Seeking Alpha
Profile| Send Message|
( followers)  

Mortgage Agency REITs are celebrating in the wake of news that the Fed did not begin its QE taper on Sept. 18, 2013, as earlier feared. CYS Investments, Inc. (CYS) led the mortgage agency party shooting up an industry-leading 3.7%; American Capital Agency, Inc. (AGNC) gained 3.5%; Annaly Capital Management, Inc. (NLY) rose 3.2%; Armour Residential REIT, Inc. (ARR) gained 3.4%, while American Capital Mortgage, Inc. (MTG) gained 2.4%. The mREIT industry as a whole gained 2.8%.

CYS Investments favors a more aggressive play

CYS Investments is trading at a deep discount of 15% relative to book value. The stock is regarded as being particularly rate-sensitive due to its relatively higher leverage and duration gap. This is the main reason why CYS gained the most after the taperless news. The recent withdrawal of Larry Summers as one of the candidates to replace retiring Fed chairman Ben Bernanke has also reduced the chances of a sharp move into higher interest rates. These new developments favor CYS Investments and other mREITs, at least in the short-term. CYS is, however, likely to respond more vigorously to stable interest rates, making the stock ideal for an aggressive play.

American Capital Agency and American Capital Mortgage are, however, better hedged against CYS Investments against higher rates. Both stocks are trading at a lower 9% discount relative to book value and offer a lower-risk investment vehicle suited for more conservative mREIT investors with less risk-tolerance.

CYS Investments' book value falls off the deep-end in Q2

CYS Investments has underperformed this year compared to leading mREITs such as American Capital Agency, American Capital Mortgage and Annaly. CYS stock has tended to trade at a steep discount relative to book compared to other mREITs. One of the biggest reasons for this unfortunate trend is because CYS typically pays out a lower dividend compared to leading mREITs as a result of its business strategy that favors holding less volatile but lower-yielding 15-year MBS. CYS' lower-yielding MBS portfolio is the reason that the company recorded horrendous second-quarter results. Book value for the company tumbled a jaw-dropping 21% compared to the first-quarter. YTD, CYS has fallen an incredible 35%. But at last, there is some light at the end of the tunnel for CYS, given that the effects of the Fed taper are now known.

The sharp fall in book value for CYS is attributed to the company fateful decision in April 2013 to issue $200 million preferred equity. It's quite likely that CYS used these funds to invest in Agency RMBS. MBS prices have been ravaged this year with yields rising at pre-1994 levels.

The ill-fated capital raise coupled with insufficient hedging lead to CYS' net asset value (also known as book value) declining sharply.

CYS' book value decline has been sharper compared to its peers such as Annaly and American Capital Agency. The whole sector, however, has massively underperformed the S&P which has returned 16% YTD.

Drop income more significant for CYS now

CYS has not been the only underperforming mREIT this year. American Capital Mortgage has also disappointed. The biggest reason why both have fared badly is due to their use of drop-income to boost their results. Drop income can be defined as ''the price difference between an MBS' back month and front month dollar roll trade.'' The price drop can be equated to the net interest carry on the MBS earned during the roll period (interest income less the implied financing cost). Drop income is associated with the purchase of agency MBS on a forward-settlement basis using the TBA (To-Be-Announced) dollar roll market. The price differentials between MBS purchased on a forward-settlement basis and the price of MBS in the current month is what is referred to as the ''price drop.''

Drop income raises a mortgage agency's leverage. CYS' overall profit has become increasingly attributable to drop income as opposed to the traditional net interest rate spread (core income). CYS' core income has collapsed 53% this year from $0.38 per share in second-quarter 2012 to $0.18 per share in second quarter 2013.

Higher net spread and bigger dividends great news

But it's not all doom and gloom at CYS Investments. The company reported a $0.34 dividend yield in the second quarter, which is equivalent to a 17.8% annualized dividend yield, which is a considerable improvement over the firm's first-quarter's 10.9% annualized dividend yield. The yield was a remarkable feat for the firm, given that it is quite common for its dividend yield to be in the low single-digits.

CYS' net interest rate spread has been on an upward trajectory in recent quarters. It rose a considerable 17% to 1.36% from first-quarter's historic low of 1.16%. CYS' net interest spread combines both ''drop'' and core ''income.''

The increased profitability enabled CYS to increase its dividend by 6% in the second quarter of 2013 to $0.34 per share from $0.32 in the first quarter.

The increase in dividends came against a backdrop of mREIT dividend cuts that was clearly evident in the second quarter (American Capital Agency's dividend yield plummeted 16% while Annaly's fell 11%).

Conclusion

CYS Investments currently trades at a 15% discount to book value. Its net interest spread is on an uptrend which is great for capital appreciation. Its dividend yield is also increasing at a time when it is falling among major competitors. The Fed cuts are expected to be modest and this means that interest rates are likely to rise only moderately.

The better predictability of future interest rates is likely to lead to the firm's more rate-sensitive stock to continue on its recent uptrend.

Source: Mortgage Agency REITs Rally On No-Taper News, CYS Investments Leads The Party