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spk04: At this time, I would like to welcome everyone to the Dynex Capital first quarter earnings conference call. All lines have been placed on mute to prevent any background noise. There will be a question and answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, again, press star one.
spk06: Thank you. Alison Griffin, you may begin your conference.
spk05: Alison Griffin Thank you, operator. Good morning, and thank you all for joining us today for the Dynex Capital first quarter 2022 earnings conference call. The press release associated with today's call was issued and filed with the SEC this morning, April 27th, 2022. 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, assume, anticipate, estimate, project, plan, continue, will, and similar expressions identify forward-looking statements. These forward-looking statements reflect our current beliefs, assumptions, and expectations based on information currently available to us and are applicable only as of the date of this presentation. These forward-looking statements 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 are contemplated 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 our disclosures filed with the SEC, which may be found on the Dynex website under Investor Center, as well as on the SEC's website. This conference call is being broadcast live over the internet with a streaming slide presentation, which can be found through a webcast link on the homepage of our website. The slide presentation may also be referenced under Quarterly Reports on the Investor Center page. Joining me on the call is Byron Boston, Chief Executive Officer and Co-Chief Investment Officer, Smriti Papano, President and Co-Chief Investment Officer, and Steve Benedetti, Executive Vice President, Chief Financial Officer, and Chief Operating Officer. And with that, it is my pleasure to now turn the call over to Byron Boston.
spk10: Thank you, Alison, and thank you everyone for joining our first quarter earnings call. I am incredibly proud of the Dynex team and the first quarter results we achieved. As we skillfully navigated a historically volatile macro environment in which all major bond indices produce negative returns, as you can see on slide five. This is the second such rapid market disruption in the fixed income market that we have seen in the last two years, during which we generated double digit returns. In the first quarter, we generated a total economic return of 3.5%. And our total economic return for our common shareholders since January 1, 2020, has been 21.3%, all while maintaining an average book value around $18 per share during this period, as you can see on slide six. There's a reason for these exceptional results. It's because of the skills of our experienced team, our risk management, our flexible mindset, our disciplined and patient approach to investing, and our differentiated top-down macro approach to capital management. As I've said many times, we invest your capital with a long-term view. Our team has navigated many complex and volatile market environments, including the 1987 stock market crash, the 1998 long-term capital crisis, the 2008 great financial crisis, the 2013 paper tantrum, and most recently the pandemic turmoil of 2020, and now the first quarter of 2022. All of the lessons learned from these historic events help us maintain perspective when navigating today's complex and volatile market environment. Our focus on a global top-down macro approach is fundamental to our strategy and our success. We have been consistent and transparent in sharing our macro views with the market and how these views have translated into our disciplined investment process. We have been positioned with increased liquidity and flexibility for some time. We continue to expect turbulence and uncertainty in global markets. The Russian invasion of Ukraine has intensified the unpredictability of geopolitical risks, and we expect this conflict to have both short and long-term market consequences. there also continues to be uncertainty around federal reserve actions to combat inflation and the corresponding impact that has on interest rates, credit spreads, and the U.S. economy. But with volatility and uncertainty also comes opportunity, and we are beginning to see opportunities to generate attractive long-term returns through increased leverage. We remain very well positioned to take advantage of market opportunities, which we believe will persist for an extended period of time. We're being measured with our approach while our balance sheet and our mindset remain flexible. We have adjusted our portfolio and we expect to navigate this environment with patience and discipline as market conditions evolve, looking for opportunities to generate accretive returns. I want all of you, our shareholders, to have confidence, confidence in our team and in our unique and disciplined approach What makes us unique? Our unwavering commitment to ethical principles. Our philosophy that starts with risk management and ends with disciplined capital allocation. Our sound investment strategies that are based on top-down macroeconomic analysis. And most importantly, our skilled and experienced people who work day in and day out to protect capital and generate attractive risk-adjusting returns for you, our shareholders. And with that, I will turn the call over to Steve and Smirti to give you more specifics regarding our first quarter performance.
spk09: Thank you, Byron, and good morning all. For the quarter, the company reported a total economic return of 64 cents per common share and comprehensive income of 65 cents. The total economic return of 64 cents includes a dividend of 39 cents and an increase in book value per common share of 25 cents. Comprehensive income of $0.65 consists of $0.44 in earnings available for distribution and $0.21 in positive fair value adjustments on our investment portfolio position net of hedges for the quarter. Earnings available for distribution per common share, a non-GAAP measure, was $0.44 this quarter versus $0.45 last. Average interest earning assets and leverage were largely unchanged while adjusted net interest spread increased five basis points during the quarter. Agency RMBS yields increased 11 basis points, while TVA drop income yields improved by 21 basis points. Agency RMBS yields benefited from slower overall prepayment speeds during the quarter, which were nine CPR versus 11 CPR last quarter. The increase in yields on TVAs was primarily due to the reallocation into higher coupons during the quarter. offsetting these items with an increase in repo financing rates of five basis points. As a reminder, the company predominantly uses Treasury futures and swaptions to hedge its exposure to interest rate risk. Unlike interest rate swaps, these instruments do not have a calculable periodic cost that can be allocated to current period hedge expense and therefore are not included in earnings available for distribution. Rather, the benefit or cost of these instruments is included in changes in fair value, total economic return, comprehensive income, and book value per share. As it relates to book value, the driver of the $0.25 per common share increase resulted primarily from the company maintaining its hedge position throughout the quarter, which mitigated declines in the fair value of the investment portfolio as interest rates increased and as RMBS spreads widened. The company's book value also benefited from its lower coupon agency RMBS allocation, which experienced less spread widening relative to higher coupon assets. It's important to note that our on-balance sheet asset prices and our book value as of March 31 reflects rate and spread volatility that occurred during the quarter. It also reflects the substantial repricing of mortgages and as such, reflects market yields for investments based on spot and forward rates on that date. All else equal, assuming projected prepayment speeds and forward interest rate curves are realized as they existed on March 31st, the yield on our agency RMBS assets from a GAAP fair value basis is approximately 3 percent, which drives forward total economic return and is substantially higher than the 182 basis points effective yield for the first quarter based on an amortized cost basis. From a portfolio perspective, investments inclusive of TBA securities increased on a quarter-over-quarter basis by $235 million, mainly due to TBA investments, and are $4.9 billion as of the end of the quarter, with 91 percent invested in agency RMBS and 9 percent invested in CMBS and CMBS-IO. From a hedging perspective, we maintain our notional coverage of approximately $4.4 billion throughout the quarter, principally in U.S. Treasury short positions. That concludes my prepared remarks, and I will turn the call over to Smriti for her comments on the quarter.
spk07: Smriti Patel- Thank you, Steve, and good morning, everyone. Let me start by saying we have witnessed historic moves in the first quarter, the fastest rise in yields and the largest percentage change in yields in 42 years. The trend continues into the second quarter, with yields up an additional 30 to 40 basis points across a steeper curve. We also saw the fastest increase in mortgage rates since 1985 to over 5%, levels not seen in 12 years. These moves were accompanied by a rapid widening of nominal and option-adjusted agency RMBS spreads, that have repriced in a sustained manner to levels that we haven't seen since the last quantitative tightening cycle in 2018. We believe we're on the brink of a historic opportunity to invest in agency RMBS, which I will discuss in more detail in my remarks. We've maintained a book value in this environment, ending at $18.24 on March 31st and holding between $17.50 and $18.10 thus far in April. We entered the first quarter with our portfolio focused in two coupons, 30-year UMDS IIs and 2.5s. We felt these were the right place to be in a rapidly rising interest rate environment. As spreads in higher coupons have widened, we've responded by moving our entire TBA position from lower coupons into UMBS 3s and 3.5s. This adjustment substantially mitigated the adverse impact of spread widening that we've seen this quarter across all coupons, but particularly in lower coupons. Now, turning to our macroeconomic outlook, the consistent overall theme remains, which is that government policy will be the main driver of returns. We believe that the global economy is in transition from the emergency phase when aggressive government policies were used to buffer the direct impacts of the pandemic, to the post-pandemic phase, where we face the consequence of massive liquidity infusions and fiscal stimulus. The Dynex team has been prepared for elevated volatility, also the increased probability of surprise factors and a bumpy ride in the markets. We continue to be alert for changes in the economic weather,
spk06: focusing on future inflation, messaging, and actions of central banks, war and pandemic-related disruptions, as well as domestic... ...significant amounts of dry powder for investment during bouts of volatility, and most importantly, a flexible portfolio and mindset to respond to evolving conditions. I want to take a few minutes to talk about our approach to managing this environment.
spk07: I use terms like prepared, ready, and respond to highlight our approach. Rather than trying to predict the future, we focus on scenario planning, which allows us to respond rather than react to market events. This is an important distinction and one of the keys to Dynex's success in navigating volatile market environments. We continuously evaluate our decisions for accuracy rather than whether we were right or wrong. This allows our team to have a performance-improved decision-making. How do we put this into practice?
spk06: During transitional environments such as the one we're in, our focus is on capital preservation. We measure ourselves, and we encourage you to measure us
spk07: on the total economic return that we generate. We believe our shareholders are better. At Dynex, we aim to generate earnings that meet or exceed the level of the dividend while ending up with the same or higher book value per share at the end of a period. By doing this repeatedly, we work towards a strong capital base that is available to deploy for future investment opportunities. Now, it isn't always possible to keep book value intact. And there are situations, like the one we're in, where book value may decline, and yet we might still be in a position to make long-term accretive investments for our shareholders, as we did in 2020. In this kind of environment, we aim to minimize the damage to book value from controllable losses by focusing on our hedge ratios, positioning across the yield curve, and managing our overall leverage to protect capital. By minimizing the downside hits to book value, we reduce the amount of time it takes to recover the capital in earnings. We can then deploy the capital at the right time and position ourselves to benefit from potential spread tightening in the future. These are the foundational elements of our investment strategy for the environment, and it is exactly what we executed in the first quarter. Now let me turn to why we believe this is a historic opportunity. The largest non-economic buyer, the U.S. Federal Reserve, is stepping back from the MBS market. And unlike the short bursts of spread widening that we saw in 2019 and 2020, we believe the conditions are ripe for a sustained investment opportunity. The Fed has also consistently messaged a desire to own fewer MBS on their balance sheets, providing a structural opportunity for private capital to step in. The MBS market has been the leader in pricing the impact of quantitative tightening. Returns are higher now than in 2018, with a significant amount of widening already behind us, possibly the majority of it. From this point on, we anticipate going through a cycle of spreads. Yes, they're wide now. We think they could go wider because the amount and pace of quantitative tightening being contemplated by the Fed is higher than it was in 2018. It's also the first time that we will not have the GSE portfolios in the secondary market. We ultimately expect support at the wider spread levels as agency guaranteed MBS will be viewed as an attractive cash flow alternative versus risky credit-oriented investment. We see this as a very positive investment environment for Dymex. We've done a good job of preserving our shareholders' capital to date And it is important to understand that at current levels of returns, we believe we can quickly earn back any incremental book value declines. This is supported by the significant dry powder that we have to invest. We are positioned with over $500 million in available liquidity. Our decision to deploy capital will be driven by two factors. First, our view of the overall macroeconomic environment. which we still believe to be vulnerable to unexpected shocks. This necessitates prudent decisions on leverage. And second, the overall level of mortgage spreads, which while already attractive today, may provide better opportunities at the wider spread levels that we expect. Let me add that at today's level of the balance sheet, we are in position to earn or exceed the level of the dividend in earnings available for distribution for the second quarter. And we expect to be able to maintain that with an additional two to three turns of leverage, even as financing costs rise to the 3.5% implied by the forward curve in 2023. From a hedge ratio standpoint, given the complexity of the global environment and the rapid move higher in interest rates that we've already experienced, we see the chance for rates to go either higher or lower from here. And that calls for a different portfolio strategy. We've therefore diversified our coupon holdings to be more balanced, with about 40% of the agency RMBS portfolio now in threes and three and a halves. While our hedges remain in the 10-year part of the curve, we expect to be more active in managing our hedge ratio in the coming quarters. We've successfully managed through the significant widening in spreads and a historic rise in rates. We're experienced at this and believe we've positioned the book to be cushioned against the worst of the widening. We stand ready to deploy capital as we move into this more favorable return environment, and we're looking forward to building a very solid stream of cash flow that will position us to deliver strong performance in the long term. I'll now turn it over to Byron.
spk10: Thank you, Smriti. I've often said on these calls that when choosing how to invest your money or assess relative performance in our sector, the key factors for consideration should be management team quality, and total economic return performance. I believe the best thing we have done for shareholders over the past two years is the preservation of our capital. Because of our focus on preserving capital, Dynex is now extremely well positioned to capitalize on this big moment in history. We believe Dynex Capital should be in the portfolios of many types of investors. What our performance demonstrates is that we have the ability to hedge our portfolio risk while we generate an above-average cash dividend yield for our investors. If you're running a traditional 60-40 investment portfolio strategy, then consider diversifying your fixed income portfolio with either Dynex Common or Preferred Stock. If you're an endowment that needs an annual draw on your portfolio, our above-average dividend yield can help meet your needs. If you are in retirement or approaching retirement, you need an asset management team that you can trust over the long term so you can simply enjoy life. Dynix Capital offers a unique investment opportunity. We are an experienced and ethical management team with strong core values, a long-term mindset, a track record of preserving capital, and very importantly, a game plan for navigating the current and anticipated market environments. To our existing shareholders, I encourage you to stay with us on this journey. And to those who are not yet Dynex shareholders, I invite you to join us. Operator, please open the lines for Q&A.
spk04: To ask a question, please press star 1 on your telephone keypad. The first question is from Doug Harder of Credit Suisse. Please go ahead. Your line is open.
spk08: Thanks. First off, congratulations on the good book value performance for the quarter. I guess just wanted to follow up. If I look at the available returns that you show in your presentation, despite the spread widening you saw, kind of only showing a widening to 100 basis points of the potential levered return, Can you just talk through sort of comparing that spread widening and why returns only increased 100 pips?
spk07: Sure. So I think it depends on the coupon that you pick to identify what the returns are, right? One of the most interesting things that's happened over the quarter is is the change in the coupon distribution with respect to what is the current coupon. And as the current coupon has migrated higher and higher, so right now if you think about it, the current coupon is actually 4.5%. That is a big driver in terms of what that marginal return looks like. From our perspective, I wouldn't take that as only a 100 basis point change in the overall return. It's simply a function of what is the $102 price coupon and how has that changed over the last quarter. If you really look at the coupon distribution in total, you'll actually see that the returns are higher by the appropriate amount, so probably close to 2.5% quarter over quarter.
spk08: Got it. Okay, that is helpful. And I know you talked a little bit, it was somewhat, you know, coupon distribution, but, you know, I guess any more color that you can give us, you know, kind of how you, you know, kind of navigated the widening of kind of all spreads and still kind of produced a positive, you know, positive book value return, you know, in the quarter?
spk10: Hey, Doug, I'm going to start, and then I'm going to let Smirtz follow up with any micro details. So we are very disciplined about our top-down approach, and I think you could probably go back to when the 10-year was about 65 to 70 basis points. We gave you a view of our process about the yield curve, about anticipated spreads, And we started to position a portfolio at that time. And we've literally, the best thing that we've done for our shareholders is remain calm, patient, and disciplined. Because it's been a gyrating ride from 65 basis points all the way up here to 280, 290 on the 10-year. But we literally sat still with our opinion about the yield curve, about rates, about spreads. If you recall also back, I don't know, a year or so ago, we did a couple of capital raises. We were very open. We said we're not deploying all of this capital because we don't believe that this is the perfect time to do so. We believe there's going to be a better opportunity. We're anticipating steeper curve, higher yields, wider spreads. We've been on this. We've been very disciplined. And the best thing I can tell you that we've delivered for shareholders is being calm, patient, disciplined, and having a short meeting and long-term deal. And that's literally it. You can go back and listen to all those calls. You're going to hear us talk. And one of my goals is to make our management of this portfolio look to you and other shareholders like a symphony. Move from one movement to the next. and you enjoy the music the entire time. But Dr. Smith, you want to add some more specific details? But go back and listen. We've been very disciplined, very patient, very calm with the same overall thing.
spk07: I would say just from a more detailed perspective, Doug, it's really three things. You know, when we talk about hedge ratios, It's really making sure that you understand what the duration of a mortgage security is. It's very hard to predict what the duration of a mortgage security is. So one of the things that we do is we, you know, I think Wayne Gretzky said, you don't skate to where the puck is, but you skate to where the puck is going to be. And we think about durations in those terms. And it takes some amount of skill and some amount of art and understanding how mortgages work. So part of it is hedge ratios. How do you hedge and what do you use to hedge? So that's positioning across the yield curve. I think it's all of the above with respect to saying our asset allocation was in lower coupons. Lower coupons did great. Our hedge selection was in the 10-year part of the curve. That part has really sold off in line with the assets. And then Look, we've been talking about low leverage all along through this period. It's not a popular thing when there's so much carry to be had in the yield curve, but I think it's served us really well. And obviously, as Byron mentioned, this is all driven by a macro view. So those four things together kind of get us here.
spk08: Great. I appreciate that answer.
spk07: Sure.
spk04: Your next question is from Trevor Cranston of JMP Securities. Please go ahead. Your line is open.
spk02: Hey, thanks. Good morning. You guys talked some about the movement up in coupon during the quarter. I was curious if you could maybe talk some more about how you're thinking about positioning within the coupon stack as, you know, rates have continued to move higher. In the second quarter, it looks like most of the portfolios probably discount bonds now. I guess I was particularly curious in the context of, you know, when you look at the effective book yield on your assets, you know, it's substantially below market rates, and it seems like there'd be a large amount of yield you could pick up by continuing to move the portfolio up in coupons. So I was just curious how you guys are thinking about that. Thanks.
spk07: Sure. Yeah, one of the most interesting things that's happened is almost the entire coupon stack is at par or below par, right? So when you're moving up in coupons, typically you think about I'm going from a discount to a premium, but really you're not. So let me take this a couple of different ways. One is we've shifted our entire TBA position last quarter up in coupon as spreads widened in the higher coupons. I think we are respecting just the idea from here on that there's a more balanced view of how rates could go from here, and that's what leads us to have a more diversified coupon distribution. The second thing I would say is that you don't want to think about the book yields per se. Every quarter, we're really marking our balance sheet to market. Those bonds that now sit at an $88, $89 price discount, they're a 3-ish percent market yield. And because we've preserved book value, we've really essentially preserved the forward NIM on those assets. So a movement out of those assets at this point is really going to depend on two things. One is, you know, what are the prepayment speeds in these lower coupons going to be? Okay, that's driven by cash out refinancing and turnover. So we're watching those to say, is this something – these are the gauges that we feel like we need to watch to get out of those positions relative to the higher coupons. And right now, just so you guys know, our portfolio of twos and two-and-a-half, the pools that we own, paid about eight to nine CPR last month, and that's worth a lot when dollar prices are 11 points below par. So we're watching that. And, you know, by no means do we feel married to those positions. And I think there will be an opportunity for us to go up in coupon as the Fed starts to step away from the higher coupons. But that's something that we're watching. The other way to think about the low coupons is, you know, we think about them as like an on-balance sheet call option. You know, swaption ball and option ball is really elevated on both the call side and the put side. So these are, right now, they're a positive carry call option that we have on the portfolio. And, you know, so at this point, I would say, you know, all these positions are temporary. We're obviously watching every single day in terms of when it's appropriate to get out of them. But we feel very comfortable at the prices where things are. You know, we've had these hedged. The forward NIM looks good. So really now at this point it's going to be about the relative value going forward.
spk02: Got it. Okay, that makes sense. And in terms of, you know, as you guys are looking to, you know, invest paydowns or potentially increase leverage, can you talk about how you're thinking about spec pools, you know, given how much payups have come down versus TBAs at this point?
spk07: Yeah, so the interesting thing about specified pools, I'll just give you some color on, you know, it's kind of bifurcated between the lower coupons versus the higher coupons. So twos through threes, you've seen just massive reduction in the pay-ups versus TBAs for those coupons, and that's appropriate because the dollar prices on those coupons are so much lower. Three and a half and above. the pay-ups have come down, and they've come down as dollar prices have come down. But in that instance, on the premium side, I say premium, but, you know, the higher coupon side, the percentage of theoretical that you're getting is still actually about the same. So those look a little expensive relative to TBAs. So in the higher coupons, I think the TBAs are still going to be where we go. The low coupons, they've gotten really beat up. And you guys know this already. We kind of stayed in the low pay-up world for that reason. Those might start to look a little bit more attractive. The other thing that's happening in the lower coupons is that because you have bonds that are $88, $89 price now, the seasoning starts to matter. And so you have a really nice buffer um, to pay ups because the seasoning will start to count. So at this point I would say three and a half and above, you know, TBA still look better, uh, cheaper from universal specs threes and below. We're a little bit indifferent. Um, and, and we'll look to pick up, you know, call protection if we think it's, it's really cheap, but, um, we're happy with, uh, with the spec pool positions we have in the lower coupons right now.
spk02: Got it. Okay. Um, And last thing, do you guys have an estimate as to, you know, how book value has moved since the end of the quarter?
spk07: Yes. I mentioned in my comments that we've been sort of sitting between 1750 and 1810 thus far in April. Okay.
spk02: Perfect. Thank you.
spk04: Your next question is from Eric Hagen of BTIG. Please go ahead. Your line is open.
spk03: Thanks. Good morning, and congrats on a great quarter. Just a follow-up on the TBA. Just a follow-up on the TBA. I just want to get your perspective on the dollar roll and how that responds in the three and the three and a half as the Fed starts to draw down the portfolio.
spk07: Hi, Eric. Thank you for that question. So I would say it less a function of the Fed's drawdown. Well, it's partially related. So, as the Fed stops buying those coupons, you would expect to see the roles in those coupons start to come off. All right? That's definitely the case. The bigger driver is going to be the level of rates. So, you can actually see just in the last week or so, the role in Fannie Fours has come down four ticks. It's really directional. And it's a very difficult thing to sort of lock in and play that game. So it's less sustainable, I would say, than it was when the Fed was buying. So the volatility in those roles is going to increase. The carry is there if you can hit the right level on these dollar roles. But at this point, I would say... you know, it's less sustainable. Okay? So as the Fed steps away, you have more production. Without a bid for that production, the specialness in these roles is not going to be sustainable without a very deep bid from a going-away buyer. And so it's just less sustainable at this point.
spk03: Right. That's helpful, Culler. And then on the hedging side, I just want to get your sense for what kind of market conditions, I suppose, would What would they need to look like in order to change the approach to hedging instead of with the futures but across the curve? And how do you also think about maybe replacing the swaptions with volatility potentially staying relatively high?
spk07: Yeah, I think the way to think about the hedges at this point, because we have a pretty flat yield curve. That's a factor. The second factor is just the overall direction of rates. So at this point, I think our inclination would be to be, I would say, more neutral relative to the level of rates. We've said in the comments that we think that we need to have a more balanced approach. And we'll be more thoughtful about where on the individual points on the curve. With respect to the swaptions, it's really tough here when you think about the level of vol. So with everything at a discount at this point, there's less of a need to use swaptions. So we're not as married to kind of continuing to have swaptions at the moment. And we do think about other ways to buy vol, right? Like in inspect pools or something else. So that's another piece of how we're thinking about it. From here, we are going to be much more active in managing the hedge piece. I think we noted that in my comments. So you're right in terms of picking that up. For me to tell you it's going to be in the two, three, five-year part of the curve at this point, don't yet have the level of certainty to say how it's going to be. I do know that we're going to be positioning our book and have positioned our book to have a more balanced view of rates from here on out.
spk03: That's really helpful, Carla. Thank you very much.
spk07: Sure.
spk04: Your next question is from Bose George of KBW. Please go ahead. Your line is open.
spk01: Hey, good morning. I just wanted to go back to the discussion on sort of incremental returns. And I think Smriti, you suggested that ROEs are up to two and a half percent. So can you just talk about, you know, where levered ROEs are just given, you know, your current leverage?
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