Business context and reporting period
Dynex Capital, Inc. is an internally managed mortgage REIT investing primarily in residential and commercial mortgage-backed securities, financed mainly with short-term repurchase agreements. This Form 10-K covers the fiscal year ended December 31, 2017; quarterly figures are noted separately. Amounts below are in U.S. dollars.
Key financial metrics
| Metric | 2017 | 2016 |
|---|---|---|
| Interest income | $94.5 million | $91.9 million |
| Interest expense | $36.2 million | $25.2 million |
| Net interest income | $58.3 million | $66.7 million |
| Net income to common shareholders | $23.1 million; $0.46 per share | $33.9 million; $0.69 per share |
| Comprehensive income to common shareholders | $47.0 million; $0.93 per share | $14.1 million; $0.29 per share |
| Core net operating income (non-GAAP) | $37.0 million; $0.73 per share | $40.9 million; $0.83 per share |
| Net interest spread | 1.74% | 1.97% |
| Adjusted net interest spread (non-GAAP) | 1.64% | 1.88% |
| Operating cash flow | $204.4 million | $210.5 million |
At year-end, total assets were $3.306 billion, shareholders’ equity was $557.1 million, and book value was $7.34 per common share, versus $3.398 billion, $467.2 million, and $7.18, respectively, in 2016. Repurchase agreements totaled $2.566 billion, down from $2.899 billion; leverage was 6.4 times equity including TBA dollar-roll positions at cost. Cash and cash equivalents were $40.9 million, with another $46.3 million in restricted cash. The company reported $283.9 million of most-liquid assets, up from $138.1 million.
Investing cash flow was positive $87.4 million and financing cash flow was negative $303.6 million. Cash, cash equivalents, and restricted cash decreased by $11.7 million to $87.2 million. The operating cash flow figure includes substantial noncash investment-premium amortization.
Material changes versus the prior comparable period
- Net interest income fell $8.3 million as interest expense rose faster than interest income. Funding cost increased to 1.32% from 0.85%, while asset yield rose to 3.06% from 2.82%.
- Core net operating income declined to $0.73 per common share from $0.83. GAAP net income also fell, reflecting lower net interest income and a larger net loss on investment sales ($11.5 million versus $4.2 million).
- Comprehensive income improved to $47.0 million from $14.1 million, helped by $23.9 million of other comprehensive income, compared with a $19.8 million loss in 2016.
- Management shifted from adjustable-rate Agency RMBS toward fixed-rate Agency RMBS and TBA positions, and added U.S. Treasuries. Year-end MBS fair value including investment TBAs was $3.858 billion versus $3.212 billion in 2016; the company’s reported balance-sheet MBS balance excludes TBAs.
- Common dividends declared declined to $0.72 per share from $0.84; the quarterly rate was reduced from $0.21 to $0.18. Preferred dividends remained at the stated annual rates.
- Equity increased approximately 19%, supported by issuance of common and Series B preferred shares. The company issued 6.60 million common shares for $47.2 million net proceeds and 1.32 million Series B preferred shares for $31.4 million net proceeds.
Outlook, management commentary, risks and unusual items
Management said 2017 brought rising short-term rates, relatively range-bound longer-term rates, tighter MBS spreads, and generally improved asset prices. It attributed pressure on net interest income and spread to higher funding costs, while identifying CMBS and CMBS IO prepayment-related income and portfolio repositioning as offsets. Management reported a 12.3% total economic return on book value for 2017.
For 2018, management expected possible improvement in marginal MBS investment returns if rates rise and the yield curve steepens, citing tax-related stimulus, Treasury issuance, and Federal Reserve balance-sheet reduction. It also cautioned that the transition could be prolonged and volatile, and that higher rates could weaken economic activity or reverse. The company had added hedges after year-end and expected to focus principally on Agency MBS and CMBS IO while actively managing duration and leverage. No specific earnings, dividend, or rate guidance was provided.
- Key exposures include interest-rate and spread movements, prepayments, credit performance, short-term repo refinancing, margin calls, TBA settlement and margin requirements, and counterparty liquidity. Management disclosed a positive net duration gap and incomplete hedging; modeled +100 basis-point parallel rate movement implied a 10.0% decline in shareholders’ equity at year-end.
- Most repo financing is short-term, uncommitted, and renewable at lenders’ discretion. Year-end repo borrowings had a 1.67% weighted-average rate; $304.0 million was under a committed Wells Fargo facility with a $400 million capacity and stated maturity in May 2019, subject to early termination provisions.
- Common dividends are discretionary and not assured. Approximately 70% of 2017 common dividends were characterized as return of capital, principally due to tax hedge-loss deductions.
- A lawsuit seeks to enforce a prior judgment against the company and a former affiliate, alleging fraudulent transfers and related claims. Dynex called the suit baseless and expected no material adverse effect based on information available, but stated the outcome cannot be predicted.
- The company reported no material off-balance-sheet arrangements and said it was in compliance with repo and bilateral swap covenants at year-end. It reported effective disclosure controls and internal control over financial reporting; the auditor gave unqualified opinions on the financial statements and internal controls.
Important facts for investors to verify
- Review the full audited statements and notes, particularly the reconciliation of GAAP net income, comprehensive income, and management’s non-GAAP core earnings.
- Track whether higher funding costs continue to outpace asset yields, and whether reported spread and core earnings support the common dividend.
- Assess repo renewal terms, lender concentration, liquidity available for margin calls, and the potential cash obligations associated with the $829.4 million year-end TBA dollar-roll position.
- Monitor book value sensitivity to interest rates and spreads, hedge effectiveness, and the portfolio’s shift toward longer-duration fixed-rate assets.
- Check subsequent developments in the litigation, REIT/NOL limitations, and the effects of the Tax Cuts and Jobs Act on the company and its investors.