Dynex Capital, Inc. (NYSE:DX) Q2 2024 Earnings Conference Call July 22, 2024 10:00 AM ET
Company Participants
Alison Griffin - Vice President, Investor Relations
Byron Boston - Chairman and Co-Chief Executive Officer
Rob Colligan - Executive Vice President, Chief Financial Officer and Chief Operating Officer
Smriti Popenoe - President, Co-Chief Executive Officer and Chief Investment Officer
Conference Call Participants
Jason Weaver - Jones Trading
Eric Hagen - BTIG
George Bose - KBW
Doug Harter - UBS
Jason Stewart - Janney
Operator
Thank you for standing by. My name is Eric and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. [Operator Instructions] Thank you.
I would now like to turn the call over to Alison Griffin, Vice President of Investor Relations. Please go ahead.
Alison Griffin
Good morning and thank you for joining us for Dynex Capital's second quarter 2024 earnings call. The press release associated with today's call was issued and filed with the SEC this morning July 22nd, 2024. 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 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 Investors 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 investors center page.
Joining me on the call is Byron Boston, Chairman and Co-Chief Executive Officer; Smriti Popenoe, President, Co-Chief Executive Officer and Chief Investment Officer; and Rob Colligan, Executive Vice President, Chief Financial Officer and Chief Operating Officer.
It is now my pleasure to turn the call over to Byron.
Byron Boston
Thank you, Alison, and good morning, everyone. At Dynex Capital, we continue to build a company that will deliver consistent monthly cash income and compelling long-term returns for our shareholders. When I first joined here in 2008, Dynex’s market capitalization was less than $100 million. This quarter, our total equity eclipsed $1 billion for the first time in our 36-year history. I'm extremely proud and excited about the progress we have made at Dynex Capital so far in 2024.
As a student of economic history and a market practitioner, I've managed investment portfolios through many cycles. This has already been an incredible decade with multiple extreme cycles. Our team here at Dynex has been prepared. Events that surprised many in the market were not surprises for this team. We were prepared and always understood that surprises were highly probable. We have a nimble mindset and we are sitting with a capital base that is extremely strong. As we start the second-half of 2024, we are well positioned to capitalize on the next cycle in the mortgage market.
Human capital remains a major focus for us. Today, we announced that we hired Harman Sahni as our new Chief Technology Officer. Harman brings a deep history in financial technology, including experience at other mortgage REITs and major financial institutions. His expertise will ensure we can continue to compete on tech-driven analytics. We also announced several executive leadership and management changes. In most cases, these actions align titles and roles with the work these exceptional people are already doing.
Jeff Childress, our Controller for nearly 20-years as the named Chief Accounting Officer. Rebecca Imhof, our current Assistant Controller, has been named our new Controller. Bob Nilson, a 30-plus year veteran of Dynex, has been named Chief Risk Officer. Our CFO Rob Colligan was named Chief Operating Officer in addition to his current title.
And finally, my long-term colleague and teammate, Smriti Popenoe, was named Co-Chief Executive Officer with me. Smirti and I have managed mortgage assets together as a team for 27 years. We successfully created our first mortgage REIT 20 years ago and executed an IPO on the New York Stock Exchange. We are the longest tenured team that has successfully managed the mortgage REIT together over this time period.
Today's action formalizes her importance at Dynex and cements her legacy as a leader in the mortgage market. Her skills and accomplishments over her career are significant as anyone I've ever met in the markets. Smriti grew and developed in this industry, one that is male-dominated and highly competitive. She has achieved great success despite obstacles. Growing up, Smriti was educated on three continents, which taught her the valuable lessons of adaptability and resilience. The kind of tenacity, resolve, willingness to learn, and leadership that she has demonstrated are beyond comparison. The global perspective that she has brought to our investment and management process has been invaluable.
Smriti, the team, and I are focused on managing our company with a long-term strategic vision, and we are methodically putting that vision in place. Dynex is the oldest publicly traded mortgage REIT, and we're building the company to endure well into the future.
I will now turn it over to Rob Colligan, our CFO and Chief Operating Officer, to review the financials.
Rob Colligan
Thank you, Byron, and good morning to everyone joining the call. I'm truly honored to be named Chief Operating Officer, adding to my Chief Financial Officer title. Earning the trust and confidence of the management team and board of the directors is something I take very seriously. I really enjoy coming to work every day and making positive changes for the benefit of Dynex shareholders and our employees.
I'll now turn to the financial results. Book value ended the quarter at $12.50 per share and the economic return was a negative 2.4% for the quarter. The 10-year treasury was up approximately 20 basis points from the end of the first quarter and spreads were broadly wider. This quarter, we raised $125 million of new capital, some of which was invested in June when spreads were wider, and some which is reserved to deploy in the second-half of 2024. We issued 10.5 million shares at $11.88 per share, which was a great execution during a local high in the stock. Smriti will cover the capital raise and deployment further during her comments.
Interest income was positive this quarter as a result of higher-than-expected pay downs on older lower yielding assets and the addition of newer higher yielding assets. We expect this trend to continue and if financing costs improve later this year then interest income would trend up on an accelerated basis. Expenses for the second quarter were down. In the first quarter, we discussed higher equity-based compensation. These expenses did not recur in the second quarter and we expect will only occur annually in the first quarter going forward.
This quarter, treasury futures remained our preferred hedge instrument. Hedge gains and losses are a component of REIT taxable income and will be part of our distribution requirements with other ordinary gains and losses. This quarter, we realized hedge gains, which added to our aggregate gains, and we have a large cumulative benefit for the portfolio. And then, in inverted yield curve, like we have now, we expect our hedges to have a positive carry and will be supportive of earnings.
Please see page six in the earnings release covering the hedging portfolio and page 11 of the earnings presentation for more detail on this topic.
I'll now turn the call over to Smriti.
Smriti Popenoe
Thank you and good morning, everyone. I'd like to congratulate my colleague and teammate, Rob Colligan, on his promotion to Chief Operating Officer. He brings energy, expertise, enthusiasm, a strong work ethic, and a collaborative approach to work every day. And these traits have clearly contributed to his success, and it is a pleasure to work alongside him. We also promoted Bob Nilson, one of Dynex’s longest-tenured employees to Chief Risk Officer. Bob has worked tirelessly to build Dynex’s sterling reputation with credit counterparties, and I look forward to his continued success at the company.
I'm also delighted to accept the position of Co-CEO to work alongside my longtime teammate, Byron. We have navigated through many storms together. We share a common vision for the company, the same commitment to integrity and core values, while each bringing a different perspective and skill set that will be a powerful combination as we lead Dynex into the future.
The investment environment continues to be very favorable for Dynex. Agency MBS spreads remain in an elevated range relative to history, offering double-digit nominal ROEs. Volatility continues its downward trend, as Fed policy is becoming slightly more certain, and data are now tracking towards a possible Fed ease in the third quarter. Our view remains that the best forward returns will come from agency MBS, which are historically cheap on an absolute and relative basis to other fixed income alternatives. Dynex’s portfolio will also perform extremely well in curve steepening environments. You can see that on our list profile on page 23 in the deck.
Looking ahead to the second-half of 2024, we believe the combination of known unknowns and unknown unknowns makes the overall macroeconomic environment vulnerable to exogenous shocks. These will result in bouts of volatility. Using these dislocations to add assets prudently remains our core tactical game plan. This view led us to raise capital in June. It was a landmark raise in many respects. This was the largest capital raise in our 30-plus year history as a public company. Dynex opened the market for a block size capital, which had been closed since early 2022. We received outstanding execution while effectively resetting the economics for such transactions, a testament to the strong reputation for ethical stewardship and solid relationships that we have cultivated.
Soon after the raise, agency MBS widened, giving us a chance to deploy about two-thirds of the raise, and we've kept the remaining as dry powder. We continue to maintain a high degree of liquidity in the form of cash and unencumbered assets, and we believe that between now and year-end, we will have chances to deploy that capital at attractive long-term returns.
We have a strong conviction that the equilibrium agency RMBS OAS and nominal spread range will be tighter than today's levels. A scenario where MBS are 20 OAS or 40 bps nominal spread tighter is highly possible over the coming three to six quarters. This would be driven by falling front-end rates, lower delivered and implied volatility, the return of banks, and the potential underperformance of credit products in a recessionary environment driving a flight to quality bid for agency MBS. We also believe rewritten capital rules for banks may be a tail end for demand. We are well positioned to capitalize on opportunities that will arise into your end.
We also strongly believe in the potential for our company to command a premium valuation. Our stock continues to trade at a discount relative to forward returns. As we continue to grow, we expect our stock will be added to more market indices, attracting passive investment, and providing support for stronger total shareholder returns.
Finally, we believe our sterling reputation, expertise in managing this business model, transparent financials, and easy to value balance sheets are not reflected in the share price and can further drive a premium to book value in the future. I am deeply grateful for the confidence our investors have in us and the team, and I continue to work diligently to deliver value to you.
We would now like to open the line for questions.
Question-and-Answer Session
Operator
[Operator Instructions] Your first question comes from the line of Jason Weaver with Jones Trading. Please go ahead.
Jason Weaver
Hi, good morning. First of all, congratulations to Smriti and Rob and all the others that have new positions or just joined. First, I was hoping you could share a bit more about the timeline to invest the new capital that you raised. Coupon-projected ROE, if you can detail anything around there?
Smriti Popenoe
Yes, hi, Jason. Good morning, and thank you for the question. So basically, we have thought in terms of the second-half of this year as being an environment that would be appropriate to deploy that capital. ROEs right now on a static basis are between 11% and call it 19% on the higher coupons. Those are good ROEs. We believe mortgages are sort of in the middle of the range on a nominal spread basis. So they've been trading as tight as like 135 versus the seven-year and as wide as 155 versus the seven-year. We're sitting right in between right now in terms of that range.
So still attractive returns, but one of the things that we're very focused on is just coming known unknowns and unknown unknowns, as I mentioned in the prepared remarks. And that we believe will actually possibly allow us to add assets at even wider spreads. And that's kind of why we're being patient about the capital deployment.
Jason Weaver
Understood, and maybe to drill down on that a little bit, when you think about the potential for interest rate volatility going forward, what sort of risks are biggest on your radar right now, whether that's the election, whether that's upcoming Fed policy, anything else out there to stands up?
Smriti Popenoe
I think what's interesting is that we are in an environment of lower [vols] (ph). So vols are actually trending down, and that's been very positive for mortgages and will continue to be positive for mortgages. So I think that is something versus last year that we feel is a big tailwind for the position. What we're thinking about are exogenous shocks, right? Things that you can't predict, stuff that you don't know that's going to come from something not visible. That's what we call unknown unknowns. That's one issue, right?
The second issue is, there is policy risk, right? So, whenever you think about elections, not just in the U.S., but globally, there are shifts and policy that can come with that. And one of the big things we're focused on is fiscal policy and how that kind of evolves. So that policy risk is binary and it's difficult to hedge. And when it does come, you will have these bouts of volatility, and that's kind of the context in which we're thinking about that risk. But overall, the vols are coming down, and that is very supportive for mortgages.
Jason Weaver
All right, that's very helpful. Thank you, and congrats once again.
Smriti Popenoe
Thanks, Jason.
Operator
Your next question from the line of Eric Hagen with BTIG. Please go ahead.
Eric Hagen
Hey, thanks. Good morning, guys. Hope all is well. A couple of follow-ups here. Did you say what your current book value was? If you could just give an update there? And then if the narrative stays focused on the Fed cutting interest rates, I think you mentioned that you see the range for volatility and spreads just being tighter. I mean, how does that factor into the amount of leverage you're applying to the portfolio and where you guys feel comfortable? Thank you, guys.
Smriti Popenoe
Hi, Eric. Good morning and thank you. Yes, so book value versus quarter-end as of Friday is up about 2%.
Eric Hagen
Okay.
Smriti Popenoe
The - in terms of leverage here, I would really go back to what we're thinking of in terms of the risk environment. Yes, so we're going to use any spread widening to add to the asset balance. Over time, this is an environment where, again, you would expect us to hold a higher asset position versus sort of when spreads are a lot tighter. So over time I think as the risk environment starts to evolve, our balance - our asset balances should go up. And right now the position just reflects our view that the second-half of the year will have chances to put money to work.
Eric Hagen
Yes, that's great. That's really helpful. Hey, and as you guys get bigger in the current coupon, I mean, how do you think about the spread sensitivity to lower interest rates? I mean, just especially given the aggressive marketing tactics that we expect to see from the originators looking to refi those borrowers?
Smriti Popenoe
Yes, look, that's one of the things that the portfolio has to be constructed for both up rates and down rates in here. We buy back options in the lower coupon positions that we own, right? So yes, there's greater spread to be had in the higher coupons, but there's two ways you mitigate that. One is using specified pools that gives you some convexity protection. The second is just having this diversified coupon position, and that's where those options get bought back.
So we are very cognizant that even without much of a rate decline in the mortgage market, you can see faster prepays. We've seen that in the higher coupons that we do own. So that is a very clear and present thought process in terms of how we're managing the book. And you'll see we have been active in specified pools. We like the idea of low pay up specs in those areas as a way to protect against some of that, that we by risk.
Eric Hagen
Yes, that's really helpful. Thank you guys so much.
Smriti Popenoe
Thanks, Eric.
Operator
The next question comes from the line of Frank Labetti with KBW. Please go ahead.
George Bose
Hey, guys. This is Bose. Congratulations, Smriti and Rob and the rest of the team. And actually a couple of questions. First, your expenses fell quarter-over-quarter by about $4 million. Can you remind us, was the first quarter a bit elevated and what's a good run rate for that number? And also any of the personnel changes going to impact that number going forward?
Rob Colligan
Sure, Bose, this is Rob. Thanks for the question. Yes, we had some accelerated vesting on equity comp by about $4 million in the first quarter. So if you just spread that out through the year, if you said it was $1 million a quarter instead of a bump in Q1, that's a good run rate. We may have that bump going forward where Q1 is a little heavier than the rest of the year. But if you just move that out over the four quarters, I think that would be a good way to model it out.
George Bose
Okay. And then apart from that, this quarter's run rate is reasonable?
Rob Colligan
Yes. Yes, just for the second part of your question, the personal changes won't materially change the run rate.
George Bose
Okay, great. Thanks. And then, Rob, you made the comment about net interest income and how it could increase, I guess, on an accelerated basis if the Fed cuts. Does that comment refer to the EAD or does that impact the economic return, as well as the Fed cuts?
Rob Colligan
Yes, it's really both. Yes, if the Fed cuts or repo rates go down, EAD goes up, and total economic return go up. So it's like a triple win. If that happens, we're not banking on that. Obviously, we can manage through even if those rates don't come immediately or come later than people expect, but if they do come sooner, we'll gladly take a lower repo expenses.
George Bose
Okay, great. Thanks.
Operator
Your next question comes from the line of Will [Technical Difficulty] with Credit Suisse. Please go ahead.
Doug Harter
Hi this is actually Doug Harter from UBS. Just hoping you could talk a little bit more about the decision to issue equity, a large amount of equity kind of below book value, you know, kind of how you see the payback period and the trade-off versus, you know, kind of increasing the position through leverage?
Smriti Popenoe
Thanks, Doug. Yes, so you know where this started off was with a tremendous amount of demand for Dynex stock, okay? You know, I talked about our reputation during the prepared remarks. People notice when your performance is good, we have been the best performing mortgage rate since 2019 or thereabouts. That is resonating with investors. People are looking for management teams that can provide value through an investing cycle here that's really attractive in agency mortgages. So it starts off with that demand for Dynex stock. So there was a very strong amount of reverse inquiry for Dynex. That's the thing number one.
Thing number two, the stock was trading at a local high. That was -- that factored into our decision. And the other piece is, look, last quarter I gave a very detailed rationale for us issuing equity. When do we issue equity? Why we issue equity? I talked about the fact that when we do it, we're considering the environment that we're investing in, and in this environment, the cost to issue, which gets subtracted up front, is actually much easier for us to make back when spreads are as wide as they are, right? And so when that payback period ends up being shorter than any other time in history, it makes sense for us to issue.
The other piece that was really important this time was that the pricing was very aggressive and advantageous for our shareholders. So those are some of the factors that played into our decision. And the last piece of it is just, look -- looking into the second-half of this year, we really believe that there will be chances for us to deploy this capital. You know, there are already known unknowns, which we witnessed in the last three weeks in the U.S. political situation, global political situation. These are all factors that we think will help us at the end of the day put the capital to work at really good levels.
Doug Harter
And, Smriti, just a follow-up. When you're talking about the local high of the stock, is that a local high in terms of, you know, kind of how you view price to book valuation, or is that kind of on an absolute, you know, just stock level?
Smriti Popenoe
All of the above. And I think that is those are all factors that go into it yes.
Doug Harter
All right I appreciate the insights Merci, thank you.
Smriti Popenoe
Absolutely. Thanks, Doug.
Operator
Your next question comes from the line of Jason Stewart with [Janney] (ph). Please go ahead.
Jason Stewart
Hi, Jason Stewart with Janney. Byron, thanks for the introduction to the new teams and congrats on the promotions. How should we think about, Byron, your role going forward given these moves?
Byron Boston
That's a great question. I've been here -- I mean my 17th year at Dynex Capital. I am so proud to be here and work with this team. Thank you for this question. This is phenomenal, I absolutely love being at Dynex Capital and I love the team that I work with. I have -- we have an extremely experienced team. I've accumulated an enormous amount of experience over time. It's not about just picking the right human beings for the seat. It's also about developing the right human beings for the seat. It's about developing the right people, the right process, and the right technology. So I am here at Dynex Capital looking to the future, looking to build our company for the future. We have more resilience in this structure. We have better opportunity for consistency over time, development of our personnel.
And to be frank and honest with you, if you look at what the moves that we've made over the last couple of years, we've outperformed everyone else in terms of human capital decisions. So I'm pretty excited here at Dynex Capital, excited to be with the team that I have here. And I couldn't have been blessed any more than to show up here in January of 2008, find a great group of people, similar culture, similar values, and methodically piece-by-piece in a very disciplined manner we've been building this company over time. And I appreciate that all those shareholders who are listening who've been with us through this journey and will keep looking for the future in terms of generating a solid cash income for you on a monthly basis.
Jason Stewart
Great, thanks Byron. And we look forward to hearing from you on these calls. I have a question for the portfolio team. When we think about the upping coupon trade, how much of that is carry-based versus shorter duration total return? And when does that dynamic shift to down a coupon? I mean, what are you looking at in terms of markers to say that that thing has played out and it's time to move down a coupon?
Smriti Popenoe
Hey, Jason. You know, I would say, can I just add one thing to Byron's comments? You know, we are a team. We've been a team for a long time and today's announcement just says we're going to keep being that team and so that's an important piece of this. I think the -- to your other question about the coupon positioning, one of the really nice things about being in this environment and having the returns that you can get in the higher coupons is that overall the volatility trend is declining. So that just means that the expense that you have to pay to hedge these coupons is lower. And you can actually have a chance of earning some of that return, the nominal return, right, the nominal spread. And the option cost isn't as high.
So when we start to see the option cost actually starting to increase, that usually happens in down rate scenarios where vol is increasing. I think that's when, and well in advance of that, really, you want to be able to adjust your position down in coupon. That is not yet the environment that we're in, we believe, but that would be one of the factors that we would consider in taking sort of a more aggressive position down in coupon.
And just to remind you guys, our book is actually fairly diversified. It's like 40% below 4s, right, and 60% above, you know, 4.5s and above. So it's relatively balanced in that way. So we're trying not to take too much of that risk, just because we're very respectful of someone else that asked the question earlier on the call, just about that down rate refinancing risk on some of the higher coupons.
Jason Stewart
Yes, got it. Okay, and just one clarification for Rob. I think you said that, I mean, we obviously noticed NII inflect, but you think that holds absent of Fed rate cut, correct? And the Fed rate cut would just amplify that?
Rob Colligan
That's correct.
Jason Stewart
Okay, great. Thanks a lot.
Rob Colligan
Yes, the point there is the lower yielding assets that we've had are paying off and actually paying off faster than we've expected. And we're adding higher yield as we go so that should continue to trend in that direction.
Jason Stewart
Great, thanks for the questions.
Smriti Popenoe
Thanks, Jason.
Operator
I will now turn the call back over to Mr. Byron Boston for closing remarks. Please go ahead.
Byron Boston
Thank you very much. Please remember, Dynex Capital, we're managing for the long-term. We look forward to seeing you on our next quarterly conference call. Thank you very much. Have a wonderful day.
Operator
Ladies and gentlemen, that concludes today's call. Thank you all for joining and you may now disconnect.