Okay. Hello, everybody, and welcome to Sidoti Small Cap Conference. My name is Brendan McCarthy. I'm an analyst here at Sidoti, and I'm pleased to welcome Dynex Capital with us today. Leading the discussion from the firm will be Co-CEO and CIO, Smriti Popenoe. Before I hand it over, a quick reminder, the Q&A tab is located right at the bottom of your screen. Feel free to type in any questions throughout the presentation, and we can save time for Q&A at the end. But with that said, Smriti, take it away.
Wonderful. Thanks, Brendan, and I am so pleased to be here, everyone, this afternoon. Obviously, Chair Powell is a super tough act to follow. But here we are, and, I'm really grateful for the opportunity to address all of you after what I feel is the event of the year with respect to the Fed. You know, we heard very clearly from Chair Powell, this is the beginning of an easing cycle. They went 50 basis points today. There was a lot of question as to whether they would or not.
One of the major shifts that I see in terms of the message we received from Chair Powell is really the idea that we are going away from a reactive Fed, a backward-looking Fed, to more of a proactive, forward-looking Fed that is acting like the risk manager for the economy, being proactive in terms of their decision-making. And then also, the other piece that was really interesting to hear from Chair Powell was the idea that they have kept a lot of optionality and dry powder in their pockets with respect to their ability to react and/or respond to any changes in the economy. So having said all of that, what does this mean for Dynex Capital? I welcome you all to this discussion. I will leave time for questions and answers later.
As you all are thinking about your portfolios, your investments, and how to allocate capital, I would like to highlight our company as a unique opportunity in which to play this idea of really two things. One is playing the Fed easing cycle and how that really uniquely impacts Dynex, and secondly, the shift that's happened in the U.S. mortgage market, to where the biggest investor in agency residential mortgages has typically been the U.S. government for the last 10-15 years. That trend is rapidly changing and persistently changing to where private investors, such as ourselves, can become investors in this very liquid sector, which has repriced ahead of all other sectors, really even in this tightening cycle, so we have a unique investment opportunity. It's happening because the government is stepping away from being an investor in the agency mortgage space.
Our financing costs, because we are a levered player, we do borrow in the open markets, in the reverse repurchase agreement market, they are coming down as the Fed has embarked on this easing cycle. This is very, very supportive of our 12% dividend, which we pay monthly today, and in addition to that, you have now the possibility and even the beginnings of the shape of the yield curve, the yield curve being positively sloped as opposed to the inverted state, which it has been for some time. That in and of itself creates a whole plethora of investment opportunities, ability to create value for our shareholders, so I'm super excited to be speaking to you today.
Our portfolio is consisted mainly of agency mortgage-backed securities, and what that means is that we are investing in securities that have a guarantee from Freddie Mac and Fannie Mae, and that guarantee says that we don't need to be concerned about the return of our capital, meaning the credit risk that is actually being borne by the agencies. We're more concerned about the return on capital. And so some of the returns on agency RMBS on a nominal basis have been somewhere between 5%-5.5% on a raw basis. Once you hedge out those returns with interest rate swaps or using US Treasuries, we try to earn the spread between investing in those agency mortgages and our hedges, which are usually taking the form of Treasury futures or interest rate swaps.
That spread, that risk premium, is historically wide, and that has been what our portfolio has been constructed for. So we have this investment opportunity. We use leverage in the markets to transform that spread into the double-digit return. The 5.5% yield turns into the 12% yield using leverage, and that's how we're able to generate these consistent double-digit returns over time. This second piece I wanna make sure you understand about Dynex, our market cap is just below $1 billion, about $950 million today. We are an internally managed company, and what that means is the capital that we raise and the capital that we deploy, we don't get paid fees based on the amount of capital that we raise or capital that we deploy.
We get paid on the returns that we generate. Our internal managed focus means that our incentives are very much aligned with that of shareholders. Externally managed companies will charge an asset management fee. You're not necessarily sure whether they're managing just your assets or somebody else's assets. At Dynex, you know, our shareholders' capital is our number one job and our number one responsibility. We have used our expertise. Our team here at Dynex has over thirty years of experience in doing exactly this, managing multi-asset portfolios through different investment cycles. This particular cycle, our macroeconomic opinion is based on the risk environment. Our macro risk view is that the global economy is more complex today than it has been in many decades, quite frankly.
It requires a slightly different risk profile and risk attitude, because the types of outcomes that we're seeing, we've called them a flat fat tail environment, so you can imagine a return distribution that is typically shaped like a bell curve. That has really flattened out, and the probabilities of different things occurring now is more equal, and there's really not much difference, and the distribution is rather wide, so in that situation, we want to have more liquidity, we want to have flexibility, we want the ability to move in and out of assets, and move in and out of risk. And so our investments are focused on this liquid agency securities portfolio. We're running somewhere between seven and eight times leverage to total capital.
We feel that's the right amount of leverage to take advantage of the investment opportunity that we see today, with the ability to flex that up or down as investment opportunities present themselves. The third point I wanna make to you all today is that when you buy a company like Dynex, what you're really getting today is the yield on the portfolio, which is about 12%, as I mentioned, our dividend yield. But there are two or three other things that can actually contribute from here on out in terms of what forward returns really look like for our sector. The first is just simply the fact that our financing costs are coming down.
In our estimate, and I've mentioned this on several earnings calls, for every 25 basis point return, decline in forward interest rates or in interest rates for our financing costs, our future return goes up by about 1%, all else being equal. So that's a very powerful tailwind in terms of positioning ourselves for rate cuts, and Dynex is very well positioned for that. The second thing I will tell you is that in terms of how we think about future returns, the risk premium between treasuries and agency mortgage-backed securities changes over time. What we have seen, because of quantitative tightening and other investors, such as banks, not being present in the agency RMBS sector, that risk premium has been historically wide.
It is wider, in fact, today than it has been in several other periods where the Fed has been coming into an easing cycle. So over time, we expect that risk premium to converge to a tighter long-term equilibrium level. And just to give you an example of where we are, so that risk premium, when things were very tight, when the Fed had a lot of QE going on, was as tight as 60 basis points over the 7-Year Treasury. Today, it is closer to 130 basis points, and at the widest levels, it was around 180 basis points. So you can see it has traded in a pretty big range. We are hovering somewhere in the middle of that right now.
We don't necessarily think it's going back to 60 basis points, but we think in the low hundreds basis points is probably where the intermediate long-term level is. And so returns today are still accreted relative to that long-term level of mortgage spreads. So that's another possible tailwind, again, when you think about where future returns could come from. The third piece that we have is just our ability to raise and deploy capital. At this point, we are seeing really good opportunities across the agency mortgage-backed security space. I've been a trader in this market for about 35 years. In this environment, we now have the ability to trade across a broader spectrum of agency mortgage securities than I've seen in my 30-year career doing this. So what do I mean by that?
We have the ability to not only invest in securities that were created in two thousand and twenty, two thousand and twenty-one, two thousand and twenty-two. Those those assets have low coupons, and they have a different risk profile. Fast-forward a little bit to when interest rates began to rise, there was a whole set of mortgage assets created during that time, and then finally, the mortgage assets that have been created in the last two years. So our ability to create value by making the decisions, the risk versus reward decisions, the relative value decisions, today is actually pretty big relative to any other time, that we've had, you know, investing in mortgage securities.
The second piece of why that's an attractive thing here is, in the past, the entire mortgage market used to float based on a particular set of instruments that was created. So for example, if interest rates were hanging around 4.5%, the mortgage universe was also hanging around 4.5%, and the entire market would float up or down, and risk would change based on that concentrated bucket, and those assets had a lot of concentrated risk. Because of the environment that we've just been through, interest rates have risen over 500 basis points. There's been origination across a series of interest rates. That creates a dispersion of risk that is also very attractive in terms of the ability to create value.
So as I sit here, you know, we've just heard Chair Powell talk. I see this environment really as being very, very strong for Dynex, not just in terms of the portfolio that we've put together and the forward returns that it can generate, but our ability to actually create value as the shape of the yield curve changes, as these different coupons reprice, and as other investors come in and out of this market. That's what makes this a really persistent opportunity for companies like us. Then finally, I just, as you all have a choice, obviously you're sophisticated investors, you're thinking through things like whether you want an allocation to fixed income. You know, where in fixed income should you be allocating as interest rates are coming down?
As you can see, you know, the market's already eased for the Fed, in that the long-term rates are down from about 4.75% to about 3.75%. So some amount of easing has already happened, and if you're thinking about where should I invest in fixed income, where is there still value? What I would say is companies like Dynex, the mortgage REIT sector especially, is a place where you can find these double-digit yields. For Dynex in particular, it is backed by money- good assets, and a team that has been really, really solid in terms of our performance. Particularly in the last five years post-COVID, Dynex is the number one total economic return producing mortgage REIT out there.
So our track record is really built on our ability to manage through stressful situations. COVID was actually one of our best years, you know, in terms of performance history, ironically. So we shine in moments of stress in the markets, and then when there's not stress in the markets, such as, you know, such as today, we do have a team that can sit and look across a series of assets and make the decisions that are needed to create value for our shareholders. So I will stop here at this point. I don't think I had any other points to make. Brendan, if there are questions and answers...
And again, I'm happy to take super basic questions if you don't understand mortgage REITs or have a question about that. I can answer macro questions specific to Dynex, whatever it is. So, ready and open to feedback and questions here.
Great. Great. Thanks, thanks for that overview, Smriti. We appreciate it. I think we can start the Q&A, maybe start off with a macro question. Can you just talk about the mortgage market in general? I know you mentioned that the Fed and other banks have been stepping out of the agency RMBS market.
Mm-hmm.
What's been driving that trend, and you know, do you expect that to continue ultimately?
Absolutely, yeah. So the two things that have been driving it, number one has been quantitative tightening, where the Fed has been reducing its balance sheet slowly over time. And you will see, if you look at a chart of the Fed's balance sheet, it peaked a couple of years ago, and it's been slowly coming back down. The Fed was the largest marginal buyer of agency RMBS. They're not selling. They're not selling, but they are allowing their portfolio to run off slowly. We expect that to continue, and we expect that to continue even if QT stops. Because when QT stops, they have expressed an interest that they do not want to continue to own mortgage-backed securities in their portfolio. So even when quantitative tightening stops, we expect them to reinvest their mortgage runoff into treasuries.
So that's a big, that's a big piece of where, and why we're saying we have a sustainable investment opportunity. It's wonderful when the government steps away from being the marginal buyer of an asset and allows private capital to come in, so that's thing number one. Thing number two is, why did banks stop? Banks stopped buying mortgages for two reasons. One was they were terrified after the rate sell-off from the last two years, the SVB, Signature. You've seen the headlines. I think there's also been some uncertainty around the Basel III Endgame rules. Those have basically allowed banks to step back from taking that risk. And you know, I said this at a conference yesterday, Dynex does not need banks or the Fed in the market to create returns. These returns are good, and they stand on their own.
If banks do come in, the chance that the risk premium I mentioned about mortgage spreads being a hundred and twenty over Treasuries, the probability that that starts to narrow really goes up, 'cause banks are a big potential buyer universe. Do we think that's gonna happen? Possibly. Do we need it to happen? Not really. Would it be great for our shareholders if it happened over, you know, over time? It would be. Personally, we prefer that, you know, us to just be able to have the investment opportunity and make the returns.
Got it, got it. And maybe you can walk us through your capital-raising process. Maybe talk about how much, you know, quote, unquote, "dry powder" you have now and, you know, maybe a timeline on deploying that capital.
Yeah, absolutely. Look, we did raise capital in June of this year. Our capital raising is typically timed with when we believe investment opportunities will arise, and we have consistently demonstrated the ability to do that. In 2022, we raised about $150 million in capital, and in early 2023, it looked like it was, it was actually raised at the wrong time because spreads tightened a whole lot, and then SVB happened, and so we were able to methodically deploy that capital throughout 2023. Very similar to that, in this year, we have had chances, and in June, we did, we did do a block capital raise.
Immediately after our raise, a month later, we actually saw some of the biggest opportunities in agency mortgages, and we were able to deploy that capital at that time. So in general, we feel this environment, and for the long-term benefit of our shareholders, when we see returns that are in excess of the dividend yield that we are paying out, we want to raise capital and put that capital to work, 'cause it's accretive to our shareholders, and that environment has continued. So that is typically the discipline that we use.
Got it, that makes sense. And looking at your leverage profile, I think you mentioned seven-to-eight times of total capital is kind of the target there. How does that compare to peers, and how has that trended over time?
So you'll see ours will be probably a little lower. Our dividend yield's actually lower than a lot of our peers. We tend to take our standard deviation of our book value is lower. So I don't wanna say that we're conservative, 'cause I don't think that's the right word. I will say that our process for managing risk leads us to have a tighter band of how much we'll let the leverage float up or down. Our leverage has been as low as four times, and that was during COVID, and that's when we felt like it was appropriate to be down there. It's been as high as 12 times, and that's been appropriate to be there. It was that high in November of 2023.
But on average, it's kind of sitting at the seven to eight times here. And what we will do is in times of where we see investment opportunity, we'll let the leverage drift up, and either by investing or allowing, you know, taking the spread widening, and either backfill with capital raises or make a de-leveraging decision when we need to make it. So in general, that is one of the most active decisions that we make. You know, in this time period, I think it's actually a good idea for us to have more mortgage assets on relative to equity, because we believe the long-term returns are actually gonna be super supportive for our shareholders.
We will want to see that, you know, all else being equal, drift up a little bit over time to be able to deliver returns to our shareholders.
Got it. Can you highlight some of the key risks in the agency RMBS market, and maybe talk about some of the risks that are currently on your radar, just as it relates to upcoming catalysts, whether it be, like, you know, the U.S. election coming up or, you know, a change in Fed policy?
Yeah. The biggest risk in agency mortgages is interest rate volatility, okay? So whenever you have really big, unexpected moves, such as what you got in November of 2023, and then you got in November of 2022, those are really sort of like the big things to be worried about. Now, Dynex prepares for those types of events by holding a very large liquidity buffer. And so when we do get that shock surprise, that liquidity buffer really serves us to cushion us from big drawdowns in our portfolio. And even if we have big drawdowns and margin calls, that liquidity is used in that environment, right? So in an agency RMBS portfolio, you have to think about big jolty moves. That's the first risk, right?
And that's, this is how we mitigate that risk. The other piece right now people have to think about is prepayment risk, right? So you saw mortgage rates up at 8%; they're now closer to 6%. That still doesn't mean a whole lot for the mortgage market, 'cause most of the mortgages that are outstanding in the U.S. are down at 3%-4%, or maybe even 2%-4%, right? So if mortgage rates are at 6%, like, I'm not really getting a lot of prepayments on the old mortgages. But I am gonna get prepayments on the ones that were just created, right? So there's a pocket of the mortgage market, especially if you own things like mortgage servicing rights, anything that's sensitive to declines in interest rates that have been just created, those instruments are going to need an extra look.
And the way Dynex mitigates that is we have a diversified portfolio. So our portfolio has mortgage assets with 2% coupons, 2.5% coupons, 4% coupons. So we have a diversified view so that we don't end up getting jolted in one direction or another, and that's, again, part of the amazing opportunity that we have, is that we, we can do that in this mortgage market. So can I just say-
Yeah
... the other big-picture risk? You asked me two questions. I'll answer the second one. So the biggest picture risk that we're focused on is unhedgeable risk, such as, right, binary outcomes from things like elections going one way or the other, you know, Republican sweep, Democratic sweep. Social unrest, right? Human conflict and the consequences of human conflict. When you have these outside exogenous things that can create some very binary outcomes, you have to think about two things: How liquid is my portfolio? How quickly can I convert it to cash? How can I get close to home?
That's the reason why we're telling our shareholders the best instrument to kind of hang out in right now in that kind of an environment is Agency RMBS, and amazingly, they still offer a really good return, so it feels like a very correct place to be.
Got it. That's very helpful. And more so out of curiosity, what, I guess maybe what level of... I guess what, what mortgage interest rate level do you see, you know, prepayments really ticking up?
Super good question, right. So I'm gonna answer that in two parts. For the mortgages that were created in 2022 and 2023 and 2024 year to date, any rate decline below 5.5%, you will see tons of prepayments on those. And we're already starting to see that on the higher coupon mortgages that were created so far this year, right? So we're already kind of there on the higher interest rate mortgages. And then to create a little bit more of a kicker, you'll see that happen as mortgage rates go down to 5.5%. Now, that's gonna take some time here, because we're only at 6.20 on the mortgage rate today.
Long-term interest rates have to come down further, or mortgage spreads have to tighten further for us to get there, but that's what it's gonna take. Then to really get mortgage activity going, you need a 3%-4% handle on interest rates, on mortgage rates, which I would say, you know, you're gonna be back to, like, a 2% 10-year note. To get that, you need a very big exogenous shock. You need not only just a recession, but a global recession, some very difficult economic situation that takes the back end of the yield curve back to 2%, which means front-end rates are down closer to 1 or, you know, half percent.
Right, that makes sense. That's interesting. Wanna close off with this question here, looking at the, you know, your premium-to-book value. I think you mentioned in your presentation... I guess, are you able to quantify that premium, how it compares to peers, and maybe where, how much more, you know, room that has to grow?
Yeah, look, in historically, Dynex has traded at a discount to book value, right? I can't make a comment on where we are relative to book value today, but I can tell you that historically we have traded at a discount. That discount has come down over time. So if I look at shareholders in general, what I say to them is, "Look, you're earning the discount to book to the extent it gets to par or above par," right? That's upside to the dividend yield that's already there. And what I will say is that the opportunity for that discount to book to be a premium to book, and for that premium to book to actually be significant in this environment is very good.
And the reason I say that, one of our peers is already trading at a 20-point premium to book, right? So relative to them, we're really cheap, right? But the probability that we could get there, just simply because you're getting this double-digit yield from an agency-guaranteed asset, that is a very powerful source of income. It's a very powerful, stable source of income over time. That is going to have appeal as you see interest rates come down in general. I think that's one of the reasons why I would say actually premiums to book can rise, and discounts will get actually accreted to par and then go above par. A 12% yield is a very good yield when forward interest rates are at 3.5%.
Absolutely. Absolutely. I think I'll turn it back over to you, Smriti. Maybe if you wanna-
Yeah
... sum up the presentation and when the value proposition for investors.
Absolutely. Look, you are getting an ethical management team. We have been around the block. My colleagues and I have done this for over 30 years. I will tell you that between the three people on the management team at Dynex, we are the ninth-largest shareholder in the company. So we eat our cooking, we believe in that. The principle by which I run the company is ethical stewardship. You'll see that on our Core Values page on the Dynex website. We have served to really protect our shareholders' book value over time. We have had an outstanding track record in periods of stress. When you buy us today, you're getting that, plus this dividend deal that's created from assets that have an agency guarantee.
You know, again, as I mentioned, the supportiveness of this interest rate environment with the ability for the curve to be steeper, that is all just incremental upside relative to what we have today. I'll leave you with that, Brendan. Thank you so much for having us on the show, and look forward to getting feedback.
Fantastic. Smriti, thank you very much for your time and the information.
Absolutely.
We really appreciate it.
Thanks.
All right. Thanks, everybody. Take care.