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 an REIT. The dividend for the most recent quarter was $0.34/share (or about 15.37% annually at the October 22, 2013 closing stock price). This is excellent, and it appears to have stabilized. The book value appears to have stabilized too. As of September 30, 2013, the book value was $10.10 per common share. This was only -$0.10 below the book value on June 30, 2013; and the current economic outlook suggests that the book value may rise in Q4 2013. With a current stock price of $8.85 as of the close on October 22, 2013, the great annual dividend (+15%) and the possible $1.15+ (+13%) appreciation of the stock price to the book value make CYS look like a very attractive investment.
CYS' results for Q3 look good. It had Core Earnings of $61.2 million, or $0.36 per diluted common share ($0.23 Core Earnings and $0.13 Drop Income). Operating Expenses were reasonable at 1.13% of average net assets. It lowered its leverage ratio to 6.5x as of September 30, 2013 from 7.5x as of June 30, 2013. This should immunize it a bit from dramatic changes in interest rates and mortgage rates. Its net interest rate spread (net of hedges and including drop income) was 1.66% versus 1.36% as of June 30, 2013 and 1.16% as of March 31, 2013. This is clear progress. Further, CYS repurchased 5.9 million shares during the quarter for an average price of $7.77 per share (for approximately $46.1 million). Given the October 22, 2013 closing stock price of $8.85 and the book value of $10.10 per share as of September 30, 2013, the repurchase actions were highly beneficial to shareholders. In sum, CYS executed well in Q3 2013.
The main issue after all of this is how the company will cope with longer term rising interest rates? The chart of the 10-year US Treasury Note yield shows that spiking interest rates have settled down quite a bit recently. In fact, they seem to have been falling backward since Larry Summers withdrew himself as a candidate for the Fed Chair (see chart below).
The yield has fallen even further after the recent government shutdown was resolved. Due to the economic damage from that and the default scare, many are expecting the Fed taper to be delayed until March 2013. That expectation has helped the yield fall even more. It stands at 2.49% as of this writing on October 24, 2013. This is down considerably from the recent closing high in September 2013 of 2.99%. It is down 12 bps from the close of 2.61% on September 30, 2013. This should translate into slightly increased book value for CYS' Agency RMBS.
The one year chart of the 30-year 3.5% FNMA MBS confirms this (see chart below).
As you can see the MBS is now 1%-2% higher than it was at the end of Q2 2013. This will probably cut into the net interest spread. However, it will also add to book value. Therefore, the current book value is likely higher than that reported for September 30, 2013. The book values of the Agency RMBS have been a bit choppy, but the near term direction seems clear. CYS should be able to continue to do well under the current circumstances; and those circumstances seem likely to continue through March 2014 at least. Investors can always re-evaluate their investment as time goes on. For now, CYS provides a great dividend with a good likelihood of share price appreciation on top of that.
The table below shows the portfolio (and the changes from the end of Q2 2013).
As you can see, CYS has decreased its percentage of 30 year and 20 year fixed rate Agency RMBS; and it has increased its percentage of 15 year fixed rate Agency RMBS holdings. CYS management's explanation for this is that the hedges for the 30 year fixed rate RMBS are getting more expensive.
The table below shows the investment scenario yields as of October 6, 2013.
As you can see the hedging costs are about 50% higher for the 30 year fixed rate Agency RMBS than for the 15 year fixed rate Agency RMBS. The company expects this difference to increase as interest rates rise. Therefore it believes it is better positioning itself for that environment. The problem with this strategy is that the net interest margin is 1.92% for the 30 year fixed rate Agency RMBS and 1.20% for the 15 year fixed rate Agency RMBS. This will likely translate into lower Core Earnings. It may mean a lowered dividend, especially with the lower leverage ratio of 6.5x. The company has made no such announcement. However, a small cut to the dividend may be in the cards. To me this is not a bad thing. The added stability of the company (book value) as an investment compensates for this to a large degree. I still expect to see the dividend well over 10%, which is still great. All told CYS is a buy, although I would be sure to re-evaluate it as an investment each quarter (or if mortgage rates begin to spike again).
The two year chart of CYS provides some technical direction for this trade.
The slow stochastic sub-chart shows that CYS is near overbought levels. The main chart shows that CYS has bottomed recently. It now appears to be establishing a new uptrend. Given the fundamentals mentioned above, it seems likely that the stock price will appreciate to a value much closer to the book value of $10.10 per share as of September 30, 2013 (roughly 13%). When you get a great dividend on top of this, it is an easy decision to buy the stock. The average analysts' recommendation of 2.3 (a buy) seems to agree with my assessment. CYS also has a four star CAPS rating (a buy). In an overbought and troubled market, stocks in this downtrodden sector (mortgage REITs) may be among the best buys in the market.
CYS is one of the first primarily Agency RMBS mortgage REITs to report in Q3 2013. Investors should be able to extrapolate CYS' good performance to other primarily Agency RMBS mortgage REITs with little trouble. The CYS results may be an all clear sign for investors to buy other popular, primarily Agency RMBS mortgage REITs such as American Capital Agency Corp. (NASDAQ:AGNC), Western Asset Mortgage Capital (NYSE:WMC), and ARMOUR Residential REIT (NYSE:ARR).
NOTE: Some of the above fundamental financial data is from Yahoo Finance.
Good Luck Trading.