Dynex Capital, Inc. — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018. Unless otherwise noted, amounts are in U.S. dollars. Dynex is an internally managed mortgage REIT investing primarily in residential and commercial mortgage-backed securities, financed mainly through repurchase agreements. Figures below are unaudited.
Financial results and position
| Metric | Q1 2018 / March 31, 2018 | Comparable period / prior year-end |
|---|---|---|
| Interest income | $25.2 million | $22.4 million in Q1 2017 |
| Interest expense | $11.6 million | $7.5 million in Q1 2017 |
| Net interest income / spread | $13.6 million / 1.34% | $14.9 million / 1.73% in Q1 2017 |
| GAAP net income | $44.3 million; $0.74 per common share | $9.1 million; $0.13 per share in Q1 2017 |
| Net income to common shareholders | $41.4 million | $6.6 million in Q1 2017 |
| Comprehensive income (loss) to common shareholders | $(4.1) million | $26.6 million in Q1 2017 |
| Core net operating income (non-GAAP) | $10.2 million; $0.18 per share | $10.8 million; $0.20 per share in Q4 2017 |
| Cash flows | $41.9 million operating; $(77.9) million investing; $35.2 million financing | Net decrease of $0.8 million in cash, cash equivalents and restricted cash |
| Total assets / shareholders’ equity | $3.206 billion / $543.6 million | $3.306 billion / $557.1 million at December 31, 2017 |
| Repurchase agreement borrowings | $2.614 billion; 1.92% weighted-average rate | $2.566 billion; 1.67% at December 31, 2017 |
| Cash and cash equivalents / restricted cash | $28.1 million / $58.3 million | $40.9 million / $46.3 million at December 31, 2017 |
Management reported $263.0 million of most liquid assets at quarter-end, versus $283.9 million at year-end 2017. Overall leverage was 6.5 times shareholders’ equity when TBA dollar-roll positions were included at cost as if settled. The common dividend declared for Q1 was $0.18 per share, paid April 30, 2018. Approximately 100% of common dividends declared in Q1 was expected to be treated as return of capital, principally because of tax hedge-loss deductions.
Material changes and drivers
- Net income rose sharply year over year, largely because net derivative gains were $38.4 million, versus $0.2 million in Q1 2017. The gain was primarily associated with increasing swap rates; it should not be read as recurring operating earnings.
- Unrealized losses on available-for-sale investments drove a $45.5 million other comprehensive loss. Accumulated other comprehensive loss widened to $54.2 million from $8.7 million at year-end.
- Net interest income declined year over year as higher repo financing costs outweighed improved interest income. Cost of funds increased to 1.75% from 1.06%; adjusted cost of funds, a non-GAAP measure, was 1.79%.
- Versus Q4 2017, net interest income fell from $14.1 million to $13.6 million and core net operating income fell from $10.8 million to $10.2 million. Management cited higher repo costs and lower CMBS/CMBS IO prepayment compensation, partly offset by growth in average interest-earning assets.
- Book value per common share declined 3.7% during Q1, as investment-value declines exceeded gains in hedges. The filing does not provide a clear dollar-per-share book value in the supplied text.
- The portfolio shifted toward 30-year fixed-rate Agency RMBS and U.S. Treasuries. Treasury holdings increased to $204.5 million from $146.5 million; the company sold $110.8 million of seasoned Agency CMBS.
Outlook, risks and other notable items
Management expected stable or improving U.S. and global economic conditions in the coming quarters and anticipated that reduced central-bank stimulus and increased Treasury supply could create a more favorable fixed-income investment environment later in 2018, with a potentially steeper yield curve and wider credit spreads. It expected those conditions to create better reinvestment opportunities, but emphasized that successfully managing the transition period would be important. These are expectations, not firm financial guidance; the filing provides no specific earnings or dividend forecast.
- Key exposures include rising interest rates, yield-curve changes, spread widening, prepayments and reinvestment, credit performance, and liquidity. Management noted a positive net duration gap and incomplete hedging. Its model estimated that an instantaneous parallel 100-basis-point rate increase would reduce shareholders’ equity by 8.4% and net interest income plus net periodic swap costs by 6.5%; actual outcomes may differ.
- Most repo financing is short-term, uncommitted and renewable at lender discretion. Falling collateral values can trigger margin calls; failure to meet them can permit lenders to terminate financing and sell collateral. TBA positions also create liquidity risk if they cannot be rolled and require cash settlement.
- Management anticipated possible wider spreads in the second half of 2018, while noting that reduced Federal Reserve purchases, market repricing and economic or policy surprises could increase volatility. Repo borrowing rates rose during Q1 as short-term rates increased.
- The company reported compliance with repo and bilateral derivative covenants at March 31, 2018. It had borrowings with 16 of 34 available repo counterparties; $273.2 million was outstanding under a committed $400 million facility scheduled to mature May 12, 2019, subject to early termination provisions.
- A Texas federal court dismissed the pending suit against Dynex and a former affiliate on May 7, 2018, but allowed plaintiffs 28 days to amend their complaint. Dynex said it believed the case lacked merit and did not expect a material adverse effect, while noting the outcome could not be predicted. A related garnishment action remained ongoing.
- Management concluded disclosure controls were effective as of March 31, 2018, and reported no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether derivative gains and investment marks explain the difference between strong GAAP earnings and negative comprehensive income, and how recurring core results compare with GAAP results.
- How continued increases in repo rates, changes in the yield curve and spread movements affect net interest spread, book value and dividend capacity.
- Liquidity and collateral headroom under repo agreements, margin requirements, counterparty concentration, and the ability to roll or finance TBA dollar-roll positions.
- Whether management’s expected later-2018 reinvestment opportunities materialized, and whether the portfolio’s shift toward Agency RMBS improved risk-adjusted returns.
- The status and potential financial impact of the amended Texas complaint and the ongoing garnishment action.