Dynex Capital, Inc. (NYSE:DX) is an mREIT with a fairly diverse portfolio of investments. The company is using RMBS (residential) and CMBS (commercial). In both categories, they invest in both Agency and non-Agency securities. The company also invests in IO (interest only) strips. The result is a company that can be difficult to explain to investors that are new to mREITs. I'll break down the values from their latest financial statements to make it easier to understand what this mREIT is doing.
The first thing to examine is the value of the different assets the company is holding. That gives us an idea for how much exposure the company has to each part of the market. See the chart below. (All images, except the last one, are original creations.)
The largest exposure by far, when considering book value, is Agency RMBS. However, the agency RMBS have a fairly low yield compared to the agency RMBS of many other mREITs I have looked at. The lower yield could indicate a lower prepayment risk on the RMBS, but there are also frequently lower yields on adjustable rate mortgages. A substantial portion of the Agency RMBS category is adjustable rate mortgages. The adjustable rate mortgages can have more favorable prepayment characteristics because their value fluctuates less with changes in the market interest rate.
My opinion on the IO strips
IO strips by definition usually carry a substantial amount of prepayment risk which would make the mREIT substantially more vulnerable to changes in the rates. However, the company is investing in IO strips on CMBS rather than RMBS and the risk factors are different for CMBS. The discussion of IO strips merits its own discussion which would overwhelm this article.
The one thing I do want to discuss here is that the position in CMBS IO strips is less risky, in my opinion, than a similar position in RMBS IO strips would be.
Premium in amortized costs
The premiums to par value look fairly large because there is no par value for an IO strip. Looking at the difference between par value and amortized cost creates the following chart:
However, if we drill in on the individual categories and remove IO strips we come up with a different perspective on the investments.
The Agency securities are being held at a fairly substantial premium to book value which means the company should have a significant exposure to prepayment risk. However, since many of the RMBS are adjustable rate, the prepayment risk may be lower than it would otherwise be.
It is worth noting that CMBS have different prepayment risks due to different contractual obligations. The exact terms of the CMBS are not stated; Management has indicated that generally the CMBS they invest in have various defenses against prepayment such as lock out periods or yield maintenance provisions.
The following chart breaks down the effective yields by the category of MBS:
It should be clear that the Agency RMBS are producing fairly low yields, which requires DX to maintain a fairly low expense for financing the position. The weak yields should not be surprising because they are offsetting the built in advantages of the adjustable rates on the mortgages.
Net Interest Spreads
The yield curve is defined as "normal" when it has an upward slope. So long as the yield curve slopes upward, then a large position in interest rate swaps (paying fixed) results in higher interest costs. Higher interest costs result in lower net interest spreads.
The following chart shows the net interest spread in each of the last several quarters.
The net interest spreads aren't bad, especially given the portfolio's strength against interest rate fluctuations.
Resilience against rate changes
Management is attempting to deal with the low interest rate environment in the U.S. by constructing a portfolio that can withstand significant changes to the interest rate environment, as shown below:
A one hundred percent shift in interest rates would be a fairly substantial move. While it would hit net interest income pretty hard, that reflects a theoretically substantial increase in the short term borrowing costs under repurchase agreements. I'm comfortable with a 1% change in market value on a 100 basis point swing.
Dynex Capital, Inc. is an interesting mREIT with a fairly complex investing strategy that may leave newer investors confused. Ironically, with all that complexity the company is hedging risk rather than creating it and the result is a company that is substantially more stable in price than many other mREITs.
So far, I like the company in the context of a single stock or as part of a diversified portfolio. In general, I'm fairly impressed with the job management has done at mitigating the impact of changes in the interest rates.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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. 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. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.