NEWS

Dynex Capital: One-Time Book Value Growth Is Not Enough

May 24, 2022

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Investment Thesis

Dynex Capital, Inc. (NYSE:DX ) is now a conservatively run mREIT with 90% of its portfolio in safe agency RMBS assets. The first quarter of 2022 was the first time in the last 5 quarters that the company could grow its book value per share. In the upcoming months, its interest expenses will rise faster than the income due to DX's funding model. The 9.7% dividend yield might look tempting, but the regular dividend cuts in the past make DX a risky choice for income investors.

Business Model

DX is a mortgage real estate investment trust founded in 1987. The company went through a major shift of assets in its portfolio, from riskier investments such as non-agency CMBS and agency CMBS to a safer agency RMBS in the last 2 years. The management significantly cut its CMBS share to a minimal of 9% of the total portfolio from the 75% share. This is not a unique move, as several other mREITs such as Western Asset Mortgage Capital Corporation (WMC) have been restructuring their portfolio since the pandemic and focusing more on residential assets.

DX portfolio restructure

Q1 2020, Q1 2021 and Q1 2022 Presentations

Financials Earnings

Q1 results and future trends

Dynex managed to grow its book value per share for the first time since Q4 2020. In the first quarter, the BV per share grew by 1.39% compared to the fourth quarter results of 2021. The net interest spread remained almost the same as previously (1.87% vs. 1.86% currently). DX also grew its leverage by 0.4x from 5.7x in the fourth quarter of 2021 to 6.1x by the end of the first quarter of 2022.

The general macroeconomic trends are in the company's favor, such as the growing demand for houses and residential mortgages, work from home trends, and the population growth of the U.S. The high inflation will further drive the interest rates upwards, which will result in mortgage rate rises. The FED has announced that it will start reducing its balance sheet, which means the mortgage rates will move up in the second half of the year, which will be an advantage for DX. Their investment yields will grow with the market and grow the company's interest income at the same time. However, the net interest expense will also rise in line with the rise of the mortgage rates.

2021 was not the best year for MBS due to the almost never-ending supply in the market. I believe 2022 will be different. DX can benefit from these positive changes, and, in addition, the prepayment risk is declining due to the rising rates and because people will not refinance their mortgages.

DX coupon change 2022

Investor Presentation

Valuation

In my opinion, DX is fairly valued. Its forward P/E ratio is 9.51, almost identical to the sector median of 9.96. Comparing it with one of DX's peers, ARMOUR Residential REIT, Inc. (ARR), which has a similar RMBS portfolio and a similar market cap to DX, ARR has a forward P/E ratio of 6.79. ARR's debt-to-equity ratio is 6.3x and the company has a leverage of 7.0x while DX has a debt-to-equity ratio of 4.52x and leverage of 6.1x. Both of the companies have issued shares heavily since the start of the pandemic. DX grew its diluted weighted average shares outstanding by a staggering 49.37%, while ARR has increased its shares outstanding by 47.19%. No surprise, then, why it is so hard to grow their book value per share.

DX shares outstanding past 5 years

Seeking Alpha

Company-Specific Risks

There are general macroeconomic risks to DX and MBS-specific risks as well. The largest macro risk for DX is the recession. Deutsche Bank has predicted a U.S. recession in the next 9 months. In recessions, people are less likely to buy new houses and commit to 15-20-30-year mortgages. In addition, if inflation remains at these elevated levels in the long term and fast interest rate rises occur, the default rates of mortgages will also grow. DX has the lion's share of its portfolio in RMBS, where most of the defaults could happen during the worst-case scenario.

The value of investments may increase or decrease in response to economic and financial events, whether real or expected, in the U.S. markets. Securities with longer durations tend to be more sensitive to interest rate changes than securities with shorter durations. DX's funding model is heavily reliant on short-term repo/dollar rolls and committed repos. The weighted average repo rate for the first quarter of 2022 was 0.25%, an increase of 4 bps from the fourth quarter of 2021. I expect further increases in DX's financing, which could hurt the company's profitability in the short term. As interest rates rise, the value of certain income investments is likely to decline. Mortgage and asset-backed securities are subject to credit, interest rate, prepayment, and extension risk as well.

My Take On DX's Dividend

Since my last article on the company, DX has been continuously paying monthly dividends. In addition, the amount of the dividend remains unchanged from $0.13 per share. I am not expecting any extraordinary events in terms of dividends in 2022.

However, if the earnings start to decline as expected by analysts, the payout ratio can easily exceed the 100% barrier by the beginning of 2023. This is why you can find a declining dividend estimate for 2023 and the consensus rate at $0.1225 per share monthly instead of the current $0.13.

Based on the management's dividend policy and dividend cuts in the past and possibly in the future, I believe DX is not a dream company for income investors in the long term. However, many investors have a view that the dividend is the only support for why DX is not a sinking ship yet.

DX dividend payout ratio

The table is created by the author. All figures are from the company's financial statements and SA Earnings Estimates.

Final Thoughts

I am happy to see that DX's management could successfully transform the portfolio into safer assets such as agency RMBS. The longer-term macroeconomic trends are also in the company's favor, but in the short term, I see more risks. The company is not an ideal choice for income investors just yet. However, if the falling earnings estimates prove to be wrong DX, might become a potential income investor's choice at the end of the year.

This article was written by

Daniel P. Varga profile picture

Started investing more than 10 years ago. Now mainly focusing on Large-Caps and occasional story stock. Investment horizon: 1-3 months. In addition regular buyer and analyzer of REITs, mREITS and asset managers. Also have a dividend focused portfolio. Investment horizon: 15-25 years.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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