Dynex Capital, Inc. (DX) Earnings Call Transcript & Summary

Good afternoon. My name is Eric Beder. I'm an equity analyst with the Small Cap Consumer Research. We're a leading company-sponsored research shop. It is a pleasure to welcome you here to the SHARE Series for our introduction to Dynex Capital. Dynex is a timely and interesting investment opportunity with attractive yield, and we believe the upside potential. It's been a public company for over 30 years, and it trades as the symbol DX on the New York Stock Exchange. It also has a preferred stock it trades to. It operates within the mortgage REIT sector and has been investing in residential and commercial markets. The current dividend yield is approximately 12%. With me today is Byron Boston. He is the Co-CEO -- excuse me, I apologize. He is the CEO, Co-Chief Investment Officer and Board member on Dynex. His team has built an impressive track record of performance across a variety of environments, producing industry-leading returns since 2019. Byron, it's a pleasure to have you here.

Let's start with -- let's begin. Could you give us pretty much a general overview of Dynex and kind of what you do?

Well, thank you, Eric. Let me just say that, first, I'm really excited to join the SHARE Series today. I can tell you about our company, and there's a historical opportunity that we are immersed in and we're very excited about it. So we're very excited to share with you what we do. So let me try to make it very simple to start with. We're a financial services company. We're dedicated to generating above-average dividends for our shareholders, while at the same time, generating a solid, long-term return experience over time. We believe in ethical stewardship of our shareholders' savings. We know the savings are very important to you. So from our perspective, our role is very, very important in society. We're expert risk managers with years of experience in the fixed income space. We believe in very disciplined capital allocation. So in other words, if you look at our balance sheet over the years, you will see that we've used various different asset classes throughout the real estate universe in the United States. And we absolutely believe in upholding our responsibility as a member of society. So since 2008, we've been at -- right at about 156% accumulative return, over 7% annualized with no dividend reinvestment. Now if you were to consider dividend reinvestments, the returns have been more like 263% over time, 9.88 annualized through August of this year. I mean we've outperformed the EPF benchmark for our space, which is called REM. We've outperformed it by 3% per year. So the -- and then let me get a little more specific in terms of exactly what do we do. How do we generate the returns? We focus on real estate-related assets in the United States. And in effect, we lend money against real estate assets in the United States, both residential and commercial. Many of you on this call probably have a mortgage. And these mortgages are generally packaged into mortgage-backed securities, what we call MBS. And we invest in these bundles of mortgages, providing essential liquidity for the housing market and our goal of generating an attractive dividend yield, as I mentioned, cash income, dividend yield with a consistent translate with above-average returns over time. And what's really important is the -- understand that what we lend against are United States assets, real estate assets. And more importantly, today, our assets are all -- have some form of United States government guarantee. And that portfolio is reflective of what we view of the global environment. So how do we do this? It all starts with outstanding people, disciplined processes and technology. Over time, we've had a diversified portfolio, as I mentioned a second ago, across many asset classes. But today, we invest primarily in agency residential mortgage-backed securities. And we invest there because of their liquidity and because of the greater guarantee of the United States. And what's even more importantly, today, there's a large opportunity as this sector has repriced. Most of you know, we've gone through a historic interest rate environment. Rates have risen more than probably back in the '80s when I first started to trade. I think a lot of people are surprised at this type of move in rates because rates have been somewhat dormant for over a decade now since the great financial crash. And it's important now than ever because of these changes that we're going through, both in interest rates and the globe as a whole, that you're able to rely on a team that has a clear strategy and deep experience in navigating uncertain environments. Now with that in mind, I'm going to give you a little bit about my background, just when I say we're expert risk management -- managers and we have some knowledge. I want to give you my background. I started at Dartmouth College as an economics major. And in 1981, I was trained, in one of the credit training programs in New York City with Chemical Bank, later got a graduate degree in finance and accounting. And then I came back to Wall Street in 1986 as a mortgage-backed securities trader. So if you can see my career, you'll see that I literally fit my entire career in the fixed income space. And I spent 11 years trading mortgages, then was asked to come to Freddie Mac to build a business plan for revamping their retained portfolio. Subsequent to that, I started my first company, which was a mortgage REIT. And subsequent to that, in 2008, I joined Dynex Capital to reinvent the business model and wrote the original -- most recent strategic plan for growing Dynex's balance sheet and being able to perform in any interest rate environment or economic cycle. So as an investor for over 37 years in this specific space, I've navigated many complex and volatile market environments. And not only me. My team has a hold on this, including the talk in the '87 stock market crash, the 1998 long-term capital crisis. 2008 financial crash, I'll emphasize, since I started January of 2008, Dynex shareholder did not lose money in that -- in the great financial crash. And we're very proud of that. The 2013 taper tantrum and most recently, we've managed through both the pandemic of 2020 and the bid cycle -- tightening cycle of 2022. In general, we believe we are in a historic period. We're in a period of transition and change, and every investor should be on alert for who they leave their money with. Experience is way undervalued.

Excellent. So let's talk about that current environment here. This year, you guys have -- Dynex has an agency portfolio, look at our higher-yielding assets. What led you to become to do this? And do you plan on being that aggressive for the rest of this year?

Can you start to move the slides forward?

Yes.

I'll see where we'll stop. Keep going. And I would say go to the next one. Okay. We'll stop there because this example, if you look at this picture, it's pretty phenomenal. You'll see how high mortgage rates have risen. And because of that, the most important thing that we have focused on is risk management. We'll call it skilled risk management first and disciplined capital allocation second. And what we saw in '20 and '21 was historic, this move, and you can see it in this chart. We talked about it. I started in 1980, so I've been comfortable with this type of volatility because it's this type of volatility that I learned to trade fixed income securities. So we had a massive amount of fiscal and monetary stimulus, and then we had a massive result of that, which is a huge inflation. And now we've entered a period of massive withdrawal of liquidity, which has created volatility throughout the marketplace. Agency mortgage-backed securities reprice for higher interest rates faster than many other sectors. And when this Fed -- also in addition to tightening the raising rates, they've also started to reduce their balance sheets. And that's put additional pressure on this agency mortgage-backed security sector, which is added to what we call a second ago, historic opportunity. Many of the credit markets have not still repriced for this environment. Agency mortgages look very attractive relative to corporate bonds. So in fact, we have taken advantage of this opportunity to add these higher-yielding assets in a very disciplined manner. And we continue to monitor such opportunities using our disciplined and patient approach. So we see this large rise in rates. We're debating now in terms of how far will rates go before they will have a significant bite on the global economy. We believe we're in a period of -- where surprises are highly probable. We feel very fortunate to have this sector guaranteed by the government with this much liquidity where we can generate income for our shareholders.

Fantastic. Okay. As you mentioned, we are in a higher mortgage rate environment. When you look at beyond 2003 and the actual housing environment, what do you see? Kind of how is your team looking at the future beyond kind of the short term here and what we're seeing in terms of what you're going to see for deals? And to your point that you just brought out, when does it start impacting the housing environment? Or does it? How do you look at that?

Well, it's impacting it. So these interest -- faster interest rates have hit homeowners pretty hard. So the housing market has slowed materially. And when we all talk about hard landing, soft landing or what's happening, a Goldilocks scenario, other sectors of the market are driving overall GDP. But the housing market has felt higher rates. They've actually risen to a significant amount. And the higher rates are for a couple of reasons. Not only have you had the Fed tighten credit and interest rates rise, but Freddie Mac and Fannie Mae and the federal government -- I mean in the Federal Reserve Bank, have all been large balance sheets over my entire career that have played a role in purchasing and owning agency mortgage-backed securities. At this point, many of you know, the Fed is shrinking their balance sheet. So it's the first time we will not have a government entity stepping in to buy potentially throughout the day, throughout the week, throughout the month, throughout the year, packages of mortgage-backed securities. Therefore, it has left a wonderful opportunity for a company like Dynex Capital and its private investors like ourselves can step in and take advantage of being [ a role ] of liquidity provider and risk manager for these assets. The assets are unique. It is our belief that you need solid experience in an environment like this to manage these assets. So I will always introduce ourselves as expert risk managers first about this type of risk because it's complex. And operating -- and the asset is not only complex, but we're operating it in a very complex global environment. The housing market has gotten hit. The rebalancing is still taking place. New home sales have been solid. But if you look at existing home sales, they've fallen sharply. And mortgage applications have fallen. Think about it, 7% rate. We have a generation of millennial and younger that only those who have the ability to potentially get a down payment help from their parents are really purchasing homes. So we've seen a major slowdown in the housing sector. And as a result, we take a very disciplined approach to assessing the future direction of mortgage rates. We expect those sales to remain low until rates come down. And there is a potential that rates will stay higher for longer than any of us expect. There is also the potential for a surprise to take place as it's happened in the past. Given how much global debt there happens to be, given how much conflict there happens to be in the world, very probable that we could get a surprise event that sends rates in the other direction. So let's attach my background to how I try to lead my team. As an athlete, I grew up as an athlete, what's drummed in your head is preparation, preparation, preparation. Scenario planning, prepare; scenario planning,research, prepare. That is the way I lead my team. I emphasize preparation. We want all of our shareholders to understand whatever the scenario might be over the next decade, Dynex Capital wants to be prepared. And we do have the ability to make money in any environment. Now we still have to make the right decisions at the moment. But our business model is such. As we are built today, we're in liquid assets, we're generating a return. At some other point in time, if the world changes and shifts, we can diversify our balance sheet to adjust to a different type of environment. But we're a disciplined top-down approach, macro perspective, and we're constantly evaluating the overall situation in the context of an interconnected global market.

Let's talk about that, what you brought up there. How do you -- you and your team have used hedging continually for the last 20 or 30 years? How do you look upon hedging as a tool to guarantee returns and to kind of offset some of the pieces you've just mentioned in terms of volatility throughout the entire kind of [indiscernible]?

Can you move the slide forward? All right. So we get an idea in terms of interest rate volatility. This is a nice picture from 2009. What do you see? You can see on the right-hand side, we showed you rates rose and we're showing you the volatility has increased -- positively should have increased. The global environment -- risk in the global environment has increased. A core part of how we run our business is hedging. So let me get real simplistic. We take cash from our shareholders. We then invest that cash into a mortgage-backed security. But we have a mismatch in terms of maturity and in terms of overall riskiness movements or volatility of prices of the different position. We then layer on top of that position a hedge instrument that may reduce some of our income that we can generate for our shareholders, but we're providing solid protection for the overall book value of the company. So we -- our core -- at our core and our beliefs is solid risk management to be better capital allocators over time. And our experience has led us to understand how these assets function throughout various different cycles. And if you look -- go back to our 2020 presentations, you'll see that we prepared ourselves for a higher interest rate environment when rates had really fallen and the yield curve was extremely flat. So when we look at this entire move, we believe we have taken care of our shareholders through this move. Oh, have we been perfect where book value hasn't moved at all? No. But our capital base is solid and in position to rebound with spread tightening or mortgages moving closer or rebounding from the widespread levels or higher yields that they have approached in the cycle. And we're in position to recoup our book value that we have lost in this period. But it's very important, we believe we are in better shape from a capital perspective than many of our peers. We believe we're in better shape from a capital perspective to many other type of fixed income companies. So we've maintained book value with a relatively tight range. This continues to long-term value for our shareholders. As I said before, I am going to overemphasize this, skilled risk management is essential in a global environment such as this. A top-down macro approach is also essential in an environment like this. We think of fundamentals, technicals and the psychology of a market. And our team is constantly quantifying how those factors will impact the market and how we hedge interest rate and credit risk. Surprise events are normal. That's the period that we live in. We're prepared for it. And as I said earlier as an athlete, preparation, preparation, preparation.

Fantastic. So we know that most of your product -- virtually all your products has some type of guarantee. But obviously, there's still some credit issues that have to go through the system. How do you look at credit? And how do you view the MBS credit levels? And actually, we have a question also kind of related to this, talking about commercial real estate. And how do you position yourself to take advantage of credit issues potentially in those areas?

All right. So we're focused on the credit cycle and always will be. And as -- again, let me tie back to my background, starting in '81. I've managed through every credit cycle. Smriti Popenoe, who's present...

I'm sorry. Let's move the slide.

Okay. Yes.

Okay. There you go.

So you can see the 35-year history. You can see how many different cycles that we have managed through. If you take my career, I go all the way back to 1981. So I started in the Volcker years. So I've watched housing. My career started trading mortgages that were 18%, 17%, 16%. So I've ridden this entire wave down to a 2.5% mortgage, which is pretty phenomenal. One thing I can say about the credit cycle today within the mortgages: there are more people who need homes than we have homes. So the actual credit of mortgage-backed securities of the mortgage sector, when we think about residential is in pretty good shape. You then think about the other asset classes that we invested in over time. If you look at our balance sheet at the end of 2019, we were 50% in residential mortgages, we were 50% in commercial mortgage-backed securities with a huge emphasis on multifamily properties. In 2020, as the pandemic hit, we went through this major adjustment. We sold almost all of our commercial exposure. So we got out of the multifamily sector, and we're all in the residential mortgage-backed security sector. And we also made a decision to stay at what we call the top of the capital stack -- [indiscernible] quality. So -- but that's not because we believe that mortgage credit is bad. As we take on more credit risk, meaning we move out of Freddie Mac and Fannie Mae agency securities, we're also taking on more liquidity risk. Because of the global environment, because of the potential for surprises to happen, because there's so much debt globally, we've emphasized liquidity. So we have not chosen to what we call go down in liquidity. We're up in liquidity, about investing in agency mortgage-backed securities. And we've invested -- if you look at our 35-year history, we've invested across the entire credit spectrum in the real estate space, commercial, residential. We finance malls, we finance large office buildings, we finance tons of commercial property, low-income tax credit properties. We have a lot of history. When you look at how narrowly we're focused today, it's because of our macroeconomic opinion. We're not taking that type of credit risk. The most important place to keep your eye on is the commercial property sector, especially in the office sector. When we talk about we're in this big moment in history, one of the large transition is around how will people work? Will they go to the office? Most companies need less office space. We don't know how this is going to turn out today. We told you we've invested in office buildings. We're not investing in office buildings today from a -- or lending money against office buildings. So regulators know that we have risk in the system. There's risk in the banking system. There are commercial loans on those balance sheets. If you want to know commercial credit, bigger problems on the commercial side, less problems on the residential side. But we've still chosen to be at the top of the capital stack or the least riskiest residential product because of the liquidity that they offer us and our shareholders to generate returns over the long term.

Thank you. Let's -- before we start, let's flip the slide. You have a very high level of core values here. It's quite obvious that you are a very dynamic leader here. And how do you look upon these core values to guide you what you do and allow you to register the returns that you have in the past and going forward?

Let me say this because I feel very strong about this. Personally, and my team feels the same way, so I'm speaking for them. Our core values are key to everything we do at Dynex. Our #1 goal is to make lives better by taking care of our shareholders' savings and delivering cash income to our shareholders and capital on the other side of that position to finance homes and to strengthen the communities in which we live and we value so much. We view our role as being a very important role in society. Our team has always operated with a great integrity. I am the gatekeeper, intense gatekeeper, of these values at Dynex Capital. What I mean by the gatekeeper, meaning that we're not going to hire anyone who does not agree with our values. And I've had many people say to us, well, we can't believe that you guys have this type of values and you work in the financial space. And I always smile and say, yes, I appreciate you saying that, but that's what we believe. We have an unwavering commitment to our values and a focus on supporting our community. We believe in our fiduciary responsibilities. And we have a strong, diverse organization that we've built over 30 years, and we're looking to build it for the next 30 years, multigenerational organization that continues to stand the test of time. And as I mentioned before, I'm going to repeat it because it's very important, our purpose is to make lives better. Let me give you a Byron -- a strong Byron opinion. This generation of baby boomers is large, and it's not only in the United States. It's all over the globe. So many will need to rely upon their asset managers to generate enough income for them to live. And if you look over a 100-year history of the S&P, you'll see there are some large periods where asset prices have gone down. Now imagine, I studied this first in grad school and I looked at 1929. And I just tried to imagine myself if I were 65, 70 or 75 years old when that type of asset price correction took place. You will be in a tough situation if you're a baby boomer relying upon your stock portfolio to live on a daily basis. At Dynex Capital, we've actually imagined ourselves in those types of scenarios. We do have a model that has the ability to make money in major asset price correction. We do have to make the right decisions at that time. But the model is -- the model that we've built can stand the test of time. And this is reflected in our long-term leading performance. We have the highest 3- and 5-year returns amongst our peers, comprising agency and hybrid mortgage REITs. And we're excited about the future as returns are attractive. And you can understand -- please understand that me talking about history in the way that I do, it's because we want to learn as much as we can from that history. We believe we're in a big transitional period globally, whether it's from a technological perspective, whether it's from a societal perspective or from a human conflict perspective, we're in a period of change. And as such, we believe we have this model and this great investment opportunity in agency mortgage-backed securities to generate income for our shareholders. So our core values are very important. When you look at history, you can -- you go through an asset price correction, you will need a team of professionals who will stand up strong from a values perspective. Our management team, our Board of Directors and myself, we're all personally committed and investing in Dynex. We're in the same boat, and we just believe that there's no better place to invest than ourselves.

Great. We've had a few questions come in. I'm going to turn to the questions here. The first one is what are the benefits of your hedging strategy using treasuries incentive swaps? What do you think about the benefits to the low-strike swap periodic income some of your competitors, I guess, utilize?

All right. So we've got -- let's go back through our history of hedging in this business model. If you look at our track record, both Smriti and I worked together Sunset Financial between 2004 and 2006. That was a pretty massive inversion of the yield curve and a large rise in interest rates before the great financial crash. Our shareholders did just find the balance sheet was in great shape. We used interest rate swaps. Swaps and treasuries, you can use either one to hedge your portfolio. They will show up differently in the statements of balance sheet, income, cash flow. But at the end of the day, what really is going to determine your value of your hedging strategy, can you pay your dividend and how well can you maintain your book value over time. One of the factors that came into play versus '06 -- '04 through '06 versus today is as more regulations have been put on to the swap market, the swap market, and this is my opinion, has become more of an enabler of risk because the government has changed where you have the swap exchanges and you have margin requirements. And in 2020, we saw the margin -- the dealers, the swap dealers, just start to demand a ton of margin right in the middle of the crisis, which then accelerates the selling that takes place. So there are many reasons where we've used swaps in the past, and we'll consider ourselves an absolute expert in using swaps in the past. We're very deliberate about our decision today to use a treasury-based hedge. In addition, our global outlook is such that we believe we may need to trade or adjust our position at any point in time throughout the day, and that includes the night. It is -- will be easier to trade the futures that we hedge with than it would be for the swaps. So this position represents this environment. The great thing about looking back to the 1980s, these instruments have really not been created. When we saw the SNLs get completely annihilated and banks, as Paul Volcker inverted the yield curve, the hedging instruments were not there. Today, we have instruments with the ability to hedge our overall maturity mismatch on our balance sheet, and we're very focused on that. And so what I would urge you and take -- tell you to take a look at is watch the book value move over time and also watch our ability to recoup book value over time. And if you do have the time to go out and look at our quarterly deck, we have a picture in there starting at the end of 2019, showing our book value and the dividends paid over time. That's a very important chart because that's where we stay focused.

Okay. One more question. A lot of interest rate volatility since quarter end. What have you done to maintain the book value given the volatility?

So I can't really speak of any nonpublic information. As a whole, we're managing the book the same way we've been managing this book throughout this entire period. So there's a certain amount of volatility that we've been willing to take in the portfolio, and that's the volatility that you see so far. That's -- we've been willing to take that type of the deterioration we've taken in our book value since December of 2019 is where we're really measuring ourselves how have we done this decade. And that's why I told you to go look at that one chart in our quarterly deck where it shows the book value plus dividend paid over time. So we're watching that very closely. And so we have -- we're at a period in time where we believe we're at the higher end of interest rates. Can interest rates go higher? Yes, they could go higher. Can they stay higher? I think it's a limited amount of time. At some point, you will break something as rates continue to move higher. We have an enormous amount of global debt. And in 2020, we increased even more global debt. So there are some limitations. So think about this: we increased the amount of global debt and then we say we're going to increase the price of debt, and then you think that we're not going to have an impact. You will have an impact at some point. So we are managing our business for a cycle. We believe that we've moved an enormous amount through the cycle higher in rates. We believe that we're getting closer. But it doesn't mean that rates may not go higher. As I said before, we're preparing for multiple scenarios. Rates could move lower. But if you look at our disclosures, they are very good. You can pretty much track and see what has happened to our book of business. We're not sleeping poorly. If we were sleeping -- If we had any problem sleeping at night. It's more worried about the global environment as opposed to how we've structured the book of business. We're very proud of how we struck this book, and we're most proud of how we put our shareholders through this -- the first initial move up in rates, first couple of hundred basis points or so, where we put -- we were very disciplined with our hedges to protect the business. So I can't give nonpublic information, but I hope you'll understand that our -- we put a lot of time into our disclosures. They do have a lot of information that you can follow.

Great. [indiscernible] a little technical. How do we think about your strategy around where you are in the coupon stack and TBAs versus spec pools?

So in our last disclosure, you were seeing us -- so let's go back. In 2020, we concentrated our investments in the 2% and 2.5% coupon. And our opinion of these -- of the easiest place to be. You could literally forecast where these assets may go, where they're durations may go. We use hedges from a longer perspective. And then somewhere within the last year, we've started to adjust our portfolio, where we've gone up in coupon. And our most recent marginal investments, even as of our last disclosure, have all been in higher coupons. So we have a diverse coupon stock much more than in 2020. We believe that's the right place to be at this point in time because this is a transitioning environment. No one knows how this will turn out. So even though I say, yes, rates may -- can go up. I also said that at some point, things will break or something, we will hit a wall, and rates will start to move back down again. And we need to be prepared by having a variety of coupons in our portfolio. Furthermore, the income from the higher-coupon assets is very attractive versus the lower assets, the 2s to 2.5s. And then from that perspective, we view our lower coupons as really an option -- a call option on a potential surprise move down in rates. So we've got a diversified coupon exposure. We believe that diversification is correct. It is different than what we did in 2020, where we had a more concentrated coupon exposure. We believe that was correct for that time period. We believe this structure is correct for this time period. And that's what we call disciplined capital allocation.

Great. I think we are pretty much at the end of our time. Do you have anything you want to finish up, Byron?

Well, look, here's the biggest thing that I will tell you as an individual because I know -- I understand a lot of individuals here: I'm very serious about you need to consider your age and consider where you're investing your money over time. We believe Dynex Capital is a vehicle that can make money in any environment and what we always add in as long as we make the right decisions. Why? Because we do hedge, we do. We're expert risk managers, expert capital allocators, which allows us to manage and generate returns in any environment. We have a huge intense focus on our ethical standards and how we manage your money. If you're part of the baby boomer generation, you need ethical asset managers, you need skilled asset managers, skilled risk managers, you need really disciplined capital allocators. And we're all invested in Dynex Capital stock. So we say, please join us, come join us on this journey. Thank you so much for your time, Eric. I really appreciate that you chose to invite us.

Thank you. This was great. Again, this is Dynex Capital, ticker DC. The company also has preferred -- excuse me, ticker DX, my bad. Company also has preferred shares that trade under ticker DX-PC. The yield is about 7.5%. And the next SHARE Series will be in 2 weeks on October 2, and we look forward to seeing you there. Again, Byron, thank you and really appreciate it.

Thank you. Appreciate it. Thank you.