2023-11-08 11:28:40 ET
Summary
- Abating short-term funding rates and sustained credit risk might result in investors prepositioning for Dynex Capital, Inc.'s repo trade.
- The REIT can be treated as a diversification vehicle. However, we see a tactical opportunity in DX REIT.
- Although risk factors such as tail risk sensitivity and interest rate volatility are present, we think fortune will favor the brave here.
- Dynex's dividends are cyclical but strong across the rate cycle. Therefore providing a partial 'hedge' against price risk.
Today's article dials in on Dynex Capital, Inc. ( DX ) , a North American mortgage REIT with interesting talking points amid a changing yield curve environment.
As its historical returns show, Dynex probably isn't suitable for long-term investors. However, we believe the REIT provides a tremendous tactical opportunity. Moreover, we think the REIT has space for dynamic asset allocation to those seeking diversified returns via a liquid alternative/diversification strategy vehicle such as Dynex Capital.
Dynex's Strategy Explained
Dynex Capital's business may seem esoteric at first glance. However, it is pretty simple to understand if you eliminate all the complex jargon. In a nutshell, the REIT funds itself with short-dated debt and invests in long-term real estate debt. In doing so, the REIT can take advantage of three essential risk premiums, namely:
- Term risk embedded in longer-duration debt.
- The credit risk embedded in risky debt.
- The equity and liquidity premiums inherent in real estate.
Furthermore, Dynex uses hedging strategies whenever it sees an unfavorable environment for its risk premiums occurring, which is usually driven by factors such as yield curve inversion or narrowing MBS spreads. However, it is important to note that hedging introduces basis risk between the fund's asset base and its hedging portfolio, meaning that it never truly phases out risks.
Lastly, let's discuss the fund's typical exposure.
Dynex Capital invests in residential MBS, commercial MBS, and credit interest-only MBS contracts. As shown in the diagram below, the fund's main exposure is to agency mortgages implicitly insured by the U.S. government. However, do not be fooled, as these mortgages aren't gold dust; their values (and coupons) fluctuate quite abruptly, leading to a lot of shareholder speculation.
As illustrated by the final diagram in this section, Dynex Capital is highly volatile. Therefore, we reiterate that this is a tactical bet in most instances or a dynamic diversification strategy in some cases. However, we do not see this fund as suitable for long-term investors or retirees.
Recent Moves
It is explained in a later section why we believe Dynex is set for short-term success. However, to set a foundation, let's first look at a few structural changes the fund recently made.
Firstly, notice that Dynex has increased its leverage from 7.2x to 8.5x between June and September. Furthermore, the fund increased its exposure to higher Agency RMBS pools, which naturally lifted its exposure to higher coupon securities. We think the leverage spans from slightly lower funding rates (discussed later), allowing for higher term spreads.
Dynex's weighted average funding rate is currently at 5.47%, with a weighted average maturity of 93 days. Of course, the elevated interest rate environment paired with exorbitant short-term nominal yields has been an issue. Nevertheless, as discussed later, we see light at the end of the tunnel.
Although it upped its leverage in recent months, Dynex has increased its hedging conviction by buying Put options on treasury futures and using futures contracts. An interesting matter to notice is its Put position, which shows that the fund probably anticipates interest rate volatility to occur, as Put options are usually heavily reliant on volatility to reach their moneyness.
Dynex Capital updated its sensitivity analysis figures in September, communicating that it expects lower sensitivity to the level and curvature of interest rates. However, the REIT thinks its portfolio's sensitivity to credit spreads has risen/will rise. In our view, the inverse relationship between the yield and credit curves plays a big role in this. Moreover, a lower yield curve environment could reduce interest rate volatility, but sustained risks related to the real economy mean credit risk is unabated.
Unfortunately, Dynex sustained a loss in its third quarter. The mishap was due to interest expenses per common share being 37 cents higher than in Q2. However, we think the contemporaneous drawdown of the REIT's market value paired with changing systematic factors presents an inflection point. Let's traverse into the next section.
Why We See Upside
Why do we think Dynex Capital REIT will surge in the short term?
Firstly, the yield curve is starting to settle lower, as displayed in the following diagram. Global central banks are pausing interest rate hikes , and we think the U.S., for one, will start tapering once oil and gas prices curtail even further. Consumer sentiment is weakening, and we believe it's time for natural economic softening.
Dynex Capital could benefit from lower funding rates if yield continues to drop. Moreover, the yield curve will likely rise in the event of a softening economy, presenting breathing space to its repo trades.
Furthermore, we see potential in credit spreads. Sure, lower interest rates often result in a better credit risk environment. However, our view is that sustained volatility in the rate environment paired with lagging real economic growth will give rise to credit spread, providing Dynex Capital with feasible risk premiums to take advantage of. For as long as late payments do not occur, we think elevated premiums will be beneficial.
Lastly, Dynex Capital's historical yield on cost suggests its dividends provide a good hedge against price drawdowns. The REIT's dividends are cyclical and mostly contingent on mortgage rates. Nevertheless, the REIT's cyclical low distributions still provide valuable income.
Valuation and Peer Analysis
One wouldn't usually place a valuation on systematic trades that have a tactical basis. However, we wanted to include one for exposition to the fundamentalists out there. I mean, it couldn't hurt phasing it in, right?
As per its Q3 results, Dynex Capital possessed a book value per share of $12.25, which was lower than the $14.20 it reported in Q2. Nonetheless, Dynex's price-to-book still equates to approximately 0.90x, suggesting a value gap could exist. Moreover, the recent drop in the level of the yield curve has arguably added to the intrinsic value of Dynex's asset base while lowering funding costs; therefore, we are willing to argue that a higher net asset value and book value alike are en route.
Variable | Value |
Q3 Book Value Per Share | $12.25 |
Share Price (at time of writing article) | $11.02 |
Current P/B Ratio | 0.9x |
Source: Seeking Alpha (Author's Calculations)
A peer analysis shows less conviction than an isolated study of Dynex Capital. In fact, the REIT stacks up quite poorly relative to its counterparts if valuation is the focal point. However, we never said that Dynex is a best-in-class asset; we are just bullish on it in general. In fact, we recently issued a buy rating on Armour Residential ( ARR ). Our feeling is that the peer group's strategy is fairly homogenous and that execution is similar; therefore, we would not be overly focused on a relative comparison.
Risks
The first and most obvious risk associated with our analysis is that it holds a one-sided assumption about the trajectory of risk premiums. We could be entirely wrong about what lies ahead, which would, in turn, throw the analysis into arrears.
Furthermore, Dynex Capital is a very volatile asset, which is echoed by its value-at-risk figure in the diagram below. Although the REIT provides a diversification tool, there's no doubting the fact that it can suffer from significant losses in tail risk events.
Lastly, as mentioned earlier in the article, the REIT just got off a bad earnings quarter plagued by high funding rates and diminishing book value, which ultimately led to a consensus EPS miss of 82 cents in Q2. In fact, Dynex has now missed half of its revenue targets and 37.5% of its EPS targets in the past two years. Although our analysis argues for an upside in fundamental performance, investors could look past fundamentals and be scared away by inconsistent earnings releases, in turn adding pressure to the stock's performance.
Final Word
We believe Dynex Capital provides an excellent tactical opportunity to investors seeking absolute returns. In our view, the month-on-month trajectory of lower funding rates will continue, but credit risk will likely remain. Therefore, we think the market will start repositioning for Dynex's repo trade.
The fund provides a solid monthly dividend as 'collateral' to price risk. Although its dividend is cyclical, Dynex's payouts are respectable across the economic cycle.
In essence, we believe there's an overlooked opportunity here, which includes onboarding risk before the repo trade/MBS market recovers.
Consensus: Buy Rating Assigned With A 3-Month Holding Period
For further details see:
Dynex Capital: Short-Term Rate Support Incoming