Good morning. My name is Rob and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Third Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks, there will be a question-and-answer session.

[Operator Instructions] Thank you. Alison Griffin, Vice President of Investor Relations. You may begin your conference..

Good morning, and thank you for joining us today for Dynex Capital’s third quarter 2023 earnings call. The press release associated with today's call was issued and filed with the SEC this morning, October 23rd, 2023. You may view the press release on the home page 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 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 home page 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 Popenoe, President and Co-Chief Investment Officer; and Rob Colligan, Executive Vice President, Chief Financial Officer. And with that, it is now my pleasure to turn the call over to Byron..

Thank you, Alison and good morning, everyone. I'd like to begin by congratulating my longtime colleague and friend Smriti, on her nomination to the Dynex board. Smriti and I have worked together since 1997. In these 25-plus years, we have forged a unique partnership based on trust, friendship, and an uncompromising focus on performance.

I'm glad to have her with me on the board as we face a rapidly evolving business landscape. Over the last few months, I have spent a lot of time with shareholders discussing the macroeconomic environment. I will share my main thoughts and my comments today before turning it over the call to Rob and Smriti.

There are three major factors that I have been focused on as we grow our business here at Dynex. Number one, human conflict. I have long emphasized the setting of investment strategy in the context of a global macroeconomic environment. For some time now, I have also identified human conflict as an important consideration.

We are now seeing it play out around the globe and within our own country. Number two, global debt. It has risen rapidly to levels that are quickly becoming unsustainable as the cost of financing has risen dramatically. While the need for more financing is also increasing due to human conflict and demographics among other factors.

Number three, balance sheet transition. There is a major transition underway globally as central banks run off their balance sheet. Private capital needs to take on the risk that was previously announced on government balance sheets at uneconomic price levels.

We are witnessing a massive and ongoing price adjustment in assets across the risk spectrum, because private capital demands a higher risk premium to hold those same assets. At the intersection of these factors, the probability of accidents increases exponentially.

You've heard me say this as the prices are highly probable in a complex macroeconomic environment. What we have done at Dynex is to keep our shareholders in the game by investing in the most liquid asset that is yielding an above average long-term return.

As the global economy transitioned from central banks to private capital, agency mortgage-backed securities have faced the earliest and steepest price correction. Our book value has felt the impact of this correction, since the second quarter of 2022.

We have anticipated and prepared for book value volatility with high levels of liquidity and a flexible position.

While no one likes to see book value decline, the majority of the impact of book value has been due to spread whitening, a risk we believe is organic and acceptable as we are invested in the highest quality asset with a guaranteed return of capital. The bonds in our portfolio are money good.

As I lead Dynex, my focus remains on generating long-term sustainable returns. In that regard, our past performance provides a strong foundation to work from as we navigate what is clearly an unpredictable and evolving environment.

I see a compelling business opportunity in agency mortgage-backed securities to earn above average returns adjusted for the risk. We have positioned our shareholders to benefit from this in the long-term. I know I've mentioned this on previous calls, but I continue to believe experience and skill are the key elements for success in this environment.

I have been doing this for a long time. Extracting the yield spread available in mortgages is complex and requires skill. There's more spread available to earn today than in the last 20-years, and the team here at Dynex is one of the best in the business to be able to accomplish this. I'll now turn it over to Rob to review the quarter..

Thanks, Byron, and good morning. For the third quarter, the company reported book value of $12.25 and a comprehensive loss of $1.59. The book value performance plus the dividend delivered an economic loss of 11% for the quarter. The performance this quarter reflects both rate increases and spread widening.

We continued the trend of the second quarter by adding pools and reducing TBAs this quarter. Leverage increased this quarter to 8.5 turns, compared to 7.7 turns last quarter. As a reminder, our EAD does not include the benefit of our hedging activities.

We continue to use features as our primary hedging instrument, due to the depth and liquidity of the markets, as well as lower capital requirements, compared to a similar swap instrument. In the third quarter, Dynex had net hedge gains of $217 million and have unamortized net hedge gains of $830 million at quarter end.

These hedge gains help to offset increase in financing costs. Page seven of the earnings release provides our estimate of hedge gain amortization over time. Please also see page six in our earnings presentation, which highlights the components of portfolio returns and recent trends in net interest income and hedge gains.

For the third quarter, we recognized $18 million of hedge gain amortization for tax purposes, or approximately $0.33. Since the amortization of hedge gains are a component of REIT taxable income, they will be part of our distribution requirement along with other ordinary income and expenses.

As we discussed last quarter, we expect hedge gains will be supportive of the dividend. As of now, we're projecting the fourth quarter to have hedge gains of $24 million, or $0.41 per share. The total amount of gain to amortize and to REIT taxable income can go up or down, depending on the hedge position and movement in rates in the future.

Dynex ended the third quarter with an unrealized gain on its hedges. With that, I'll now turn the call over to Smriti for comments on the quarter..

Thank you Rob. I'd like to thank Byron and the other members of the Dynex Board for my nomination and appointment to the Board of Directors. I'm delighted to join them in steering our company's growth in the coming years.

Signing various board documents in the past months gave me a new perspective on what it means to be a steward of our shareholders capital. I feel humbled and grateful for the responsibility and will continue to work diligently to fulfill it. I also want to welcome T.J. Connelly to the Dynex team.

He joined us in September to head up strategy and research. T.J. has a long history with Byron and me going back over 20-years. He brings a wealth of experience in asset management, macroeconomic analysis, modeling, and technology.

He will spearhead our thought leadership efforts and you will begin hearing from him directly in the coming months and quarters. His addition greatly broadens our decision-making capabilities and I'm thrilled to have him as part of our team.

Let me start by covering the markets and decisions around positioning, after which I will give you my thoughts on the outlook. Last quarter, U.S. Treasuries resumed one of the deepest and most prolonged drawdowns in nearly 50-years since the inception of major bond indices. Through last week, U.S.

Treasury yields have risen some 75 basis points to 100 basis points on the year, to levels not seen since 2007. The yield curve has reversed a significant portion of its inversion and has continued to steepen into the fourth quarter, meaning that longer maturity treasury bonds are moving higher in yield relative to shorter term treasuries.

These changes represent major shifts in market expectations for the future path of interest rates. The agency MBS market has felt the impact of higher rates. Weighted average OASs of our portfolio widened 15 basis points through quarter end, and we are wider by an additional 15 OASs since quarter end.

Spreads now stand at both year-to-date and multi-year-wide on a nominal and option-adjusted basis. Book value declined by $1.95 or 13.7% on the quarter, driven equally by rates and spreads, and as a result adjusted leverage also increased from 7.7 times to 8.5 times.

Year-to-date, our models attribute the majority of the move in book value to wider spreads. Over the quarter, we adjusted our hedge ratios, which were designed for a portfolio that included higher coupons in a heavily inverted yield curve environment.

Our adjustments incorporated more optionality and protected the position from a less inverted or steeper yield curve. You'll see the impacts of our positioning on page 14. The net result is a position that is less exposed to changes in the level of rates. Our focus remains on the net spread between agency RMBS and our treasury hedges.

The recent moves in agency RMBS spreads are happening for several reasons. You've heard me discuss in the past of how the native balance sheet for mortgage risk in our country is changing. For much of the last 15-years the U.S. Federal Reserve was the largest holder of agency RMBS and before that the GSEs retained portfolios with the largest holders.

These entities crowded out private capital and removed a risk premium from the asset class. Private capital must now replace these government balance sheets. And in agency RMBS, that risk premium has now returned. Spreads are historically wide and they compensate private capital appropriately for the risk.

This is why I have been saying we are in the middle of a persistent investment opportunity for our shareholders. As we show on slide nine, agency RMBS spreads to a blend of treasuries are likely to trade in the 120 basis point to 200 basis point range. We are currently near the wide end of that range.

And we expect that returns from owning hedged agency mortgages will be sustainably higher for some time. While volatility and spread widening has caused pockets of stress, the best managed mortgage rates like Dynex remain a source of stability for the U.S. Housing System.

We see that in the financing markets, which continue to function in an orderly manner, our counterparties have access to liquidity and haircuts are stable. They report that their customers' liquidity profiles remain solid. Our hedges are in the most liquid part of the global financial system, the exchange traded U.S. treasury futures market.

So what does this mean for Dynex shareholders? We are invested in money good assets trading at historically low prices that offer accretive forward returns. Agency RMBS return projections look about as robust as I've seen them in my 10-plus years at Dynex and nearly 30-years as a fixed income investor. With that, I'll turn it over to Byron..

Thanks, Smriti and Rob. I would like to leave you with the following thoughts. The opportunity to earn a compelling return only mortgages on a hedge basis is as attractive as I've ever seen in my 40-plus year career.

Our portfolio is mark-to-market daily, and while there can be periods of volatility, lower prices mean higher future returns on bonds like ours. That our money good. Our management team is extremely skilled at earning his returns and our portfolio is well positioned to earn outsized returns going forward.

Very important for you to understand, we, the management team and the board, own our stock. Management has a material interest in the company and our focus is on extracting the historic returns available in the market today. With that, operator, I will open the call to questions..

[Operator Instructions] And your first question today comes from the line of Bose George from KBW. Your line is open..

Hey, everyone. Good morning. Actually, first I wanted to ask that you guys noted book OAS is at 14 basis point -- 15 basis points this quarter.

Can you just give us an update on what that means for book value?.

Yes. Hi, Bose. The number I quoted was actually as of a couple of days ago. So the number since quarter end is closer to 25 OAS on our portfolio. And the book value has been volatile somewhere between 10.50 and 11.50 as of last week per share, so that's where it's been ranging.

I do want to say a couple things, you know, just on what's been happening in the last week, right? One of the main observations we have in terms of why OASs are wider is -- it's been a technical widening.

This is not a widening that's based on the credit quality of the asset or that the money isn't coming back at par, right? These are money good assets. It's been really a factor of technical selling. One of the most interesting things that has happened in the sector is that money managers very wisely went overweight mortgages earlier this year.

That's because they were the cheapest asset out there. They were cheap versus corporates. We like to make a joke internally, they were cheap versus Bitcoin, they were cheap versus everything, right? So that was the appropriate trade to do. And what's happened with the sell-off in the last few weeks is that they have been receiving redemptions.

And when those redemptions come, they choose to sell the most liquid asset. We felt this last year at the same time in October, where the most liquid asset got sold, that happens to be the asset that we own. And that's actually one of the biggest drivers of why mortgage spreads are sitting out here in the past week. So this is technical selling.

The selling is happening as money managers get redemptions. And for that reason, we just want to be cognizant that this isn't a judgment on the quality of the asset. And our level of comfort withholding this asset class is the idea that these are money good..

Yes, yes, that’s absolutely -- that definitely makes sense. Thanks. And then, actually, just given the declining book value since quarter end, obviously your leverage is higher, all else equal.

How are you guys just thinking about leverages? Would you let it ride up a little bit, just given this uncertainty, and hold the assets? Or is there a situation where you might have to reduce the size of the portfolio to get your leverage back in a range where you become more comfortable?.

Yes, look, one of the nicest things about the way we have been positioned coming into this environment is having a massive amount of liquidity. So we've closed the quarter with $450-plus million of cash and unencumbered assets. That leaves us in a very flexible position here as we look at what's going on in mortgages.

You know, you guys know us to be very astute risk managers. We're sitting here evaluating exactly all of those decisions every day for on behalf of our shareholders, right? One thing that gives us a lot of conviction in our position and anything that we do to manage it. Number one, we're sitting here with a very liquid asset.

Number two, we're sitting with a big pile of liquidity. Number three, we have the scale to manage through these volatile environments, right? And the last thing, as we make these decisions, we're always going to be thinking about the through the cycle returns. The returns here are very accretive for our shareholders.

So we're not, and I've said this a few times, you know, we're not invested in agency mortgages, because we expect spreads to tighten day after tomorrow. We're invested in them because we generate an accretive rate of return versus our cost of capital. And that's true today.

And that's really the underlying tenet with why we're comfortable holding the positions that we have. So we're going to risk manage the position, Bose, and I think our shareholders have come to expect us to be very good at that. But that's kind of our thinking behind it..

Let me add Bose -- Bose, let me add one other thing which is, this is very simple, this is really quick. We came into this decade with an opinion about surprises and about global risk. And I think a year ago or so, we talked about having a ship that's built for this type of environment. That's basically Smriti gave you the details.

I'm just giving you a little history to know that we came into this decade preparing for this type of environment..

Okay, great, that's helpful. Thanks, guys..

And your next question comes from a line of Trevor Cranston from JMP Securities. Your line is open..

Hey, thanks. Good morning. Just to follow-up on that last question for my own clarity, have you guys made any significant changes to either the portfolio or the hedge position since quarter end? Sorry..

So, Trevor, I think we've managed the position actively since quarter end. I can't comment on significant changes or not significant changes. I will tell you that, that, you know, we manage the position actively. You can see the risk position on page 14. That's sort of the beginning part of how we've adjusted the position.

Rob, can you tell me how much I can disclose in terms of post-quarter end actions?.

Sure. And I think, you know, Trevor, good question. We've had over $100 million over the hedge gain, you know, since quarter end, given the moving rates. And as Smriti said, and you can see it in some of the slides, we've hedged at some different points on the curve. You know, we've been out a little bit longer. There's some 30-years in there now.

And with the move in the yield curve, we'll continue to actively look at where we want to be and where we want to have our hedges. But, Smriti, if you want to add some more color in terms of where you've been recently, that's fine..

Yes. So, I mean, we've been hedging in the back end of the yield curve, that's been our focus. We've used a combination of options and futures. And one of the hard things about giving a lot of detail on this is that it changes quite a bit.

So, you know, if we had a very substantial update, in the past, we've actually been willing to give out a disclosure that reflects that substantial update. I think if we do that, we'll be willing to do that in the future, like if that's something that we think is appropriate. But for now, I think we feel really good about what we've disclosed..

Got it. Okay, that's helpful. And then, you know, you guys talked about the technical picture for MBS, which seems, kind of, weak, at least in the near-term. And also, you know, you mentioned the sort of band you think spreads could trade in.

So I was curious, how much conviction or confidence do you think there is around sort of the upper end of that band, particularly if rates keep moving higher, just given the fact that it seems like at least in the near-term there's, kind of, an absence of many buyers in the market?.

Yes, yes, I mean that's interesting. So let me give you some fundamental observations about the mortgage market here. The Fed is basically coming out and telling us that they're pretty much done raising rates.

Now the argument is, are they going to raise in November or December? Either way, you're looking at maybe one more hike and then they're going to stop for some time. So this limits how much front-end rates can rise from here, alright? So you now have the front-end a little bit pegged.

The second thing is the biggest bank selling that we had, you know, this year is done right? Now there might be some shadow banking, bank stuff, you know, bank supply stuff out there but by and large the active selling is over, okay? The third thing that's happened here at this which is really important is the yield curve is substantially steeper and for the first time now you actually have agency mortgage yields at a positive yield spread versus Fed funds.

So the yield on current coupon mortgages is around 6.5%, 7%. Fed funds is at 5.5%, that's a lot of carry in mortgages. It's very positive in terms of just sitting here and keeping on owning the asset, right? Another point, the net supply picture for the first time is actually starting to look positive.

The Fed's runoff from their balance sheet is going to shrink from, let's say, $15 billion to $20 billion a month. It's going to go down to maybe $13 billion to $15 billion, so there's a few less mortgages that the market is going to need to absorb from the Fed.

And with mortgage rates around 8%, supply is really going to start to taper off here, especially in the winter, right? And then the last piece of this is that you are starting to see credit trends deteriorate, right? There's headlines about auto loan delinquencies rising, corporate bond delinquencies rising, percentage of bonds that could be downgraded rising, all of those things eventually, right, make it, make your money good asset worth more.

So in general, right, is that 200 basis points, upper end of the range, you know, intact, solid. I can't say that to you. I can say that there are many factors in play today that really limit how much further that those spreads can go.

Now, because we're cognizant of the technical picture, we're prepared for whatever, you know, for it to blow out past that.

But in general, there are many things we see in place right now that say, okay, look, even if we get out there, there's a reasonable thought process around why you could quickly come back to more tighter levels of spread from those extremely wide levels..

Yes. Okay, that makes sense. Thank you..

Sure..

Your next question comes from a line of Matthew Erdner from Jones Trading. Your line is open..

Hey good morning guys. Smriti, congrats on the board nomination and thanks for taking the questions. So you mentioned the spread range and I'm going to kind of follow-up on the question before.

What do you think drives them tighter? Is it other people getting in the market to, kind of, absorb some of the supply and stop the technical selling? Or is it the Fed, kind of, hinting that they're going to start to cut rates? Or just, kind of, figure out the duration of how long that they will hold?.

I think it's all of those things, Matthew, and I appreciate the congrats. Thank you for that. Look, I wish, I could say, hey, these are there -- these are -- if this happens, they're going tighter, right? One of the things that's happened right now is that you've got a technical situation where money managers have become net sellers.

One thing that keeps me, sort of, like very disciplined about my view on mortgage spreads is what happened to mortgages in January of this year. This year, once retail and RIAs and basically, the investor universe decided that it was going to be the year of the bond, mortgage spreads tightened to like 120 bps.

That's a very positive outcome when you go back and see what happened to mortgage spreads this year, okay? That can definitely happen again.

Now why do I say that? The yield curve is almost flat like a pancake at 5%, okay? So now for the first time, investors can look out of the yield -- look out the yield curve and say, hey, I can earn a 5% yield, you know, for taking duration risk. And in mortgages, you can actually earn a spread over the financing cost.

These are very positive, sort of, inherent things in the way the market is structured today. But you've got to get through this technical pressure first. So the number one thing that's keeping mortgages from tightening right now is this is the supply technical.

The number one thing that's going to get mortgages to tighten from here is a demand technical. And that demand technical has got to come from a marginal buyer. That marginal buyer right now is really investors, any investor that's basically willing to take that duration risk.

And investors will make that decision, we think, when they believe the Fed is done, which the Fed is kind of telling us we're close to being done, right? And when they feel like they're being adequately compensated for taking on that risk, which the curve has deepened, and that risk premium has been built back into the curve.

Now, whether that's enough or not is yet to be seen, but the factors are here for that switch to occur..

Got it, that's helpful. And then one quick question on the portfolio. You guys have trimmed the TBA position for the past couple of quarters.

Should we expect that to continue going forward?.

We like the TBA position where it is. We believe that having a mixture of TBAs and pools is a very smart thing to do here in this, kind of, an environment. TBAs are very easy to trade. So I don't think we'll be moving that exposure much higher here from this point on..

Yes. Thank you..

Your next question comes from the line of Eric Hagen from BTIG. Your line is open..

Hey, thanks. Good morning. I think a couple here.

I mean, a follow-up on leverage and maybe just how you think about your own stock valuation, just where you could trade and the cost of maybe raising incremental capital in light of that leverage? And then the second one here, I mean, just how sensitive are you to additional realized gains from the hedge portfolio if rates are expected to keep on rising, like what is the offsetting benefit to maintaining that structure of the hedges if there's this realized gain to think about on top of that? Thanks..

Hi, Eric. I'll let Rob answer your second question first, and then I'll take the leverage question after that..

Great. Thank you, guys..

Yes.

Eric, so can you clarify your question a little bit on realized gains?.

Yes, just like how sensitive you guys are to taking additional realized gains from that hedge portfolio if rates are rising and you know just explaining, kind of, like what the offsetting benefit is to maintaining that structure of hedges if we have to think about this realized gain component too?.

Got it, got it. Yes, you know I think we come in today and every day trying to figure out which direction we should go in and how to best position in the short-term, right? So that's one of the focuses. As I mentioned earlier, we've had over $100 million of realized gain, or I'm sorry, of gain, our features roll quarterly.

So they haven't been realized, but if the quarter ended today, we would have over $100 million of gain that we will have. And if you were looking at this in terms of an equivalent swap, you know, that would be coming to us over time.

The nice thing about the feature is we have that cash in our pocket today and can be very flexible with that and can make adjustments very quickly. But, you know, we've done a very good job of managing rate risk really from early 2020 to now and you can expect us to continue to do that..

Okay, thank you..

So I think on the leverage, there are really two big considerations, okay? One is what's causing the leverage to go up? Right now we have the number one thing that's causing our leverage to go up is wider spreads period. And wider spreads is an inherent risk that we take.

It's a native risk to our balance sheet and I think that's something that we evaluate every day to be able to say, is this risk a risk that we want to cut or is this risk -- a risk that we want to continue to take? All right.

When you have high levels of leverage, if you will, let's just say when we're calling this high here, wherever we are, the number one consideration is how much liquidity you have. Now, we walked into this month with $450 million of unencumbered assets in cash. And we consider that liquidity position -- a position of strength.

So we want to use our liquidity position to buffer further increases in spreads. And we only do that, obviously, if we believe that risk is worth taking.

So I'm giving you the framework with which we use to think about risk versus return and how we've thought about whether it's good or not good to take the organic risk that's within our balance sheet, right? We have a very high conviction that the forward return on these assets is outstanding relative to our cost of capital.

So all of those things are in our minds right now as we evaluate what to do going forward. I know that's not a clear answer. People are looking for us to say, yes, we're cutting risk or we're taking on the risk. You know, we're managing the risk. You know, our shareholders have become very accustomed to us doing the right thing in these circumstances.

I will remind you guys in October, November of last year when we got to these types of spread levels I will remind you guys we cut risk. We weren't afraid to do it and I'm going to tell you I think it was the right call given everything that's happened this year that was the right call.

Okay, so we're going to manage it actively when we have a disposable event relative to material change in our position, we will disclose it. You know, you have also a tradition of transparency and disclosure from us..

Smriti, let me add one other thing for Eric, which is because you've listened to us over the years and these moments like these are evolving. They're changing rapidly. And in some situations, like March of 2020, we just didn't take questions at one point, because it was just changing too much.

So I understand some of the things we asked some questions about, our position changes just as it's not. It is changing, it is evolving, and we've talked about that. And we are prepared as a company to withstand what we’ve said in the past, we've used a sailboat as an example, the shifting and changes in the market. Boy, I can't tell you everything.

We sold this, bought that, sold that, we’ve bought this. So that's, I just want to emphasize, just the moment in which we are right now in the markets, the team is prepared, and I think Smriti wants to jump back in here too with a couple of other thoughts..

Look, with regard to raising capital, all right? This asset class is cheap, period. It's the cheapest asset class out there. It's the asset class that every astute investor should be looking at, because the forward returns are extremely compelling.

So if we're out there raising capital, the story we're telling is, number one, this is the asset class that's gotten the cheapest. We know why it's here. We know why it's cheap. We know why we're getting to earn this incremental spread, because private capital now can earn a risk premium that wasn't previously there to earn.

We have the skill to manage this asset class, and that's the premise on which we go raise capital, right? So our current position, our track record, all of that are nice things to have on the side.

The most compelling thing about what's going on in this environment right now is that these things are cheap and they're money good and relative to everything else that's going on in this macroeconomic environment. They're the most liquid thing out there for you to be able to put your money in right now. So that's the premise on the capital raising..

And Smriti, this asset class has made it through every crisis in my career. And I've watched the other one get annihilated for whatever reason investors forget that took place in the past. But this asset class has made it through every crisis that I've been involved with in my career..

Well, thank you guys very much. We appreciate you..

Thanks, Eric..

[Operator Instructions] And there are no further questions at this time. I will turn the call over to Byron Boston for some final closing remarks..

Thank you all. We appreciate you joining us today. We look forward to you joining us in the future. We'll leave you just with the thought of an environment -- involving environment. We've been prepared for it. We're prepared for it. We've got a great opportunity. Thank you very much..

This concludes today's conference call. Thank you for your participation. You may now disconnect..