Updated on July 1st, 2020 by Nate Parsh
Dynex Capital (DX) is a mortgage Real Estate Investment Trust (mREIT) that offers a lucrative 11.6% yield, making it a potentially attractive ‘high yield’ stock.
Dynex Capital also pays its dividends on a monthly basis, which is rare in a world where the vast majority of companies that pay a dividend, pay them quarterly.
There are currently only 56 companies with monthly dividend payments. You can see the full list of monthly dividend stocks (along with relevant financial metrics such as dividend yields, payout ratios, and more) by clicking on the link below:
Dynex Capital’s high dividend yield and monthly dividend payments make it an intriguing stock for dividend investors, even though its dividend payment has been declining in recent years.
However, as with many high-dividend stocks with yields above 10%, the sustainability of the dividend is in question. This article will analyze the investment prospects of Dynex Capital.
Business Overview
As a mortgage REIT, Dynex Capital invests in mortgage-backed securities (MBS) on a leveraged basis in the United States. It invests in agency and non-agency MBS consisting of residential MBS, commercial MBS (CMBS), and CMBS interest-only securities.
Agency MBS have a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity, such as Fannie Mae and Freddie Mac. Non-Agency MBS have no such guaranty of payment. Dynex Capital, Inc. was founded in 1987 and is headquartered in Glen Allen, Virginia.
The company is structured to have internal management, which is generally positive because it can reduce conflicts of interest. Additionally, when they increase total equity, there is no material impact on operating expenses. Over time, Dynex’s management team has built a strong track record of generating attractive total returns for shareholders:
Source: Investor presentation, page 14
Dynex’s portfolio is structured to be widely diversified across residential and commercial agency securities. This diversified approach creates an attractive risk-to-reward balance that has benefited the company for many years. Over time, the mix of CMBS and RMBS investments has reduced the negative impacts of prepayments on portfolio returns. Furthermore, agency CMBS acts as a cushion in the event of unexpected volatility in interest rates.
Finally, the high-quality CMBS IO are selected for shorter duration and higher yield, with the intended impact of limiting portfolio volatility. Ultimately, 90% of Dynex’s Agency 30-year RMBS fixed rate portfolio has prepayment protection via limits on incentives to refinance.
Management anticipates opportunistically increasing leverage in the high-quality asset portfolio while avoiding credit sensitive assets that are leveraged with short term financing. As a result, the company enjoys a highly flexible portfolio that frees management to rapidly pivot to other attractive opportunities as markets remain volatile.
In the company’s most recent quarter, core net operating income came in at $0.51 per common share while book value per common share decreased $1.94 per share, or 10.7%, to $16.07. Meanwhile, the net interest spread of 1.32% increased from 1.10% for the fourth quarter of 2019. Adjusted net interest spread of 1.47% was a slight decline from 1.53% sequentially, primarily due to lower TBA dollar roll income.
This poses a challenge for growth moving forward and requires management to further leverage positions (i.e., take on more risk) in order to sustain income levels. Leverage stood at 4x shareholders’ equity at the end of the last quarter. While high, this is significantly lower than the previous year where leverage was 8.5x shareholders’ equity.
Growth Prospects
Given that interest rates are expected to remain in a narrower and lower range for a longer period than ever seen in recent history, returns will likely suffer substantially. This is because the economies of the world will continue to be weighed down by large pools of negative yielding debt, forcing central banks to remain accommodative in their monetary policy.
That being said, such a low-yield environment creates an opportunity in high quality real-asset backed loans. While numerous short-term headwinds remain (as we will discuss next), Dynex still benefits from several long-term factors that could enable them to continue growing.
First, an aging population in a low yield world should foster a growing demand for the cash flow that their business can generate, thereby boosting valuations and making attracting capital easier for mortgage REITs. Second, as the Federal Reserve attempts to reduce its investment in Agency RMBS and GSE reform opens new investment opportunities, demand for private capital in the US housing finance system should grow.
Third, the shortage of affordable housing means that there is a need for additional investment into the sector.
Source: Investor presentation, page 24
Finally, Dynex brings to the table several competitive advantages which should enable it to generate strong returns for investors throughout business cycles on the back of these long-term tailwinds.
These include the company’s experienced management team with expertise in managing securitized real estate assets through multiple economic cycles. It also includes their emphasis on maintaining a diversified pool of highly liquid mortgage investments with minimal credit risk, and the attractive dividend yield.
Risk Considerations
While the long-term outlook is more promising, several challenges remain in the near term. First, this includes a shrinking spread between 3-month LIBOR and short-term repo rates as repo rates remain elevated due to a Fed Funds rate of 0.25%.
That being said, management has structured the portfolio so that any change in the Fed’s policy towards a further ease in 2020 will offset the headwind to earnings.
Source: Investor presentation, page 9
Another risk is that prepayment speeds that could rise due to seasonal factors. Additionally, the drop in mortgage rates could increase refinancing activity, further cutting into profits.
While some cash-out refinancing is already factored into the company’s prepayment expectations and their portfolio has been structured to hedge against some of this, there will still likely be some lost profits. This explains the company’s recent pattern of dividend reductions.
Dividend Analysis
The latest earnings results revealed a dividend that appears covered by earnings, as the company paid a $0.45 per share dividend in the quarter. Dynex delivered $0.51 of earnings-per-share during the quarter. That said, Dynex announced a 13.3% dividend cut for the July 1st payment. This is the second dividend cut in 2020, which follows a cut made in the previous year.
Including dividends distributed thus far in 2020, as well as those expected for the rest of the year, Dynex will pay out $1.66 of dividends this year. Based off of the June 30th closing price of $14.30, shares have a yield of 11.6% today. On the surface, Dynex appears to be an attractive high-yield dividend stock.
However, the dividend could be in jeopardy even following the most recent cut. We expect Dynex to produce $1.00 of earnings in 2020. This puts the payout ratio well above 100%, making it possible that the most recent dividend cut will not be the last.
Final Thoughts
Dynex Capital’s high dividend yield and monthly dividend payments make it stand out to high-yield dividend investors. However, we remain extremely cautious on the stock.
The company is covering its dividend for the time being. But declining interest rates will continue to force the company further out on the risk spectrum to maintain its cash flows, as its older mortgages roll off the balance sheet. This sets them up for potentially steep losses if the economy slips into recession and defaults rise.
If the company cuts its dividend yet again, it will likely continue the stock’s sell-off. This makes the investment highly speculative right now. Despite the double-digit yield, investors looking for monthly income have much better choices with more favorable growth prospects, and safer dividends.
