Dynex Capital: A Substantial Discount To NAV Represents A Solid Sale

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About: Dynex Capital, Inc. (DX)
by: Colorado Wealth Management Fund
Summary

Management was comfortable raising leverage despite the challenging environment for mortgage REITs.

DX hedged against some of their prepayment risks by including a large allocation to CMBS in the portfolio.

Most mortgage REITs already announced dividend reductions. DX is included within that group, but shares are attractively priced today.

Dynex Capital (DX) took leverage up a notch in Q2 2019 compared to Q1 2019. They ended with leverage at 9.4x compared to 8.5x at the end of Q1.

Source: DX Investor Presentation

While agency mortgage REITs can push leverage even higher (into the low teens or so), it is extremely rare. Relative to the last few years, we believe the spreads between MBS and hedges are pretty attractive. That's generally a positive situation for raising leverage. However, we have to highlight that spreads are wider relative to the last few years, not relative to the last 7 or 8 years. We don't expect to see spreads on MBS get much wider than they are today (August 7, 2019).

Prepayment Risk

DX indicated that they wanted to reduce prepayment risk over the coming years. RMBS (Residential Mortgage-Backed Securities) face a significant risk from prepayments. When interest rates fall, more homeowners decide to refinance their mortgage. The owner of the MBS is paid $100 in principal for each $100 that was refinanced, but the fair value may have been higher (say $102 to $104).

On the earnings call, management highlighted that even "specified pools" (RMBS which tend to prepay at slower rates) would still be subject to prepayments if rates fell much further. To reduce their exposure, they increased the portion of their allocation allocated to CMBS (Commercial Mortgage-Backed Securities):

CMBS are different because they have protection from prepayment built into the contract. That doesn't make prepayment "impossible", but it makes it extremely difficult. The homeowner (loan goes into RMBS) is not punished when they refinance. The borrower in a CMBS must pay a significant penalty. By position in CMBS, DX is reducing its risk of elevated prepayments. They still carry some of this risk as fixed-rate agency RMBS remains their largest single position, but they have a very substantial portion of their portfolio within fixed-rate agency CMBS.

Hedging Against Changes

We don't see any reason to change our view on DX at this point. We remain long DX and see it trading at a material discount. DX indicated BV was up by about 1% on the earnings call, but the initial BV reported came in slightly lower than expected. Since then, we saw a rapid decline in interest rates. We expect a little additional pressure on book value as a result, but DX hedged quite well against major decreases in interest rates.

Consequently, we see DX trading at one of the larger discounts among the residential mortgage REITs today. Should DX trade at a larger discount? We don't think so. The company announced a pending reduction in the dividend, which puts them in line with most of the sector. We saw these risks coming for the entire sector years in advance as gradual declines in book value made it more difficult to cover the prior dividend levels.

The announcement by DX may have placed some pressure on the share price, but it was still a prudent move. Management is carefully monitoring the ability to earn net interest income in the current environment.

Using the expected monthly dividend level of $.15 per share, we see an 11.56% dividend yield. Following the reduction, dividend coverage looks much better.

Outlook

We're bullish on DX. We see shares trading a price-to-trailing book value ratio of .87. Adjusting for the change in interest rates as a headwind to book value suggests the current ratio may be closer to .89. That is still a significant discount.

Disclosure: I am/we are long DX. 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.