Q3 2022 Dynex Capital Inc Earnings Call
Okay.
Good morning, My name is Dennis and I will be your conference operator today at this time I would like to welcome everyone to the <unk> capital third quarter 2022 earnings conference call.
All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. If you would like to ask a question. During this time simply press Star then the number one ardmore telephone keypad to withdraw your question Press Star one again.
I would now like to turn the conference over to Alison Griffin Vice President of Investor Relations. Please go ahead.
Thank you Dan Good morning, and thank you all for joining us today.
Or the dynamics Capital's third quarter 2022 earnings call. The press release associated with todays call was issued and filed with the FCC. This morning October 24th you May view the press release on the homepage of the <unk> website at <unk> capital Dotcom as well as on the SEC's website at SEC.
<unk> Dot Gov.
Before we began we wish to remind you that this conference call may contain forward looking statements within the meaning of the private Securities Litigation Reform Act of 1995.
The words believe expect forecast anticipate estimate project plan and similar expressions identify forward looking statements that are inherently subject to risks and uncertainties some of which cannot be predicted or quantified the company's actual results and timing of certain events could differ considerably from those projected in or.
Contemplated by those forward looking statements as a result.
Unforeseen external factors or risks for additional information on these factors or risks. Please refer to our disclosures filed with the SEC, which may be found in the direct website under Investor Center as well as on the SEC's website.
This conference call is being broadcast live over the Internet with a streaming slide presentation, which can be found through a webcast link on the homepage of our website.
The slide presentation May also be referenced under quarterly reports on the Investor Center page joined.
Joining me on the call is Byron, Boston, Chief Executive Officer, and co Chief Investment Officer.
Murphy Pappano, President and co Chief investment Officer, and Rob Collagen Executive Vice President Chief Financial Officer, and with that it is my pleasure to turn the call over to Byron.
Okay.
Okay.
Thank you Allison and good morning, and let me start the call off with a few messages you thought for our shareholders and then Robin Smriti will take over with more specifics so to our shareholders as I've mentioned in the past. This is an incredible moment in history.
Cross all major asset classes prices have fallen and volatility is materially increase, especially during the last two to three weeks of the quarter.
And even though all asset managers are in the same storm.
Once you didn't know where not all in the same boat the dynamics capital bolt was built to withstand a store.
We have been preparing for this type of environment for years, we have managed to markets like this before and it is our experience and flexibility that will guide us through to the other side of this complex market cycle.
Given these challenges and complexity I want to maintain our tradition of transparency and open dialog by simplifying my takeaways on this quarter.
Key points.
Our portfolio.
<unk> is solid.
<unk> is prepared for this market several years ago, we proactively moved up in credit and up in liquidity and we further increased our focus on liquidity after March of 2020.
Our portfolio with government guaranteed and is backed by U S borrowers and U S real estate.
Agency mortgage backed securities are second and liquidity only to U S treasuries and mortgage backed securities have a history of being a very liquid and very efficient corner of the fixed income markets even in turbulent markets like the one we're in now.
Second.
Our liquidity position is strong.
Most of our liquidity is in cash the most liquid asset a ball, but we also have one pledged agency securities that are easily financed or sold.
As the markets took a decisive move toward chaotic volatility we have been able to manage our balance sheet with confidence we all.
Have enough capital to be opportunistic when the market's com and we take advantage of this great return environment.
Third our strategy was built through this the core tenet of dynamics of investment strategies preparation and flexibility and over the past several years. We've said repeatedly that we believe surprises are highly probable.
Again talking with our investors about the increasing complexity of global markets as far back as 2014, we understand through our experience that the global risk environment by its nature is too complex to allow us to predict what will happen, but that doesn't mean, we can't prepare which is what we've done.
For.
Our management team is experienced and disciplined.
And in this volatile market environment more than ever you need an experienced a trustworthy team at the helm, we have proven the value of experienced in the past as we've reacted to other market events in a very thoughtful manner as shown in our long term results, we manage our business for the long term and just as we've done in the past we're determined to guide you our shareholders.
<unk> through this disruptive market environment and.
And as always we're committed to provide transparency and insights into our strategy as we guide the di next ship through this storm to the inevitable Sunshine, who will come out tomorrow with that I'm going to turn the call over to Rob and Smriti and let him give you more details.
Yeah.
Thank you Byron and good morning all.
The company reported a comprehensive loss of $2 20 per common share and a negative total economic return of 12, 9%.
The negative total economic return was driven by declines in the value of our mortgage backed securities and TBA positions exceeding the increasing value of our interest rate hedges as spreads widened significantly this quarter, especially in the month of September .
Spreads are near historically wide levels, driven by recent economic policy and geopolitical risks.
We believe our portfolio will recover a significant amount of value when our flows and mortgage backed securities.
Improve or simply as paydowns occur over time.
Smriti will cover market activity, including spreads in her comments.
Earnings available for distribution or <unk> was 24 cents for this quarter.
G&A expenses at the AAD include a onetime cost of $2 7 million or <unk> <unk> of severance costs related to the CFO transition during the third quarter.
At <unk>, our key strategies include the management of interest rate risk liquidity management and protecting shareholder value.
We accomplished this through thoughtful asset selection and hedging activities.
This quarter, we're highlighting the benefit of our hedging activities as our earnings available for distribution calculation does not incorporate the positive impact of the company's interest rate risk mitigation strategies, because our primary hedging instrument interest rate futures.
If the company used interest rate swaps instead of futures the hedge benefit of the swap would be included in both net interest spread and earnings available for distribution.
Through September 30th dynamics has over $500 million of hedge gains primarily on features instruments.
These realized hedge gains are recognized immediately for GAAP reporting, but our deferred for tax.
Amortized into REIT taxable income over the hedge period of approximately 10 years.
The benefit of interest rate hedge gain amortization was approximately 9 million or <unk> 21 for the third quarter and is estimated to be $12 million or 25 per common share for the next five quarters.
The total amount of gains amortize into REIT taxable income can go up or down depending on the companys hedge position and movements in rates in subsequent quarters.
Since hedge gains are a component of REIT taxable income they will be part of the company's distribution requirements, along with other ordinary gains and losses.
As we move into the fourth quarter, we expect hedge gains will be supportive of the dividend in 2023 and beyond even if net interest income and earnings available for distribution declined due to rising financing costs.
Please see the additional disclosures in our release and be on the lookout for our 10-Q, which will have additional information and will be filed next week.
I'll now turn the call over to Smriti for her comments on the quarter.
Thank you Rob.
And welcome everyone as a long time sailor I can certainly appreciate byron's analogy of about navigating a storm.
I've done that in real life with my family and board, our sailboat and during my 25 plus years of experience in the fixed income markets I've often felt that sailing offers important lessons to me as an investor.
I will structure my comments today on our path through this storm.
We're navigating it our short term views on strategy and then I'll turn to our long term outlook.
The storm we are in represents a transition from an era of low inflation low interest rates financialisation leverage globalization.
Peace and a global pandemic.
On the other side of this storm is an environment, where the amount and mix of all of these factors will be different.
And there will be new factors to contend with.
We believe the storm and its effects will present excellent long term investment opportunities.
But we have to navigate through the storm first.
We prepared for this environment with the highest level of liquidity in over five years.
The highest allocation to the most liquid instruments backed by U S Real estate agency guaranteed residential mortgage backed securities.
Our TBA position has given us flexibility and maneuverability to adjust risk the <unk>.
Financing markets are functioning in an orderly manner, our counterparties have access to liquidity haircuts are stable and from our perspective. They are currently do not appear to be any signs of financing dislocation.
We can trade are highly liquid futures hedges 24 six.
Our balance sheet is mark to market daily. So there is no mystery about the value of our positions at the end of each day.
We had anticipated that as global central banks withdrew liquidity and raised interest rates to combat inflation, the price of government bonds and risky assets would adjust down.
This price adjustment has been underway since September of 2022.
Treasuries and mortgage backed securities have led the way and most of it has been orderly until this last quarter.
So the storm really intensified in late September and early October .
You can see this in agency MBS spreads, which widened dramatically in September and have continued the widening trend into the fourth quarter.
Now standing at levels within a few basis points of the peak spreads seen in March of 2020 as shown in our slide deck on page 10.
Simultaneously the entire yield curve has shifted up as of last Friday. The two year is 157 basis points higher and the tenure is 125 basis points higher just since June 30.
This type of interest rate volatility has not been seen in the bond market since the early 19 seventies.
You can see this represented in the chart in the slide deck on page 24.
As the year has progressed the ride has really gotten rougher.
Now here's what's unique about what's happened in traditional fed tightening cycles, the yield curve inverts. The carry in agency MBS is negative and it's usually not a great investment environment until the next fed easing cycle.
But it is different this time.
Mortgage rates have been rising higher and faster than financing costs, causing spreads to widen to historically wide levels, making this the best investment environment in agency MBS since the great financial crisis, and we expect this to continue.
Now the recent moves are happening for several reasons.
The structure of the agency MBS market is different.
The largest non economic buyer of agency MBS that as the fed is stepping back creating net supply into the market.
Unlike any other time since the 19 seventies, there is no going away buyer, there's no DSC and the <unk>.
Banks are also out of the market and they have no appetite for MBS because their loan portfolios have grown.
So now the marginal bid for mortgages is now being driven by relative value players. This is money managers they are facing outflows.
So the technical demand picture for MBS is the poorest it has been since in several decades.
Second there has been selling of agency MBS by many types of accounts, including non U S based investors.
Domestic money managers continue to face net outflows from fixed income.
And MBS are a liquid asset and they are being sold first.
So we expect this to continue.
And finally, we're seeing higher than normal levels of supply for the environment because loan sizes for next year are getting baked in origination pipelines are getting slashed and we're seeing some cash out activity, that's keeping volume elevated.
We do expect this to reverse course over the next few months.
So at the storm intensified we used our instruments, our principles of risk management disciplined top down analysis and a focus on capital preservation in our last call. We discussed our strategy is being prepared for this rough ride with liquidity and dry powder as we entered an environment.
Of higher return standing ready to deploy capital and what we saw as a persistent opportunity in agency MBS.
We have also repeatedly discussed the idea that we are in an environment, where surprises are highly probable and that we must be ready to adjust as those occur.
That posture and mindset has not changed as the right became rough with you in October with no shortage of unexpected surprises from across the Atlantic We made some tactical adjustments to the portfolio those reduced interest rate sensitivity and some spread risk and you can see the direct result of that on pages 11 and <unk>.
12 on our slide deck.
The book value decline, we experienced in the third quarter is a function of these market moves.
And mostly attributable to the gapping wider by about 50 basis points in agency MBS spreads in late September .
Post quarter end as spreads have continued to widen about 15 to 20 basis points across the coupons that we own book value at the end of last week was down about 8% to 10% versus quarter end.
Our liquidity is estimated at $430 million and leverage to total capital is approximately seven two times.
For your information the book value during the quarter traded up as high as 7%.
Up from the second quarter and before ending the quarter down 15%. This should give you some idea of the volatility in spreads as well as the rebound potential in the portfolio.
So now with the existing position, we hold more than enough liquidity and capital to withstand the spread shocks that we saw in 2008 as you can see on chart 10 that is another 40 to 50 basis points wider from here and nominal spreads on the current coupon.
We also stress our portfolios to include include haircut increases and other unanticipated calls on liquidity.
We are keenly aware of the potential for counterparty stress as well as the actions of other players in the market and for those reasons and more our view on the risk environment has shifted to a more cautious stance going into year end.
We've also rolled about 20% of our repo book over yearend and we continue to term out financing to minimize year end issues.
Let's now look ahead.
It usually comes after storms as some type of calming of disease. It is important to look and plan ahead with an intermediate term view to steer the boat to its destination.
At some point the fed will signal a pause or stop tightening when that happens there will be a period of lower volatility and evaluation.
This is where we see a target rich environment, which persist for some time.
Agency MBS returns are already in the high teens and low Twenty's and we're really looking forward to getting to that target rich environment, but we're not there yet.
The key is being able to navigate through this rough ride in the near term to get to the longer term stronger fundamental and technical environment.
So we see at least four positive catalysts for agency MBS in the intermediate term.
First one very simply.
The raw return in agency MBS. This can be a major catalyst five 5% to six 5% base case yield we haven't seen those in at least 15 years. These are great returns relative to a lot of other risky assets today and will likely be great returns in the future once.
You adjust for liquidity and credit risk.
Second lower net supply in the future we are approaching a seasonal winter slowdown mortgage rates are at or near 7%. This will eventually slow originations to at least 50% of current levels shrinking the overall net supply.
Forming a technical tailwind.
Third any decline in realized volatility is also a tailwind for MBS and will take spreads tighter and finally, if a recession indeed materializes.
<unk> will be the credit risk free asset to own versus riskier corporate and consumer back debt.
A few other points on the intermediate term.
At current levels MBS offer almost 200 basis points of spread over treasuries. It at nominal interest rates that have not been seen.
For credit risk free asset in decades.
These returns required less leverage to earn mid teens or higher returns.
Going forward the mortgage market will be operating without a stabilizing agents such as the fed or the gse's. This means spread volatility could be higher but at the same time returns will be higher. This is why we are calling the opportunity persistent and finally.
The demand for income remains strong global demographics still favor income producing investments and especially in the absence of a permanently rising stock market investors may finally seek fixed income instrument at these higher yields.
This is work can eventually turn the tide of money manager selling as inflows return into bond funds.
So for now while we position the portfolio to a more neutral stance. We're also thinking about what the catalyst is for adding risk as we navigate through this near term poor technical backdrop to the longer term stronger fundamental and technical backdrop for mortgages.
An additional word on our positioning we expect to be active across both our assets and our hedges over time.
Can think of it as a position designed to weather the storm that will change as time goes on the.
The beauty of a flexible strategy with TBA and the position is our ability to change as the market changes as we continue to evolve our portfolio structure, we will provide additional timely disclosures to be fully transparent as we transition to a more long term position and.
Until then you can see by the numbers, we've moved to shield the portfolio from large moves in interest rates and cut our spread risk.
I remind you the greatest by our long term total economic performance and that EAP alone is an incomplete metric to assess economic performance our dividend stability as Rob mentioned substantial hedge gains exists in the portfolio to support our forward dividend.
A final word on the dividend and forward returns on page 13 of the deck as.
As of last week, the weighted average market forward yield of our portfolio is approximately five 4%.
And we are hedged with treasuries, yielding about four 2%.
This produces a 120 basis points of net spread at eight times leverage to common.
Forward Roe of about 15%.
This is the foundation of the economic return that supports our dividend it will not be evident in earnings available for distribution because that does not include the benefit of our futures. It will show up mostly in book value and taxable income.
In addition, <unk>.
The current portfolio will add 70 per share and book value for every 10 basis points of spread tightening from these very wide levels further boosting the forward return.
Any incremental return will be driven by adding assets. During this persistent and attractive investment opportunity in agency MBS for which we are prepared.
We expect to eventually return to a diversified portfolio over time as new opportunities evolve.
I'd like to leave you with the following thought.
We are liquid and we are prepared for the storm that we are in.
We expect the rough right to continue for some time and we've moved to mitigate interest rate risk and preserve capital as we navigate through this short term transition to what we believe will be a highly favorable investment environment.
MBS spreads are wide and returns are in the 19% to 25% range on the margin. While this is a target rich environment, we would like to see the levels of macro risks subside to change and add significant risk.
In the intermediate term, we expect MBS to outperform many other asset classes as fundamentals and technical shift.
This is the environment when book value can be recovered.
We take our responsibility of capital stewardship, very seriously and the team and I remain focused on making the next decision to maximize value on your behalf I'm truly grateful for your trust and confidence and with that I'll turn it over to Byron.
Okay.
Thanks Marty.
Let me remind you again this is a historical moment that is evolving as we transitioned to a new global economic market and geopolitical environment.
I want to also remind you that we have built <unk> capital towards band the surprise market gyrations that we're encountering during this transitional period, we're committed to providing long term attractive returns to our investors and our focus on these long term returns has not wavered in this environment.
Take note of our track record as displayed on slide 15.
<unk> has proven to be a better cash generating alternatives to many other debt and financial alternatives through all cycles over the past 15 years.
This is not our first storm and this will not be our last and just as in the past we're prepared to remain patient and.
And disciplined until the Sun comes out.
Finally, we are in the boat with you.
Both management and the board are comfortable owning both dynamics capital common and preferred stock as we ride out this current transitional period in history.
Stormy environment will evolve.
This transitional period will end and we will have the flexibility to adjust our posture to a more offensive stance to take advantage of these truly attractive return opportunities.
So with that operator, we can open the call him up.
Four questions.
At this time I would like to remind everyone in order to ask a question simply press Star then the number one on your telephone keypad will pause for a moment to compile the Q&A roster.
Yeah.
And your first question is from the line of Doug Harter with Credit Suisse. Please go ahead.
Thanks.
You guys look unbalanced.
Short term and the intermediate to long term can you just.
Kind of arrived.
Seven times leverage that you talked about and that you are currently.
Hey, Doug I didn't quite hear that would turn it over again.
Sure kind of as you guys work to balance kind of the short term versus the attractive intermediate to long term can you just talk about how youre kind of arrived at the current leverage level.
Yes, great.
Yes.
Good morning, yes, so it's a function of two things right.
The level of spreads where they are today relative to where we think they could go that's that's the first thing.
We're being very respectful.
Of the technicals in the mortgage market.
And the probability here I think.
As I said on the call the catalysts for things to go tighter or fewer than the catalysts for things to go wider in the near term.
So that seven times leverage.
Flex the ability of the portfolio to really withstand substantial further widening in spreads.
And we believe that's the appropriate position as we as we navigate the next few months.
So the things that we take into account, where our spreads today, where could spreads go in the near term how much liquidity in capital do we want to have to be positioned with that how much leverage do we want going into that and then finally as I mentioned, sometimes in the storm is when you can actually.
Get most of your opportunities we want to make sure that we're positioned in a way that we're not hampering our ability to to take that offensive posture when when the opportunity does come.
And when that opportunity comes.
Where do you think what where would you feel comfortable taking leverage kind of when you think that some of those catalysts.
So I'm going to play out.
Yeah look that is that's like the $90000 question, which people have been asking us since July right.
We have actually faced a lot of pressure.
From our investors and others, saying when are you going to take leverage up how much are you going to take leverage up.
And I think I think the right answer to that is it depends it depends on what the market is doing at that time.
And what I can tell our investors and I can tell you and you've seen US do this now time and again.
Is when that when the opportunity presents itself, we will take advantage of it it's going to be in the context of the broader macro environment and if we believe the risk return trade off is.
If positive that leverage will go up right. So it's always going to be made in the context of that decision and what I can tell you right now we said in the deck. We think we have somewhere between two and four turns of of incremental dry powder.
That's what we hope to to deploy but we'll do it slowly and we'll do it prudently.
And Dave Let me add one other thing I might add.
One other thing on this Doug.
You heard Smriti tell you how broad our book value swung during the quarter.
And so we're sitting here in the world starts to change the environment changes and we're looking at a book value of that could potentially going to be materially higher than where we sit that's going to have a material impact on where leverage happens, we'll take that into account in terms of how we're managing the portfolio. So we're not sitting here thinking in terms of the.
Static moment in time, you can you can see how much volatility there are.
That's in the in the marketplace now, but really take note about.
Dwayne and book value, because we were up book value solidly at.
At the end of August right, and so it's pretty fascinating to see this with the book value up that high leverage goes down immediately but one two turns potentially so very important that we are thinking in terms of top down approach where spreads.
Spreads ahead of 20 to 30 basis points tighter leverages handed down we're not going to wait till they get there to make the appropriate adjustments in investments as we think about it so just to add that little piece in there too.
I'll give you some more clarity.
Great. Thank you.
Okay.
Your next question is from the line of Bose George with <unk>. Please go ahead.
Hey, everyone. Good morning, actually just sticking to the theme of leverage.
Obviously with spreads wider here your mark to market leverage has increased.
Back of the envelope is that the mark to market Leverages like around 95, now and you noted that there is the risk that spreads widen further.
That backdrop like how willing are you or what's kind of the range are you willing to let you and mark to market leverage.
The run up to and.
Is there because I guess the concern is there some level at which you might want to delever.
And that sort of remove some of the upside when spreads tightened so just kind of how you're thinking about that thanks.
So <unk>, we did we did talk about the adjustments that we made in the portfolio.
As of the end of last week.
Our leverage is actually down.
From quarter end.
Leverage of total capital we disclosed was seven two times during my comments.
So we have taken the opportunity.
To actually not take the write up on the entire portfolio of effort to further spread widening.
And I think that.
That's what we believe is the right approach here coming into.
What we still see is going to be a rough ride here through year end.
And again in terms of like how high would you let it how how.
It is it is that type of decision at this point is <unk> is almost like a day to day moment to moment decision.
If we believe the market environment.
Acquired further deleveraging, we're going to do that right, but as of now we're operating with enough liquidity and capital more than enough liquidity and capital.
Withstand basically a spread widening out to the peak of 2008 and beyond.
So the liquidity position will be able to withstand that whether or not we actually choose to allow it to do that is a function of where we actually see.
The market environment evolving now in the intermediate term.
We are saying the environment is going to improve for all the reasons I outlined in the call right.
Got raw returns that are really outstanding you've got supply that's coming down.
And ultimately you know.
Unfortunately, the people who are selling bonds in this market are selling what we own and when all of this is over they're going to want them all back.
So at that point, it's going to be nice to have that so it's a delicate line walking.
To say you want to you don't want to be in a position of giving up a lot of that upside when it eventually comes.
<unk> got to get there you got to make it there.
Intact.
We're very very cognizant of the risks involved with that and so we haven't allowed our leverage to float up.
We've made that adjustment and <unk>.
And that's that's.
That's part of how we are navigating the sense Byron I think you want to yes.
Me add something to this from the last two questions.
Bose and Doug.
As this when we say we went up in credit and up in liquidity.
We increased liquidity on the balance sheet, such that from 50 basis points on the tenure. This ride we've said here we.
We have plenty of liquidity not to worry about making adjustments to the portfolio, because leverages moving around or because margin calls or come in.
Ben.
Very easily actually managing our balance sheet as Mercury youll have probably sandy because they feel the stress that the investment team is all investment teams do in the world with this type of market volatility.
But in terms of the way I'm listening to your line of question around leverage leverage will pressure both companies that don't have enough liquidity, because they will scramble as leverages moving to meet their liquidity.
And if you look at the internal operation there'll be scrambling.
We don't have that issue.
Because we went up in credit and up in liquidity you can see all the decisions we made over the years.
I have enough liquidity to deal with a surprising environment.
And the real key is that as leverage moves around we may make.
Very tactical decisions, but it won't have any.
I have anything to do with needing liquidity.
We'll have something to do with the risk posture. We're taking your best example is March of 2020.
We operated in exactly the same way, we had a ton of liquidity, we didn't worry about any type of margin calls we adjusted the portfolio two or three times within that major storm and by the end of the year.
Everything was fine so.
You need a benchmark go back and look at how we've made decisions in 2020 look how we made them in 2019 before 2020 and look how we made in 2020.
That's it.
Okay. Great. That's helpful. Thanks, guys and then actually just one on the funding markets any changes youre seeing their volatility haircuts any anything to comment on.
The answer to that is no.
The agency RMB S repo market has been very very stable.
We've had zero haircut issues.
The market is functioning in a very orderly manner.
So no issues there.
Great. Thanks.
Your next question is from the line of Trevor Cranston with JMP Securities. Please go ahead.
Alright. Thanks.
<unk>.
Question on the.
The change in sensitivity you guys were showing.
As of October versus where you were at at the end of the quarter can you go into some detail on.
What the changes you've made to hedge portfolio and the asset composition.
Sort of.
Kind of led to that.
Material change, particularly on the rate exposures.
Yeah, So a big a big part portion of that is a combination of two things.
It's a combination of hedges that we put on.
And second.
A reduction in the credit spread sensitivity. So some some reduction in the level of assets some increase in the level of hedges.
And Trevor what we're doing is making these adjustments sort of in real time, and what we commit to do on this call is as we make those adjustments and we complete making those adjustments will actually give them more.
More detail around exactly what those what those moves were.
Over time.
Suffice to say, what we're really trying to demonstrate in those two slides is number one.
As it relates to interest rate sensitivity.
Thats substantially down versus quarter end, and then as it relates to sensitivity to credit spreads that's down some right.
But but on a percentage basis less than the interest rate sensitivity and.
In the book.
Okay got it.
And then the <unk>.
Western rests on the.
The coupon composition of the portfolio.
Given how much rates have moved obviously.
The coupons of show in the portfolio as of September 30th Anyways.
Trading at meaningful discounts.
On the margin as you guys are deploying capital can you talk about like if you guys are looking at deploying at the current coupons or if youre still kind of focused on more discount securities.
Yes.
That's a great question.
One of the things that the principles that you've probably seen us now follow for a few a few years is.
You want to you want to generally try to have.
Instruments that are.
I'm going to say Hedgeable in that you know the duration or are you trying to to.
To estimate the duration as well as possible the amazing thing about the coupons that we have owned and continue to own.
Is that right now with everything trading below 95 dollar price most of those coupons are fully extended into the duration of those is not hard to estimate.
And that's a really nice position to have.
In this volatile interest rate environment.
So I'm very comfortable positioning us in that manner.
Hill, we get through this transitional period as we go through the transition we're evaluating all kinds of things right. So yes current coupons, we are evaluating that theres risk and reward associated in the current coupon.
As well as the lower coupon so the tradeoff is always going to be.
What's the incremental return that I'm getting for the risks that I am taking and and yes current coupons offer more return, but there is a different type of risk that's involved and there'll be a time and a place to put that risk on the balance sheet.
We haven't we haven't felt like thats appropriate yet, but that is exactly the type of.
Offensive thought process that we're going through at the moment.
Okay that makes sense. Thank you.
Sure.
Your next question is from the line of adjacent Stewart with Jones trading. Please go ahead.
Hi, good morning, Thanks, guys.
I wanted to ask about the cost to operate in a sort of defensive lower leverage environment and how you guys are thinking about that.
Sure.
Okay.
Yeah.
When you say the cost to operate Jade you mean, just the overall cost of running the business.
Correct.
Our cost levels are basically the same in terms of just it hasn't increased any cost or grabbing this type of market volatility where the cost is coming is on our side.
Focus level is that a materially higher level in terms of our personal time and how much time, we're focused on the markets you go from.
Kind of a normal workdays with $24 seven type of environment, but in terms of just the cost of running the business.
We have a long term perspective.
And we're putting the right amount of money into our business to ensure that we are in great shape.
1235, and 10 years short term medium and long term.
So we're making some major changes in terms of our technology platform and other.
Different areas that we're really a year from now two years from now proved extremely beneficial. Furthermore back to us believing that surprises are highly probable in the world become more complex. We started to make these types of technology changes to put us in better shape demand.
This type of market environment that market environment. So this.
And Brian that doesn't have any impact.
Overall cost of doing our focus on the long term still exactly the same we're investing in people process and technology to build a sustainable organization over the long term we.
We believe that the world needs, a solid asset management team like dynamic scafell, especially a cash generating vehicles such as this so I hope that gives you some insight.
No that's great.
Perfect.
To ask you two other quick questions. One any expected changes that you guys think come out of FHFA given this environment.
Great question, Yeah, I mean, I think this is the environment in which they open up the credit box right too.
To potentially.
Change the affordability picture for as mortgage rates are up here at 7%.
We're looking at the at the loan loan size issue, obviously that that is a that is something that will come up here towards yearend.
And those are two big Big factors.
Nothing in the news so far that we can see.
Where where there has been movement towards opening up that credit box.
We're looking at the November elections, that's going to be something that we're focused on is as potential signaling of how this might evolve over the next two years.
So.
Right now I think.
Nothing is on the radar as far as we as far as we can see in terms of any major changes here.
Can I add one other thing this suggests a buyer and prominent whereas your asset out in public so I'm going to make the comment.
As a country. The agency security is a phenomenal asset for the United States.
Like our government and our FHFA.
Sure.
Fannie Mae temporary stabilizing agencies for this market.
To grow the portfolio like they did before.
It is ludicrous that these organizations sitting there when they could actually be a stabilizing agent and ensuring that these markets trade smoothly.
The mortgage market has traded anything but smoothly over the last few months. They can play a minor role. They could've played a minor role in March 2020, I think it would've been a lot easier.
So could you talk to government regulators bring that issue up.
I worked at Freddie Mac no role they can play they don't need to play the big portfolio role they played before.
But they can play a stabilizing agent in terms of how the agency mortgage market trades and I would hope that one day, our regulators FHFA or whoever else well I understand that.
Hey, Tim.
Last one for me how are you guys looking at buybacks on common or preferred versus investment opportunities.
Yes.
Both present pretty good opportunities in my view right now.
Pretty aggressive in our system.
Long term debt, 19% to 25% are facing.
Marginal returns are.
The buybacks makes sense when your investment opportunities.
Relative to <unk>.
Our cost of capital are inverted that's not the case right now.
And so again this is an investment environment in which we're going to want to hold and deploy capital.
Got it thanks for taking the questions.
Sure.
Your next question is from the line of Eric Hagen with BTG. Please go ahead.
Hey, Thanks, good morning.
Just a couple more on relative value within the coupon stack and how you guys think about managing liquidity just in light of the Paydown differential for securities across the stack.
How you mix that with TBA pools, and then on the funding side is there any value in borrowing with longer term repo right. Now can you comment on the liquidity that you see for repo along the yield curve.
Yes.
I'll answer your second question first Eric.
We.
I think the.
The idea that that you can borrow across term right.
Something that we've used very flexibly and well here at <unk> and it continues to be sort of a mainstay of how we get through quarter ends and so on and so forth. So.
There is a term premium that is currently being charged in the markets to go through year end.
It is actually not as big as as Tom premiums that we've seen in the path for the year and turn but there is a premium and I think that that's a big piece. The other thing that youre seeing is substantial amounts of uncertainty in the repo market with respect to when the fed will will make their 75 basis point hike move or their <unk>.
50 basis point hike move or 75%. So theres a lot of just price discovery, that's going on for November and December and beyond with respect to the magnitude of rate hike. So.
But none of that has prevented us from a being able to term out our financing or b just the availability of financing. So we are able to term things out.
Financing is available we have not seen any issues with respect to haircuts or anything like that.
We are seeing a term structure to those those interest rates as you would as you would expect.
But again.
Not not a problem with respect to actually how we operate.
So your first question.
Regarding relative value and scale.
Yes.
So he is here is really how we're thinking about it.
The first.
Principal is just the principle of risk management.
When you have coupons that are fully extended and the prepayment risk is more or less baked into the price there.
They are much easier to hedge so.
Holding the lower coupons, primarily is just simply a function of saying.
I can I can I know, what the duration is and unable to hedge those instruments with instruments that that are like that like features and so on and so forth. So that's the primary driver.
Of owning.
No coupons that that are below par now over time.
That will shift that will shift because the carry in higher coupons is higher it will shift because.
And many other reasons prepayments on the on the lower coupons could shift it becomes slower so on and so forth. So so that is sort of the next decision to be made.
And as you know like in these higher coupons.
You have no prepayment risk you have more extension risks you have more contraction or if theres more convexity.
So that relative value at this point is is it still sort of a thought process that we're going through the higher coupons do offer more current return but.
The hedge ability of them.
All of that is is still in question because we're still in a transitional period.
Anyone who bought higher coupons in this move as <unk> gone from two 5% to 4%.
And you thought you could hedge them.
With whatever duration. Your model said, that's been a very very difficult trade and for us sitting in the lower coupons with.
More extended profile, that's been sort of a big stabilizer as we've gone up in interest rates here.
It's also much more exacerbated when you see rates up spreads wider in the current coupon versus the lower coupon.
So as we're thinking about relative value the number one thing is.
Cannot hedge it.
And how can a hedging that's first because we are still in the transitional period. The time to have the relative value discussion of course is all the time, but but you then once youre approaching the end of that transitional period, that's when we'll be thinking through more about where do we play offense hiring play often now.
Don't get me wrong, we're thinking about this all the time, but that's kind of the way we're approaching as its not an environment, where you can just sit here and say well let me just one the highest coupons because that's what I think is the fundamentally the right thing to do you can't have that discussion without understanding that that's a macro.
Macro risk decision and and that's what's really driving the way we're thinking right now.
That's good color I appreciate it that with respect to the comments around the <unk>.
Dividend and such are we hearing that your dividend will most likely be characterized as a return of capital for both 2022 and 'twenty three.
Any guidance I suppose on that thank you.
Yeah, Thanks, Eric No, we're not saying that at all.
Because the hedge gains in particular that would all be ordinary income and we will look at it.
Distribution calculation so.
Yeah, we're not we're not saying that at all.
Okay, we're going to provide continue to provide color on.
Our hedge gains and the impact on that.
To the portfolio to financing and to taxable result, so everyone can.
Understand where we are we can be transparent.
And you see you can model out where we are.
I understand the direction that we're going in.
Great. That's helpful clarification. Thank you guys.
Okay.
Your next question is from the line of Christopher Nolan with Ladenburg Thalmann. Please go ahead.
Hey, guys.
Are you continuing to issue any shares into the fourth quarter here.
Okay.
Did you say a week are we.
Issuing shares.
Would that with our price this fall, but this type of chaotic market. Chris I. Appreciate you asking this question this type of chaos.
Says you hunker down.
On all aspects of the balance sheet.
Wait out the storm.
Purpose, we pulled this analogy of the boat out for very strong reason to mercury as a sailor.
Tom akin who was CEO before this is say look we're serious and a storm you're hunkered down the bulk put down anchor awakens door amount. This is on both sides of the balance sheet here and so no. The short answer is that good news, let's say.
No.
Right now we're in a storm in the storm took an interesting twist mid September .
The other key point here is that you leap towards zone.
Where we are patient on all aspects of the balance sheet.
Want to make sure everyone understand this point about what we're saying we've talked about whole Tom Staab coupons or vol. Bottomline is mid September with the chaotic British situation, along with the labs inflation number created complete chaos.
And market trading across the globe treasuries mortgages corporate whatever you want to mention.
And in a situation like that is smart border hunkered down and weights those storms out.
That's what we're doing in diagnostics do you want to take away any message from here.
The weight in the storm out they have a boat thats built for storm and we've got the ability to wait the storm out built the boat.
Plenty of liquidity, starting multiple years ago.
Great. Thanks, that's.
Thats It from me thank you.
Okay.
And at this time there are no further questions I will now turn the call back to Byron for any closing remarks. Thank.
Thank you all I really appreciate you being here. Thank you for the questions stay tuned we'll be transparent we're hunkered down.
We really appreciate all of the reward shareholders in the call. Thank you very much and we'll look forward to chatting with you at our next call.
This concludes the <unk> capital third quarter 2022 earnings Conference call. Thank you for your participation you may now disconnect.
Yes.
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