Interview With Byron Boston, CEO Of Dynex Capital
Seeking Alpha Analyst Since 2013
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- We recently sat down with Byron Boston to get his thoughts on how to manage a mortgage REIT. DX thoroughly outperformed peers over the last year.
- Byron shares his ideas on the importance of having sufficient liquidity and being flexible in a challenging environment. These techniques helped Dynex Capital generate higher levels of Total Economic Return.
- Byron also shares ideas about the most common mistakes for retail investors and analysts within the sector.
- Our notes section at the end includes lessons on Total Economic Return and Total Shareholder Return. Many new investors get these terms mixed up.
- We’ve included a written transcript for investors who like to read and an embedded audio file for those who like to listen. If you can’t hear something, check the transcript.
We just uploaded an interview with Byron Boston, CEO of Dynex Capital (DX) for our subscribers.
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We're going to share part of the interview in this instablog.
We are thrilled to have the opportunity to interview Byron Boston, CEO of Dynex Capital (DX). We went over several topics that will be relevant to mortgage REIT investors and may help readers get a more complete grasp of mortgage REITs in general and Dynex Capital in particular. We’ve included a transcript below with minor modifications for clarity. Scott Kennedy covers Dynex Capital in his weekly articles on mortgage REITs. This is one of the mortgage REITs currently tied for the lowest risk rating within our coverage. They got there by maintaining a defensive position and having a long history of making solid decisions on how to manage the portfolio. Since our ratings are based on price-to-projected-book-value throughout the sector, we encourage investors to always check Scott Kennedy’s latest articles on The REIT Forum to get an updated rating. We also program Scott’s price targets into our Google Sheets, so you’ll have a real-time view on where prices stand relative to our ranges.
Subscriber note: At the time we are publishing this article, Scott’s latest update was published on 12/06/2020.
- Click here to access Scott’s ratings as of 12/06/2020. (Note: That's paywalled for subscribers)
We have slightly modified the transcript for clarity. The difference between audio and text is extremely small.
Note: That link won't work in the instablog and you won't be able to Google for the file.
Modified Transcript Starts
I am here with Byron Boston from Dynex Capital and we have a few questions we’re going to go over to try to help investors understand a little bit more about mortgage REITs and about how Dynex Capital has managed to perform so well.
Dynex Capital outperformed peers over the last year and in several cases the gap was dramatic. At the end of Q3 2019 book value was $18.07 per share. Following the pandemic which wreaked havoc on the sector, your book value ended Q3 2020 at $18.25 per share. That increase occurred while paying out a significant dividend. Clearly, you were way ahead of the markets in understanding the risks. How did you recognize the risks so much earlier?
So, Michael, we believe the key to success in managing a mortgage REIT is risk management first, followed by effective capital allocation across multiple asset classes.
At Dynex, we use a top-down approach to investing, starting with the macroeconomy and bringing that thinking into our daily asset allocation, funding, hedging, leverage, risk, and capital management decisions. We were very public and transparent about our macroeconomic opinions.
Our macro view shifted in 2015 when we saw that the global investing environment began increasing materially in complexity.
This led us to an up in credit, up in liquidity strategy for some time. It also led us to do a lot of scenario planning.
We were prepared for surprises. We entered 2020 with a significant liquidity position, a more liquid portfolio, and a robust scenario plan. This discipline served us well, and we navigated through March by protecting ourselves and the balance sheet with no “forced sales”.
One of the unique things in the DX portfolio is the role of CMBS. At the end of 2019, the DX portfolio included 10% in CMBS IO and 39% in agency CMBS. Before we get into the current portfolio, how important was the use of high-quality CMBS to hedge against the convexity risk?
You know, it was essential. It worked phenomenally. As a core principle, we believe in managing a diverse portfolio of assets with a combination of residential and commercial exposure. The commercial sector helps reduce the negative convexity exposure in our portfolio. The commercial securities will generally widen in ‘spread’ as the dollar prices rise but the structure of most commercial loans provides us with meaningful compensation if the borrower chooses to prepay the loans. The commercial securities were critical to our performance in 2020. The CMBS worked extremely well when the rates dropped below 136.
A minute ago I said we had ‘scenario planned’ around a break below 136. Our portfolio was, at the end of 2019, I think we were half CMBS and half RMBS.
We believe 136 was a critical technical point in yields. The CMBS gave us enormous flexibility to move out of negatively convex positions, such as 30-year high-coupon residential pass-throughs. At one point we breakthrough 136 and it becomes clear we’re challenging the 1% area of the 10-year.
We’re now in uncharted territory, Michael, by anyone’s career. Our first key decision was we sold all of our residential securities and we went into two asset classes: cash and more agency CMBS. That would’ve been early March. Before things got really bad. We had a ton of liquidity at the end of 2019, over $200 million of liquidity - probably $225 million or more. We increased that liquidity by selling [almost all of our 30-year]. We sold probably 80% and maybe 85% to 90%. The reason [for selling] was we broke to new lows in yield with a security that prepays which was uncharted territory. As such, we knew we could sell and we knew we could get back in when we wanted to. CMBS allowed us to do that. We went into cash and we increased our holdings in agency CMBS in March at very wide spreads.
I should add that as we progressed, we then got to April. We finished the first quarter in good shape. We got to April and you should know that the [sale] in the 30-year security was not a forced sale. We broke through new levels and our scenario plan basically said: there’s a problem here and we are at new lows. An enormous amount of the coupons in the residential world are now prepayable. So, we responded.
We increased our agency CMBS. In April, we started to reduce our agency CMBS. Why did we start to reduce them? One of the key macro factors at that time was that the government allowed renters to stop paying rent. So, we still don’t understand fully what happens when people don’t pay rent. I don’t know that the world fully understands yet what happens when people don’t pay rent whether they are apartment dwellers or whether they are small companies and malls. So, we pulled back from the commercial sector in April. We literally reduced the majority of our commercial position with the exception of our CMBS IOs and a few stragglers.
We went back into the residential sector because we had a better understanding of what happens when people don’t pay mortgage payments. We had gone through 2008 and had gone through other periods. We watched and understand how Freddie and Fannie have tons of options to manage a portfolio when a homeowner doesn’t pay/make a mortgage payment. They can tack the payments on at the end, they can refinance the mortgage, they can restructure the mortgage, but when homeowners don’t pay rent, we’re in uncharted territory. So, we reduced. We still have a core belief of a diverse portfolio, but that’s the way we’ve moved our portfolio around. We’ve moved the portfolio around in 2020 more than we have in the 12 years I’ve been at Dynax, but it was very disciplined. It was very thoughtful and it started with a macroeconomic view.
It looks like the ability to be nimble really helped the company.
It’s essential. There’s only so large that Dynex will ever be with me as the CEO. I do want to grow the company. Everyone wants to talk about cost ratios. We don’t believe cost ratios have any predictive value for the long-term performance of a mortgage REIT. What will make a difference in long-term performance will be the decisions of the management team. So why am I saying that we don’t want to be as large as the largest players in this industry? We believe being nimble and the ability to move positions around is essential. We would like to be larger than we are. We would love to be able to share some of the expenses of running the business with a larger base of shareholders. However, nimbleness and the ability to be very disciplined in capital allocation is essential for the long-term success of a mortgage REIT.
The full interview also includes the following questions:
In your Q3 2020 earnings announcement, DX announced the sale of $382.3 million of agency CMBS with a gain of $20.8 million as the spreads tightened substantially. Many investors may not fully grasp the role of spreads between securities. What would you tell them?
Would you share your thoughts on the interplay between the Federal Reserve and Treasury for financial markets?
What is the most common thing for retail investors to misunderstand about mortgage REITs?
What would you say is the most common thing for analysts to get wrong or to misunderstand about mortgage REITs?
What else would you like investors to know about Dynex Capital?
Looking out one year from now, do you think there will be more mortgage REITs, fewer, or the same number?
Great, Thank you.
Did you have any comments? You mentioned before talking a little bit about the history of mortgage REITs and what it looked like over the last few decades.
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For transparency, our open positions in mortgage REITs as of 12/07/2020 at market close are shown below:
Analyst's Disclosure: I am/we are long all shares in cwmf's portfolio.
At the time of writing this, we do not currently have a position in any Dynex Capital share (common or preferred) or any options contract related to a Dynex Capital share.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.