13.9% Div. CYS Investments And 18.4% Div. Western Asset Mortgage Capital Are Winning Their Bets

Jun.20.14 | About: CYS Investments, (CYS)


Both CYS and WMC employed strategies in Q2 2014 that would perform well if interest rates went down.

10 year US Treasury Note yields as of June 19, 2014 were down -11 bps since March 31, 2014.

CYS pays a 13.9% dividend, and WMC pays an 18.4% dividend. How reliable are these?

What risks are CYS and WMC taking to outperform most other primarily Agency mortgage REITs?

CYS Investments Inc. (NYSE:CYS) and Western Asset Mortgage Capital Corp. (NYSE:WMC) are both primarily Agency RMBS investing mortgage REITs. In Q1 2014 CYS had a total economic return of 8.2% for that quarter alone. This was composed of $0.32 dividend per common share and a $0.44 increase in book value. WMC had a -2.69% total economic return. This was composed of a dividend of $0.67 and a book value loss of -$1.08 (or -$0.41 per common share). This was worrisome. However, it may be partly an artifact of the $2.35 per share dividend that was declared on December 19, 2013. This was paid in Q1 2014 on January 28, 2014. For Q1 2014 WMC was back to its more normal dividend of $0.67 per common share. WMC has already declared this same dividend for Q2 2014. CYS has declared its same dividend of $0.32 per common share too.

Since CYS had great results in Q1 2014, one can probably assume that it will have great results in Q2 2014 if the quarter ends with the 10 year US Treasury Note yield down the approximately the -11 bps it was as of June 19, 2014 (from March 31, 2014). In WMC's case that result might be a bit more obscure, but the company claimed to have already seen its book value rise to approximately $14.92 to $15.02 as of May 5, 2014 from the $14.19 book value per common share as of March 31, 2014. Using the midpoint of $14.97, the gain in book value in just a little over a month would have been +$0.78 per common share. The yield on the 10 year US Treasury Note is just 1 bps different from May 5, 2014 to June 19, 2014, so one might presume that the book value would be very close to the same now as it was on May 5, 2014.

Accepting the May 5, 2014 WMC provided book value data point as genuine, WMC will provide an approximate +$.78 book value gain and a $0.67 dividend for Q2 2014 for a total return of $1.45. This amounts to a 10.22% total return for Q2 2014 alone (or +40.88% annualized). Not many investors would turn their noses up at that.

In CYS' case, it cited no book value increase data for Q2 2014 in its earnings release data from Q1 2014. However, it had a book value increase of $0.44 in Q1 2014. Since the 10 year US Treasury Note yield went down less to date in Q2 than in Q1, one might guesstimate that the book value gains on the Agency RMBS portfolio would be less. I will therefore guesstimate a book value increase of $0.22 per common share. If you add the already declared $0.32 per share Q2 dividend to this, you get a total economic return of $0.54 or +5.58% just for Q2 2014 (or 22.31% annualized). This is a great return too; and the actual result could be significantly higher.

I will not get into the hedges for WMC; but WMC's claim that the book value went up approximately $0.78 per common share by May 5, 2014 likely means WMC is managing them well. In CYS' case it had $9,700,000,000 in notional amount of hedges at the end of Q1 2014. Its total portfolio fair value was $13,307,735,000 as of March 31, 2014. This means the portfolio was about 73% hedged as of March 31, 2014. This relatively light level of hedging should allow CYS to benefit from MBS book value increases due to interest rate decreases to a greater extent than companies that are more heavily hedged against interest rate rises.

In order to examine their strategies more thoroughly, it is best to have their portfolios to look at. CYS' portfolio as of March 31, 2014 is below:

Click to enlarge

The above shows that CYS had (as of March 31, 2014) 48% 15 year fixed rate Agency RMBS and only 24% 30 year fixed rate Agency RMBS. This should make CYS' portfolio much less susceptible to interest rate increases. It should also mean its repos and its hedges should be cheaper. CYS would seem to be reasonably well positioned for an upturn in interest rates. It does not have enough hedges yet; but this seems likely to have been by plan. As the situation changes, it can change its amount of hedging relatively easily. Then it will be ideally positioned. Meantime it is gaining more in book value by having a lower amount of hedges as interest rates go down. This looks like a good strategy; and it is paying off well for CYS so far this year. The net interest rate spread of 1.89% net of hedges including Drop Income for Q1 2014 will probably be a bit lower in Q2 2014; but the dip in the net interest rate spread should be small. This should not put the dividend in danger. CYS had Core Earnings plus Drop Income of $56.7 million (or $0.35 per diluted common share) in Q1 2014. Even with a slight drop, CYS should be able to cover its already declared $0.32 per diluted common share dividend.

WMC's portfolio as of March 31, 2014 is below:

Click to enlarge

WMC, by contrast, has a large amount of 30 year fixed rate Agency RMBS in its portfolio. Plus, it has some 20 year fixed rate Agency RMBS. It has no 15 year fixed rate Agency RMBS in its portfolio. This means it is more susceptible to interest rate increases. The 30 year fixed rate Agency RMBS move approximately twice as fast as the 15 year fixed rate Agency RMBS on interest rate changes. This probably accounts for WMC's relatively higher amount of hedging. WMC has a total portfolio fair value of approximately $3.3B as of March 31, 2014. Yet it has a notional amount of hedging that is much higher than the value of the portfolio. This may make some sense given the makeup of the portfolio.

However, it may prove to be expensive as interest rates are down again in Q2 2014. I do not have enough information to examine everything the company has done. However, it claimed in early May to have regained a good deal of book value. I have looked at the fixed rate Agency RMBS; and they are as of June 19, 2014 at approximately the same value that they were on May 5, 2014. Ditto the US 10 year Treasury yield. Therefore, I choose to believe that WMC will see a good book value increase in Q2 2014. If it is much less than cited by WMC as book value on May 5, 2014, it will probably be due to hedging losses.

Overall I much prefer CYS' portfolio. It is much safer; and CYS should be able to add more hedges when it needs them. In contrast, WMC will have to get rid of some of its 30 year fixed rate Agency MBS eventually. They represent too much interest rate risk for the current situation. If WMC does this in a relatively quiet time such as we see currently, it will not be too expensive. If it tries to do this in a spiking interest environment, it will likely be very expensive. Overall I like CYS's strategy much better. I concede that WMC, at least from the information it has given out, should do better in Q2 2014. However, I like to sleep at night, and CYS' portfolio is much more conducive to my being able to do that.

CYS had a book value as of March 31, 2014 of $9.68 per common share. If it gains about $0.22 per share in Q2 2014, the ballpark book value will then be $9.90 per common share. The stock price at the close on June 19, 2014 was only $9.16 per share. Hence CYS is trading at a substantial discount to book value while it is still paying a great 13.9% annual dividend. It is also likely growing its book value from $9.68 to my guesstimate of $9.90 per common share in Q2 2014. Investors have to like such a performance.

WMC had a book value of $14.19 as of March 31, 2014. However, the midpoint of its book value estimate on May 5, 2014 was $14.97 per share. Since fixed rate Agency RMBS were (on June 19, 2014) trading at almost identical levels to those of May 5, 2014, I would expect WMC to gain most or all of the book value gains claimed on May 5, 2014. At a closing price of $14.52 on June 19, 2014, it is trading at significantly under its projected book value of approximately $14.97 per common share at the end of Q2 2014.

I would worry a bit about the sustainability of its dividend, though. It had Core Earnings plus drop income of $15.2 million (or $0.56 per basic and diluted share) in Q1 2014. The slight drop in interest rates will likely have a slightly negative impact on that income in Q2 2014. Yet WMC has already declared a $0.67 per basic and diluted share dividend for Q2 2014. This may not be sustainable with the current level of Core Earnings. Investors should be worried about an interest rate cut in future quarters. The dividend for Q2 2014 has already been declared as $0.67 per common share.

Both CYS and WMC would have to be considered buys given the currently available information. However, I would be more interested in CYS because I enjoy a certain amount of safety. Apparently CAPS agrees with my assessment. It gives WMC four stars (a buy rating); and it gives CYS five stars (a strong buy rating).

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

Click to enlarge

The slow stochastic sub chart shows that CYS is neither overbought nor oversold. The main chart shows that it is in a weak uptrend. Technically and fundamentally CYS is very buyable at the moment.

The two year chart of WMC provides some technical direction for a trade.

Click to enlarge

The slow stochastic sub chart shows that WMC is neither overbought nor oversold. The main chart shows that it continues to be in a weakening downtrend technically. I think I have shown that from the information that the company provided in early May 2014, it fundamentally deserves to go up some more. However, I consider the portfolio to be a much higher risk one than I would like. Investors can make their own decisions. It is buyable at the current time both technically and fundamentally. However, I would give it a weak buy rating because it has too risky a portfolio in my opinion. Still, it pays a great 18.4% annual dividend, so investors must decide for themselves how much risk they may want to endure.

NOTE: Some of the fundamental financial information above is from Yahoo Finance.

Good Luck Trading.

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