Dynex Capital, Inc. (NYSE:DX) Q2 2022 Earnings Conference Call July 25, 2022 10:00 AM ET
Company Participants
Alison Griffin – Vice President, Investor Relations
Byron Boston – Chief Executive Officer and Co-Chief Investment Officer
Smriti Popenoe – President and Co-Chief Investment Officer
Steve Benedetti – Executive Vice President, Chief Financial Officer and Chief Operating Officer
Rob Colligan – Incoming Executive Vice President and Chief Financial Officer
Conference Call Participants
Bose George – KBW
Trevor Cranston – JMP Securities
Eric Hagen – BTIG
Christopher Nolan – Ladenburg Bauman
Jason Stewart – Jones Trading
Doug Harter – Credit Suisse
Operator
Thank you for standing by. My name is Cheryl and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Second Quarter 2022 Earnings Conference Call. [Operator Instructions] Thank you. Alison Griffin, Vice President of Investor Relations, you may begin your conference.
Alison Griffin
Good morning and thank you for joining us today for the Dynex Capital second quarter 2022 earnings conference call. The press release associated with today’s call was issued and filed with the SEC this morning, July 25, 2022. You may view the press release on the homepage of the Dynex website at dynexcapital.com as well as on the SEC’s website at sec.gov.
Before we begin, 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, assume, anticipate, estimate, project, plan, continue, will, and similar expressions identify forward-looking statements. These forward-looking statements reflect our current beliefs, assumptions and expectations based on information currently available to us and are applicable only as of the date of this presentation. These forward-looking statements 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 and/or contemplated by the forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, please refer to our disclosures filed with the SEC, which maybe found on the Dynex 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 Dynex website. The slide presentation may also be referenced under quarterly reports on the Investor Center page.
Joining me on the call, I have Byron Boston, Chief Executive Officer and Co-Chief Investment Officer; Smriti Popenoe, President and Co-Chief Investment Officer; Steve Benedetti, outgoing Executive Vice President, Chief Financial Officer and Chief Operating Officer; and Rob Colligan, incoming Executive Vice President, Chief Financial Officer.
And with that, it is my pleasure now to turn the call over to Byron Boston, CEO.
Byron Boston
Thank you, Alison and thank you everyone for joining our second quarter earnings call. Before I move into the broader market discussion, I want to address our recent news that Steve Benedetti will be stepping down as CFO after 28 years with Dynex and Rob Colligan has joined the firm to transition into the CFO position at the end of next week. Steve has been a key business partner for me and instrumental in building a world class finance department at Dynex and his generosity, humor and leadership have contributed immeasurably to our unique team-oriented culture. He will be greatly missed by all of us, and we wish him the best.
At Dynex, we often really discuss our long-term strategy. And while succession planning is not something that we discuss publicly often, it is absolutely a key component of our strategy as it should be for any strong and successful company. With that in mind, I have known Rob for many years and believe he would be an excellent fit for Dynex. As you know, we value experience at Dynex and Rob’s background in Bear Stearns, Starwood and Chimera will provide valuable insights to our team as we continue to navigate this current challenging environment and position the company for long-term growth and success. We are excited that he has joined our team and we look forward to you getting to know him.
Now, moving on to the second quarter. The first half of 2022, I witnessed some of the most volatile moments in the fixed income market in my career, especially during the month of June. Over the last 2 years, the Dynex team has protected book value as tenured treasury yields moved from 60 basis points to over 3%. Our second quarter performance reflects spread widening in June and we have used this as an opportunity to grow our balance sheet. On a year-to-date basis, we reported a negative total economic return of 2.3% and we continue to outperform the broad fixed income sector as shown on Slide 5 of our investor presentation. We achieved this while maintaining our priority on preservation of capital and our book value, while down this quarter, has remained within this decade’s range, as shown on Slide 6.
Our performance and capital preservation focus has put Dynex in an extremely strong position entering the second half of the year, because we believe it will enable us to take advantage of the attractive opportunities as we are currently seeing in the mortgage market. We have begun to allocate incremental capital through these opportunities, as Smriti will discuss in more detail, but remain thoughtful and judicious as to the pace and size of our investing.
The second quarter was a strong reminder of the importance of not only having a strategy built on top-down macroeconomic analysis, but having the experience and discipline to stick with that strategy in a turbulent market environment when there were plenty of opportunities to waiver and to make mistakes. Because our strategy is developed by a management team with decades of experience and is built with flexibility as our core principle, it continues to guide us through these volatile times and we believe into a period of tremendous opportunity.
Throughout this year, we have approached the markets with our hallmark patience and discipline. You hear us say these words often patience, discipline, flexibility. But I want to emphasize that these aren’t just worries. To us, these are actions and key components of our long-term strategy. Our active patience and discipline during the first half of 2022 resulted in meaningful capital preservation for our shareholders. And our decision to maintain a high level of liquidity means that our upside potential going to the next stage of the market cycle is significant as we are poised to benefit from the wider mortgage spreads as we deploy additional capital.
Believing that we were in a prolonged period of greater return opportunities, we raised the capital throughout the quarter. During the quarter and into July, we have been putting that capital to work as incremental risk-adjusted returns improve. However, we have maintained significant dry powder as the market evolves and accretive opportunities arise. I cannot emphasize enough that we are at the crossroad with some significant historical events. As the market grapples with issues such as QT, increasing global conflict, the lingering impact of the pandemic and a potential energy crisis, just to name a few. And while many of these issues are new, this provides a roadmap to help us successfully navigate times like these.
As an example, mortgage spreads have essentially widened back to where they were in March 2020. And we are seeing many of the same potential investment opportunities now that we did then. Our business model and strategy are designed to thrive and find opportunities in any economic environment, not just periods of quantitative easing. We believe that this sets us apart from other opportunities in the mortgage space and you are seeing evidence of that differentiation in our results. During these challenging environments, there will be risk and there will be opportunities. In the first half of this year, as we have throughout multiple market cycles, we effectively and skillfully navigated the risk and we are prepared to capitalize on the opportunities.
We have a great liquidity position. Our book value has been well-protected and long-term return opportunities are compelling. I am proud of the results our team has produced. Our commitment to providing attractive long-term returns for our shareholders is unwavering. And I am excited about the opportunities ahead of us.
And with that, I will turn the call over to Steve Benedetti to give you more specifics regarding our second quarter performance.
Steve Benedetti
Thank you, Byron and good morning all. For the quarter, the company reported a comprehensive loss of $0.85 per common share and a negative total economic return of $1.06 per common share or 5.8% of beginning book value. The negative total economic return of $1.06 consisted of dividends declared of $0.39 per share and a decrease in book value of $1.45. Comprehensive loss for the quarter consisted of $0.40 in earnings available for distribution, or EAD and $1.25 in negative fair value adjustments and realized losses on our investment portfolio position net of hedges.
EAD per common share declined $0.04 this quarter versus last is on balance the higher cost of repo funding outweighed benefits from an increase in both average interest-earning assets and asset yields. Furthermore, while leverage ticked up from quarter-to-quarter, it was virtually unchanged throughout the quarter as we were methodical investing the capital that we raised into spread widening toward the end of the quarter.
Net interest income was down $1.6 million sequentially, while adjusted net interest income, a non-GAAP measure, which includes TBA drop income, was down approximately $300,000. Adjusted net interest spread likewise declined to 1.84% in the second quarter from 2.06% last quarter. As previously noted, higher repo funding cost as the Fed continues to raise short-term rates, were the main driver of the decline in all three measures. Repo cost averaged 68 basis points this quarter versus 25 basis points last quarter and TBA implied financing rates were only slightly better than repo rates during the quarter.
As it relates to book value, the driver of the $1.45 per common share decrease was principally spread widening on Agency RMBS. Interest rates were up substantially during the quarter, but the company’s hedge position mitigated declines in fair value of the investment portfolio. Book value was also impacted approximately $0.21 per common share or 1.1% from the company’s capital raising activities during the quarter. From a portfolio perspective, we added higher coupon Agency RMBS exposure principally through TBAs and adjusted our hedge position accordingly for the shift in portfolio construction and consistent with our macroeconomic view. Almost all additional investment activity has been in Agency RMBS and TBAs. It’s important to note that our on-balance sheet asset prices, hedges and book value as of June 30 reflect the rate and spread volatility as well as the substantial repricing of mortgages that occurred during the quarter.
As a result, they reflect market yields for our investments based on spot and forward rates on June 30. For example, the amortized cost basis or book price that we own our Agency RMBS, excluding TBAs, is 102.75%, while the fair value price is 89.5%. The estimated market yield on the investment portfolio based on the fair value is 4% versus a yield of 2.4% based on book price. In general, amortized cost basis yields drive EAD, while the excess of market yields of our amortized cost basis will benefit book value and total economic return performance. Therefore, from a total economic return outlook perspective, all else equal, in future periods, the company will show a total economic return as if it had sold its portfolio assets and bought them back at market yields on June 30.
And finally, this will be my last quarterly call as CFO at Dynex. I have immensely enjoyed my time interacting with our investors, analysts and business partners, and of course, working side-by-side with my many talented colleagues at Dynex. I have the utmost confidence in Rob who has significant experience that will serve Dynex well in the future and who I believe is the right choice at this point in the history of the company. I also want to express my sincere thanks to Byron and Smriti. It has been a privilege to work with him, and I look forward to watching Dynex continue to grow and succeed under their leadership.
I will now turn the call over to Smriti for her comments on the quarter.
Smriti Popenoe
Thank you, Steve and good morning everyone. I’d like to start by recognizing Steve for his 28 years of service at Dynex Capital and to thank him for facilitating a smooth transition at the executive leadership level. Steve has been instrumental in maintaining Dynex’s sterling reputation with our lenders and counterparties and providing us a solid foundation with his leadership of the finance and accounting team. We will miss his daily banter and his unique sense of humor. Thank you, Steve, and best wishes to you in your future endeavors. I am very excited to have Rob Colligan join us on the executive team. Welcome, Rob. Rob’s experience, skill set and mindset are an excellent fit for the performance and stewardship culture of our company and I look forward to building the future Dynex with him as my teammate.
Turning now to the markets, this quarter, interest rates were much more volatile than the beginning and closing numbers would suggest. 10-year yields rose 113 basis points from $2.34 to $3.47 in mid-June before falling 47 basis points to close the quarter at about 3% on June 30. The same was true for 2, 3 and 5-year parts of the treasury yield curve, each rising about 110 basis points before falling 50 basis points to close the quarter. 30-year mortgage rates rose 93 basis points on the quarter to 5.83%. Market gyrations across the curve have continued into the third quarter.
Realized volatility that is how much prices actually move in a given day is the highest it has been since the early 1980s. And this is true across prices for many asset classes, including mortgages, treasuries, equities, credit-sensitive assets, currencies and cryptocurrencies. During the quarter, we also saw spread widening across many fixed income sectors, including investment grade and high-yield corporate bonds, CLOs, CMBS and Agency RMBS.
Agency RMBS had been leading the way on widening, because they are linked directly to the reduction of the Fed’s balance sheet, but this quarter, many other sectors caught up. As you can see on Page 21 of the investor presentation, 30-year Agency RMBS moved wider overall, but more so in the lower coupons. And this was primarily driven by a fear that the Fed would sell lower coupons to combat inflation, a notion that the market has since discounted. Against this backdrop, the Dynex team delivered a total economic return for the quarter of negative 5.6%, bringing our 6-month total economic return to negative 2.3%.
Book value ended the quarter at $16.79 per share and includes approximately $0.21 of dilution associated with capital raising activities during the quarter. Book value as of July 20 is estimated to be between $17.30 and $17.40 per share, up about 3% from quarter end. This reflects the spread tightening on lower coupons post quarter end and the modestly tighter spreads on incremental additions to the portfolio in higher coupons. We were active in raising capital. We are adding $105 million in equity capital at a marginal net cost of capital of 9.7%. We are raising capital in an environment where we have significant investment opportunity with a short earn-back period for any book value dilution, which is offset by high marginal returns on capital.
We believe that we are in the middle of a persistent and historic investment opportunity for the following reasons. We are still in the early months of quantitative tightening. And in our view, the markets are yet to price the full impact of the actual liquidity drain from the Fed’s exit of the mortgage and treasury markets. For the first time since the 1970s, there will be no secondary market presence from the GSEs or the Fed. Starting in September, we expect to be at zero net purchases from the Fed. This is a major technical factor in our focus. The demand that was previously provided by the Fed must be replaced by private capital and current conditions do not favor bank or money manager flows to absorb this net supply beginning in September.
As of last week, MBS spreads are at greater than two standard deviations wide when looking back all the way to the 1990s. We are now at peak spreads versus March of 2020 and versus a funding rate as high as 3.75%. Agency RMBS offer attractive returns in the mid-teens ROE. We see no clear impetus for a significant drive titer in spreads. We do see several factors in play that can keep spreads here or wider, particularly in lower rate scenarios and this is why we see this as a persistent opportunity.
Let me review the specific actions we took in addition to capital raising last quarter. Please turn to Page 10. You can see the progression on this page during and after the quarter. At the end of the first quarter, our leverage to total capital was 6.1x. Over 60% of our agency portfolio was in the 2% and 2.5% coupons, and we initiated new positions in 3% and 3.5%. Throughout the second quarter, we rebalanced the asset portfolio to diversify the coupon exposure, adding 4% and 4.5% in TBA form to the mix and increasing leverage to 6.6x, all in the last 2 weeks of June. We also adjusted our hedge ratios at this time to have a longer duration profile to benefit the portfolio in lower rate scenarios. Post quarter end, as mortgages widen further, we increased our asset balance and replaced our entire 3% position with an allocation to 4% and 4.5%. Leverage to total capital as of July 20 reflects business in earning assets, which was offset by approximately the 3% higher book value quarter-to-date.
Turning now to our macroeconomic view going forward, as Byron mentioned, the global economy is an evolving post-pandemic situation with increasing complexity across many factors, including energy, human conflict, geopolitics, inflation, climate change and the global supply chain. Central banks are facing conflicting mandates between supporting employment and generating growth, versus combating the worst global inflation since the 1970s. As a result, markets have been somewhat range bound in a level-seeking mode as we get data. And we appear to be in a tug of war between inflation and growth with intermittent shocks from a variety of exogenous factors. The U.S. treasury yield curve is moving to invert between the 2-year, the 10-year and the 30-year points of the yield curve, reflecting market pricing of the possibility of a recession and an eventual Fed easing cycle. This means based on what the forward curve is pricing today that our short-term financing costs will likely face a temporary increase through year-end of 2022, and decline thereafter in 2023.
To put the moves in the yield curve in context, historically, flattening or inverting yield curves are often associated with faster prepayment speeds and wider mortgage spreads in the Agency RMBS market. We believe that in this environment, continued inversion that results in lower 10-year yields and lower mortgage rates, especially mortgage rates below 5%, in combination with the expected quantitative tightening from the Fed in September, could set the stage for wider MBS spreads and very solid returns in the second half of 2022 and beyond. This is a scenario that we have moved to prepare for in the positioning of the portfolio. We also remain prepared for the possibility of continuing inflation pressures and coordinated hawkish behavior across global central banks. We expect that these factors will define the range in interest rates and keep market volatility elevated. What does all this mean for Dynex shareholders? Protecting capital and generating total economic return to meet or exceed our dividend through this transitional period remains our core focus. A component of total economic return is earnings available for distribution.
As Steve has previously mentioned, our head strategy of using futures contracts instead of interest rate swaps, means that our hedge costs and benefits are reflected in book value, not earnings available for distribution. So as financing costs rise, adjusted net interest spread will appear to decline because the offsetting benefit is recognized in book value, which will reflect the benefit of our hedges. We believe we can continue to generate solid EAD over this quarter. Next quarter’s levels will be a function of portfolio size, coupon selection and the Fed’s actions post the July meeting.
We are in an attractive total economic return environment, and we encourage investors and analysts to focus on total economic return, which we believe is the appropriate long-term metric that drives shareholder value and shareholder returns. On book value, we are in an environment where book value may be volatile. And barring extraordinary circumstances, we expect to take it as an opportunity to make long-term accretive investments for our shareholders. Having minimized large downside hits to book value to date and holding significant liquidity, we can now play offense to deploy capital and benefit from potential spread tightening in the future. This has been the foundation of our investment strategy, and this is exactly what we executed in the first quarter and repeated in the second quarter.
On the timing of our investment activity, we were very patient and disciplined in changing the composition and size of the balance sheet. Although we had previously viewed returns as attractive, we waited to add assets until this last round of widening in late June and July. We have been accurate thus far in focusing on the quantitative tightening calendar. And we believe that, that will continue to offer chances to deploy capital at excellent returns. I’d like to leave you with the following thoughts, the Dynex team is prepared and ready to execute on our investment strategy, and we are putting capital to work at highly accretive returns.
We will continue to be disciplined in our management of capital on both sides of the balance sheet. We expect this historic opportunity to persist for some time in the midst of a highly volatile market and a rapidly changing environment, and we are adjusting our investment actions and mindset accordingly.
I’ll now turn it over to Byron.
Byron Boston
Thank you, Smriti. Let me close by reiterating that at Dynex Capital, we are guided by our core values and our long-term vision for the company. All aspects of our decision-making has developed from this perspective. For example, our dividend policy is not based on short-term quarterly EAD, we set our dividend based on our assessment of long-term returns. EAD may fluctuate from quarter-to-quarter, but our goal is to give our shareholders a solid stream of cash flow while creating an attractive total return experience over the long-term. Please note on my favorite chart on Slide 15 that a substantial portion of our returns over the past 15 years have come in the form of cash dividends.
Furthermore, we are making meaningful changes in Dynex in multiple operational areas to better position us for this complex global environment that is evolving as we speak. We’re excited about the future because returns are attractive. We have a plan, and we have a solid base of core values to guide our decision-making. We, the management team and the Board continue to remain personally invested in Dynex as there is no better place to invest than with ourselves. Please join us on this journey as we look to the future.
With that, operator, we will open the call for questions.
Question-and-Answer Session
Operator
Thank you. [Operator Instructions] The first question is from Bose George of KBW. Please go ahead. Your line is open.
Bose George
Hi, everyone. Good morning. Actually, first, can you just discuss your thoughts on just the outlook for leverage? And just given some of the commentary that spreads could widen further in September, what does it suggest for the outlook for leverage?
Smriti Popenoe
Hi, Bose, so I think it’s really consistent with the comments made during the call, which is a disciplined stepping forward. We think that the real spreads are wide here, and they are going to move in a range not too much tighter from here and could get back to the wides or even wider. We think that sort of happens in sync with the further reduction in the Fed’s balance sheet in September, and we see that as a real window for where we would meaningfully take leverage up at that time. So in the second half of this year is where we expect to see more opportunities like that to happen. And once again, I think we – I’ve said many times on this call that every time we invest, it’s a function of the risk environment and if the risk environment warrants it, and we feel really good about the long-term return, putting that capital to work.
Bose George
Okay, great. Excellent, thanks. And then just switching to the earnings available for distribution. I know you guys don’t want to put out like multiple metrics. But I mean is there any way to sort of think about how the treasury futures gains kind of translates into a spread benefit? Just because the market obviously focuses on that number, and that number is going down and doesn’t reflect the returns you’re generating.
Smriti Popenoe
Right. I would say there is actually two ways to kind of think about that. One way is to simply mark the treasury future is using quarter end market yield or even an instantaneous market yield and see what that difference is quarter-to-quarter. An easier way might be simply to do what Steve mentioned during his comments, which is take a look at the market yield of our assets versus the market yield on the financing, and that should give you an idea of the economic return that’s just embedded in the portfolio. So that’s – there is two ways to do it. And the funny thing about EAD is that it has a non-mark-to-market yield on the assets compared to a mark-to-market yield on the financing. So you’ve just got to adjust one or the other.
Bose George
Yes. Yes. Okay, makes sense. Great, thanks.
Smriti Popenoe
Sure.
Operator
Your next question is from Trevor Cranston of JMP Securities. Please go ahead. Your line is open.
Trevor Cranston
Hi, thanks and congratulations, Steve, on the retirement.
Steve Benedetti
Thanks, Trevor.
Trevor Cranston
Couple of questions about your comments around MBS spreads and the technical backdrop I guess as you guys look at the market and what the Fed has communicated, how much risk do you see at this point of the Fed potentially deviating from what they have currently stated in the path of quantitative tightening? And do you see any possibility that they could potentially need to accelerate that at some point?
Byron Boston
Hey, Trevor, I am going to start this and then I’m going to turn it over to Smriti with some of her thoughts. But I think we are in a global macro environment where there is absolutely an enormous probability all the central banks could deviate at some point in time, we call it a fat tail environment here, there are so many global factors that could surprise the market, the world, every home on the planet, every asset manager. I absolutely believe that the Fed is vulnerable to shift their policy at some point in time. So that’s a bigger, higher level macro view. That is what we believe at Dynex. We’ve talked a gazillion times with you guys about being a big moment in history and surprises are highly probable. And that’s the way we think about the larger picture. At the end of the day, Central Bankers are human beings, and they will respond like human beings. And when large events in history have taken place, human beings have to respond. So that’s just a higher level view. I’ll let Smriti chime in with anything more specific.
Smriti Popenoe
Yes. I mean one thing that’s really interesting right now is that the Fed seems to be using interest rate hikes as the main tool with which to address inflation. I think it psychologically impacts the market in a way that they want it to. And they have really indicated that the balance sheet is a tool that’s going to sit in the background. And Janet Yellen used to say watching paint dry. And I believe that that’s what they are trying to achieve with that. At Dynex, our scenario planning, when we go through that, we basically feel like the way that the Fed accelerates any kind of sales from their balance sheet is going to be an environment when there is really out of control inflation, much more so than what we have today.
One of the most interesting things that the Fed focuses on, obviously, is inflation expectations. And those expectations of inflation have all come down over the past 6 weeks. So the likelihood that they are going to need to use that big stick of the balance sheet has actually declined. So no, could they deviate from that path? Yes. And I think the way that, that happens is an exogenous surprise where they are forced to either stop running off the balance sheet or the force to accelerate what’s already in place.
Trevor Cranston
Got it. Okay. That makes sense. And then the second question was when you guys were talking about spreads today in historical context versus where they have been over the last 20 or 30 years, do you guys look more at OAS or nominal spreads when you make historical comparisons? And I was curious what you guys think of a more meaningful metrics to look at given the volatility of the market today?
Smriti Popenoe
Right. Yes, it’s a very good question. And we have – we track probably all in, maybe 10 or 15 different things that help us go back in time and see – normalize for coupons and production and things. One of the neatest metrics that someone can use is to take the price of whatever the $102 price coupon was and impute OASs or nominal spreads based on that. And that’s actually, in my experience, been one of the best ways to do comparisons across time when the coupon stack is changing so much. So that’s really the metric that we are using to go back and say, look, if you just look at the par plus 2 points dollar price coupon over time, you can see that we are really sitting at the wide since the ‘90s. And that’s why we’re saying this is a historic opportunity and a great environment for us in which to raise capital and deploy that capital.
Trevor Cranston
Got it. Okay. And then the last question, I mean, again, given how high volatility is today, does that impact kind of how you guys are thinking about the use of options within the hedging strategy? And does it potentially make sense to use less options in there given the potential for volatility to maybe come down over the next few months?
Smriti Popenoe
Another great question, Trevor. I think one of the most interesting things about this market environment is the inability of – as an investor to go back in time and look at the period between 2008 and 2022 and believe that, that you can normalize for the impact of the Fed. So the Fed clearly has had a huge impact on market volatility, dampening that volatility as long as they have been doing QE. So we’re being challenged right now to look at the markets and say, look, in a historic context, going forward, right, your volatility environment is going to be very different than what it was with the actively involved in the market. So you have to take the pricing of options in that context. So having said that, options are expensive and we are actually finding that the cheaper place to buy optionality in the market right now is actually in the MBS market, relative to, say, just a straight up to – options or treasury options. So – but we’re looking at the triangulation between those three things all the time. And I would say to our investors is it’s the forward volatility that matters. And if you’re expecting forward volatility be high, you have to make your options purchases in the context of that mindset.
Trevor Cranston
Sure. Okay, that’s interesting. I appreciate the comments. Thank you, guys.
Smriti Popenoe
Thanks, Trevor.
Operator
Your next question is from Eric Hagen of BTIG. Please go ahead. Your line is open.
Eric Hagen
Hi, thanks. Good morning, Dynex team. And thank you to Steve for all the great work and leadership. Welcome back, Rob. Just one on the hedging, quickly, what would you say the range was by which you adjusted the hedge position in the quarter? Like it started around $4.5 billion, it ended a little closer to $5 billion. You guys raised capital in there, too. But intra quarter, what would you say the range was and the kinds of variables which drive you to maybe fine-tune that hedge piece a little bit more?
Smriti Popenoe
Right. I think – so we adjusted our 10-year futures position down over the quarter. We added to our 5-year futures position. But Eric, if you go to Page 11 on the deck, we show kind of our portfolio equity sensitivity to rates and spreads. And we actually decided to include the portfolio sensitivity as of July 20th, which is a post quarter-end update on that. So, really between the end of June and early July or even the third week of July, we have got longer duration. You can see that. Our sensitivity to down rates increased in a positive way, our sensitivity to upgrade increased in a negative way. So, we have gotten longer duration in the portfolio, more beneficial from a rate-flattening, rate-curve inverted, rates down type of situation. So, our hedges migrated from the back end of the yield curve to the front end of the yield curve and overall our duration position is a little bit longer than where we were. And we really kind of executed a lot of this as yields or have just gone through that most recent peak.
Eric Hagen
Right. Yes, that’s really helpful. Thanks for putting that out on Slide 11. I am also glad that you mentioned the difference between your cost basis and the market value of securities. I guess the question is, how do you think about managing that unrealized loss position if we stay in this elevated rate environment? And more specifically, how much of a driver a long-duration position is slow speeds and such, it is for the amount of leverage you are willing to tolerate more holistically, if you will?
Smriti Popenoe
Yes. The one thing about those positions you also want to remember is they are way out of the money with zero convexity. So, the hedging costs on those are really basically zero related to convexity, right. All of the risk in those positions is sitting on the prepayment side. Dynex’ portfolio, in particular, is over somewhere between 15 months and 20 months seasoned. Even in an elevated rate environment, you are going to see some level of turnover from just people moving houses and things like that. So, that’s going to be a key factor in our thought process with respect to the relative value on that position, Eric. And we are always – just someone asked the question earlier, about the price of options. And those coupons at this point are very cheap call options that we can own in the portfolio. So, there are uses of capital for investment purposes, there are uses of capital for risk management purposes, and we are always thinking through where and how best to allocate that. So, for now, from a risk-reward perspective, those coupons look like a great alternative to buying call options in the market. There is still positive yield relative to financing when we talk about market yields. And then the interesting thing is each month, we have seen these prepayments come in, and the book value is where you will see the pop from the prepayment. So, the market value of these securities is in the mid to high $80 price, you are getting prepayments back at par, that accretes directly to book value. And so that has actually been a tailwind as well for us.
Eric Hagen
Got it. That’s really helpful. Can you remind us if you have a loss carry-forward that you are still utilizing? And where you guys sit from a taxable earnings standpoint?
Steve Benedetti
Sure, Eric. And by the way, thank you for the very nice comments. We are – estimated tax characterization right now, about 80% ordinary income, 20% return on capital. We really do not have a meaningful operating loss carry-forward at this point. We do have and we will have disclosure in the Q on this. We do have capital loss carry-forwards, and we do have deferred hedging gains as well.
Eric Hagen
Got it. That’s very helpful. Thank you and thanks again Steve.
Smriti Popenoe
Thanks Eric.
Operator
Your next question is from Christopher Nolan of Ladenburg Bauman. Please go ahead.
Christopher Nolan
Hey everyone. Congratulations to both Steve and Rob. Could you give us a little guidance in terms of where your average repo funding costs are quarter-to-date?
Smriti Popenoe
Yes. So, right now, I would say we are seeing levels in the 220s for the one-month and three-month period, and that’s going to reflect the 75 basis point hike that people expect the Fed to make this month – actually, a couple of days from now.
Christopher Nolan
And then given the changes to the longer-duration investments, do you expect your investment spreads to widen a little bit in the third quarter, or is it too early to say?
Smriti Popenoe
I think it’s too early to say, Chris. What they do this month plus the composition of the book and any rebalancing that we continue to do. We feel really good, as I mentioned, about this quarter’s EAD. And then it’s really the fourth quarter and how – it depends on exactly what the Fed does this quarter and next quarter our portfolio composition. And then as I was also saying on the call, if you look at forward rates, which is out into 2022, you are actually seeing lending cost decline over time. So, we think of it as a temporary hike up in rates. And then if the forward curve realizes, obviously, stuff coming back down next year.
Christopher Nolan
And did I hear correctly, Byron mentioned where book value per share was 3% higher quarter-to-date?
Smriti Popenoe
Yes. I said that, but we will give Byron the credit as we always do.
Christopher Nolan
Final question. Are you guys continuing to raise equity in July?
Byron Boston
Look, we have got a long-term view in terms of growing our company, and I am pretty – we have been very strong about this opinion about how we look to the future over the long-term. We are building our company. We are growing our company. We have no desire to be the largest company in this industry by any stretch of the imagination. But we are in a phenomenal time to deploy capital with returns this attractive. We fully intend to be very strategic about continuing to try to grow our company in this type of environment. We didn’t grow it as much when spreads were really, really tight. Now our spreads are really, really wide and returns are high, so the right time to try to grow our company. But we want to do it in a manner that really favors our shareholders. And as again, we have a long-term – we are going to create a solid long-term shareholder experience. So, we are very thoughtful in the process. But this is a great return environment to grow our company. We don’t grow for just growth’s sake.
Christopher Nolan
Great. Thanks guys.
Smriti Popenoe
Thanks Chris.
Byron Boston
Thanks Chris.
Operator
Your next question is from Jason Stewart of Jones Trading. Please go ahead. Your line is open.
Jason Stewart
Thank you. Steve, congrats on a great career at Dynex.
Steve Benedetti
Thanks.
Jason Stewart
I wanted to ask – and welcome, Ben, I mean Rob. I wanted to ask where you guys think terminal Fed funds get to and the duration of the inversion of the yield curve?
Smriti Popenoe
Well, it’s like, are you making me predict, Jason?
Jason Stewart
Well, I just want – like a base case.
Smriti Popenoe
Okay. So, we – look, the Fed said to us that they think neutral is 2.5%. But they also said that they think that they need to hike beyond neutral in order to control the inflation that they see. And so if you hold them to their word, you would say peak Fed funds is 3.5% to 3.75%, which is another 100 basis points to 125 basis points higher, assuming they go 75 this time around, right. But you can see that – you asked about the inversion in the yield curve. Once again, I think this is one of these things where the beatings will continue until morale improves, and that’s literally what’s happening at this point in the yield curve is the Fed is being challenged to go ahead and raise rates at 3.75% because the market believes that those rates will have to come right back down because they are going to push the U.S. into a recession. So, how long that lasts and how long the curve remains inverted, I think it’s directly related to this idea that we could already be in a recession, that the recession – the slowdown will be not insubstantial, obviously, because they are killing off demand. And that the Fed will be easing here in the first or second quarter of 2023. So, the inversion can lap, and we saw this in 2018 where the Fed was very stubborn about continuing to raise. And look, don’t forget, not only are they raising as much as they are raising. They also are doing QT at the same time. And they have done more QT this time around or the amount of QT they are doing is much, much higher than last timeline. So, there is a significant tightening of financial conditions already underway. And for that reason we are respecting that inverted yield curve scenario, we have to think about that very seriously when we look at our risk positions.
Steve Benedetti
And let me take – one second, Jason. I just want to take a thing just on here about this because I laugh, I chuckle every time I look at Bloomberg, and they say, what’s your prediction, what do you think, you what, this is an unbelievable moment in history. No one can predict, to be frank with you. And what I am proud of at Dynex is preparation. The greatest athletes are prepared. They prepare, they prepare and prepare over and over again. And this team is preparing for multiple scenarios, and we are preparing to respond to multiple scenarios. And as great as we all talk about what’s going to happen in the U.S. and what the Fed is going to do. Europe has enormous amounts of problems, from a war, to energy, self-sufficiency to a union that may not hold with this type of situation. So, we are preparing for multiple scenarios as opposed to trying to rely on our ability to predict the future in this unbelievable moment in history. And if I want to say anything to our shareholders, understand that we are preparing. And preparation is extremely important in our daily workouts.
Jason Stewart
Yes. And you guys have done a great job with that. I guess what I am trying to get to is in the environment where we have an inverted yield curve, where does the base stand and why not go down a coupon?
Smriti Popenoe
Well, we are done in coupon. I am joking a little bit, but we have had that down in coupon position already. So, we have actually felt like getting longer duration has been a move to make, which we have done. And as I pointed out in our risk stats, you will actually see that. As yields peaked in June and then beyond that, we have been actually taking some of our long-term hedges off. But yes, I mean those are all strategies under consideration. We have hung on to our low coupons because we felt like they were – again, they were good call options for us to have in the book. We are adjusting our hedge ratios. And yes, I mean I think we have looked at the inversion. And again, we don’t – we are not saying this is the only way that the curve could be shaped, because it could go back to being steeper in a moment. But we believe for now, right, like this is what the market is pricing. And we are planning around that scenario at this point with the positioning in the portfolio.
Jason Stewart
Okay. Thanks for taking the questions and congrats again, Steve.
Steve Benedetti
Thanks Jason.
Operator
Your next question is from Doug Harter of Credit Suisse. Please go ahead. Your line is open.
Doug Harter
Thanks. Hoping you could walk me through your thought process as you look to grow assets between increasing leverage and reducing capital that, at least in the short-term, is dilutive?
Smriti Popenoe
Sure. So, one thing we look at, first off, I did say in my comments that our net cost of capital after issuance costs is 9.7%. That’s kind of what it was for our last block here. And when we look at that and we lay that up against the investment environment where we are really – we are seeing returns in the low to mid to high-teens depending on the coupon. Those are massively accretive returns relative to a 9.7% cost of capital. So, in terms of when should management raise capital, when you have accretive investments to make, and we feel like this is a great time to do that. So – but it’s not costless as you point out, right. So – but what we think about there is just there is an earn-back period that you have for spending that dilution. And that earn-back period right now is as short as we have seen it in decades. Going back to the first QE period, I think you would have to go back that far to find returns like this. And we are not by any stretch of the imagination, back at those levels. But still, these are really good levels at which we feel that, that earn-back period is very, very low. So, the main decision though is, what’s my cost of capital versus where I can put the money to work, and we think that this is a very accretive environment for that.
Doug Harter
Okay. And then just thinking about the construct of what’s kind of economic return and the potential of the portfolio, I guess how would you compare the in-place return of the portfolio through mark-to-market basis versus that low to high or low to mid to high-teens that you just talked about for new investments you see today?
Smriti Popenoe
Right. So, yes, the entire book is marked to that return environment, if you will, each time, obviously, we mark the book. As our coupon profile changes, you will also see more of a reset to what our current market yields. So, if you look at the sheet where we are talking about what our coupon distribution is, we have gone up in coupon a fair amount. And I would say, in general, right, over the very, very long-term, we have said generating an 8% to 10% total economic return is a good total return. There are times in which we are going to exceed that on a weighted average basis, right, where those returns look more like 12%, and there is going to be times when we don’t even make the 8%. We are in an environment where going forward, we believe with the mix of existing and new capital that we are raising that we are going to be on the upper end of that range. I mean that’s why we are saying it’s a historic opportunity. And we have the ability to put this capital to work. And so right now, we are sitting with 6.8x leverage to total capital as of July 20th. We have said we can take that leverage up another two to four turns, which would be, again, a two-third size larger than where we are today on the balance sheet. And those are the types of returns that we are getting on that incremental deployment of capital.
Doug Harter
And I guess, can you just remind me, when you talk about the mid-teens returns on incremental capital, what leverage are you assuming on that? Is that kind of consistent with the current succeed or are you assuming kind of the normalized leverage?
Smriti Popenoe
We think about it always in normalized leverage terms, Doug, because our leverage is always a function of our risk posture. And so in order to compare apples-to-apples, we look at it in terms of normalized leverage. So, for agencies, it’s 9x to 10x to common, is kind of how we think about it.
Doug Harter
Great. Appreciate the answers.
Smriti Popenoe
Thanks Doug.
Operator
There are no further questions at this time. I will turn the call over to Byron Boston for closing remarks.
Byron Boston
Thank you very much for joining us today and we look forward to you joining us for our third quarter conference call sometime in late October.
Operator
This concludes today’s conference call. Thank you for your participation. You may now disconnect.
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