Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

CYS Investments Inc (NYSE:CYS)

Q4 2013 CYS Investments, Inc. Earnings Conference Call.

February 11, 2014 / 9:00 A.M. E.T.

Executives

Rick Cleary – COO

Kevin Grant – CEO, President and Chairman

Frances Spark – CFO

Bill Shean – Managing Director

Analysts

Steve DeLaney – JMP Securities

Dan Altscher – FBR

Joel Houck – Wells Fargo Securities, LLC

Douglas Harter – Credit Suisse

Mike Widner – Keefe, Bruyette & Woods

Jim Young – West Family Investments

Operator

Good morning and welcome to the CYS Investments, Inc. 2013 fourth-quarter earnings conference call. During management's presentation, your line will be in a listen-only mode. At the conclusion of management's remarks, there will be a question-and-answer session. I will provide you with instructions to enter the Q&A queue after management's comments.

For opening remarks and introductions, I will now turn the call over to Rick Cleary, CYS Chief Operating Officer. Please go ahead, Mr. Cleary.

Rick Cleary

Thank you. Good morning and welcome to CYS 2013 fourth-quarter earnings conference call. Today's call is being recorded and access to the recording of the call will be available on our website at www.cysinv.com beginning at 12 PM Eastern Time this afternoon.

Please be reminded that certain information presented and certain statements made during this morning's presentation with respect to future financial or business performance, strategies or expectations may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements indicate or are based on management's beliefs, assumptions, and expectations of CYS's future performance, taking into account information currently in the Company's possession. Beliefs, assumptions, and expectations are subject to change, risk, and uncertainty as a result of possible events or factors, not all of which are known to management or within management's control. If management's underlying beliefs, assumptions, and expectations prove incorrect or change, then the Company's performance and its business, financial condition, liquidity, and results of operation may vary materially from those expressed, anticipated, or contemplated in any of their forward-looking statements. In any event, actual results may differ.

You are invited to refer to the forward-looking statement disclaimer contained in the Company's Annual Report on Form 10-K and Quarterly Reports on Form 10-Q filed with the SEC, which provide a description of some of the factors that could have a material impact on the Company's performance and could cause actual results to differ from those that may be expressed in forward-looking statements.

Also, please note that the content of this conference call contains time-sensitive information that is accurate only as of today, Tuesday, February 11, 2014. The Company does not intend to and undertakes no duty to update the information to reflect future events or circumstances. To better understand our results, it would be helpful to have available the press release that we issued last night. As in past releases, the earnings release includes information regarding non-GAAP financial measures including reconciliation of those measures to GAAP measures, which may be discussed on the call.

I would now like to turn the call over to our CEO, Kevin Grant.

Kevin Grant

Thank you, Rick. Good morning and welcome to our fourth-quarter 2013 earnings conference call. As usual, joining Rick and myself this morning is our CFO, Frances Spark, and Bill Shean from our investment team. We look forward to your questions.

I’d like to divide my comments into three pieces. First, some thoughts on Q4; second, the bond market so far in 2014 and the almost complete reversal of Q4; and three, hedging, what it can do for us and what it cannot do for us. During the quarter, we continued to reduce our gross portfolio size in a disciplined fashion by about $500 million in the quarter. We continued to reduce our exposure to the more volatile 30-year sector while maintaining the earnings power of the business. The goal here is to reduce the NAV volatility, but to do so opportunistically and in a paced and very careful way.

The spread environment continues to be very good so the cash flows should continue to generate attractive dividends. However, the Agency at mortgage securities market continues to be quite volatile.

Q4 was a good example. Interest rates backed up by nearly 50 basis points through the quarter. This pushed down the price of our assets. Interestingly, prices have almost completely reversed that past year in 2014. Our net interest spread continued to climb during the quarter and our core plus drop income was very strong.

Prepayments continued to drop to extremely low levels and this is largely driven by the very narrow credit box that the regulators have defined for mortgage originators coupled with last year's backup in rates and, of course, the usual winter slowdown in refinancing activity and home purchases. Of course, the seasonals will begin to trend upwards, but the regulators show no signs that the very narrow credit box will broaden to help more homebuyers and re-financers.

The NAV was down in Q4, but we have so much liquidity that that does not create any issues for us. And mortgage securities prices nearly completely reversed in January anyway.

Turning to 2014, I think it is now clear to everyone and somewhat priced into the Treasury bond market, at least, that the Fed is on a path to eliminate asset purchases, almost regardless of the short-term noise in GDP and employment numbers. The Fed seems to recognize that there really is no amount of monetary accommodations that can reverse the contractionary effects of technology on labor markets and wages, shifting demographics, and the drags that the tax and regulatory environment impose on business investment, and actually homeowner investment as well.

If their current pace of tapering continues, by fall, for the first time in 30 years, there will no longer be a trillion dollar buyer in the mortgage securities market. Prior to the Fed's multiple asset purchase programs over the past several years, Fannie Mae and Freddie Mac were the trillion-dollar bid. At their peak, their portfolios totaled well over $3 trillion. Prior to the GSEs, it was the SNLs. Today the Fed is well above that $3 trillion number, close to $4 trillion. It has been well over 30 years in the mortgage market when we had no trillion-dollar buyer.

Prior to Fannie Mae, Fannie and Freddie's massive portfolio bulk up in the 1990s and early 2000s, Oregon spreads word notably wider and we think that an opportunity is coming and we want to be ready for it.

Having said this, on a cash flow basis, it is a very good spread environment. The yield curve is steep, financing has gotten a little cheaper and more abundant since year-end, but hedging costs continue to be quite high. The net of all this is that the spread environment, even with the hedge, is still very attractive even at more conservative leverage levels.

So let's talk about hedging for a minute. We use interest rate swaps to hedge the cost of our borrowings. Under the REIT rules, we can only hedge our borrowings. Anything else creates bad REIT income and there's a pretty meaningful limit on that.

The swaps do two things. First, they have a floating rate leg where we receive LIBOR and receiving LIBOR serves to offset the cost of our borrowing, and at the end of 2013, we had $10.2 billion of hedges covering $11.2 billion of repo borrowing. The $1 billion difference is the uncovered exposure to short-term borrowing costs and this, of course, is determined largely by the Fed.

The swaps also have a fixed rate leg and that is driven by the term that we choose when we put them on, usually four or five years in CYS's case. The swaps are mark-to-market and this provides an offset to the mark-to-market of our assets. This mark-to-market offset is very noisy and never perfect. The cash flows are much clearer, however, and once the Fed actually starts tightening, which is a ways out now, the floating-rate leg should provide a good offset for our borrowing costs.

While we are waiting for the Fed to get back to using only its traditional policy tools, we should all expect the volatility to continue on a mark-to-market basis. Regardless, the cash flows are much clearer and should continue to generate attractive dividends along the way.

The key to withstanding the volatility in our NAV is the excess liquidity, which continues to be very, very substantial. And we are very disciplined about maintaining that liquidity.

I would like to ask Frances to make a few comments about our Qs and Ks going forward.

Frances Spark

Good morning, everyone. Thank you, Kevin. In the third-quarter 2013 10-Q, we disclosed that the Company would discontinue use of investment company accounting effective January 1, 2014. Just want to give you a few points with regard to this change.

So as of 12/31/2013, there have been no changes to financial statements for the year ended as presented in this earnings release and in the 10-K, which will be filed in the next few days.

From Q1 2014 onward, all investments will continue to be recorded at fair value on the balance sheet. Realized and unrealized gains and losses on our securities and hedges will continue to flow through net income. We will not have OCI and our core earnings calculation will remain unchanged. We will not be required to present our scheduled investments in the financial statements, but we will continue to provide transparency and details of our portfolio going forward.

Kevin Grant

Thank you, Frances. At this point, we would like to turn it over to your questions, give the operator a few moments to give you instructions and assemble the queue.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And our first question comes from Steve DeLaney from JMP Securities. Please go ahead.

Steve DeLaney – JMP Securities

Thank you. Good morning, Kevin.

Kevin Grant

Good morning.

Steve DeLaney – JMP Securities

When I reviewed fourth quarter, I get the impression that you and the team was trying to strike a balance between playing offense and playing defense. Your leverage went up a touch. You did slightly reduce the portfolio, but you know, you also had the book value come down, so leverage went up a little bit. But then the defensive aspect would be being opportunistic and buying back the stock.

So my question is, is that – are you in an environment now, you know, where it is not just one or the other, but you are trying to thread the needle to get it just right from an operating strategy? And the pace of the buyback of about 5 million shares for quarter in 3Q and 4Q are about 3% of total shares, do you see that – assuming the stocks or the trades in this mid-80% of book – do you see that pace of the buyback continuing? Thanks.

Kevin Grant

Thanks for the questions, Steve. You know if you think back to Q4, the sentiment in the bond market was profoundly and wholly bearish and we’ve been around long enough to recognize basically, when everybody is on one side of the boat. And we were very aware of that, and that was reflected in the equity markets for, you know, not just the Agency mortgage REITs, but all sorts of dividend paying stocks.

So, we see this as an opportunity to buy back stock, but we don't panic. There's really no reason to panic and aggressively lighten up on assets when that’s already priced in. And that, I think that balance really bore fruit in January because we entered January – as you have observed at starting the month, anyway – at about seven times leverage. So I think this worked out pretty well for us.

We do think longer-term that we – you know, and I’ve said before that the curve is in this normalization process. It will probably take two or three years. We’re going to have some commentary from Chairman Yellen this morning,, which I think will support that thesis.

In that kind of environment, it makes sense to run this business at the lower end of our leverage range. So then the question is, “How do we pace the rebalancing to get there?” And I think slow and steady kind of wins the race. The cash flows are very good because the spreads are so good.

Now, on the buyback, I've said before we don't tell the market when we are in the market buying back our stock and we are not going to do that. But we’ve got plenty of room and we’ve got capacity and, you know, it’s easy to up – a buyback program if we need the room. So, we’ll leave it there.

Steve DeLaney – JMP Securities

I appreciate it and I’m sorry for the multi-part question, but you replied to all of it.

Just the last thing, you mentioned the way the bond market is – we sort of done a round trip. I mean, if we look at a 3% 15-year security, it was 103.5 spot [ph] on September 30 and I think we’re pretty much right on that level today.

And so, given that kind of recovery, would it be reasonable for investors to think that your book value, it would be back somewhat in the general neighborhood that it was at September 30 when it was a little over $10?

Kevin Grant

I appreciate that question. I’m sure everybody wants to know. If you look at the bond market, 30-year 3s, which is a very large holding for us are basically the same price that they were at September 30.

30-year 4s are higher. Is that right, Bill?

Bill Shean

They’re up about a quarter-point, Steve.

Kevin Grant

They’re up about a quarter-point.

Steve DeLaney – JMP Securities

Yes, yes.

Kevin Grant

Interest rate swap levels are roughly the same. You know I don't think I need to say anything else.

Steve DeLaney – JMP Securities

No, I think the math kind of is obvious. But thank you for the comments.

Kevin Grant

Yup.

Operator

Our next question comes from Dan Altscher from FBR. Please go ahead.

Dan Altscher – FBR

Hey. Thanks. Good morning, everyone. You know I had a question on the dividend, Kevin, I think because we spoke last quarter. I think you said maybe the Board was reviewing the dividend policy in light of core plus drop exceeding the dividend level, but maybe retaining some dividends for – from book value.

Can we maybe talk a little bit about how the Board has decided to go forward around the dividend and how it’s going to shake out as long as core and drop and taxable income is holding up pretty well, it looks like?

Kevin Grant

Yes. I can only really give you color on what information we provide to the Board and the way we think about it. I don't know what the market is going to do over the next couple of quarters, but we try to forecast the year. We actually try and go a little bit longer.

This is an environment with speed so slow that the sensitivity to our reinvestment assumption is – it's actually pretty low because there’s not as much runoff as there has been in prior years. So, we try to set a dividend where investors have some stability and perspective.

You know, obviously we – last quarter, we retained about $0.06. We love retaining. It’s the best way to grow the NAV of the business, but I think at that $0.32 it’s a good balance. That’s kind of the way we’re thinking about it right now, but who knows what is going to happen later in the year.

Dan Altscher – FBR

Okay. Then, a question actually on the G&A, as this is probably maybe an overlooked point by a lot of folks. But the absolute dollar level of the G&A was down,. The actual ratio was down pretty good, both amongst the lowest levels we have seen in probably a couple of years now. You know is there any – is that just a catch-up for the end of the year or is there a change going on in compensation or anything that we should think about that for going forward?

Frances Spark

Dan, this is Frances responding to the your question. I think you’ve hit the point really. At the end of fourth quarter, we will always review for the full year, primarily related to compensation. We set the incentive compensation based on certain expectations at the beginning of the year and then, as the year draws to a close, you know, we true up.

And so it's purely – I think we reflected exactly the same thing in our 2012 Q4, too. So I think this is what should not be surprised by this sort of slightly lower dollar number in the fourth quarter. But there's nothing, nothing has changed otherwise in the G&A composed – composition in the Company.

Dan Altscher – FBR

That's perfect. Thanks for the answers, everybody.

Operator

Our next question comes from Joel Houck from Wells Fargo. Please go ahead.

Joel Houck – Wells Fargo Securities, LLC

Thanks. Good morning, everybody.

Kevin, I’m wondering. Are you surprised at the bond market, I guess the Agency market reaction this year, given that the tapering has actually started. I mean, I think conventional, you know…

Kevin Grant

No, I’m not – Joel, I’m not surprised at all. Sorry to interrupt, but I’m not surprised at all. I mean how many times have we seen – sell the river by the fact. I mean, this is – you know. And this is why we’re so cautious about rebalancing the portfolio in reaction to the height that we all have when we watch the NBC.

Joel Houck – Wells Fargo Securities, LLC

And so, is that – you know if – for those who aren't bond market experts and trade MBS, I mean you look out this year, what is the case for a selloff if, you know, the expectation is already priced in and people kind of – unless it's the Chairperson does something substantially outside the box, wouldn't – is it – wouldn't volatility come down instead of go up?

Kevin Grant

I think this is what is getting built into the consensus now. I wouldn’t say everybody is on one side of the boat yet. But I don't know whether you have seen the early release of Chairman Yellen's commentary this morning where we had a chance to take a look at it.

You know it’s right down the middle of what you would expect, basically continue with the taper and be accommodative on short rates for a long, long, long time. So I think on the short end, what’s going to get built in is, you know, pretty stable short-end rates probably five years and in, and then the 10-year part of the Treasury market is going to reflect the economy, essentially.

So it’s awfully difficult – it’s difficult enough to predict tomorrow, but it’s awfully difficult to predict two, three, four quarters out.

Joel Houck – Wells Fargo Securities, LLC

Okay and then I guess in light of that, when you look at how you’re positioned, you have got a very high current ROE on core earnings with a, you know, higher than average hedge ratio, which would seem to be in a good place to be. Is there any – you know what circumstances would dictate kind of a move off of that either taking down hedges or repositioning the book as you look out this year?

Kevin Grant

Well, the way we’re really looking at it is we want to run the leverage at the low end of our longer-term range. Spreads are fine.

And here’s the issue. The Fed is tapering. They’re – as of a couple of months ago, they were buying basically all of the new net supply into the mortgage market. And by the summer, early fall, they will not be buying anything. And we’ve never entered an environment like this where the trillion-dollar bid goes away actually simultaneously with the pickup in supply because there’s a normal spring/summer pickup in supply with the home-buying season.

So I – just as I said in my commentary, I think we’re going into a period here where there’s going to be a better opportunity to buy mortgages. Now, that's basis risk right there. There's no interest rate hedge that’s going to cover that because that is an idiosyncratic exposure that the Agency mortgage market has.

Joel Houck – Wells Fargo Securities, LLC

Right, so I guess the message is we are not out of the woods yet. We can't signal the all clear.

Kevin Grant

We’re never out of the woods, Joel. That’s the nature of the beast.

Joel Houck – Wells Fargo Securities, LLC

Right. All right, fair enough. Thank you.

Kevin Grant

Yes.

Operator, are you there?

Operator

And our next question comes from Douglas Harter. Please go ahead.

Douglas Harter – Credit Suisse

You mentioned that you were looking to opportunistically reduce some of the book value volatility. I guess how do you think about you know the – how you balance the rate at which to reduce that volatility versus, you know, the current returns?

Kevin Grant

Yes. That is a good question. I think slow and steady kind of wins the race, as I mentioned. And we think that the lower end of our leverage range is really, really where we’d like to stay.

Now having said that, if we are at the lower end of our leverage range, and there's some, you know, whatever, some kind of flight to quality rally in treasuries, we could actually end up below our leverage range just because mark-to-markets go up. So this is why we like to do this slowly and very in a very steady fashion. So, it’s less science, more art, I'm afraid. I know that’s not a great answer, but that's the reality.

Douglas Harter – Credit Suisse

I mean I guess when you think about what's happened here in the first quarter, given that you know kind of your comments that you know as we move out later in the year, there's basis risk and obviously we’ve had that flight to quality risk so far in the first quarter. You know is that an opportunity to try to take some of the volatility off the table and try to protect some of that book value that you’ve sort of regained here?

Kevin Grant

I would say absolutely yes.

Douglas Harter – Credit Suisse

Great. Thank you, Kevin.

Operator

Our next question comes from Mike Widner from KBW. Please go ahead.

Mike Widner – Keefe, Bruyette & Woods

Hey. Good morning, guys. I guess you know you’ve answered a lot of questions. Let me follow up on the topic of the day. And so you know you’ve mentioned leverage and you know running low leverage and leverage at the bottom and sort of your range, but obviously the other component in book value sensitivity is the duration gap and, you know, by our math, you’re still running by, you know, pretty wide margin, you know, the largest duration gap in the sector. And, you know, that seems to be coming through in the book value volatility.

I mean so, number one, I guess I wonder sort of how you think about that in conjunction with leverage? And then, you know, sort of related to that, you know with rates basically having made a round trip between September 30 and today, you know, you lost 8.5% of book value. But if you‘ve gained most of it back, you sort of get a chance to, you know, approach it again. And, you know, I mean to some degree it seems like rates have staked out their range.

So, I’m just wondering how that fits in with the slow and steady philosophy? And then, you know, is there not a time when you say, “You know what? We just got a free pass and maybe we take that duration gap in more narrower.” I don't know. I guess it just – acceptance of volatility seems to be your sort of view right now and I’m wondering if I’m just hearing that right.

Kevin Grant

I don't think you’re hearing that right and I don't think that ‘s what I said. I think at – Mike, I think at the beginning of my commentary I said we are looking to reduce the NAV volatility. And we’re just going to – we’re going to get there in a measured and careful way as opposed to panicking about, you know, some short-term market event.

Mike Widner – Keefe, Bruyette & Woods

So, yes, I mean I guess, you know, so I do hear that. I guess I'm just I am wrestling with slow and steady versus – you know I mean, rates have made a big move, book value has made a big move and it just seems to me like you’ve got an opportunity here with rates all the way back to where they were before the tapering actually started.

And I guess maybe I'm torn a little bit because it seems like you’re sort of saying, you know, two things. We know that we want to reduce the rate risk profile, you know, but at the same time we think that rates are going to remain volatile, but at the same time we’re going to sort of take it slow and steady. So I guess I’m not sure quite how to interpret that. And again, I mean the reason I ask is because we’re sort of taking it on faith that, you know, book value really is back to, you know, sort of call it the $10-ish range, but, you know, a lot could have changed since, you know, January 1 or December 31.

Kevin Grant

Yes, you know, Doug just asked me this exact question in a different way.

Mike Widner – Keefe, Bruyette & Woods

No – I know he did.

Kevin Grant

So, you know, when I say slow and steady, you know we’re not blind to market opportunities and if the market is going to give us a gift, thank you very much.

Mike Widner – Keefe, Bruyette & Woods

Okay, well that's fair. I mean I suppose that's the answer to the question as best we’re going to get it. So I appreciate it.

Kevin Grant

Yeah.

Operator

Our next question comes from Jim Young from West Family. Please go ahead.

Jim Young – West Family Investments

Yeah hi, Kevin, could you share with us some of your thoughts about what’s happening on the regulatory front since Mel Watt assumed the responsibilities it seems to be somewhat quiet?

Kevin Grant

Yeah, it’s a good observation, Jim. It does seem to be pretty quiet. I would say from what I can gather, and it's – frankly, it’s really tough to know exactly what’s going on, but I think he’s going to work on things more related to Fannie and Freddie's balance sheet where they basically have free range to do whatever they want as opposed to monkeying around with outstanding Agency pass-throughs.

And keep in mind that our portfolio is pretty new. So we’re not really exposed to some of the legacy issues that he’s probably trying to address.

You know he certainly wants to accommodate homebuyers and, you know, for the country this is all a good thing and I think we’re just going to have to see what longer-term policies can actually come to fruition, given all of the other regulators involved. I think it’s a very complex regulatory regime right now. I can't see him being able to do a whole lot.

Operator

And did that answer your question?

Jim Young – West Family Investments

Yes, it does. Thank you.

Kevin Grant

Yeah. Thanks, Jim.

Operator

Our next question comes from Ben Walker [ph] from Argentine Capital [ph]. Please go ahead.

Unidentified Speaker

Hi. Good morning. My question…

Kevin Grant

Hey, Ben. How are you doing?

Unidentified Speaker

I’m well. Thank you. My question relates to the buyback. I'm noticing that your Series B preferred is trading at a larger discount to par than your common is to its book. I’m wondering if the preferreds are eligible for repurchase.

Kevin Grant

Ben, yes. They can certainly be bought back. The issue is a practical issue and it’s daily trading, average daily trading volume and all the limits that repurchase programs imposed. So it’s – because it seems these things don't trade a whole lot, it’s hard to buy back chunks of them. But it's possible.

Unidentified Speaker

Okay, sure. Thanks.

Operator

(Operator Instructions). And I’m showing no further questions at this time. I will now turn the call back over to Mr. Richard Cleary for closing remarks.

Rick Cleary

Thanks, Robert. And on behalf of Kevin, Frances, Bill and the entire CYS management team, I’d like to thank you for taking the time to participate and speak with us this morning. And thank you for your continued support and interest. Have a nice day.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: CYS Investments Inc's CEO Discusses Q4 2013 Results - Earnings Call Transcript
This Transcript
All Transcripts