Dynex Capital, Inc.

Ladies and gentlemen, thank you for standing by and welcome to the Dynex Capital's second quarter 2020 earning results and conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 on your telephone. If you require any further assistance, please press star 0. I would now like to hand the conference over to your speaker today, Alison Griffin, Vice President, Investor Relations. Thank you. Please go ahead.

Thank you, Casey. Good morning, everyone, and thank you for joining us. With me on the call today is Byron Boston, President and CEO, Smirthy Papano, EVP CIO, and Steve Benedetti, EVP CFO and COO. The press release associated with today's call was issued and filed with the SEC this morning, July 29, 2020. You may view the press release on the homepage of the Dynex website at dynexcapital.com, as well as on the SEC's website at sec.gov. Before we begin, we wish to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan, and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. The company's actual results and timing of certain events could differ considerably from those projected and or compensated by those forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, please refer to the annual report on Form 10-K for the period ending December 31, 2019, as filed with the SEC. The document may be found on the Dynex website under Investor Center, as well as on the SEC's website. This call is being broadcast live over the internet with a streaming slide presentation, which can be found through our webcast link on the homepage of our website. The slide presentation may also be referenced under quarterly report on the Investor Center page. I now have the pleasure of turning the call over to our CEO, Byron Boston.

Good morning, and thank you very much for joining our call today. As the CEO and a shareholder of Dynix Capital, I am excited about the future of our business. I have a strong and experienced team of professionals managing our capital. We believe it is an exceptional environment to generate solid cash flows for our shareholders. Financing rates are low, and the liquid assets we're invested in offer attractive risk-adjusted returns and are generating solid net interest income. And our balance sheet gives us flexibility to navigate the complex environment. For over 30 years, Dynex Capital has managed leveraged, securitized asset portfolios to generate cash income for our shareholders. We've managed every asset class that you see represented across the mortgage REIT industry today. Over the past few years, however, As global risks have intensified, we have chosen to limit our investment focus to assets with the highest credit quality and highest levels of liquidity. In addition, we have chosen to maintain a higher level of overall liquidity on our balance sheet. This is a choice that has served us well if you look at comparative long-term returns through the second quarter of 2020. We believe the key to a successful long-term strategy of managing a mortgage REIT Is risk management first and effective capital allocation across multiple asset classes? We have been consistent in our approach to the market, so let me recap what we have said to help you understand why we are excited about our business today. So since the fall of 2018, when the Fed was still tightening credit and allowing the balance sheet to run down, we pointed out to you that we did not believe the Fed could continue on that path and that our financing costs would begin to decline. And as a result, our net spreads would increase. Well, today, our financing costs are pegged at low levels, and as a result, we're generating substantially more net interest income. We noted that surprise events were highly probable because global risks have intensified. In fact, March of this year represented a surprise event similar to what we saw in 1998. We had the experience, and we were prepared to weather this storm. We also highlighted that we were excited about the future outlook for our business model because the demand for yield would increase globally. We feel stronger about our expectations now that global yields have continued to plummet further towards zero and below. And finally, for the past decade, we have also said that government policy would drive returns, but we did not anticipate the extent to which this would evolve. A profound shift is taking place in economics. as we all adjust to a supersized level of state intervention in the economy and financial markets. I will now turn the call over to Steve Benedetti to go through our second quarter results.

Thanks, Byron, and good morning to everyone listening. For the quarter, we posted a total economic return of $1.05 per common share, or 6.5%. Book value per common share was the largest contributor, increasing a net $0.62, or 3.9%, to $16.69. Of this increase, $0.79 per share came from changes in the value of the investment portfolio net of hedges as volatility ebbed during the quarter and credit spreads tightened versus benchmarks across the investment portfolio. This was partially offset by $0.07 in declared dividends and excess of core EPS, and $0.10 in costs related to restricted stock grants made during the quarter. From an earnings point of view, we reported comprehensive income of $1.15 per common share and core net operating income of $0.36 per common share. The decline in core EPS from last quarter was really a function of the size of our investment portfolio as we maintained a lower leverage profile and a higher liquidity buffer early in the quarter. For the quarter, average interest earning assets, including TBA securities, were approximately $3.2 billion versus $5.1 billion last quarter. Offsetting the smaller size of the investment portfolio was an increase of 49 basis points and adjusted net interest spread. Net interest spread and adjusted net interest spread benefited from the rapid decline in financing costs by 112 basis points, driving the interest spread expansion and more than offsetting the decline in earning asset yields of 48 basis points from sales of higher yielding assets and the addition of new assets on balance at lower overall yields. Drop income on TBAs also increased as we added them throughout this quarter given implied financing costs on dollar rolls being more favorable versus repo, as Smriti will discuss later in the call. Our hedging activity continued to favor a mix of interest rate swaps, options, and treasury futures. The average notional outstanding for swaps was $351 million, down from $2.9 billion in the first quarter. The notional balance of our swaps at the end of the quarter was $475 million, with a pay fixed rate of just over 70 basis points, and the notional balance of our outstanding options and treasury futures was $2.65 billion. With that, I will turn the call over to Smriti.

Thank you, Steve, and good morning, everyone. I will briefly review our performance for the quarter. Then I'll talk about our actions taken last quarter and discuss our current outlook and strategy. In terms of performance, please turn to slide 22, titled Fixed Income Market Update. As Steve mentioned, our book value moved up during the quarter by 4.9%. This was partially offset by 1% from dividends in excess of earnings, capital stock transactions, bringing overall book value up 3.9% for the quarter. This was primarily driven by spread tightening on agency CMBS IOs, which you can see on the bottom of this page. Spreads tightened in approximately 140 basis points from 400 to 275 on agency IOs and from 450 to 300 on non-agency CMBS IOs. We also saw modest tightening in agency CMBS DUS. You can see that on the next page, page 23, on the top right-hand side, as well as a tightening in agency pass-throughs. It's important to note that while spreads on par-priced agency CMBS DUS have come in almost 35 basis points, as you can see on the top right panel on page 23, Premium DUS did not experience similar tightening. Premium DUS are actually only 11 basis points tighter on the quarter. Our current rough estimate is that book value in July is a little over 1% higher than at quarter end, although we have not yet completed our standard month-end closing process. Turning to our actions last quarter. In March, we shifted our thinking on cash flow risk and started to reevaluate our agency CMBS DUS portfolio for the increased possibility of delinquencies and defaults. While dust paper has a government guarantee of principle, in a default scenario, the entire premium of the bond over par goes away in a repayment. Our bonds were very high premium, close to 118, $120 price. And during the month of April, we reduced that position from 2.1 billion to 800 million, realizing gains of $193 million. and cutting the majority of our premium exposure in that sector. These sales, as well as those made earlier in March of high premium agency RMBS pools, fours and four and a halves, brought our leverage to total capital down to about four times at the end of April. In May, we rapidly deployed that capital into agency RMBS, aligning the investment strategy with government policy actions, focusing on liquidity and flexibility. If you turn to page seven, titled Business Activity, you can see we increased our leverage from a low point of four times in the quarter to eight times by the end of the quarter, investing primarily in lower coupon pass-throughs and TBAs. As you can see on slide 10, titled Investment Portfolio, as of June 30th, agency RMBS were 76% of the portfolio. 15% of the portfolio was agency CMBS, and 96% of the portfolio is agency guaranteed. On page 11, we have allocated, you can see we've allocated capital to lower coupons with a mix of TBA and specified pools, primarily twos and two and a halves. We're diversified in specified pools between higher pay-up stories and lower pay-up stories. The TBA market and the 2% coupon currently offers attractive financing relative to pools, as Steve mentioned, in the REVO market. At some points in the last settlement cycle, the financing rate in the dollar role market was as low as minus 90 basis points, an advantage of 120 basis points all in versus pools, almost doubling the return in TBAs versus owning pools. We see structural demand in the 2% coupon that supports continued specialness in the role in the coming months. Please turn to page 12. We are operating today with a larger liquid diversified portfolio focused on liquidity and flexibility. As you can see on this chart, our net interest spread has been widening as financing costs have declined. At current leverage levels and the mix between pools and TBAs, we feel the portfolio has the flexibility to navigate the coming months. Assuming no changes from the current portfolio size, and with financing costs trending as described in the forward markets, factoring in leverage and prepayments, the earnings from the portfolio are expected to exceed the level of the dividend for the remainder of 2020. Turning now to our macroeconomic opinion and outlook. We have assessed the environment as a health and economic crisis layered on top of the already existing fault lines that we identified before, socioeconomic, global debt, technology, environmental, geopolitical and demographic factors. A major consequence of this crisis is a significant disruption to cash flows, which is now colliding with huge amounts of government intervention through monetary and debt-driven fiscal policy. Many questions still abound. Will the government actions be enough to minimize the disruption to cash flows? How do the structural factors evolve as we see the duration and severity of the health and economic crisis play out? What is the risk return trade-off we need to make in the short, medium term versus the long term? These are all still open questions. We're also still tracking risk events in the upcoming quarters. We have known unknowns like the election and the continued geopolitical and trade frictions, as well as the continued possibility of an exogenous shock. It is very likely that we will have an environment with periods of calm created by massive central bank interventions punctuated by bouts of volatility from surprise outcomes. With this in mind and so many factors in play, our investment strategy is built around what is relatively more certain in the short and medium term so that capital is preserved and available for opportunities in the long term. What we see clearly is that financing costs are low and we expect will stay low for high-quality assets for some time. This is a major positive for investing in agency RMBS. Government policy, central bank policy, and specifically the Fed, is also aligned with investing in this sector, and the assets continue to offer an attractive return in the low teens ROE, as you can see on page 13. With front-end rates anchored, central banks actively purchasing their own country sovereign debt, volatility in interest rates has materially declined. and will likely continue to remain contained in the absence of exogenous shocks. This is also supportive for investing in agency RMBS. Please now turn to page 24. Our portfolio is constructed for this environment to capitalize on earning returns