Dynex Capital (NYSE:DX) delivered an exceptionally strong second quarter. The core EPS figure of $.21 matches the dividend and the book value moved higher by $.15. The result is a 4.77% economic return in a single quarter. I have frequently cautioned investors about relying on values like "Core EPS" without looking deeper into the REIT to see if they are distorting the results. That is never a concern with Dynex Capital. Their non-GAAP values have regularly represented a realistic presentation of their performance.
Analysis starts with understanding the portfolio:
The portfolio emphasizes a mix of agency RMBS, Agency CMBS and CMBS IOs with high credit quality (often agency supported). The agency RMBS positions are seasoned adjustable rate mortgages and performed fairly well. The thing that made Dynex Capital particularly interesting to me was their use of CMBS and CMBS IO strips.
How Do Those Positions Work?
The agency CMBS positions (88% of the CMBS portfolio) have the exceptional credit quality seen in agency RMBS. Unlike agency RMBS, they don't have much prepayment risk because of prohibitions on prepayments by commercial borrowers. Consequently, the agency CMBS adds dramatically more duration to the portfolio than fixed-rate agency RMBS. That extra duration requires some hedging through LIBOR swaps, but the terms are favorable.
If the REIT can hedge their duration risk with a 10-year LIBOR swap, they would be paying a fixed rate of about 1.41%, but the 10-year Treasury had a yield of 1.52%. Consequently, even if the repo agreements require paying 5 basis points above the short-term LIBOR rate, the effective cost of funds can still be a few basis points under the Treasury rate. The difference between LIBOR rates and Treasury rates is smaller at the shorter durations. If a mortgage REIT is hedging agency RMBS, it makes more sense to be using hedges with three to seven years to maturity.
For comparison, the difference in LIBOR rates and Treasury yields is around 3 to 4 basis points at the five-year range. That is materially weaker than the 11 basis point spread offered at the 10-year range.
By using agency CMBS, Dynex Capital is able to take advantage of owning assets with less prepayment risk. When assets have less prepayment risk, they have a higher effective duration. Though it may seem strange, higher effective duration requires more hedging. Yes, that means less prepayment risk means more hedging is necessary.
A Great New Slide
This is another slide from the earnings presentation:
Most REITs do not have this level of breakdown. Some will provide the "Book Value Rollforward," but they rarely break down the results by the change in spreads relative to the increase or decrease in interest rates. The slide allows investors to see at a glance that the main reason book value moved higher was because of the positive duration in the portfolio.
That brings us right back to that issue of using the CMBS. The extremely low prepayment risk on those securities makes them an ideal tool for holding positive duration. The high duration was the major factor driving returns.
Outlook on Dynex Capital
I agree with management about the macroeconomic situation. I agree with both the decision to run positive duration and the decision to run a portfolio using agency CMBS and CMBS IO strips. Those are some very positive factors. The only thing that keeps me from hitting Dynex Capital with a buy rating is their discount to book value. The discount is comparable to larger peers. As an analyst, I'm seeking opportunities where the market has failed.
There is one drawback for Dynex Capital. A larger capital base would be favorable for reducing the operating expenses as a percentage of equity. If Dynex Capital could quadruple their capital base, I think they would be in an exceptionally strong position.
My overall rating here has to be neutral. The discount relative to peers is similar and the challenge of being a smaller mREIT offsets part of the benefits of running a great strategy.
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Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.