Dynex Capital: One-Time Book Value Growth Isn’t Enough (NYSE:DX)

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Investment thesis

Dynex Capital, Inc. (NYSE: DX) is now a conservatively managed 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 increase its book value per share. In the coming months, its interest expense will grow faster than revenue due to DX’s funding model. The 9.7% dividend yield may sound tempting, but 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 has seen a major shift in assets in its portfolio from riskier investments such as non-agency CMBS and agency CMBS to an agency RMBS safer in the last 2 years. Management has significantly reduced its CMBS share to a minimum of 9% of the total portfolio from the 75% share. This is not a one-off move as several other MREITs such as Western Asset Mortgage Capital Corporation (WMC) have restructured their portfolios since the pandemic and focused more on residential assets.

Restructuring of the DX portfolio

Presentations Q1 2020, Q1 2021 and Q1 2022

Finances and income

First quarter results and future trends

Dynex managed to increase its book value per share for the first time since the fourth quarter of 2020. In the first quarter, BV per share increased by 1.39% compared to the results of the fourth quarter of 2021. The difference of net interest remained almost the same as before (1.87% against 1.86% currently). DX also increased its leverage by 0.4x, from 5.7x in Q4 2021 to 6.1x at the end of Q1 2022.

the general macroeconomic trends are in favor of the company, such as the growing demand for homes and residential mortgages, work-from-home trends and the growing population of the United States. High inflation will push interest rates up even further, which will lead to higher mortgage rates. The Fed has announced that it will begin to reduce its balance sheet, which means that mortgage rates move up in the second half, which will be an advantage for DX. Their investment returns will increase with the market and increase the company’s interest income at the same time. However, the net interest expense will also increase in line with the rise in mortgage rates.

2021 has not been the best year for MBS due to the almost endless supply in the market. I think 2022 will be different. DX can benefit from these positive changes and, in addition, prepayment risk is reduced due to rising rates and because people will not refinance their mortgages.

DX Coupon Change 2022

Investor Presentation

Evaluation

In my opinion, DX is quite valued. Its forward P/E ratio is 9.51, almost identical to the sector median of 9.96. Comparing it to one of DX’s peers, ARMOR Residential REIT, Inc. (ARR), which has a similar RMBS portfolio and similar market cap to DX, ARR has a forward P/E ratio of 6.79. ARR’s debt ratio is 6.3x and the company has a leverage of 7.0x while DX has a debt ratio of 4.52x and a leverage of 6.1x. Both companies have issued shares massively since the start of the pandemic. DX increased its diluted weighted average shares outstanding by 49.37%, while ARR increased its shares outstanding by 47.19%. It is therefore not surprising that it is so difficult to increase their book value per share.

DX shares outstanding in the last 5 years

Looking for Alpha

Company specific risks

There are also general macroeconomic risks associated with DX and MBS-specific risks. The biggest macro risk for DX is recession. Deutsche Bank predicted a US recession in the next 9 months. In times of recession, people are less likely to buy new homes and commit to 15, 20 or 30 year mortgages. Furthermore, if inflation remains at these high levels over the long term and rapid increases in interest rates occur, mortgage default rates will also rise. DX holds the lion’s share of its portfolio in RMBS, where most defaults could occur in a worst-case scenario.

The value of investments may rise or fall in response to actual or expected economic and financial events in US markets. Securities with longer durations tend to be more sensitive to changes in interest rates than securities with shorter durations. DX’s funding model is heavily dependent on short-term repos/dollar rollovers and committed repos. The weighted average repo rate for the first quarter of 2022 was 0.25%, a increase of 4 basis points starting in the fourth quarter of 2021. I expect further funding increases from DX, which could hurt the company’s profitability in the near term. As interest rates rise, the value of some income investments may decline. Mortgage and asset-backed securities are also subject to credit, interest rate, prepayment and extension risk.

My take on the DX dividend

Since my last company post, DX has continuously paid monthly dividends. In addition, the amount of the dividend remains unchanged at $0.13 per share. I don’t expect any extraordinary events in terms of dividends in 2022.

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

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

DX Dividend Payout Ratio

The table is created by the author. All figures are taken from the company’s financial statements and SA earnings estimates.

Final Thoughts

I’m glad to see that DX management has managed to turn the portfolio into safer assets such as agency RMBS. Longer-term macroeconomic trends are also in favor of the company, but in the short term I see more risk. The company is not yet an ideal choice for income investors. However, if declining earnings estimates turn out to be wrong, DX could become a potential year-end earnings investor’s choice.