Revisionist Thinking On Dynex Capital

Aug.27.12 | About: Dynex Capital (DX)

We did an article a while back on trying to play the Dynex Capital (NYSE:DX) dividend, and there have been some interesting developments, which are worth a follow-up.

Here is the stock chart. This mREIT has had a couple of good months.

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The original article appeared at the end of March, with the price being about $9.40. The theory at the time was that there might be a way to play the generous Dynex 10% dividend every quarter by buying the stock right before the record date, and selling it shortly afterward.

We demonstrated at the time that it was a bad idea, but there was some notion that the opposite strategy, namely selling the stock right before the dividend and buying it afterward (after the price drop), would have been marginally successful.

Here is an updated chart with the last two dividend payments:

EX-Div Date Div/Share $/share Price Before ($) Price After ($) Price +87 ($) Div % 87-Day Gain ($/share)
6/28/2012 0.29 10.38 10.00 ? 2.8% ?
4/3/2012 0.28 9.52 8.99 10.38 2.9% 15.5%
12/28/2011 0.28 9.48 9.13 9.52 3.0% 4.3%
9/28/2011 0.27 8.43 7.51 9.48 3.2% 26.2%
6/28/2011 0.27 9.98 9.62 8.43 2.7% -12.4%
3/29/2011 0.27 10.4 9.82 9.98 2.6% 1.6%
Average 7.0%
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The earlier conclusion was confirmed for the last two dividend payments: The post-dividend drop was greater than the dividend amount, thus making it futile to try to play the dividend. The opposite strategy, namely buying the stock when it is cheap right after the dividend and selling it just before is now actually looking a lot better. Thanks to the last two good quarters, the average effect per quarter, of doing this was a 7% gain, which is greater than the 2.7% or so per quarter dividend.

But while we were watching this unfold, something else has happened. Dynex has increased its dividend, and the fund is now worthy of some consideration as an actual mREIT investment.

Here is a comparison between DX and American Agency Capital (NASDAQ:AGNC) which is a widely held mREIT that we have been following for awhile now:

Current Yield Portfolio ($B) Portfolio Growth(MRQ) Leverage Interest Spread (%)
Dynex 11.50% 3.73 13% 6 2.18
AGNC 14.90% 77.90 -3.40% 7.5 1.65
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To be sure, these are slightly different types of investments. First of all, Dynex is obviously much smaller than AGNC and more specialized. Dynex deals in agency-backed residential mortgage securities, as well as non-agency backed and commercial mortgages (the ratio is about 75/25). AGNC is known for 100% agency-backed mortgages. The Dynex portfolio is paying a higher average interest rate spread than AGNC's right now, however, by 50 basis points.

The above comparison is an example of why big is not necessarily good in this industry. It is relatively much easier for Dynex to grow a $3B portfolio by 15% than it is for AGNC to grow an $80B portfolio by the same percentage. Dynex is leveraged less aggressively than AGNC as well.

In July, Dynex accomplished the offering of some cumulative preferred stock. Here is the detail of that offering:

Dynex Capital Convertible Preferred
Shares Issued 2,300,000
Price/Share $25
Proceeds $57,500,000
Preferred Dividend 0.085
Annual Dividend Payout $4,887,500
Dynex Leverage 6.1
Potential Portfolio Increase $350,750,000
Interest Rate Spread 0.0218
Potential Revenue Stream $7,646,350
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When AGNC did its most recent offering of common stock, the potential revenue stream was actually smaller than the potential dividend payout. Most of the mREITs, including AGNC are now offering preferred stock as a lower-cost way to raise money, and you can see from the above calculation, this will probably be successful for Dynex.

Hedging and other investment activities are an important part of this business, and here is a summary of the most recent quarter for each of these two companies:

Net Interest Income $M 384 19.0
Gain on Sale of Securities $M 417
Loss on Derivatives (Net)$M -1029
Unrealized Gain on AFS Securities $M 689
Unrealized Gain on Derivative Instruments $M 52
Net of Income and Hedging $M 513
Net Effect of Hedging Program $M 129
Gain on Sale of Investments $M 2.6
Change in Mkt Value of AFS Investments $M 9.8
Net unrealized gain on cash flow hedging instruments $M -11.2
Net Effect of Hedging Program $M 1.2
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The Dynex quarterly report is accessible here. As a percentage of its overall business, the DX hedging activity is relatively low, which is consistent with a slower growth, less aggressive approach that is also reflected in the lower leverage, above.

So, if we were to sum up the Dynex strategy, it would appear to be to have a higher spread portfolio, and offset the potential risk by using lower leverage and more conservative hedging activities. The next growth phase will be financed by the lower-cost preferred stock, the $350 million could be just under a 10% portfolio increase.

I have to also say something about the Dynex risk management strategy. We have done a lot of work to try to understand how these mREITs manage risk, as disclosed in their "Discussion of Qualitative and Quantitative Risk" in their quarterly reports.

Here are the Dynex risk curves for the past 4 quarters:

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You can see what happened. The financial engineers that are running Dynex's hedging program have changed the interest risk curves in such a way as to potentially take advantage of a further decline in interest rates.

So, what are we to make of all of this:

The dividend games aside, Dynex is looking more attractive as an investment, in light of its dividend increases, potential portfolio increase of around 10%, participation in a higher-yield marketplace, and relatively conservative hedging strategy.

The drawback is that with a yield at just more than 11%, which is a bit lower than many of the mREITS, some of the overall rate of return for investors may have to come from future appreciation of the stock rather than solely with dividends.

The world is full of chaos and there are no guarantees on anything, but DX is worthy of some additional attention, particularly if there is a bad day or two and the price pulls back a little.

Disclosure: I am long AGNC. 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.