CYS Investments Took Its Lumps In Q2 2013, But Expectations For Q3 Are Looking Up

| About: CYS Investments, (CYS)

CYS Investments (NYSE:CYS) is a specialty finance company. It operates with the objective of achieving consistent, risk-adjusted investment income. It does this primarily through investment in Agency RMBS; and it has elected to be taxed as a REIT. The dividend for the most recent quarter was $0.34/share (or about 17.1% annually at the September 20, 2013 closing stock price).

The problem that most mortgage REITs have been having in recent quarters is a loss of book value as interest rates and mortgage rates have risen dramatically in Q2 2013. CYS has suffered losses similar to those of its peers. Its net asset value per common share was $13.31 on December 31, 2012. It was $12.87/share on March 31, 2013 (-3.3%). Then it dropped precipitously to $10.20 per share by June 30, 2013 (-20.75%). Much of the large Q2 2013 loss occurred due to the roughly 1% rise in mortgage rates and long-term US Treasury yields. Low rate Agency RMBS' book values fell as a result. Some of CYS's peers' losses are in the table below.


Stock Price at the Close September 20, 2013

Book Value Loss in Q2 2013

Book Value % Loss in Q2 2013

Book Value as of Q2E 2013






American Capital Agency Corp. (NASDAQ:AGNC)





Armour Residential REIT (NYSE:ARR)





Hatteras Financial Corp. (NYSE:HTS)





CYS had among the worst losses in the industry in Q2 2013 with a GAAP net loss of $402.3 million. This was comprised of: (1) a net realized loss from investments of -$211.4 million, (2) a net unrealized depreciation of investments of -$444.9 million, and (3) a net unrealized appreciation on swap and cap contracts of +$215.5 million. Still CYS managed Core Earnings (plus Drop Income) of $63.4 million (or +$0.37 per diluted common share). Operating Expenses were 0.98% of average net assets. The interest rate spread net of hedges (including drop income) was 1.36%. CYS ended Q2 2013 with leverage of 7.5x to 1, which was slightly lower than the 7.8x to 1 at the end of Q1 2013.

The good news is that the company says that it expects the net interest spread to be higher in Q3 2013. It sees its 30 year Agency mortgages with a spread of 200+ bps. It sees its 15 year Agency market at 150+ bps. It sees its Agency Hybrid ARM market at about 150 bps. The rising interest rates and mortgages rates would tend to confirm this. One might posit an average portfolio net interest margin of 1.60%-1.75%. This is substantially higher than the 1.36% of Q2 2013. The chart below shows CYS's approximate portfolio allocation as of June 30, 2013. The dividend chart next to it gives an indication that the dividend may have bottomed for the near term.

The Q3 dividend has already been announced as $0.34, so you can tack that on to the end of the dividend chart. In fact CYS went ex-dividend on September 20, 2013. The portfolio breakout and the increased interest rate spreads for its components would suggest that the dividend may have near term upside.

The table below of CYS's portfolio characteristics gives a more in depth idea of CYS's portfolio.

Investors should particularly note that the average coupon rate of the portfolio is 3.27%. This is low in a rising mortgage rate environment. National Average Mortgage Rates for a 30 year Freddie Mac backed mortgage were 4.62% with 0.3 points as of September 20, 2013. This is significantly above CYS's average 30 year Agency fixed rate coupon rate of 3.59%. It means CYS will probably have to sell many of these in the near future to safeguard its portfolio for the longer term. Eventually the cost of financing (repos and hedges) used to buy these with leverage will go up, especially in a rising interest rate environment. When this happens, the bottom will likely fall out of low coupon rate Agency RMBS. Mortgage REIT companies will not want to be holding the lower coupon Agency RMBS then. Hence I believe CYS will have to roll its portfolio to higher coupon rates over time. This will probably involve some book value losses.

The good news for Agency mortgage REITs for now is that the Fed delayed its tapering due to a slowing US economy. The yields on the US long bonds were already easing a bit before this. With this announcement, they fell further. The 30 year US Treasury bond yield, which had closed as high as 3.92% in Q3 so far, has fallen as of the close on September 20, 2013 to 3.76%. This is still a rise over the 3.50% on June 28, 2013; but it is a much smaller rise (26 bps). Plus the yield could keep falling in the coming week with no tapering. The chart below of the 30 year FNMA 3.5% rate RMBS shows how much of its recent losses this example RMBS has recouped in the last month.

Its price is virtually up to its Q2 end 2013 value. Some might consider this strange with the still significant rise in the 30 year US Treasury bond yield since then (26 bps), but volatility has gone down significantly. This is probably leading to increased prices for the RMBS. In other words, Q3 prices are benefiting to a degree from the settling of the disorderly market that existed at the end of Q2 2013. This bodes well for CYS's Q3 earnings report.

The chart below of CYS's net interest margin for 30 year and 15 year MBS also shows a clear trend upward in Q2 2013. This trend has assuredly continued in Q3 2013. Mortgage rates have risen. Plus the settling in volatility and the likely lower CPRs (constant prepayment rates) in Q3 2013 should have pushed up the net interest margins too. This bodes well for CYS's dividends and profitability in Q3 2013.

In sum, CYS looks like it should perform decently in regard to book value (perhaps flat) in Q3 2013. It seems likely to exceed its Core Earnings of Q2 2013, which are used for dividends. This should be a plus for the company going forward. I am not enthralled with CYS's hedging; but it will do better than some others if rates continue to fall in the near term. Overall it is a hold at this time. However, I think other mortgage REITs will likely outperform it in both the near and longer term. Still it is a solid stock; and it does currently pay a 17%+ dividend.

The two year chart of CYS provides some technical direction for this trade.

The slow stochastic sub chart shows that CYS is neither overbought nor oversold. It took a little dip as it went ex-dividend on September 20, 2013; but that is nothing to worry about longer term. It may also be suffering a bit from Annaly Capital's (NYSE:NLY) recent dividend cut. However, CYS did not cut its dividend; and there does not seem to be a big impetus for it to do so at this time. Overall CYS seems likely to rebound from its recent sell off. A likely net interest income increase in Q3 2013 should help this.

I think if you own CYS, you can continue to hold it for the near term. If rates start rising again, you might consider exchanging it for another mortgage REIT that is more diversified; but for now the dividend is great. The book value seems relatively safe given the above charts. Plus KBW came out with a positive note on CYS after Larry Summers (more hawkish) withdrew his name from consideration for the Fed Chairmanship. If CYS is not going to lose much book value in Q3 2013 (if any), it is trading at ($7.95) a 28% discount to its June 30, 2013 book value ($10.20). This may be a good value; and some traders may wish to try to trade this discrepancy. Current owners probably want to continue to own it.

NOTE: Some of the fundamental fiscal data above is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CYS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.