A few days ago, CYS Investments (CYS) announced a major $250 million stock repurchase program. This was a major announcement, since the amount will buy around 21 million shares, or well over 10% of shares outstanding. The market reacted favorably and drove up the share price by almost 5% the next day. Other REITs have already announced share repurchases. On October 16th, 2012 Annaly Capital Management (NLY) announced a $1.5 billion share repurchase program. This was followed on October 29th, 2012 by the announcement from American Capital Agency (AGNC) of a $500 million share program. Below, I will show that CYS is undervalued along with several of its peers, trading at a 15% discount to net asset value. This compares with a 6% discount for American Capital Agency and an 11% discount for Annaly Capital Management. I will also discuss Two Harbors Financial (TWO), PennyMac Mortgage (PMT), Apollo Residential Mortgage (AMTG), Chimera Investment (CIM) and NorthStar Realty Finance (NRF).
CYS Investments reported net income of $241.9 million during the third quarter of 2012 ($1.46 per diluted share) compared to net income of $101.7 million ($0.87 per diluted share) in the second quarter of 2012. During the third quarter of 2012, the company had core earnings of $41.2 million ($0.25 per diluted share) compared to $44.8 million, ($0.38 per diluted share) in the second quarter of 2012. Core earnings is a non-GAAP financial measure and is defined as net income (loss) available to common shares excluding net realized gain (loss) on investments and termination of swap contracts and net unrealized appreciation (depreciation) on investments and swap and cap contracts.
Drop income is an item of net income accounted for as net gain from investments in the statement of operations and therefore excluded from Core Earnings. During the third quarter of 2012, the company generated drop income of approximately $36.9 million ($0.23 per diluted share) compared to approximately $15.0 million ($0.13 per diluted share) during the second quarter of 2012. Core earnings plus drop income was $0.48 per diluted share during the third quarter of 2012 compared to $0.51 during the second quarter of 2012. The drop of $0.03 quarter on quarter was primarily the result of a lower adjusted interest rate spread net of hedge, which decreased to 1.41% during the third quarter of 2012, compared to 1.82% during the second quarter of 2012.
CYS Investments sold approximately $5.5 billion of Agency RMBS during the third quarter of 2012, generating $27.3 million in net realized gain. It was able to use the proceeds of these sales to reinvest in the forward market and derive the benefit of favorable pricing of Agency RMBS. As a result, drop income increased during third quarter of 2012. The company made $10.9 billion of forward purchases during the third quarter of 2012, with weighted average drop of approximately $0.19 per $100.00 par value per month, compared to $5.1 billion of Agency RMBS forward purchases in the second quarter of 2012 with weighted average drop of approximately $0.18 per $100.00 par value per month.
The interest rate spread net of hedge decreased to 1.24% for the third quarter of 2012 from 1.71% in the second quarter of 2012. The third quarter of 2012 interest rate spread is low because of the hedging of forward settling purchases in advance of their earning interest income During the third quarter of 2012, the average cost basis of the company's settled Agency RMBS was $13.4 billion, average unsettled Agency RMBS was $5.3 billion, and average total Agency RMBS was $18.7 billion. The adjusted interest rate spread net of hedge for settled Agency RMBS positions was approximately 1.41%, compared to 1.82% in the second quarter of 2012. The net asset value per common share on September 30th, 2012 was $14.46, after declaring a $0.45 dividend per common share on September 11, 2012, compared with $13.52 at June 30th, 2012.
The portfolio recorded $745.3 million in scheduled and unscheduled principal repayments and prepayments, which works out to a constant prepayment rate ("CPR") of approximately 17.3% and net amortization of premium of $29.5 million for the third quarter of 2012. This compares to $651.7 million in scheduled and unscheduled principal repayments and prepayments, which equated to a CPR of approximately 18.1% and net amortization of premium of $22.7 million for the second quarter of 2012. The decrease in CPR during the third quarter of 2012 is a seasonal trend, but the company expects that CPR in the fourth quarter of 2012 will increase because of plans by the Fed to buy $40 billion worth of Agency RMBS per month until the unemployment rate and other economic indicators show signs of improvement. The CPR of the Agency RMBS portfolio was approximately 15.4% for the month of October 2012.
As these figures suggest, there is definitely downward pressure on dividend yields from mortgage REITs and a number of them have progressively reduced their dividend. Many of them, apart from CYS, have seen its share values drop recently and this has been true for both Two Harbors Financial and PennyMac Mortgage. Annaly, the largest of them all has seen an even bigger drop. While mortgage REITs were never ideal income investments, the current low interest rate scenario should protect their interest spreads at least through 2014. There is thus no immediate interest rate risk but the Fed purchases of mortgage backed securities definitely increase prepayment risk. For companies like CYS, prepayment is a double whammy because it takes a loss on the prepayment and is simultaneously forced to reinvest the proceeds in lower yielding securities.
In looking at the peers and competitors of CYS, you should take a good look at Apollo Residential Mortgage because it is trading at a discount of over 11% to the present book value. In addition to this discount, the dividend yield is mouthwatering at over 17%. One REIT that has benefited from the monetary policy of the Fed, even though it has been forced to cut its dividend is Chimera Investment. With continued low interest rates, Chimera has received the benefit of higher interest rate spreads and the dividend yield is still in excess of 14%. Turning away from the mortgage REIT companies, another interesting investment prospect is the commercial loan company NorthStar Realty Finance. It trades at a 29% discount to its book value pays a dividend yield of just under 12 %. You could also try and pick up the preferred shares which yield over 9% and trade at a discount to par.
Having said all this, there is no denying that mortgage REITs are some of the most attractive income investments in the market currently, and cannot be matched by other kinds of more traditional income investments. CYS itself is available at a substantial discount, and the dividend yield of more than 15% is extremely attractive. I recommend investing in CYS Investments now, especially if you are an income investor. Investors should also consider buying the other mortgage REITs mentioned above. At the same time, investors should watch prepayment rates closely as well as other economic factors such as interest rate movements.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.