thank you, Byron. The first question I have is, what can a share holders expect from the company in terms of reinvestment activities to the balance of 2016, given the continues decline in the balance sheet? How does the reinvestment environment look and what are the most attractive uses of capital today?
Thanks, Alison. This is Smriti Popenoe. So we have chosen to delever the balance sheet for the first six months of this year, focusing instead on reducing hedge costs and building capital and liquidity. We believe this was the appropriate strategy and the appropriate risk profile for the environment. And having said that, we’re seeing considerable opportunity right now to replace one off and maintain the size of the balance sheet.
The opportunities continue to be in the up and credit, up and liquidity side of our strategy, this is really where we see the best risk reward. CMBS right now offers us better value than RMBS, and even in the CMBS world we’re finding that agency CMBS actually offers us better risk adjusted returns versus non-agency CMBS.
The current size of the balance sheet provides us a reasonable opportunity to earn what we believe to be the appropriate returns in this environment.
The other comment I would make is that we remain ready to change this poster if necessary, if we believe the risk environment determines it or requires it the balance sheet will shrink. If we determine the risk environment a support of risk taking and increasing of leverage, we believe we have the flexibility to do that, and that’s what we can do with the kind of capital and liquidity position we have in place right now.
The other comment I would make in terms of the equity allocation as it stands current, it appears on our – in our presentations that are equity allocation towards RMBS increase versus CMBS and what that is, is a function of how we manage liquidity on a month-to-month day-to-day quarter-to-quarter basis. I would actually focus on our long term average equity allocation versus for RMBS versus CMBS, you probably see that fluctuate some over the next few quarters as we manage what we call our unencumbered asset, so we try to focus on that over the longer term.
Thanks Smriti. The next question is how do the low rate environment impacts prepayments on the investment portfolio?
Okay, so on this what I would ask people to do is to go to page 16 which basically shows us on the bottom left hand side, the amount of premium exposure that we have on our balance sheet. And what percentage of that premium exposure is truly exposed to prepayments, all right. So you can see on the bottom left hand chart that 92% of our unamortized premium is actually not exposed to prepayments because the underlying loans have a 10 year lock out and a nine and a half year lock out, because they’re CMBS related IOs.
Only 8% of the total premium on our book unamortized premium on our book is actually related to the residential RMBS portfolio and that even in that particular exposure if you turn to page 23, we’re breaking out for you how that exposure really comes to path in our portfolio. So most of the premium setting in hybrid arm securities 33% of these hybrid arm securities have prepayment protection in that – they’re actually interest only loans which at current rates it is very uneconomical for these borrowers to refinance. That’s not to say we have no exposure to prepayment risk or we have no chance or prepayments increasing on our book.
The point I want to make here is that Dynex’s portfolio is fairly shielded from these shocks and prepayments number one, because of the diversification between CMBS and RMBS. And number two, because the RMBS we do have are what we believe to be relatively more call protected.
The other point I’ll make here is that the loans that the – loans underlying these IOs actually still have 47 months left of protection, so it’s not something that’s going to wear out this year or next year.
The other – the last thing a point I’d make Alison is that, if you look at our prepayment history for this portfolio in the past, our prepayments have ranged between 13 CPR and somewhere around 19 or 20 CPR. As we look ahead, we do expect to see that number rise because we have seen all-time lows and interest rates in the last few months. But unlike a lot of sort of real negatively converts portfolios we don’t expect to see speeds of 40, 50, CPR, 35 CPR. It may happen for one or two bonds, but on average we expect the portfolio to be fairly well behaved. In other words, it’s manageable within the context of how we run our portfolio.
Smriti, please tell us what’s the outlook for the multifamily market from a credit perspective and how will that impact your investment performance and potential future allocations and capital?
Okay, so multifamily as we have articulated in our shareholder letter as well as other calls that we had with our investors it’s a very core component of our investment strategy, it’s a key thesis. We believe the demographics in the United States is going to support the multifamily market for many, many years to come. We tend to have multifamily exposure in two areas, one through a [indiscernible] guaranteed security called a DUS bond where the timely payment of interest and principle is guaranteed by Fannie Mae. The other place is through Freddie Mac in their K program and we’re typically buyers right now of the interest only strips in those securities so we have more exposure to the underlying credit. But still even there the payment of interest is guaranteed by Freddie Mac and the securities are rated triple.
So in terms of the credit outlook, what I can tell you is that the credit specs are changing. The reason they’re changing is that the agencies are expanding into newer markets, they’re putting out different products with different structures to manage their customer base and they’re being allowed also to expand the amount of loans that they originate, Fannie and Freddie expected to each originate about $50 billion in loans this year each so that $100 billion in production.
So new stuff is happening, things we haven’t seen before markets in which we haven’t – the agencies haven’t necessary played. So that’s not a concern, it’s just new, we’ve been – there is not much history but we can certainly manage that. One thing of concern is the incredibly low cap rates in the sector and also the continued massive increases in multifamily property valuations. Those things are costs for concern, we’re also seeing little bit more use of interest only feature which can be good or bad depending on the situation.
And some pro forma underwriting but not really as bad as we saw things in 2005, 2006 area, so even so I think our strategy still remains to be – to focus on the high quality paper. We still see that as an attractive option, we don’t feel like we have to go down and credit right now to generate good returns. And so, because we’re playing in this agency guaranteed space, we’re able to find that risk reward that we need. At some point there will be turn in the credit cycle in the multifamily sector. It is incredibly tight to employment, it’s incredibly levered to wage growth. Those are two things that we follow very closely and that’s what drives us, quite frankly to be in the long – in the high credit space.
The next question. How is the company positioned today from an interest rate risk perspective and can we expect to continue to see changes in the hedge position in the future?
Yes. So, yes you can expect us to continue to see changes in the hedge position, particularly in our hedges out in the 2017, 2018 area. We continue to look for opportunities to restructure those hedges, reposition ourselves to reduce our hedging costs in that particular part of the curve. So we are looking at that opportunistically and we’ll make that change. But I want to remind you, everybody on the call in general, we’ve always had a history of maintaining a long duration position, it’s been our position since 2008. I think one of the first things we said was maintaining a long duration position was appropriate for a securitized portfolio which has negatively [indiscernible] characteristics.
So this is not a departure and the positioning changes that we’re making, even in the last quarter are not a departure from our core thesis. And you guys heard Byron talk here just a few minutes ago about what we really think about the macro environment and our positioning really reflects that view very, very closely.
So, the answer is yes, you can expect us to continue to focus on that and that really – this is just a reflection of what we’ve always believed to be in appropriate position for a securitized book.
Thank you, Smriti. And the final question, has there been any impacts on the retail market from the recent market disruption and has the recent increase in [indiscernible] rates impacts at our borrowing cost?
So this is Steve and I’ll take that one Alison. We’ve not really seen any impact on the availability of repo from the recent market volatility. Investment security values on net actually increased debt to [indiscernible] given our high quality paper would not really had any problems financing our balance sheet.
As far as the recent increase in LIBOR, most of our agency product is financed via short term rates other than LIBOR, so the increase in LIBOR itself really only impacts our non-agency investments. We’ve seen some very modest increase in repo rates as we’ve rolled maturing repo, however we do expect that asset pricing ultimately could adjust up if financing cost continue to increase.
We also often get the question on the impact on repo markets from recent regulatory activities, so let me comment on that. While the footprint of large broker dealer participation in the markets has been reduced, we’ve really not seen any net contraction in balance sheet availability and no recent impact on our repo cost. Several key regulatory provisions were not affected for several years, but most counterparties seemed to have largely considered the implications. So for now, markets seem to fully adjusted to the new regulation.
Thank you, Steve. Operator, we would now like to open the call up for any additional questions our audience, participants may have.
We will now begin the question-and-answer session. Our first question comes from Douglas Harter from Credit Suisse. Please go ahead.
Thanks. Sort of a follow-up to the hedging question, can you just talk about how you think about sort of the economic return versus maybe how they might differ from the GAAP return in using euro dollars versus swaps which obviously have different accounting treatment and how you think about that?
Shall I take that please?
Well in terms of the accounting treatment…
Well I’ll take probably at the end of that.
Yeah, the accounting treatment is actually we’re not using hedge accounting anymore so that whatever the derivative instrument is that we use is being recorded in our accounting financing statements on a mark-to-market basis. So whether it’s a euro dollar or a [indiscernible] derivative instrument interest rate swap, there is no difference in the accounting methodology.
And I don’t know Doug if you – if this has any relevance to what you’re asking, I’m just throwing that’s out there. When we’re thinking about that hedge issue, especially with euro dollars versus swaps, the number one thing we’re thinking about is where do we want to hedge on this, managing the yield curve where managing it is extremely important. And so where you’re long, where you’re short is extremely important and those euro dollars plus the regular swaps gives us more flexibility for managing that process. Smriti, do you want to add something to that?
I do, and I think the thing you want to understand is, from our stand point – from my standpoint, I’m agnostic in terms of whether we’re using euro dollars versus swaps because like Byron mentioned, there is some flexibility that we have when using futures because we can hedge specific quarters versus an interest rate swap where we’re really locking in multiple quarters in a row. And if you think about it, the euro dollar mark is already in our book value and the rate that you’ve locked in is just what’s out there. So at any given time the economic returns always reflected in our books and records, always reflected in the book value.
So we – I, my team, in terms of how we’re thinking about it economically, we really think about the economic return and as Steve mentioned, we don’t do the hedge accounting anymore. So it really is sort of the economic return that drives our decision and then we’re on the position – the curve we’re positioning.
All right, that’s very helpful Smriti.
Our next question comes from Bose George from KBW. Please go ahead.
Hey good afternoon. Actually a couple of little things – actually one, just first on leverage, do you guys think your leverage is currently low and in terms of leverage potentially going back up is it really just a function of finding assets that are – that you find attractive or otherwise you kind of keep at these levels?
I’ll take that first Bose and then Byron you can jump in on that. So here is how we think about leverage. We actually think first in terms of the size of the earning assets. And what the size of the earning assets needs to be, and what’s supported by the risk environment. So right now we’ve allowed that to come down and as I mentioned in my comments earlier, you’ll probably see that creep back up and leverage sort of moves around based on the book value and other things, so we’re not managing “the leverage” per se, the leverage ends up being sort of on outcome, that’s not to say we ignore it but that’s kind of how we think about it.
So you’re right, we have allowed – we’ve chosen to delever the balance sheet, we’re reducing hedging costs, we built capital and liquidity. The redeployment are the size of the assets – earning asset that when that is going to go up is really a function of looking at what risk adjusted returns are, and whether or not they’re appropriate at this time to make longer term returns.
And the size of capital and liquidity that’s available we have to marry all those things in the context of the risk environment. So right now you’ll see our leverage is at 6.1, and you can think of it in terms of how much liquidity in capital we have. We think that’s the right, the correct amount of capital for this environment. So at this point I expect us to maintain or have this level of earning assets for some period of time. And as I also mentioned, Byron always tells me this, I deserve the right to change my mind on a dime because that’s the kind of environment we’re in.
So, as we’re managing this those were sort of the three different thought processes that we’re considering. And we don’t think it’s too low, we think it’s appropriate, I guess that’s the other thing I’m saying, the amount of capital that we have is appropriate for the environment and you should probably say something about that Bryon.
Yeah, that’s correct. I do say this here internally and I’ve said it really sense the third quarter of 2013 or it was right after the [indiscernible] I started to use the phrase that I reserve the right to change my opinion immediately. And that’s because that’s the type of environment I think we’re in and there were several people argued with me over this issue but I think they’ve all come around to the fact that we’re very subjective to surprises and we’re very subsequent to [indiscernible] type of events.
And so we are managing our risk position appropriately, but we do have room if necessary to potentially add assets.
Okay, great, that makes sense. Thanks. And just one on the duration gap, do you have an estimate for why the duration gap was at the quarter end?
So we don’t really talk in terms of duration gap Bose, but there is a slide and I forgot the number of it right now that just gives you the exposure for on assets. It did increase over the quarter and I can probably want to do that, yeah.
Slide 20 Bose says our duration exposure in terms of [indiscernible] and then it also – we also include in that same chart spread.
Okay. Okay, great. Okay, thanks a lot.
[Operator Instructions] This concludes our question-and-answer session. I would like to turn the conference back over to Byron Boston for any closing remarks.
Sure. Today didn’t turn out exactly as we wanted it from an operational perspective. So I really appreciate everyone being very patient. I especially appreciate Bose George, Doug Harter, [indiscernible] you guys were wonderful in supplying with those questions that I hope everyone else found useful that we were willing to answer. We were just simply trying to put together a solution to the problem on the situation we found ourselves in this morning.
So again, thank you so much. Thank you for your patience and we look forward to you joining us for our third quarter conference call in a few months. Thank you very much.
The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.
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