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Text: Joining me on the call is Byron Boston, Chief Executive Officer, and Co-Chief Investment Officer; Smriti Popenoe, President and Co-Chief Investment Officer; and Steve Benedetti, Executive Vice President, Chief Financial Officer, and Chief Operating Officer.
I'm extremely pleased with our first-quarter results, which Steve and Smriti will review in more detail in a minute.
Our current total economic return for the quarter was 7.2% on a quarterly basis, and we have generated a total economic return of 34.8% over the last four quarters, averaging 8% per quarter.
We achieved this during an unprecedented time in the markets.
Most importantly, since this new era in history began in January 2020, we have outperformed our industry and other income-oriented vehicles with a 27.1% total shareholder return as noted on Slide five.
Our performance during the first quarter continues to demonstrate that Dynex has the skills and experience necessary to navigate the current environment.
The Dynex team relied heavily on our deep experience in managing the embedded extension risk in a mortgage-backed security, and we use this tactical expertise to take advantage of the environment.
We created value during the first quarter in four ways.
We've managed the existing portfolio, optimized our capital structure, raised equity, and invested capital to generate an excellent return for the quarter.
We have been strategically focused on our investment strategy at capital allocation as well as simplifying and enhancing our capital structure.
We have been executing the strategy to grow the company to drive operating leverage and to improve our common stock's liquidity while balancing our equity capital.
This quarter was unique in providing us the opportunity to raise $128 million in new common equity and invest that capital accretive.
We also called our higher coupon preferred Series B, further optimizing the right side of the balance sheet.
Both decisions added to earnings and book value in the first quarter and our view -- and in our view, will strengthen our performance over the long term.
Now from a macro perspective, we're at a critical inflection point in the global economy as the pandemic evolves in a disparate fashion and the impact of government responses and the vaccine takes hold.
We are preparing in our usual disciplined manner for multiple scenarios.
And as we have said before, surprises are still highly probable given the geopolitical backdrop.
We firmly believe that we can deliver value to our shareholders across multiple market scenarios, as Smriti will elaborate in her comments.
This remains a very favorable return environment with funding costs anchored and the curve steeper.
We believe the liquidity and flexibility inherent in our agency-focused strategy are essential for a highly uncertain global environment with many complex and interrelated risks.
The first quarter continued the excellent performance for the company.
For the quarter, we recorded a comprehensive income of $1.76 per common share, a total economic return of $1.38 per common share or 7.2%, and a core net operating income of $0.46 per common share.
Overall, total shareholders' capital grew approximately $100 million or 15% during the quarter as we raised $128 million in net common equity through two public offerings, as Byron noted, redeemed $70 million in higher-cost preferred equity and added approximately $36 million in capital from excess economic return over dividends paid.
The excess economic return was largely driven by our hedging strategy as we actively managed our position and timed our hedging adjustments as the curve steepened during the quarter, resulting in gains of $166 million, more than offsetting the impact of higher rates in our investment portfolio.
Book value per common share during the quarter rose $0.99 or 5.2%.
Absent the cost of the equity raises, book value grew approximately 7.5% during the quarter.
Core net operating income to common shareholders sequentially improved this quarter to $0.46 from $0.45 in Q4, principally resulting from lower G&A expenses and the reduction in the preferred stock dividend with the redemption of the remaining $70 million in Series B preferred stock outstanding mid-quarter.
Average earning assets marginally increased to $4.3 billion as we opportunistically deployed the capital raise throughout the quarter.
At quarter-end, leverage was 6.9 times shareholders' equity, and earning assets were $5.2 billion.
With the growth in the investment portfolio and the continued favorable conditions for the TBA dollar roll market, we expect sequential core net operating income growth for the second quarter versus the first quarter.
Adjusted net interest income was essentially flat as declines in RMBS pool balances were offset by an increase in TBA investments.
The adjusted net interest spread was slightly lower at 187 basis points versus 198 basis points last quarter.
On the balance sheet, portfolio asset yields and TBA specialness were 12 basis points lower during the quarter, which was partially offset by the benefit from lower borrowing costs, which declined five basis points.
TBA drop income increased 33% during the quarter as we more heavily invested in TBAs, but at slightly lower net interest spreads as TBA specialness was lower in the quarter.
TBAs continue to offer superior returns versus repo borrowings.
And today, our expectations are that adjusted net interest spread will be flat to modestly higher for the second quarter depending on prepayment speeds.
With respect to prepayment speeds, the increase was well within the expected ranges during the quarter.
Agency RMBS prepayments speeds were 18.4 CPR for the quarter versus 17.1 CPR for Q4, while overall portfolio CPRs, including the CMBS portfolio, were approximately 14 CPR.
I will begin with a review of the markets, our performance and then cover our current macroeconomic view and the outlook.
And I'm going to bring your attention to the line at the top of the panel that says 10-year treasuries.
We've now completed an incredible round-trip in the 10-year treasury yield.
As of December 31, 2019, you can see that was at 1.92%.
That yield touched something like 50 basis points in the first quarter of 2020, and we've come all the way back to 1.74% at the end of the first quarter.
So it's been an incredible round-trip.
I just wanted to point that out.
The other thing to note here is just the incredible decline in repo rates.
Again, on December 31, 2019, repo rates stood at 2%.
And now -- one-month repo rate now is sitting in the mid-teens, 14 basis points.
So it's -- the curve is steeper, and it's been quite a ride in the markets.
For the quarter, two-year treasury rates were up to four basis points, while ten- and thirty-year rates rose eighty-two and seventy-six basis points, respectively.
Implied volatility on swaptions broke out of the tight range of sixty to sixty-five where it traded in the second half of last year.
It increased to an elevated seventy-five to eighty basis points per day range where it remains today.
Shorter tenors were even more elevated during the quarter, which prompted us to rebalance our hedges.
As you can see on this chart, MBS OASs were within a range of about fifteen to twenty basis points with even wider ranges when you include intraday volatility.
Agency repo rates on the quarter declined seven basis points, and this reflects significant liquidity in the front end, some technical factors that have kept favorable financing costs at record low levels.
We had an excellent quarter in which the cost of our two equity raises was more than offset with active management of the balance sheet.
As Steve mentioned, book value increased to $1.44 or 7.5% on a gross basis, less $0.45 cost of the capital raises, we get to the net of $0.99 or 5.2% increase reported for the quarter.
Roughly 65% of the $1.44 or $0.90 of the book value increase was due to the portfolio positioning from the existing portfolio.
MBS performed very well, and our hedges were positioned appropriately for the most.
As we explained on last quarter's call, we came into this quarter with a view that a steeper curve was highly probable given vaccine development and deployment, fiscal stimulus, treasury supply, and inflation dynamics.
Hedging positions in the long end and options reflected this view, and this view largely played out over the quarter.
The other 35% of the book value increase came from the timely deployment of capital from the two raises.
As we mentioned last quarter, we expected curve volatility to create opportunities to add assets at attractive returns, and we were able to capitalize on the spread widening that accompanied large moves in interest rates.
We're ending the quarter with leverage at 6.9 times, up about 0.5 times from year-end.
It's important to understand the numbers behind the leverage.
Earning assets actually ended up quarter-over-quarter, almost $1.1 billion higher, including TBAs.
The decline in leverage also includes the fact that book value increased and the equity raise also reduced leverage.
Peak month-end leverage during the quarter was 7.7 times.
So the balance sheet is actually larger, even though the leverage doesn't seem to have been affected as much.
So this last quarter, we were active in managing all aspects of our balance sheet, both the left and right-hand side, as Byron mentioned.
Our options-based hedges on the long end of the yield curve performed very well, and we actually booked gains and rebalanced into more future-based hedges to navigate the coming quarters.
You can see that on Page 11.
In terms of repo management, our focus on the technicals was essential this quarter to position our book to be more short-term to take advantage of falling repo rates, and we're now locking in much lower rates into the second and third quarters.
Post-quarter-end, we took some profits on our 30- and 15-year MBS TBA positions.
We're expecting to reinvest at wider levels.
Leverage is about 6.1 times and book value is flat versus quarter-end.
Turning now to our near-term macroeconomic view and outlook.
We expect a range-bound environment to support MBS valuations with the ability to invest during bulks or volatility.
Specifically, declining pay-ups on specified pools, historically low repo rates, and unprecedented dollar roll specialness are unique potential opportunities in our focus.
In terms of rates in the curve, the front end is still anchored.
The Fed has defined itself as being very patient, having an outcome-based response function versus projection-based.
In our view, this means preparing for a more volatile set of outcomes in the longer end of the yield curve as the data begins to flow.
And the environment has shifted from rates just moving steeper and higher to more range-bound with possible surprises in both directions.
While we think the market eventually evolved into a steeper curve and higher rates, we think it will chop through some range-bound action in the interim.
And the implications for Dynex, a range-bound environment is really a great environment to earn carry.
And so we spend time on disciplined preparation for more volatility and surprises, we focus on the data, and we believe we'll have chances to add assets at low double-digit returns just as we did last quarter.
And eventually, the steeper curve will lead to a higher return environment and wider net interest spreads.
In terms of mortgage spreads and returns, Agency RMBS has been very well supported by both bank demand and Fed demand coming into this quarter.
We've also had lower net supply, slower prepayment speeds and now we have slightly higher mortgage rates.
We expect strong MBS performance to continue, supported by these technical factors.
And the implication for Dynex is that book values will be supported by this performance.
Any discussion of the taper or technicals where demand starts to fall away from mortgages, we believe, creates investment opportunity and we're well-positioned to take advantage of that.
In terms of prepayments, they remain a driver of returns, particularly in higher coupons and in specified pools.
The winter seasonal slowdown that typically comes was actually very modest.
Interest rates, mortgage rates specifically were lower during the season and the responsiveness of borrowers to low rates now appears to be really strong.
So the implication for Dynex here is that our coupon selection and flexibility from moving between TBA and pools will still be a major differentiating factor in creating returns, and we believe, again, provides the opportunity to add assets accretive.
Turning to specified pools.
On-Page 19, we have a pricing matrix that just goes through by coupon, what happened to various types of specified pools over the quarter.
And the first quarter unequivocally was a bad quarter for specified pool pay-ups as interest rates rose.
You can see there's been a dramatic decline in pay-ups since year-end, particularly on the higher coupons.
And in our opinion, this offers the opportunity to be very strategic and shift between TBA and pools, which is also supported by low repo rates at this point.
And finally, just a comment on dollar roll specialness.
We expect to see continued specialness in the two and 2.5 coupons well into the third quarter.
And the decline in repo rates that we've recently seen has actually made pools more attractive than they were before compared to TBAs.
And so we continue to look at that trade-off and invest selectively in spec pools.
Over the next few quarters -- last quarter, flexibility and nimbleness were really important, and I think they both remain very key to our success in managing the portfolio.
At the current leverage, which I mentioned, we had delivered post-quarter-end and balance sheet size, which is about $1 billion higher versus quarter-end -- versus year-end, we still expect core net operating income to continue to exceed the level of the dividend.
And as Steve mentioned, the second quarter will include some accretive benefits of really good dollar roll levels that we have locked in through June.
We are looking ahead in the next few quarters the actual data, the potential for a Fed discussion of tapering, possible technical reduction in demand away from the Fed, so perhaps banks stepping away; and overall volatility in the long end of the yield curve to offer opportunities to add assets.
We're also watching carefully the evolution of credit markets, particularly the transition from -- for banks to foreclosure in residential and commercial sectors.
And we think that there might be some opportunity there, but believe that develops closer to the second half of the year.
In terms of leverage, I mentioned we'll continue to manage the portfolio composition and size based on the opportunities in the market.
At this point, we're estimating, again, another two to three turns of capacity that offers additional total economic return power of anywhere between 1% to 3%.
And just as an example, one turn of leverage invested at 10% economic return is $0.24, which represents a meaningful upside to returns from today.
First, let me finish with a couple of thoughts.
Our team has always operated with great integrity and unwavering commitment to our values and a focus on supporting our community.
Given our fiduciary responsibilities, our highest priorities are to be a reliable steward of capital, transparent in our actions, and good corporate citizens.
Dynex is a strong diverse organization, building on a thirty-year vision to create a multi-generational organization that continues to stand the test of time.
In our annual report this year, please take a look, we shared our purpose, core values, and vision.
We live and breathe these elements in our daily work and believe this is a distinguishing factor for our company.
This is reflected in our long-term industry-leading performance as shown on Slides five and six.
Dynex has the highest three- and five-year returns, along with the best Sharpe ratio among fifteen peers, comprising agency and hybrid mortgage REITs.
Our management team, our Board of Directors, and I are personally committed to investing alongside our shareholders.
As we disclosed in the proxy, together, we are among the top five shareholders on a percentage basis in our common stock.
Let me leave you with this thought.
This continues to be a great environment to generate a strong economic return.
We remain optimistic about our future and our prospects for 2021 and beyond.

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q1 non-gaap core operating earnings per share $0.46.

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