Checking In On The 11.4% Yield From Dynex Capital

| About: Dynex Capital (DX)

Summary

Dynex Capital is a small mortgage REIT that rarely gets attention from analysts or shareholders.

The portfolio of Dynex Capital is very unique in the mortgage REIT space.

The REIT has internal management and invests in commercial MBS that are usually held by mREITs with higher cost external management structures.

The portfolio uses agency ARMs for the RMBS and mixes high quality CMBS with CMBS IO Strips.

Because ARMs are heavily exposed to prepayment risks, the CMBS are an ideal asset class to combine with the RMBS.

Dynex Capital (NYSE:DX) is a small mortgage REIT that doesn't get as much attention as it deserves. The common shares carry an 11.4% dividend yield after the company sustained its quarterly dividend at $.21. To help readers understand the strategy that supports the dividend yield, I want to discuss the portfolio.

The REIT has a few things that make it very unique from other mortgage REITs. The first is internal management. I like internal management because it offers better alignment off shareholder interests and management interests. It doesn't hurt that internal management also provides better economies of scale when the company is growing. The biggest challenge for Dynex Capital is the price-to-book ratio. Due to great management and the unique portfolio, Dynex Capital demands a premium on price-to-book value relative to the other mREITs. It still trades below trailing book value, but it has a higher ratio than most other mortgage REITs.

The analysis on Dynex Capital should focus on what makes its portfolio unique. Values are pulled from its second-quarter presentation. DX has three major kinds of assets. The portfolio includes residential mortgage-backed securities (known as RMBS), commercial mortgage-backed securities (known as CMBS) and commercial mortgage-backed security interest only strips (known as CMBS IO Strips).

RMBS

Within the RMBS part of the portfolio, it is holding primarily agency adjustable-rate mortgages (known as ARMs). Because these securities are adjustable rate, they require dramatically smaller amounts of hedging. Consequently, the hedging performed by Dynex Capital can heavily emphasize the CMBS with only a small level of hedges needed for the RMBS portfolio.

I do have one concern about adjustable rate mortgages. The variable rate on these securities after they reset is not particularly attractive to the homeowner. Many investors could skip right past that issue, but I believe it provides a material challenge to interest income off of the securities in future periods. The major risk here is that homeowners may decide to refinance out of their adjustable-rate mortgage into a fixed-rate mortgage when they can get roughly the same interest payment. These adjustable-rate mortgages are worth (speaking of fair value) more than par value. Therefore, when the securities are prepaid it creates a real economic loss.

The nice thing about this risk factor is the treasury yields moved to materially higher levels during the third quarter. Even though mortgage rates didn't move much, the higher level of the treasury yield curve should prevent mortgage rates from falling as rapidly in the future. If mortgage rates do not fall further, the incentive to refinance into a fixed-rate mortgage is materially lower.

CMBS

On the other hand, the CMBS are ideally positioned against prepayment risk. CMBS feature a "lockout". That prevents the borrower from making prepayments or punishes them if they do. Generally those punishments serve to provide a cash value to the holder of the CMBS to compensate them for the prepayment. Within the CMBS part of the portfolio 86% of the securities are agency CMBS. Therefore, credit risk is largely eliminated. The non-agency CMBS still have mostly high credit ratings. I'm perfectly comfortable with a AAA-rated CMBS as an investment. When the AAA-rated CMBS has a materially higher yield than the LIBOR swap used to hedge the interest rate risk, it provides a very compelling investment strategy. Mortgage REITs holding CMBS tend to trade at higher price-to-book value ratios.

CMBS IO Strips

It becomes even more interesting when we look at the CMBS IO strips. Within this part of the portfolio, only 53% of the securities are backed by an agency. However, IO strips offer exceptionally high yields and the CMBS version does not have the same negative duration expected in IO strips on residential mortgage-backed securities. There's nothing wrong with negative duration, it can be a very attractive feature. However, many mortgage REITs have struggled with the performance of their IO strips on RMBS over the last several periods. The IO strip on the RMBS struggles when prepayment expectations increase. The CMBS IO strip could still get hammered, but it requires companies defaulting on their mortgages with a high recovery rate on the property. If the default occurs but the recovery on the property is weak, it would hammer away at the value of the first-loss tranche. DX doesn't hold those assets, so that wouldn't be a problem. I find the odds of this kind of event pretty low, so I can't help but appreciate the way management designed this portfolio.

Conclusion

The only challenge here is the price-to-book ratio. Dynex Capital often trades at a premium to the average discounts in the sector because it's simply a strong mortgage REIT. Management was smart enough to spot the opportunity in CMBS and solid spread between CMBS and LIBOR swaps which allowed them to reduce prepayment risk while hedging their interest rate risk. While Dynex Capital still trades at a discount to trailing book value, I see some other mortgage REITs that trade at materially larger discounts. I don't consider the alternatives to be higher in quality than Dynex Capital, but the extra discount there is high enough that I picked them first.

Any time Dynex Capital is available near the average discounts for the sector, it should be seen as one of the most attractive opportunities. We aren't there right now, but I keep glancing over Dynex Capital to watch for that opportunity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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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