Dynex Capital, Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Dynex is an internally managed mortgage REIT investing primarily in Agency and non-Agency residential and commercial mortgage-backed securities, financed mainly through repurchase agreements. Unless stated otherwise, dollar amounts below are in millions.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Interest income | $26.9 | $23.1 | $78.0 | $70.4 |
| Interest expense | $14.8 | $9.9 | $40.5 | $26.1 |
| Net interest income | $12.2 | $13.2 | $37.5 | $44.3 |
| Net income | $25.6 | $10.3 | $85.5 | $11.9 |
| Net income to common shareholders | $22.6 | $7.5 | $76.7 | $4.0 |
| GAAP diluted EPS | $0.39 | $0.15 | $1.35 | $0.08 |
| Comprehensive income (loss) to common shareholders | $0.7 | $13.6 | $(0.4) | $42.5 |
Q3 net interest spread was 1.08%, down from 1.47% a year earlier; the nine-month spread was 1.23%, versus 1.71%. Management reported Q3 core net operating income of $10.8 million, or $0.19 per common share, a non-GAAP measure. Adjusted net interest income was $18.1 million and adjusted spread 1.41%; these measures include TBA drop income and swap interest benefits and should be considered alongside GAAP results.
Financial position and cash flow
- At September 30, total assets were $3.448 billion, including $3.295 billion of mortgage-backed securities; total shareholders’ equity was $546.8 million. Accumulated other comprehensive loss was $85.8 million, compared with $8.7 million at year-end 2017.
- Repurchase agreements were $2.691 billion, up from $2.566 billion at year-end 2017, at a weighted-average rate of 2.36% versus 1.67%. Repurchase financing is predominantly short-term and generally renewable at lenders’ discretion. An additional $182.9 million was payable for unsettled securities.
- Cash and cash equivalents were $55.3 million and restricted cash was $58.3 million. Management reported $286.1 million of most liquid assets, including eligible unencumbered securities, and leverage of 6.7 times shareholders’ equity including TBA dollar-roll positions at cost.
- Cash provided by operating activities was $138.6 million for the first nine months, versus $156.1 million in 2017. Investing activities used $216.3 million; financing activities provided $104.1 million. Cash, cash equivalents and restricted cash ended at $113.6 million.
- Book value per common share was $6.75 at September 30, down $0.18 from June 30. Q3 declared dividends of $0.18 per common share offset that decline, resulting in 0% total economic return for the quarter; year-to-date total economic return was negative 0.7%.
Material changes and notable items
- Higher short-term rates raised financing costs: Q3 repurchase-agreement cost averaged 2.25%, versus 1.48% a year earlier. The resulting pressure on spread more than offset improved asset yields.
- Net derivative gains were $19.5 million in Q3 and $78.5 million for nine months, compared with $6.0 million and a $9.6 million loss, respectively, in 2017. These gains materially contributed to reported net income. At the same time, nine-month unrealized losses on available-for-sale investments contributed to $77.1 million of other comprehensive loss.
- The company issued 1.4 million common shares through its ATM program in Q3 for $13.4 million net, at an approximately 6.2% discount to quarter-end book value. It also issued 32,660 Series B preferred shares for $0.8 million net. Common shares outstanding increased to 59.0 million at quarter-end from 55.8 million at year-end 2017.
- The Q3 common dividend was $0.18 per share, paid October 31, 2018. The filing estimates that approximately 79% of common dividends declared during the first nine months would be treated as return of capital, principally due to tax hedge-loss deductions.
Outlook, risks and contingencies
- Management outlook: Management expected the Federal Reserve to be nearing the end of rate increases, while markets priced in about three additional increases through 2019. It described Agency RMBS as attractive and estimated leveraged returns on Agency RMBS investment capital in the low teens as of September 30. These are management views, not formal earnings guidance. Management also cautioned that its outlook and investment, leverage and hedging strategies could change rapidly with economic and market conditions.
- Market and funding risks: Rising rates and a flattening yield curve can increase financing costs faster than asset yields and reduce portfolio values. The company reported a positive net duration gap, meaning it had not fully hedged the sensitivity of assets relative to liabilities. Its model estimated that an instantaneous 100-basis-point rate increase would reduce shareholders’ equity by 11%; modeled results are assumptions, not forecasts. A 50-basis-point spread widening was estimated to reduce investment market value by 3%.
- Liquidity and leverage: Most repurchase agreements are short-term, uncommitted and renewable at lenders’ discretion; falling collateral values can trigger margin calls, and missed calls may lead to termination and collateral sales. TBA positions may also require cash settlement if they cannot be rolled. The company reported compliance with financing covenants at September 30.
- Other risks: Results are exposed to prepayment, reinvestment, credit and market-spread risks, as well as reduced financing availability or market liquidity. Non-Agency securities and CMBS IO have credit and loan-performance exposure. Management found no impairment requiring OTTI recognition on the securities assessed at quarter-end.
- Legal matters: Previously disclosed litigation against the company and DCI Commercial remained ongoing; the filing reported no material developments during the quarter. Legal expenses contributed to higher Q3 general and administrative expense. No material off-balance-sheet arrangements or capital-expenditure commitments were reported.
Important facts for investors to verify
- How much reported earnings depend on derivative fair-value gains, and how those gains compare with recurring net interest income and non-GAAP core results.
- Whether higher short-term borrowing costs and a flattening yield curve continue to compress spreads, and whether hedges adequately offset rate exposure.
- Liquidity under adverse collateral values, margin calls, and potential non-renewal of short-term repurchase agreements or TBA rolls; review the disclosed leverage and rate-sensitivity assumptions.
- The effect of ATM share issuance below book value, dividend coverage and tax treatment, and any subsequent change in book value or capital structure.
- Developments in the ongoing litigation and the associated legal expenses.