Dynex Capital, Inc. — Q1 2013 Form 10-Q
Business context and period. Dynex is an internally managed mortgage REIT investing in Agency and non-Agency mortgage-backed securities (MBS), primarily using short-term repurchase financing. This unaudited report covers the three months ended March 31, 2013; balance-sheet comparisons are to December 31, 2012. Amounts below are in millions unless stated otherwise.
Key financial results
| Metric | Q1 2013 | Comparable period / change |
|---|---|---|
| Net interest income | $22.5 | $19.1 in Q1 2012; up 17.7% |
| Net income | $19.6 | $16.5 in Q1 2012 |
| Net income to common shareholders | $18.4 | $16.5 in Q1 2012 |
| Diluted earnings per common share | $0.34 | $0.33 in Q1 2012 |
| Common dividend declared per share | $0.29 | $0.28 in Q1 2012 |
| Net interest spread | 1.89% | 2.41% in Q1 2012; 1.93% in Q4 2012 |
| Comprehensive income | $28.6 | $42.7 in Q1 2012, including higher OCI in the prior period |
- Portfolio and balance sheet: Total assets were $4,628.1, including MBS of $4,267.9; shareholders’ equity was $633.3, versus $616.7 at year-end. Management reported common equity of $10.50 per common share, up from $10.30.
- Debt and financing: Repurchase agreements totaled $3,708.3, up $144.1 from year-end; their period-end weighted-average rate was 0.65%. Non-recourse collateralized financing was $28.5. Repo borrowings are short-term and generally renewable at lenders’ discretion.
- Cash flow and liquidity: Operating cash flow was $45.4; investing activities used $186.7 and financing activities provided $129.6. Cash declined $11.7 to $44.1. Management reported available liquid assets of $178.2, including $134.1 of unencumbered Agency MBS.
- Other income and expenses: Net gains on investment sales were $1.4, versus $0.4 in Q1 2012. Loan-loss provision was $0.3, versus $0.1. General and administrative expense increased to $3.8 from $3.1, principally due to incentive compensation.
Material changes and management commentary
- Net interest income increased year over year, supported by a larger Agency portfolio and lower-than-expected Agency RMBS prepayments and premium amortization. Q1 also included $1.2 of prepayment penalties on CMBS IO securities.
- Despite higher net interest income, the spread narrowed year over year and quarter over quarter. Management attributed the sequential decline from 1.93% to 1.89% primarily to higher funding costs, including expense from $250 million of forward-starting swaps that became effective during Q1.
- Portfolio allocation at March 31 was 84.9% Agency MBS, 13.6% non-Agency MBS and 1.4% other investments, compared with management’s stated target allocation of 60% Agency and 40% non-Agency MBS. Management cited attractive Agency CMBS IO opportunities and said it had recently directed capital primarily to Agency RMBS as CMBS supply diminished.
- Return on average common equity was 13.0%, consistent with Q4 2012. The reported increase in equity reflected net income in excess of dividends and a $9.0 increase in accumulated other comprehensive income.
Outlook, risks and unusual items
- No formal earnings guidance was provided. Management cautioned that low rates may pressure reinvestment yields and future profitability; the Federal Reserve’s asset purchases were also described as contributing to low rates and pressure on reinvestment and Agency RMBS prepayments.
- Interest-rate sensitivity modeling estimated that an instantaneous +100-basis-point parallel rate move would reduce projected 24-month net interest income by 6.4% and portfolio market value by 1.7%; a −100-basis-point move would increase them by 6.4% and 1.7%, respectively. These are model estimates based on a static portfolio and assumptions, not forecasts.
- The company said new requirements would require registration and clearing of interest-rate swaps entered into after June 10, 2013. It expected swap costs to increase significantly and was considering alternative hedges, which could be less effective and operationally more complex.
- Key exposures include interest-rate and spread movements, prepayments and reinvestment risk, credit risk on non-Agency assets, repo renewal and margin-call risk, and counterparty concentration. The company reported compliance with financing and derivative covenants at quarter-end.
- Subsequent event: On April 19, 2013, Dynex completed an offering of 2.25 million Series B preferred shares at a 7.625% dividend rate, receiving net proceeds before expenses of $54.5. It expected to use the proceeds for investments and general corporate purposes.
- Contingencies: Litigation includes Allegheny County tax-lien matters and a Texas case involving former affiliate DCI. A court reinstated a $25.6 damage award against DCI and ordered further proceedings; management stated it did not expect Dynex to be liable for amounts awarded against DCI. The filing says litigation could affect results or cash flows in a future period.
Important facts for investors to verify
- Whether portfolio yields and net interest spread continue to decline as funding costs rise and assets reprice or prepay.
- The company’s reliance on short-term repo financing, including renewal availability, margin-call capacity, collateral values and lender/counterparty concentration.
- Whether the expected higher cost or changed use of cleared swaps affects hedging effectiveness, earnings and liquidity.
- Performance and valuation assumptions for non-Agency securities, including Level 3 assets and underlying credit, prepayment and loss estimates.
- How the Series B proceeds are deployed and the effect of the additional preferred dividend obligation on returns to common shareholders.
- Developments in the disclosed litigation and any resulting financial exposure; the filing does not provide a clear quantified estimate for the Allegheny County claims.