Dynex Capital (NYSE:DX) is an mREIT with a large focus on holding agency ARMs (adjustable rate mortgages) and high-quality (agency or AAA-rated) CMBS and CMBS IO strips (Commercial Mortgage Backed Security Interest Only Strips). It has been one of my favorite mREITs because it was internally managed with a strong team, a solid history, and a strategy that allowed them to use the CMBS positions to offset prepayment risks on the ARMs.
Why I Walked Away
On February 22, 2016, I sold my shares with an average price of about $6.24. My reason for walking away has more to do with the sector than with DX. Shares were rallying substantially during a quarter (Q1 of 2016) where the yield curve flattened, prepayments on agency MBS appeared to be climbing, and credit spreads were widening. Seeing shares of mREITs rise across the sector despite deteriorating fundamentals made me wary about the potential for adverse price movements. When I saw relatively strong pricing again, it was time to take it. Shares are still trading significantly below book value, but for most of the mREITs that I'm tracking, the discount has become substantially smaller than the values I'm used to.
The mREIT recently provided its fourth quarter results. The Core EPS figures looked solid because the $.25 covers a $.24 dividend. However, its book value took a fairly significant hit from $8.19 down to $7.71. Based on higher expectations for prepayments, wider credit spreads, and declining rates on LIBOR swaps, I'm concerned that values may have weakened further. I'd love to run book value estimates on DX the way I do on some agency mREIT peers, but projecting changes for ARMs and CMBS is more difficult.
It was the earnings call that kept running through my head over the last few days. The term "2011" comes up 4 times in that transcript. The total return for 2011, measured as the change in dividend adjusted close from the last day of 2010 to the last day of 2011, was negative 6.1%. Hearing about "2011" that many times is like hearing about your significant other's ex. It should bring you to full attention that something could be materially wrong.
During that earnings call, the following statement came up in the prepared remarks:
"Even if we have a situation of mandatory minimum haircuts, we will be looking at a scenario where pricing would need to be adjusted and with that perhaps an adjustment of return expectations."
I added the bold for emphasis. Those words caught my attention as well since I'm expecting most of the sector to face dividend cuts at some point during 2016. The discount to its end of Q4 book value is currently about 19.3%. This is fairly normal for discounts to end of Q4 book value, but I'm pegging several mREITs as having lost book value during the quarter. Without being able to be confident that DX has performed better, I couldn't justify staying in when I'm concerned about the sector having moved significantly higher.
The biggest risks facing Dynex Capital right now is the risk of prepayments on ARMs driving down the yield on assets and the smaller size of the mREIT limiting the ability to drive total economic return (change in book value + dividend) through repurchasing shares. This is a shareholder-friendly management team that hasn't been afraid to repurchase shares at a significant discount to raise the book value and increase their ability to earn net interest income. Unfortunately, it is also one of the smaller mREITs, which limits its ability to keep using that technique.
I'm growing a little weary of seeing headlines regarding the refinance index. High refinancing activity is a very bad sign for mREITs when rates are dropping. The increase in prepayments drives down the yield on assets because it requires the premiums to be amortized over a shorter time period. It also returns cash to the mREIT at a time when rates are lower and thus reinvesting is less appealing.
This is an important sign for the success of the sector and I'm glad that the data is being posted, but the trend towards even higher prepayments represents a significant problem for the mREITs.
Dynex Capital has a great management team and has been one of my favorite mREITs. Despite the positive factors, I can't justify holding a position in the sector when the yield curve is flattening, prepayments are rising, and discounts to book value are shrinking. A month ago, several of these headwinds were already in place, but the share prices were overwhelmingly attractive.
With the sector moving significantly higher, I'm sitting on the sidelines and waiting before I put my cash back to work. At the time of my writing, the closing share price was $6.22. Investors should be aware that my opinions move when prices go up or down. If share prices moved above $7 or below $5.40, my opinion would be substantially different.
If shares move 10% in either direction, my analysis would be out of date. Analyzing the share prices is a critical part of mREIT analysis.
My view on Dynex Capital is neutral on the stock with a bearish view on the sector. That leads me to believe there is more risk than reward left at current prices of $6.22.
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.
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.